The Hidden Costs of Rotating Auditors

The avalanche of accounting scandals in the late 1990s and early 2000s triggered major changes in the corporate accounting world. The Sarbanes-Oxley Act of 2002 (SOX) stampeded in, promising tightened audit regulation aimed at easing the minds of frightened market participants. Given heightened concern over excessively “chummy” relationships between corporate management and its auditors, one rule set forth in SOX requires more frequent client rotation of audit partners (every five years rather than seven) and greater time required before partners may return to the same client (five years rather than two).

While there is little doubt that this rule was well intentioned, some commentators argued the new rotation standards would impose significant costs on clients, audit firms, and investors that would undermine effective audit regulation. Regulators persisted, citing the benefits of a fresh perspective and enhanced independence that a new audit engagement partner would bring. However, the accounting profession argued that not only would audit quality be harmed, but audit effort would drop, learning and training costs would increase, client-specific expertise would disappear, and inefficiencies affecting both the client and the auditor would rise. The Securities and Exchange Commission (SEC) eventually acknowledged that the more stringent rotation requirements might substantially raise audit fees and slow audits, but the rules remain.

Given the insight provided by empirical examination of these issues, we studied whether more frequent audit partner rotation creates additional audit costs, and whether firms will pass such costs to clients in the form of higher fees or slower audits.  Given the lack of publicly available data on audit partners in the United States, we used a novel measure of audit partner change and studied its implications. Our results show significantly higher audit fees and significantly less timely audits in the year following rotation. We find these effects to persist over subsequent rotations, giving us greater confidence in the robustness of the results.

There are several implications of these findings, shedding light on rotation effects brought about by SOX. First, partner rotation increases audit fees  while decreasing audit timeliness. Second, we found that non-Big Four firms are particularly affected,  performing less timely audits and passing on rotation costs to their clients through significantly higher audit fees. In contrast, Big Four firms perform less timely audits of their larger clients but seem to absorb additional rotation costs rather than pass them on to clients in the form of higher audit fees.

Third, our sample consists of companies that initially change audit firms. Therefore, we examine successive rotations to rule out any confounding effects of audit firm change. We find consistent audit fee and audit timeliness results with the second and third partner rotations following the initial firm and partner rotation. Therefore, loss of client-specific knowledge at the partner level is not significantly mitigated by increased tenure and client-specific knowledge at the firm level, as some have suggested. This further supports the consistent fee and time consequences of changing audit partners.

Fourth, our study enhances the general understanding of the consequences of audit partner rotation, and informs the literature, regulators, and the profession. We also find the regulatory argument of a fresh partner perspective to come at a price, especially given recent U.S. literature showing poorer financial reporting quality following rotation – a study we published in 2014 in Auditing: A Journal of Practice & Theory. Further, we find evidence supporting the profession’s arguments that partner rotation is costly, both financially and in terms of timely audits, and, thus, timely financial reporting. We also find support for the profession’s contention that smaller audit firms find it particularly difficult to comply with the new rotation requirements.

Finally, we raise potential long-term concerns of mandatory audit-partner rotation. As noted, we find consistently higher audit fees and less timely audits with each successive partner rotation, even as client engagement with the same audit firm office remains uninterrupted. This is important given that we may be the first to examine the persistence of rotation effects. Since audit partner performance evaluations consider factors like whether costs are passed on to clients or audits are delayed, we may see audit partners shifting to other accounting areas to avoid poor evaluations. If partners shy from audits, auditing resources – already strained by mandatory audit partner rotation – may become even scarcer, which the profession argues could further increase audit costs, reduce timeliness, discourage clients from paying auditors, and possibly drive some audit firms out of business.

Tightening audit partner rotation requirements is beginning to look like a classic case of unintended consequences.

This post comes to us from Professor Divesh Sharma of Kennesaw State University School of Accountancy, Professor Paul Tanyi of the University of North Carolina at Charlotte’s Belk College of Business and Professor Barri Litt of Nova Southeastern University’s H. Wayne Huizenga College of Business & Entrepreneurship. It is based on their recent paper, “Costs of Mandatory Periodic Audit Partner Rotation: Evidence from Audit Fees and Audit Timeliness,” which is available here.