Auditor rotation may actually inhibit skepticism

Auditor rotation may actually inhibit skepticism

While enhanced skepticism is a key argument for requiring auditor rotation, a new report suggests that what really happens is the opposite.

An intricate experiment reported in a leading accounting journal has cast new light on a contentious issue regarding the auditing of financial statements — namely, whether companies should be required to periodically change their auditors.

A paper in the new issue of The Accounting Review, an American Accounting Association journal, calls the entire practice into question. The paper puts forth the surprising discovery that rotation inhibits skepticism, a perspective universally viewed as essential to effective auditing. The primary reason traditionally advanced to require rotation is that it encourages skepticism.

“Professional skepticism requirements are intended to elevate auditors’ skepticism of their clients and, ultimately, audit quality,” the paper says. “This benefit disappears and even reverses when auditors rotate. That is, rotation and a skeptical mindset interact to the detriment of audit effort and financial reporting quality.”

How so? “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 or dishonesty of the [corporate] manager relative to auditors who do not rotate,” write authors Kendall Bowlin of the University of Mississippi, Jessen Hobson of the University of Illinois at Urbana-Champaign, and M. David Piercey of the University of Massachusetts Amherst. As a result, “rotating auditors would find it difficult to garner psychological support for the probability of manager dishonesty, leading them to be less likely to choose high levels of audit effort than non-rotating auditors.”

Further, “Auditors prefer low-effort and low-cost audits, but only if managers are unlikely to choose aggressive financial reporting.” The study suggests, however, that rotation increases the incidence of precisely this pairing and may thereby boost “the likelihood of audit failures with negative legal, regulatory, and business implications.”

The diminution in accounting vigilance that makes this possible, the authors add, tends not to be conscious and purposeful but rather a “subtle psychological effect about which [audit] decision-makers rarely have accurate insight. Standard setters, auditors, investors, and academics should consider this effect when evaluating the relative costs and benefits of a rotation mandate. Given the significant costs associated with mandatory rotation, focusing auditors on a skeptical assessment frame without requiring mandatory rotation may be a less costly way for standard-setters to improve audit quality.”

Companies in European Union countries will be required, starting next June, to change accounting firms (or at least put their audit out for bids) after 10 years. While the United States does not mandate rotation of firms, it does insist that accounting companies rotate the engagement partner primarily responsible for a client’s audits after five years. Presumably the skepticism-inhibiting effect that the new Accounting Review study uncovers would come into play most significantly in the first year or two following mandated rotations.

The study’s findings are based on a behavioral experiment in gamesmanship involving 226 U.S. college students who competed for payoffs through decisions that parallel those made by auditors and managers in the course of corporate audits.

Why use college students with no accounting or management experience to probe the behavior of these professionals? Explains Bowlin, “Archival studies typically probe the relationship between auditor tenure and the quality of financial reports but fail to sort out cause and effect — whether auditors’ long tenure, for example, reflects quality reporting or whether quality reporting results from long tenure.”

“Here we employed techniques of experimental economics to pare decision-making down to the bare bones of gamesmanship, so that cause and effect were quite clear. The participants were simply told that this was an experiment about decision-making, and were not even aware that this had anything to do with auditing. At the same time, however, the decisions they made have close parallels in the maneuvering that goes on every day between corporate managers and their external auditors, thereby providing us with insight into the basic psychological processes at work in those interactions.”

In the 90-minute experiment, which was carried out anonymously via computer, participants were paired randomly, with one member of each duo identified as belonging to the green group (a proxy for corporate managers) and the other to the blue group (proxy for external auditors). Half the participants were in the rotating condition, meaning that they changed partners after each of the experiment’s 20 rounds, while the other half, in the non-rotating condition, communicated with the same partner through all 20 rounds (without, however, knowing who that individual was).

Each round began with greens choosing between right (proxy for aggressive reporting) and left (proxy for conservative reporting), each featuring different opportunities to earn points (with number of points and percentage chances of earning them spelled out in charts available to each player).

Green then conveys to blue whether right or left was chosen but is allowed to lie about it. Blue then responds by choosing between up (proxy for low-effort audit) or down (high effort). At the end of the round the players learn how many points both earned, then proceed to the next round until they play the full 20 and collect a payoff in real dollars based on total points earned.

Here’s an example of how one round might play out. Green (manager) chooses right (aggressive reporting) over left (conservative reporting) but informs blue the choice was left. Blue knows that green may be lying, but can’t help notice from the chart that the pairing of left and up offers a 70% chance of a big payoff, reflecting the fact that the most advantageous audits from an accountant’s perspective combine conservative reporting and low effort.

Letting hope outweigh caution, blue chooses up (a low-effort audit), and loses out, since green has actually chosen right. The result is a 90% chance of a big payoff for green (reflecting the advantage for managers of aggressive reporting combined with low-effort audits) but a meager one for blue.

In their analysis of participants’ interactions over 20 rounds, the professors drew on a body of psychological research in what is called “support theory”, which explores the extent to which decisions result from the way issues are framed as distinct from their substance.

Thus, half the experiment’s participants, serving as proxies for auditors, were asked to gauge the dishonesty of the proxy manager with whom they were paired, while the other half were asked to assess honesty. The study equates the dishonesty frame with professional skepticism, since, as the authors observe, “standard-setters have recently noted that auditors often focus on verifying the honesty of management representations and have encouraged auditors instead to evaluate them more skeptically in terms of their potential dishonesty.”

The professors found that when the proxy accountants didn’t have to rotate, the ones with the more skeptical frame of mind — that is, in the dishonesty assessment frame — were considerably less likely than those in the honesty frame to choose low-effort audits (54% vs. 64%). But when the accountants had to rotate, those in the dishonesty frame were substantially more likely than their less-skeptical counterparts to choose low effort (64% vs. 53%).

In addition, without rotation the combination of aggressive manager reporting with low-effort audits occurred significantly less frequently when accountants were in the dishonesty frame than when they were in the honesty frame (25% vs. 33%). But with rotation that outcome was reversed, as aggressive reporting/low-effort auditing occurred 38% of the time with accountants in the dishonesty frame, compared with only 23% of the time for those in the honesty frame.

In sum, rotating auditors, lacking the familiarity with clients that comes with tenure, “will likely encounter difficulty finding psychological support for the probability of their current assessment frame, making them less likely to choose the audit action associated with their mental frame.”

The professors’ advice: “Newly rotated auditors should be extra vigilant in fraud planning and procedures, perhaps focusing on best practices of high-quality fraud brainstorming and on falsifying (rather than verifying) management assertions during the audit.”

Entitled “The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality,” the study is in the July/August issue of The Accounting Review, published every other month by the American Accounting Association.

Source: CFO – By David McCann

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