The CFO of the audit client that you are a member of the audit engagement team

The purpose of this study is to explore whether the extent of personal / professional relationships that develop over time – measured by the consecutive number of years that an audit firm and their client’s CFO work together – affect audit quality. This research is motivated by a response from the Center for Audit Quality (CAQ) to the Public Company Accounting Oversight Board's request for public comment on auditor independence and audit firm rotations stating:

“We [CAQ] also note that there are many existing factors that already limit the tenure of the engagement team and company management. In addition to the natural turnover within the audit engagement team, due to staff attrition and promotion, current independence requirements require lead audit partners and engagement quality control review partners to rotate every five years. Certain other partners involved with a company’s audit must be rotated after seven years. Moreover, there is a similar natural turnover of public company CFOs…. As detailed in a Crist/Kolder Associates 2011 study on executive management volatility, from January 1, 1995 through July 31, 2011, the average CFO …tenure within the S&P 500 was 5.1 …years …. We believe that the factors described above already limit the length of the relationships between the engagement team and company management and stifle any opportunity for 'coziness' between the auditor and the company's senior management team. [Emphasis added]” (CAQ 2011, 9).

This research empirically examines this statement to ascertain its validity and inform discussions regarding mandating audit firm rotation.

We investigate mutual audit firm / CFO tenure as another setting to investigate potential independence impairment. In a report released in August of 2011, the PCAOB expressed concern that inspection reports continue to indicate a failure of auditors to exercise appropriate levels of objectivity and professional skepticism during the audit of their clients’ financial statements (PCAOB 2011a). Although the PCAOB cannot document that this loss of objectivity is directly related to long audit firm tenure, questions nevertheless persist (PCAOB 2011a). Academic investigation likewise produces inconsistent results regarding the effects of long audit firm tenure on professional skepticism and ultimately on audit quality. Although a few recent studies report decreased audit quality, most research finds audit quality improves as audit firm tenure increases. The PCAOB and the accounting profession can be informed by additional investigation of this issue.

An important aspect of the auditor-client relationship is the professional interaction between the auditing firm and their client’s personnel, specifically the CFO. CFOs are directly responsible for the company’s financial statements (Gibbins et al. 2007), negotiate with the audit partner regarding the fair presentation of reported balances (Gibbins et al. 2005), and normally have compensation and equity incentives based on operating results. Because of their role in financial reporting, CFOs and auditors interact frequently. Further, the CFO has more direct communication with the audit committee than any other party, and the CFO participates in the setting of the audit committee agenda 75% of the time. This gives the CFO the ability to broker knowledge between the auditor and the audit committee, and the ability to engage in negotiations with the auditor before information reaches the audit committee.

The Metcalf Report notes, “long association between a corporation and an accounting firm may lead to such a close identification of the accounting firm with the interests of its client’s management that truly independent action by the accounting firm becomes difficult.” (U.S. Congress 1976, 19). In addition, out of concern of relationships forming between audit firm personnel and client’s personnel the Cohen commission stated, “many of the asserted advantages of rotation can be achieved if the public accounting firm systematically rotates the personnel assigned to the engagement.” (AICPA 1978, xxx). Further, at a meeting of the PCAOB’s Investor Advisory Group (IAG), some members of the IAG advocated mandatory firm rotation stating that “key to concern over independence was the level of ‘coziness’ the firm had with the management of the company being audited.” (PCAOB 2011b, 6).

On the other hand, the mutual trust that develops over time can improve inter-organizational communication, and in turn benefit the financial reporting process. If the negative aspects associated with long audit firm tenure dominate and are due to the “coziness” with client management then a frequent break-up in this relationship (either due to CFO turnover or audit firm rotation) should strengthen auditor independence and skepticism. The average mutual tenure between and audit firm and their client’s CFO tenure for U.S. public companies of approximately three years likely creates a setting where sufficient time is not available for strong relationships and potential biases or trust to form. The “break” in the relationship between audit firm and CFO may reduce the influence that long audit firm tenure may have on audit quality. In the end, it could be that such breaks, if frequent enough, can provide a reasonable alternative to mandatory audit firm rotation.

Prior research investigating the influence of audit firm tenure on audit quality has not considered that underlying the audit firm’s tenure is a subset of important relationships that form and break between client and audit firm personnel. We single out one set among many relationships: the tenure of professional relationships between a client CFO and their audit firm. By analyzing this relationship and its effect on audit quality our investigation extends the understanding of the influence of audit firm tenure on audit quality by identifying the influence of these relationships.

Specifically, we investigate audit quality measured as 1) the absolute value of discretionary accruals, and separately the income increasing and income decreasing discretionary accruals present in reported financial statements, 2) the issuance of a going-concern opinion for distressed companies, and 3) the receipt of an Accounting and Auditing Enforcement Release (AAER) from the US. Securities and Exchange Commission (SEC). For each examination, we use the complete time period where data is available.

