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.

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.”

Corporate Perspective

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.”

Bogle noted that when he was the chairman of audit committees at Instinet and Chris-Craft, he considered retaining independent staff members and consultants. “I have an uneasy feeling that corporate management may not warm to that issue, but we have to work on it,” he said. He noted that there are too many short-term decisions made by management with the goal of appealing to investors that are too frequently supported by the accountants. “You’ll meet your earnings guidance and please Wall Street,” he said. “Pleasing Wall Street should not be part of the accounting profession’s mandate.”

Bogle compared earnings guidance to financial engineering. “We’re going to get to those earnings by hook or by crook,” he said. “I always found it amazing that corporations could tell you what their earnings are going to be [in advance]. There’s a lot of finagling to get there.”

“While I do not believe that mandatory rotation would come close to resolving the plethora of issues surrounding auditor independence, such rotation would be a step in the right direction,” Bogle added, noting it would be reasonable to undertake a formal review of the existing auditor no later than at the 10-year mark of service, and that there should be a flat limit of 20 years for any audit firm’s service with a client.

“Cost is going to be over-exaggerated,” Bogle noted. “We complain about the costs, but we never complain about the management fees in the mutual fund business. Let me say this about cost benefit analysis. The worst thing Congress did was require a cost benefit analysis. Cost is so easy to measure and benefit is so difficult to measure. What would be the benefit of having a truly independent accounting system? It’s priceless.”


Audit Firm Chiefs Testify

The PCAOB also heard from the heads of the major auditing firms, who all objected to mandatory rotation, but offered alternative suggestions.

“We believe that the vast majority of auditors want to do what is right,” said Grant Thornton CEO Stephen Chipman. “They undertake their professional responsibilities with great seriousness. However, we also believe that audit firm tenure over a period of many decades can create the perception of impaired objectivity, and in some instances, increase the risk of a reduced level of auditor objectivity. As ours is a profession based on trust, it is important to remain vigilant in our demonstration of that core value. In circumstances of extreme tenure, mandatory audit firm rotation could be a component of a potential solution to this perceived loss of auditor objectivity. Although there is no empirical evidence to suggest rotation will improve audit quality, and its potential negative consequences may be significant.”

Chipman noted that mandatory audit firm rotation would have an effect on the overall cost, conduct and timing of an audit, and that the initial years of implementation would result in the most significant challenges, while any improvements in audit quality might not be seen in the short term. He added that if not appropriately implemented, mandatory rotation would “accelerate the current trend of large audits gravitating to a small group of firms and therefore, absent a change in audit appointment patterns, will further negatively affect audit firm concentration.”

Chipman believes it would also lead to a diminishment of the audit committee’s role in appointing, approving and overseeing audit firms. “We’ve concluded that taking the option of retaining the auditor out of the hands of the professional that knows their skills and competencies would likely diminish audit quality and harm investors,” said Chipman. “We stress the importance of effective regulation and oversight. Regulators need to work together to improve objectivity and skepticism.”

Deloitte LLP CEO Joe Echevarria noted that auditing and audit quality require expertise, experience and in-depth knowledge, and said he believes those qualities could be adversely affected by mandatory rotation. “The current system is sound,” he said. “It could be improved, but it’s the best system in the world. It builds on the current Sarbanes-Oxley framework where audit committees engage with auditors directly.” He suggested the PCAOB consider the over 600 comment letters that have been submitted on the concept release, most of which oppose mandatory auditor rotation. He added that the PCAOB should also study the unintended consequences in countries where mandatory rotation has been tried.

He noted that in Deloitte’s comment letter, the firm over a dozen ideas designed to build upon the framework created by the Sarbanes-Oxley Act, to reinforce the audit committee’s responsibility for overseeing the audit firm; expand communications between the audit firm and audit committee; initiate PCAOB actions that would increase understanding of and compliance with expectations regarding auditor independence, objectivity, and professional skepticism; enhance the expertise of audit committees; create audit quality councils to advise audit firms; and conduct further study to provide additional facts and insights.

Stephen R. Howe, Jr., Americas managing partner at Ernst & Young LLP, said that mandatory audit firm rotation would lead to a decrease in audit quality. “Ernst & Young audits more than 1,000 public companies,” he said. “Excellent work is being performed by many of our auditors.” He said the firm supports increasing communications with shareholders as well as audit committees and the PCAOB itself and developing practices that promote auditor skepticism.

“We need to build on, not undermine, the reforms that SOX put in place,” said Howe. He added that there needs to be engagement by the PCAOB, the SEC, and capital markets regulators outside the U.S. to enhance corporate governance globally.

Howe also recommended empowering the PCAOB to recommend firm rotation to an audit committee in situations where it has been demonstrated through the PCAOB’s enforcement process that objectivity was significantly lacking. “Collectively embracing these efforts offers a positive way forward,” he added.

PricewaterhouseCoopers LLP chairman and senior partner Robert E. Moritz noted that PwC’s auditors make the “tough calls.”

“One of the ironies of this profession is that the public rarely hears or sees anything when an audit is done well,” he said. “A lot of good work is done behind the scenes. Our auditors make the tough calls, and 92 percent of our audit firm staff reported that in the last two years they had a difficult conversation with a client about an audit firm judgment or suggested an improvement. I recognize we need to do more. Beauty is in the eye of the beholder, but making the tough calls is at the core of PwC.”

Moritz said that audit firms need to have a tremendous network around the world to do an expert job and they need to continuously assess the work product. He noted that PwC supports several of the other PCAOB proposals, such as changing the auditor reporting model, and he agreed there needs to be more robust communication among audit firms and audit committees.

“Firms need to be more transparent in what we do,” said Moritz. “We cannot increase the trust in what we do without increasing that transparency.” He warned against a rush to judgment to react to perceived problems that could risk audit quality.

KPMG LLP chairman and CEO John B. Veihmeyer said his firm also largely supports the PCAOB’s concept releases on expanding the auditor’s reporting model and enhancing transparency. “I too believe audit quality has improved since Sarbanes-Oxley,” he said. “We need to remediate problems as quickly as possible once problems have been identified.” He noted that a quality audit requires applying professional skepticism at the critical point when an auditor needs to push back against management’s decision, even when there’s a desire to maintain a long-term relationship with a client.

“We at KPMG we don’t find a nexus behind long tenure and professional skepticism,” he said. “A constant stream of retendering would likely create a potentially adverse increased sales culture at the audit firms. Mandatory audit firm rotation would increase those forces and could decrease a skeptical mindset. Another effect would be on attracting and retaining quality people at KPMG. We have a sincere concern that mandatory audit firm rotation would make that considerably more difficult.”

The firm leaders remarked on the need to set the right tone at the top. PCAOB chairman Doty wrapped up the first day of the meeting by pointing out that he had heard substantial support from the firm leaders for the concept releases on audit committee communications and the auditor’s reporting model.

“I was really struck by the notion that there should be greater strength in key performance indicators,” he said. “You would start building morale and attraction to recruits and retention policies by way of key performance indicators to assure that incentives are aligned. I think this is extraordinary, and then the notion that the PCAOB should engage the audit committee directly. I thought that was an extraordinary thing, and that the PCAOB should make a recommendation to the audit committee when we saw a lapse in governance related to tenure. Whether it’s something we should do or would do, it would be a grave responsibility.”

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