PCAOB Hears Further Debate over Audit Firm Rotation

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The Public Company Accounting Oversight Board held a daylong meeting to gauge reaction to its proposal for mandatory audit firm rotation.

The San Francisco roundtable followed a two-day meeting in March in Washington, D.C. (see Hot Topic, Cool Talk (Mostly)). Many of the comments seemed more supportive of the concept of requiring public companies to rotate their auditing firms.

Former Securities and Exchange Commission chairman Harold Williams said in his testimony Thursday that he supports mandatory rotation but was not sure it would produce the desired result of breaking up the "oligopoly" of the Big Four. “There may be, but not necessarily would be, costs associated with the rotation,” he added. “I believe the concern is exaggerated and to the extent that there are costs, I believe they would be justified. I do not believe that the quality of the audit needs to deteriorate for the first year or two of the new auditor’s work. The concern that audit quality might deteriorate in the last several years of the departing auditor’s engagement casts serious doubt on confidence in its professionalism and suggests a more serious problem that I trust is not warranted.”

Duke University professor James Cox told the PCAOB they could sanction firms by requiring rotation if they find a problem during inspections. “It’s time for the accounting profession to step up,” he said. “It’s the last go to demonstrate their professional independence.”

Stanford University professor Maureen McNichols questioned how independent an auditing firm can be when its job depends on the client. “When a firm hires its auditor, it is hard for the auditor to be truly independent,” she said. “One has only to look at the common language describing this relationship to see this. Audit firms speak of the companies they audit as their clients. When you look at the Web sites of public accounting firms, you see language that describes how their purpose is to provide value to their clients and to build relationships, to help clients solve complex business problems and enhance their ability to build value. I believe public accounting firms were created to serve a different client, the investing public.”

Former SEC deputy chief accountant Andrew Bailey, who now teaches at the University of Illinois at Urbana-Champaign, told the PCAOB he doesn’t have much confidence in audit committees to detect audit failures.

C. Brian Fox, founder of Confirmation.com, said that fraudsters oppose audit firm rotation because it helps expose fraud. He advised the PCAOB to put itself in the position of a fraudster. “I’d like to ask the board to consider any current standards or proposed standards from the viewpoint of a fraudster,” he said. “The PCAOB was created because of fraud and the billions of dollars of resulting investor losses. I believe that it is imperative to look at any PCAOB standards and proposed changes through the lens of a fraudster. So in this case, what would a fraudster say about audit firm rotation? The answer is obvious; a fraudster would be whole-heartedly against it. You see, a fraudster has already fooled their external auditor. That is what has allowed the fraudster to already be getting away with fraud. Results from the Association of Certified Fraud Examiners show that frauds usually take place for multiple years before they are discovered – which is too late for investors who have already invested in the company. If I were a fraudster, I’d have written the PCAOB not just one comment letter against audit firm rotation, I’d have written four letters using four different company names and letterheads since anyone can copy and paste legitimate company logos using the Internet.”

Steven Thomas, a partner at the law firm Thomas, Alexander, Forrester LLP, contended that most accountants don’t see a responsibility in servicing the public. “I ask an auditor what the P in CPA means and they don’t know it stands for public,” he said. “The auditors don’t have an incentive to act in the public interest. They only have an incentive to act in their financial interest. We need to change the incentives. Auditor rotation is good, but you can’t put another fox in the henhouse. We have to change the incentives, particularly for audit committees.”

He noted that many members of management can come from the Big Four audit firms. “If there’s an issue about management representations, those must be disclosed in writing to the audit committee," he said. "Those disclosures should say what the auditor did to test management representations.” He would like to see public audits of public companies.

Conrad Hewitt, a board director at the Bank of the West and former SEC chief accountant, said he opposed mandatory audit firm rotation. “I do not believe that the policy would prevent accounting scandals and frauds, such as Enron, World Com, Sunbeam, AIG, Freddie Mac, HealthSouth and Madoff,” he said. “There has never been any evidence that a mandatory rotation of auditors would have prevented these frauds or improve the quality of an audit. Please keep in mind that these terrible events occurred over many years. Many of these accounting scandals were due to existing accounting standards which were based on rules and not principles, and permitted such abuses of GAAP. Fraud is always difficult to detect and prevent. A mandatory change in auditors would not stop such frauds.”

Hewitt recommended that the PCAOB should focus on strengthening the audit committees so that they can carry out their responsibilities and auditing under SOX without making mandatory rules and regulations. “The PCAOB should focus on its own reasonable judgment internal policy, the training of auditing firm’s staff with respect to independence, determining the root causes of past, current and future independence cases, and providing more transparency to the auditing firms and investors concerning independence problems,” he added. “The PCAOB inspection process should identify, classify and determine solutions to any results concerning an auditor’s independence.”

Bonnie Hill, co-founder of Icon Blue Inc., and president of B. Hill Enterprises LLC, has been a board director at several companies, including Home Depot, Yum! Brands, AK Steel Corporation and California Water Services Group. She told the PCAOB the costs are high in changing auditors and said they should not be incurred unless there is good reason to change auditors. She pointed out that at Home Depot, even though KPMG is the lead audit firm, the company also uses Deloitte for tax-planning strategies so it would not be able to rotate to Deloitte. At certain times, Home Depot uses PricewaterhouseCoopers and Ernst & Young as well.

PCAOB chairman James Doty noted, “We are here today because at a certain point in history the accounting profession dug its heels in and said no change.”

Eric Keller, chief operating officer of venture capital firm Kleiner Perkins Caufield & Byers, said he sees no collusion between management and auditors, particularly after the Arthur Andersen accounting scandal. However, he noted that at a certain point Silicon Valley went from hardware to intangibles like software. “By shining a light on bad things that had happened with revenue recognition in a software company, auditors could do an enormous benefit."

He noted that he chairs an audit committee of a public company and suggested that the PCAOB communicate to the audit committee when it finds a problem during its inspections that would require a restatement. Doty noted, however, that Congress took a different view when it wrote the Sarbanes-Oxley law, which does not give the PCAOB to power to communicate directly with companies about audit failures.

In an interview after the panel discussion, Fox of Confirmation.com said he believes there eventually will be a proposal to Congress to allow the PCAOB to share its audit inspection reports with the audit committees. “I think the PCAOB would like to do so, but they probably feel their hands are tied,” he said.

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