The second day of the Public Company Accounting Oversight Board’s two-day public meeting on its proposal for mandatory audit firm rotation had its share of drama, with accusations that the Big Four firms are monopolizing the audit market at the expense of minorities, and a demand from the U.S. Chamber of Commerce that the PCAOB shelve the proposal because of “mission creep.”

“Main Street, at least as much as Wall Street, is adversely affected by the present lack of independent CPA audits,” said Mia Martinez, deputy director for a coalition of the Black Economic Council, the Latino Business Chamber of Greater Los Angeles and the National Asian American Coalition. “This is in part due to the lack of competition even among the Big Four firms.”

In her testimony Thursday and a report submitted to the PCAOB, she pointed out that only two CPA firms effectively bid for audits of the major financial institutions, and only two firms appear to bid for audits of utilities, and only two for high-tech firm audits. The coalition estimated that 95 percent of Fortune 500 corporations are audited by the Big Four, and noted that all four firms have been “chastised” by the PCAOB.

Her coalition supports mandatory auditor rotation and recommends that it occur every six years, instead of an average of approximately every 25 years. They also called for other reforms.

“We strongly support the barring of any audit contract where the auditor is also paid for other services, such as management services,” said Martinez. “As previously identified by the PCAOB, this creates a far too cozy relationship between the auditor and management.”

Martinez also accused the auditing firms of supporting major utilities in their requests for large rate increases in California. Her coalition has initiated discussions with the California Public Utilities Commission contesting the rate increases. She also contended that the accounting profession is “white male dominated,” and should follow the lead of the legal profession in pursuing more diversification.

Her organizations have received support from the influential California Public Employees’ Retirement System. A CalPERS representative testified alongside Martinez and supported mandatory audit firm rotation. Mary Hartman Morris, an investment officer for corporate governance at CalPERS, noted that the primary objective of an auditor is to provide an independent opinion.

“Audit committees should promote the rotation of the auditor,” she said. Morris recommended that audit committees engage in a competitive bidding process to select or retain the auditor. “Audit committees should regularly assess the independence of the auditor,” she said. “The need for professional skepticism and objectivity in an audit cannot be overemphasized. The public company accounting market is quite concentrated. We need to expand the pool of auditors.”

Morris also recommended that any non-audit services provided by the auditing firms should be disclosed by the audit committee when evaluating the auditor, and auditors should provide a written disclosure on an annual basis.

Insurance Model
Jack T. Ciesielski, president of investment research and portfolio management firm R.G. Associates, and publisher of the Analyst’s Accounting Observer, testified alongside Martinez and Morris, but disagreed with mandatory auditor rotation.

“Well-intentioned as it is, I don’t believe that required auditor rotation addresses the root cause of objectivity problems within the audit profession,” he said. “The root cause is that auditors’ interests are aligned with management, and not aligned with the interests of shareholders. Simply changing the auditors every few years only treats the symptom of the problem, and not the cause. There is no guarantee that a new auditor will do a better job than a previous auditor, and it is very possible that newly installed auditors might not be effective in the early part of their stint. Rather than encouraging skepticism and increasing financial reporting quality, auditor rotation might actually work counter to investor interests.”

Ciesielski instead recommended that the PCAOB align the interests of auditors with shareholders in more fundamental ways, such as by avoiding the “client-payer model” in which the client pays for auditing services, and instead consider an insurance-based model.

“Consider a model where financial statement issuers would purchase financial statement insurance that covers investors against losses resulting from financial reporting misrepresentations,” he suggested. “You could think of it as a guarantee by the insurance companies that the financial statements are fit for use by investors. By transacting with the insurance company, the issuing firm would have a direct interest in the quality of the reporting process: the more confidence the insurer can place in the financial reporting process of the insured, the lower the premiums they should need to charge the issuer.”

Chamber of Commerce Weighs In
Some fireworks erupted later in the day when David Hirschmann, a senior vice president at the U.S. Chamber of Commerce, and president and CEO of the Center for Capital Markets Competitiveness, appeared before the PCAOB. He was asked by PCAOB chairman James Doty about a letter that had come “over the transom” the previous day from the Chamber of Commerce accusing the PCAOB of “mission creep” and requesting the board to withdraw its concept release on mandatory audit firm rotation.

