Auditors’ Need for a Cooling-off Period
A Study of State Board of Accountancy MembersR)

By Carl N. Wright and Quinton Booker

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The Sarbanes-Oxley Act of 2002 (SOA) requires a one-year cooling-off period# before publicly held companies may hire their auditor’s former employees or owners for key positions. Section 209 of the law indicates that state boards of accountancy should make an independent determination of whether a similar requirement is needed for nonpublic companies under their jurisdiction.

State boards of accountancy have the legal responsibility to regulate the professional relationships between CPA firms and nonpublic audit clients. State boards promulgate guidelines on independence and determine the services that CPA firms may perform for nonpublic clients within the board’s jurisdiction. One purpose of independence guidelines is to protect the public interest. As such, state boards of accountancy are advocates for users of audited financial information. Failure of CPAs to follow state boards’ guidelines could result in sanctions or other penalties, including the revocation of licensure.

Given SOA’s call for consideration of its provisions at the state level, the authors conducted a study to investigate the perceptions of members of state boards of accountancy when nonpublic audit clients were involved in the revolving-door phenomenon. The results could assist state boards in determining whether the presence or absence of a cooling-off period influences perceptions of independence. Results may also provide state boards with relevant information to assist them in determining whether provisions similar to those of SOA should be mandated for nonpublic entities.

Independence and the Revolving Door

Independence is widely viewed as the cornerstone of the public accounting profession and is accorded that importance in Generally Accepted Auditing Standards (GAAS). Opinions are more mixed concerning whether the potential hiring of employees or owners of an audit firm jeopardizes the firm’s independence. The practice has existed for years. As a recruitment tool, large CPA firms sometimes indicate to potential recruits that clients often seek individuals from the audit team to fill senior-level accounting positions. Those who join the firm and decide not to stay often have the option of taking such a position. A 1978 study estimated that 18.55% of auditors would accept positions with their former CPA firm’s clients [Eugene A. Imhoff, Jr., “Employment Effects on Auditor Independence,” The Accounting Review, LIII (4), 1978]. According to the Independence Standards Board (ISB) in Independence Standard 3, the revolving-door enticement allows public accounting firms to recruit qualified graduates by offering a better opportunity to become corporate executives than that for similar students that do not start their careers with CPA firms.

Negative publicity from audit failures such as Enron and WorldCom has increased public skepticism about the practice of companies hiring individuals that worked on their audits or worked for their auditors. The Washington Post reported that Enron hired its chief accounting officer from Arthur Andersen, its auditor. In addition, Global Crossing, which filed for bankruptcy amid allegations of improper accounting, had hired its former Arthur Andersen engagement partner as its senior vice president for finance, and a senior audit manager from Pricewaterhouse-Coopers solicited a job as CFO of a subsidiary of MicroStrategy while conducting its annual audit (K.D. Grimsley, “Auditors Pushed Into ‘Revolving Door’; Ex-Clients Hire Accountants Forced to Retire at 60 or 62,” Washington Post, February 19, 2002).

On March 20, 2002, Financial Executive International (FEI) recommended to the U.S. House of Representative Financial Services Committee that companies adopt policies that restrict the hiring of engagement audit and tax partners or senior audit and tax managers that have worked on the affected company’s audit for a period specified by the board of directors. FEI believes that this period should be no shorter than two years. A business investment community representative, John H. Biggs, former chairman and CEO of TIAA-CREF, testified on February 27, 2002, before the U.S. Senate Committee on Banking, Housing, and Urban Affairs about the need for some basic common sense regarding auditors’ independence. He called on companies to ask the following question: Is the CFO, the chief accounting officer, or any other financial manager a former employee of the audit firm? According to Biggs, any company that would answer yes to this question has a questionable relationship with its audit firm that would likely impair auditor independence (Accounting and Investor Protection Issues, 2002). The Public Oversight Board (POB), in its final 2001 annual report, agreed with its member Biggs that rotation of audit firms every seven years is a “powerful antidote” to the revolving-door phenomenon.

Not all stakeholders believe in the need for additional controls to address the revolving-door phenomenon. James E. Copeland, representing the AICPA in a March 14, 2002, speech before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, indicated that any restriction on the revolving-door phenomenon “would impose unwarranted costs on the public, the client, and the profession. Indeed, limiting the career opportunities of accountants would make the profession less attractive and make it more difficult for CPA firms to hire qualified people.” He indicated that this would be especially true for small to mid-sized CPA firms and would likewise affect these firms’ nonpublic clients accordingly.

