raiborn et al - 2006 - should auditor rotation be mandatory

I
n response to the
widespread and
financially devas-
tating business scan-
dals (Enron, Adelphia,
HealthSouth, and
WorldCom, to name
just a few) that took
place during 2001 and
the first half of 2002, Congress
passed the Sarbanes-Oxley Act
(SOX) on July 30, 2002. This act
was designed to address
accounting reform, improve cor-
porate governance, and restore
investor confidence. The depth
and breadth of SOX’s legislative
coverage provide a basis to sup-
port broad reform within the
auditing profession. Within Title
II (“Auditor Independence”) of
the Act is a small, three-para-
graph section that has the poten-
tial to change the way the audit-
ing profession interacts with
client companies.
Section 207 of the Act
required a study of the potential
impacts of requiring mandatory
rotation of audit firms for pub-

licly held companies. In Novem-
ber 2003, the Government
Accountability Office (GAO)
delivered the results of this study
to the Senate Committee on
Banking, Housing, and Urban
Affairs and to the House Com-
mittee on Financial Services.
This article discusses the study
and several audit firm/client
company issues related to the
potential for mandatory rotation.
AUDITOR INDEPENDENCE
Although the first audit cer-
tificate was issued in 1903 for
financial statements of U.S.
Steel Corporation, it was not
until early 1934 that a booklet
titled Audits of Corporate
Accounting was published
(Davidson & Anderson, 1987).
Then, Section 12 of the Securi-
ties and Exchange Act of 1934
required registered firms to have
their financial statements audit-
ed by an independent public
accountant: “The auditor was to
be an independent overseer of
the integrity of information pro-
vided to the capital markets, and

this role was granted as a public
trust to the profession”
(Hunt, 1997).
The concept of
auditor independence
has always consisted of
two parts: indepen-
dence in fact and inde-
pendence in appear-
ance. Independence in
fact reflects a state of mind,
while independence in appear-
ance reflects an external assess-
ment. Both elements of inde-
pendence must exist: the public
(assuming the reasonable person
standard) cannot perceive that an
auditor or an audit firm is biased
or has conflicting interests with
the client company. If indepen-
dence in appearance is tainted,
the sense of confidence that the
audit opinion was designed to
engender will be diminished.
The financial fiascoes occur-
ring in the new millennium
caused the investing public as
well as Washington lawmakers to
take a long look at the issue of
auditor independence. Although

most audit firms would assert
that both aspects of indepen-
dence are stressed at all person-
nel levels, auditors may find it
difficult to interpret the true pri-
ority parameters if the firm is
sending mixed messages. Audi-
The Sarbanes-Oxley Act (SOX) has brought many
changes. But buried within SOX is a small, three-
paragraph section that could change the face of
auditing. The authors discuss mandatory rotation of
auditors: the pros and cons, how it might work, and
the changes it might bring.
© 2006 Wiley Periodicals, Inc.
Cecily Raiborn, Chandra A. Schorg, and Morcos Massoud
Should Auditor Rotation Be Mandatory?
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© 2006 Wiley Periodicals, Inc.
Published online in Wiley InterScience (www.interscience.wiley.com).
DOI 10.1002/jcaf.20214
tors must attempt to interpret the
rules of professional conduct
within the context of their per-
ceptions about the audit firm’s
objectives relative to client
engagements. Is the audit firm’s
objective to perform the best
audit possible, retain the audit
client company, increase audit
revenues, reduce audit billable
hours, or detect misleading, inap-
propriate, or fraudulent account-
ing practices? Unfortunately,
each of these objectives is rea-
sonable—and yet potentially in
conflict.
For instance, at Arthur
Andersen LLP, independence in
fact was “an ingrained part of the
culture,” but other activities
that could have impacted
independence in appear-
ance were encouraged and
were seemingly “undertak-
en especially to build inter-
dependence with the client”

(Toffler, 2003, pp.
187–188). In the Enron case,
David Duncan (the lead member
of the Andersen audit team for
Enron) and Richard Causey (for-
mer Andersen employee and then
executive VP and chief account-
ing officer at Enron) “were virtu-
ally inseparable. They worked
together, went to lunch together,
and played golf together. Their
families even went on vacations
together” (Squires, Smith,
McDougall, & Yeack, 2003, p. 2).
Other instances that would cause
the questioning of independence
at Arthur Andersen included giv-
ing tickets to the U.S. Open to
clients, buying tables at clients’
favorite charity events, providing
summer employment for clients’
children, and sending a limousine
to take a client and his daughter
to a Yankees game, wait for them,
and return them home to the sub-
urbs (Toffler, 2003, pp. 125, 188).
Sarbanes-Oxley has dramati-
cally changed the relationships
between auditors and client man-
agement. One CFO remarked,

