Audit Rotation

INTRODUCTION

The business scandals around the world triggered another phase of reforms in corporate governance, accounting practices and disclosures. The particular attention has been paid on the relationship between auditors and clients that potentially impact the audit independence and hence the audit quality. Audit rotation is one of the rules that set out in response to this concern as certain auditors, who are engaged for a prolonged period of time, may develop a certain level of close relationship to the clients.

The objective of this audit research report is to provide information on the application of auditor rotation rules in the present. The report also illustrates the possible impact of both the audit partner rotation and the audit firm rotation to the audit quality and audit cost.

The research was carried out by reviewing documents, research papers and websites. The interview with the audit partner of a local firm in Thailand had been conducted to give more practical perspective of the regulation.

The auditor rotation: The application and the impact to audit quality and audit costs

BACKGROUND

The scandalous event from the business and audit failures of Enron, which was revealed in October 2001, eventually led the seventh largest company in United States of America into bankruptcy. After a thorough investigation was taken place, SEC has uncovered that the collapse of was not common or mainly a result of the business failure. However, it was the management executives of Enron that lacked managerial integrity and committed financial fraud and illegal practices. The result of the downfall has severely affected the investors and capital markets around the world.

The Enron incidence has also been recognized as the biggest audit failure in the history. The issue of audit independence has been raised since many companies with the same problems have used the same audited firm or audit partner for a long consecutive time. US survey of Fortune 100 companies in 2003 revealed that the average term of the same auditor's tenure was at 22 years. Andersen had served Enron for sixteen consecutive years since Enron's establishment in 1983. The Sarbanes-Oxley Act of 2002 was enacted as a consequence to enhance the company disclosures and strengthen the auditor independence. The rotation rule was considered as a reform to enhance auditor independence and audit quality. Title II of the Sarbanes-Oxley Act, entitled "Auditor Independence," requires the Commission to adopt, by January 26, 2003, final rules under which certain non-audit services are prohibited, conflict of interest standards, auditor partner rotation and second partner review requirements are strengthened, and the relationship between the auditor and the audit committee are clarified and enhanced.

THE AUDITOR ROTATION AND ITS APPLICATION

Under the Act, audit partners who either have performed a role as audit services or been responsible for a role of reviewing the audit of a particular client must be rotated every five consecutive years, and that after rotation, they would be subject to a five year time-out before they could return to that engagement. Therefore, neither role is performed by the same audit partner for more than five consecutive years in the hope that the rotation would prevent that sort of problem in the future. Additionally, mandatory audit firm rotation is proposed but not required in Sarbanes-Oxley Act of 2002.

As mentioned above, there are two degrees of auditor rotation: an audit firm rotation and an audit partner rotation. The entire audit firm rotation is considered as the more stringent method. According to the study of U.S. General Accounting Office(GAO), GAO states that mandatory audit firm rotation may not be the most efficient way to strengthen auditor independence and improve audit quality. To rotate the entire audit firm does require the additional audit costs including financial costs and the loss of industry knowledge. However, mandatory audit firm policies have been adopted in some countries such as Italy, Brazil, Austria and Singapore, while they have been adopted and scrapped later in Spain and Turkey due to ineffectiveness.

The favorable method is to only rotate the audit partner who is in charge of the audit team. Different audit partners within the same audit firm have been used and the audit firm still retains the engagement.

In Thailand, SEC approved a regulation requiring all listed companies to rotate their auditors every 5 fiscal years, while the auditor rotation can be made within the same firm. The preceding auditors can return to serve the same firm after the grace period of two years. The requirement has take effect since January1, 2006.

THE IMPACT OF THE AUDITOR ROTATION

The auditor rotation and audit quality

The auditors act the two valuable and important roles for capital market participants: an information role and an insurance role. Investors often use audited financial statements by auditors as the basis for their investment decisions. Therefore, auditors are expected to act like a public watchdog to protect the best interest of all stakeholders and provide a high quality of audit.

* The audit firm rotation

Many researches and studies have suggested that auditors are likely to develop closeness to management, pay less attention to details due to staleness and redundancy, and attempt to please the clients as they serve the client a prolonged period of time. In this case, the audit partner rotation practically partially solve the problem since sometimes the same members of the audit team still serve the same client for a longer period. An entire audit firm rotation is expected to give the fresher perspective to the audit engagement.

(i) Closeness to the management

A long-term relationship between clients and auditors is perceived as a vital factor that impairs and threatens the auditor independence and objectivity, and eventually decreases audit quality. Familiarity or trust threat is likely to arise. The audit firm rotation is conceived to be a solution to possible familiarity threat between personnel of the audit firm and the client because it would