Audit Firm Rotation Idea Scrapped?

For more than a year, audit regulators have threatened to impose mandatory audit firm rotation. But now that drastic idea seems finally to be heading to the dustbin­—at least for the foreseeable future.

Through several meetings, missives, and public comments, the Public Company Accounting Oversight Board had suggesed that it was seriously considering imposing a system of term limits for audit firms as a way to break the client-service provider ties that audit firms have forged with senior management over generations.

PCAOB Chairman James Doty put the bold idea into motion with a concept release last August that asked whether mandatory rotation would sever long-standing relationships to help auditors become more objective and more skeptical of management assertions in financial statements. On several occasions Doty appeared to back the idea as the best chance to raise the quality of public company audits.

Audit firms and corporate issuers, who largely opposed the idea, can now breathe a sigh of relief, however. After sifting through hundreds of comment letters, hearing dozens of roundtable speakers, and facing an angry Congressional panel threatening legislation to block a rotation rule, it's becoming clear that the PCAOB, and Doty in particular, don't have the support to pursue audit firm rotation any further.

PCAOB member Jay Hanson aired his doubts openly at the national regulatory conference of the American Institute of Certified Public Accountants last week. “Personally, I struggle to see how we would ever do a mandatory rotation standard,” he said. Hanson said the board's search for evidence has not turned up the data it needs to show that rotation would produce better audits, a key requirement of Congress to reverse its plans to block a rule.

In fact, Congress­—particularly Republicans in the House—disliked the idea so much, it adopted a provision in the JOBS Act requiring any new PCAOB standard to be backed with evidence showing that its benefits justified its costs. The PCAOB recently lengthened its entire standard-setting process to allow about six months or more on most projects so that a full cost-benefit study could to be performed. “We have to find a causal link between tenure and rotation,” Hanson said. “We've asked for that, but haven't seen it.”

Another difficult hurdle for auditor rotation is that under the Sarbanes-Oxley Act, all PCAOB standards need to be approved by the Securities and Exchange Commission, which Hanson cited as a concern. “There would be enormous obstacles even if we found all the evidence we would need to support that it's the right thing to do,” he said. “It's hard to imagine how we would go forward.”

Heaps of Opposition

PCAOB member Jeanette Franzel, speaking at the same conference, wasn't as direct as Hanson, but made it clear that the board is regrouping after hearing heaps of criticism about pursuing the rotation concept. The board received nearly 700 comment letters, very few of them supportive of rotation as a solution to independence. It also held three separate roundtable sessions, but drew few speakers who would provide strong support for rotation. Even investors were largely skeptical that a workable plan could be assembled.

“We have to find a causal link between tenure and rotation. We've asked for that, but haven't seen it.”

—Jay Hanson,

Member,

PCAOB

“We've learned a lot, and we're starting up some additional initiatives in those areas,” said Franzel. “At the same time, we're taking a pause on the original concept release. The focus right now is on areas where practice can be improved. We will take it up in 2013 to decide what our next steps will be.”

The board heard specifically from audit committees that they believed a rotation rule would interfere with their role under Sarbanes-Oxley to hire and fire the external auditor, said Franzel. That inspired the board to issue guidance directed at audit committees to help them better understand how to use PCAOB inspection reports to press auditors on where they might need to do a better job. The board also is awaiting SEC approval on a new standard it developed to govern what auditors say to audit committees, hopeful the standard will give audit committees more information to use to encourage an objective audit.

AREAS OF CONCERN

The excerpt below from the PCAOB's practice alert provides examples of times when auditors did not appropriately apply professional skepticism.

PCAOB inspectors continue to observe instances in which the circumstances suggest that auditors did not appropriately apply professional skepticism in their audits. As examples, audit deficiencies like the following raise concerns that a lack of professional skepticism was at least a contributing factor:

For certain hard-to-value Level 2 financial instruments, the engagement team did not obtain an understanding of the specific methods and/or assumptions underlying the fair value estimates that were obtained from pricing services or other third parties and used in the engagement team's testing related to these financial instruments. Further, the firm used the price closest to the issuer's recorded price in testing the fair value measurements, without evaluating the significance of differences between the other prices obtained and the issuer's prices.

