Mandatory Audit Firm Rotation: Evidence from Illinois State Universities (2009)

ABSTRACT A component of the Sarbanes-Oxley Act required the GAO to survey financial statement stakeholders to evaluate the key issues regarding mandatory audit firm rotation. The State of Illinois legislates that all government agencies change auditors every six years. This unique environment provides the opportunity to investigate audit behavior given mandatory audit firm rotation. This research analyzes audit findings using the sample of all Illinois state universities governed by the Illinois Auditor General's audit firm rotation program. By examining a mandated audit firm rotation program, new evidence is obtained to add to this debate. The results of this research indicate that more audit findings are reported in the first year under the new auditor. It may be that afresh look initiates different audit findings or that auditors are more rigorous in the first year of an audit. Also, the fewest number of findings are reported in the last year of the audit prior to mandatory audit firm rotation. This suggests that either the auditor is less diligent in the last year or that over the course of the auditor is tenure, the university was able to correct prior audit findings. Finally, there is evidence that findings increase with the new auditor, which contradicts the proposition that the university has improved all of its systems and supports the idea that a fresh look is provided by the new auditor. Regardless of the interpretation, audit results differ over the course of the mandated audit cycle. More research is needed to determine the specific reasons for these differences. INTRODUCTION This paper examines auditor's findings when audit firm rotation is predetermined and mandated. Section 207 of the Sarbanes-Oxley Act of 2002 commissioned the General Accounting Office (GAO) to conduct a study of audit firm rotation. That report, issued in November of 2003, identified strengths and weaknesses of mandatory audit firm rotation as specified by the various constituencies, but made no specific recommendations. Instead, it suggested that the SEC monitor the effectiveness of other provisions of SOX and revisit the role of mandatory audit firm rotation at a later date if necessary. The State of Illinois requires all of its agencies to be audited annually by the Illinois State Auditor General who hires special assistant auditors. The special assistant auditors are external, independent certified public accountants who conduct financial and compliance audits of the state agencies. By law, each agency must change special assistant audit firms every six years. This provides a unique opportunity to investigate the behavior of auditors in a mandatory audit firm rotation environment. The State of Illinois issues a report summarizing the results of the financial audit including the number of findings, the number of repeat findings, and a brief description of the most significant findings. Data for fiscal years ending June 30, 1994 through 2005 from these Report Digests were obtained from the Illinois Office of the Auditor General for each of the nine Illinois state universities. There were thirteen full audit cycles to compare amongst the nine universities. The number of audit findings throughout the audit firm rotation cycle is investigated. In general, auditors have more audit findings in the first year of the audit and the least number of findings in the final year. When the new auditor is appointed, the number of findings again increases. This suggests that audit findings differ within the rotation cycle. This paper is organized as follows. First audit firm rotation will be examined and the hypotheses are developed. Next, a summary of the Illinois State Audit Act is presented. This is followed by a description of the sample, the results, and then our final conclusions. AUDIT FIRM ROTATION Audit firm rotation has been debated for decades as a possible solution to auditor independence problems (Blough, 1951; Seidman, 1967; the Metcalf Report (US Senate, 1977)). …