A new academic study casts doubt on whether efforts to require companies to rotate their audit firms lead to greater professional skepticism on the part of auditors.

A paper published in the new issue of an American Accounting Association’s journal The Accounting Review calls the entire practice into question. Based on a complex experiment involving students who did not even know they were playing the role of auditors, the study concludes that mandatory audit firm rotation could inhibit professional skepticism rather than encourage skepticism.

“Professional skepticism requirements are intended to elevate auditors' skepticism of their clients and, ultimately, audit quality,” said the study, by Kendall O. Bowlin of the University of Mississippi, Jessen L. Hobson of the University of Illinois at Urbana-Champaign, and M. David Piercey of the University of Massachusetts Amherst. “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 study argues that auditors who are subject every few years to mandatory rotation feel less confident about their ability to audit a new client.

"Rotating 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," the authors wrote. 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."

Clients may be more likely to take advantage of the relative inexperience of the new auditors in assessing their financial statements. "Auditors prefer low-effort and low-cost audits, but only if managers are unlikely to choose aggressive financial reporting," said the study. What the study suggests, however, is that rotation increases the incidence of precisely this pairing and may thereby boost "the likelihood of audit failures with negative legal, regulatory, and business implications."

The decline in accounting vigilance that makes this possible, the authors add, tends not to be conscious and purposeful but rather a "subtle psychological effect about which [audit] decision-makers rarely have accurate insight. Standard-setters, auditors, investors, and academics should consider this effect when evaluating the relative costs and benefits of a rotation mandate. Given 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."

Companies in the European Union will be required, starting next June, to change accounting firms (or at least put their audit out for bids in a process known as retendering) after 10 years. While the U.S. does not mandate rotation of firms, it does insist that accounting companies rotate the engagement partner primarily responsible for a client's audits after five years. The Public Company Accounting Oversight Board had issued a concept release in 2011 that proposed requiring mandatory audit firm rotation, but the proposal was essentially shelved after members of the House of Representatives voted overwhelmingly in 2013 for a bill that would prohibit such a rule (see House Approves Bill Banning Mandatory Audit Firm Rotation).

Presumably the skepticism-inhibiting effect that the new Accounting Review study uncovers would come into play most significantly in the first year or two following mandated rotations.

The study's findings are based on a behavioral experiment in gamesmanship involving 226 U.S. college students who competed for payoffs through decisions that parallel those made by auditors and managers in the course of corporate audits. Why use college students with no accounting or management experience to probe the behavior of these professionals?

"Archival studies typically probe the relationship between auditor tenure and the quality of financial reports but fail to sort out cause and effect— whether auditors' long tenure, for example, reflects quality reporting or whether quality reporting results from long tenure,” explained Bowlin, one of the researchers who authored the study. “Here we employed techniques of experimental economics to pare decision-making down to the bare bones of gamesmanship, so that cause and effect were quite clear. The participants were simply told that this was an experiment about decision-making, and were not even aware that this had anything to do with auditing; at the same time, however, the decisions they made have close parallels in the maneuvering that goes on every day between corporate managers and their external auditors, thereby providing us with insight into the basic psychological processes at work in those interactions."

In the 90-minute experiment, which was carried out anonymously via computer, participants were randomly paired, with one member of each duo identified as belonging to the green group (a proxy for corporate managers) and the other as belonging to the blue group (proxy for external auditors). Half the participants were in the rotating condition, meaning that they changed partners after each of the 20 rounds of the experiment, while the other half, in the non-rotating condition, communicated with the same partner through all 20 rounds (without, however, knowing who that individual was).

Each round began with greens’ choosing between right (proxy for aggressive reporting) and left (proxy for conservative reporting), each featuring different opportunities to earn points (with number of points and percentage chances of earning them spelled out in charts available to each player). Green then conveys to blue whether right or left was chosen but is allowed to lie about it. Blue then responds by choosing between up (proxy for low-effort audit) or down (high effort). At the end of the round the players learn how many points both earned, then proceed to the next round until they play the full 20 and collect a payoff in real dollars based on total points earned.

The professors 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 percent vs. 64 percent).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 percent vs.53 percent).

The rotating auditors, who lacked the familiarity with clients that comes with tenure, "will likely encounter difficulty finding psychological support for the probability of their current assessment frame, making them less likely to choose the audit action associated with their mental frame.”

The professors advised, "Newly rotated auditors should be extra vigilant in fraud planning and procedures, perhaps focusing on best practices of high-quality fraud brainstorming and on falsifying (rather than verifying) management assertions during the audit."

The study, "The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality," appears in the July/August issue of The Accounting Review, published every other month by the American Accounting Association.

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