“only half jokingly,” that he didn’t
consider the auditors his “friends
anymore” (O’Sullivan, 2004a).
In an attempt to minimize
the potential for lack of inde-
pendence in appearance (or a
true lack of independence in
fact), Section 203 of SOX stated
that the lead, coordinating, or
reviewing audit partner must be
rotated from an audit engage-
ment every five years. Such a
rotation process was designed to
reduce the possibility that the
audit partner and members of
client management would devel-
op improper, nonindependent
relationships with one another.
However, given that professional
standards already required such a
rotation process, Congress was
not certain that mandated partner
rotation was sufficient to pre-
clude public concerns about audit
firm independence—in either
fact or appearance—from clients.
PARMALAT SpA
The issue of mandatory
auditor rotation has recently
been raised because of numerous

cases of financial misconduct by
firms in the United States. How-
ever, the Italian requirement for
auditor rotation did nothing to
prevent one of the worst finan-
cial scams to date on the Euro-
pean continent at Parmalat SpA,
a multinational dairy food giant.
Prior to the scandal creating
losses of about $10 billion, Par-
malat had been included in the
30 most valuable companies on
the Milan Stock Exchange.
Deloitte & Touche of Italy
served as Parmalat’s primary
auditor between 1999 and Janu-
ary 2004; the Italian rotation
requirement allows an audit firm
to serve as auditor of record for
a maximum of nine years, re-
competing every three years for
the engagement (GAO, 2003).
Grant Thornton SpA rotated out
of the Parmalat engagement in
1999, after serving as the com-
pany auditor since 1990. Accord-
ing to one source, the fraud at
Parmalat started around 1989
when the company went public
and the “auditors never noticed”

(Norris, 2003). At the time
the Parmalat fraud was dis-
covered, Grant Thornton
SpA was auditing “Par-
malat’s offshore assets,
where investigators say the
fraud appears to have taken
place” (Landler, 2003). In
fact, in 2003, Grant Thorn-
ton SpA received approximately
2 percent of its total audit fees
from auditing Parmalat units—
creating a question as to why
Italian rules allow an audit firm
to continue as a secondary audi-
tor after relinquishing its pri-
mary auditor position to another
firm (Babington, 2004). A law-
suit filed by Enrico Bondi, the
new Parmalat chairman, states
that two partners in the now-
former Grant Thornton Italian
affiliate “were active conspira-
tors with Parmalat’s management
in setting up fictitious compa-
nies and structuring fake transac-
tions . . . to siphon off ” Par-
malat’s assets (Norris, 2004).
RESULTS OF THE GAO STUDY
ON MANDATORY AUDITOR

ROTATION
In developing the indepen-
dence provisions of SOX, testi-
38 The Journal of Corporate Accounting & Finance / May/June 2006
DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc.
The issue of mandatory auditor rota-
tion has recently been raised because
of numerous cases of financial mis-
conduct by firms in the United States.
mony to Congress was heard on
the positive and negative impli-
cations of instituting mandatory
rotation of audit firms relative to
client companies. Mandatory
rotation implies that an explicit
limit is placed on the time dur-
ing which a specific audit firm
may be the auditor of record for
a specific client company. The
maximum time limit for the rota-
tion process has not been indi-
cated.
Although the issue of
mandatory audit firm rotation
has previously been investigated
(and rejected) by both the Secu-
rities and Exchange Commission
(SEC) and the Committee of
Sponsoring Organizations
of the Treadway Commis-

sion, the Comptroller Gen-
eral of the United States,
through the auspices of the
Government Accountability
Office, was required under
Section 207 of SOX to per-
form a study about manda-
tory rotation. The GAO reviewed
research studies and documents,
developed and administered sur-
veys to public accounting firms
and appropriate parties in large
public companies, and identified
restatements of financial state-
ments and cross-checked those
with auditor changes. Analyses
were made of the arguments
contained in the GAO studies
and the responses that were gen-
erated. The final report was
issued in November 2003.
Arguments in Favor of
Mandatory Auditor Rotation
Individuals who support
mandatory audit firm rotation
contend that pressures faced by
the incumbent audit firm to
retain the client company could
adversely affect the auditor’s
actions to appropriately deal

with financial reporting issues
that materially affect the compa-
ny’s financial statements. Con-
sider the following simplistic
summary of the cooperative rela-
tionship between auditor and
client: the client corporation
engages in and accounts for
transactions that create the
financial statements; auditors
examine the financial statements
and the underlying data to assess
fair presentation based on the
guidance provided under
accounting rules and standards;
and the desired result of this
process is an unqualified audit
opinion for the client. The fewer
adjustments that need to be
made to the financials and the
more quickly (thus, less expen-
sively) the audit can be per-
formed, the more satisfied the
client company is with its cho-
sen audit firm (and individual
employee auditors), the more
likely it is that the auditing firm
will retain the client and the
individual auditors will have
continued future employment,

and the stronger the auditor-
auditing firm-audit client rela-
tionship becomes. In other
words, “auditors have strong
business reasons to remain in
clients’ good graces and are thus
highly motivated to approve their
clients’ accounts” (Bazerman,
Loewenstein, & Moore, 2002).
A second argument in favor
of mandatory audit firm rotation
is that it would increase the pub-
lic’s perception of auditor inde-
pendence—in other words, the
element of independence in
appearance would be raised.
Such a positive perception was a
conclusion of the Bocconi Uni-
versity Report from Italy, which
has a mandatory auditor rotation
requirement (Arel, Brady, &
Pany, 2005). Prior to the
issuance of SOX, discussions of
the public’s lowered perception
of auditor independence in
appearance typically focused on
the provision of nonaudit servic-
es to client companies. Section
201 of Title II has basically
eliminated that concern. Howev-

er, it is not unrealistic for the
public to be concerned as to the
innate impartiality and objectivi-
ty that should exist between
audit firm and client employees
given the instances of out-
of-office familiarity that
have been made public
during the various corpo-
rate scandals. Mandatory
rotation would provide the
basis for a distancing
between the parties
involved.
A third reason in favor of
mandatory rotation is that it
would allow audit firms to be
more vocal about disagreeing
with questionable client prac-
tices. Knowing that a client com-
pany would only “belong” to the
audit firm for a limited period of
time, the firm would not be risk-
ing a perpetual revenue stream
by agreeing to overly aggressive
practices, deterring questionable
judgments, or taking compro-
mise positions on recording
business transactions (Confer-
ence Board, 2003, p. 34).

