Does the Rotation of Auditors Improve the Quality of Auditing - Essay Example

? Does the rotation of auditors improve the quality of auditing? BY YOU YOUR SCHOOL INFO HERE HERE Does the rotation of auditors improve the quality of auditing? Introduction It is a highly contested issue as to whether rotation of auditors actually maintains the ability to improve auditing quality. There are those that argue that long-term relationships (auditor tenure) build more knowledge about the firm and its accounting procedures which, in turn, translates into more effective auditing practice and skills. Other stakeholders in the business world believe that audit quality is reduced when rotating auditors due to the lack of familiarity about business processes and accounting, thus impacting the ability of auditors to do a thorough job in assessing best practice within the organisation. Based on all conjecture about such rotations and research studies on auditing tenure versus rotation, it would appear that the quality of auditing is actually improved by rotating auditing firms. The evidence Pozen (2012) argues that when an organisation decides to rotate auditors, there is the need for significant investment on behalf of the new auditing firm to gain important institutional knowledge about the industry which has already been learned by the incumbent auditing firm. Research studies have illustrated that there is reduced quality in auditing practice and competency during the initial years of appointment as the new auditing firm attempts to familiarise itself with specific business practices (Pozen 2012). Especially apparent in multi-national firms, new auditing companies must learn highly extensive information about corporate finance and accounting in a complex, global accounting environment. This requires time and perhaps even training, however once this information is gleaned, the auditor can provide better quality audits even though this quality took considerable time to develop and enhance. The International Federation of Accountants sees the situation from a rather different perspective outside of the time and labour investment in learning business processes. Elongated and long-standing relationships with existing auditing firms are recognised as becoming too cosy with their corporate employers which changes the dynamics of how incumbent auditing firms view business practices and ideologies. When long-standing relationships are developed with existing auditing firms, auditors tend to give favourable opinions, rather than unbiased opinions, about the corporate-mandated auditing processes. Existing auditor relationships that have endured over time leads to trust-building between business and auditor which, in turn, creates a situation where the auditor handles investigations carelessly and are more willing to accept business written statements rather than inspect the situation to ensure that the business is actually performing compliance-based activities to general accounting standards (IFA 2010). Boxer (2008) absolutely agrees with the aforementioned notion of corporate cosiness developed over time and in the face of trust that endures through familiarity with business leaders. This author representing the Office of the Comptroller of the state of New Jersey refers to this scenario as familiarity fatigue stating that such familiarity with management leaders of the business leads to a lack of independence where professional ties create a complicity that reduces auditing effectiveness and lack of unbiased auditing support (Boxer 2008). When this type of relationship is developed, the auditor loses their scepticism about the oral and written information that is provided to the auditor by the company leadership and, therefore, begins to overlook important facts and figures associated with financial statement production during the auditing processes. Boxer (2008) indicates yet another scenario that occurs, potentially, when maintaining enduring relationships with existing auditing firms. Auditors will have the tendency to desire corporate approval in the hopes of maintaining a continuous revenue flow for the auditing firm. If the auditor recognises that there are opportunities for maintaining employment over an elongated period of time, they will attempt to get into the business’ “good graces” and will sustain an attitude that the business’ accounting practices should always be approved even if they know that such practices are deceptive or fraudulent (Boxer 2008, p.3). What this suggests is that there might be motivations and even psychological needs associated with wanting to receive corporate approval that the existing auditor will work diligently to protect the interests of the business leadership rather than following appropriate auditing standards effectively. This would have significant implications for stakeholders of the business and its shareholders that rely on accuracy and compliance to the auditing process. Carey and Simnett (2006) absolutely agree with the cosiness that occurs as a result of increased familiarity with corporate leaders. These authors suggest that when auditing relationships