Research in Accounting Regulation 23 (2011) 78–82
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Research in Accounting Regulation
journal homepage: www.elsevier.com/locate/racreg
Research Report
The effects of audit firm rotation on perceived auditor independence
and audit quality
Bobbie W. Daniels a,⇑, Quinton Booker b
a
b
Jackson State University, College of Business, P.O. Box 17970, Jackson, MS 39217-06700, United States
Professor and Chairman, Department of Accounting, Jackson State University, MS, United States
a r t i c l e
i n f o
Article history:
Available online 17 April 2011
Keywords:
Audit firms’ independence
Mandatory firm rotation
Audit quality
a b s t r a c t
Our study explores loan officers’ perceptions of auditors’ independence and audit quality
under three experimental audit firm rotation scenarios. We use a case experiment with
a between-subjects design to determine whether rotation of the audit firm impacts financial statement users’ perceptions of auditor’s independence and quality. Findings based on
212 useable responses indicate that loan officers do perceive an increase in independence
when the company follows an audit firm rotation policy. However, the length of auditor
tenure within rotation fails to significantly change loan officers’ perceptions of independence. Findings also indicate that neither the presence of a rotation policy nor the length
of the auditor tenure within rotation significantly influences the loan officers’ perceptions
of audit quality.
Published by Elsevier Ltd.
Introduction
Several audit failures (e.g., Enron, WorldCom, Sunbeam,
and Waste Management) have prompted regulators to
question whether external auditors are independent
(Commission on Public Trust & Private Enterprise, 2003).
Requiring audit firm rotation by limiting the number of
consecutive years that a particular audit firm can audit a
public company has been discussed as one means of
improving auditor independence (AICPA, 1978; POB,
2001; SOX, 2002; U.S. Senate, 1976). The Sarbanes-Oxley
Act (2002) requires the lead audit partner and audit review
partner (or concurring reviewer) to be rotated every five
years on all public company audits.
Audit firm rotation is not a new concept. It has been
implemented in several countries such as Israel, Brazil,
Spain and Italy (Catanach & Walker, 1999). Several bills
with provisions dealing with audit firm rotation were debated alongside the Sarbanes-Oxley Act (SOX) as a means
of enhancing auditor independence. Nothing was enacted,
⇑ Corresponding author.
E-mail address: bobbie.w.daniels@jsums.edu (B.W. Daniels).
1052-0457/$ - see front matter Published by Elsevier Ltd.
doi:10.1016/j.racreg.2011.03.008
but Congress decided further study was needed on the potential effects of mandatory rotation on registered public
accounting firms. In this study, we examine whether loan
officers perceive audit firm independence and audit quality
is affected by an audit firm rotation policy.
Background and research questions
Over the years, practitioners and academicians have debated the pros and cons of long-term auditor–client relationships. Some believe that the length of time an audit
firm maintains a relationship with the client jeopardizes
the public perceptions of auditor independence and audit
quality. DeAngelo (1981b) defines audit quality on two
dimensions: the market-assessed joint probability that
auditors will discover a breach in the client’s accounting
system; and the likelihood an observed breach will be reported. DeAngelo reasons that an auditor who has an economic interest in their client or lacks auditor independence
will be less likely to report a discovered breach, thus reducing audit quality (DeAngelo, 1981a).
The AICPA issued a report, ‘‘Statement of Position
Regarding Mandatory Rotation of Audit Firms of Publicly
B.W. Daniels, Q. Booker / Research in Accounting Regulation 23 (2011) 78–82
Held Companies’’ in 1992. The AICPA opposed mandatory
rotation citing that mandatory audit firm rotation was
not in the best interest of the public. According to this
study, the AICPA examined 400 cases of audit failures between 1979 and 1991 and found that audit failures were
about three times more likely when the auditor was performing the first or second audit of that company. The
study asserts that requiring firms to change auditors would
increase the risk of audit failures because auditors would
not have sufficient knowledge of the client’s business,
which is important to identify problems early in a business
(AICPA, 1992).