A fourth reason in favor of
mandatory rotation is that it
would, to a limited extent, help
level the playing field for audit
firms. The SOX partner rotation
and five-year “time out” require-
ments are “tantamount to firm
rotation” for the smaller firms
that are “not large enough to
have a substantial number of
The Journal of Corporate Accounting & Finance / May/June 2006 39
© 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf
A second argument in favor of
mandatory audit firm rotation is that
it would increase the public’s
percep-
tion
of auditor independence…
partners available to rotate”
(American Institute of Certified
Public Accountants [AICPA],
2003). Essentially forcing firm
rotation among smaller firms
provides a distinct advantage to
the larger public accounting
firms that have the partnership
personnel available for rotations
into engagements. Thus, manda-
tory rotation puts all audit firms
on some degree of level footing

and could encourage smaller
firms to grow and develop niche
specializations that would allow
greater competition with the Big
Four.
Fifth, some individuals
believe that the costs associated
with mandatory rotation would
be less than the costs associated
with audit failures. For example,
Morgan Stanley estimates that
the increased cost of mandatory
rotation would be approximately
$1.2 billion per year, versus the
$460 billion loss in market capi-
talization caused by the failures
of Computer Associates, Enron,
Quest, Tyco, and WorldCom
(Healey, 2004). The increase was
calculated using $10 billion of
audit fees in 2000 for the (then)
Big Five, a 30 percent increase
in audit fees for the first two
years, and a rotation period of
every five years.
Finally, knowing that another
audit firm would, at some specif-
ic future time, be reviewing the
financial statement judgments
made by the current audit firm

would simultaneously create
some internal pressure to be less
amenable to potential client
manipulations. The successor
audit firm would bring “fresh
eyes” and limited “relationship
baggage” to the engagement—
new brooms to sweep away any
financial statement fictions that
may have been overlooked,
ignored, encouraged, or acqui-
esced to by a predecessor audit
firm. Awareness that the succes-
sor auditor might readily identify
the lapses of a predecessor audi-
tor could reduce the possibility
of overlooking accounting irreg-
ularities or signing off on con-
troversial accounting procedures;
obviously, a continuing auditor
would be less likely than a new
auditor to reverse an accounting
position taken in a prior year on
a client’s accounting transac-
tions.
The arguments in favor of
mandatory audit firm rotation
are summarized in Exhibit 1.
Arguments Against Mandatory
Auditor Rotation

It is no wonder that terms
such as client entrenchment,
vested interests, and fraterniza-
tion have proliferated through
the recent corporate audit scan-
dals: the GAO survey (2003)
indicated that the average auditor
tenure at Fortune 1000 public
companies was 22 years. The
accounting profession and many
others abhor the concept of
mandatory auditing firm rotation
for a variety of reasons.
First, those in opposition
contend that the new auditor’s
lack of knowledge of the compa-
40 The Journal of Corporate Accounting & Finance / May/June 2006
DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc.
Arguments for Mandatory Rotation of Auditing Firms
• Decreases the development of friendships and “coziness” between audit firm and client employees
• Decreases the potential for auditors to succumb to management pressure to use questionable accounting tech-
niques or accept compromised accounting procedures
• Increases public perception of auditor independence
• Increases the potential for audit firms to be more vocal about disagreeing with questionable client practices
• Potentially increases the supply of audit firms that are of the size and have developed the specialized industry
expertise to audit the larger publicly held companies in niche sectors
• Increases the level of competition among audit firms for clients, which could possibly reduce audit fees
• Increases audit quality by providing a “fresh look” at client reporting practices
• Increases audit quality because the current audit firm would be aware that a successor auditor would be more
likely to detect and disclose predecessor auditor errors or inefficiencies

• Increases the possibility that audited firms might reexamine their audit needs and negotiate for more experi-
enced auditors on the engagement
Exhibit 1
ny’s operations, information sys-
tems that support the financial
statements, and financial report-
ing practices will dramatically
reduce audit quality. According
to PricewaterhouseCoopers
(2002), audit quality depends on
numerous factors, ordinarily
including “the experience,
integrity, and training of the
auditors and the firm with which
they are associated; their inde-
pendence and objectivity; their
knowledge of professional stan-
dards; and their knowledge and
understanding of the company
being audited and the industry in
which it operates.” The issue of
audit quality was specifically
addressed in an AICPA
Statement of Position
(1992), which discussed
the substantial learning
curve that is needed for
auditors to become not
simply acquainted or con-
versant with, but accom-

plished in the corporation’s
operating environment, risks,
and technical accounting policies
and procedures. It is estimated
that two to three years on an
engagement are necessary for an
auditor “to understand fully the
business, procedures, and
nuances of a complex client”
(Terry, 2002). This factor is
especially important when the
company being audited had
numerous domestic and/or for-
eign locations. A logical exten-
sion of the 2001 Report of the
Review Group on Auditing in
Ireland comment that “audit
quality would be detrimentally
affected by the removal of expe-
rienced personnel from the audit
team” is that audit quality would
be even more greatly affected by
a change in the entire audit team
that would occur through manda-
tory rotation (Institute of Char-
tered Accountants in England &
Wales [ICAEW], 2002). One
study of business failures
between 1996 and 2001 conclud-
ed that a company’s risk of audit

