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Abstract
The Indonesian regulators have made it compulsory to
rotate the appointments of public accountants every 3
years and the appointment of public accounting firms
every 5 years, since the end of 2002. The purpose of this
study is to investigate the effects of auditor rotation and
audit tenure of the public accountant and the public
accounting firm, on audit quality (before and after the
implementation of the mandatory auditor regulation). The
results do not support that mandatory auditor rotation
increases audit quality or that a shorter audit tenure (both
partner and firm level) increases audit quality. Regulators
may need to consider revising the regulation (i.e. related to
maximum years allowed for auditor to audit their client)
and/or introduce other regulations to increase audit
quality.
1. Introduction
*
Corresponding author. Sylvia Veronica Siregar is a Lecturer at the Faculty of Economics,
Universitas Indonesia, Depok, Indonesia, e-mail: sylvia.veronica@ui.ac.id. Fitriany
Amarullah is a Lecturer at the Faculty of Economics, Universitas Indonesia, Depok,
Indonesia, e-mail: fitri_any@yahoo.com. Arie Wibowo is postgraduate student at Graduate
Program in Accounting, Faculty of Economics, Universitas Indonesia, Depok, Indonesia, e-
mail: ariewibowo@gmail.com. Viska Anggraita is a Lecturer at the Faculty of Economics,
Universitas Indonesia, Depok, Indonesia, e-mail: viskaviska257@yahoo.co.id
least once every five years. In the UK, audit partner rotation has been a
requirement for many years, and in January 2003, the maximum period
for rotation of the lead partner was reduced from seven to five years.
Requirements for audit partner rotation also have been adopted in the
Netherlands and Germany. In Japan, beginning from April 2004, audit
partners and reviewing partners were prohibited from being engaged in
auditing the same listed company over a period of seven consecutive
years (Chen, Lin, & Lin, 2008).
Regardless of the debate surrounding audit firm rotation, this
audit firm rotation rule was introduced in a few countries (Comunale &
Sexton, 2005; Cameran, Di Vincenzo, & Merlotti, 2005). Italy has adopted
mandatory audit firm rotation, while Brazil has adopted mandatory
audit firm rotation for banks and listed companies. Several Asian
countries have adopted mandatory adoption too. South Korea requires
mandatory auditor firm rotation for companies listed in KSE (Korean
Stock Exchange) or registered with KOSDAQ (Korea Securities Dealers
Automated Quotations) every six years (starting in 2006). Exceptions are:
1) foreign-investment companies, which are subsidiaries of foreign
parent companies as defined by the laws of that country and which
intend to appoint the same auditors as the parent and 2) companies
listed on foreign exchange (NYSE, NASDAQ, and London Stock
Exchange only). Singapore has adopted a similar requirement for banks
from March 2002. The Monetary Authority of Singapore requires that
banks incorporated in Singapore should not appoint the same public
accounting firm for more than 5 consecutive financial years. This
requirement does not apply to foreign banks operating in the country.
India also requires mandatory auditor rotation every 4 years for banks,
privatised insurance companies, and government companies. Austria,
Spain, Canada, Slovakia, and Turkey adopted mandatory audit firm
rotation but have since eliminated their requirements. Ireland considered
and rejected a policy of mandatory audit firm rotation. Table 1 shows
countries in Asia that have adopted mandatory audit firm and partner
rotation.
In the case of Indonesia, collapses of many companies and banks
during the Asian crisis in 1997-1998 have also raised concerns about the
poor audit quality associated with a perceived lack of auditor
independence. Only a few months after the enactment of the Sarbanes-
Oxley Act in July 2002 in the U.S., in September 2002, the Indonesian
Finance Minister signed a Decree on Public Accountant Services (Finance
Minister Decree No. 423/KMK.06/2002). This decree mandates auditor
partner rotation for three years and audit firm rotation for five years.
