PCAOB Chair Comments on Internal Controls and Auditor Rotation

News Brief
November 11, 2011

By Cydney Posner

Reuters apparently ambushed PCAOB chairman Jim Doty on the sidelines of the PLI securities regulation conference yesterday with some interesting results.  First Doty commented that auditors are not properly testing U.S. companies' internal controls, a failure he characterized as a "very major issue" for the PCAOB. Instead of gaining an understanding of the controls companies have put in place and testing them, "'some auditors are just taking the business process that the company has put in place as a control,'" Doty said in the interview.

Doty also seemed to walk back his prior strong advocacy of auditor rotation. The PCAOB has previously issued for public comment a concept release suggesting possible ways to enhance auditor independence, the primary focus of which was mandatory rotation of audit firms, i.e., term limits for auditors of public companies. (See my article of 8/16/11.) At the open meeting during which the PCAOB voted to issue the release, Doty appeared to be a strong proponent of rotation. (Regarding the hundreds of inspections conducted by the PCAOB that uncovered a troubling number of audit failures, Doty argued: "The fact that our inspections cannot always link a specific failure to an absence of objectivity in the auditor's mindset does not establish that the auditor was unaffected by the pressures and incentives inherent in the system. To the contrary, our experience teaches that those pressures and incentives are powerful and pervasive." The "central question" is whether "term limits, set at some appropriate length, with due regard for implementation complexities, reduce the pressures auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets….") While Doty apparently remains concerned that independence issues have adversely affected auditor skepticism in the hundreds of instances where auditors have failed to obtain reasonable assurance to support their opinions, according to Reuters, Doty acknowledged that he "'recognize[d] now that audit firm rotation presents considerable operational challenges.'""Reuters reports that about 175 companies in the S&P 500 "have had the same auditor for 25 years or more, according to Audit Analytics, and some of relationships date back more than a century."

Doty also reiterated urgent concerns about audit firm inspections in China, noting that the PCAOB needs to gain entrance soon to China to inspect firms that audit U.S.-listed companies. If not, it is even possible that audit firms in China could lose their U.S. registration, although that would certainly not be a desirable outcome.