PCAOB Kicks Off Auditor Rotation Debate

Even the best-intentioned auditors can't help themselves, says Harvard University business professor Max Bazerman: They're human, and therefore interpret information the way they want to see it based on a desire to please a client.

Bazerman's view was just one of many voiced during two days of roundtable discussions hosted by the Public Company Accounting Oversight Board last week, on whether rules are needed to mandate auditor rotation. The board convened nearly 50 speakers to explore its concerns that auditors aren't adequately independent of their public company clients, and can't be objective or skeptical enough when auditing their financial statements.

The board has published a concept release asking for views on whether a system of term limits on audit engagements, a forced process of mandatory rotation, or some other solution would create more independence for auditors. The PCAOB will continue to accept comments on its concept release through April 22.

The European Union is a step further in the process, considering a law that would limit audit engagements to six years with a four-year cooling off period before a firm could be rehired. The law also would require large audit firms to separate their audit and non-audit services into separate firms to avoid conflicts of interest.

Europe's considerations certainly have the attention of PCAOB Chairman James Doty, who refers often to regulators in other countries that are taking bold action to address concerns about auditor independence, objectivity, and skepticism. One of the main goals of the PCAOB roundtables was not only to hear views for and against mandatory rotation, but also to hear alternative ideas. Although the rotation idea has drawn heavy criticism in the United States, Doty has become passionate in his hunt for ways to bring about more auditor independence, even getting testy during the roundtable with the U.S. Chamber of Commerce for suggesting the board should abandon the idea altogether.

Bazerman said the board should prohibit audit firms from establishing long-term cooperative partnerships with public company clients or providing any non-audit services and also prohibit individual auditors from taking jobs with client companies. He had plenty of company. Several former securities regulators, other academics, and investor advocates who support auditor rotation expressed similar views.

But the board also heard from plenty more speakers with various roles in capital markets—most notably audit firms, companies that hire them, and audit committee members—that rotation would be costly, disruptive, and not address the main goal of stoking auditor independence.

Corporate chief financial officers told the PCAOB that a rotation system would diminish audit quality, since each new firm would require time to learn the business, especially global companies with complex operations and processes. They also argued that an already-constrained choice among the Big 4 would get smaller when companies take industry experience and existing consulting arrangements into consideration in selecting a new firm for each tenure period, they said.

Valerie Sheppard, comptroller for Procter & Gamble, said her company has consulting arrangements with all three major firms that aren't performing its audit. Deloitte & Touche is P&G's auditor, and has been “for many years” according to P&G's Website.

“A mandatory rotation system would, in short, leave the external auditor without effective oversight.”

— Roderick Hills,

Partner,

Hills Stern & Morley

To achieve rotation, Procter & Gamble would have to rotate those consulting contracts as well, laying off at least one firm so that it would have one independent firm to select when the company needed to change auditors. With the choice pre-determined, that leaves no room to negotiate fees, Sheppard said.

Some organizations told the PCAOB they already rotate auditors. For example, CalPERS follows a policy of rotating its audit firm for its own financial statement audits every five years and has found the process workable, said Mary Hartman Morris, investment officer for the retirement system. 

“From our perspective, it has enhanced the integrity of financial reporting,” she said. “And I don't believe there was additional cost involved.” To be fair, CalPERS didn't use a Big 4 firm, instead relying on regional firm Macias Gini & O'Connell for its 2011 audit. That may not be an option for most multi-national companies.

PCAOB QUESTIONS

Below is a sampling of questions from the board to which companies can offer comments:

1. If the board determined to move forward with development of a

rotation proposal, what would be an appropriate term length?

2. Should different term lengths for different kinds of engagements be

considered? If so, what characteristics, such as client size or

industry, should this differentiation be based on?

3. Does audit effectiveness vary over an auditor's tenure on a

particular engagement? For example, are auditors either more or

less effective at the beginning of a new client relationship? If there

is a “learning curve” before auditors can become effective,

generally how long is it, and does it vary significantly by client type?

