Monday, January 09, 2012

In Letters to PCAOB, EU, Australian and Japanese Accounting Groups Oppose Mandatory Audit Firm Rotation

Comment letters to the PCAOB reveal a strong consensus among global accounting associations that mandatory audit firm rotation could reduce audit quality without increasing auditor independence or enhancing professional skepticism. The comments were in response to a PCAOB concept release on auditor independence and auditor rotation.

Mandatory audit firm rotation would not be conducive to enhancing either auditor independence or professional skepticism, said the European Federation of Accountants, and could even have a potential adverse impact on audit quality. In its letter to the PCAOB, the Federation noted that mandatory audit firm rotation would contradict the objective of reinforcing audit committees since it would take away one of the key roles of audit committees to decide when and whether a new audit firm should be appointed. Similarly, in its letter, the Japanese Institute of Certified Public Accountants said that mandatory audit firm rotation would adversely impact audit quality and financial reporting.

The Institute of Chartered Accountants in England and Wales believes that mandatory audit firm rotation would be a counter productive step that would remove authority from the audit committee and hence negatively impact sound corporate governance, while not concomitantly improving audit quality. In fact, continued the Institute, studies have concluded that discarding the audit firm’s cumulative understanding every few years will inevitably lead to a higher risk of audit failure in the early stages of a new appointment. In its letter to the Board, CPA Australia opposed mandatory audit firm rotation due to a lack of clear evidence of audit quality improvement that would result from such a measure. CPA Australia would support a pilot program to try to obtain such evidence.

The Federation observed that the European Commission is also considering mandatory audit firm rotation as well as other measures. The European debate focuses mainly on market related issues when discussing mandatory audit firm rotation, noted the Federation, while the PCAOB approaches the debate from the angle of independence, professional skepticism and audit quality. Due to the evident extraterritorial consequences of such requirements, emphasized the Federation, it is essential to carefully consider the practical feasibility of the measures if introduced in only one jurisdiction for companies with global activities and their auditors.
Thus, the Federation urged the PCAOB to coordinate any initiatives with its international counterparts in order to achieve a coherent, practical and sustainable solution.

Mandatory audit firm rotation is not the most practical or cost-effective way to respond to concerns regarding independence, said the Federation, citing the alternative of greater involvement of audit committees and making the auditor appointment process more independent of management. This could be combined with tendering procedures under the responsibility of the audit committee and through more transparency by the company regarding the selection and appointment process. Further, guidance could be given to audit committees on how they make proper use of their duty to monitor auditor independence.

The Federation also posited that there is no direct link between mandatory audit firm rotation and professional skepticism. International auditing standards professional skepticism requirements, which are similar to requirements in the current US standards, highlight that the auditor should not solely rely on the honesty and integrity of management and those charged with governance, but must obtain evidence and evaluate the persuasiveness of this evidence. Moreover, while recognizing that earlier decisions can always be challenged, engagement quality control review is an integral part of the audit of listed companies.

Thus, the Federation suggested that it may be more relevant to consider further improvements to the auditing standards on professional skepticism with the aim of enhancing the application of this principle, rather than seeking enhancements of professional skepticism through other policy measures, such as requiring audit firms to rotate on a regular basis.

The Institute of Chartered Accountants emphasized that mandatory rotation of audit firms will not address the concerns the PCAOB has about professional skepticism. In fact, the Institute cautioned that auditors are only in a position to fully apply skepticism when they have developed sufficient knowledge of the client and industry, which mandatory audit firm rotation could undermine. As an alternative, the Institute suggested enhancing auditor documentation of the approach to skepticism and increasing audit committee involvement.

The Federation also pointed out that, since Korea introduced mandatory audit firm rotation in 2006, a Korea University study concluded that audit hours and fees increased while audit quality remained unchanged or decreased slightly. In addition, a recent European Parliament report on the European Commission’s Green Paper on Audit Policy endorsed the concept of internal key audit partner rotation instead of external audit firm rotation.

The Japanese CPA Institute said that mandatory audit firm rotation would make it difficult for audit firm personnel to gain specialized knowledge and experience in specific industries or areas. Mandatory audit firm rotation may also result in low-balling of audit fees, while increasing audit cost.

In its comment letter, the German Institute of Public Auditors cautioned that mandatory audit firm rotation could increase market concentration because audit firm changes would be mainly restricted to larger firms, since audit committees perceive that medium firms lack the resources and expertise. Thus, rather than facilitating access of the medium-sized firms to more audit clients, said the Institute, it would make it easier for large audit firms to encroach on smaller firm audit clients. The German Institute also believes that mandatory audit firm rotation would intensify a price spiral that could threaten audit quality. More broadly, it would lead to permanent movement in the audit market that, in the view of the Institute, would ultimately detract from the value of auditing and lead to an audit being seen as a mere commodity to be valued by price alone, which would also undermine audit quality.

1 comment:

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