Study: Mandatory Audit Firm Rotation - it’s not so bad once you give it try

Audit partners and audit committee chairs often changed their negative views regarding Mandatory Audit Firm Rotation (MAFR) once they’ve implemented it, according to a recent study.

However, the study also confirmed that costs of transitioning are high and cut into audit firms’ profitability. 

• Although MAFR was recently struck down in court, most firms have rotated and a new study offers insight into the pros and cons these firms are experiencing. 

• A survey of audit partners and audit committee chairs of JSE companies found that after firms implement mandatory audit firm rotations, partners and committee chairs often change their negative perceptions. 

• Fresh perspectives, an increase in professional skepticism are among reasons for the change in opinion. 

• However, audit firms are picking up the cheque for the increased costs that come with understanding a new client’s business. 

• The study raises  the concern that – because audit firms are carrying the transition costs – they may feel pressured to retain their new contracts to the detriment of their independence.

Although Mandatory Audit Firm Rotation (MAFR) was recently struck down by the Supreme Court, most firms have rotated and a new study offers insight into the pros and cons these firms are experiencing.

The study, published in the academic journal Accounting Forum, captured the lived experience of eleven audit committees and their matched audit partners from JSE listed companies.

The pairs each recently completed their first audit engagements following a MAFR. 

Prior to the MAFR, almost all the participants were against the concept. However, after experiencing it, two of the audit chairs and five of the audit partners changed their minds from negative to positive. 

The majority of audit partners interviewed favoured MAFR after experiencing it. 

The authors note that while the majority of audit committee chairs still opposed MAFR, “Most were impressed by the better than expected benefits of the fresh perspective offered by new auditors and their willingness to challenge management on key financial reporting assumptions. 

“Audit Committee chairs also conceded that the costs of losing an incumbent auditor’s knowledge were less than expected.”

Why opinions changed

The study authors list several reasons for the increase in support for MAFR 

“Firstly, the audit partners and audit chairs were genuinely surprised by the benefit to financial reporting quality resulting from the fresh perspective and challenge offered by the newly appointed audit firm and audit partner. Audit chairs observed the incoming audit partners grappling with the complexities of their businesses to form their views on audit risk areas, key accounting estimates and the application of accounting standards.”

One audit committee chair wrote, “...you’ve got a set of key audit matters, which the incumbent auditor has thought important...then a new firm comes in and they completely change all those. They go“no, no, those are the wrong ones–these are the right ones”. I certainly see that as an advantage.”

Audit firms and their clients also mitigated one of the biggest critiques of MAFR – that a change in auditors would result in a loss of expertise and client specific knowledge. Instead, both are investing extensive time and resources to avoid this loss in quality. However, audit firms are largely carrying this financial cost. 

MAFR is expensive especially for audit firms

“...you need to be appointed long ahead of the time, and you need to spend at least a year with the previous auditor, attending audit committees, almost shadowing them...you really have got to get that understanding, and it takes time,” one respondent wrote. 

Almost all the new audit firms experienced budget overruns, with audit firms incurring between 20 and 50 percent additional audit costs and all needing additional audit partner time.

However, this cost is not being passed on to clients. 

“ These overruns were generally absorbed by the audit firm because audit partners experienced ‘quite a lot of resistance [from the audit committee] to increasing the fee’. This was corroborated by the audit committee chairs who shared how the competitive tender process had resulted in downward pressure on audit fees.”

These costs mean firms’ initial years of their new audit engagements are often loss making and they may only generate profit in the longer term. On the one hand, increase in competition is one of the reasons IRBA implementedMAFR.

However, the study authors point out, “Audit committees,contrary to their intentions (or the objective of MAFR), may be putting audit quality at risk by refusing to pay higher audit fees after a mandatory rotation.”

The authors note that if these costs are not shared, it could lead to firms sacrificing independence for fear of being replaced midway through a term – and missing out on audits during years where they already understand their clients’ business and their costs are less.

The paper this article references is titled: Costs and benefits of mandatory audit firm rotation: initial engagement experience of audit committee chairs and engagement partners. The authors are Michael Harber, Alan Duboisée de Ricquebourg and Warren Maroun.