This decree was revised with the PMK No. 17/PMK.01/2008 where
restrictions on the provision of services of audit firms was changed to a
Table 1: Countries in Asia that have Adopted Mandatory Audit Firm and
Audit Partner Rotations
Country Mandatory audit firm rotation Mandatory audit partner rotation
Bangladesh Yes - every 3 years for listed Yes - every 3 years for listed companies
companies
China Yes - every 5 years for Yes - every 5 years for all listed companies
government state-owned
companies
Hongkong No Yes - every 5 years for all listed companies
India Yes - every 4 years for banks, Yes - every 4 years for banks, privatised
privatised insurance companies insurance companies and Government
and Government companies companies
Indonesia Yes - every 6 years for all Yes - every 3 years for all companies
companies
Japan No Yes - every certain period within 7 years
for listed companies
Malaysia No Yes - every 5 years for listed companies
and public interest entities
Pakistan Yes - every 5 years for listed Yes - every 5 years for listed companies
companies
Philliphines No Yes - every 5 years for listed companies
and bank
Singapore Yes - every 5 years for local bank Yes - every 5 years for listed companies
Srilanka No Yes - every 5 years for listed companies
South Korea Yes - every 6 years for KSE listed Yes - every 6 years for KSE listed
companies or KOSDAQ companies or KOSDAQ registered except
registered except foreign- foreign-invested companies and/or listed
invested companies and/or listed on foreign exchange
on foreign exchange
Taiwan No Yes - every 5 years for listed companies
Thailand Yes - every 5 years for listed Yes - every 5 years for listed companies
companies
partner tenure. Fanny & Siregar (2007) examine both audit firm and
audit partner tenure and rotation. They find that audit firm rotation
increases discretionary accruals but audit partner rotation does not have
significant effects; whereas both audit firm tenure and audit partner
tenure are associated with lower discretionary accruals. This study adds
to existing literature in Indonesia by examining non-linear relationships
between audit partner and audit firm tenure and audit quality.
Both proponents and opponents of mandatory rotation have
their own arguments with evidence to support them. Proponents of
mandatory rotation (Catanach and Walker, 1999; Johnson et al., 2002;
Crabtree, 2004; Chen et al., 2008) argue that it will prevent long-term
auditor-client relationships that could impair independence and
objectivity. Over time, auditor’s incentives shift toward maintaining and
profiting from the client and auditors become less concerned with
litigation relating to client. Auditors become less objective and apply less
effort toward the detection of material misstatements. They propose that
mandatory rotation would bring a “fresh look” at firm’s financial
statements which might increase the likelihood that the auditor will
uncover misstatements and/or challenge questionable accounting
practices. Rotation could lead to audit innovations that allow auditors to
audit new clients more efficiently. If the tenure period were limited,
auditors also would have greater incentives to resist management
pressures (AICPA, 1992, 1–2). Finally, supporters of rotation suggest that
it would foster a more competitive market.
Opponents of auditor rotation argue that mandatory auditor
rotation increases audit start-up costs and increases the risk of audit
failure because new auditors must rely more heavily on management
estimates and representation in the initial years of an audit engagement
(Myers et al., 2003). As auditor tenure increases, the auditor learns more
about the client and its business processes, allowing the auditor to
reduce reliance on management estimation and representation, resulting
in a more effective audit (Crabtree, 2004). In addition, new auditors will
not have the benefit of client-specific knowledge of a previous auditor
(GAO, 2003), and this weakens the effectiveness of the audit process (Lu
& Sivaramakrishnan, 2009). Another argument against mandatory
rotation (Catanach and Walker, 1999) is that the predecessing auditors
will not be able to transfer their knowledge of the client, its accounting
system, and market to successors, and this “value is destroyed by
rotation”. Managements tend to be opposed to mandatory auditor
rotation because they face potentially disruptive, time-consuming, and
expensive processes of selecting new auditors, and familiarising them
with the organisation’s operations, procedures, systems, and industry
(AICPA, 1992). Another concern is that new auditors may not have the
industry expertise or may not possess the same level of firm specific
knowledge required to audit a new client effectively (Dunham, 2002).
Based on two arguments above, the relationship between audit
tenure and audit quality can be depicted as follows:
3. Research Method
Whereas:
Table 2 presents descriptive statistics for both periods i.e. before and
after mandatory auditor rotation regulation. The mean of DAC after
mandatory auditor rotation (0.0640) is smaller than periods before
(0.1151). Audit tenure, for both audit partners and audit firms, is shorter
for the periods after. PTENURE and FTENURE have high standard
deviations because of auditor switching for several firms, especially large
ones, and in certain industries they are not always easy. They may need
specialised auditors and more auditor resources in terms of audit staff
force, to audit their financial statements. Hence, this condition makes
PTENURE and FTENURE longer in some firms but shorter for other
firms, resulting in a high standard deviation. Auditor rotation also
increased due to the effect of the regulation. After the implementation of
the regulation, fewer firms were audited by the BIG4. This is a
consequence of the regulation, which reduced the market share of the
Big 4 accounting firms.
