Is Mandatory Auditor Rotation a Good Thing?

Auditor rotation has been recommended by many years as a way to cut down on the cozy relationship that develops between an auditor and the client. Given that independence, objectivity, and integrity are cornerstone ethical values in accounting, it does make sense to change auditors every so often. In the past a five-year rotation has been suggested.

This is too short a period of time because it takes a few years to become familiar with the client’s systems. Audit firms invest much time and effort in the learning process. They should be able to benefit from their time and expertise with respect to servicing a client and earning audit fees. It seems to me ten years might work better. After all, it can be a good thing if new auditors take a fresh look at a client’s financial results every ten years.   

Let’s look at the recent past. Companies that ran into trouble in the financial crisis—Lehman Brothers, AIG and GM, for example—were with their auditors for decades without obvious benefit to investors. And regulators are increasingly worried that being overly-friendly with clients erodes auditors’ independence. In August James Doty, the head of the Public Company Accounting Oversight Board, (PCAOB) suggested forcing companies to rotate audit firms after a set (and as yet undefined) period.

According to Audit Analytics, a research firm in Sutton, Mass., 30% of the 1,000 leading U.S. companies have used the same firm to audit their books for at least a quarter-century. Fully 11% have used the same audit firm continuously for 50 years or more. Eight companies haven't changed auditors in at least a century; the last time any of them hired a new accounting firm, William Howard Taft was in the White House.

The PCAOB has asked whether long tenure might lead to complacency. Late last year, the board sought opinions on whether it should require listed companies to rotate their accounting firms every few years. The last of those 611 public comments came in to the PCAOB last month. An overwhelming 94% were opposed to term limits.

Auditors say it helps to know their clients’ business intimately. The Big Four accounting firms—PwC, Deloitte, Ernst & Young and KPMG— agree that forced rotation will impair audit quality. PricewaterhouseCoopers and Deloitte pointed to studies casting doubt on whether changing auditors improve financial reporting. Ernst & Young said that some clients have threatened to hire a different firm if E&Y didn't bless a dubious decision—which E&Y refused to do. KPMG said it evaluates the judgment and ethics of each partner at least once every three years.

As for the PCAOB, James Doty, chair of the Board, recently said: "We know from our own inspection reports that there is a problem." Without independence, it's unlikely you're going to get skepticism or a healthy look for disconfirming evidence."

This certainly was the case before Sarbanes-Oxley because not one of the accounting frauds in the late 1990s and early 2000s that led up to the Act were reported by the external auditors. In fact, peer review reports indicated the firms were doing just fine.

The problem, says Howard Schilit, an accounting expert at Financial Shenanigans Detection Group in Key Biscayne, Fla., is simple: "When you're an auditor who's trying to protect a long-term relationship, you have to suck up to the client, and the client knows it."

Since floating the idea last August about mandatory rotation, the PCAOB has received 620 letters, about 20 times the normal amount, with most warning of unintended consequences if rotation is passed.

Chief among the critics are auditors, who warned rotation would raise audit costs and hurt the quality of audits as new audit firms got up to speed. Board audit committees also complained about rotation, saying it would usurp their choice over auditors, a responsibility given them by the Sarbanes-Oxley Act. And financial officers at some large companies said they might have trouble finding a new auditor at all because of the shortage of firms with necessary industry expertise.

John Biggs, former chair and CEO of the mega-retirement fund TIAA-CREF, testified in favor of rotation during hearings on audit reforms that became part of the 2002 Sarbanes Oxley Act. Rotation was left out of Sarbanes-Oxley Act in lieu of other measures to shore up auditors’ independence, such as making board audit committees rather than company managers responsible for hiring audit firms.

In Biggs’ view, the recent financial crisis shows those reforms may not be doing the job. He wrote:

“The financial collapse of 2008-2009 certainly suggests that public confidence still needs to be restored in the financial management of our banking institutions. In particular, investors have to wonder about the independence and professional skepticism of the auditing profession.”

While many have criticized sloppy underwriting by banks and securities firms and rating agencies’ lack of skepticism, they were not alone, Biggs wrote.

“Shouldn’t there have been some skeptical auditors, of say, triple-A valuations of CDO’s (collateralized debt obligations) based on sub-prime mortgages?”

Many audit committees have become more diligent about assuring the independence of their auditors since Sarbanes-Oxley was passed, Biggs said.

If rotation is not found acceptable, regulators should at least require that companies disclose how long they have had the same auditor in annual proxy statements sent to investors, he said.

This makes a great deal of sense to me. Transparency is always a good thing. I would think the accounting profession would embrace this proposal if for no other reason than to rebuild trust in the public arena.

Blog posted by Steven Mintz, aka Ethics Sage, on March 8, 2012