endure over time with existing auditing firms, audit quality is reduced in terms of creativity in the auditing process. Auditing requires various testing approaches in order to identify potential best practices that would be appropriate for various businesses and industries. It is believed that maintaining relationships, rather than rotating, reduces the production of various, creative methodologies of audit process that would not have occurred through auditor rotation (Carey and Simnett 2006). This opinion would suggest that innovation in audit services and practices are somehow stifled through long-term relationship development which, therefore, reduces the overall quality of auditing and financial reporting analyses. Jackson, Moldrich and Roebuck (2008) absolutely disagree and see the situation from a reverse angle. These professionals insist that tenure with the corporation provides more significant knowledge about business and accounting practices which actually improves their judgment and ability to make more appropriate auditing decisions. When rotating auditing firms, all of the specialised knowledge that has been gleaned through experience reduces audit quality as the new auditors attempt to learn about the complexities of financial reporting practices and accounting (Jackson et al. 2008). Tenure appears to have the tendency to improve the method by which the auditors want to justify their own competencies, creating the incentive to qualify their auditing opinion as a means of improving their own reputation in the industry (Vanstraelen 2000). Hence, there is a self-protectionist phenomenon with auditing firms that have maintained long-term relationships with the business and its leadership that tends to motivate more emphasis on quality and competence in the auditing process. Internationally, there are the Big 4 auditing firms that dominate the industry and have built solid brand identities and are favoured by many multi-national organisations. Therefore, smaller auditing firms, in an effort to compete with the Big 4 auditing organisations, want to build solid reputations to ensure they are competitive, desirable and can provide higher revenue streams through competency and quality in the auditing process. Carcello and Nagy (2004) absolutely disagree. These researchers discovered that fraudulent reporting methods are more likely to happen within the first three years of an auditing firm tenure with the corporation. This is due to the lack of familiarity about error patterns that occur in particular industries which essentially leads to incompetence associated with identifying errors when they occur which leads to inaccurate financial evaluation by the auditor (Maletta and Wright 1996). Quality, in this situation, is not driven by a genuine desire by the auditor to allow fraudulent financial reporting to occur, but is driven by a generic lack of knowledge about how to properly spot accounting and reporting errors. Under this assumption, if the corporation were to maintain enduring relationships with the same auditing firm, they would be able to better familiarise themselves with error patterns in the industry and be better equipped to spot discrepancies when they are present or occurring by business leadership and accountants. The United States General Accounting Office (2003) believes in a more simplistic view that actually supports rotation of auditors rather than maintaining enduring relationships. The GAO offers that it provides opportunities for new auditing firms to take a fresh perspective at financial reporting processes of companies which would assist in identifying errors that could be overlooked by incumbent auditing firms (GAO 2003). Though the GAO does not provide specific data or knowledge about why long-term auditing firms have a larger tendency to overlook errors or problems in financial reporting processes of business, this rather basic viewpoint is that existing auditing firms might be so familiar with corporate financial reporting practices that they become so comfortable with the business and its leadership that they are less scrutinising than another, new auditing firm that might be more concerned with building a positive reputation and, therefore, are more focused on quality outputs in the auditing process. Fiolleau, et al. (2010) call the competitive nature of competing auditing firms to be a beauty contest whereby after a few years of enduring relationships with a business, new auditing firms that could potentially gain business opportunities want to increase their industry exposure and build revenues for the firm. This competitive activity is driven by very low market power of auditing firms where bidding wars (price low-balling for auditing services) attempts to convince corporate management of businesses that one auditing firm is a better value than another in the industry (Fiolleau et al. 2010). In an effort to gain business and favour of companies in highly competitive environments, the new auditing firm (if hired) would be more diligent in attempting to justify their status and repute which, therefore, provides more incentive to produce