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Auditor Rotation: A Cost-Benefit Analysis

A new rule adopted by the U.S. Securities and Exchange Commission requires disclosure of the tenure of a public company’s external auditor in the annual report. KPMG recently reported that it has audited GE since 1909. This raises the question whether there should be mandatory audit firm rotation after some period of service. Right now, other than the tenure disclosure, there are no requirements for mandatory auditor rotation.

The fact that KPMG has audited GE for 100 years is coming under greater scrutiny given that the SEC disclosed on January 24, 2018, that it was beginning an investigation of the company’s accounting practices. The regulators are investigating a $6.2 billion insurance loss from GE Capital, the troubled financial service business that the company is trying to wind down. GE announced it would take a $6.2 billion charge because of the loss. GE Capital will also set aside $15 billion to cover the costs of health insurance companies’ policies that it re-insures.

The SEC is also looking into “revenue recognition and controls” for the company’s long-term service agreements including insurance reserves. GE restated its 2016 and 2017 quarterly numbers to reflect new accounting standards. The company lost $9.8 billion in its most recent quarter. With the company’s stock down more than 40 percent the last twelve months, the uncertainty of the accounting investigation raises questions about for John L. Flannery, the new CEO of GE.

This isn’t the first rodeo for GE. In 2009, the company settled civil fraud and accounting charges with the SEC for using improper methods to steadily increase its reported earnings to meet or exceed the consensus earnings estimates of analysts and avoid any negative results. GE agreed to pay a $50 million penalty as part of the settlement for its income smoothing techniques.

The obvious question is: Where were the auditors during the accounting scandals? The answer is nowhere to be found. In fact, two shareholder watchdog groups – Glass-Lewis and Institutional Shareholder Services -- urged shareholders not to ratify KPMG as GE’s auditor at the company’s annual shareholders meeting last April. GE shareholders approved KPMG for another year, but only after overcoming substantial opposition in the wake of GE’s accounting issues. Only 65 percent of shareholders supported GE, an historically low percentage of support. Last year 94 percent of shareholders supported GE.

Let’s examine the potential costs and benefits of auditor rotation. The costs should be obvious. There is a learning curve during which time the audit may not be as efficient and increase the costs to the client. Moreover, a relationship of trust between the audit firm and client builds up over several years and any forced rotation may make it more difficult to build trust simply because of the lesser passage of time.

The benefits of forced rotation are subtler. After a period of service, say 20 years, the auditors become too complacent and close to the client creating a familiarity threat to independence. Audit independence and objectivity may fall by the waist side. Conflicts of interest develop over time making it more difficult for auditors to exercise professional skepticism in gathering and evaluating financial data to ensure the financial statements do not contain any material misstatements.

The benefits of auditor rotation also are getting a fresh look at the company’s accounting methods and financial reporting techniques. The new firm may not be biased by past audits and would critically challenges accounting techniques that smooth net income or create earnings to meet or exceed financial analysts’ earnings consensus estimates.

The accounting profession contends that the mandatory rotation of principal audit partners sufficiently protects the public interest and builds in the “fresh look” critics are looking for. The Sarbanes-Oxley Act created a five-year auditor requirement. The SEC enforces it through the Public Company Accounting Oversight Board (PCAOB). Critics contend this is not enough and mandatory audit firm rotation is necessary to compensate for years of influence by audit clients over their auditors.

Academic studies have looked at these issues. One found that mandatory rotation of audit partners – as opposed to firm rotation – “did not eliminate the negative effect of long auditor tenure on audit quality.” This study looked at 3,465 corporate misstatements by U.S. companies during a 14-year period, focusing exclusively on serious accounting errors that occurred and were corrected during the tenure of the same auditor. The research question was how the duration of auditor tenure affected the auditors’ speed in addressing misstatements. The overall finding was a positive correlation existed between auditor tenure and misstatement duration. “’In other words, auditors with shorter tenures are faster to discover financial misrepresenting.’” For example, when auditor tenure was three years or less, the average misstatement duration was less than one year, whereas when it was 11 years or more, average duration was about a year and a half, more than 50 percent greater. However, the authors also found that this disparity tailed off after tenure of about 10 years: Up until 10 years, ‘a one-year increase in auditor tenure increases the misstatement duration by approximately 2.02 percent, therefore, on average misstatements are 18.18 percent longer after 10 years of auditor tenure than after one year. Beyond ten years of auditor tenure, the association between auditor tenure and misstatement duration is insignificant.’” The authors concluded that the benefits of a fresh look exist only in the first 10 years of the auditor-client relationship.[1]

The 10-year time frame is interesting because the European Union recently mandated that public interest entities put the audit out for bid, after tenure of 10 years, although they may then decide to extend the tenure period for another ten years. Auditors must change every 20 years.

Another study shows opposite results. This study, reported in The Accounting Review, reaches the conclusion that auditor rotation impairs professional skepticism thereby challenging one of the primary reasons for rotation – improving audit quality. The authors say: The audit firm rotation benefit disappears and even reverses when auditors rotate because rotation and a skeptical mindset interact to the detriment of audit effort and financial reporting quality. The authors suggest that rotation appears to increase the incidence of aggressive financial reporting together with “low-cost, low effort” audits, boosting the likelihood of audit failures, most significantly during the first two years following rotation. Based on their study, the authors speculate that “rotating auditors, aware that they will not be in a long-term relationship, will…likely perceive themselves to be less competent in evaluating the honesty and integrity of the [corporate]manager relative to auditors who do not rotate. As a result, ‘rotating auditors would find it difficult to garner psychological support for the probability the manager dishonesty, leading them to be less likely to choose high levels of audit effort than non-rotating auditors.’”[2]

The key factor in evaluating the net benefits of mandatory audit firm rotation is the public interest. The problem is there hasn’t been sufficient research on this issue because the mandatory partner rotation requirement under Sarbanes-Oxley is relatively recent and less time has gone by since the European Union required a 10 to 20-year firm rotation.

I have a different perspective. The PCAOB conducts inspections of public company audits every year or so. Why can’t the PCAOB look at the retention issue based on noted deficiencies in audits examined. It’s true that the Board may not look at the same client each year. Still, the recommendation can be made based on the overall deficiency rate and whether the deficiencies include a lack of independence, integrity, objectivity, and professional skepticism, the bedrocks of audit quality. The presence of these factors suggests ethical failures in the audits. By making the recommendation public so shareholders can consider it in their annual retention vote, the firms may internalize the noted ethical failures and make the changes required by the inspection report. This may not be the perfect solution, but it does begin the process of holding audit firms accountable for their audits by having meaningful consequences for repeated failures in ethics, and it protects the public interest.

[1] Myers, James & A Myers, Linda. (2018). Mandatory Auditor Rotation: Evidence from Restatements.

[2] Kendall O. Bowlin, Jessen L. Hobson, and M. David Piercey (2015) The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality. The Accounting Review: July 2015, Vol. 90, No. 4, pp. 1363-1393.

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