Wednesday, March 21, 2012

Former Fed Chair Volcker and former US Comptroller Bowsher Endorse Mandatory Audit Firm Rotation

At a PCAOB roundtable on auditor independence, Former Federal Reserve Board Chair Paul Volcker endorsed mandatory audit firm rotation, noting that the audits of company financial statements should not become a long-term annuity for the audit firm. It must be remembered that the true client of the firm is the investing public, he emphasized. While conceding a reluctance to disrupt relationships between company and auditor, the former Fed Chair said that audit firm rotation would be a powerful incentive for professional discipline since the audit firm would know that its work would be looked at by another audit firm.

Also supporting auditor rotation, former US Comptroller General Charles Bowsher noted that the first consideration is that there is an inherent conflict of interest when the corporate client pays the audit fees to the firm auditing its financial statements. The challenge is how to address the conflict and enhance auditor independence. Sarbanes-Oxley Act has been successful in enhancing audit independence in small and medium sized companies, he noted, but not as successful with the largest companies.

It is overdue for SEC and PCAOB to consider post-Sarbanes-Oxley auditor independence measures. He recommended that any mandatory audit firm rotation begin by limiting rotation to the 40-50 largest companies, including largest financial institutions, who are clients of the Big Four audit firms, which would help obviate concerns about increased costs. He praised the comment letter of John Biggs to the PCAOB as showing a need for the periodic rotation of audit firms.

According to the former Comptroller, the two main benefits of audit firm rotation are an incentive to resist management pressure and a fresh viewpoint. The downside of a steep learning curve can be addressed by requiring a dual audit in the last year of the audit term and by requiring the outgoing audit firm to submit a report on the overall condition of financial statements and the system of internal controls. Mr. Bowsher dismissed the concern that mandatory rotation is disruptive to audit firms by noting that the independent look is more important. He also noted that if mandatory rotation is limited to the top 40-50 companies, the Big Four would lose one or two clients a year and pick up one or two.

The former Comptroller endorsed a letter to the PCAOB from John Biggs, former Chair of TIAA-CREF, stating that mandatory auditor rotation produces a kind of real time peer review. The outgoing auditor wants the work papers to be complete and of high quality with all problems clearly resolved, said Mr. Biggs, while the new firm reviews them and could either challenge their results, or start with fresh eyes.

Former SEC Chair Richard Breeden, while not taking a definitive position on mandatory audit firm rotation, agreed with Mr. Bowsher that mandatory rotation should begin with the largest companies. He said that mandatory rotation will benefit some companies and harm others. The issue of auditor concentration is important, he said. For both companies and their audit committees, the lack of competitive choices limits them. Chairman Volcker noted that you do not have a problem of auditor concentration with small and medium-sized companies, adding that they have a number of audit firms to select from.

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