The Public Company Accounting Oversight Board heard testimony from a series of high-profile auditing experts on the advantages and disadvantages of requiring companies to rotate their auditing firms on a regular basis.
Like what you see? Click here to sign up for Accounting Today's daily newsletter to get the latest news and behind the scenes commentary you won't find anywhere else.
The testimony came in response to a concept release that the PCAOB proposed last year on the controversial matter of mandatory audit firm rotation. On the first day of the two-day hearing, the PCAOB heard from former Federal Reserve Chairman Paul Volcker, along with several former chairmen of the Securities and Exchange Commission—Arthur Levitt, Harvey Pitt and Richard Breeden—and the heads of the five largest auditing firms.
“Many people are troubled by reports of audits that span decades, even a century,” said PCAOB chairman James Doty on Wednesday. “These are the engagements that no partner wants to be the one to lose. At the same time, we should be concerned about the relatively new audit that the auditor may hope to turn into a long-term engagement.”
Volcker came out in favor of mandatory auditor rotation. “It does seem to me that regular audits should not become a sort of long-term annuity for the accounting firm paid for by the company being audited, rather than being responsive ... to the investing public,” he said, according to Reuters.
However, Pitt, who is now CEO of Kalorama Partners, said he did not favor the idea. “Nothing the PCAOB or SEC will do can prevent future fraudulent financial statements,” he said, comparing the notion of mandatory rotation to a “dead hand switch,” never allowing a company’s audit committee to exercise its own judgment. “The cure could turn out to be worse than the disease, depending on the amount of time people would be required to rotate off,” said Pitt. He instead recommended that the onus be placed on an independent audit committee “armed with the necessary information.”
Levitt noted that most auditing work today is done by staff members who rotate from audit firm to audit firm. “The real continuity is by the partners who oversee the work,” he said. “The argument about institutional memory seems to me misplaced.” He sees a much greater threat on the horizon in the JOBS Act that was passed earlier this month by the House, which would exempt so-called “emerging growth companies” from many Sarbanes-Oxley rules.
“There would be very little public policy benefit,” said Levitt. “I would urge the PCAOB to resist the legislation.”
Breeden also took issue with the JOBS Act. “Sadly, many people in official Washington seem prepared to jettison the interests of investors without reason as would occur in the proposed JOBS legislation, which as currently written would unnecessarily savage important barriers against fraud and manipulation of markets,” he said.
Breeden said he had not specific yes or no answer on mandatory audit firm rotation, but he noted that the level of concentration of audit firms limits the practical choices of audit committees, and means that rotation now would be much more difficult than it might have been 20 years ago.
“No director would want to be forced to appoint an audit firm that they believe has a material conflict with the company and its interests,” said Breeden. “And, if there are only two viable competitors, you will think long and hard before burning your bridges with the incumbent firm due to the risk that the new firm might develop an independence problem or otherwise not work out, which would prejudice the entire company.”
Breeden said he agreed with former Comptroller General Charles Bowsher’s suggestion that if mandatory rotation is to be implemented, it should be tried first among the very largest audit engagements. “However, that is the group where finding a capable and conflict‐free alternative firm would be the most difficult,” said Breeden. “Thus the benefits of rotation in enhancing professional objectivity may well be offset by increased conflicts, loss of an important non‐audit service provider or other adverse impacts. Since it will be different for every company, that is a difficult cost benefit analysis to make.”
In his testimony, Bowsher came out in favor of mandatory rotation and agreed with the Cohen Commission report of 1978, which found that since the tenure of the independent auditor would be limited, the auditor’s incentive for resisting pressure from management would be increased, and a new independent auditor would bring a fresh viewpoint. The downside, according to the report, would be increased cost, a steep learning curve for the new auditing firm which might lead to an audit failure, and too much disruption for auditing firms.
“I believe that it would be wise to limit the adoption of audit firm rotation at the beginning to somewhere between 25 and 40 very large companies,” said Bowsher. “The selection should include all the major financial institutions (and certainly any firm that is designated as ‘too big to fail’ by the FDIC). Also, the selection should include some of the biggest industry leaders, such as General Motors, General Electric, etc.”
Theodore Bunting, Jr., senior vice president and chief accounting officer at the energy company Entergy, noted in his testimony that the utility industry is complex and requires expert auditors. “These complexities can require significant time to comprehend,” he said. “Mandatory change in audit firms would result in disruption to our business and loss of auditor knowledge. It seems counterintuitive.”
Valarie L. Sheppard, senior vice president and comptroller at consumer products giant Procter & Gamble, said the disruption and added cost caused by mandatory auditor rotation would be more significant for larger companies, which need to retain their own tax, treasury and audit experts. “The institutional knowledge of the audit firm enables them to assess risks and design audit procedures,” she said. “The requisite knowledge cannot be effectively gained over a few years. It is built over much more time.”
She noted that the Government Accountability Office has estimated that initial audit fees would go up about 20 percent after a company changed audit firms. “We believe this estimate is rather low,” she said. “It would force us to discontinue relationships with one of the audit firms to guarantee we could rotate to another one. We do business with all of the Big Four audit firms for consulting and audits. It would effectively lock us into our next auditor and likely would result in higher fees.” She added that it would also decrease audit quality and significantly increase costs.
John H. Biggs, former chairman and CEO of insurance provider TIAA-CREF, contended that his company has an auditor rotation cycle that has worked excellently. He disagreed with the GAO assessment that there would be a 20 percent increase in fees the first year and put the figure at closer to 2 percent. “There’s a rejuvenation with new people and new processes,” he said. “When major firms come in, the senior people would find their way, and they would have access to the work the previous audit firm did,” he added.
Auditor rotation also gives the company to reassess practices, Biggs noted. While at TIAA-CREF, he had learned that the former CFO was an avid golfer who had enjoyed the occasional golf outing at the audit firm’s golf club. He said TIAA-CREF adopted a policy not to allow that in the future, and JPMorgan Chase chief Jamie Dimon adopted a similar policy. Biggs said a cost-benefit analysis should have been performed by academics when large companies were forced to switch auditor after the demise of Arthur Andersen, but then Sarbanes-Oxley came along that year and the costs skyrocketed.
Darren Wells, executive vice president and CFO of Goodyear Tire & Rubber Company, said he does not support the proposal for mandatory audit firm rotation. “While not perfect, the current procedures support auditor objectivity and promote professional skepticism,” he said. He added that he supports more timely inspections of auditors.
John C. Bogle, founder and former chief executive of the Vanguard Group investment firm, said many of the previous witnesses made it sound like audit firms should never be rotated. “The current system is not working,” he said. “Maybe we should be more concerned with the proper governance at these firms,” he added. “Are audit committees equipped to do the job? I think they are not.”