PCAOB Floats Possibility of Mandatory Audit Firm Rotation
This article discusses a recent Public Company Accounting Oversight Board concept release airing concerns regarding auditor independence, objectivity and professional skepticism and raising the possibility of requiring mandatory audit firm rotation as a means to redress, at least partially, a perceived cause of their auditor independence concerns.
The Public Company Accounting Oversight Board (“PCAOB”) issued a concept release (the “Release”) airing concerns with auditor independence, objectivity and professional skepticism and raising the possibility of requiring mandatory audit firm rotation as a means to redress, at least partially, a perceived cause of their auditor independence concerns. The PCAOB sought the public’s comments on those concerns, the advisability of making audit firm rotation mandatory and alternative means to address its concerns. Public companies and their audit committees may want to comment to the PCAOB on whether mandatory audit firm rotation is needed or even prudent and what alternatives to rotation would better address the PCAOB’s concerns. Comments were due by December 14, 2011.
The Release gives notice of a public roundtable to be held on the topic in March 2012. Due to the timing of the roundtable, even if the PCAOB determines to pursue mandatory audit firm rotation, final rules would likely not be adopted until late 2012 or 2013. Any rules could provide subject public companies a further transition period to comply with the rules.
Auditor independence is one of several subjects that the PCAOB is actively considering, as the Release follows closely the issuance of the PCAOB’s concept release concerning a possible expansion of the nature and scope of the auditor’s report on audited financial statements. The PCAOB recently held a public roundtable on September 15, 2011 to discuss the matters contemplated by this prior concept release.1
BACKGROUND
Congress and others have considered requiring audit firm rotation before, most recently in conjunction with the enactment of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”). Those considerations occurred, as will the current one, in a regulatory environment in which the auditor-audit client relationship mandated by the federal securities laws is perceived to have a built-in conflict of interest for auditors who are engaged, paid and, in some instances, terminated by their audit clients or, after Sarbanes-Oxley, those clients’ audit committees — without any circuit breaker to disrupt that conflict.
Public companies currently enjoy wide latitude in their choice of auditors, and a public company may continue to engage a particular audit firm indefinitely so long as the selected audit firm is independent as to the company under the auditor independence rules of the PCAOB and the Securities and Exchange Commission (“SEC”). Although those rules specify circumstances, the existence of which results in an audit firm not being independent as to a particular audit client, the rules cannot effectively regulate the auditor’s mindset when conducting an audit. The inherent potential for an auditor’s independence, objectivity and professional skepticism to be weakened, intentionally or not, by the pressures to provide client service and to maintain long-standing and lucrative audit engagements has long concerned investors, legislators, regulators and other interested observers.
PCAOB INSPECTIONS RAISE CONCERNS REGARDING A LACK OF AUDITOR INDEPENDENCE
The PCAOB, itself a creature of Sarbanes-Oxley, notes that it has been engaged in annual inspections of the largest audit firms for the last eight years and has reviewed at least portions of over 2,800 audit engagements and analyzed “several hundred cases” involving audit failures (i.e., instances in which the audit firm failed to obtain reasonable assurance as to the freedom of financial statements from material misstatement). However, the PCAOB makes clear that it does not suggest that all of the audit failures and deficiencies its staff has identified stem from a lack of objectivity or professional skepticism. In fact, one may conclude from the discussion in the Release that little evidence exists of an overall cause-and-effect relationship between audit failures and audit firms’ lengthy tenures with the companies suffering those failures.
Nevertheless, the PCAOB is clearly concerned that many of the audit problems it has identified through its inspections and other oversight activities may have a lack of auditor independence as a root cause, and management pressure is a perceived cause of independence issues. Despite the PCAOB’s belief that audit quality has improved since the adoption of Sarbanes-Oxley, it still believes that “more can be done to bolster auditors’ ability and willingness to resist management pressure.” These concerns and the possibility of enhancing the auditors’ independence, objectivity and professional skepticism appear to have motivated the PCAOB to raise anew the possibility of mandatory audit firm rotation.
