Will rotating accounting firms enhance audit quality?

As the economy wrestles to recover from a tumultuous period marked by corporate scandals, mortgage defaults, record unemployment and an overall lack of investor confidence, there has been a renewed emphasis on improving accountability, transparency, credibility and trust.

The Public Company Accounting Oversight Board’s (PCAOB) concept release on mandatory rotation of audit firms lends weight to this movement. This proposed regulation would set limits on the number of consecutive years that a registered public accounting firm could serve as the auditor of a public company. This proposal is largely borne of a perceived need for improved audit quality. ‘One cannot talk about audit quality without discussing independence, skepticism and objectivity,’ says PCAOB chairman James Doty.

Improved independence, skepticism and objectivity are certainly crucial to enhancing audit quality, but what are the implications of mandatory rotation of audit firms on the audit profession as a whole – on audit firms, clients and investors? Is rotation the most practical or feasible approach for achieving enhanced audit quality, and if so, what is at stake?

Perceived advantages

The perceived advantages to mandatory rotation of audit firms largely center on increased audit quality. Proponents of the proposal posit that term limits would help to eliminate some of the ‘chumminess’ that may exist between audit firms and clients, thereby promoting increased independence, skepticism and objectivity. ‘It’s going to make the audit profession concentrate on what it needs to do in terms of getting audits done,’ says Paul Hodgson, chief communications officer and senior research associate at GMI Ratings. ‘There are often situations where auditors may want to maintain the relationship as opposed to performing the best audit. When you know that your relationship is nearing its end in the future, your main concern should be to conduct the audit effectively and efficiently rather than getting hired next year.’

Investors are also potential beneficiaries of this proposal. Investors have been adversely affected by audit failures, some of which have arguably resulted from a lack of auditor skepticism. The proposal seeks to enhance auditor independence and audit quality, which could serve to increase investors’ confidence in the audit process and the audit profession.

Fraud detection, while not the express purpose of an audit, may also be more likely with a change in audit firms in that successor auditors may not be as easily dissuaded from questioning long-standing practices. ‘For fraudsters it’s all about the opportunity to establish and maintain a trusted relationship with the auditors,’ notes Brian Fox, founder and chief marketing officer of Capital Confirmation. ‘Fraudsters need the auditors to trust them in order to get the auditor’s signature on the audit report.’

Perceived disadvantages

As with any proposal, there are perceived disadvantages to mandatory rotation of audit firms. It is apparent that term limits could result in the loss of major clients and sources of revenue for audit firms. Also, the specialized nature of certain industries often necessitates that companies engage audit firms, which have staff with the appropriate level of industry expertise, but audit firm term limits may preclude companies from selecting audit firms; thus, the company’s audit committee may have to relinquish its role in the vetting and selection of the audit firm, thereby diluting the committee’s impact.

In order to perform a quality audit, auditors have to understand their clients’ businesses. This process requires time and resources on the part of both the audit firm and the client. Further, the time it takes to understand a new client may in fact increase the risk of audit failure in the first few years of an audit. Mark Plichta, a partner at Foley & Lardner’s transactional and securities practice, notes, ‘Looking at the downside of mandatory rotation of audit firms, there are a lot of costs, and as is the case with any audit, there is a learning curve where auditors have to spend time getting up to speed with their clients. Someone is going to have to pay for the time commitment, whether it’s the auditors or the company.’

The increased need for, and costs associated with, communication between the successor and predecessor audit firms also has to be considered, given that under the proposal transitions would be more commonplace than they have been in the past.

Recommended alternatives

Why not focus the conversation on auditors’ professional development as a means of strengthening due diligence as it relates to fieldwork practices? After all, a quality audit results from, among other things, audit firms having technically proficient staff following robust and effective procedures that create a sound basis for a formal opinion, or disclaimer thereof. Audit engagement team members’ technical proficiency arises from training within the firm as it relates to accounting and auditing developments, as well as a sound knowledge of the firm’s audit model.

The audit report is the primary communication between the audit firm and investors, yet due to its standardized nature, it provides investors with very little insight into significant aspects of the audit process. Investors are therefore unable, from the audit report, to determine what the important issues were during the audit, and how they were resolved. Enhanced language in the audit report, especially as it relates to the area of accounting estimates, could help investors understand the level of judgment employed by management and the auditors.

