PCAOB Nixes Mandatory Auditor Rotation

News Brief
February 6, 2014

By Cydney Posner

Public companies can now breath a big sigh of relief. According to this article in the WSJ, , at a budget meeting before the SEC yesterday, the PCAOB indicated that it is no longer pursuing a mandatory auditor rotation project, i.e., term limits for auditors. According to Jim Doty, chair of the PCAOB, "'We don't have an active project or work going on within the board to move forward on a term limit for auditors….We nevertheless will continue to think about what impacts independence. There may be a change of focus here.'" However, the article reports that the Chair confirmed that the project "would remain on its activity list"; auditor independence has been a "perennial issue" as "hundreds of its inspections continue to reveal serious deficiencies in auditor independence." Meanwhile, the article reports, the European Union has recently signed on (in principle anyway) to mandatory auditor rotation every 10 to 24 years.

The article observes that the PCAOB "has encountered heavy resistance to the idea of auditor rotation, receiving hundreds of comment letters from corporate board members and companies who argued that auditor rotation would leave companies with inexperienced auditors and harm audit quality. Research by the PCAOB itself showed that in several industries, companies faced a choice of just one or two big audit firms with expertise in their sector, complicating the feasibility of mandatory rotation. Congress accused the PCAOB of potentially overreaching its mission, and in July the House of Representatives passed a bill to prevent the board from ever requiring mandatory auditor rotation."

Currently, only audit partner rotation is required. However, mandatory auditor rotation has been on everyone's shopping list of favorite corporate governance reforms for decades: former SEC Chair Richard Breeden imposed mandatory 10-year auditor rotation on WorldCom, when he was the court-appointed monitor for WorldCom following the scandals there, and SOX required the GAO to study the possible effects of mandatory audit firm rotation and report to Congress on its findings. In 2011, the PCAOB issued for public comment a mandatory auditor rotation concept release. (See my email of 8/16/11.) At that time, Mr. Doty appeared to be a strong advocate of auditor rotation, arguing 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 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…."

But how serious was the PCAOB about mandatory rotation in the first place? Probably not very. Even at the 2011 meeting, PCAOB members approved issuance of the concept release on the basis that it was time to consider new tools to promote independence, at the same time expressing serious doubts that mandatory rotation was either practical or cost-effective. The 2011 concept release may well have been intended more as a tool to encourage vigorous debate than an actual proposal on the table. Barely a few months after the concept release was issued (and probably after having his ear bent by more than a few CEOs and directors), Mr. Doty walked back his strong position, acknowledging to Reuters that he "'recognize[d] now that audit firm rotation presents considerable operational challenges.'" (See my article of 11/11/11.)