MANDATORY AUDIT FIRM FOTATION WOULD ENTAIL DISADVANTAGES AND RISKS
Without mandatory rotation, large public companies seem not to be motivated to change auditors routinely. In fact, the Release notes that for the “largest 100 companies, based on market capitalization, auditor tenure averages 28 years.” The reason for such a long tenure may well have more to do with the numerous disadvantages and risks to a company that makes such a change than with the audit firm’s perceived deference to the company’s management.
These disadvantages and risks include increased audit costs and the need to divert precious management resources to educate a new audit firm about the company, its industry, its accounting practices and its internal controls, as well as possible audit risk in the early years of a new firm’s engagement. A new auditor may also disagree with a company’s historical accounting methods and treatments or present alternative methods and treatments that run contrary to those reflected in the company’s historical financial statements audited by the prior audit firm. Without the prospect of a long-running engagement, but knowing that companies will try to avoid changing auditors quickly after a required rotation, the new audit firm may be more inclined to take positions contrary to those blessed by the prior audit firm, which might lead to a restatement of the company’s historical financial statements.
In addition, difficulties may be encountered by an issuer in a capital markets transaction occurring soon after a change in audit firms, such as with obtaining consent to the inclusion of a former auditor’s audit report in a registration statement, with comfort letters and with the new auditor’s views of the issuer’s accounting treatments. Mandatory audit firm rotation may make those difficulties a more common experience and may affect the timing of capital markets transactions being considered at a time close to a required change in auditors.
Furthermore, large, multinational companies with needs for very specific industry expertise would likely face selecting new auditors from a very small number of audit firms with the necessary expertise, experience, number of audit professionals and international footprint. Some of those candidates may already provide non-audit services to the company, which might, for practical and legal reasons, further narrow the field.
For a public company, these disadvantages and risks greatly outweigh the perceived value of having a new auditor take a “fresh look” at the company’s financial statements and accounting practices.
RELEASE FOCUSES ON MANDATORY AUDIT FIRM ROTATION
Various statements made by PCAOB members during the open meeting at which the Release was approved suggest that the Release was issued to solicit public comment on ways that auditor independence, objectivity and professional skepticism may be enhanced. However, the Release and other statements by PCAOB members clearly focus on the potential for mandatory audit firm rotation as a possible, if partial, solution to what may be fundamental concerns with an almost century old model of audit firm engagement and payment.
The PCAOB’s chairman began his statement at the open meeting where the Release was approved by stating “I believe that the long association of the largest audit firms with their major audit clients is an issue that must be addressed in order to fulfill the mission of the PCAOB.”2
Signaling a potential willingness to shift the regulatory landscape on an even more basic level, he followed up by stating that “[a]ny serious discussion of [auditor independence, skepticism and objectivity] must take into account the fundamental conflict of the audit client paying the auditor.”3
While members of the PCAOB may have reservations about mandatory rotation (one member expressed doubts about its practicality and cost-effectiveness), in view of the general tenor of the Release and various statements of the PCAOB members, public companies should not proceed on the assumption that this consideration of mandatory audit firm rotation will, like prior considerations, end with today’s status quo intact.
POSSIBLE APPROACHES TO MANDATORY AUDIT FIRM ROTATION RULEMAKING
Maximum Engagement Term
The PCAOB notes that if it were to move forward with consideration of a rotation requirement it could propose a rule providing that an audit firm is not independent as to a company if the audit firm has provided an audit opinion on the company’s financial statements for a certain number of consecutive years. Despite recognizing that the length of the term will be a “key variable” of mandatory rotation, the PCAOB does not suggest what the term should be. However, the PCAOB expresses interest in receiving comments on the advantages and disadvantages of terms of ten years or longer. This interest may indicate that the PCAOB likely sees shorter terms as impractical (or at least politically infeasible).
