Competitive Tendering & Audit Quality
In September 2014, the UK Competition and Market Authority (CMA) issued a compulsory Order，requiring that all FTSE 350 companies should conduct a competitive tendering process for auditor appointment at least every 10 years, and should change their statutory auditor at least every 20 years. This order aimed to solve the prevalent long-term relationships between auditor and a firm and thus improve auditing quality.
In the review paper of DeFond and Zhang (2014), they admitted that although the most common definition portrays audit quality to be just a binary process that auditor either succeed or fail in detecting any possible GAAP violations, audit quality demands far beyond just detection of any GAAP violations but providing fair assurance of financial reporting quality. They further note that auditor’s responsibilities, reflected in the audit opinion, arise from professional auditing standards, such that auditors should consider “the quality rather than just acceptability” of the firms’ financial reporting and provide assurance of whether “financial statements are fairly presented in accordance with GAAP”. Thus, audit quality is more than quantitatively acceptable but also qualitatively acceptable.
The order of CMA takes a focus on the prevalent fact that there usually exist long-term relationships between the firm and auditor and such long-term relationship raises the concern of lack of independence, which is a fairly important factor that determines audit quality. This essay argues that long tenure does not necessarily destroy or decrease audit quality but sometimes would even improve audit quality, documented by prior literature. However, mandatory rotation constraints auditor-client specific knowledge and expertise, which would decrease audit quality. Additionally, tendering process, though provides incumbent auditor the opportunity for future service, may hurt future audit quality by incurring the probability of “opinion shopping”. Consequently, this essay concludes that the 2014 UK CMA order would not achieve its goal but may hurt audit quality.
Regulators emphasize auditor quality focuses either primarily on audit process (International Auditing and Assurance Standard Board 2013 framework) or on key indicators of audit quality (Department of the Treasury’s Advisory Committee on the Auditing Profession, 2008). Those audit indicators are mainly from auditing firms’ point that include audit firm average headcount, yearly staff turnover, industry diversity, client satisfaction, audit and non-audit service, tendering win rate, average revenue, profit growth, and profit per partner per year.
DeAngelo (1981) defined audit quality as “the market-assessed joint probability that a given auditor will both detect a breach in the client’s accounting system, and report the breach”. While DeFond & Zhang (2014) argue that though assuring financial statements are free of any possible material misstatements or manipulations is the major responsibility of auditors, auditors are expected to provide more than just assurance of no GAAP violations. Thus they expect high quality auditors to consider not only whether technical compliance of GAAP in financial reporting but also whether firms’ financial reporting fairly and faithfully reflect the underlying economics. Generally, this notes that auditors not only “evaluate the qualitative aspects of the company’s accounting practices, including potential bias in management’s judgment” (PCAOB, 2010) but also “judge the quality, not just the acceptability” (Statement on Auditing Standards, 90).
Supported by Simunic (1980), which viewed auditor-provided assurance services as one kind of specific economic good, both the demand of client and supply of auditor, which, depend on the incentives and competencies of the client and auditor, determine the audit quality. Though the generally accepted definition of audit quality is not that straightforward, prior literature normally use output-based measures: material misstatements such as restatements and Accounting and Auditing Enforcement Releases (AAERs) and auditor communication such as modified opinions or issuance of going concern.
Auditor independence and CMA order
Auditor’s incentives for independence and competency affect the outcome of audit quality. Independence is determined by reputation concern, litigation costs and regulatory concerns, while competency is determined by expertise and engagement-level inputs to the audit process that refers to the auditor’s ability to deliver high audit quality.
The 2014 CMA order is an audit market regulation that is intended to improve audit quality by changing auditors’ and clients’ market-based competencies and incentives, using a non-market-based mechanism. Such intervene emerges from the fact of existence of cases that market-based incentives and competencies fail in their effects. From an economic theory point of view, such order may alter the equilibrium of audit market. However, whether such switch in equilibrium is a Pareto optimal is an open question.
From the preface, 2014 CMA order explicitly express regulators’ concerns of long auditor-client tenure that would bring familiarity which would threatens auditor independence. And such order is generally consistent with US audit standards that alter client demand for audit quality by mandating auditor rotation. (e.g., AICPA, 1978; PCAOB, 2011) Auditor independence means auditor should keep independence from any related parties meaning that those who might have an interest in a firm’s financial statements reports. The support from the audit committee, the contractual reference to accounting standards, the code of ethics all help mitigate and provide independence from both firm management and also third parties.
