The perceived financial effects of mandatory audit firm rotation

• Published date: 01 June 2020
• Author: Michael Harber,Phillip De Jager,Ben Marx
• Date: 01 June 2020
• DOI: http://doi.org/10.1111/jifm.12115

J Int Financ Manage Account. 2020;31:215–234.

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wileyonlinelibrary.com/journal/jifm

DOI: 10.1111/jifm.12115

ORIGINAL ARTICLE

The perceived financial effects of mandatory audit

firm rotation

MichaelHarber1

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BenMarx2

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PhillipDe Jager3

© 2020 John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

1College of Accounting, University of Cape

Town, Cape Town, South Africa

2Department of Accountancy, University of

Johannesburg, Johannesburg, South Africa

3Department of Finance and Tax,

University of Cape Town, Cape Town,

South Africa

Correspondence

Michael Harber, College of Accounting,

University of Cape Town, Leslie

Commerce Building, Upper Campus,

Rondebosch, Cape Town 7000, South

Africa.

Email: michael.harber@uct.ac.za

Abstract

This paper explores the perceptions of key audit industry

stakeholders concerning the direct and indirect financial ef-

fects of the implementation of mandatory audit firm rota-

tion (MAFR) in South Africa. Globally, concerns over audit

quality, in response to corporate failures, have resulted in

renewed debate over MAFR as a solution. The European

Union and South Africa have recently ruled in its favor,

while other countries have rejected it on grounds that the

benefits do not exceed the costs. Using structured surveys,

the informed perspectives of experienced auditors, chief

financial officers, audit committee chairs, and equity fund

managers are explored and contrasted. We find that con-

siderable costs will be imposed on audit firms in the form

of “setup and transition costs,” as well as costs incurred to

submit and present competitive tenders to secure appoint-

ment. Although auditors will try to recoup these costs with

fee increases, this will likely not be allowed by the clients,

resulting in a squeeze of audit firm profits. The Big 4 firm

fee premium, relative to non-Big 4 firms, will decrease due

to increased competition. From the clients’ perspective, the

costs will be in the form of audit inefficiency translating

into staff time and disruption, caused by the incoming audi-

tors being less familiar with the complexities of the busi-

ness. We contribute to the literature detailed descriptions

and estimations of the nature and extent of potential cost im-

plications, as expressed by experienced practitioners. The

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INTRODUCTION

This study explores the nature and extent of potential financial costs to audit firms and audit clients

from the adoption of mandatory audit firm rotation (MAFR) regulations in South Africa. Globally,

corporate failures have revitalized the debate on whether the work performed and opinions provided

by auditors are fit for purpose (Casterella & Johnston, 2013; Hay, 2015). Audit regulators are respond-

ing with additional regulations, including MAFR, as a solution to preserve and improve audit quality,

intending to increase public trust. However, the necessity and efficacy of MAFR is contested, with

some claiming that the costs of MAFR do not outweigh the expected benefits (Fontaine, Khemakhem,

& Herda, 2016; Laurion, Lawrence, & Ryans, 2017). In this paper, we extend previous exploratory re-

search by Harber (2016) and Fontaine et al. (2016) to understand in more detail the potential financial

costs of MAFR to the audit firm and to the audit client. An improved understanding of the costs of

MAFR, especially those that are unintended and unexpected, is necessary to better evaluate the desir-

ability of MAFR, as well as mitigate its negative effects. In addition, our South African setting enables

us to contribute to the global debate on auditor rotation while focusing attention on an unintended

consequence of MAFR that is perhaps unique to South Africa: its potential impact on socioeconomic

transformation in the audit industry.

The concept of audit quality is central to the MAFR debate. MAFR limits audit firm appointment

tenure, thereby mitigating the threats to independence that develop between auditor and client over

time. Proponents argue that audit firm rotation, instead of, or in addition to, audit partner rotation,

is needed to prevent “too cozy a relationship” and undue familiarity developing between the auditor

and the audit client, thereby safeguarding the independence of the auditor and promoting a high level

of audit quality (Aschauer & Quick, 2018). Compromised auditor independence impairs audit and fi-

nancial reporting quality (Knechel, 2016), which then reduces investor and stakeholder confidence in

the financial performance and position of the audit client. This confidence is necessary for the proper

functioning of capital markets, as it lowers the perceived risks inherent in financial decision-making

(Firth, Rui, & Wu, 2012). High-profile financial scandals have resulted in auditors being accused of

lacking the requisite degree of independence and professional skepticism to prevent, detect, or “blow

the whistle” on corrupt or negligent behavior (Ball, Tyler, & Wells, 2015). This criticism of auditors

and the loss of confidence in their work, where auditors fall short of societal expectations, is a further

sign of the growing distrust of the audit function and the expectation gap phenomenon (Porter, Ó

hÓgartaigh, & Baskerville, 2012; The Economist, 2018).

Both MAFR and the more common audit partner rotation seek to preserve auditor independence by

limiting auditor tenure. However, many advocate partner rotations over MAFR as it attempts to “main-

tain auditor independence and bring a fresh look to audit engagements, while maintaining continuity

and overall audit quality” and introducing significantly less “switching costs” (Laurion et al., 2017,

p. 209), thereby achieving a better compromise in a cost–benefit analysis. Therefore, in one sense,

findings inform audit industry regulators, standard-setters,

and practitioners to more effectively mitigate potential un-

intended consequences of the regulation.

KEYWORDS

audit fees, auditing, auditor regulation, auditor rotation, mandatory audit

firm rotation