Are there good reasons for auditor rotation? Auditor rotation remains a concern of regulators and governance activists, and Financial Executives Research Foundation (FERF) asks whether it's good corporate governance or a question of costs versus benefits.

The controversial issue of mandatory auditor rotation--which again caught fire in the immediate aftermath of the Enron Corp. collapse and the subsequent demise of its auditor, Arthur Andersen--isn't going away, despite generally firm opposition from corporate America, auditors themselves and a government study suggesting that its cost benefits may be elusive.

[ILLUSTRATION OMITTED]

Shareholder activists and pension funds seem to be the forces still fanning the embers for reform. CalPERS, the California Public Employees Retirement System, for one, says it is continuing to assess the rotation issue as part of its more general stance of stressing auditor independence.

In February 2002, for instance, when the Enron collapse was still fresh, CalPERS publicly asked the Securities and Exchange Commission (SEC) to adopt a package of financial market reforms, and listed a series of proactive efforts of its own. One would be to publicly oppose shareholder approval of any auditor that has been retained by a company for more than five years.

At the time, questions were raging about whether Andersen, Enron's independent public auditor, was indeed "independent" of its client, and CalPERS thought that auditor rotation would prevent that sort of problem in the future. Ensuring auditor independence has been a long-standing objective of good corporate governance, and some have questioned whether public auditors can truly be independent from the public companies that pay for their own audits.

In the years since, CalPERS hasn't actively challenged companies about auditor rotation, but it "is still an issue for CalPERS today," says Brad Pacheco, a spokesman for CalPERS. "The auditor independence issue is still important to our board. While we do support auditor rotation, and continue to support it, we did not withhold our vote on this issue last proxy season. We only withheld our vote when the auditor was performing non-audit services."

CalPERS' February 2002 press release on the subject was the focus of a Feb. 21, 2002, article in The Wall Street Journal. This article provided the germ of an idea for an accounting research project by Dr. James N. Myers and Dr. Linda A. Myers, assistant professors of accountancy at the University of Illinois at Urbana-Champaign, and Dr. Thomas C. Omer, associate professor of accounting at the University of Illinois at Chicago (see sidebar).

The three professors designed a research project to determine if there was any relationship between auditor tenure and auditor independence. The results are described in their academic paper, "Exploring the Term of the Auditor-Client Relationship and the Quality of Earnings: A Case for Mandatory Auditor Rotation?"

"Because the push for mandatory auditor rotation stems from the belief that extended auditor tenure impairs auditor independence, we decided that the relation between auditor tenure and earnings quality is central to the debate," explains Myers. In the study, he says, "we assert that earnings quality can be used to draw inferences about audit quality, and when audit quality is high, auditors constrain the extreme, sometimes self-serving, choices made by management in presenting the financial position of the firm. To measure earnings quality, we used accounting accruals, such as asset write-downs and restructuring charges, as proxies."

Additionally, Meyers says the results show that higher earnings quality is associated with longer auditor tenure. "We interpret our results as suggesting that longer auditor tenure, on average, results in auditors placing greater constraints on extreme management decisions in financial reporting," he says.

GAO Studies Auditor Rotation

Mandatory auditor rotation has also been the subject of a recent government study. Section 207 of The Sarbanes-Oxley Act of 2002 (enacted on July 30, 2002) asked the Comptroller General of the U.S. Government Accountability Office, or GAO (previously known as the General Accounting Office) to conduct a study on the potential effects of mandatory auditor rotation.

Between November 2002 and November 2003, the GAO surveyed 97 large public accounting firms, with at least 10 public clients registered with the SEC, 330 of the Fortune 1000 public companies, 450 other domestic companies and mutual funds, and 391 foreign companies registered with the SEC. The results were published as Required Study on the Potential Effects of Mandatory Audit Firm Rotation (GAO-04-216) in November 2003.

Through its surveys, the GAO found that almost all of the large public accounting firms, the Fortune 1000 companies and the companies' audit committee chairs believed that the costs of mandatory audit firm rotation were likely to exceed the benefits.

In its research of other related studies, the GAO had read that the primary arguments for mandatory audit firm rotation related to auditor independence, audit quality and audit cost. So the GAO included questions about these issues in its survey of public accounting firms and public companies.

Regarding auditor independence and audit quality issues, the GAO found the following:

* The average length of the auditor of record's tenure was about 22 years for Fortune 1000 public companies.

