Mandatory Auditor Rotation Debate Still Not Settled

The nation's top audit regulator still hasn't given up the idea of mandatory auditor rotation as a potential way to break cozy ties between auditors and corporate management, even while practically everyone else is pointing to the role of audit committees as a path to a less drastic solution.

During a third public roundtable held in Houston by the Public Company Accounting Oversight Board to gather ideas about how to get auditors to think and act more skeptically and more independent of management, an academic panel offered research they said suggests that a system of rotating auditors would be effective. Most other panelists continued to raise concerns about the costs and complexities of rotation and offered several other ideas for improving audit quality—including strengthening the role of the audit committee as overseer of the external audit firm.

Scott Whisenant, an associate professor of accounting at the University of Kansas, said his own research and his review of other academic research suggests long-term relationships between auditors and public companies increase the likelihood of clean audit opinions, meaning that auditors are less likely to raise issues the longer they have been conducting a company's audit. He also presented research that finds earnings management is less evident in the countries where rotation is practiced or required. Other accounting professors said auditors under the present model are more likely to be biased toward management than under virtually any other arrangement and auditors are taught to memorize standards rather than think critically.

PCAOB Chairman James Doty—perhaps the strongest advocate for rotation on the five-member regulatory board and not easily swayed by the heavy criticism, at least so far—latched onto the data, even though some of the research is based on just a few countries where auditor rotation is practiced or required. “The numerosity of comments is not going to determine, or should not determine, this issue,” he said. “We've got to get to more specifics and focused discussion about what the consequences [of auditor rotation] are, what the unanticipated consequences might be, and what you do to address those. What, in fact, is required to avoid having it become a blunt instrument?”

However, the vast majority of opinions—even from some investor groups—continue to focus on concerns over significant disruption and increased cost that would come with rotation. Greg Smith, interim executive director and chief operating officer for the Colorado Public Employees' Retirement Administration, said the board needs to produce more cost-benefit information before moving to a rotation requirement.

Smith, who is also chairman of the policies committee of the National Institute for Retirement Security Board Council, said the committee has studied the issue intensely but can't reach a consensus on whether rotation is a good solution. Instead, the committee's existing policy calls on audit committees to at least rebid the audit every five years and it is considering a new policy to strongly urge audit committees to hire a new auditor when there are indications that independence is at risk. The committee is also looking at new disclosure requirements and is considering whether to adopt a “comply-or-explain” policy, requiring audit committees to justify their decision to retain an auditor under its conditions.

“I think there are things we can do to make sure the auditing team is sufficiently independent. I personally believe the audit firms have gotten religion on this.”

—Larry Rittenberg,

Professor Emeritus,

University of Wisconsin-Madison

Cindy Fornelli, executive director at the Center for Audit Quality, ticked off a list of initiatives and materials that have emerged in recent months to call audit committees to a more robust oversight process, including a new assessment tool developed by several corporate governance groups to help audit committees better evaluate their auditors and a series of Webinars on how to help foster greater skepticism in the audit process. “Even the investor panel was hesitant to embrace mandatory firm rotation without first exploring other alternatives,” Fornelli noted after the roundtable.

Improving Audit Committee Oversight

Larry Rittenberg, professor emeritus at the University of Wisconsin-Madison and former chairman of the Committee of Sponsoring Organizations (COSO), offered specific ideas on how audit committees can improve the management of external auditors to assure their independence and objectivity. They can add more audit expertise to the audit committee, get more proactive in consulting with management and auditors on tough accounting issues, call on the audit firm to conduct more rotation of its non-partner staff, and assure the auditors are paid a fair price. A recently adopted standard requiring auditors to provide more communication of tough issues to the audit committee will also help, he said. “There's been a big change in focus away from just auditor rotation to other ways to enhance independence and skepticism,” he said.

ROTATION OPINIONS

Below are some comments from some participants in the PCAOB's auditor rotation roundtable:

After much study of this Concept Release, including recent member surveys and focus group discussions among audit committee chairs, NACD has concluded the following:

The corporate director community shares the PCAOB's view that external auditor independence, objectivity, and skepticism are critical objectives to pursue. NACD supports a rigorous process led by the audit committee, endorsed by the board, and communicated to shareholders.

Mandatory audit firm rotation is not an effective way to achieve that objective. The audit committee has a statutory responsibility for the external audit relationship, and we see no evidence that a requirement for mandatory audit firm rotation will increase the quality of financial reporting and therefore investor confidence.

There is an alternative solution that audit committees have suggested and NACD presents in this letter. It is a solution in which boards own and execute a rigorous process for oversight, act on the results as necessary, and proactively communicate the process and outcomes to shareholders.

—Ken Daly

President and CEO

National Association of Corporate Directors

There is much that an audit committee can do to support the independence and professional skepticism of the audit profession. It starts with greater audit expertise on audit committees and a process that focuses on better understanding of the business and less on pre-formed audit programs that become somewhat mechanical in approach. In my view, some of the changes will require the PCAOB to re-think some of its guidance regarding integrating business-knowledge into the conduct of an audit.

—Larry Rittenberg

Professor Emeritus

University of Wisconsin-Madison

Source: PCAOB.

As a member of a corporate audit committee, Rittenberg expressed strong objections to mandatory rotation. “I think there are things we can do to make sure the auditing team is sufficiently independent,” he says. “I personally believe the audit firms have gotten religion on this.”

Ken Daly, president and CEO of the National Association of Corporate Directors, says he saw the roundtable as an exercise in gathering whatever data could be found to support rotation. “What we saw was a number of witnesses who had very limited actual experience but nevertheless strong opinions about how much they liked mandatory rotation,” he says. “People are looking for data to support opinions, but that empirical analysis simply is not available.”

Daly acknowledges that smaller audit firms perhaps are not performing at the same level as those of larger, Fortune 500 companies. “You pick that up by talking to persons in the profession, and by talking to audit committee members,” he says. That's part of what inspired the NACD to collaborate with the CAQ and other groups to produce the guidance to audit committees on how to evaluate the auditor. The guidance represents the best ideas and practices that are already in use by audit committees of larger companies, he says.

He believes evidence of improved audit committee performance can be found in a decline in restatements in recent years. He also believes that the increase in negative remarks in PCAOB inspection reports, which is driving the PCAOB's consideration of new rulemaking, is based more on opinion than fact. “If the findings are so draconian as to cause concern for the audit committee, then there ought to be restatements to reflect that,” he says. “I hear it, but you know what? I don't see it.”