Sunday, February 12, 2012

Committee on Capital Markets Urges Rigorous Cost-Benefit Analysis for Any Mandatory Auditor Rotation Regulations

A robust cost-benefit analysis is critical if the PCAOB decides to take further action on mandatory audit firm rotation, said the Committee on Capital Markets Regulation. Citing the DC Circuit’s 2011 decision vacating the SEC proxy access rule, the Committee cautioned that a rule regarding mandatory audit firm rotation could be subject to a similar successful judicial challenge if it does not exhibit adequate cost-benefit analysis. Thus, in a letter to the Board, the Committee urged the PCAOB and SEC together to continue to collect and analyze information relating to the costs and benefits of mandatory audit firm rotation. It would be ill-advised, emphasized the Committee, to implement mandatory audit firm rotation, with its enormous known costs, without strong empirical evidence that the proposal will achieve the PCAOB’s goal of enhancing auditor independence, objectivity, and skepticism.

In this regard, the Committee noted that the PCAOB has presented no empirical evidence to suggest that mandatory audit firm rotation would improve auditor independence and skepticism. The PCAOB acknowledges that professional skepticism is a state of mind and may be difficult to identify as the cause of an audit failure, and that audit failures can also reflect a lack of technical competence or experience. Perhaps more importantly, continued the Committee, a preliminary analysis of the PCAOB’s inspection data appears to show no correlation between auditor tenure and number of comments in PCAOB inspection reports. Academic research suggests similar conclusions.

Formed in 2005, the Committee has been dedicated to improving the regulation of U.S. capital markets. In May 2009, the Committee released a comprehensive report entitled The Global Financial Crisis: A Plan for Regulatory Reform, which contains fifty-seven recommendations for making the U.S. financial regulatory structure more integrated, more effective, and more protective of investors in the wake of the financial crisis. Since then, the Committee has continued to make recommendations for regulatory reform of major areas of the U.S. financial system. The Committee is co-chaired by Glenn Hubbard, former Chair of the President’s Council of Economic Advisers, and John Thornton, former President and Co-Chief Operating Officer of the Goldman Sachs Group. Former SEC Commissioner Roel Campos is a Committee member.

In the Committee’s view, mandatory audit firm rotation would impose significant costs both on audit firms and on companies. Transitioning to a new audit firm will result in the loss of institutional knowledge, including both an audit firm’s substantive knowledge of a company as well as its practical knowledge of, for example, a company’s accounting and recordkeeping systems. These costs take several forms: there would be financial costs as the auditors must educate themselves about their new client and its operations, as well as costs incurred by companies who will be required to expend significant time and resources researching, assessing, and selecting new auditors and then bringing them up to date on the company’s business. There could also be potential costs related to audit failures, which a 2003 report by the General Accounting Office indicated are more likely in the early years of an audit.