Efforts in the U.S. and Europe to encourage public companies to change auditors have largely failed, according to a new academic study.
The study examined how audit regulators in the U.S. and Europe have responded to calls for mandatory auditor rotation. The European Union began requiring companies in 2014 to invite bids from other audit firms after 10 years, also known as retendering. In the U.S., the Sarbanes-Oxley Act of 2002 mandates rotation after five years of the principal engagement partner who oversees audits of a corporate client, but doesn’t demand rotation of the partner’s audit firm itself. The Public Company Accounting Oversight Board had considered requiring mandatory audit firm rotation in a 2011 concept release, but backed away from the proposal in 2014 after strong opposition from audit firms and lawmakers in Congress.
However, the new study finds that both of the limited approaches in the U.S. and Europe haven’t succeeded in avoiding overly cozy auditor tenures. It appears in the March issue of The Accounting Review, published by the American Accounting Association.
The study, by Zvi Singer of HEC Montreal and Jing Zhang of the University of Alabama in Huntsville, found that only changing audit partners, as mandated by SOX, wasn’t enough of a substitute for audit firm rotation. “Overall, the results indicate that SOX did not eliminate the negative effect of long auditor tenure on audit quality,” the professors wrote.
As for the E.U.’s requirement that companies seek offers from other accounting firms after having the same audit firm for 10 years, known as retendering, the study found that 10 years was around the time when the negative effects of long auditor tenure recede. “Beyond 10 years of auditor tenure, the association between auditor tenure and misstatement duration is insignificant,” the researchers wrote. “The benefits of a fresh look exist only in the first 10 years of the auditor-client relationship.”
The researchers dispute some of the earlier studies on the subject. “The common conclusion of prior studies is that short auditor tenure leads to low financial-reporting quality because the new auditor lacks the client-specific knowledge accumulated over time,” they wrote. “However, an alternative interpretation is that low financial-reporting quality leads to short auditor tenure…because the auditor and the client are more likely to run into disagreements when [the firm’s own] financial-reporting quality is low.”
The study focuses on serious accounting errors that occur and are corrected during the tenure of the same auditor (meaning that tenure precedes the problem not vice versa). The researchers drew on data on 3,465 corporate misstatements by U.S. companies during a 14-year period, to see how length of tenure affects auditors’ speed in coping with misstatements. In approximately 35 percent of the cases, misreporting occurred in only a quarterly statement but not in the next annual financial report, suggesting better auditor vigilance and high audit quality. In the other instances, misstatements happened in one, two or more annual reports that auditors signed off on, with a longer duration signifying less auditor vigilance and lower audit quality.
The study analyzed the relationship between auditor tenure (the number of years from hiring date to misreporting) and misstatement duration (how many misstated annual reports the auditor signed before the client issued a restatement). It found a positive association between them. Auditors with shorter tenures were faster at discovering financial misreporting. When the auditor tenure was three years or less, the average misstatement duration was a little less than a year. On the other hand, when it was 11 or more years, average misstatement duration was about a year and a half, or more than 50 percent more.