James E. Copeland, the CEO of Deloitte and Touche,
speaking before the U.S. Senate Committee on Banking,
Housing, and Urban Affairs, indicated that rotation would
increase start-up costs for auditors. He points out that
requiring rotation of auditors would mean that institutional
knowledge will be lost and on each new engagement the
auditors will be climbing a steep learning curve (Copeland,
2002). John H. Biggs, Chairman and CEO of TIAA-CREF, which
practices mandatory rotation, testified before the U.S.
Senate Committee on Banking, Housing and Urban Affairs
about the positive aspects of rotation for companies.
According to Biggs, if Enron had been required to rotate its
auditors every five to seven years, they would not have continued to issue misleading financial information (Biggs,
2002). Furthermore, Biggs noted that rotation would also
reduce low-balling of other non-audit services and eliminates the revolving door phenomenon (Biggs, 2002).
SOX required the General Accounting Office to study the
potential effects of mandatory audit firm rotation on public
companies. GAO surveyed and interviewed accounting
firms, chief fiscal officers and audit committee chairs of
the Fortune 1000 publicly-traded companies. The majority
of the largest public accounting firms and the Fortune 1000
companies interviewed agreed that the costs associated
with audit firm rotation are likely to exceed the benefits.
Many of the participants surveyed indicated that SOX’s
requirements regarding audit partner rotation (using different individuals within an audit firm) and auditor independence would achieve the same benefits as audit firm
rotation (using different audit firms). GAO also interviewed
other interested parties (consumer groups, institutional
investors, accountants, etc.). Views of these groups were
consistent with the overall views of other survey respondents interviewed by GAO. GAO acknowledges that it will
take several years of experience with the implementation
of SOX before the effectiveness of the act can be fully assessed (GAO, 2003).
Research questions
This study addresses two research questions. First, we
address whether periodic rotation of the external audit
firms would affect bank loan officers’ perceptions of external auditor independence. While this topic has been studied, the answer remains unclear. Numerous researchers
have addressed this topic by using accruals-based measurements, (Myers, Myers, & Omer, 2003), earning management tools (Ghosh & Moon, 2005), financial reporting
79
failures (Carcello & Nagy, 2004) and Judges’ perceptions
(Jennings, Pany, & Reckers, 2006). Some researchers have
argued that audit firm rotation appears to increase the perception of auditor independence (Arel, Brody, & Pany,
2005; Brody & Moscove, 1998; Jennings et al., 2006; Kemp,
Reckers, & Arrington, 1983; Ramsey, 2001; Winters, 1978;
Wolf, Tackett, & Claypool, 1999). However, because there
are no regulatory requirement for audit firm rotation and
99% of the fortune 1000 public companies do not have a
policy that requires audit firm rotation (GOA, 2003), archival data is not available for research in this area. Our experimental design circumvents the endogeneity problem. We
do so by using an experimental design that manipulates (1)
an audit firm rotation policy versus no rotation policy and
(2) the effects of tenure within a rotation policy.
The profession maintains that auditors must be independent ‘‘in fact’’ and ‘‘in appearance.’’ While both must
be studied to understand independence, to research independence ‘‘in fact’’ requires information that is not publicly
available. Prior researchers (Hill & Booker, 2007; Imhoff,
1978; Knapp, 1985; Lowe, Geiger, & Pany, 1999) have used
perception to measure independence in appearance.
Perception of independence is important as financial
statement users rely on auditors to provide an unbiased
opinion and to provide a level of confidence about the reliability of financial statements.
The Commission on Public Trust & Private Enterprise’s
(2003) report recommends that audit committees consider
rotation of auditors as a means of enhancing auditor independence and building investor confidence. The Commission believes that the cost of auditor rotation is less than
the costs of crises in investor confidence. Accordingly, we
develop the following research questions:
RQ1a: Does the rotation of the external audit firm affect
the bank loan officers’ perceptions of audit firms’
independence?
RQ1b: What impact does the length of the auditor tenure within rotation have on the bank loan officers’ perceptions of audit firms’ independence?
RQ2a: Does the rotation of the external audit firm affect
the bank loan officers’ perceptions of audit quality?
RQ2b: What impact does the length of the auditor tenure within rotation have on the bank loan officers’ perceptions of audit quality?
