PCAOB Starts Audit Reform Debate

Nearly a decade after an overhaul of how corporate financial statements are audited, regulators have pulled out a fresh sheet of paper to ponder how they can prod audit firms to think more objectively.

The Public Company Accounting Oversight Board launched its shake-up of the longstanding relationship between public companies and their auditors last week, voting to publish a concept release seeking comment on what to do. The most controversial idea the board has floated so far: requiring audit firms to rotate off their public-company clients every few years.     

More fundamentally, however, the PCAOB is trying to answer this question: When a public company is paying an audit firm to provide an independent, objective assessment of the financial statements, just how independent and objective is that auditor's assurance really?

The PCAOB—and practically everyone else who has thought about it—concedes that an inherent conflict exists; minimizing that conflict is the tricky part. The board, reinvigorated earlier this year with a new chairman and several other new members, is troubled by evidence from inspections that auditor judgment is sometimes clouded by concerns over keeping the client happy. Hence the concept release, and a roundtable planned for next March to discuss the feedback received.

PCAOB Chairman James Doty says inspectors still find pervasive audit failures and still find documentation suggesting auditors market themselves to potential clients as partners who will support a client's financial statement assertions and help achieve its goals. “It's hard not to question whether their mindset might have contributed to some of these audit failures,” Doty said as the board published the release.

Term limits or some similar system of mandatory rotation might help sever that connection, Doty said. He acknowledged that the idea has been explored and dismissed before, most recently in the wake of the Sarbanes-Oxley Act of 2002; at the time, the Government Accountability Office said the cost of such a system would overtake any benefit. Instead, Congress and regulators established requirements for the audit firm's engagement and reviewing partners to rotate, and imposed restrictions on non-audit work that audit firms can perform for clients as alternative measures intended to foster greater independence.

But the core conflict remains unresolved, Doty said. “The reason to consider the concept [of rotation] is to resolve the question to which the discussion of independence, skepticism, and objectivity always seem to return,” he said. “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 relationships to the detriment of investors and our capital markets?”

The concept release asks a long list of questions about how mandatory rotation might work. Would it help or hurt audit quality? Should it apply to all public companies and all audit firms, or just the big ones? Should it apply only to certain sectors? Would it restrict choice? Would it be costly or disruptive? Would it cause capacity or personnel problems? Should it be accompanied by other restrictions on a company's ability to fire the audit firm?

Dan Pedrotty, director of the Office of Investment for union giant AFL-CIO, says he supports anything the PCAOB can do to make auditors more independent. “Pension funds and long-term investors have lost billions of dollars because of fraud and audit failures,” he says. “We think having a fresh set of eyes, a truly independent auditor, is absolutely critical to the integrity of the financial statements.”

“We think having a fresh set of eyes, a truly independent auditor, is absolutely critical to the integrity of the financial statements.”

—Dan Pedrotty,

Director of the Office of Investment,

AFL-CIO

Pedrotty is like many investors who have come to wonder whether auditors are doing all they can to protect investors. “We've seen it all too often,” he says. “An auditor worried about the ongoing business relationship refuses to really push hard on questionable finances. If the firm knows they are going to be rotated out by law, the hope is this opens up more room for them to ask tough questions.”

Finding Objective Evidence

While all five PCAOB members agreed to publish the concept release, they clearly are not unanimous in supporting the notion of mandatory rotation or term limits. PCAOB member and former Acting Chairman Dan Goelzer was blunt: “I have serious doubts that mandatory rotation is a practical or cost-effective way of strengthening independence,” he said. But he agreed that after nearly a decade of inspection work, it's appropriate to reflect on what can be gleaned from that experience to further promote independence.

Goelzer and fellow board member Jay Hanson focused more attention on the additional questions asked in the concept release. What else can we do besides imposing term limits to enhance independence? For example, should the PCAOB use term limits on a case-by-case basis as a remedial or punitive measure? Should it conduct a pilot program? Should it look at other ways for the auditor to be engaged and paid for audit work? Should it look more closely at the duty of audit committees to consider independence and the need to hire a new auditor? What about joint audits? Should the board somehow address independence concerns through its existing inspections and enforcement processes? Or should it defer any action and do nothing?

AUDITOR DEPARTURE STATS

Below are two charts from Audit Analytics. The first provides information on the number of auditor departures during the years 2007 to 2010; the second shows 2010 auditor changes by company size:

Source: Audit Analytics.

Tim Follett, national director of quality control at Mayer Hoffman McCann, says it's not clear that a rotation system would lead to greater independence, and it's even more unclear how many years might constitute an appropriate term limit. “Who's to say whether five years or 10 years is right?” he asks. “When, all of a sudden, do you become not independent? There's no hard line in the sand on that.”

Audit firms have long insisted that mandatory rotation would increase cost because of the constant churn associated with taking on new audit work. “There's no question in my mind it would increase cost for companies,” says Greg Bailes, a partner with audit firm Weaver. “There's a learning curve involved when you get a new client, and there's some concern that audit failures increase in the initial year or two after an auditor change. That's a significant risk that needs to be explored.”

Doty made it clear he's looking for empirical data, not anecdotes, before he will believe arguments against rotation, especially when audit firms talk about the learning curve. He cited data from research firm Glass Lewis that said from 2003 to 2006 (as Corporate America adjusted to the post-SOX regulatory world), more than half of all public companies changed auditors voluntarily. “How did auditors and companies manage those changes?” he asked. “The learning curve, and cost-based issues involved in changing audit firms, cannot be fairly described as uncharted waters.”

Coincidentally, separate research by Audit Analytics and Compliance Week has shown that restatements and material weaknesses in internal control also spiked during that same SOX implementation period. But none of that can be tied together in any kind of clear cause-effect relationship, as Goelzer pointed out.

“Not all audit breakdowns are the result of the auditor approaching his or her work with a pro-client bias,” Goelzer said. Audits also fail because of inexperience, technical incompetence, staffing, or fee pressures, inadequate supervision, audit methodology breakdowns, and any number of other problems. “It may be possible to draw relevant conclusions about the impact of tenure on audit quality from our inspections records, but the necessary analytical work has not yet been done.”