Does auditor rotation impair professional skepticism?

by Cydney Posner

CFO.com is reporting on a study published in a leading accounting journal The Accounting Review (payment required) that reaches the counter-intuitive conclusion that auditor rotation  actually impairs professional skepticism.  Skepticism is “a perspective universally viewed as essential to effective auditing. The primary reason traditionally advanced to require rotation is that it encourages skepticism.”

The study turns that assumption on its head: “’Professional skepticism requirements are intended to elevate auditors’ skepticism of their clients and, ultimately, audit quality,’ the paper says. ‘This benefit disappears and even reverses when auditors rotate. That is, rotation and a skeptical mindset interact to the detriment of audit effort and financial reporting quality.’” The authors suggest that rotation appears to increase the incidence of aggressive financial reporting together with “low-cost, low-effort” audits, boosting the likelihood of audit failures, most significantly during the first two years following rotation. Not that these factors are intentional, the authors contend, but rather reflect a “subtle psychological effect about which [audit] decision-makers rarely have accurate insight.”

Interestingly, there were no actual accountants used in the study.  Instead, employing techniques of experimental economics, the study used college students who competed for points by maneuvering and making decisions that parallel those made by auditors and corporate managers in the course of corporate audits. The intent was to provide “insight into the basic psychological processes at work in those interactions.” In the study, the professors relied on “support theory,” which examines “framing” of issues in the context of decision-making. Half the participants, representing “auditors,” were asked to gauge the dishonesty of the “corporate manager,” while the other half were asked to assess the manager’s honesty. (The study viewed the dishonesty framework as comparable to the exercise of professional skepticism, in light of recent admonitions by standard-setters to auditors to focus on evaluating the potential dishonesty of management representations, instead of verifying their honesty.) According to the article, the authors

“found that when the proxy accountants didn’t have to rotate, the ones with the more skeptical frame of mind — that is, in the dishonesty assessment frame — were considerably less likely than those in the honesty frame to choose low-effort audits (54% vs. 64%). But when the accountants had to rotate, those in the dishonesty frame were substantially more likely than their less-skeptical counterparts to choose low effort (64% vs. 53%). In addition, without rotation the combination of aggressive manager reporting with low-effort audits occurred significantly less frequently when accountants were in the dishonesty frame than when they were in the honesty frame (25% vs. 33%). But with rotation that outcome was reversed, as aggressive reporting/low-effort auditing occurred 38% of the time with accountants in the dishonesty frame, compared with only 23% of the time for those in the honesty frame.”

The study authors speculate that “’[r]otating auditors, aware that they will not be in a long-term relationship, will … likely perceive themselves to be less competent in evaluating the honesty or dishonesty of the [corporate] manager relative to auditors who do not rotate.’ As a result, ‘rotating auditors would find it difficult to garner psychological support for the probability of manager dishonesty, leading them to be less likely to choose high levels of audit effort than non-rotating auditors.’”  The study authors caution that in light of the “’significant costs associated with mandatory rotation, focusing auditors on a skeptical assessment frame without requiring mandatory rotation may be a less costly way for standard-setters to improve audit quality.” further, the authors advise that new auditors “should be extra vigilant in fraud planning and procedures.”

Companies in the EU will have to begin mandatory auditor rotation next year.  In the U.S., only audit partner rotation is mandatory. However, mandatory auditor rotation has been on everyone’s shopping list of favorite corporate governance reforms for decades: former SEC Chair Richard Breeden imposed mandatory 10-year auditor rotation on WorldCom, when he was the court-appointed monitor for WorldCom following the scandals there, and SOX required the GAO to study the possible effects of mandatory audit firm rotation and report to Congress on its findings. In 2011, the PCAOB floated a mandatory auditor rotation concept release. (See this news brief.) At that time, PCAOB Chair, Jim Doty appeared to be a strong advocate of auditor rotation, arguing that any serious discussion of independence, skepticism and objectivity “must take into account the fundamental conflict of the audit client paying the auditor. That leads to consideration of firm rotation as a counterweight to that conflict…”  Barely a few months after the concept release was issued (and probably after having his ear bent by more than a few CEOs and directors), Mr. Doty walked back his strong position, acknowledging that mandatory auditor rotation would present “significant operational challenges.” (See this news brief .)  Finally, in 2014, the PCAOB indicated that it was not pursuing a mandatory auditor rotation project, although the idea remains on its “activity list.” (See this news brief.)

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