Wanda A. Wallace John N. Dalton Professor of Business Administration, College of William and Mary

Auditor Rotation: A Bad Governance Idea

Would you change your doctor every three years believing you’d get better medical attention?

Whenever a debacle grabs hold of the headlines, debate begins to offer “answers.” Intelligent public policy crafters must pause and sort out such answers from “really bad ideas.” The auditor rotation proposal is one of those bad ideas.

If you were forced to change your doctor every few years, do you believe you would receive better medical attention -- or worse? Is value added from the experience that doctor has had with your personal medical history? Or, is the benefit of “a fresh look” dominant? While the latter might be sought through second opinions, who would voluntarily embrace the idea of mandatory rotation of a personal physician?           

Yet why do people believe the diagnosis of a company would somehow benefit from forcing it to lay aside the experienced professional at set intervals? Do those offering such proposals comprehend the role of a learning curve effect, the importance of an understanding of context, the ability to detect changes in individuals with whom one is acquainted as opposed to total strangers? Has any consideration been given to the actual evidence from the past?

 The first fact to recognize is that when left to the marketplace, the tenure of auditors tends to be rather long. As economists such as Freidrich Hayek have counseled, one ought not to ignore actual market exchanges that are commonly superior to any centralized planning. Moreover, deep knowledge is important to an economic organization's adaptation, a principle put forth by Chester Barnard in his 1938 book, The Functions of the Executive. The marketplace and need for knowledge prefer longer-term relationships.

The second pattern is a larger incidence of auditor change among entities identified as fraudulent financial reporters. Research demonstrates that longer auditor tenure, on average, is associated with higher earnings quality, suggesting auditors placed greater constraints on extreme management decisions in the reporting of financial performance. Such results are consistent with the role of expertise in continuing audit engagements.

 A third consideration is the available lessons from the public sector -- where the term "bare-bones" audit evolved and mandatory auditor rotation is commonplace, with everyone thereby given the chance at the government contract. Some argue governments demonstrate cost consciousness via the discipline of lowest-bid practices. Yet how bereft of incentives is a relationship that is capped at three years no matter how a professional performs? Indeed, the learning curve effect on each new team of auditors can provide management with the upper hand in deterring audit effectiveness.

At the invitation of Charles A. Bowsher, then Comptroller General of the United States, I served on the Government Auditing Standards Advisory Council from 1991 through 1996 and participated in debates on internal control standards. The council recognized that less effective controls in public entities were a real cost -- in part, due to "bare bones" auditing. Too often, the audit process was performed as efficiently as possible, constrained by short-term contracts, competitive bidding effects, and limited scope assignments. Rather than proffer suggestions and related services for enhancing controls and operating effectiveness, the professional service providers focused on only the audit report ("Just the facts, Ma'am").

A key assertion has been a need for greater expertise on boards. Why, then, neglect the substantial evidence of industry expertise within professional accounting firms?

Research has found quality of audits, in part, to be a function of an auditor’s industry expertise. We should recall that the dominant specialists in savings and loans before the debacle tried in vain to align regulatory accepted accounting principles (RAAP) promulgated by government agencies with generally accepted accounting principles (GAAP) to make the troubled state of the industry transparent to investors. When this could not be accomplished, the specialists systematically divested their participation in the industry. Had this change in auditors initiated by firms choosing not to stand for reappointment been coupled with the public record of these experts striving for timely improvement in reporting practices, the debacles might have been averted.

The point is that the experts recognized the situation, spoke out on the problems, and prudently stepped aside, and the new providers of the services failed, even then, to see the “writing on the wall.”