The Public Company Accounting Oversight Board held a public meeting in Houston to hear feedback on its proposals for mandatory audit firm rotation and auditor independence.

Thursday’s meeting at Rice University’s Jones School of Business marked the PCAOB’s third after meetings in March and June in Washington, D.C., and San Francisco (see Hot Topic, Cool Talk (Mostly) and PCAOB Hears Further Debate over Audit Rotation).

Panelists included several academics who presented research challenging assertions that audit firm rotation would do little to aid with auditor independence. Professor Henry T.C. Hu of the University of Texas at Austin’s School of Law discussed a paper challenging the reliability of information in financial disclosures to the Securities and Exchange Commission. Hu’s paper argued that corporations are essentially able to manipulate the depiction of the financial reality that they present to the investing public. PCAOB chairman James Doty called the paper “absolutely terrifying.” Hu also discussed his suggestions for an alternative approach to mandatory audit firm rotation based on “exemplary performance.”

Professor Karen Nelson of Rice University said that if the PCAOB cannot require mandatory rotation of auditing firms, the next best things would be mandatory retendering, in which audit committees look for alternative auditing firms periodically, or mandatory rotation when PCAOB inspections identify significant audit failures. But she noted that this would be “nibbling around the edges rather than tackling the problem head on.”

“Of these two options—mandatory rotation versus mandatory tendering—I believe that rotation offers the greatest potential to fundamentally realign auditors’ interests to the benefit of the investing public,” she said. “Tendering is more likely to result in a form over substance solution with little effective change in the auditor-client relationship beyond a periodic justification for retention.”

Professor Mark Nelson of Cornell University suggested that PCAOB inspectors should look for a lack of “presumptive doubt” during audit firm inspections. “A benefit of mandatory rotation is a forced reconsideration that provides a fresh look beyond what would occur by only rotating personnel within the same firm,” he said. “One approach to reducing the loss of client-specific knowledge associated with mandatory rotation could be to enhance predecessor/successor auditor communications. However, that enhanced communication likely would reduce the extent to which the successor auditor provides a fresh look.”

Stephen Zeff, an accounting professor at Rice University, criticized the lack of professional skepticism of many auditors. “Another indicator of the decline of professionalism in the United States in accounting is the virtual absence of intellectual leadership shown by partners in the major audit firms or by other important figures in the profession. There was a time, prior to the 1980s, when partners in the major firms gave speeches and wrote articles and even books on controversial areas in accounting principles,” he noted. “They seemed to be genuinely concerned that sound accounting should prevail over unsound accounting. … These days, when partners of audit firms are invited by accounting academics to address controversial issues on panels at academic meetings, they utter little more than platitudes. One wonders whether practitioners who decline to enter into the spirit of debate and discussion on controversial issues in financial reporting will also be inclined to give vent to professional skepticism in audit engagements over such matters as management’s assumptions and the application of accounting standards.”

The PCAOB also heard from non-academics, including a representative from the European Commission, who described the progress of proposals for mandatory firm rotation in the European Union. Nathalie Berger, head of the European Commission’s audit and credit-rating agencies unit, told the PCAOB they are seeing support in the European Parliament for mandatory firm rotation. She also noted that the commission has proposed that audit firms post a “transparency report” on their Web sites.

“There are obvious reasons and good grounds on which the introduction of mandatory audit firm rotation can be based,” she said. “It would strengthen the independence of auditors by mitigating the familiarity threat. Let us please remind ourselves that regulated professions are regulated in the interest of the public. It is only natural, therefore, that the privileges accorded to those who are entrusted in law with the conduct of audit respect their responsibility to the public. We have to ensure that we have robust custodians of information as well as total integrity in the performance of such custodianship, especially when related to financial information. We strongly believe that this total integrity is achievable only if there is complete and undisputable independence with no semblance whatsoever of any conflict of interest.”

Kenneth Daly, president and CEO of the National Association of Corporate Directors, told the PCAOB there should be a rigorous annual evaluation of the external auditor. “The corporate director community shares the PCAOB’s view that external auditor independence, objectivity and skepticism are critical objectives to pursue,” he said. “NACD supports a rigorous process led by the audit committee, endorsed by the board, and communicated to shareholders.”

However, he contended that 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,” he said.

Cindy Fornelli, executive director of the Center for Audit Quality, told the PCAOB that there are inherent conflicts of interest in the “issuer pays” model for audit firms, but said they could be mitigated. She described auditor tools that the CAQ, the NACD and several other organizations had recently introduced (see Tool Helps Audit Committees Evaluate Auditing Firms).

“We believe the responses received from a broad cross-section of stakeholders have demonstrated that mandatory audit firm rotation and mandatory tendering of audit engagements do not have support, and would present significant risks to audit quality,” she said. “However, the public dialogue has surfaced numerous other ideas and prompted constructive actions that we believe will contribute directly to enhanced auditor independence, objectivity and professional skepticism, and to overall audit quality. As the PCAOB continues to solicit feedback on its concept release, we encourage you to focus the ongoing global dialogue on consideration of these alternative ideas and actions that we believe have a direct and demonstrable nexus to audit quality.”

Gaylen Hansen, the chairman-elect of the National Association of State Boards of Accountancy and an audit partner and director of quality assurance at Ehrhardt Keefe Steiner & Hottman in Denver, noted that smaller auditing firms often get shut out of the process when large companies go through a retendering process. He also emphasized the importance of quality control in auditing firms.

“You have to watch out for that lone audit partner,” he said. “Silos are dangerous in the auditing world.” Hansen emphasized the importance of mentoring and coaching of fledgling auditors.

W. David Rook, partner-in-charge of firm assurance and advisory services at Weaver & Tidwell in Houston, said Weaver does root cause analysis after the firm receives an inspection report from the PCAOB to see what went wrong. However, while he agreed that independence, objectivity and professional skepticism are critical to the viability of auditing, he said the firm opposed mandatory rotation.

“While we support the board’s on-going efforts to improve independence, objectivity and audit quality we do not believe that mandatory audit firm rotation is a concept that will work and, if enacted, could raise significant risks and result in unintended consequences,” he said. “We have always believed that the danger of a failed audit is greater when the auditor does not fully understand the client’s business than from the auditor being too familiar with the client’s business.”

PCAOB chairman Doty concluded the hearing by noting that the number of comments they had received one way or another on the concept release should not alone determine the issue.