Additionally, current practice dictates that the audit engagement partner signs only the firm’s name at the end of the audit report, but the suggestion has been made that the partner should also sign his or her name. This is proposed in anticipation of partners being more circumspect when signing, given that personal information directly connects them to the audit report. Finally, consideration could also be given to the idea of audit firms providing investors with communications similar to the management comment letter, which would detail important areas of interest to investors.

Lead audit engagement and review partners are currently required to rotate from an audit engagement after five years. However, engagement teams, the members of which do most of the detailed audit fieldwork procedures, often remain at the same client for many years. Consideration could therefore be given to rotating audit engagement team members. ‘The question is, if you don’t do rotation, what would be the impact of having engagement team member rotation?’ asks Fox. ‘Even if you are not switching firms, which can be costly, you can still have the ability to get a fresh set of eyes to look at your financials, as opposed to the same people doing the same thing every year.’

A fundamental consideration in the decision made by the PCAOB should be that companies’ audit committees are an integral part of establishing and maintaining a strong independent relationship, in fact and appearance, with audit firms. ‘On a company-by-company basis, if you can get strong, active, interested audit committee members that oversee the audit relationship and governance practices to ensure that the auditors are independent, and have an open dialogue with the auditors, it can facilitate a better audit firm-client relationship,’ says Plichta. ‘It is something that can’t be mandated by rules.’

Whatever the final verdict is by the PCAOB as it relates to mandatory rotation of audit firms, the approach taken should be about restoring public trust and confidence, strengthening compliance and transparency, and making best practices better.

Recommendations from the Institute of Internal Auditors

Lawrence Harrington, chairman of the North American board of the Institute of Internal Auditors (IIA), delivered the following recommendations regarding mandatory audit firm rotation at a PCAOB hearing on March 22, 2012.

I am strongly opposed to mandatory rotation of external auditing firms based on a fixed time schedule. Much of the potential benefit of auditor rotation has already been achieved through mandatory partner rotations, and any incremental benefit from requiring audit firm rotation is not clear. I believe these incremental benefits would be nominal and that we may actually damage the quality of our financial statement audits by mandating a ‘one-size-fits-all’ approach to auditor selection.

Members of the Institute of Internal Auditors (IIA) believe that actions other than mandatory auditor rotation could be taken which would be more likely to result in overall improvement in audit quality, at less risk and at less cost than we would expect from a change to audit rotation requirements. The IIA strongly believes that the following alternatives to mandatory rotation based solely on passage of time should be considered:

• Introducing a mandatory change of auditors in limited circumstances such as financial statement fraud.

• Requiring increased disclosure about the audit committee’s role in overseeing the quality of the audit, including its periodic  evaluation of auditor independence.

• Implementing a system whereby audit committees could request the PCAOB to perform an enhanced inspection of the audit of their company, with reporting of results to both the company and its auditors.

We believe that it should be the responsibility of each audit committee to review its audit firm’s performance annually and recommend changes when deemed necessary. The organization’s internal audit function can greatly support this assessment, and we encourage the PCAOB to consider ways in which the review process might be improved.

In the quest to improve audit quality, I also believe we need to work toward strengthened coordination between internal auditors and external auditors, to leverage the knowledge, skills, experience and expertise of internal audit. This enhanced coordination could lead to a deeper understanding of company risks and controls and to a more appropriate reliance on internal audit results, thereby enabling external auditors to concentrate more of their resources on higher-risk areas.

In summary, I believe the establishment of the PCAOB and other recent reforms have significantly improved audit quality and auditor independence. I applaud the board’s efforts to address the financial reporting concerns of investors and other users of financial statements, especially in light of the recent global financial crisis.

I believe the board should continue to focus on ways to enhance auditor independence, objectivity and professional skepticism. To this end, rather than requiring mandatory firm rotation, the PCAOB should consider each of the alternatives presented above, with the goal of increasing the overall efficiency and effectiveness of auditing without incurring the significant risks inherent in mandatory auditor rotation.