Friday, January 13, 2012

In Comments to PCAOB, Large Audit Firms Oppose Mandatory Audit Firm Rotation

In letters to the PCAOB, large audit firms said that the costs of mandatory audit firm rotation outweighs the benefits and that implementation of an audit firm rotation regime could undermine the critical role of audit committees and detract from sound corporate governance. The firms were commenting on a concept release issued by the PCAOB on auditor independence and audit firm rotation.

In its comment letter, KPMG said mandatory audit firm rotation could present risks to audit quality as well as significant costs and practical problems for auditors and public companies. There is some evidence that mandatory audit firm rotation could decrease audit quality and that fraudulent financial reporting is more likely to occur in the early years of the audit-client relationship.

In addition, KPMG believes that it would be arbitrary under applicable legal standards for the Board to move forward with a proposal that would dramatically change the fundamental principle that the audit committee is in the best position to decide which is the best external audit firm to audit the company’s financial statements without more empirical evidence that the perceived problem can be solved by the proposed solution. Moreover, mandatory audit firm rotation likely would place significant burdens and costs on auditors and public companies. For example, mandatory audit firm rotation would present audit firms with significant uncertainty regarding audit capacity needs and where best to locate talent with particular skill sets, and also inhibit longer-term investment in the development of specialized industry sectors.

Mandatory audit firm rotation also presents many practical implementation problems that could significantly increase costs to public companies and their shareholders, noted KPMG, costs which have not been fully quantified in any study. Most obvious is that companies would suffer increased costs as new auditors are appointed and seek to understand fully the work of the company and the prior auditor. Also troubling from the perspective of a public company is that mandatory audit firm rotation would undermine the audit committee’s ability to always select the best auditor for the job and determine whether changing auditors is in the best interests of the company and its shareholders.

Mandatory rotation divorces decisions about auditor appointment from the circumstances of the individual company and does not allow for situations in which it may be important not to change the auditor, such as when there are major changes underway at a company like a merger or acquisition or implementation of new financial reporting software.

Similarly, Ernst & Young said that mandatory audit firm rotation is neither a necessary nor a constructive means to promote auditor skepticism. E&Y was aware of no evidence suggesting that mandatory firm rotation will improve audit quality. Moreover, there are many identifiable and known downsides to such a policy with little to no certain benefit. A mandatory audit firm rotation model would not only give rise to substantial costs and disruptions, posited E&Y, it would also impair audit quality, undermine sound corporate governance, and detract from the ability to maintain a robust accounting profession.

In the view of PricewaterhouseCoopers, mandatory audit firm rotation does not pass a cost-benefit test. The most significant cost relates to diminished audit quality and less reliable financial reporting. Mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality considering the additional financial costs and the loss of institutional knowledge of a public company’s previous auditor of record. The potential benefits of mandatory audit firm rotation are harder to predict and quantify.

Mandatory audit firm rotation also would involve considerable disruption, said PwC, which could further impact audit quality and the financial reporting process. In the initial years of an auditor's tenure, there is a significant effort from all parties in the financial reporting process to assist the audit team in understanding the business and internal control over financial reporting. PwC also believes that mandatory audit firm rotation would diminish audit committee effectiveness by preventing the audit committee from making the judgment to retain its existing firm in some circumstances and require it to choose a firm which it does not believe would be in the best interest of its company’s shareholders.

There will no doubt be many circumstances in which the audit committee determines that retaining the existing audit firm beyond the statutory period would be the best alternative for achieving the highest quality audit. In turn, mandatory audit firm rotation also presents significant corporate governance implications since a principle of sound governance is that the audit committee is in the best position to determine whether auditor rotation is appropriate. Since the passage of the Sarbanes-Oxley Act, audit committees on the whole have embraced their responsibility as independent stewards of the auditor relationship and function effectively in discharging those responsibilities.

While Deloitte & Touche said that mandatory audit firm rotation is not as effective as would be making improvements in the existing system, the firm allowed that a limited form of mandatory rotation, what Deloitte called remedial rotation, should be considered. For example, the PCAOB might recommend to the audit committee an auditor change as a result of serious adverse inspection findings that the Board believes cannot be resolved otherwise. In appropriate circumstances, the PCAOB or the SEC also could seek agreement from an audit firm to resign from an engagement, or a company to change auditors, as a condition for resolving an enforcement investigation. These measures would allow for change in specific auditor-company relationships, reasoned Deloitte, without mandating audit firm rotation for the entire system.

In its comment letter, BDO noted under mandatory audit firm rotation the audit learning curve would be significantly steeper because an entire audit firm is being replaced, rather than just the lead partner and engagement quality reviewer. Thus, the institutional knowledge a firm gains during its tenure is lost, reasoned BDO, and the successor firm would need to devote substantial time in building an appropriate level of knowledge.

While acknowledging that companies do change auditors in the normal course of business, BDO pointed out that these voluntary changes are effectively managed. In contrast, the exponential increase in the rate of audit firm changes under a mandatory rotation regime would place excessive burdens on management, the audit committee, and the new audit firm in implementing a smooth transition, with the potential negative effect on audit quality.

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