failure increased with each
change in auditing firm and that
there was a reduction in audit
quality when a new auditor was
unfamiliar with the client’s busi-
ness or operations (George,
2004). However, a different
study concluded that increased
audit tenure does not lead to
reduced audit and earning quali-
ty (Myers, Myers, & Omer,
2003, p. 798).
The learning curve issue is a
primary causal factor in the sec-
ond reason against mandatory
rotation: an increase in costs
within the audit firm so that per-
sonnel can get “up to speed” on
engagement issues and a corre-
sponding increase in audit fees
for the client company to com-
pensate for the additional audit
staff time. In the past, an audit
firm might have set the first-year
audit fee at an “average” level,
in anticipation of the long-term
revenue stream from the client,
rather than attempting to cover
true costs of the new engage-
ment. Costs of familiarizing

audit personnel with the new
client and its practices will now
be spread out over the shortened
rotation period (rather than the
average 22-year tenure) and
would, therefore, have to cause
an increase in billed audit fees.
Third, the learning curve is
also cited as a crucial source of
increased risk of audit failure in
the initial years of an audit
engagement, during that time
needed to acquire the knowledge
of financial reporting issues that
could materially affect the client
company’s financial statements.
This audit risk potential, in and
of itself, creates an extremely
negative cost/benefit relationship
in the eyes of both audit firms
and client companies. In addi-
tion to the accounting matters
that create audit risk, there are
also risk factors created by the
organizational change that has
occurred. Regardless of the fact
that audit personnel are not an
internal part of the client compa-
ny, relationships have been
established between individuals.

The client employees must
attempt to form new per-
sonal linkages with mem-
bers of the incoming audit
firm and establish the
same level of trust that
existed with staff of the
predecessor audit firm. In
all instances of relationship
change, there is a high
potential for misunderstanding,
uncertainty, and ambiguity—all
of which could have critical
impacts on the level of audit
risk.
A fourth reason against
mandatory rotation relates to the
number of audit firms that have
the quantity of personnel, depth
and breadth of industry exper-
tise, or merely the name recogni-
tion to satisfy large domestic and
international client companies.
There are approximately 18,000
domestic and foreign entities
registered with the SEC, and, as
of 2001, the current Big Four
public accounting firms audited
approximately 10,500 of those
registered companies. The

remaining public companies
were audited by almost 700
accounting firms (GAO, 2003).
If a publicly held company wants
to continue to be audited by a
Big Four firm and, because of
The Journal of Corporate Accounting & Finance / May/June 2006 41
© 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf
In all instances of relationship
change, there is a high potential for
misunderstanding, uncertainty, and
ambiguity…
SOX, is precluded from hiring a
firm that is performing specified
nonaudit services, the choice is
extremely limited. After deciding
in December 2004 to dismiss
KPMG as its outside auditor,
Fannie Mae was basically left
with two choices (Deloitte and
PricewaterhouseCoopers) for its
new auditor, because Ernst &
Young (E&Y) has been advising
Fannie Mae’s audit committee
and management in response to
various government probes. This
situation “highlights the account-
ing profession’s increasingly
fragile state of affairs” and the
“dwindling choices available to

large corporate clients” (Weil,
2004b). Although this
auditor change was volun-
tary on the part of Fannie
Mae, a similar outcome
would result from manda-
tory audit firm rotation.
Additionally, since Sar-
banes-Oxley was enacted,
Big Four accounting firms
are “shedding clients at almost
three times the rate they did in
2002,” generally those clients
that are “too small to be worth
the extra work” and “those
judged too risky to work with
under the new accounting rules”
(Browning, 2005). Given this
scenario, there might be few
firms willing to accept the rota-
tion onto a new client engage-
ment.
Fifth, those opposed to
mandatory rotation point to the
fact that the new Sarbanes-Oxley
independence and partner-
rotation requirements have not
had a reasonable amount of time
to be fully implemented. Until
the full effects of such imple-

mentation can be assessed, “it
would be premature to impose
mandatory audit firm rotation at
this time” (GAO, 2003).
Sixth, even without compul-
sory rotation, new hires and the
normal attrition of personnel
within a given auditing firm will
cause the audit team on an
engagement to change over
time. These factors, combined
with partner rotation, should
help provide the periodic fresh
perspective on an audit engage-
ment that is desired by the
investing public.
Seventh, the potential shift-
ing of auditors from one client to
another is a reason against
mandatory rotation. Many audit
firm respondents to the GAO
survey indicated that they would
shift “their most knowledgeable
and experienced audit person-
nel” from a current engagement
to another audit as the end of the
rotation period neared—even
though they believed that re-
assigning these individuals
“would increase the risk of an

audit failure” (GAO, 2003).
Several other justifications
have been made against enforced
rotation. Mandatory rotation
might minimize attempts at con-
tinuous improvement efforts
because the audit firms would be
aware that client retention would
soon end, thus minimizing or
negating any investment effect.
Mandatory auditor rotation
might result in “opinion shop-
ping” among the audit firms.
And mandatory rotation might
create, in the minds of the pub-
lic, a negative perception or “red
flag” toward the company
engaged in the change. This rea-
son, however, does not appear to
hold much credibility. Although
such a perception is fairly com-
mon when firms change auditors
in the current business environ-
ment, most of the Fortune 1000
company respondents to the
GAO survey did not believe this
perception would be continued if
the rotation process were made
mandatory.
Finally, there is the issue of

