PCAOB Votes to Issue Concept Release Regarding Mandatory Audit Firm Rotation

News Brief
August 16, 2011

By Cydney Posner

This morning, the PCAOB voted to issue for public comment a concept release suggesting possible ways to enhance auditor independence, objectivity and professional skepticism. The primary focus of the release is mandatory rotation of audit firms, i.e., term limits for auditors of public companies. (That ought to be a big hit!) Comments are due December 14, 2011. This initiative is just one of several that the PCAOB is considering. See, for example, my article from 6/21/11, discussing the PCAOB concept release related to alternatives for changing the auditor's reporting model.

PCAOB Chairman Jim Doty noted that any serious discussion of independence, skepticism and objectivity "must take into account the fundamental conflict of the audit client paying the auditor. That leads to consideration of firm rotation as a counterweight to that conflict. " The PCAOB has conducted hundreds of inspections that have uncovered a troubling number of audit failures: "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…." The proponents contend that auditor rotation "could free the auditor, to a significant degree, from the effects of client pressure and offer an opportunity for a fresh look at the company's financial reporting." Opponents, however, have raised concerns about cost and adverse impact on audit quality in the early years of an engagement. One possibility is that a rotation requirement be limited to audit tenures of more than 10 years or to the largest issuer audits.

Board member Lewis Ferguson agreed with the Chairman: "Despite the numerous rules, regulations and judicial decisions intended to promote auditor independence,… many of [the audit deficiencies] appear to be attributable to a lack of appropriate skepticism on the part of the auditor. This apparent absence of skepticism may be attributable to many factors, but one of which may be a subtle restraint on the auditor's willingness to challenge management judgments for fear of losing a client and a stream of revenue. Experience also leads at least this Board member to suspect that while auditors may want to do the right thing, no auditor wants to have a dissatisfied client or to be the reason his or her firm lost a long standing audit engagement, particularly if the sources of disagreement do not have answers that are crystal clear." Board member Steven Harris likewise observed that "inspectors have raised numerous concerns about professional skepticism in their inspections of both large and small firms, and these concerns are cited too often to ignore." All recognize, however, that there would be significant implementation challenges related to costs and disruption.

But how serious is the mandatory rotation idea in this concept release? Probably not very. It appears that the concept release is intended more as a tool to promote vigorous debate than an actual proposal on the table. Board member Dan Goelzer welcomed the concept release as a way to "trigger a wide-ranging discussion about auditor independence, objectivity, and professional skepticism. The release particularly invites comment on whether there should be mandatory audit firm rotation. I have serious doubts that mandatory rotation is a practical or cost-effective way of strengthening independence. However, with nearly nine years of inspections experience under our belts, the time is right to step back and thoughtfully examine whether we need to deploy new tools to promote independence…. Independence is a state of mind, not simply the state of being in compliance with a set of rules." He also noted that a correlation between audit tenure and audit deficiencies does not necessarily establish causation. In addition, cost-benefit analysis should be central to this project, and there may be more effective alternatives to mandatory rotation.

Board member Jay Hanson echoed that view to some extent, but focused his remarks in part on soliciting comments about the role of the audit committee in ensuring auditor independence, including through voluntary auditor rotation. He cited the 2003 report of the Conference Board Commission on Public Trust and Private Enterprise, which advocated that audit committees consider rotating audit firms "when there are circumstances that could call into question the audit firm's independence from management. These circumstances included when (1) significant non-audit services are provided by the auditor of record to the company (even if approved by the audit committee), (2) one or more former partners or managers of the audit firm are employed by the company, or (3) lengthy tenure of the auditor of record, such as over 10 years—which our survey results show is prevalent at many Fortune 1000 public companies. We believe audit committees that encounter these circumstances, at a minimum, need to be especially vigilant in the oversight of the auditor and in considering whether a ‘fresh look' (e.g., new auditor) is needed. We also believe that if audit committees regularly evaluated whether audit firm rotation would be beneficial, given the facts and circumstances of their companies' situation, and are actively involved in helping to ensure auditor independence and audit quality, many of the benefits of audit firm rotation could be realized at the initiative of the audit committees rather than through a mandatory rotation requirement."  It's not hard to imagine that, as an intermediate step, the PCAOB takes action to highlight the issue for audit committee consideration on a voluntary basis.