Monday, December 19, 2011

Corporate Secretaries Society Says Costs of Mandatory Auditor Rotation Outweigh Benefits, Urges PCAOB to Use ``Bully Pulpit''

In a letter to the PCAOB, the Society of Corporate Secretaries and Governance Professionals said that the cost of mandatory audit firm rotation outweighs the benefits. Moreover, the Society believes that mandatory auditor rotation will introduce significant issues that would likely contribute to an actual decrease in audit quality. In the Society’s view, existing Sarbanes-Oxley regulations, including the rotation of the lead audit partner every five years and other audit firm employees with significant involvement in the audit every seven years, adequately addresses the concerns of professional skepticism and ongoing objectivity. Essentially, reasoned the Society, the rotation of audit firm personnel gives the audit a fresh look without disrupting the continuity of audit firm service. The Society was responding to a PCAOB Concept Release on enhancing auditor independence and audit quality.

The Society noted that there would be considerable costs underlying an auditor rotation requirement for both audit firms and public companies at the various stages of the process, including the selection of the new audit firm, the costs of changing firms and finally the costs of rotating the audit firms after a certain amount of time. Each time an audit firm rotation occurs, noted the Society, the company’s audit committee, management and employees in its finance, legal, tax, accounting, and internal audit organizations, across all the jurisdictions in which the company operates, will have to invest significant amounts of time and money to ensure selection of an appropriate new audit firm.

The complex process of evaluating a potential new audit firm includes consideration of numerous factors, including the firm’s reputation; the firm’s knowledge and experience in the company’s lines of business; potential conflicts of interest or independence issues; and the scope of the audit firm’s international network in the countries and regions in which the company operates. According to the Society, the thoughtful consideration of each of these factors in support of the important decision on the best audit firm for a company at a given time would likely necessitate thousands of hours of work and analysis and concomitant expenditures. More broadly, the Society said it would be inefficient to require thousands of company hours every five or ten years to assess an audit firm change, especially when such a change may not be needed or be in the best interests of the company or its shareholders.

Further, once a new audit firm has been retained, observed the Society, a significant amount of company management time is required to provide the successor firm with the information needed to plan its audits and gain familiarity with the company and its accounting policies and methodologies, and its internal controls. The company’s audit committee must maintain an appropriate level of oversight throughout the entire process.

Contrary to the Concept Release’s position that mandatory auditor firm rotation would enhance auditor quality, the Society believes that it will actually harm audit quality. Evidence in the Concept Release indicates that audit quality in the first years of an engagement tends to be lower, and therefore could lead to a greater risk of audit failure. Because the start-up requirements for a new audit, such as gaining familiarity with the client’s particular practices, are significant for an incoming auditor, the ability to conduct the audit with the degree of diligence and thoroughness possible in later years is lessened.

With a mandatory rotation rule in place, reasoned the Society, companies will spend more time in a short-tenure audit situation, and overall audit quality will be negatively impacted. Also, incoming auditors, unfamiliar with the details of a new client’s business, will be less likely to identify fraud or deception. The accumulated experience of a longer audit tenure helps a firm better spot and account for these issues.

The Society also posited that mandatory rotation of external auditors would be an ineffective means of addressing the risk of inadequate professional skepticism, primarily because it fails to consider that professional skepticism is a skill the auditor employs, and instead confuses it with the normal questioning that takes place as a new auditor tries to understand a new client. Professional skepticism is most effectively used by an auditor with a full understanding of the facts and circumstances related to the clients’ businesses, emphasized the governance group, and mandatory rotation of external auditors will not cure this purported problem.

Indeed, continued the Society, there is no foolproof method for ensuring that professional skepticism is maintained throughout the life of an audit firm’s tenure. However, the Society believes that the inspection and enforcement tools that the PCAOB already possesses are sufficient to ensure professional skepticism. These tools provide an effective arsenal to address issues with the firms through monetary penalties, professional penalties and by publicity of failures that would adversely impact their customer base and, ultimately, an audit firm’s ability to retain clients. In this regard, the Society urged the PCAOB to use its “bully pulpit” to speak out on the need for auditor skepticism and thereby heighten sensitivity to the topic.