The Virtues of Mandatory Audit Rotation

IMGCAP(1)]In early 2014, the Public Company Accounting Oversight Board in the U.S. announced that it was officially abandoning its pursuit of mandatory audit rotation—the somewhat controversial practice that requires publicly traded companies to change their auditor after a designated number of years.

This decision was made despite a fairly recent history of accounting malfeasance and the continued faltering of audit quality in this country. In fact, the PCAOB’s own recent evaluation of audit quality among the Big Four firms—KPMG, PricewaterhouseCoopers, Deloitte & Touche and Ernst & Young—revealed that 39 percent of audits inspected were found to be deficient.

In the European Union and India, mandatory audit rotation has taken hold and prompted a flurry of tendering activity, particularly in the U.K. Despite the negative perceptions and opposition to the rotation mandate, the results have been positive and productive over a relatively short sampling of time. While U.S. executives and regulators may be adamantly against it, the evidence suggests mandatory audit rotation can be beneficial. Let us examine how:

Innovation and Audit: Strange Bedfellows No More
When the status quo is accepted and competition is stifled, the opportunity for innovation is limited. This sums up the state of public company auditing. However, when the threat of losing business is introduced, along with competition from new market entrants, the establishment is forced to examine its methodology and practices and consider how they might innovate to deliver a better product for their clients. Audit rotation has the capacity to drive this behavior change.

Erosion of Complacency
Most other industries would not abide the level of quality degradation demonstrated by the PCAOB evaluation. In most cases, a diminished product would certainly prompt the customer to find a new service provider. Yet, it would appear that few in the U.S. are deeply moved by the results.
Auditors therefore lack the motivation to make the types of improvements required to uplift their product. Why? Complacency. With audit rotation in place, auditors will feel less secure—a good thing—knowing that a fresh pair of eyes may someday soon scrutinize their work and that repeated poor performance can and will negatively impact reputation in an extremely narrow market.

Driving Down Costs
Industry studies suggest that cost is not usually a decision driver in the auditor selection process. That said, since the introduction of audit rotation in the EU, an analysis of FTSE 350 companies that have engaged in rotation shows a cost reduction of nearly 10 percent on average, along with increased value for their money. With knowledge of competitor pricing a transparent part of the process, bidding auditors must design a competitively priced bid and look for ways to drive costs out of the equation.

This could include using lower cost individuals or offshoring mundane, highly administrative tasks. Smaller, nimbler auditors entering the fray are forcing the Big Four to accommodate their pricing models. In many cases, money is saved while value increases. 

Denting the Monopoly
For as long as anyone can remember, the auditing market has been dominated by the Big Four. In some cases, the reality is those firms are truly the only ones equipped to manage the auditing responsibilities of some of the gargantuan global monoliths that comprise the Fortune 500 or FTSE 350…but not all of them.

There is no reason why even large enterprises with more straightforward businesses cannot enlist the services of a smaller, second-tier auditing firm. And with audit rotation, those firms are now getting a chance to bid and introduce themselves to companies to whom they may not previously have had access.

It would be shortsighted and disingenuous to not acknowledge that audit rotation poses certain challenges and potential hardships as well. For those companies with oversized, complicated audit requirements, their options may be limited to the Big Four. And if that company has an existing consultancy relationship with one or more of those firms, the options may be even further limited.

Onboarding a new auditor can be time consuming and distract senior executives from day-to-day business requirements.

On balance, however, the recent implementation of rotation elsewhere in the world suggests that the benefits outweigh the downsides and that many of the fears have been overplayed. U.K. companies that have engaged a new auditor are even reporting the onboarding process to be easier than expected, as the auditors themselves are cooperating in the transition process, knowing they may be in a similar situation in short order. In the final analysis, audit rotation can benefit both company and auditor in the long run and in any established market. It would behoove U.S. regulators to take note.

Richard James is audit category director for Proxima, a global procurement services provider offering an alternative approach to conventional in-house procurement and helping companies align their organization’s third-party costs with their corporate aims.

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