* About 79 percent of public accounting firms and public companies believe that changing audit firms increases the risk of an audit failure in the early years of the audit, as the new auditor labors to acquire an understanding of its new client's business.

* Most public accounting firms and public companies believe that mandatory audit firm rotation would not have much effect on the pressures faced by the audit engagement partner in dealing with material financial reporting issues.

On audit costs, the GAO survey found that:

* Nearly all large public accounting firms estimated that initial year audit costs under mandatory audit firm rotation would increase by more than 20 percent over subsequent-year costs to acquire the necessary understanding of the new client and its business.

[ILLUSTRATION OMITTED]

* Most Fortune 1000 public companies estimated that under mandatory audit firm rotation, they would incur auditor selection costs totaling at least 17 percent of initial year audit fees.

The GAO concluded that "mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality, considering the additional financial costs and the loss of institutional knowledge of a public company's previous auditor of record." The GAO then recommended that both the SEC and the Public Company Accounting Oversight Board (PCAOB) continue to monitor the effectiveness of existing requirements for enhancing auditor independence and audit quality.

Should mandatory auditor rotation be a question of costs versus benefits? Not according to Dr. Robert A. Howell, distinguished visiting professor at the Tuck School of Business at Dartmouth College. "The Enron collapse cost investors $70 billion and WorldCom cost another $120 billion," Howell says. "Spreading the additional audit costs for auditor rotation over 1,000 corporations is a small price to pay to avoid another $100 billion blow-up," he adds.

A more compelling argument against mandatory auditor rotation would be "choice," argues Howell. "Assuming that each of the Fortune 500 uses one of the Big Four accounting firms for audit and one for MIS consulting services, there would only be two firms left for rotation. That may not present much of a choice."

So, the SEC and PCAOB will each continue to monitor the effectiveness of existing requirements for enhancing auditor independence and audit quality. If history is any guide, there will likely be other major frauds or audit failures similar to Enron. At that time, it's likely that, once again, there will be calls for mandatory auditor rotation.

RELATED ARTICLE: Objective Evidence for a Subjective Debate

"We read the February 2002 Wall Street Journal article and asked ourselves, 'Is there any empirical evidence that lengthy auditor tenure compromises auditor independence?'" Dr. James Myers recounts. "Or does extended auditor tenure just give the appearance of a compromise of independence?"

Dr. Myers and his colleague, Dr. Linda A. Myers, both assistant professors at the University of Illinois at Urbana-Champaign, working with Dr. Thomas C. Omer, associate professor of accounting at the University of Illinois at Chicago, designed a research project to determine if there was any relationship between auditor tenure and auditor independence.

[ILLUSTRATION OMITTED]

The results of this research project are described in their academic paper, "Exploring the Term of the Auditor-Client Relationship and the Quality of Earnings: A Case for Mandatory Auditor Rotation?" The paper was submitted in June 2002 to The Accounting Review, the prestigious academic quarterly journal of the American Accounting Association (AAA), and was published in July 2003.

This resulting paper was one of five papers from The Accounting Review that was reviewed by a panel of judges assembled by Financial Executives Research Foundation (FERF). The paper was awarded the second annual Academic Paper of the Year, an award jointly sponsored by FERF, Baruch College and the AAA, because of its relevance to current issues in financial reporting, as well as its practical application. Myers and his co-authors will be presented with their award at Baruch College on Nov. 5.

Dr. Raj Aggarwal, Firestone Chair in Finance at Kent State University and one of the judges on the panel, commented on the paper: "We hear so many comments on auditor rotation that come from personal opinion and judgment, but these comments are not based on research. This is an important paper, because it provides empirical evidence for the debate on a very timely subject. While accruals are only one measure of earnings quality, they were related to the question of auditor rotation in a disciplined manner. There are other measures of earnings quality which may or may not be related to auditor rotation, so there is certainly room for more research."

Bob Laux, director of technical accounting and reporting for Microsoft Corp. and also a judge, commented: "As a member of both FEI and the AAA, I applaud FERF and Baruch College for their efforts to bridge the gap between academia and practice with this award. Useful research is important to both practice and standards setting. We will always need good research, and this award should encourage more academic research with direct practical applications."

Information on the Baruch/FERF conference can be found at FEI's Web site at www.fei.org/rf/ferf_conf_9_5_2004.cfm.

William M. Sinnett ([e-mail]) is Manager of Research for Financial Executives Research Foundation (FERF), and can provide more information on the Baruch/FERF Accounting Research Conference referenced in the sidebar.