global credibility. At present,
mandatory audit firm rotation
for public companies is required
only in Italy and Brazil; Singa-
pore requires audit rotation for
banking engagements. Italy’s
requirement was introduced in
1975 and Brazil’s in 1999.
Canada, Spain, Austria, and
Greece previously had mandato-
ry rotation requirements
for auditors, but these
countries have revoked
such laws, citing an
increase in audit cost and a
lack of cost effectiveness,
as well as achieving a stat-
ed objective of increasing
audit service competition.
The Italian experience has pro-
vided evidence that mandatory
rotation “increases costs to busi-
nesses, creates problems with
audit quality in the period
immediately after the change of
audit firms, and leads to further
consolidation of audit work
amongst the largest audit firms”
(Wyman, 2005).
The arguments against

mandatory audit firm rotation
are summarized in Exhibit 2.
After hearing arguments on
both sides of mandatory audit
firm rotation, the GAO report
indicated that audit firms, client
companies, and managers of
audited companies must have a
reasonable amount of time to
adjust to the numerous changes
that were mandated by Sarbanes-
Oxley. Surveys by the GAO of
the largest public accounting
firms and the Fortune 1000 pub-
licly traded companies indicate
42 The Journal of Corporate Accounting & Finance / May/June 2006
DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc.
…the potential shifting of auditors
from one client to another is a rea-
son against mandatory rotation.
that both believe that the costs of
mandatory audit firm rotation
are likely to exceed the benefits.
Thus, the GAO decided the most
practical strategy at the time of
the report’s issuance was to let
the Securities and Exchange
Commission and the Public
Company Accounting Oversight
Board observe and assess the

ramifications and effectiveness
of the new SOX requirements.
CULTURE CHANGES IN AUDIT
FIRM AND AUDIT CLIENT
RELATIONSHIPS
The independence provisions
of Title II of SOX will affect how
audit firms interact with their
clients as well as how audit clients
interact with the audit firms—and
the changes to these interactions
will affect the culture of these
entities. Some of these changed
interactions have now been man-
dated by law; others may be legal-
ly mandated in the future. But
many of these issues (summarized
in Exhibit 3) can simply be
viewed from a customer relation-
ship management (CRM) per-
spective. While often associated
with technology applications and
substantial investments in detailed
databases, the goal of CRM is to
allow a company to gain a better
understanding of customers in
order to serve them more effi-
ciently and effectively.
In addressing some CRM
issues between audit firms and

audit clients, two points must be
clarified. First, the audit client is
not the true customer of an audit
firm. After the 1929 stock mar-
ket collapse, accountants
“acquired a legally defined
social obligation—to assist in
creating and sustaining investor
confidence in the public capital
markets” (Previts & Merino,
1979, p. 245). This viewpoint
was expressed in a slightly dif-
ferent manner in 1974 by Harvey
Kapnick, then-Chairman of
Arthur Andersen & Co., who
stated that accountants “are
accountable not to management,
not to government regulators,
The Journal of Corporate Accounting & Finance / May/June 2006 43
© 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf
Arguments Against Mandatory Rotation of Auditing Firms
• Increases audit risk and potential for audit failure because the new audit firm is less familiar with client practices
• Increases audit costs because the new audit firm must become familiar with client practices; such costs would
be passed along to the client company through increased audit fees
• Increases selection and support costs to the client company; such costs would reduce company profitability and
shareholder value
• Decreases the level of open communications between the audit firm and client employees who are not familiar
with one another
• Limited number of available audit firms of the size or with the industry expertise necessary to perform client
engagements; the lack of competition could create higher audit fees for the client company

• Limited number of available audit firms that are not performing restricted nonaudit services for the client
• Increase in the possibility that the new audit firm may be overly aggressive in challenging the predecessor audi-
tor’s judgments because the new firm is less familiar with client operations; such challenges could, in turn,
increase the tension between the new audit firm and the client
• Possibility that the audit firm may rotate its most qualified audit staff off the client engagement in years close to
the mandatory rotation date and place those staff members on new client engagements
• Possibility that the audit firm might begin focusing on marketing nonaudit services to the client in years close to
the mandatory rotation date rather than concentrating on providing the highest-quality audit services
• Difficulty in resolving issues such as the maximum number of years prior to mandatory rotation, the number of
years before a firm could recompete for an audit client after mandatory rotation, whether mandatory rotation
would be applied uniformly to all publicly held companies, and how the mandatory rotation process would be
implemented for the companies
• Excessive overreliance of successor auditors on the work of predecessor auditors
Exhibit 2
not to the profession, but . . . to
the public at large” (Kapnick,
1974, p. 49). This position rela-
tive to accountants can easily be
extrapolated to address auditors,
as indicated by the following
excerpt from testimony on audi-
tor independence rules before
the SEC: “The SEC’s position is
that the auditor ‘owes ultimate
allegiance to the corporation’s
creditors and stockholders, as
well as to the investing public’”
(Goodkind, 2000).
Second, in the primary sense
of the term, the audit firm is not