Doty asked Hirschmann if he understood the process behind concept releases and that the meeting was intended as a way to get feedback from outside parties such as the Chamber of Commerce. Doty asked Hirschmann to explain the letter, “You want us to say we stopped the concept release because the Chamber asked us to?”

In the letter, the Chamber wrote, “The concept release on mandatory audit firm rotation taken together with audit committee communications, a proposed auditor discussion and analysis and now proposals for executive compensation review have the Chamber concerned that the PCAOB is engaged in mission creep, crossing the threshold of audit regulation into an attempt to regulate corporate governance—a subject area that has been left to state corporate law, or in the federal context with the SEC. Let me be clear, we support strong audit committee communications and auditor independence, but it is a hallmark of the American corporate structure, as reaffirmed by the D.C. Circuit Court of Appeals last summer that directors and shareholders must be allowed to govern the corporation and that one size fit all mandates do not work. Because of these reasons we ask the PCAOB to withdraw the concept release. Such action will allow the PCAOB to work on other issues of importance to financial reporting and we would wish work in partnership with the board to insure that we have high-quality auditing for the benefit of all involved in capital formation.”

Audit Firm Chiefs
In the last panel of the day, a group of audit firm chiefs testified about mandatory audit firm rotation. Unlike the previous day, the panelists did not include representatives from the Big Four (see PCAOB Hears Pros and Cons of Audit Firm Rotation). However, even the heads of the smaller firms did not favor mandatory rotation.

“We believe that McGladrey and the other large firms are clearly aligned with investors,” said McGladrey & Pullen managing partner and CEO Joe Adams. He acknowledged that the firm must “continue to do more to remain vigilant on behalf of investors who rely on our audits," but added that the firm has concerns that mandatory rotation would eliminate competition and weaken audit committees. He supports the current requirements under Sarbanes-Oxley to rotate the lead engagement partner and concurring review partner every five years, but said he had seen no empirical evidence to support mandatory firm rotation. “We don’t believe audit quality, objectivity and professional skepticism can be legislated,” he said.

Adams instead suggested several other improvements that had been implemented at McGladrey, such as establishing an independent SEC client commission to ensure those engagements are staffed by subject matter experts. The firm has also established a quality control committee and a partner compensation system that emphasizes a longer-term view and gives recognition to audit quality. There is also a system in place to review auditing questions at the firm through its national office.

“Our national office is our final word on auditing matters and nobody can override them,” said Adams. “The consultation process is collaborative. At the end of the day we reach a firm conclusion.” McGladrey is also developing a framework to educate staff on auditing matters after busy season and assist auditors in making decisions.

Crowe Horwath CEO Charles M. Allen also stated his opposition to mandatory rotation. “It is no secret that many are strongly opposed to mandatory firm rotation,” he said. He discussed two processes in place at Crowe designed to strengthen independence, objectivity and skepticism.

“The pressures on objectivity and skepticism are primarily on the engagement partner,” said Allen. “To further mitigate those risks, we have an additional review beyond those provided by the engagement partner and the engagement quality reviewer.”

For every public company audit, Crowe’s national office reviews the draft financial statements, draft filings with the Securities and Exchange Commission or other regulators, and documentation of consultations and significant audit conclusions looking for potential sources of significant accounting or auditing errors. The national office reviewer is required to “sign off” prior to the issuance of the financial statements and the filings with the SEC or other regulator. Allen noted that Crowe’s partner compensation model also reduces the concern that partners might have about losing a client. There is no direct linkage of client retention, the size of a book of business, or sales activity to an individual’s compensation. “Rather our income and share ownership is anchored in a concept of equally sharing changes in the firm’s income and equity,” he said. “This is a strong incentive to preserve each partner’s objectivity and skepticism.”

