Auditors have many stringent standards that must be followed in order to maintain their independence from the companies they audit. One of the most important is the mandatory rotation of the lead auditor every five years. Last year, two major pension funds opposed the ratification of Wells Fargo's external auditor and asked the bank to consider changing auditing firms, but the 85-year relationship between the two continues despite the objections of the two major shareholders and two US Senators. So, how effective are these mandates in encouraging high-quality audits that investors can trust? According to an academic article published in The Accounting Review, a peer-reviewed journal of the American Accounting Association, both fall short on critical issues.
The study, conducted by Zvi Singer of HEC Montreal and Jing Zhang of the University of Alabama at Huntsville, casts doubt that the turnover of auditing partners, as required by SOX, is a sufficient substitute for turnover among auditing firms. The EU also has similar regulations in place. To avoid confusion between cause and effect, the investigation focused exclusively on serious accounting errors that occurred and were corrected during the term of office of the same auditor (meaning that the mandate preceded the problem). Based on data including 3,465 corporate misstatements from the US over a 14-year period, researchers investigated how term of office affects how quickly auditors deal with misstatements.
In approximately 35% of these cases, the misinformation occurred only in a quarterly statement, but not in the subsequent annual financial report, suggesting commendable auditor oversight and high audit quality. In the remaining cases, inaccuracies occurred in at least one annual report approved by the auditors, and the longer duration indicates less auditor oversight and lower audit quality. The core of the study is the analysis of the relationship between the auditor's tenure (years from date of hire to submission of erroneous reports) and duration of “erroneous statement” (time elapsed since first misstated annual report signed by auditor to issuance of new statement by customer's auditor). Auditors with shorter mandates discover erroneous financial reports more quickly, authors write.
For example, when auditor's term of office was three years or less, average length of erroneous statements was just under one year. When tenure was 11 years or more, average duration was approximately one and a half years. To corroborate these findings, Singer and Zhang took advantage of a natural experiment in which a select group of companies were forced to change their external auditors due to Arthur Andersen's collapse in 2002. By investigating Andersen's clients' financial reports before and after its fall and comparing them with companies that hired only one Big Four auditor during that same period, professors found that erroneous statements lasted an average of 15% longer for those who changed auditors. This statistically significant difference leads them to cite this as further proof of beneficial effect of new auditor's new vision. The study comes to a more skeptical view than is generally prevalent in academic literature or among key players in investment world regarding long-term tenure of auditors. The latter reward long term with lower corporate borrowing costs, better responses to earnings reports, and increases in stock ratings. By applying their novel research methods to evaluate current US and EU rotation requirements for auditors, researchers discovered serious mandate deficiencies.
Although Sarbanes-Oxley reduced negative effect of prolonged tenure by approximately 50%, effect remains significant. Changing auditing firms is a huge task that requires careful consideration but learning from experiences of other audit committees can simplify what is often a difficult decision. If you're thinking about creating a new auditing firm, be sure to ask about its ability to conduct audit virtually or if regulations become more stringent. We provide specialized independent auditing and examination services for SMEs, charities, non-profit organizations and medical sector. In conclusion, it is important for organizations to consider changing their audit firm periodically in order to ensure high-quality audits that investors can trust. While there may be some benefits associated with long-term tenure with an audit firm, it is important to remember that shorter mandates can lead to quicker discovery of erroneous financial reports.