PCAOB Chair Speaks on the Cultural Importance of Auditor Independence and Skepticism

By Cydney Posner

Following is a link to an interesting speech –spotted by thecorporatecounsel.net blog – given by new PCAOB chair, Jim Doty.

Among other things, the speech discusses challenges to maintaining auditor independence and skepticism and potential policies designed to address those challenges so that auditors do not "allow themselves to be caught up in their audit clients' business goals."

Doty identifies the recent financial crisis as the worst on record for "an entire business culture suspending skepticism," including various folks at the Federal Reserve: "Former Fed Chairman Alan Greenspan was shocked to find that senior managers of the major financial institutions did not behave the way the laws of economics should have dictated: how could they all have abandoned the caution necessary to the survival of their institutions and (by the way) to the preservation of their considerable stakes in those entities?"

Auditor independence requirements are designed to guard against the tendencies of even "well-intentioned auditors, [who]as with other people, fail to recognize and guard against their own unconscious biases. Auditors are, after all, paid by the clients they are charged with policing. As in other professions, auditors want to advance in their chosen profession which often means keeping the client happy and growing their business." However, these requirements are not as effective a barricade as hoped. (Doty cites several instances of auditors breaking the rules to "help" long-term clients.) The PCAOB expects to issue several policy documents in the near-term regarding ways to counteract the conflicts auditors face, with the objective of "foster[ing] broad debate and research about ways to enhance both the relevance and credibility of audits, and to provide the investing public a better understanding of what an audit is through enhanced transparency."

The following are among the approaches being considered:

• Mandate audit firm rotation, i.e., term limits for auditor firms, not just audit partners; 
•  Help audit committees be better informed about PCAOB processes and better equipped to engage with their auditors about inspections "without settling for responses [from auditors] that distort the significance of inspection results" (Apparently, auditors "are often less than forthcoming with audit committees that try to elicit information about inspection results");
• Change the auditor's report so that it is more informative; <br>• Require audit partners to sign audit reports; and
• Enhance transparency about the conduct of multi-national audits (especially where audit firm affiliates overseas are not subject to PCAOB inspection).

Regarding the first pretty big bombshell, Doty reminds us that the idea of a regulatory limit on auditor tenure is not new. Most recently, "in 2002, Congress considered requiring firm term limits during the debates that led to the Sarbanes-Oxley Act. It ultimately decided that the idea required more study and directed the GAO to prepare a report. That report, issued in 2003, noted that the SEC and the Board would need several years to evaluate whether the Sarbanes-Oxley reforms — including audit partner rotation — were sufficient, or whether further independence measures are necessary to protect investors.

"The PCAOB has now conducted annual inspections of the largest audit firms for eight years. Our inspectors have reviewed more than 2,800 engagements of such firms and discovered and analyzed hundreds of cases involving what they determined to be audit failures. We have conducted more than 1,500 inspections of smaller domestic firms and of non-U.S. firms. These include multiple inspections of hundreds of those firms. And our inspectors have identified hundreds more cases involving what they determined to be audit failures.

"Based on this work, 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. 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.

"As such, the Board plans to issue another concept release to explore whether there are other approaches we could take that could more systematically insulate auditors from the forces that pull them away from the necessary mindset."