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PCAOB Opens Discussion on Audit Firm Rotation

 

August 16, 2011

The PCAOB on Tuesday launched a new phase of its examination of potential limits on audit firm tenure with public companies. The board voted to issue a concept release on the topic. It plans to gather feedback by mid-December and hold a public forum on the issue in March 2012.

 

According to the release, the board is particularly focused on weighing the advantages and disadvantages of audit terms of 10 years or greater. The board is also mulling the scope of any potential requirement, such as whether the rules would apply only to audits of the largest public companies.

 

The 41-page document poses 21 questions about which the board is most interested in gathering opinions. The topics range from the appropriate length of the term, if term limits are imposed, to implementation considerations. Comments are due Dec. 14.

 

“There are, of course, considerable implementation challenges associated with mandatory rotation. The concept release invites study and consideration of whether there are ways to mitigate those challenges,” PCAOB Chairman James Doty said in remarks at Tuesday’s meeting. “But the reason to consider the concept is to resolve the question to which the discussion of independence, skepticism and objectivity always seems to return. That is the central question of this concept release: Will term limits, set at some appropriate length, with due regard for implementation complexities, reduce the pressures auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets?”

 

“With this release, I hope to challenge critics and proponents alike to do their homework, come forward with facts, and add meaningful depth to the discussion, in order that we might reach resolution,” Doty said.

 

Cindy Fornelli, executive director of the Center for Audit Quality, which is affiliated with the AICPA, said, in a statement issued after the meeting, “The CAQ looks forward to a constructive dialogue with the PCAOB and all interested stakeholders on these important issues.”

 

PCAOB member Jay Hanson, a former national director of accounting for McGladrey & Pullen LLP and former chairman of the AICPA’s Financial Reporting Executive Committee, supported the concept release but urged the board to proceed with caution. “The primary focus of the concept release is mandatory auditor rotation. Before we determine whether that is in the best interests of investors and the public, we will need to weigh carefully whether its benefits would outweigh its costs and potential unintended consequences,” Hanson said. “We also need to further analyze our inspection results and other available information to determine whether audit deficiencies are attributable to a lack of auditor objectivity and skepticism and, if so, whether those symptoms are best remedied through mandatory auditor rotation or some other measure.”

 

Tuesday’s release and comments from several board members pointed out that a 2003 GAO report concluded that “mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality.”

 

Board member Daniel Goelzer said he has “serious doubts” that mandatory rotation is a practical or cost-effective way of strengthening independence. “However, with nearly nine years of inspections experience under our belts, the time is right to step back and thoughtfully examine whether we need to deploy new tools to promote independence,” he said.

 

Goelzer urged those commenting on the PCAOB concept release to be open-minded and creative in approaching the debate on audit rotation. He said a cost-benefit analysis of mandatory rotation would be critical.

 

“Firm rotation would not be cheap for American business,” Goelzer said, pointing to the GAO report, in which large firms estimated that, under rotation, first-year audit costs would increase by 20% as a result of work associated with getting up to speed about the new client.

 

Goelzer listed two potential alternatives to mandatory firm rotation should new regulatory measures be needed: empowering the SEC or the PACOB to require rotation on a case-by-case basis when a board inspection finds that long tenure and lack of independence have combined to result in an audit failure; or imposing special obligations on audit committees to justify the retention of the auditor after some period of time, such as 10 or 15 years.

 

“Objectivity, independence, and professional skepticism are the foundations of a high-quality public company audit,” the CAQ’s Fornelli said in her statement. “The auditing profession is continually working to improve performance in these areas and is eager to explore ways to enhance confidence in the financial statement audit. It is important that any new requirements in this area, including mandatory firm rotation, meet the objective of improving audit quality. As stressed by several board members, a cost-benefit analysis should be central to the project. It is also important that, as they are doing with possible changes to the auditor’s report, the PCAOB seek additional input from the full range of stakeholders who will be significantly affected by any changes in this area.”

 

According to the concept release, proposals being considered outside the U.S. would put in place measures such as regulation of engagement tenders, mandatory rotation, dual-firm audits and “audit-only” firms.

 

If the board determined to move forward with development of a rotation proposal, it would also need to consider whether the requirement should be paired with other changes to existing requirements, the release states. Such procedures could include heightened internal supervision or oversight requirements for the first year or two of a new engagement, increased required communications between predecessor and successor auditors, or other steps auditors could be required to take during the transition from one firm to another.

 

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