Interim reviews and the association between partner rotations and audit fees

• Author: Tom Scott,Matthew Grosse,Nelson Ma
• DOI: http://doi.org/10.1111/ijau.12116
• Date: 01 July 2018
• Published date: 01 July 2018

ORIGINAL ARTICLE

Interim reviews and the association between partner rotations

and audit fees

Matthew Grosse

1

|Nelson Ma

1

|Tom Scott

2

1

Accounting Discipline Group, University of

Technology Sydney, Sydney, Australia

2

Accounting Department, Auckland University

of Technology, Auckland, New Zealand

Correspondence

Tom Scott, Accounting Department, Auckland

University of Technology, Private Bag 92006,

Auckland 1142, New Zealand.

Email: thomas.scott@aut.ac.nz

This paper considers whether the association between partner rotation and audit fees varies based

on whether the partner is rotated before the interim review or annual report audit. Consistent with

prior literature, there is some evidence of higher fees in the yearof rotation, but we find this effect

is driven by partner rotations that occur before the interim review, which are 7.14% higher on

average. We argue that rotations before the annual report audit are less likely to be planned, and

thus audit firms cannot pass on increased costs due to a weaker bargaining position. Supporting

evidence is provided, as results only persist when client bargaining power is low, and in contrast

there are lower fees for rotations that occur before the annual report audit when client bargaining

power is high.

KEYWORDS

audit delay,Audit fees, auditor reviews, bargaining power, interimreports, interim reviews,partner

rotation

1|INTRODUCTION

Regulators have expressed concerns around auditors' overfamiliarity

with clients, leading to calls for auditor rotation; however, there

has also been apprehension that auditor rotations may impose costs

(e.g., Australian Securities & Investments Commission [ASIC], 2014;

Crowe Horwath, 2012; Public Company Accounting Oversight Board,

2011; Treasury of Australia, 2012). Prior literature has found that audit

partner rotations can result in higher audit quality (e.g., Fargher, Lee, &

Mande, 2008; Laurion, Lawrence, & Ryans, 2017; Lennox, Wu, &

Zhang, 2014), although there is evidence to the contrary (e.g., Litt,

Sharma, Simpson, & Tanyi, 2014). Partner rotations are costly and have

been found to lead to higher audit fees, which vary based on client size

segments (Ferguson, Lam, & Ma, 2017; Sharma, Tanyi, & Litt, 2017;

Stewart, Kent, & Routledge, 2016). However, it is not clear whether

the higher audit fees surrounding partner rotations are caused by

greater audit effort, a fee premium, or the audit partner convincing

the client to purchase more assurance. Documenting both the costs

and benefits of partner rotation is important as it allows regulators to

make an informed assessment of partner rotations. We extend this

literature by disaggregating partner rotations into whether the rotation

occurred before the half‐yearly financial statement (hereafter

described as an interim review) or before the annual report audit. We

argue that differences in when the partner is rotated reflect relative

client–auditor bargaining power and thus the ability to pass on the cost

of rotation.

Companies listed on the Australian Stock Exchange (ASX) must

disclose both half‐yearly (interim) financial statements and an annual

report. The interim financial statements must be reviewed by an

auditor, as opposed to having a full audit conducted.

1

Thus, a new lead

audit partner could first sign‐off on an assurance engagement at the

interim review or the annual audit. We argue that partner rotations

occurring earlier in the year before the interim review are more likely

to represent planned rotations, in which the new audit partner can

learn about the firm in a lower risk assurance engagement. Alterna-

tively, partner rotations occurring later in the year before the annual

audit are less likely “planned”but rather stem from client dissatisfac-

tion with the partner, or the audit firm managing unexpected changes

in workloads. This would suggest the audit firm has less bargaining

power and cannot charge a fee premium or pass on the costs of audit

partner rotation when the partner is rotated before the annual report

audit. We use the Australian setting, as interim financial statements

are required to be reviewed and disclosed with the audit partner's

name identified. This contrasts with other jurisdictions, such as the

USA, where interim financial statements must be reviewed, but the

disclosure of the review report with the interim financial statements

is voluntary, and disclosure of audit partner identities has only recently

been mandated. Thus, Australia provides a strong institutional setting

Received: 26 March 2017 Revised: 7 January 2018 Accepted: 25 January 2018

DOI: 10.1111/ijau.12116

214 © 2018 John Wiley & Sons Ltd Int J Audit. 2018;22:214–229.wileyonlinelibrary.com/journal/ijau

to examine the role of partner rotation timing on the functioning of the

audit market.

Our sample is based on the largest 500 Australian publicly listed

companies on the ASX in any year through the period 2007–2014.

As we require companies to have data over the whole period and

exclude financial institutions, our final sample is 3,480 firm‐year

observations from 566 unique firms. We document a rate of 22%

(769) partner rotations, similar to Stewart et al. (2016). Eighty‐five per-

cent of partner rotations occur before the interim review, suggesting

rotations are often planned, while unplanned rotations before the

annual report audit are a sizable minority. We find that audit fees are

significantly higher by 7.14% in the year of a partner rotation only

when the rotation occurs before the interim review. Additionally, audit

fees are significantly lower by 12.63% for rotations occurring before

the annual report audit for clients with higher bargaining power. This

result is robust to controlling for partner rotations due to regulatory

requirements for periodic rotation.