a customer of the audit client: a
customer is a “buyer of goods
and services” (Zikmund &
d’Amico, 1996, p. 104). Howev-
er, according to Webster’s New
Twentieth Century Dictionary
(1977, p. 450), the secondary
definition of a customer is some-
one “with whom one has to
deal”—a definition that certainly
indicates the relationship
44 The Journal of Corporate Accounting & Finance / May/June 2006
DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc.
Audit Firm/Audit Client Relationship Issues
Audit Firm to Audit Client
• Design an organizational policy on potential conflict-of-interest guidelines and review these on a client-by-client
basis annually.
• Develop an organizational policy against offering of gifts to audit clients.
• Review the organizational policy on mandatory rotation of audit partners on client engagements and possibly
extend that mandate to senior staff members on an engagement.
• Develop an organizational policy as to reliance on predecessor auditor work product when beginning a new client
engagement; this policy might contain a list of risk factors to include issues such as the number of predecessor
auditor clients that issued restated financial statements in the past five years.
• Develop an organizational policy to help evaluate the ethical “tone at the top” in current and potential client
companies.
• Develop an organizational policy about the aggressiveness that will be accepted in clients’ handling of financial
transactions under alternative generally accepted accounting principles.
• Perform profitability analyses on clients, being certain to include liability risk levels in such analyses. Such analy-
ses should indicate if there are clients that should be “fired” or that merit justifiable increases in audit fees.
Audit Client to Audit Firm

• Have policies providing potential conflict-of-interest guidelines and have members of management and the board
review these annually; conflicts should be addressed by the board audit committee.
• Develop organizational policies against acceptance of gifts from audit firms; such policies can typically be drawn
from those developed for the purchasing department.
• Charge the board audit committee with ascertaining that senior audit firm personnel are not continued beyond a
five-year period.
• Have the board audit committee analyze the positive and negative aspects of having a mandatory rotation of the
organization’s audit firm.
• Develop an organizational policy about hiring audit firm personnel for in-house positions; such a policy should
begin with communications to the desired employee and then, if appropriate, with audit engagement partners
about rotating the individual off the audit engagement.
• Have a joint meeting with employees and audit firm personnel at the start of the audit engagement to review and
reiterate the whistleblower provisions to employees.
• Consider the appropriateness of instituting a compliance officer position to serve as a liaison between the audit
firm and the board audit committee.
Exhibit 3
between an audit firm and an
audit client.
Thus, there are similarities
of a customer relationship
between the entities of audit
firm and audit client. In the tra-
ditional buyer/seller relationship,
the seller wants the buyer to be
pleased with the services being
rendered so as to retain the
buyer for multiple years. In this
case, to make the buyer (client
company) “pleased,” the seller
(audit firm) has to render a clean

audit opinion. But, in fact, the
audit firm seller is truly in more
of an adversarial role to the
client buyer—possibly wanting
the client buyer to adjust its
desires (clean opinion on
internally developed finan-
cial statements) to conform
to the seller’s demands
(revisions to those internal-
ly developed statements).
In the end, neither the
buyer nor the seller renders
the ultimate judgment as to
“service” acceptability: society,
which is not even privy to the
purchasing contract, makes the
final determination of whether
audit services were performed
properly.
Although the buyer/seller
relationship between audit firm
and client company is seemingly
in limbo, it is obvious that these
entities have both a monetary
(audit fees and engagement
costs) and nonmonetary (public
trust and legal liability) relation-
ship with one another. And, as in
all relationships, both parties

should act in ways that enhance,
rather than damage, the affilia-
tion.
SOX has established specific
details related to what services
may not be provided to audit
clients. However, no law can
address all circumstances that
currently exist or that may arise
and have not yet been contem-
plated. Thus, audit firms and
client companies should each
develop internal policies about
potential conflicts of interest for
audit engagements. For example,
conflict-of-interest policies
might have prevented the follow-
ing two instances. In November
2004, American Express Co.
dropped Ernst & Young as its
auditor, even though E&Y had
that client since 1975; during
2004, the SEC was investigating
whether E&Y “violated federal
auditor-independence rules by
entering into a so-called profit-
sharing agreement in the 1990s
with American Express’s travel
service unit” (Weil, 2004a). At
the end of December 2004, Best

Buy Co. dismissed Ernst &
Young (auditor since 1994)
because one of Best Buy’s board
members “had a personal-service
agreement with [the audit firm]
during part of the time he served
as an independent director” of
the company (Carlson, 2004).
Audit firms and audit clients
should be proactive and have
policies in place to guide deci-
sions relative to possible con-
flicts of interest—not wait for
laws to be passed such as the
one currently proposed on audit
firm sales of tax shelters to
clients and client managers.
Given the earlier discussion
about gifts between Arthur
Andersen and individuals work-
ing at audit clients, it is impera-
tive that audit firms and client
companies each develop organi-
zational policies related to the
acceptance or provision of gifts.
The idea of giving gifts general-
ly creates a connotation of mutu-
al respect or caring; however,
there is a possibility that giving
gifts may influence, or have the

potential to influence, an indi-
vidual in a way that could com-
promise or appear to compro-
mise that individual’s integrity or
impartiality. In fact, the ultimate
negative perception of gift giv-
ing would be that it constitutes
commercial bribery or the
“offering, giving, receiving, or
soliciting” of something of value
“to influence a business deci-
sion” (Association of Certified
Fraud Examiners [ACFE],
1996).
Most organizations
currently have internal
policies that discourage the
receipt of gifts by purchas-
ing agents from supplier
firms. Given this aware-
ness by management of the
potential for independence
problems relative to gifts
from suppliers, it is not unrea-
sonable to assume that indepen-
dence in appearance could be
jeopardized if gifts are provided
by audit firms to their client
companies. It is impossible to
know when an offered or accept-

