What Is Audit Rotation? Why Should Managers Rotate The Auditor Firm?

The auditor conducts the audit to examine the accounting records, financial statements, and other non-financial procedures within a business entity. As defined by L.R. Dicksee, the audit examines accounting records to make an opinion if the records completely and accurately represent the transactions that actually took place.

An audit’s primary objective is to get an independent view of the fairness of financial statements and observe compliance with prescribed laws and accounting policies. The secondary objectives of auditors also include detection and prevention of errors and frauds.

Since the independent view is the most critical aspect of audit evaluation, external independent audit firms audit business entities. They charge an audit fee to the client and provide their services. However, if the same audit firm gets hired repeatedly, it can impact the audit report and judgment.

Wondering how?

The opponents of hiring the same audit firm claim a familiarity risk when an audit of the same company for years over the years. Sometimes, the auditors give poor judgments on the fairness of the statements to satisfy their clients and get hired again. Therefore, skepticism about repeatedly hiring an audit firm exists among the audit stakeholders.

However, the internal regulatory bodies introduce the practice of audit rotation to maintain the independence of audit. What is audit rotation, and why should managers rotate the auditors more often? This article will answer all your questions. Let’s get into it.

What Is Audit Rotation?

In the simplest terms, audit rotation can be explained as changing the audit firm or auditors after a certain period. The audit rotation can be formally defined as,

After many consecutive audit assignments given to the same audit firm or auditor, the company might appoint a different audit firm or auditor to perform an audit. The practice of changing audit firm or the auditor is called audit rotation.

In principle, the audit rotation can be segregated into two types of rotation:

  • Rotating the audit firm
  • Rotating the audit partners

Rotating The Audit Firm

Rotation of audit firm signifies that the tender for audit is given to another audit firm, and the previous audit firm is replaced.

Rotating The Audit Partners

A more practical practice for audit rotation is rotating the audit partners. The senior audit staff or head of audit teams are replaced in an audit partner rotation, keeping the same audit firm.

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Why Should Managers Rotate Auditors: A View From Audit Quality Perspective

We have defined what an audit rotation is. Let’s answer the question that why should managers rotate auditors more often?

 Since independence is the cornerstone of auditing practices, managers should analyze the audit reports and professional judgments skeptically. If found necessary, the auditors must be rotated to ensure the independence of the audit judgment.

Many proponents of the audit rotation present another argument favoring the audit rotation. They propose that the audit rotation improves the quality of the audit. However, the opponents of audit rotation argue that audit quality can be enhanced by other practices.

Let’s analyze how audit quality is improved or diminished by the frequent audit rotation.

Different research studies have discussed the relationship of auditor independence with audit quality. Most of the studies have shown a positive relationship between the two. The audit quality is defined as the probability that the auditor will reliably identify and evaluate the mistakes & errors in the records of the company and report them in the findings.

 A study was conducted to find the impact of voluntary audit rotation on audit quality in many firms. The findings suggest that the rotations at the audit partner level increase the audit quality. On the other hand, the audit firm rotations negatively impact the audit quality. Another study was conducted to find the correlation between the years of client-auditor engagement and the number of errors. The findings suggested an increase in the number of errors with increasing years of client-auditor engagement.

However, the different research studies conducted show a mixed point of view on the audit firm rotation and audit quality.

The opponents of the audit firm rotation present other ways to enhance the audit quality as,

  1. The company should perform independent quality control reviews to assess the independence of audit firms and audit teams.
  2. Improving the quality controls and governance mechanisms of the audit firms
  3. Inspection and skeptical oversight of audit firm performance and independence.

Benefits Of Audit Rotation

Based on the research studies, international practices, and regulations, the audit rotation at firm level or partner-level has the following reported benefits for all stakeholders:

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Increased Independence

When a business entity adopts the practice of audit rotation, it significantly improves the auditor’s independence. Various studies have discussed the impact of auditor tenure and audit rotation on the auditor’s opinion. Most of the studies found a positive relation of audit quality with audit rotation. The benefits of auditor rotation are based on familiarity risk mitigation.

Better Objectivity

Objectivity is the unbiased mental attitude that helps the auditors perform the audit engagements to give an independent judgment. When the audit firms or partners are rotated, they are unbiased to give a compromised opinion about the financial statements. As a result, the objectivity of an audit is not hurt during the process.

Fresh Eyes And Fresh Perspective

When the audit firms are rotated frequently, the new auditors engage in the audit process. The new eyes and fresh perspective on a business entity’s financial and non-financial records lead to a more independent and fair judgment.

Enhanced Audit Quality

There is strong evidence on how the firm audit rotation tends to increase the audit quality of a business entity. Besides, all the benefits discussed above positively relates to audit quality. Therefore, it can be said that the audit rotation leads to better audit quality.

Demerits Of Audit Rotation

There are many demerits of audit rotation too.

Increased Costs Of Audit

When an audit firm frequently rotates the audit, it increases the audit costs as well as the time to conduct an audit. When the same audit firm is hired repeatedly, they have a perspective, information, and understanding of its internal controls and checks. The audit costs significantly reduce over time if the same firm is hired.

However, a new firm hiring requires additional costs as the new firm has no understanding of the company’s internal procedures. Therefore, more rigorous activities will be needed to perform the audit, which requires more time and financial resources as well.

Steeper Learning Curve

As discussed, the new firm and auditors have no information regarding the company. They will need more time, effort, and resources to familiarize themselves with the internal control procedures, environment, checks, and systems. Therefore, frequent rotation of audit firms will have a steeper learning curve for the auditors.

Potential Opportunities For Opinion Shopping

A lot of research studies have conducted the impact of audit rotation on the opportunities of opinion shopping. An American study found that 54% of the auditor dismissals were signaling towards the opportunities of opinion-shopping. The opinion-shopping practice hurts the audit quality and auditor’s independence. However, the studies are focused on the mandatory audit firm rotation.

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What is mandatory audit rotation?

The mandatory audit rotation implies that the business entities are bound to rotate the audit firm or audit partners after a specific interval of time as prescribed in the law and regulations. The purpose of mandatory audit rotation is to ensure and reinforce auditor independence and overall audit quality. The new auditors have no previous ties or relationships with the business entity. Therefore, the risk of bias and familiarity risk is mitigated by this practice.

Which countries have mandatory audit rotation?

Brazil, Iceland, Italy, Pakistan, Spain, and Peru follows the mandatory audit firm rotation. The countries that follow the mandatory audit partner rotation include Australia, China, Denmark, Finland, France, Germany, Greece, Malaysia, Singapore, United States, and the United Kingdom.

Does audit rotation improve audit quality?

Yes, various research studies, working papers, practical implications, and empirical evidence have shown that the audit quality improves if the rotation is made at the partner level. However, insufficient evidence of audit firm rotation has been found.

How often do you have to change auditors?

Most commonly, the auditors or audit firm should be rotated every five years.

Is audit firm rotation mandatory in the USA?

The Sarbanes-Oxley Act dictates the regulations for the rotation of auditors. The act does not require changing the audit firm for the publicly trading company. However, the lead auditor of the audit team of a publicly-traded company must be rotated every five years. However, there is no implication for the periodic rotation of the auditors in non-profit organizations.

In A Nutshell,

The audit rotation is a very useful and productive practice regardless of which level it is done at. However, the benefits of audit rotation at the partner level are more than those of audit firm rotation. If the pros and cons of audit rotation are compared, the benefits outweigh the demerits. Therefore, the companies must go for voluntary or mandatory audit rotation to enhance auditor independence and audit quality.