Long auditor-client tenure would indeed improve familiarity as both audit firms and clients get used to the other party’s work preferences and business model. Such familiarity is a double-edged sword. On one hand, auditors develop client-specific knowledge or contractual expertise from long relationship with client. On the other hand, long-term relationship increases threats of collusion. Anecdotal evidence such as Enron and Anderson provides practical supports for the argument that long tenure increases possibility of collusion. In fact, many previous external auditors join their clients as internal auditors or other financial positions. This situation increases the concern of revolving door issue that former auditors are familiar with firms’ audit weakness and could be able to manipulate financial statements without detection of their former employers, the auditing firms. In addition, such human capital movement builds social connection between the auditing firms and the clients. Such social connection strengthens the concerns of collusion. Indeed, prior literature documented that long tenure is associated with fewer going concerns opinions and more benchmark beating in Australia (Carey & Simnett, 2005), higher audit fees for former clients of Andersen, and lower earnings quality (more discretionary accruals) even before SOX (Kealey et.al, 2007).
However, most other studies find the opposite that long tenure does not impair and even improve audit quality sometimes. Specifically, long tenure is negatively related with frequencies of AAERs, more going concern opinions (Louwers, 1998; Knechel & Vanstraelen, 2007), higher earnings response coefficients (ERCs) (Myers et.al, 2003), and lower cost of debt (Mansi et.al, 2004). However, fraudulent financial reporting and misstatements are more likely to happen during the first a couple of years of audit tenure. (Carecello & Nagy, 2004) Another issue of mandatory rotation is that “opinion shopping” referring to clients would seek to find auditor successors who commit to issue a clean audit opinion when the incumbent auditor threatens to issue a going concern opinion (GC). Prior evidence with regard to opinion shopping is also mixed. Chow & Rice (1982) found that firms are more likely to switch auditors after receiving qualified opinions. Lennox (2000) tests for “opinion shopping” by predicting the opinions that companies would have received what if they had made other opposite switch decisions, using UK setting. His results show that firms indeed successfully engage in “opinion shopping” as they have received unfavorable audit opinions more often if they had made different switch decisions.
When evaluating the effectiveness of 2014 CMA order, the uniqueness of the order should not be neglected, comparing with SOX and other regulations that require mandatory auditor rotation. The 2014 CMA order requires a competitive tendering process in auditor appointment instead of mandatory rotation. By employing competitive tendering process, the incumbent auditors still have the chance to get the auditing contract if they win in the tendering. Thus, any concerns about mandatory rotation would destroy audit quality with regard to auditor-client specific knowledge is less severe. The incumbent auditor would be able to sustain its expertise and firm specific knowledge. However, on the other hand, tendering itself may not be a fair game if the participants include both incumbent auditor and new comers. The incumbent is more likely to get the auditing contract, supported by previous long relationship that accumulated enough information of firm specific needs and requirements. Moreover, there exists the possibility that incumbent auditor wins the tendering on the condition that warranty of future going concern opinions issuance. Under such circumstances, audit quality would decrease because auditor’s incentive changes while no change of competencies. This increases the chances of collusion between auditing firms and clients as “opinion shopping” happens. Following these argument, both mandatory rotation and tendering process would add no value to audit quality but bring a new equilibrium with social loss.
This essay is aimed to evaluate the effectiveness of 2014 CMA order in regard to tendering process every 10 years and mandatory rotation of auditor every 20 years for FSTE 350 firms. Regulators’ concern of long auditor-client tenure is the main driver of the new order, after many scandals and following other countries’ regulatory changes. This essay argues that audit quality depends on both client demand and auditor supply. Assuming no change of client demand, auditor’ supply of auditing services changes under the new regime. On one hand, change of auditor if incumbent lose in the tendering destroys the client specific expertise and knowledge accumulated during the contracting period. On the hand, winning the tendering may change auditor’s incentives as the condition of winning the tendering rests on acceptance of “opinion shopping”. Thus, UK CMA may not be able to achieve its goal in improving audit quality by requiring mandatory tendering every 10 years.
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