4. Some have also suggested that, in addition to being less effective

at the beginning of an engagement, an auditor may be less diligent

toward the end of the allowable term. On the other hand, others

have suggested that auditors would be more diligent toward the

end of the allowable term out of concern about what the

replacement auditor might find. Would auditors become more or

less diligent towards the end of their term? Does the answer

depend on the length of the term?

5. How much time should be required before a rotated firm could

return to an engagement?

6. Should the board consider requiring rotation for all issuer audits or

just for some subset, such as audits of large issuers? Should the

board consider applying a rotation rule to some other subset of

issuer audits? For example, are there reasons for applying a

rotation requirement only to audits of companies in certain

industries?

7. To what extent would a rotation requirement limit a company's

choice of an auditor? Are there specific industries or regions in

which a rotation requirement would present particular difficulties in

identifying an auditor with the necessary skills and expertise? Is it

likely that some smaller audit firms might decide to leave the public

company audit market due to the level of uncertainty regarding their

ongoing client portfolios?

8. If rotation would limit the choice of auditors, are there steps that

could be taken to allow a company sufficient time to transition out of

non-audit service arrangements with firms that could be engaged to

perform the audit? Are there other steps that could be taken to

address any limitation on auditor choice?

9. If rotation were required, would audit firms have the capacity to

assign appropriately qualified personnel to new engagements? If

they do not currently have that capacity, could firms develop it in

order to be able to compete for new clients, and would they do so?

10. Would rotation create unique challenges for audits of multinational

companies? For voluntary rotations that have taken place, what

have been the implementation and cost issues and how have they

been managed?

Source: PCAOB.

Some participants said the PCAOB could improve auditor independence with other tactics beyond auditor rotation. Focus instead on enhancing the independence and performance of audit committees who are responsible for hiring auditors, said Roderick Hills, former chairman of the Securities and Exchange Commission and a partner at law firm Hills Stern & Morley. Audit committees could be required to review their choice of audit firm periodically and explain their reasoning if they decide to retain the same firm. “A mandatory rotation system would, in short, leave the external auditor without effective oversight,” he said.

Audit committees could benefit from more guidance and training, said Catherine Lego, chairman of the audit committees for SanDisk and Lam Research Corp., to improve their oversight of the external auditor in a way that would make them more independent. They could also benefit from getting more information on PCAOB findings from inspection and enforcement activities, Lego said, but that information is heavily protected under the Sarbanes-Oxley Act. “I would love to see what you see,” she told Doty.

Former SEC Chairman Harvey Pitt told the PCAOB that the investing world still needs more research to determine that auditor rotation would indeed make auditors more independent. The board should gather more empirical data to show rotation would achieve the objective without harming audit quality, he said, and should avoid a uniform approach that would strip directors of their decision-making authority. Pitt also suggested that the board consider making incremental changes rather than radical ones to guard against unintended consequences.

Pitt also agreed with Lego that audit committees need to know when the PCAOB has concerns about a particular firm. “There needs to be a way for an audit committee to know if a firm pops up on the PCAOB's problematic list,” he said, acknowledging it might take an act of the SEC or Congress to make such alerts available to audit committees.

Darren Wells, CFO at Goodyear, agreed that the board should explore other ideas before giving further consideration to mandatory rotation. He suggested that companies and audit firms could benefit from more timely audit inspections. Currently it typically takes a year or more for inspection reports to be made public, Wells noted. The board also should consider requiring rotation only in the event of an audit failure, he said, and it should require auditors to communicate to audit committees alternative accounting considerations for significant transactions.

Jack Ciesielski, president of investment research firm R.G. Associates, said the PCAOB should study an alternative payment model for auditors to sever the client relationship between audit firms and public companies entirely. Public companies would purchase financial statement insurance to cover losses due to misstatements, and insurers would hire the auditors to perform the audit work. “You could think of it as guarantee by the insurance companies that the financial statements are fit for use by investors,” he said.