Levitt Committee Proposes Major Changes to PCAOB-SEC Auditor Oversight

A blue-ribbon Treasury advisory committee has proposed significant and far reaching changes in SEC-PCAOB oversight of the outside auditors of public company financial statements. The Advisory Committee on the Auditing Profession, co-chaired by former SEC Chair Arthur Levitt, focused on improving audit quality and oversight, enhancing the ability of auditors to detect fraud, strengthening corporate governance at audit firms, and expanding the number of global audit firms.

In a major step, the committee urges the SEC to mandate annual shareholder ratification of the company’s outside auditor. Under Sarbanes-Oxley, the audit committee hires, pays and oversees the work of the outside auditor. The committee believes that shareholder ratification of the audit firm will enhance the audit committee’s oversight to ensure that the auditor is suitable for the issuer’s size and financial reporting needs. At the same time, shareholders will be given a voice on the reasonableness of audit fees and any apparent conflicts of interest.

The committee reasoned that shareholder ratification of the outside auditor would be more meaningful if accompanied by the disclosure of key indicators of audit quality, Thus, the panel asks the PCAOB to develop key indicators of audit quality and require audit firms to publicly disclose them. The Board could monitor the audit quality indicators through its inspection process. Audit quality indicators could be the average experience level of auditing firm staff on individual engagements, the average ratio of auditing firm staff to auditing firm partners on individual engagements, and annual staff retention.

More granularly, the committee urges the PCAOB and SEC to clarify in the auditor’s report the auditor’s role in detecting fraud; and the limitations on that role imposed by current auditing standards. An expectations gap has arisen between the public’s perception of the ability of outside auditors to detect and prevent fraud, noted the panel, and the actual capability of auditors to do so under current regulation. In light of this continuing expectations gap, the committee asks the PCAOB to review the auditing standards governing fraud detection and fraud reporting and update these standards as needed..

The panel believes that a collective sharing of fraud prevention and detection experiences among auditors and other market participants will provide a broad view of auditor practices and ultimately improve fraud prevention and detection capabilities. With that in mind, the committee urges auditors, in consultation with the SEC and PCAOB, to develop best practices for fraud prevention and detection.

In an effort to help investors determine the quality of financial reporting and make investment decisions, the committee asks the SEC to amend Form 8-K to characterize appropriately and report on every public company auditor change. The SEC should also require audit firms to notify the PCAOB of any premature engagement partner changes on audit clients if made before the normal rotation period and, expect in cases of retirement, the reason for the premature change.

The committee tackles the salient and seemingly intractable problem of auditor concentration and the need to expand the number of global audit firms. Noting that underwriters and lenders often insist that the company employ a Big Four audit firm and thereby limit auditor choice, the panel urges the SEC to require disclosure in the annual report and proxy statement any agreements with third parties that limit auditor choice. The UK auditor overseer has also suggested similar disclosure of contractual obligations limiting auditor choice. In addition, the panel asks the SEC and PCAOB to include smaller audit firms in their public forums.

It is also important to auditor choice that the Big Four not become the Big Three. To this end, the PCAOB should monitor potential sources and situations of catastrophic risk at he audit firms that it oversees. The Board could conduct this monitoring through its existing inspections, registration, and reporting regimes.

At the same time, the panel proposes a two prong governance mechanism for larger audit firms to assist in the preservation and rehabilitation of a troubled firm. The first step would be for the SEC and PCAOB to encourage larger audit firms to adopt a voluntary internal governance mechanism that could be triggered in the event of threatening circumstances.

If the governance mechanism failed to stabilize the firm, a second step would permit the SEC to appoint a court-approved trustee to preserve and rehabilitate the firm by addressing the threatening situation, including through a reorganization, or if such a step were unsuccessful, to pursue an orderly transition. If this second mechanism includes addressing claims of creditors, the panel recognizes that legislation to integrate this mechanism with the judicial bankruptcy process may be necessary.