Overall, we interpret our results as suggesting that higher fees

around audit partner rotations vary based on relative auditor–client

bargaining power. We argue that rotations before the interim review

are more likely to be planned, providing the audit firm a stronger

bargaining position to pass on the cost of rotation and any additional

assurance work to clients through higher audit fees. Consistent with

this interpretation, the results differ based on client bargaining power,

with higher (lower) power segments linked to lower (higher) fees for

rotations occurring before the annual report (interim review) audit.

Furthermore, we find significant increases in the reporting lag for both

rotations at the engagement immediately following the rotation (i.e., at

the interim review or the annual report audit) despite audit fees being

11.96% higher on average in rotations occurring before the interim

review relative to the rotations before the annual audit. This suggests

that the difference in audit fee is not driven by the cost of greater

auditor effort, but rather the pricing effect reflects relative client–audi-

tor bargaining power. Thus, our main contributions are to highlight that

the costs of partner rotation are not always immediately passed on to

clients, and documenting that relative bargaining power influences the

ability of the auditor to recoup the costs of rotation. One interpreta-

tion of our results is that planned rotations appear to maintain client

satisfaction, allowing the auditor to recoup the costs of rotation, while

poorly managed rotations result in further costs to the auditor from

discounting fees for more economically important clients.

This paper contributes to the literature on the assurance of

interim financial statements by examining how audit firms manage

client and partner relationships across interim and annual reports to

provide new insight into audit market structure. Current research on

interim assurance has predominately taken the perspective of clients

investing in greater assurance levels (Bédard & Courteau, 2015;

Ettredge, Simon, Smith, & Stone, 1994, 2000; Haw, Qi, & Wu, 2008;

Krishnan & Zhang, 2005). We find that the interim review lag is signif-

icantly shorter than the annual audit lag by almost 13 days, which is

consistent with auditing standards requiring significantly less

assurance on an interim review.

The remainder of the paper is structured as follows. Section 2

provides background information on the institutional setting, reviews

the previous literature, and develops the hypotheses. Section 3

describes the research method and sample. Section 4 reports the

results, and Section 5 concludes.

2|LITERATURE REVIEW AND HYPOTHESIS

DEVELOPMENT

2.1 |Institutional setting

Companies listed on the ASX must disclose half‐yearly and annual

financial statements as material price‐sensitive announcements. The

half‐yearly financial statements are mandated periodic disclosures that

report on the first six months of the financial year. Half‐yearly reports

are governed by AASB 134 Interim Financial Reporting, which requires

the preparation of condensed financial statements. Quarterly financial

statements are not mandated in Australia.

2

The disclosure of the half‐yearly financial statements must

also include the interim review report.

3

Reviews offer a lower level of

assurance than an audit. ASIC describes an audit opinion as expressing

whether the financial statements are prepared in accordance with the

financial reporting framework and are free from material misstatement.

In contrast, a review expresses whether anything has come to the

auditors' attention that signals the financial statements are not prepared

in accordance with the financial reporting framework.

4

Krishnan and

Zhang (2005) summarize the differences between a review and an audit

as providing negative and positive assurance on misstatements

respectively.

The Australian Auditing and Assurance Standards Board has differ-

ent standards on reviews for assurance practitioners who are (ASRE

2410 Review of a Financial Report Performed by the Independent Auditor

of the Entity) and who are not (ASRE 2400 Review of a Financial Report

Performed by an Assurance Practitioner Who is Not the Auditor of the

Entity) the auditorof the entity. The underlying rationale is that an assur-

ance practitioner performing a review, who is not the auditor, may be

less knowledgeable about the entity and should perform more tests to

reach the same level of limited assurance. ASRE 2400 suggests, but does

not require, that more procedures are performed by the assurance prac-

titioner to obtain understanding, such as reading documentation and

considering significant risk (e.g., material weakness in internal control).

However, we do not know how much time a review takes relative to

an audit, and this is further complicated as audit planning and testing

of internal controls would likely have benefits for both engagements.

The Corporate Law Economic Reform Program (Audit Reform and

Corporate Disclosure) Act of 2004 (Commonwealth of Australia, 2004)

requires the mandatory rotation of audit partners every 5 years. Indi-

viduals cannot be the audit or review partner in the audit of a listed

entity for more than five successive years, or for more than five out

of seven successive years. As regulators in Australia require partner

sign‐off data on both interim reviews and annual audits, unlike in the

USA or Canada, Australia is a strong institutional setting to examine

the effect of audit partner rotation timing.

2.2 |Literature review

Prior literature studies include both the benefits and costs of audit

partner tenure and audit partner rotation. In an Australian setting,

GROSSE ET AL.215