Research methods
We use a between-subjects experimental design for this
research with three versions of a case. The versions of the
case are different only as it relates to the rotation policy
and length of tenure within the rotation policy. This section provides details on participants, data gathering and
variables, and statistical methods.
Participants
Our population consists of one thousand bank loan officers who were randomly selected from a database of more
than 16,000 U.S. bank loan officers. We randomly assigned
the loan officers to one of three versions of the research
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B.W. Daniels, Q. Booker / Research in Accounting Regulation 23 (2011) 78–82
sures the perceived likelihood that the auditors would report the error. These variables are similar to those used
in similar studies (Hill & Booker, 2007; Lowe & Pany,
1995; Lowe et al., 1999).
instrument. We received 207 useable responses, representing a response rate of 24.07%. The 207 responses are evenly
distributes among the three experimental groups. Five
respondents who failed the manipulation checks were removed from our analyses. The participants are comprised
primarily of executives (77.9% – president or vice presidents). In addition, participants are mostly college educated with 77% having baccalaureate degrees or higher.
Finally, participants have significant experience, with 87%
having over 10 years of banking experience and 67% having
10 years or more of bank lending experience.
Statistical methods
We use univariate Analysis of Variance (ANOVA) to
compare the means of each of the three groups for our
independence question, the Scheffe’s post hoc test to test
for differences among all possible combinations of groups,
and chi-square analysis to compare proportions of ‘‘Yes’’
and ‘‘No’’ responses to the question concerning whether
the audit firm should be allowed to do the audit. This
dichotomous response question is designed to have the
participant make a firm decision based on the perceivedlevel of independence recorded for the first question.
Data gathering and variables
Each of the three experimental scenarios used involves
a company’s audit firm rotation policy. The focus of the
case is a material error in the pre-audit financial statements which management does not want to correct because of the impact it would have on the firm’s current
year financial statements. The audit firm rotation policy
and length of tenure were manipulated. The rotation
policy was either: the absence of an audit firm rotation
policy (AFR0 hereafter); a seven-year rotation policy with
one-year auditor tenure (AFR1 hereafter); or a seven-year
rotation policy with six-year auditor tenure (AFR6 hereafter). Loan officers were instructed to read the case materials, render their perceptions of the independence of the
CPA performing the financial statement audit, and render
a decision on the perception of audit quality.
The independent variable (audit firm rotation) is the
length of time the CPA firm has been performing the audit
(22 years, seven years, or one year). The first dependent
variable (independence) measures the confidence that
the CPA firm performing the audit is independent. The second dependent variable (discovery), measures participants’
confidence that the CPA firm will discover the error. Both
variables (independence and discovery) are measured on
an eleven-point scale from ‘‘no confidence’’ to ‘‘extreme
confidence.’’ The third dependent variable (report), mea-
Results
The first research question asks whether the presence of
an audit firm rotation policy impacts bank loan officers’
perceptions of auditor’s independence and quality. The results are summarized in Table 1. ANOVA results for question Q1a indicate that the perceptions of auditor
independence are significantly different among the three
groups (F = 4.476, p < .05). These results suggest that
respondents’ perceptions are influenced by the presence
of an audit rotation policy.
To compare the three groups, we use Scheffe Tests of
Multiple Comparisons. The rotation groups are perceived
as having a significantly higher level of auditor independence than the no rotation group (p < .05). The mean response of AFR0 is 5.65 and mean response for AFR1 and
AFR6 are 6.70 and 6.77, respectively. Thus, a significant difference in perceptions exists between a firm that has a
rotation policy and one that does not. These results suggest
that loan officers are more confident that the external CPA
firm is independent when a rotation policy is present. The
Table 1
Bank loan officers’ perceptions of auditor independence and quality.