Scope
The PCAOB would need to determine whether to consider a rotation requirement for all audits conducted pursuant to PCAOB standards or whether to limit the rotation requirement to some subset of public companies. For example, the PCAOB suggests that it might consider having mandatory rotation rules apply only to audits of the largest companies. Any mandatory rotation requirement is not expected to apply to audits of non-issuer brokers and dealers.
Transition and Implementation Considerations
The PCAOB recognizes that choosing a new audit firm and transitioning from one audit firm to another will present difficulties, including those raised by SEC rules relating to the provision of non-audit services, that should be considered in the mandatory rotation rules. To mitigate these transition issues, the PCAOB is seeking comments regarding steps to provide a company sufficient time to transition out of non-audit service arrangements with firms that could be engaged to conduct the audit.
Other matters that the PCAOB should consider if it intends to propose mandatory audit firm rotation rules include: (1) whether the rotation rules would need to be accompanied by changes to existing requirements (e.g., additional quality control or other procedures to mitigate greater audit risk in the engagement’s early years); (2) whether to adopt some measure of tenure protection for auditors so that the audit committee could not remove an auditor without good cause for a certain period; and (3) whether SEC rules would also need to be amended.
IMPLICATIONS OF THE RELEASE
As discussed, mandatory audit firm rotation may create numerous disadvantages and risks for public companies. Moreover, the PCAOB is seeking comment on whether audit committees have considered voluntary audit firm rotation, and, if not, why they have not done so, as well as on audit committees’ experiences with audit firm rotation. In light of that interest, even if the PCAOB does not make audit firm rotation mandatory, it could suggest that the SEC consider rulemaking to impose more specific responsibility on audit committees for oversight of auditor independence. Considering the PCAOB’s concerns and the current initiative, audit committees may wish to reevaluate their existing audit oversight processes and the content of their communications with management and audit firms.
The PCAOB is also interested in the public’s views and data on how the cost and disruptions associated with mandatory audit firm rotation could be contained and will seriously consider views and data that mandatory rotation would have an effect opposite to that intended by the PCAOB. The PCAOB’s interest in the costs associated with mandatory audit firm rotation is likely the result of the recent federal court decision to strike down the SEC’s proxy access rule. The court struck down the SEC’s proxy access rule because the court determined that, among other failings, the SEC had not sufficiently assessed “the rule’s effect upon efficiency, competition, and capital formation.” The SEC would need to approve any PCAOB audit firm rotation rule, which could result in the PCAOB considering public comments about the cost and disruptions of a shift to a mandatory rotation model more seriously than it might otherwise have been inclined to do. Those factors may also result in the PCAOB being more rigorous in assessing whether the costs of any rotation rule are justified by its anticipated benefits in order to enhance the rule’s ability to withstand judicial scrutiny.
In view of the potential disadvantages and risks that mandatory audit firm rotation poses, public companies and their audit committees and trade associations, as well as audit firms, should consider commenting on the matters discussed in the Release and appearing at the public roundtable in March 2012 to express their views and to help shape the debate and any decision as to potential PCAOB rulemaking.
NOTES
1 See Press Release, Public Company Accounting Oversight Board, PCAOB to Host Roundtable on the Auditor’s Reporting Model (Aug. 25, 2011), at http://pcaobus.org/News/Releases/Pages/08252011_Roundtable.aspx.
2 James R. Doty, Remarks at PCAOB Open Board Meeting (Aug. 16, 2011), at http://pcaobus.org/News/Speech/Pages/08162011_DotyStatement.aspx.
3 Id.
Dudley Murrey is partner at Andrews Kurth LLP practicing in numerous areas of corporate and securities law. Quentin Faust, also a partner at the firm, has a wide-ranging business law practice where he functions as outside general counsel to a variety of public and private corporations. The authors may be contacted at dudleymurrey@andrewskurth.com and quentinfaust@andrewskurth.com, respectively.
