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The value of 'cooling off': do stakeholders worry when firms hire members of the independent audit team?

Article Excerpt
Firms often find it both efficient and effective to hire accounting overseers who have previously served as members of the firm's external audit engagement team. For example, a company's external audit manager may be an appropriate controller or CFO candidate, or former audit partners may be appropriate board and audit committee members. Hiring former audit engagement team members is efficient because those individuals are already familiar with the company's policies, practices, and corporate culture, requiring less "startup" time and the cost of their practical training has been borne by the auditing firm. It is also effective, as those individuals tend to be well-educated, are already knowledgeable about the client's industry-specific risks and internal control mechanisms, and they have an existing working relationship with client employees and those charged with corporate governance (e.g., board of directors, audit committee). Simply put, they are a known commodity.

The Sarbanes-Oxley Act of 2002 (SOX) mandated that an auditing firm's independence is impaired if a former member of a public company's audit engagement team (without regard to level, tenure, or extent of involvement) accepts a supervisory accounting position or financial reporting oversight role with the audit client, unless that individual observes a one-year "cooling off" period. We question whether investors prefer this "one size fits all" mandate, or whether a company-specific disclosure alternative would have equal or greater value relevance.

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HIRING FORMER AUDITORS

Approximately 33 percent of CFOs at Fortune 1,000 companies have prior experience with their company's current auditing firm (Behn et al. 1999). This suggests that those charged with hiring decisions view such practices as enhancing value. While some companies adopting this practice have had questionable accounting practices and well-publicized frauds (e.g., Enron, Waste Management), the findings of empirical research related to the association between the employment of former auditors and earnings management are mixed.

Some studies suggest that the likelihood of earnings management and financial statement fraud increases in the period following the hiring of former employees of companies' external auditors (e.g., Dowdell and Krishnan 2004; Menon and Williams 2004; Beasley et al. 2000). Other studies, however, fail to find significant differences in earnings management (Geiger et al. 2005). Further, the results of Dowdell and Krishnan (2004) and Imhoff(1978) suggest that the strength of the...

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