The results indicate that a lengthening of the mutual tenure between an audit firm and their client’s CFO leads to higher levels of discretionary accruals, measured using absolute total and income increasing accruals.1 There is also a decrease in the issuance of going concern opinions for distressed companies and an increase in AAERs for clients with elevated levels of mutual tenure. Additionally, when we split our samples between high and low quality corporate governance firms we find that, generally, mutual tenure is associated with reduced audit quality in firms with higher numbers of corporate governance concerns than strengths.

We provide a additional tests investigating the influence of mutual tenure on the presence of material weaknesses in the internal control over financial reporting (ICFR) report and additional untabulated analyses examining the influence of short periods of mutual tenure, the presence of financial restatements from fraud, and differential affects for companies in high risk industries. The results of these tests generally support the implications of our main results, that mutual tenure negatively influences audit quality and suggest that a significant portion of audit quality concerns arising from auditor tenure are a function of the mutual tenure between the CFO and the audit firm and that this effect is concentrated withing firms with lower quality corporate governance.

This paper makes an important contribution to the literature. By examining the relationships that develop between audit firms and their client’s CFOs, we contribute new insights to the debate on audit firm rotation. We contribute to the literature by examining the bonding relationship between auditor and CFO. We suggest this is an important modification to prior research that more directly examines the role of relevant auditor tenure. The PCAOB is concerned that audit firms that identify with their clients because of a long association can compromise audit quality. The solution prescribed is to require mandatory audit firm rotation to “break” this relationship. However, the extant research suggests that perhaps it is not the long audit firm tenure per se that might lead to lower audit quality but the underlying relationships between audit firm and client personnel that can give rise to professional or even personal ties which in turn can contribute to lower auditor independence. We examine such relationships and find that increasing audit firm tenure improves audit quality, but the length of the relationship between audit firm and the client CFO weakens it. Perhaps this suggests a more sensible approach to deriving the perceived benefits from mandatory audit firm rotation, targeting those cases where the audit firm has formed and maintains long-term ties to client personnel. Thus, an audit firm's tenure with their client's CFO is an important relationship to consider when evaluating audit firm tenure effects on audit quality.

The remainder of the paper is organized as follows. Section 2 describes the background research and states the hypothesis. Section 3 describes the method, analyses, discusses limitations, provides supplemental analysis, and Section 4 concludes the paper.

Audit firm rotation

Requiring audit firms to rotate from clients is a topic of current (PCAOB, 2011a, House of Lords, 2011, European Commission, 2010, European Commission, 2011, European Commission, 2013)2

Discretionary accruals

We present the descriptive statistics of the discretionary accruals sample in Table 1, Panel C. The mean (median) value of ABSDA is 0.10 (0.06) and is consistent with levels reported in prior research. The mean (median) values of AUDTEN and CFOTEN are 10.58 (9.00) and 3.80 (3.0) years, respectively. Panel C provides a correlation matrix that indicates auditor tenure and CFO tenure are negatively associated with the absolute value of discretionary accruals.13

Internal control over financial reporting (ICFR)

In addition to the procedures described above we also performed additional investigations of the relationship between mutual tenure and audit quality. First, we examined the relationship between mutual tenure and identified deficiencies within internal control over financial reporting. We collect material weakness information from the Audit Analytics database and set an indicator variable equal to one if the firm reports at least one material weakness in year t (ICFR). We then regress this

Limitations

As with prior studies on the determinants of audit quality, there are several potential disadvantages to the measures used to assess audit quality. Schelleman and Knechel (2010) question the appropriateness of discretionary accruals as they are likely closely monitored by auditors. Discretionary accruals also likely contain measurement error (DeFond and Zhang 2014). Another limitation is that the absence of a going concern opinion or AAER cannot be interpreted as high audit quality as less

Conclusion

This paper makes an important contribution to the literature. By examining the relationships that develop between audit firms and their client’s CFOs, we contribute new insights to the debate on audit firm rotation. In this paper, we examine the influence of the relationship between the audit firm and their client’s CFOs on audit quality. Previous research that has extensively examined the effects of audit firm tenure on the quality of the audit provides inconsistent evidence. We argue that

Acknowledgement

We appreciate the comments and suggestions from two anonymous reviewers, the editor (Divesh Sharma), and senior editor (Marco Trombetta). We acknowledge the financial support from the Von Allmen Research Support Endowment at the University of Kentucky, the financial support from the KPMG Professorship/Fellowship Endowment at the University of Kentucky, and the Institute for the Study of Free Enterprise at the University of Kentucky. Comments received participants in workshops at the University

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