He maintained that this policy helps reduce the pressure on the engagement partner. “We truly do not worry about our partners failing to properly confront tough issues because they have lost their objectivity or skepticism,” he said. “We do, however, worry about the potential for failure from other directions. Upon reflection on the root cause of failures, we find they are principally due to companies taking risks that they cannot appropriately manage. Complex transactions are now found in every size of entity. This risk is particularly acute in the companies of the size and nature we audit, as they are continually challenged to devote the necessary resources to very complex accounting requirements.”

Allen believes mandatory audit firm rotation would undermine the role of the audit committee. “We certainly need to do all we can to further strengthen the audit committees’ role,” he added.

Wayne Kolins, global head of audit and accounting at BDO International Limited, suggested that changes should be made in firm audit quality inspections. He suggested several areas for improvement, including strengthening communications between the audit firm and the audit committee, and enhancing auditing firms’ internal quality control systems, as well as improving the composition of audit committees by adding members with practical auditing experience. “We urge the PCAOB not to dilute the audit committee’s role,” he said.

EisnerAmper CEO Charles Weinstein suggested mandatory audit firm tenure as an alternative to mandatory rotation. “We believe the systematic requirements of the Sarbanes-Oxley Act, such as partner rotation and the PCAOB’s inspection program have greatly enhanced audit quality,” he said. “The current client pay model creates a conflict. Audit firms are aware of this conflict. Our firm spends substantial resources to monitor and mitigate this conflict.”

Weinstein added that mandating audit firm rotation would be unwise and the potential negative consequences include significant costs and the loss of knowledge about a client’s business that is built up over time. “There is no mechanism to transfer that knowledge base to a successor firm,” he said.

Weinstein noted that the timing of a mandatory rotation could come at a time ill-suited for the client and not in the company’s best interest. There would be the additional risk of audit failures at the end of a rotation period when audit teams would be focused on their next post-rotation assignment. Auditors would also feel pressured to replace audit services with non-audit services in order to preserve the client relationship after a mandated rotation.

He also predicted that mandatory rotation could lead to more contraction of the industry as firms merged with other qualified auditing firms. Firms could decide that it was too difficult to audit public company clients with the increased pressure of having to continually replace their rotating clients. Many firms don’t have the resources to retain clients, he pointed out, and rotation would make it harder to attract qualified audit professionals by offering them longer-term career development opportunities.

“Instead of mandatory audit firm rotation, you may consider mandatory audit firm tenure,” he suggested. “During this time, a company could only dismiss the auditor for cause, which would have to be approved by the SEC. This would serve to free the auditor from management pressures without the costs and unintended consequences of mandatory rotation. It still leaves auditor selection in the hands of the audit committee who are in the best position to evaluate the needs of a company and shareholders. We believe that the audit committee’s role in appointing the external auditor and overseeing the audit process is a strong mitigating factor against management pressures on the auditor. At the end of the minimum tenure, the audit committee could decide to continue with the same firm for another minimum tenure period or select a new audit firm.”

Weinstein and the other auditing firm heads were joined on the panel by Cindy Fornelli, executive director of the Center for Audit Quality. “Audit quality has improved, but we must not let down our guard,” she said. “The CAQ believes that audit committees should be further strengthened and empowered to take on more.”

One potential enhancement she suggested would be for the audit committee to select the lead engagement partner on an audit. Audit committees would also need to be satisfied that a member has the necessary technical competence and experience and that would set the tone for the relationship with the auditor. There could also be an annual assessment of the auditing firm and the lead audit partner, she suggested. Best practices for an assessment might include a review of compliance with the independence requirements, along with the application of objectivity and professional skepticism, followed by a disclosure by the audit committee.

In wrapping up the two-day meeting, PCAOB chairman Doty noted that it would take a while to assemble all of the information and suggestions from the panelists and their organizations, which would be grouped topically. The PCAOB plans to conduct further meetings around the country to elicit feedback on the proposal (see PCAOB Plans Meetings across U.S. on Audit Firm Rotation). The CAQ will be assisting the PCAOB in assembling and organizing the plentiful feedback from the meetings.

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