Research Questions

The overall objective of this exploratory study was to provide a more complete understanding of the perceptions of members of state boards of public accountancy regarding the impact that the revolving-door phenomenon has on independence. A questionnaire was used to address general and specific aspects of the revolving-door practice, including the impact that both the current and former positions of the auditor had on the perception of audit independence.

SOA addresses corporate accountability issues by increasing the transparency of corporate financial statements. It requires a one-year cooling-off period before public companies may hire former auditors from their current audit firm in senior-level accounting positions, assuming that the company wishes to retain the same audit firm. Section 209 of SOA also addresses audit firms’ independence with regard to audits of nonpublic companies in the following statement:

In supervising nonregistered public accounting firms and their associated persons, appropriate State regulatory authorities (state boards of public accountancy) should make an independent determination of the proper standards applicable, particularly taking into consideration the size and nature of the business of the accounting firms they supervise and the size and nature of the business of the clients of those firms. The standards applied by the Board under this Act should not be presumed to be applicable for purposes of this section for small and medium-sized nonregistered public accounting firms.

On April 3, 2002, the California Board of Accountancy proposed a policy that would have imposed a two-year cooling-off period before supervisory members of an audit team would be allowed to accept employment with a company they have just audited. However, in August 2002, the Governor of California signed into law a requirement that auditors have a one-year cooling-off period before they join a publicly traded audit client as a financial officer. As in California, other states are looking at state regulatory agencies for accounting reform at the state level.

Questionnaire Development

Section A of the questionnaire contained six statements about CPA firms’ independence, three general statements, and three about the revolving-door phenomenon. Responses were rated on a scale from 1, strongly disagree, to 5, strongly agree.

Section B of the questionnaire contained six scenarios involving the revolving-door phenomenon. Each statement identified the position held by the former auditor, the length of the cooling-off period, and the new position at the former client. Responses were rated on the same scale of 1 to 5, with regard to whether independence would be impaired.

The study was sent to all 357 active National Association of State Boards of Accountancy (NASBA) members, and 48.8% responded. Such widespread input enhances the external validity of the results of this study.

Exhibit 1 contains demographic information on the respondents. CPAs constituted 80% of the respondents. Nearly three-quarters of the respondents reported having 10 or more years of public accounting experience.

The demographic information indicates that the respondents possessed the characteristics necessary to make informed judgments on independence issues impacted by the revolving-door phenomenon.

Survey Findings

Research question 1. Research question 1 addressed perceptions regarding independence and the revolving-door phenomenon: “In general, what are the perceptions of members of state boards of accountancy regarding CPA firms’ independence and the revolving-door phenomenon of nonpublic audit clients employing their current CPA firms’ former auditors in accounting positions?”

Section B of the survey contained six items to address this research question. The specific items and results are included in Exhibit 2. On the five-point scale, 3 was considered to be a neutral response, 1 and 2 were disagreement, and 4 and 5 were agreement.

As indicated in Section A of Exhibit 2, nearly all respondents, 98.2% (mean of 4.93), agreed that CPA firms should be independent of their audit clients. Consistent with this, the great majority of the respondents, 98.3% (4.89 mean), agreed that CPA firms should be independent of audit clients in fact. Finally, 91.9% of respondents agreed that CPA firms should be independent of their audit clients in appearance. These results collectively indicate that members of boards of accountancy overwhelmingly believe in CPA independence in both fact and appearance.

The last three statements in Section A depicted the revolving-door phenomenon of audit clients’ hiring former auditors for various generic supervisory and nonsupervisory accounting positions. The responses to statement 4 revealed that respondents were almost equally split between agreeing (43.7%) that the audit firm’s independence was impaired when a former senior-level auditor currently holds a supervisory accounting position with the client, and disagreeing that independence was impaired (42.5%). Neutral responses totaled 13.8%.

According to statement 5, 64.4% disagreed that a CPA firm’s independence would be impaired if a former staff auditor, nonsupervisory, held a supervisory accounting position with an audit client. Only 21.2% of respondents thought independence would be impaired, and 14.4% were neutral. If the former staff auditor is employed in a nonsupervisory accounting position, the disagreement rate increased to 80.4%.

One-way repeated measure ANOVA results from statements 4, 5, and 6 collectively suggest that members of state boards of accountancy perceive that the ranks of the positions involved in the revolving-door phenomenon do influence perceptions of independence. That is, when the current accounting positions are nonsupervisory, and the former auditors were nonsenior, it appears that the respondents generally did not perceive a significant risk that the audit firm’s independence was impaired. When talking about senior-level auditors that had accepted senior-level accounting positions with the client, respondents perceived significantly greater risk that independence was impaired due to the revolving-door phenomenon.

