Mandatory audit firm rotation and prohibition of audit firm‐provided tax services: Evidence from investment consultants’ perceptions

• Author: Ewald Aschauer,Reiner Quick
• Published date: 01 July 2018
• Date: 01 July 2018
• DOI: http://doi.org/10.1111/ijau.12109

ORIGINAL ARTICLE

Mandatory audit firm rotation and prohibition of audit firm‐

provided tax services: Evidence from investment consultants’

perceptions

Ewald Aschauer

1

|Reiner Quick

2

1

Department of Auditing, Accounting and

International Accounting, Johannes Kepler

University Linz, Linz, Austria

2

Department of Accounting and Auditing,

Faculty of Business and Economics, Technical

University Darmstadt, Darmstadt, Germany

Correspondence

Ewald Aschauer, Department of Auditing,

Accounting and International Accounting,

Johannes Kepler University Linz,

Altenbergerstraße 69, 4040 Linz, Austria.

Email: ewald.aschauer@jku.at

The European Union has discussed and recently implemented both audit‐firm instead of audit‐

partner rotation and a restriction against audit‐firm‐provided tax services in order to improve

auditor independence and audit quality. This study provides experimental evidence of the effects

of the rotation system, the impact of audit‐firm‐provided tax services, and, for the first time, the

interplay between both regulatory measures. Based on the assessments of 140 professional

investment consultants from credit institutions, the results show that an audit‐partner rotation

regime which allows audit‐firm‐provided tax services generates the lowest assessments of

auditor independence and audit quality. While investment consultants view both audit‐firm

rotation and a prohibition against audit‐firm‐provided tax services as beneficial, the joint imple-

mentation of a prohibition against audit‐firm‐provided tax services and audit‐firm rotation leads

to no additional benefits in either the appearance of independence or the perceived audit quality.

Besides the theoretical contribution, we discuss the practical implications of our findings, in

particular that more regulation does not automatically lead to higher audit quality.

KEYWORDS

audit firm rotation,audit quality, audit‐firm‐providedtax services, experiment, independence in

appearance

1|INTRODUCTION

External auditing services are key contributors to financial stability,

trust, and market confidence, constituting control mechanisms to pro-

tect shareholders and investors from agency risk (Newman, Patterson,

& Smithe, 2005). The purpose of an audit is to raise the credibility of

financial reports by verifying the accounting information management

has prepared (Watts & Zimmerman, 1986). This function can only be

fulfilled through audits of adequate quality. According to the generally

accepted definition of DeAngelo (1981b), audit quality is the market‐

assessed joint probability that a given auditor will both (a) discover a

breach in the clients’accounting system (perceived auditor compe-

tence), and (b) report the breach (perceived auditor independence).

Major accounting scandals (e.g., Enron, Parmalat, Ahold, Comroad)

and the worldwide financial crisis have raised serious doubt about

whether traditional audits suit this purpose and whether audit

regulations require improvement. One prominent discourse in auditing

research argues that rotating audit firms instead of partners and

prohibiting audit firms from providing tax services are needed to

sustain a high level of audit quality (e.g., Gavious, 2007; Moore,

Tetlock, Tanlu, & Bazerman, 2006). Although the debate on the role

of auditor rotation and the provision of tax services has lasted more

than four decades (e.g., Metcalf Report, 1986/1977), these policy

issues remain highly topical. The US Government Accountability Office

(GAO) called for more research on auditor rotation after the enactment

of the Sarbanes Oxley Act (GAO, 2003), and it investigated the impact

of audit‐firm‐provided tax services (GAO, 2005) on audit quality and

independence in appearance. Furthermore, the Public Company

Accounting Oversight Board (PCAOB) has concluded that it is

appropriate to consider the impact of auditor‐provided tax services

on independence (PCAOB, 2004), adopting rules for such provision

(PCAOB, 2005).

1

Recently, the PCAOB once again raised the question

of the need for mandatory audit‐firm rotation, issuing the concept

release on auditor independence and rotation (PCAOB, 2011).

In April 2014, the European Parliament endorsed a new regulation

on the statutory audits of public‐interest entities, one which is directly

applicable, which means it does not need to be implemented in

national law. It prohibits the provision of specific nonaudit services

Received: 19 September 2016 Revised: 1 November 2017 Accepted: 3 November 2017

DOI: 10.1111/ijau.12109

Int J Audit. 2018;22:131–149. © 2018 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 131

(NASes), such as tax services, known as the “black list”(Article 5).

Under certain conditions, member states can choose to diverge from

the list of prohibited NASes and permit some selected tax and valua-

tion services, but they may also prohibit additional NASes. Most

member states (e.g., Austria, Belgium, Germany, Denmark, Spain, and

Ireland) decided to allow certain audit‐firm‐provided tax services;

namely, the preparation of tax forms, the identification of public subsi-

dies and tax incentives, and the provision of tax advice. The provision

of non‐blacklist NASes is subject to the approval of the audit commit-

tee. Additionally, nonaudit fees are capped at 70% of the audit fee,

based on a 3‐year average (Article 4). Furthermore, the regulation

requires mandatory audit‐firm rotation after 10 years, though member

states may set a maximum duration of less than that. Furthermore,

member states may extend the maximum duration to 20 years when

a public tendering process for the statutory audit is conducted and

may extend the maximum duration to 24 years when joint audits are

performed (Article 17). The new legislation became applicable in mid‐

2016 (EU, 2014); however, its implementation is characterized by long

transition arrangements.