ed item will have significant
impact to influence a business
decision in any particular indi-
vidual. Thus, audit firms should
have a policy to mitigate this
opportunity for influence—and
client companies should need
only to simply revise any poli-
cies against the receipt of influ-
encing gifts to include all orga-
nizational members who have
contact with the audit firm.
The provision in SOX that
requires communication between
the auditors and the audit com-
mittee on the financial statement
implications of alternative
accounting treatments for signif-
icant items essentially forces
The Journal of Corporate Accounting & Finance / May/June 2006 45
© 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf
Audit firms and audit clients should
be proactive and have policies in
place to guide decisions relative to
possible conflicts of interest…
these two parties to come to an
agreement on how “aggressive”
the client wants to be in han-
dling financial matters—and the
level of aggression that the audit

firm is willing to sign off on rel-
ative to those matters. Many of
the recent fraud cases have cited
instances of what the public
would view as aggressive
accounting positions relative to
revenue recognition, reserve
recognition, asset valuation
bases, or asset amortization peri-
ods. The determination between
conservative versus aggressive
positions is not a clear-cut one
but should be based on the trans-
parency of information that
results from the use of
alternative principles in the
current and future periods.
The differentiation
between conservative and
aggressive application of
principles should “connote
management judgments
that are within the range of
reasonableness but are on the
safe side or on the cutting edge
of the range of reasonableness.
Any discussions . . . about the
aggressiveness or conservatism
of accounting principles should
address the manner in which a

reasonable range is determined
and how choices are made and
applied within that range”
(AICPA, 2000).
The SOX prohibition (Sec-
tion 206) on audit firm staff
moving directly into high-level
positions at client companies
basically quashes one of the oft-
lauded aspects of working for a
public accounting firm. This
provision recognizes that audit
firm alumni bring to their new
positions significant knowledge
of how the audit engagement is
planned and implemented,
including details of audit testing
that could be used to circumvent
the audit process. Consider that
Richard Causey, Enron’s chief
accounting officer, had been a
senior manager with Arthur
Andersen prior to his employ-
ment at Enron and had primary
responsibility for the Enron
engagement; additionally, Jeffrey
McMahon, Enron’s chief finan-
cial officer, was also an Ander-
sen alum (Smith, 2002). It is not
unreasonable for a client compa-

ny to want to hire someone who
has intimate knowledge of that
organization into an executive
officer position, nor is it unrea-
sonable for audit staff members
who want to leave public
accounting to desire to take posi-
tions in organizations with which
there is familiarity. However, the
question of independence in
appearance could naturally be
raised in the now-prohibited
“exchange of personnel” circum-
stances. Assuming that the audit
firm/audit client relationship is
amiable and both parties wish to
continue that relationship, a
client company should have a
policy addressing the potential
hiring of audit firm personnel. In
many cases, the client may not
have an overwhelming immedi-
ate need to fill the position and,
thus, after ascertaining interest
by the employee, client manage-
ment should communicate with
the audit engagement partners
about rotating that individual off
the audit engagement. The
change in client assignments

should be made so as to ensure a
smooth transition for the audit
team to complete the engage-
ment as well as for the desired
audit employee to enter the new
position at the client company.
Such actions are essential to
maintaining the integrity of the
audit, obtaining the desired
employee for the position, and
eliminating a forced need to
change audit firms (which would
have the potential for increased
audit risk and audit fees).
Two final relationship issues
must be considered. First, audit
firms must develop an analysis
technique that will help them
determine which clients to keep
and which to “fire.” Over the
past ten years or so, businesses
have often been told that they
need to assess customer prof-
itability and, after doing so,
eliminate or change the
relationships that exist with
customers that are unprof-
itable. Some audit firms
have begun to make the
same types of determina-

tions and are now trimming
their client lists. According
to Mark Cheffers, CEO of Audit-
Analytics.com, the trend is
toward “bigger firms resigning
from smaller accounts,” but the
Big Four accounting firms do
not agree that the partings are
always from small companies
(O’Sullivan, 2004b). As in all
analytical decisions, client analy-
sis should include both quantita-
tive measures, such as profitabil-
ity, and qualitative measures,
such as number and type of
client disputes over financial
statement reporting issues and
risk of legal liability related to
lack of transparency in client
reporting.
Second, client companies
may want to consider instituting
a new chief compliance officer
(CCO) position. In some compa-
nies, such as The Men’s Wear-
house, Inc., the CCO is in charge
of the overall SOX effort; in
other companies, such as Arrow
46 The Journal of Corporate Accounting & Finance / May/June 2006
DOI 10.1002/jcaf © 2006 Wiley Periodicals, Inc.