The issuer discontinued production of a significant product line during the prior year and introduced a new product line to replace it. There were no sales of the discontinued product line during the last nine months of the year under audit. The engagement team did not test, beyond inquiry, the significant assumptions management used to calculate its separate inventory reserve for this product line.

The engagement team did not evaluate the effects on the financial statements of management's determination not to test a significant portion of its property and equipment for impairment, despite indicators that the carrying amount may not have been recoverable. These indicators in this situation included operating losses for the relevant segment for the last three years, substantial charges for the impairment of goodwill and other intangible assets during the year, a projected loss for the segment for the upcoming year, and reduced and delayed customer orders.

After the date of the issuer's balance sheet, but before the release of the firm's opinion, the issuer reported that it anticipated that comparable store sales for the first quarter of the year would be significantly lower than those for the first quarter of the year under audit. The engagement team had performed sensitivity analyses as part of its assessment on the issuer's evaluation of its compliance with its debt covenants, the issuer's ability to continue as a going concern, and the possibility of the impairment of the issuer's long-lived assets. The engagement team did not consider the implications of the anticipated decline in sales on its sensitivity analyses and its conclusions with respect to compliance with debt covenants, the issuer's ability to continue as a going concern, and impairment of long-lived assets.

The PCAOB's enforcement activities also have identified instances in which auditors did not appropriately apply professional skepticism. For example, in one recent disciplinary order, the Board found, among other things, that certain of a firm's audit partners accepted a company's reliance on an exception to generally accepted accounting principles ("GAAP") requirements for reserving for expected future product returns even though doing so conflicted with the plain language of the exception and the firm's internal accounting literature. The partners were aware of, but did not appropriately consider, contradictory audit evidence indicating that the returns were not eligible for the exception. This illustration of a lack of professional skepticism reappeared in the firm's response when the issue was questioned by the firm's internal audit quality reviewers. Although certain of the partners involved determined that the company's reliance on the exception to GAAP did not support the company's accounting, they, along with other firm personnel, formulated another equally deficient rationale that supported the company's existing accounting result.

Source: PCAOB.

Another recent step, said Franzel, is the board's latest guidance reminding auditors of requirements to approach engagements with objectivity and skepticism. With it, PCAOB Chief Auditor Martin Baumann said there's plenty auditors can do without a new standard to take a more objective view of the public companies they audit. He said audit firms should look hard at institutional practices that inspire auditors to think of public company management as their clients. Audit firms focus on providing “high-quality client service,” he said, “keeping the client happy,” and “forming relationships.” He would prefer to see firms focus on high-quality audit work. “These all inhibit professional skepticism,” he said.

Baumann also questioned such audit firm practices as undercutting audit pricing and cross-selling professional services to the companies they audit. He questioned whether a focus on keeping costs low could lead to scheduling and workload demands that force auditors to work too quickly. That might inspire them to gather evidence that's easiest to obtain or to give too much weight too hastily to whatever confirming evidence they find. “The importance of an effective audit can't be overstated,” he said.

During his keynote address at the AICPA conference, Doty spent little time talking about rotation. “Above all, emphasis should be placed on identifying and reacting appropriately to risk, and on establishing counterweights to circumstances that could detract from the ultimate goal of obtaining a high level of assurance that the financial statements are free of material misstatement,” he said. “This is why I believe it is so important to re-examine how we protect the auditor's independence, including by considering term limits.”

Doty said after his speech that nothing has changed in terms of the board's consideration of independence or mandatory rotation. He said it remains an important initiative, but simply wasn't the subject of that particular speech.

The European Union continues to consider whether it will adopt a requirement for audit firms to follow a system of mandatory rotation and to separate their audit business from their consulting business, although cost-benefit concerns there have stalled the discussion as well. A report by a European Parliament agency raised questions about whether the European Commission had adequately established that rotation would correct the problems of market dominance that the Commission hoped to address.

Here in the United States, audit firm rotation isn't officially dead yet, but a way forward—and possibly more importantly a will to go forward by the PCAOB and others—doesn't appear to be on the horizon.