Regression results for periods before and after the mandatory
auditor regulation are presented in Table 3. From regression results in
Panel A and Panel B of Table 3, we can see that hypotheses 1a and 1b
regarding non linear relationships between auditor tenure (both for
audit partner and audit firm) are not supported. AUDIT PARTNER
TENURE has a negative significant relationship with discretionary
accruals for the period before mandatory auditor rotation regulation, but
it has a positive significant relationship for the period after. These
findings indicate that before auditor rotation became mandatory, longer
audit partner tenure was associated with higher audit quality (lower
discretionary accruals), whereas after auditor rotation became
mandatory, a longer audit partner tenure became associated with lower
audit quality. There is no significant relationship between AUDIT FIRM
TENURE and discretionary accruals for the period before auditor
mandatory regulation, but there is a positive relationship for the period
after. The positive result for audit firm tenure is consistent with audit
partner rotation result as well.
LEV and SIZE are the only control variables which have
consistent results as predicted. These findings are consistent with the
‘debt covenant’ hypothesis and the ‘political cost’ hypothesis. SPEC only
has negative effects on discretionary accruals (positive effect on audit
Asian Journal of Business and Accounting, 5(1), 2012 69
Sylvia Veronica Siregar, Fitriany Amarullah, Arie Wibowo and Viska Anggraita
quality) in the period before the regulation. This may be due to the
existence of other new regulations besides mandatory auditor rotation
that enhance quality such as the adoption of IFRS convergence, so it will
mitigate SPEC’s effect on audit quality. Firms audited by the BIG4 had
lower discretionary accruals than firms audited by non Big 4 accounting
companies only in the years after the regulation. because in that period a
firm had to hire a new public accounting firm after 5 years, and the BIG
4 had better resources, human capital, and quality than the non Big 4 in
the first year assignment, despite the familiarity effect. GROWTH,
however, had inconsistent results between both periods. This maybe
because the proxy we chose (PBV) was not the best proxy for growth.
Market value may include such subjective elements as analyst views and
speculation and book value may depend on subjective estimation of
assets (Kogan & Papanikolaou, 2010).
Overall results show evidence more consistent with opponents
of the ‘auditor rotation’ arguments. Although there is evidence that
longer audit tenure results in lower audit quality for the period after
mandataory auditor rotation, this relationship does not hold for the
period before mandatory auditor rotation; and the results also show that
auditor rotation after the regulation was enacted do not have positive
effects on audit quality. These findings suggest that extended auditor-
client relationships seems to increase audit quality, which may stem
from the fact that as auditor tenure increases, the auditor learns more
about their client and the client’s business processes, which results in a
more effective audit (Crabtree, 2004). Also, new auditors may not have
the industry expertise or may not possess the same level of firm specific
knowledge required to audit a new client effectively compared to old
auditors (Dunham, 2002).
5. Conclusion
Our results show that longer audit tenure became associated with lower
audit quality for the period after mandataory auditor rotation, but
conversely for the period before it became mandatory, longer audit
tenure increased audit quality. The results also show that auditor
rotation before regulation (voluntary rotation) did increase audit quality,
whereas mandatory auditor rotation does not show having positive
effects on audit quality. Overall, we do not find strong evidence to
support the notion that the existing mandatory auditor rotation is
effective to increase audit quality. The conflicting results are probably
due to the low law enforcement in Indonesia. Besides, there is a loophole
in the rotation regulation that allows audit firms to do quasi rotation.
Further research about audit rotations can examine the effect of quasi
and rill rotation on audit quality. The evidence suggests that the
regulator may need to examine whether the negative effect of auditor
tenure on audit quality may become positive if the regulator changes the
maximum years allowed for an auditor to audit their clients and/or
develops other mechanisms to increase audit quality and also to
maintain auditor independency.
There are several limitations to this study. First, we only used
discretionary accruals as a proxy of audit quality. Further studies may
use another proxy for audit quality or use several proxies for audit
quality. Second, we have not examined the relationship between audit
tenure and auditor rotation on audit quality for each industry. Third, we
have not considered corporate governance variables as a variable that
may affect the relationship between audit tenure and auditor rotation
with audit quality.
The results of these findings can be a valuable input for
regulators to reconsider the rules of the rotation in Indonesia. The
decline in audit quality following the rules of rotation indicates the need
for other mechanisms created by the institutions of public accountants
Indonesia (IAPI) such as peer review and effective training to improve
the competence of auditors. The other implication is the desirability of
enriching Indonesia’s literature on the relationship between the auditor
rotation, audit tenure, and audit quality in the context of developing
countries, and supporting future possible research.
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