Benjamin V. Titera and Dr. Jeff Wilks, Accounting and Information Systems
As time moves on, the number of accounting firms has decreased and the lengths of the remaining firm’s names have increased. Firms such as Arthur Anderson, Coopers & Lybrand, Price Waterhouse, Touche Ross, KPMG, Ernst & Young, Peat Marwick International, Klynveld Main Goerdeler, and Laventhol & Horwath have either evolved or disappeared. Ten years ago, it was the Big 8, by 1993, it was the Big 6, in 2001, it was the Big 5, and today it is the Big 4.
With the number of Big accounting firms decreasing, the question of the audit quality is increasing. In April 2002, the U.S. House of Representatives passed a bill that prohibited auditors from performing internal auditing and systems work, and in July 2002, the Senate approved a compromise version that banned most non-audit services. President Bush then signed the final legislation, now known as the Sarbanes-Oxley Act, into law.
The Sarbanes-Oxley Act of 2002 affects the auditing and accounting profession in many ways. One of these ways focuses on the maximum allowable term- length an audit partner may serve on an SEC client’s engageme nt. Concerns about auditor independence and objectivity have prompted Congress to enact legislation that restricts these client relations. Because of the Sarbanes-Oxley Act, mandatory partner rotation has already decreased in tenure from 7 years to 5 years, and could potentially become even more restricted.
The Sarbanes-Oxley Act requires the US General Accounting Office (GAO) to study several issues relating to the accounting profession and capital markets. Under the act, GAO is to study and review the effects of potentially requiring the mandatory rotation of registered public accounting firms as opposed to the current mandatory rotation of audit partners within the same firm.
The research question I worked on was an issue of economic theory dealing with the benefits associated with mandatory audit firm rotation. This research project set out to accomplish two purposes: (1) explore the option of mandatory audit firm rotations, and (2) pioneer the theoretical insight necessary to justify an extensive market-setting project.
Initially, I thought this research project would be conducted through collecting secondary data by studying comparable market situations in analogous industries. My goal was to determine if any correlation could be traced from other professions that have similar regulatory characteristics. However, I found that to truly understand if this was a distinctly different institutional factor, the great bulk of my research first dealt with understanding the related foundational assumptions/implications of audit firm rotation, namely:
The relative efficacy of audit firm rotation based on the audit services’ market concentration (when one client forms a significant element of total fee income for an auditor, the auditor becomes more susceptible to managerial influence).
The economic tradeoffs facing auditors, such as the incentives for a new auditor to provide sufficient effort to understand a client, and the incentives for an incumbent auditor to be influenced by reappointment concerns.
Information sharing in a market setting related to reciprocity/cooperation, competition, game theory modeling, mandatory rotation, behaviorally psychology, and potential hindsight and anticipated bias.
As a brief overview, the benefits associated with mandatory audit firm rotation and the benefits of increasing the number of competing firms have become particularly important because of the decreasing number of Big audit firms. The anticipated benefits from mandatory audit-firm rotation include a possible increase in information sharing and a fresh perspective on the financial well-being of the client. Arguably, if incumbent audit firms are limited in their years of services, they could potentially see each other less as competitors, and cooperatively share valuable information to make each other better off. In contrast, the anticipated drawbacks of requiring mandatory audit- firm rotation include the monumental start-up costs of a new audit and the potential loss of long-term job satisfaction.
Ultimately, the consideration of requiring audit firm rotations will be based upon a cost-benefit analysis weighing the previously mentioned factors. Concerning potential benefits, few would contest the attractiveness of having a fresh perspective from a new audit firm—however, no conclusive evidence exists regarding the sharing of information related to the mandatory rotation of audit firms.
Many firms are merging to stay competitive. Due to the complications of accounting issues, current Big audit firms all maintain a national research office to help solve their most difficult accounting concerns. Trends toward increasing globalization and the rapid rate of change in information technologies have placed new demands on accounting firms and the general practice of auditing. With many multinational clients, audit firms have now assumed a global emphasis with an extensive framework of offices outside of the United States. These movements have created the opportunity for accounting firms to benefit from economies of scale and scope.
One proposed solution is to artificially induce the same benefits of a more competitive market by requiring audit-firm rotation. Proponents of a few large audit firms argue the firms are more efficient and their size is a business necessity. However, others believe having fewer firms encourages an abuse of power due to the lack of competition. In other words, if the benefits associated with having more firms and audit-firm rotation are arguably similar in nature, mandatory audit rotatio ns can be seem as a substitute for the lack of other Big firms.
This research project began with the objective of accomplishing two goals: (1) explore the option of mandatory audit firm rotations, and (2) pioneer the theoretical insight necessary to justify an extensive market-setting project. Through my preliminary research, I believe that the impact of having fewer competing accounting firms has increased the need for audit rotation. The research I was able to do in conjunction with my mentor, largely refined the research that he is working on, and for this reason alone, my research project was a complete success. Even beyond this measure of being able to provide the foundational precursor research for a more professional study, I consider my work an even greater personal success for what it taught me about academic research and thank all those who have helped me.