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5/15/2007

Research@Rice

Mandatory audit firm rotation may not be the panacea its proponents claim. After the corporate and financial reporting scandals at Enron, WorldCom and other firms, there was an understandable outcry from investors and government regulators. Among the suggested solutions to these accounting fiascos, which eventually led to the collapse of the Big Five accounting firm Arthur Andersen, was forcing businesses to rotate the companies that audit their books. According to new research by Brian Rountree, an assistant professor at Rice University’s Jesse H. Jones Graduate School of Management, the benefits of mandatory rotation are uncertain at best. Rountree’s research also examines how former Arthur Andersen clients selected new auditors, and the factors that drove their decision.

When the Sarbanes-Oxley Act -- which was passed in 2002 following the corporate and financial scandals at Enron, Tyco International, WorldCom and other firms -- was initially being debated, there was a great deal of controversy around whether companies should be forced to rotate auditors every few years as a way to improve financial reporting. A recent study co-authored by Brian Rountree, an assistant professor at Rice University’s Jesse H. Jones Graduate School of Management, found that mandatory audit firm rotation has uncertain benefits when it comes to financial reporting quality.

Rountree’s study, which he conducted with Jennifer Blouin from the University of Pennsylvania and Barbara Grein of Drexel University, took advantage of the unique and perhaps not replicable circumstance surrounding the collapse of Arthur Andersen, a onetime Big Five accounting firm that surrendered its license to practice as a certified public accountant in the wake of its involvement in the Enron debacle. Seizing on a situation in which many businesses simultaneously were forced to find a new auditor -- because Arthur Andersen no longer existed -- Rountree and his colleagues were able to study the factors that influence the choice of a new auditor, as well as the potential impact mandatory rotation would have.

The study, which examined 407 companies faced with finding a new auditor, cast doubt on the argument that mandatory rotation would improve financial reporting. Rountree came to that conclusion by studying the accruals -- which are estimates of future cash inflows or outflows -- of companies that hired new auditors. "The single takeaway we made was that for the companies that severed ties with Andersen, their financial reporting really didn’t change at all," said Rountree. "Therefore, if you take this as a reasonable approximation of a mandatory rotation, then it doesn’t look like mandatory rotations would be all that beneficial to financial reporting."

Rountree’s research is also unique in that it was able to delve into the factors companies consider when choosing a new auditor. In this case, even though Arthur Andersen as an entity ceased to exist, companies were often able to retain the same Andersen audit teams they had by simply hiring them when they moved to a new accounting company, like KPMG or PricewaterhouseCoopers. Those who stuck with Andersen personnel, the study points out, did so for a variety of reasons, including cost; switching to a new auditor can be expensive since it takes time to get educated about how a business and industry operate. Another reason for not making a change is a comfort level with how the accounting is currently being done. "People that are ‘more aggressive’ with their accounting opted to follow Arthur Andersen," said Rountree. "They could be more aggressive, and they wanted to follow their former audit team that opined on that aggressive behavior."

The study also found that firms that were more complex -- in particular, those that were more geographically dispersed -- were more likely to sever ties with their former Andersen audit teams. So, too, were companies that had what Rountree terms "blockholders," such as an institution with a significant stake in a company. Because they have such an interest in the company, Rountree said, they monitor it closely. "The impetus behind the switch was that they wanted to make sure to have a completely independent view of the firm now," he said. "Given they have to switch auditors, there are going to be costs anyway. Let’s go ahead and get an entirely new auditor, just to make sure we have total independence."

For more information, contact Brian Rountree or Laura Hubbard of the Jesse H. Jones Graduate School of Management.