"[T]he global financial crisis has tested the credibility of the audit in the public mind once again," notes the Public Company Accounting Oversight Board, the private-sector non-profit corporation created by the Sarbanes-Oxley Act. "What is clear from the Board's inspections, as well as from the experience of other audit regulators, is that questions persist about whether more can and should be done to enhance auditor independence, objectivity and professional skepticism."
If one uses the number of restatements of financial filings as a barometer of audit quality, the trends are improving, albeit not in a straight line.
Of course, one would expect the number of restatements to tail off sharply after the initial post-Sarbox wave of them, when reporting issues were cleared up for many companies. Indeed, the number of restatements jumped from 613 in 2001 to 1,795 in 2006, then dropped to 735 in 2010, according to the research firm Audit Analytics, after some year-to-year ups and downs. (Its numbers showed a 2010 rise from 683 restatements in 2009, for example.) Audit Analytics' database includes about 7,000 public registrants.
Could mandatory audit firm rotation drive the number of restatements even lower, and improve the overall quality of public company audits? To be sure, a credible argument can be made in support of the idea. "When you have a long auditor tenure, the auditors tend to develop a familiarity (with the client) that can manifest itself in negative ways. They may lose the healthy skepticism that auditors are supposed to have," says Don Whalen, director of research with Audit Analytics.
At the same time, a lengthier auditor tenure offers benefits, as well, Whalen points out. Perhaps most obviously, the auditors gain a thorough understanding of their client's industry and business. That can make them less likely to overlook mistakes or wrongdoing. If they notice an entry that seems off, experienced auditors are less easily persuaded that it's normal, he adds.
Studies on mandatory auditor rotation show mixed results, at best. (Note: many of the studies date to 2003; this was the year that requiring audit partners to rotate every five or seven years, depending on their involvement with a client.)
Consider a 2003 study, "," which examined 562 public companies that announced financial statement restatements between January 1997 and October 2001. The study authors concluded, "We find no evidence that changing auditors before the announcement of a restatement affects the likelihood that the auditor (as opposed to the company or the SEC) identifies the need for restatement. Further, we find no evidence suggesting that the nature or severity of a misstatement is related to auditor tenure."
A (now the Government Accountability Office) concluded that "mandatory audit firm rotation may not be the most efficient way to strengthen auditor independence and improve audit quality, considering the additional financial costs and the loss of institutional knowledge of the public company's previous auditor."
Most auditors and CFOs are decidedly chilly to increasing rotation requirements. "...[W]e believe mandatory rotation could have significant adverse consequences that should be carefully weighed," reads a statement from the accounting firm BDO USA. "These include the new auditor's steep learning curve in gaining knowledge of the company's business, disruption within the company, increased costs, and a greater propensity for fraud as has been found in some studies."
Regulations already in place -- including those requiring audit partner rotation and those limiting the non-audit work that audit firms can engage in -- do much to ensure auditor independence, says Joseph Slattery, executive vice president and chief financial officer with TranS1 Inc., a Wilmington, N.C.-based medical device company. "The continual turnover in the team creates a good bit of distance," Slattery says.
Audit team members already have a significant incentive to maintain their integrity and independence, Slattery adds. "If I'm a partner in an accounting firm, the last thing I need is for my firm to lose an account because I made a mistake or did something improper."
And certainly, the partner rotation creates more work for both the audit firm and TranS1, Slattery notes. "Every time the partner changes, it's an exercise." Members of his staff need to take time to bring the new partner up to speed on the company and its industry.
Adding a requirement that the entire audit firm periodically remove themselves from a client engagement would place even more of a burden on Slattery's small finance staff. "I would have to plan for that and have extra staff that would only be needed every couple of years," he says.
The has been cautious in its reactions as it prepares a comment letter. The initial reaction to the proposal, from Executive Director Cindy Fornelli, said that "a cost-benefit analysis should be central to the project," and added that it is important that "the PCAOB seek additional input from the full range of stakeholders who will be significantly affected by any changes in this area."
As an overview, the CAQ noted: "Objectivity, independence, and professional skepticism are the foundations of a high-quality public company audit."
cites the position it previously took in response to a European initiative, saying "we do not support mandatory audit firm rotation for a number of reasons, including our belief that it will not result in improved audit quality and, in fact, past studies have shown it could have negative consequences." The statement from Michael J. Gallagher, PwC managing partner, assurance quality and transformation, continues: "As one example, we believe this 'one size fits all' requirement is not conducive to audit quality in that it limits the discretion of an audit committee in choosing the audit firm it believes is best suited to meet a company's specific quality requirements."
Whalen of Audit Analytics agrees, adding that before a move to mandatory audit firm rotation, greater study, not only of the pros, but of the cons, is needed.
The pros are fairly obvious: you remove the risk that auditors become overly familiar with their clients, and fail to maintain the skepticism required for thorough, questioning examinations. Conversely, the shortcomings of mandatory auditor rotation, such as the loss of expertise and the costs imposed on both auditors and the companies that hire them, are significant, yet often overlooked.