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The major financial reporting failures at Enron and WorldCom, as well as apparent failures at Qwest, Tyco, Adelphia, and others, led to the financial reporting reforms contained in the Sarbanes-Oxley Act of 2002 (SOA). SOA's reforms directly related to auditors include the establishment of the Public Company Accounting Oversight Board (PCAOB), increased audit committee responsibilities, and mandatory rotation of lead and reviewing audit partners after five consecutive years on an engagement.
In addition, regulators and the business press have shown interest in considering whether long-term relationships between companies and their auditors create a level of closeness that impairs auditor independence and reduces audit quality. Questions have arisen about whether SOA's requirement to simply rotate personnel-the lead and review partners-within the same audit firm is adequate. SOA section 207 required the U.S. comptroller general to conduct a study to review the potential effects of requiring mandatory rotation of registered public accounting firms. The subsequent study by the General Accounting Office (now the Government Accountability Office), issued in November 2003, Public Accounting Firms: Required Study of the Potential Effects of Mandatory Audit Firm Rotation, concludes that the benefits of mandatoiy firm rotation were not certain and that more experience with the effects of SOA's other requirements was needed. The study also acknowledged that nearly 99% of the Fortune 1000 public companies have no public accounting firm rotation policy.
Mandatory Audit Firm Rotation
The ultimate question about mandatory audit firm rotation is whether such a policy enhances audit quality, and if so, at what cost. Operationally, the primary audit quality question is whether such a policy will lead to more-independent auditors performing better audits by either detecting or reporting material misstatements in the financial statements, or whether the constant rotation of audit firms will result in inferior audit performance. Three related conditions affect issues of audit quality and audit firm rotation:
* Closeness to client management;
* Lack of attention to detail due to staleness and redundancy; and
* Eagerness to please the client.
Closeness to Management
Why audit firm rotation might be the answer. The nature of auditing requires that auditors interact extensively with their clients. Long-term relationships may result in a troublesome degree of closeness between management and the auditor. Enron and Andersen, its long-time audit...