Research question 2. Research question 2 addressed in a more specific sense perceptions regarding independence and the revolving-door phenomenon: “What impact, if any, will the combinations of the following revolving-door phenomenon’s factors have on the perceptions of members of state boards of accountancy regarding the independence of CPA firms: 1) position held by the former auditor, 2) the client’s accounting position accepted by the former auditor, and 3) the length of time of the cooling-off period?”

Section B of the questionnaire contained six statements with varying permutations of the revolving-door phenomenon. Two specific employment scenarios (audit manager becomes the client’s controller versus engagement partner becomes the client’s chief accounting officer) were posited under three different cooling-off periods (none, one year, two years).

Respondents were to indicate on the same 1 to 5 scale the extent of their agreement or disagreement that independence would be impaired on the next audit. Responses are displayed in Exhibit 3.

Statements 1, 3, and 5 (audit manager to controller). Statement 1 depicts a former audit manager who accepted the controller’s position with the audit client with no cooling-off period. A slight majority of the respondents, 52.3% (mean of 3.31), agreed that independence would be impaired, 33.7% disagreed, and 14% were neutral.

When Statement 3 introduced a one-year cooling-off period, 65.7% of respondents disagreed that independence would be impaired, 19.8% thought independence would be impaired, and 14.5% were neutral. When the length of the cooling-off period was increased to two years (statement 5), 79.2% disagreed that independence would be impaired.

These results suggest that members of state boards of accountancy perceive that a cooling-off period can significantly reduce the negative impact on independence from the revolving-door phenomenon of former audit managers accepting controllers’ positions with former clients.

Statements 2, 4, and 6 (partner to CAO). Statement 2 depicts a former engagement partner who took the CAO position with the audit client with no cooling-off period. A majority of the respondents, 60% (mean of 3.67), agreed that independence would be impaired, 25.2% disagreed, and 14.8% were neutral.

For statement 4, which introduced a one-year cooling-off period, a majority of the respondents, 59% (mean of 2.38), disagreed that independence would be impaired. This suggests that the presence of a cooling-off period positively impacts the perception of audit firms’ independence by members of state boards of accountancy. Increasing the length of the cooling-off period from a one-year period to a two-year period (statement 6) appeared to have reduced the revolving-door even further: 76.8% of respondents (mean of 1.79) disagreed that independence would be impaired with this length cooling-off period.

These results suggest that members of state boards of accountancy perceive that having a cooling-off period can significantly reduce the possible negative impact on independence from the revolving-door phenomenon of former audit engagement partners accepting the CAO positions with former audit clients.

Demographic Issues

Did the survey respondents’ opinions differ significantly based upon demographic characteristics? To answer this question, the mean-response scores for the 12 statements on the questionnaire were compared along the following three demographic axes: professional certification (CPAs versus non-CPAs); primary employment (CPA firms versus non-CPA firms); and public accounting experience.

Generally, analyses based on each of the three demographic characteristics above yielded significant differences on all questions except Section A, item 1, and Section B, items 1 and 2. Analysis for the remaining nine items indicated that respondents that were not CPAs, were not employed by a CPA firm, or had no public accounting experience were generally more conservative in their responses than were others. It is interesting to note that significant differences were not found relative to the general statement that CPA firms should be independent of their audit clients (Section A, item 1), and perceptions regarding CPA firms’ independence for a manager (Section B, item 1) and an engagement partner (Section B, item 2) without a cooling-off period.

Conclusions and Limitations

Financial statements users’ perceptions of CPA independence have been tarnished by recent events involving the bankruptcies of entities that employed their current CPA firm’s former audit personnel in senior-level accounting positions. SOA was passed in part as a reaction to the revolving-door phenomenon. It requires a cooling-off period of one year before a publicly held entity may fill specified positions with individuals that worked on the audit. SOA also indicates that state boards of accountancy should make an independent determination of whether similar rules should be applied to other entities.

This study indicates that members of the 54 U.S. jurisdictions of state boards of accountancy—the majority of whom are CPAs in public practice—perceive that the lack of a cooling-off period threatens a CPA firm’s independence for nonpublic entities, especially when employees at a more senior level (e.g., audit managers) and owners of the firm (e.g., engagement partners) accept positions with an audit client. Furthermore, results show that board members believe a CPA firm’s independence would be enhanced by a required cooling-off period.

The results of this study are limited to the perceptions of members of state boards of accountancy. The perceptions of other groups, such as users of financial statements of nonpublic entities, must be considered. The results suggest that boards should address this issue weighing all the evidence and make an independent determination of whether a cooling-off period should be required for nonpublic entities.