The Public Company Accounting Oversight Board could begin requiring public companies to rotate their auditing firms on a regular basis to reduce conflicts of interest.

In a speech Thursday at the University of Southern California’s Leventhal School of Accounting in Pasadena, Calif., PCAOB Chairman James R. Doty talked about some of the changes in the auditor’s reporting model that the PCAOB is planning to propose.

“Considering the disturbing lack of skepticism we continue to see, and because of the fundamental importance of independence to the performance of quality audit work, the board is prepared to consider all possible methods of addressing the problem of audit quality—including whether mandatory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client,” he said.

Doty noted that the PCAOB plans to issue several documents in the next two months, including a “concept release” on firm tenure, along with changes in the auditor’s reporting model.

“I believe it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against,” he said. “I don’t have a predetermined idea as to whether the PCAOB ultimately should adopt term limits. My only predilection is that the PCAOB deepen the analysis of how we can better insulate auditors from client pressure and shift their mindset to protecting the investing public.”

The European Commission has also been examining the possibility of requiring companies to rotate their auditing firms as a way of increasing competition in the audit profession (see Europe Mulls Limits on Audit Firm Concentration).

The PCAOB is already planning to recommend changes in auditor reports to better address investor needs. “We’ve heard from many investors that the current auditor’s report, which provides only a pass-fail opinion, is of limited relevance,” said Doty. “Given the effort involved in an audit of a large company, and the complexity of many financial statements, investors want deeper insight from the auditor, especially in the aftermath of the financial crisis.”

In March, the PCAOB held an open meeting to hear from its chief auditor about the staff's outreach efforts on changing audit reports, Doty noted. At the meeting, the PCAOB staff presented views they had received during meetings with investors, auditors, preparers, audit committee members, researchers and others. The PCAOB plans to issue a concept release later this month on how to change the auditor’s reporting model. The concept release will present a number of options, he noted, including more insight into areas of disclosure that auditors already review. 

In his speech, Doty emphasized the need for auditors to approach their work with the necessary independence and skepticism.

“To perform their role properly—to assure that reported financial and economic successes are not illusory—auditors must approach their jobs with independence and skepticism,” he said. “They cannot allow themselves to be caught up in their audit clients’ business goals.”

He noted that an audit only has value to the public to the extent that it is performed by a third party who is viewed as having no financial stake in the outcome. 

“Auditors face real pressures to please their clients,” said Doty. ”Too often, PCAOB inspectors find that auditors have failed to exercise the required skepticism and have accepted evidence that is less than persuasive. Indeed, the examples are galling in their simplicity.”

For example, PCAOB inspectors found at one large firm that an engagement team was aware that a significant contract had not been signed until the early hours of the fourth quarter, Doty noted.

“Nevertheless, the audit partner allowed the company to book the transaction in the third quarter, which allowed the company to meet its earnings target,” he said. “Although the firm discussed the timing of the transaction with the customer, it failed to obtain persuasive evidence of an arrangement for revenue recognition purposes in the third quarter. The company had been an audit client of the firm for close to 50 years.”

Doty also expects the PCAOB to consider several initiatives relating to audit transparency. In July 2009, the PCAOB issued a concept release seeking comment on whether it should require engagement partners to sign audit reports. Doty expects the PCAOB to broaden the proposal to include another disclosure issue in which large multinational companies have a significant portion of their audits conducted abroad by overseas firms. 

“Many of those non-U.S. firms, including the affiliates of the largest audit firms, are independently registered with the PCAOB, but are based in jurisdictions that bar our inspections,” he said. “Nevertheless, investors are left with the impression that the signing firm performed all the procedures described in the audit report. That is generally not the case. Nor is it always the case that the PCAOB has inspected affiliates that participated. Enhancing transparency about how multinational audits are conducted should help investors and audit committees gain a better understanding of how an audit was conducted and make more informed decisions about how to use the audit report.”

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