How can we stop the auditing scandals?

16 July 2021

Core Insights: Finance

By Jo Horton

The auditing industry and its governance has come under increasingly intense scrutiny in recent years.

In 2020, for example, there were ongoing investigations by the Financial Reporting Council (FRC) in the UK involving all of the Big 4 accounting firms (EY, PwC, Deloitte and KPMG).

While in the US, the Securities and Exchange Commission is examining the running of the Public Company Accounting Oversight Board - the independent body set up in 2002, following the Enron scandal where billions of dollars of debt were hidden before its collapse, to provide external oversight of auditing in the US.

Much of the attention has focused on the relationship between the major accounting firms and their publicly-listed corporate clients.

Critics argue that the auditor-client relationship can easily become too close and mutually dependent, undermining the objectivity and independence needed to deal with reporting irregularities appropriately. Yet, as the auditing related investigations in the UK and elsewhere demonstrate, efforts to regulate away this problem have had limited success. 

But this need not be the case. As research conducted with my colleagues Gilad Livne, of the University of Exeter, and Angela Pettinicchio, of SDA Bocconi School of Management, shows, regulatory measures that mandate changing the audit firm and partner periodically can have a significant impact on improving audit quality and thereby reducing financial fraud. The key to the success of these measures is the way in which they are applied.

The corporate financial reporting system is integral to the smooth functioning of financial markets. At its heart is the complex relationship between auditor and corporate client, as the route to a signed-off set of accounts invariably involves a process of negotiation between audit partner and the client's audit committee and key executives, including the CFO and CEO.

The audit partner's role is pivotal. They are responsible for instigating an auditing process that enables the appropriate exercising of independent judgement in a specific auditing engagement. They liaise directly with the client to decide what adjustments may be needed to sign-off the accounts in light of the audit team's findings.

Understandably, a degree of relationship building between auditor and client is necessary to facilitate the audit process. Historically, however, auditor-client relationships have often extended over many decades.

Take recent FRC investigations as an example - KPMG was with its client Carillion for 19 years before the construction and facilities giant crashed into liquidation with £7 billion in liabilities. While PwC was with retailer Tesco for 32 years when the retailer was hit by an accounting scandal in 2014, in which its profits were overstated by £326 million.

The auditors are expected to apply professional scepticism when examining the numbers. Clearly, though, there is scope for the familiarity and financial interdependence developed during a lengthy relationship to compromise the independence and even, on occasion, the integrity of the audit.

The most obvious solution is to apply measures that attempt to prevent the nature of the auditor-client relationship affecting the independence of judgement. The main options here have been to require a regular change of audit partner at the accountancy firm involved, audit firm, or both.

How rotating auditors can stop the accounting scandals

Globally, there is little consistency in the regulatory approach to audit rotation applied to publicly-listed companies. The EU, for example, has introduced dual rotation with a maximum engagement period of seven years for key partners and re-tendering after 10 years for firms.

Post-Brexit the UK could, theoretically, diverge from these obligations. While in the US there is lead audit partner rotation every five years, but no mandated firm re-tendering.

For their part, the major audit firms have tended to lobby vigorously against constraining the audit-client relationship through forced rotation. A common objection is that rotation limits the auditor's ability to gain the client-specific knowledge and understanding that enables them to evaluate decisions taken by the client.

They also argue that it removes incentives to invest resources into building that knowledge and understanding, as well as increasing costs overall.

And, although rotation seems a strong candidate for a measure that could promote better quality auditing (and is mandated in a number of regulatory environments), empirical evidence of its efficacy is limited. Indeed, recent research has cast doubts on the merits of partner rotation in the US.

We set out to provide greater clarity on the impact of partner and firm rotation, in various combinations, on both audit quality, and the perception of audit quality in the financial markets.

To do this we used reporting and market data from Italy (for the period 1993 to 2012). Italy operated a firm rotation only policy until 2006, followed by a dual firm and partner rotation regime (audit firm change after nine years, internal partner change after six years). This allowed us to isolate and compare the impact of the different rotation regimes.

Ideally a more direct measure of audit quality would be to compare the original financial reports before and after any auditor recommended amendments. But even without access to these documents a reasonable assessment of audit quality is possible by examining the discretionary reporting items (abnormal accruals and discretionary revenues) as a window on how judgement is used to vary the numbers. Here, a greater use of discretion to create a particular version of a company's financial position correlates with a lower quality of audit.

Why rotating firms and audit partners can stop the scandals

We also examined the change in market price, following rotations, over the fiscal year to evaluate the market's impression of audit quality.

Our findings show that while partner rotation correlates with better audit quality, firm rotation does not. However, the timing of partner rotation and the context within which it occurs appear to be critical in achieving the desired effect.

This helps to explain the findings of a recent study of US firms that found no benefit from rotating partners. There is a key difference between the regulatory situation in the US and Italy. In Italy, as in the rest of the EU, there is dual rotation, with the audit partner rotated internally several years prior to changing the audit firm.

In the US there is only audit partner rotation. Therefore it is quite possible that firm rotation is a precondition for obtaining a positive impact from partner rotation.

We believe that a probable explanation for the positive impact of partner rotation on audit quality is the "embarrassment effect".

Knowing that a competing firm's audit partner will be going through the accounting numbers in a few years' time is a powerful incentive to resist client pressure and any excessive exercise of discretion, and to enhance audit quality.

The threat to an incumbent auditor's credibility and reputation from a new auditor demanding corrections or exposing poor auditing (and the risk of sanctions), acts as an additional safeguard to the quality of the audit process and results.

At the same time, the overlap of the firm and partner rotation period reduces the extent to which positive effects from partner rotation might be offset by any negative impact of firm rotation due to a lack of client-specific understanding.

There is little doubt that audit quality needs improving. That much is evident from both recent auditing related investigations involving listed corporations and longstanding efforts by governments to restore trust in audit governance.

A positive step in that direction would be to implement a dual rotation system (if not already mandated), where partner and firm rotation periods are offset. In addition, perhaps more controversially, a requirement to exchange working papers could be introduced. Passing on details of historic audits to the incoming audit firm would help mitigate any negative impact due to an incoming auditor needing time to fully acclimatise to the new client and build client-specific knowledge.

Dual rotation may not be a panacea for the problems afflicting the audit industry, but these rotation measures make sense for all the stakeholders involved.

Confidence that audited reports accurately reflect the financial position of a firm is essential to the effective functioning of capital markets and national economies.

If governance issues with the auditing process for major corporations are allowed to persist, not only will it damage economic growth, but it could well lead to the breakup of the audit firms that currently dominate the market.

Further reading:

Horton, J., Livne, G. and Pettinicchio, A. (2021) "Empirical evidence on audit quality under a dual mandatory auditor rotation rule", European Accounting Review, 30, 1, 1-29.

Horton, J., Tsipouridou, M. and Wood, A. (2018) "European market reaction to audit reforms", European Accounting Review, 27, 5, 991-1023.

 

Jo Horton is Professor of Accounting and teaches Accounting and Financial Management on the Executive MBA and Executive MBA (London).

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