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May 10, 2012

How Would Mandatory Audit Firm Rotation Affect Your Board?

Second Quarter 2012
Corporate Board Member
by Kimberly Crowe

rotationThe Public Company Accounting Oversight Board has certainly hit on a hot-button issue with investors, auditors, and audit committee members with its call for comments on the idea of mandatory firm rotation (MFR). To date, the concept release, initially put forth last August, has received more than 600 comments. And according to Cindy Fornelli, executive director of the Center for Audit Quality, more than 90% of those commenters oppose MFR for a variety of reasons, chief of which are the costs involved in complying with such a measure, the loss of control audit committees would be forced to endure, and the overarching fact that there is no evidence to suggest that such a move would increase audit quality.

“This is an issue that has been debated on and off for decades,” Fornelli notes. “There are huge costs and burdens associated with it, and there’s no evidence we’ve seen that supports mandatory firm rotation being a driver of audit quality. In fact, there is some empirical evidence cited by the academic community that indicates it can be harmful.”

So why is this issue up for discussion once again? Fornelli says it’s a legitimate debate to have and one that involves questions audit committee members should be asking on a regular basis. “Auditor independence, objectivity, and skepticism are important cornerstones of audit quality,” she affirms, “ones that should be continually monitored by the audit committee and the auditing profession.”

Monitoring is one thing– being compelled to change firms is quite another, according to Dennis Beresford, Ernst & Young executive professor of accounting at the University of Georgia and a current audit committee chairman at Legg Mason. “It’s something that should be left in the hands of the audit committee to review on an annual basis as they do presently to recommend the current firm for reappointment or to consider another firm,” Beresford says.

The PCAOB, supervised by the Securities and Exchange Commission, was established by the Sarbanes-Oxley Act of 2002 to provide external and independent oversight of the public company auditing profession. SOX also required the U.S. Government Accountability Office to study the potential effects of requiring public companies registered by the SEC to periodically rotate the public accounting firms they retain to audit their financial statements.

The GAO did so, issuing a report in November 2003 that concluded “mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality,” though it recommended that the newly formed PCAOB revisit the topic in the future.

Cost is a major concern, according to both Beresford and Fornelli. Studies on MFR over the years reveal heavy costs without the commensurate benefits,” Fornelli points out. Beresford agrees. “If every company had to change firms every five years, for example, there would be huge distress in the market” due to the expense involved as well as the pressure on audit firms to compete.

Fornelli says that many of the directors who commented on the concept release believe that MFR would usurp the important role audit committees play. “It’s the audit committee, working to oversee the external auditor, that is really the backbone of the system to help drive independence, objectivity, and skepticism,” she explains.

As Beresford noted in his comment letter to the PCAOB, “Audit committees take their responsibilities very seriously and will consider a change when they feel the current firm … is not up to the standards they demand.” Auditors and investors are somewhat more mixed in their opinions, though a review of comment letters indicates that most auditors and at least half of the investors who wrote in do not support MFR. Chris Kolenda, an attorney and CPA, wrote in his comment letter that “required rotation of auditors is absolutely necessary to maintain auditor objectivity.” However, Thomas Cotton and Grady Hazel of the Society of Louisiana CPAs indicated in their letter that while they “applaud the PCAOB’s interest in improving auditor independence, objectivity, and skepticism, we see no evidence to support mandatory audit firm rotation as a strategy to realize that goal.”

At a two-day public meeting held March 21–22 at the PCAOB’s offices in Washington, D.C., and in a comment letter, CalPERS representatives have backed mandatory firm rotation, with the letter noting that “our Principles state that ‘audit committees should promote the rotation of the auditor to ensure a fresh perspective and review of the financial reporting framework.’” Yet, Steven Buller, managing director of BlackRock, a global investment manager with $3.35 trillion of assets under management, disagrees. “We do not support mandatory auditor rotation,” Buller states in his comment letter, “principally because we are not aware of any empirical evidence that indicates that mandatory rotation would improve auditor independence and skepticism.

“While auditor rotation may theoretically reduce certain risks,” Buller continues, “it also is likely to create other risks, such as auditor loss of institutional knowledge and a reduced incentive for audit firms to invest in the audit relationship.”

Beresford believes audit committees just need to do a better job of communicating the work they already do to promote independence and objectivity. “The reports that audit committees include in their proxy statements tend to be boilerplate and don’t really communicate very well what is being done,” he says, “and I think they could be improved.”

topic tags: audit committee, audit firm rotation, board of directors, corporate governance