Academic journal article Management Accounting Quarterly

Insights on Auditor Rotatation

Academic journal article Management Accounting Quarterly

Insights on Auditor Rotatation

Article excerpt

Agency theory suggests that managers' primary objective is to maximize their own utility in the most expedient manner. (1) Given the opportunity, they may make decisions that impact firm value negatively, such as maximizing short-term results to increase bonuses. Owners' primary objective is to increase firm value, so they must monitor the behavior of managers in a cost-efficient manner. One mechanism for doing this is requiring periodic reports of a company's financial position, results of operations, and cash flows--in other words, financial reporting.

To help increase the likelihood that financial reports reflect a company's operations accurately, owners elect board members to, among other things, hire and oversee managers as well as engage and oversee independent auditors. Accordingly, the competence of financial management, the sufficiency of board member oversight, and the competence and independence of auditors are all important determinants of financial reporting quality.

In this article, we focus on one of those determinants: auditor independence. In the sections that follow, we describe the nature of auditor independence, provide a brief history of regulation intended to enhance auditor independence, and present the results of a survey of audit partners reporting their perceptions of the value of mandatory auditor rotation as a means of enhancing auditor independence and improving financial reporting quality. The final sections present conclusions and implications for practicing management accountants and academics.

The Nature of Auditor Independence

AU Section 220--Independence requires that auditors maintain an unbiased mental attitude when engaged in the performance of an audit. (2) That is, it is both improper to presume a given set of financial statements is both relevant and reliable and improper to presume it is not. Auditors must be objective and make impartial judgments. In addition, according to AU Section 230--Due Professional Care in the Performance of Work, auditors should maintain an attitude of professional skepticism, requiring evidence to support their ultimate conclusion as to the fair presentation of the financial statements.

This unbiased mental attitude is commonly described as "independence in fact." Monitoring "independence in fact" is difficult because it is not readily observable. That is why established rules and regulations are aimed at reducing the possibility that an auditor will succumb to bias, for example, the rules prohibiting an auditor from providing audit services to a company in which he or she has a financial interest.

Aside from independence in fact, there is also the concept of "independence in appearance." Even when an auditor approaches the audit with the appropriate mind-set and meets all the regulatory requirements of auditor independence, independence may still be impaired if a reasonable investor, with all relevant facts and circumstances, concludes that the auditor is not objective based on the auditor's activities or relationships with the client.

Regulating Auditor Independence

Audit firms recognize the benefits associated with independence in terms of the perceived value of their audits to owners and the investing public as well as their risk of financial or reputational loss should an audit fail (that is, the audit does not uncover one or more material misstatements) and the auditors assigned to the engagement are found to be lacking independence. Accordingly, audit firms establish policies and procedures to reduce the likelihood that their partners and employees will succumb to bias. (3) Such policies and procedures may include:

* Independence checks prior to engagement acceptance,

* Annual employee independence certifications,

* Verification of the independence of engagement team members,

* Multiple layers of engagement documentation reviews,

* Assignment of independent engagement quality review partners, and

* Periodic rotation of engagement team members. …

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