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In the wake of reporting catastrophes, the PCAOB is proposing mandatory auditor rotation in the US. But is this a solution in search of a problem, asks Ramona Dzinkowski

This article was first published in the May 2012 International edition of Accounting and Business magazine

Since the early 1970s, auditor rotation has been the subject of some debate in America and elsewhere. With the recent financial market crises, the topic has again reached the public policy domain with the US Public Company Accounting Oversight Board’s (PCAOB) Concept Release on Auditor Independence and Audit Firm Rotation on 16 August 2011. At that time the PCAOB reported that, for the largest 100 companies (based on market capitalisation), auditor tenure averaged 28 years, and 21 years for the 500 largest companies.

According to PCAOB chairman James Doty, the main reason to consider auditor term limits is that ‘they may reduce the pressure auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets’. More specifically, the release states: ‘By ending a firm’s ability to turn each new engagement into a long-term income stream, mandatory firm rotation could fundamentally change the firm’s relationship with its audit client and might, as a result, significantly enhance the auditor’s ability to serve as an independent gatekeeper’ (PCAOB Release No. 2011-006).

Audit deficiencies

In the concept release, the PCAOB, while indicating that improvements in the rigour of inspections and the remediation process have improved audits, expressed concerns about both the frequency and the type of audit deficiencies it continues to find. For example, in its inspections of the largest accounting firms from 2004 to 2007, it noted:

‘Inspectors continue to find deficiencies in important audit areas, both established and emerging. These areas include critical and high-risk parts of audits, such as revenue, fair value, management’s estimates, and the determination of materiality and audit scope. These deficiencies occurred in audits of issuers of all sizes, including in some of the larger audits they reviewed. In some cases, the deficiencies appeared to have been caused, at least in part, by the failure to apply an appropriate level of professional scepticism when conducting audit procedures and evaluating audit results. In addition, even in areas where inspectors have observed general improvement, deficiencies continue to arise.’

In particular, the PCAOB noted that the audits in which inspectors faulted the firms’ application of professional scepticism and objectivity included ‘some of the larger audits inspected’.

With this in mind, the release focused on the role of mandatory auditor rotation in improving independence and objectivity in audits, and asked for feedback on the following key issues, among many others:

  • Will rotation significantly enhance auditors’ objectivity, professional scepticism and ability and willingness to resist management pressure?
  • What effect would a rotation requirement have on audit costs?
  • Would a periodic ‘fresh look’ at a company’s financial statements enhance auditor independence and protect investors?
  • If the board decided to move forward with the proposal, what would be an appropriate term?
  • To what extent would a rotation requirement limit a company’s choice of an auditor?

With the comment period closing in December, we see the balance of the argument in the ‘nay’ camp, with the majority of corporate respondents decidedly against mandatory rotation. More specifically, they suggest that in today’s complex environment a deep level of knowledge around a company and its industry, its operations and financial history is mandatory in conducting an effective audit, which calls into question the wisdom of shortening engagements. Under these circumstances, rotation will result in less effective audits, not the other way around. For example, says Douglas Muir, CFO of Krispy Kreme Doughnut Corporation, ‘Forced rotations may remove valuable institutional knowledge from the audit process precisely when the audit committee believes that such expertise is necessary for the protection of investors and other users of financial statements.’

Cost concern

Also, at a time when the US economy is still struggling to regain its economic footing, costs are the biggest concern, with rotation potentially significantly increasing audit fees and related expenses. As Scott Kuechie, executive vice president and CFO of Goodrich Corporation, explains: ‘The cost of the audit would most likely increase significantly as more audit hours would be required to learn the accounting and processes at the new client. Likewise, the cost of client support would also increase to support the auditors.’ Therefore, he concludes, ‘We do not believe that the benefit of mandatory auditor rotation would exceed the cost.’

And what do the auditors have to say about mandatory rotation if in fact there is an opportunity to increase audit fees? This time, the auditors seem to be decidedly in agreement with corporate America. More specifically, Deloitte and Touche (the only Big Four firm to have responded in writing to the proposal) makes clear that they really don’t think auditor rotation will cut it when it comes to ‘increasing auditor independence, objectivity and professional scepticism’. CEO Joe Echevarria, commenting on behalf of Deloitte, concludes the following based on ‘an objective assessment of the literature on mandatory rotation’:

  • Research studies show that restatements and frauds are less likely to occur with longer auditor tenure.
  • The majority of studies on mandatory rotation reach an unfavourable conclusion on the balance between costs and benefits.
  • If mandatory rotation were required at the 500 largest US companies, a 10-year phase-in process would entail 50 auditor changes every year compared to the recent average rate of five per year.
  • The economies and capital markets of countries that have adopted mandatory rotation are not directly comparable to those of the US. Some countries that have adopted the policy have discontinued or curtailed it.

Research that is available tends to be unfavourable on the effects of mandatory rotation.

Sarbox sufficient?

Finally, as to the need for the PCAOB to explore extra rules around auditor independence, others suggest that Sarbanes-Oxley has actually covered it off quite nicely. Says Robert C Greving, chairman of the audit and enterprise risk committee of CNO Financial Group, a US$32bn holding company: ‘The rules put in place by the Sarbanes-Oxley Act charge the audit committee with the selection and oversight of the audit firm... We believe the audit committee is in the best position to evaluate whether the auditors are independent and objective and whether it is in the best interests of the shareholders to initiate the process of selecting a new firm.’

At the end of the day, would shorter engagements have prevented some of the reporting and assurance catastrophes of the last two decades? Arnold Hanish, CFO of Eli Lilly, calls into question any relationship between audit failure and audit tenure outlined in the PCAOB release: ‘We are not aware of any relevant data or evidence linking lengthy audit firm tenure to audit failures. In the release, the PCAOB attempts to draw a line between the numbers of audit failures identified as part of their inspection process and the tenure of the audit firm. In evaluating this relationship, it is important to note that the sample of audits that the PCAOB inspects is not a representative sample as a risk-based approach is utilised so that the board can focus their review on the most error-prone situations.’

He concludes that the evaluation of this topic as a concept release is ‘premature without the existence of any factual data to establish a clear link between mandatory audit firm rotation and increased independence, objectivity and professional scepticism on the part of the auditor’.

Hanish suggests that in place of mandatory rotation, the PCAOB considers further limiting the scope of non-audit services the audit firm can provide to its audit clients. In particular, he calls for the PCAOB to be more prescriptive on all other non-audit services that can be provided, potentially limiting all advisory services. ‘We believe,’ he says, ‘that action in this area may address the PCAOB’s concern that the auditors are attempting to maintain good client relationships at the expense of performing a quality audit to engage in more lines of business and provide additional services to the company.’

Other observers, like Richard Hawley, CFO of Nicor, also suggest that audit rotation answers nothing. Having been on both sides of the situation (as an audit partner, a Fortune 500 and 1000 CFO and chair of a public company audit committee), he is ‘very concerned that consideration of mandatory rotation of audit firms is a wonderful theoretical solution looking for a non-existent problem’. Furthermore he questions the need for yet more government intervention in corporate business. ‘My issue with the proposal are many,’ he says. ‘First, it presumes the company boards and management...are not capable of selecting firms that will live up to professional standards, and are in need of government assistance in making a change when necessary. I don’t believe there is any significant evidence to suggest that is the case.’

Ramona Dzinkowski is a Canadian economist and award-winning journalist

Last updated: 7 Apr 2014