…audit firms must develop an
analysis technique that will help
them determine which clients to keep
and which to “fire.”
Electronics, the CCO is in
charge of a multitude of legal
issues but has nothing to do with
SOX (O’Sullivan, 2004c). Given
that there is no distinctive job
description for this position, one
possibility is for the CCO to act
as a liaison between the audit
firm and the board audit com-
mittee—hopefully eliminating
potential problems before they
occur.
WHAT’S AHEAD?
The Sarbanes-Oxley Act was
a historic piece of legislation for
the accounting profession, espe-
cially in regard to the issues of
auditor independence. It
places major restrictions on
a public accounting firm’s
ability to engage in certain
types of services for audit
client companies, even
though some of these now-
prohibited services are
ones that smaller audit

clients often relied on their audit
firm to provide. Services other
than the ones specified in the
original Act can be added to the
“prohibited” list, as illustrated
when the PCAOB (2005) adopt-
ed a rule to bar an auditing firm
from providing aggressive tax
shelter services or any contin-
gent fee services to public audit
clients as well as any tax servic-
es to people in financial report-
ing oversight roles in public
audit clients. Auditors may, how-
ever, continue to provide public
audit clients with other nonpro-
hibited tax services if those ser-
vices do not affect independence
and have been preapproved by
the audit committee. This rule
was enacted in response to a
multitude of tax shelter abuse
cases that highlighted the news
in 2003 and 2004—cases in
which audit firms sold audit
clients and audit client managers
questionable tax minimization
strategies that were “designed to
create large paper losses that a
corporation or individual [could]

use to erase unrelated taxable
income” (Bryan-Low, 2004).
Although mandatory rotation
does not appear to be in the off-
ing in the near future, one possi-
ble method to handle it would be
to utilize the tradition of law in
which lawyers essentially “draw”
a judge for a case (Weymann,
Raiborn, & Schorg, 2003). Audit
firms could be categorized by
the Public Company Accounting
Oversight Board into tiers simi-
lar to those used in conducting
the GAO survey and/or into
industry specialist groupings.
Any firm could petition the
PCAOB for placement into a tier
or grouping; the audit firm
would bear the burden of proof
to justify its petition. When the
time for rotation at a specific
client company came, the names
of all firms in the tier or group-
ing appropriate to provide audit
services to the client would
become the potential list of suc-
cessor auditors—such a list
could easily include the prede-
cessor auditor. A client wanting

to exclude an audit firm from
the list would have to provide
reasons to the PCAOB, which
would have the final authority to
accept or deny the petitioned
exclusion. As in the court sys-
tem, a draw would be made, and
the client company would never
be certain which audit firm
would be the next one chosen.
Thus, it would be possible that a
single audit firm could essential-
ly be both the predecessor and
successor auditor.
One important consequence,
good or bad depending on per-
ception, of mandatory rotation is
that the process is likely “to
draw attention to the limited
choice of audit firms available to
larger companies” (Evans,
2002)—making corporate clients
and the investing public acutely
aware of the potential for disas-
ter should additional audit firms
merge or become nonviable. This
problem will be especially per-
verse for companies operating in
a niche business environment.
Some companies are actually

beginning to think that
mandatory rotation may be
a good idea. The GAO
report indicated that about
4 percent of the Fortune
1000 public companies and
their audit committees are
currently considering a
policy of mandatory audit
firm rotation. For example, in
April 2003, Intel’s audit commit-
tee indicated that it would con-
sider changing auditors regularly
in order to obtain “a fresh look”
at its financial accounting and
internal controls and would also
“consider the advisability and
ramifications of a formal rota-
tion policy” (Hill, 2003).
Regardless of whether audit
firm rotation is ever mandated
by law, there will be a natural
rotation of audit firms in and out
of client companies over time. In
the process of those rotations,
there will always be a learning
curve as audit firms take over
new engagements with which
they lack familiarity. To help
flatten that learning curve, a suc-

cessor audit firm, in beginning
any new audit engagement, often
places significant reliance on the
work performed by the predeces-
sor auditor. Although it is unlike-
The Journal of Corporate Accounting & Finance / May/June 2006 47
© 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf
The Sarbanes-Oxley Act was a historic
piece of legislation for the accounting
profession, especially in regard to the
issues of auditor independence.
ly that a predecessor auditor will
generally continue to be involved
after rotating out of an audit
engagement, the Parmalat case
emphasizes the importance to a
successor audit firm of inde-
pendently ascertaining the level
of reliability of a prior firm’s
work product as well as the level
of honesty of a new client’s man-
agement.
In the end, it is clear that
mandatory audit firm rotation
has its benefits and its draw-
backs. It could solve some prob-
lems but could, in turn, create
others. However, there is one sit-
uation that mandatory audit firm
rotation, in and of itself, will

never be able to solve: it will not
preclude people in either the
audit firm or the client company
from acting unethically. Ethical
behavior cannot be mandated; it
can only be personally devel-
oped—and encouraged through
the “tone at the top” of the audit
firms and the client companies.
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The Journal of Corporate Accounting & Finance / May/June 2006 49
© 2006 Wiley Periodicals, Inc. DOI 10.1002/jcaf
Cecily Raiborn is the Fr. Joseph A. Butt, S.J., Distinguished Professor in Accounting at Loyola University
New Orleans. She received her PhD in accounting from Louisiana State University. Her areas of teaching
and research are financial and cost/managerial accounting and ethics. Chandra A. Schorg is an assistant
professor of accounting at Loyola University New Orleans. She received her MBA from the Texas Woman’s
University. Her areas of teaching and research are financial and managerial accounting. Morcos Massoud
is the Robert A. Day Distinguished Professor of Accounting at Claremont McKenna College in California. He
received his PhD in accounting from New York University. His areas of teaching and research are financial
and international accounting.