2

Prior research has left significant ambiguity regarding the impact

of audit‐firm rotation and audit‐firm‐provided tax services on auditor

independence and the audit quality of public‐interest entities (e.g.,

Quick, 2012). Furthermore, no experimental investigation of their joint

effects on auditor independence in appearance and perceived audit

quality has thus far been conducted. This is rather surprising, since

theoretical arguments do not necessarily suggest additional benefits

from joint implementation. First, a ceiling effect might occur. Negative

effects on auditor independence induced by audit‐firm tenure and the

provision of tax services by the audit firm might be fully alleviated by a

single regulatory measure. For example, audit‐firm rotation reduces

adverse economic incentives regarding auditor independence by

mandatorily capping future quasi‐rents, leading to a control mechanism

by the succeeding audit firm that might mitigate the adverse economic

effects of audit‐firm‐provided tax services on auditor independence in

appearance. The effects on auditor expertise also possibly offer a

restraint to the additive effects on audit quality of the joint implemen-

tation of both measures. Since prior theory (Arrunada & Paz‐Ares,

1997; Warming‐Rasmussen & Jensen, 1998) suggests that audit‐firm

rotation leads to lower auditor expertise, audit‐firm‐provided tax

services might, in an audit‐firm‐rotation setting, advantageously offer

auditors a higher level of client‐specific expertise, as they have more

frequent contact with and better insights into the client's business.

On the other hand, under audit‐partner rotation, which already

ensures better transfer of knowledge from the client to the auditor

than audit‐firm rotation does, the knowledge effects from audit‐firm‐

provided tax services will not lead to significant improvement. While

the application of only one regulatory measure might alleviate negative

knowledge effects, the application of both regulatory measures could

cause an even higher loss of expertise if a degressive learning curve

exists. This raises concern that implementing both regulatory measures

together will not be beneficial.

We use an experimental design that previous auditing research

has well established (Gul, 1991; Kaplan & Mauldin, 2008; Libby &

Kinney Jr, 2000). In a 2 × 2 between‐subjects experiment, the rotation

system and the provision of tax services by audit firms are manipulated

to investigate the perceptions of auditor independence and audit

quality by professional investment consultants at banks. Our results

indicate that auditor independence in appearance improves with a

ban on tax services, while the rotation system does not significantly

affect auditors’independence in appearance. Likewise, audit quality,

as perceived by investment consultants, improves with a restriction

on audit‐firm‐provided tax services, while the rotation system does

not to a significant extent. The implementation of both regulatory

measures improves neither auditor independence in appearance nor

perceived audit quality, compared with the implementation of a single

measure. Auditor independence in appearance improves with the pro-

hibition of audit‐firm provided tax services, while audit firm rotation

does not exert a significant effect. Interestingly, while both regulatory

measures individually improve the assessment of audit quality, we find

no additional evident effect of joint implementation on audit quality, a

finding we attribute to a degressive learning curve and a ceiling effect.

Our findings show that investment consultants consider not only audi-

tor independence but also other factors (e.g., auditors’client‐specific

expertise) when assessing audit quality. Given that high audit quality

is the ultimate objective of regulators in general and EU regulators in

particular, our results show that stricter regulation would not lead to

additional benefits beyond balanced regulation, although it would have

higher costs.

The present work contributes to scientific discourse and practice

in several ways. First, we provide experimental evidence of the useful-

ness—in terms of enhancing perceptions of auditor independence and

audit quality—of two important regulatory measures that the EU has

jointly implemented. The long lag of time between the implementation

and legal enforcement of audit‐firm rotation and the possibility that EU

member states can continue to permit audit‐firm‐provided tax services

provide ample reason to try to anticipate possible effects of the ongo-

ing regulatory debate in the EU. To the best of our knowledge, this

paper is the first to formulate and investigate research questions on

the interaction effects between audit‐firm rotation and tax advisory

services. By revealing that regulators must not only focus on auditor

independence (in appearance) but must also balance regulatory

measures to raise perceptions of audit quality among professional

investors, our findings offer new evidence and direct implications for

regulators and indirect implications for investors, who can choose

different global jurisdictions to invest. Second, while prior experimen-

tal research has mainly investigated nonprofessional investors (i.e.,

student subjects) and archival studies have examined the perceptions

of institutional investors, our study uses professional subjects from

an important group using financial statements, a group which prior

research has neglected. Since other investors pay for the advice and

follow the suggestions of investment consultants in their investment

decisions, we expect the perceptions of investment consultants to trig-

ger multiplier effects. Third, prior research on this topic—the impact of

audit‐firm‐provided tax services and the rotation system on indepen-

dence in appearance and perceived audit quality—has mainly been

conducted in the USA and other Anglo‐Saxon countries, with results

that are not fully generalizable to different settings. There is a lack of

research regarding continental European countries. We conducted

our analysis in Austria, thus narrowing this gap. This environmental

setting has particular interest, for two reasons: (1) Austria implemented

132 ASCHAUER AND QUICK