Group
Independencea
Discoveryb
Report (%)
No Audit Firm Rotation (AFR0)
5.65
(2.38)
6.70
(2.33)
6.77
(2.39)
5.87
(2.23)
6.30
(2.43)
6.12
(2.43)
73.3
p < .05
p = .584
p = .212
p < .05
p < .05
p = .986
p = .585
p = .829
p = .897
p = .297
p = .519
p = .684
Audit Firm Rotation with one year tenure (AFR1)
Audit Firm Rotation with six year tenure (AFR6)
Significance of overall differences across groups
Pairwise Differencesc
AFRO versus AFR1
AFRO versus AFR6
AFR1 versus AFR6
85.7
80.5
a
Auditor Independence is measured on an 11-point scale anchored at 0 (no confidence) to 10 (extreme confidence). Significance of the overall difference
in means are assessed using ANOVA: F-statistic (2 and 204 degree of freedom) = 4.476.
b
Discovery and report are use as proxy for audit quality based upon DeAngelo’s two-dimensional definition of quality. Discovery is measured on an 11point scaled anchored at 0 (no confidence) to 10 (extreme confidence). Significance of the overall difference in means are assessed using ANOVA: F-statistic
(2 and 204 degrees of freedom) = .540. Report represents the percentage of Loan officers who answered yes to the reporting variable. Significance of overall
differences in the means is assessed using a v2 test of proportions; X2 = 3.107.
c
Scheffe Test of Multiple Comparisons is used for pairwise comparisons.
B.W. Daniels, Q. Booker / Research in Accounting Regulation 23 (2011) 78–82
means for AFR1 and AFR6 do not differ significantly. Thus,
findings fail to indicate a significant difference in perception of auditor independence when the firm is performing
the audit in the first year of a rotation policy versus in sixth
year of a rotation policy.
The second research question asks whether the presence of an audit firm rotation policy impacts bank loan
officers’ perceptions of audit quality (Q2a) and the impact,
if any, of the length of the auditor tenure within rotation
(Q2b). Results reveal no significant differences in loan officers’ confidence that the auditors would discover the
inventory error in the financial statements. The statistical
findings suggest that the presence of a rotation policy or
the length of the auditor-tenure within rotation does not
influence the respondents’ perception of the auditors discovering errors in the financial statement. Finally, the rotation policy did not significantly affect the beliefs of the loan
officers regarding whether the audit firm would report the
error in its opinion.
In summary, the perceptions of loan officers relative to
discovering errors in the financial statement are only
slightly modified when a company employs the same audit
firm as compared to rotating their audit firms. Furthermore, the length of the auditor tenure within a rotation
policy fails to significantly change the loan officers’ perceptions of audit quality.
Conclusions, limitation, and future research
Loan officers’ perceive that the presence of an audit firm
rotation policy enhances the perceptions of auditor independence, but does not enhance perceptions of audit quality. Further, increasing the length of the auditor tenure
within rotation from a one-year period to a six-year period
fails to significantly impact respondents’ perceptions of
CPA firm independence. The findings in this study may
be of interest to board of directors and audit committees
in establishing policies regarding rotating the external
auditors. Since rotating appears to enhance perceptions
of auditor independence, publicly traded companies that
have used the same auditor for years should consider
whether they should voluntarily adopt a rotation policy.
A key issue that must be addressed in deciding whether
to rotate auditors is whether the benefits (i.e., greater perception of independence) exceed the costs (e.g., possibly
higher fees, spill-over knowledge.
The results of this study are limited to the perceptions
of bank loan officers. Therefore, the results may not be generalized to other groups. Secondly, our sample selection
was limited to only one group of financial statement users.
Perceptions of other users groups must also be considered.
A third limitation is the realism of the scenario. In actual
situations, loan officers would have had access to more
information. Therefore, their decisions might have been
different if additional information had been available. A
fourth possible limitation stems from the possibility of
nonresponse bias. We did conduct tests for non-response
bias that did not indicate a problem. Finally, this study applies to audit firm rotation in an environment whereas the
board of directors has a policy of systematically changing
auditors every seven years. It is possible that the results
81
would not extend to a regulatory regime of mandatory
audit rotation.
Future research could explore whether user groups
views are differ from loan officers (e.g. financial analysts,
investors, fund managers, audit committee members,
etc.). The AICPA (2006) published a document containing
safeguards to mitigate or eliminate threats to independence. Research is needed regarding the effectiveness of
different safeguards in different situations. Other scenarios
involving various lengths of time for the rotation period
could also be explored, such as a 3-year, 5-year or 10-year
rotation period.
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