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PCAOB panelists say mandatory firm rotation could be harmful, helpful

 

By Ken Tysiac
March 21, 2012

Panelists voiced opposing views of mandatory audit firm rotation Wednesday during the first of two days of PCAOB hearings on the concept. Critics of mandatory rotation said it would be costly with questionable benefits, while proponents said rotation would increase auditors’ objectivity.

Many panelists proposed strategies other than rotation that they argued could help enhance auditors’ independence and professional skepticism.

Former SEC Chairman Richard Breeden took the middle ground, saying he doesn’t have a yes or no answer on audit firm rotation and said it would benefit some companies and probably would harm some others.

“I’m not sure improved objectivity would be the result,” Breeden said. “If the mandatory rotation is reasonably long, such as 10 or 12 years, the partners of the incumbent firm would still be afraid of losing the audit in the early years of that tenure.”

PCAOB Chairman James Doty asked for ideas and a robust debate, and panelists including prominent figures from government, audit firms, audit committees, business, and academia delivered a variety of opinions and alternatives for the PCAOB to consider as it decides whether to require audit firm rotation. Another day of hearings is scheduled for Thursday.

A PCAOB concept release on Aug. 16 asked for comment on whether firm rotation would improve audits and said the board is particularly focused on weighing the effect of audit terms of 10 or more years.

Breeden suggested a middle course of using a system similar to the U.K. “comply or explain” corporate governance model. He said the PCAOB could set a 10-year time frame for a “rebuttable presumption of loss of independence.” Under his scenario, the PCAOB would inspect the audit of a large company in the seventh or eighth year.

If the inspection showed problems in objectivity or independence, firm rotation would be mandated. But if the inspection report raised no concerns, the audit firm would be allowed to propose an extension of the relationship. Upon review of that proposal and alternatives, the audit committee would be free to vote to continue with the same firm.

Charles Bowsher, a former U.S. comptroller general, suggested implementing mandatory rotation that would be limited to 25 to 40 very large companies. These would include all the major financial institutions; any firm designated as “too big to fail” by the FDIC; industry leaders such as GM and GE; and large companies that appear to have significant audit and accounting problems.

He said that would help reduce critics’ concerns about the cost of mandatory rotation.

“If rotation is limited to the very large companies, the cost issue really is moot,” Bowsher said. “The cost of an audit for the various largest companies is a very, very small percentage of their overall cost structure.”

Audit firm officials generally opposed rotation. Stephen Howe, Americas managing partner of Ernst & Young, testified and released a written statement to the board that said any real or perceived improvement in independence, objectivity, and skepticism that might result from mandatory firm rotation would come at great expense to audit quality.

“We believe audit quality has improved in recent years,” Howe’s statement said, “and the board and profession should seek to build on this foundation rather than strike out in a new and, we believe, damaging direction that poses risks not only to audit quality but to our capital markets as well.”

Howe’s statement said the Sarbanes-Oxley Act of 2002 (SOX), which created the PCAOB and required increased oversight of auditors’ work by independent audit committees, has enhanced audit quality. He also stated that firms have made internal efforts to enhance audit quality that are continuing.

The AICPA has opposed mandatory firm rotation for reasons similar to Howe’s and sent a comment letter to the PCAOB saying requiring rotation would have costly and unintended consequences.

Former SEC Chairman Harvey Pitt said mandatory audit rotation would require auditors to be switched even if they had been serving ably. He advocated strengthening audit committees’ review of audit firms rather than implementing audit firm rotation.

Pitt proposed a system where the ultimate deliverable for an audit firm would be a finding by an audit committee that its external auditors exceed quality-control levels set by the PCAOB. This would allow the company to retain the audit firm for a certain period. He said the PCAOB and SEC should assist public company audit committees in developing a methodology for assessing the performance of external auditors and defining the circumstances under which audit firms should be discharged.

Cindy Fornelli, executive director of the Center for Audit Quality, which is affiliated with the AICPA, also is focusing on the audit committee. She will speak in the final session Thursday and released a statement Wednesday saying that the current system of investor protection that SOX put in place is fundamentally sound.

Fornelli wrote that mandatory firm rotation would hinder the ability of audit committees to oversee external auditors.

“The CAQ believes that audit committees, instead, should be further strengthened and encouraged to take an even more proactive role in their oversight of the independent auditor,” Fornelli said.

Former Federal Reserve Chairman Paul Volcker said his experience “does suggest to me the importance of requiring auditor rotation.” He also said a senior auditing partner should sign the auditing report to add to the sense of personal responsibility in the audit.

“It does seem to me that regular audits should not become a sort of long-term annuity for the accounting firm, paid for by the company being audited, rather than being responsive to the true client, the investment public,” Volcker said.

Doty asked about changing the payment system to one in which perhaps a third-party payer or insurance fund would pay for the audit so firms are not directly paid by the companies they are auditing. Volcker said changing the payment system would be a fundamental improvement.

“I don’t know how you would do it,” Volcker said. “With some government agency saying, ‘This is who your auditor is going to be, and this is how you’re going to get paid’? If you can deal with that payment problem, it’s more important than auditor rotation, in my view. Auditor rotation is a way of getting around the existing problem.”

Breeden said any system where payment would be channeled through a government agency “would be an unmitigated disaster.” He said audit firm “concentration” limits the practical options of large companies. He said the Big Four firms may be the only viable candidates to audit them.

He said Ford, for example, might be reluctant to have the same audit firm as GM, and therefore Breeden said it’s possible that there may be only one viable option for some large companies.

But Arthur Levitt, a former SEC chairman, said mandatory rotation is preferable because audits are not performed according to a mathematical formula where the answers always come out precisely the same.

“Professional judgment figures into the results,” Levitt said, “and therefore investors deserve the perspectives of different professionals every so often, particularly when an auditor’s independence can be reasonably called into question.”

Deloitte CEO Joe Echevarria testified and submitted a written statement that summarized alternatives to mandatory rotation, including expanding communications between audit firms and audit committees; enhancing the expertise of audit committees; and creating audit quality councils to advise audit firms.

Echevarria also proposed that the PCAOB broaden its inquiry beyond enhancing independence, objectivity, and skepticism to address audit quality as a whole.

“It is overall audit quality that contributes to financial reporting quality,” Echevarria wrote, “which should be the ultimate goal of any regulatory system that holds investor protection as its mission.”

Ken Tysiac (ktysiac@aicpa.org) is a JofA senior editor.

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