accurate auditing outputs during the first years of engagement with the hiring corporation. Essentially, this perspective of beauty contests between competing auditing firms serves as the catalyst for a newly hired auditing firm to be more painstaking and conscientious about auditing services to ensure the competitive standing of the new audit firm in a dynamic industry environment. Hence, the viewpoint of the aforementioned beauty contest scenario is market driven in the competitive auditing services industry that creates more desire by auditors to be diligent if they are able to convince corporate leadership that a new auditing firm could provide more value for their auditing needs. Quality of audit services would, theoretically, be a consequence of business-to-business marketing and not necessarily from assiduousness under any moral and ethical codes associated with audit service provision. However, it is a recognised fact that in competitive industries, a business must differentiate itself from competitors and the guarantee of quality audit production would serve as a marketing tool and guarantee to the corporate, hiring leadership that they can be assured significant quality outputs. This provides more support that rotation of auditors could be highly beneficial to the business and its leadership. It is a form of business self-protectionism that provides the incentive to guarantee better quality audits that could have very positive implications for business leaders to reduce risk, improve audit quality, and ensure that shareholders are protected against auditing errors or auditor lack of understanding about acceptable accounting and financial reporting standards. Conclusion Based on all of the research evidence provided, it would appear that rotation of auditors maintains better opportunities to ensure quality auditing services over that of enduring relationships. The ability to take a fresh look at auditing, the incentivisation of quality outputs by newly hired auditing firms as a marketing tool, the desire of new auditing firms to establish positive reputations and the potential cosiness that occurs with long-standing auditing firms would justify that rotation improves quality overall. Even though there is some support that tenure with a corporation by auditing firms could improve quality through enhanced knowledge and understanding of industry dynamics, there is more evidence that rotation provides the best quality outcomes in the audit service industry. Therefore, it would be recommended for businesses to consider rotation of auditors in order to better satisfy the needs of shareholders and ensure the business is insulated from the potential risks that could occur through audit tenure by existing auditing firms. Even though knowledge production is a benefit of maintaining long-term relationships with certain auditing firms, over time it would appear that these tenures can erode the effectiveness and quality of auditing outputs as auditors ultimately become complacent and therefore are not providing accuracy and strong oversight of corporate financial reporting. References Boxer, A.M. (2008). Selection and use of audit firms by New Jersey government units, State of New Jersey. [online] Available at: http://www.state.nj.us/comptroller/news/docs/080812_report.pdf (accessed 18 November 2013). Carcello, J.V. and Nagy, A.L. (2004). Audit firm tenure and fraudulent financial reporting, Auditing: A Journal of Practice and Theory, 23(2), pp.55-68. Carey, P. and Simnett, R. (2006). Audit partner tenure and audit quality, The Accounting Review, 81(3), pp.653-676. Fiolleau, K.J., Hoang, K.J., Jamal, K. and Sunder, S. (2009). Engaging auditors: field investigation of a courtship, University of Alberta School of Business. [online] Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1535074 (accessed 18 November 2013). GAO. (2003). Required study on the potential effects of mandatory audit firm rotation, United States General Accounting Office. [online] Available at: http://www.gao.gov/new.items/d04216.pdf (accessed 18 November 2013). IFA. (2010). Handbook of the code of ethics for professional accountants, International Federation of Accountants. [online] Available at: http://www.ifac.org/publications-resources/2012-handbook-code-ethics-professional-accountants (accessed 18 November 2013). Maletta, M. and Wright, A. (1996). Audit evidence planning: an examination of industry error characteristics, Auditing: A Journal of Practice & Theory, 21(Spring), pp.71-86. Pozen, R. (2012). Search for auditors; don’t rotate, Crain Communications Inc. [online] Available at: http://www.pionline.com/article/20120514/PRINT/305149960/search-for-auditors-dont-rotate (accessed 20 November 2013). Vanstraelen, A. (2000). Impact of renewable long-term audit mandates on audit quality, The European Accounting Review, 9(3) pp.419-441. Bibliography Collins, D.W. and Hribar, P. (2002). Errors in estimating accruals: implications for empirical research, Journal of Accounting Research, 40(March), pp.105-134. Krishnamurthy, S., Zhou, J. and Zhou, N. (2006). 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