Auditor switching would have big implications for valuation practices
Recently, James Doty, the chairman of the Public Company Accounting Oversight Board ("PCAOB") suggested that public companies be regularly required to change their auditors. Doty cited unconscious biases in favor of the client, a lack of skepticism, and unrestrained enthusiasm in selling additional services to clients.
Currently, a firm cannot perform a valuation service such as a purchase price allocation for an audit client, as the auditor would be reviewing its own work, which is an obvious conflict of interest. Earlier concerns about conflicts of interest led some of the Big Four to spin off valuation (and other consulting) services roughly ten years ago.
PriceWaterhouseCoopers ("PWC") sold its valuation business to Standard & Poors. Unfortunately, S&P found out that its debt rating business similarly conflicted with valuation, and after a few years sold the valuation practice to Duff & Phelps, which was not successful in debt ratings, but became a major player in valuation services.
KPMG spun off its valuation services along with most of its other consulting services into a separate public company called Bearing Point. Without KPMG's audit network to feed it, Bearing Point's business ground to a halt like a ball bearing dipped in grit. The Company was carved up and the pieces sold in 2009.
Ernst and Young and Deloitte retained their valuation practices. Both KPMG and PWC rebuilt valuation services for the purpose of reviewing valuation work for their audit practices, and after the non-compete agreements attached to their spinoffs expired, they reentered the market for valuation services as well.
With all the Big Four providing valuation services again, it was an easy choice for a company with a Big Four auditor to use another Big Four firm for its valuation work, particularly for purchase price allocations, goodwill impairment testing and other valuations related to fair value financial reporting.
A requirement for public companies to regularly change auditors could disturb this cozy arrangement. Imagine that a global public company decides it needs a Big Four auditor, and that it is required to change auditors every three years. That would mean it would go through the entire Big Four in less than 10 years. As many intangible assets have long lives, rotation could easily put the Big Four auditor in the position of auditing its own prior valuation work. Even worse, the auditor might have to audit a goodwill impairment analysis where it originally did the purchase price allocation that put the goodwill on the books. The possibilities for conflicts of interest are endless.
It would appear the best solution would be to choose a valuation expert from a solid regional firm. Such an expert would have the necessary experience doing purchase price allocation work and impairment testing, yet be small enough that his or her firm would not be considered as the next auditor. It will be interesting to see if the market moves in that direction if the PCAOB recommendations are approved.
But if conflicts of interest are a problem, and a firm should not be able to pass judgment on its own work, why stop with auditors? A far bigger conflict of interest in my view is when an investment bank puts together a merger or acquisition, and then performs a fairness opinion on the deal. Shouldn’t the firm doing the fairness opinion be different from the firm putting together the deal?
Raymond J. ("RJ") Dragon MBA, MS, ASA, CFFA is a Principal in Citrin Cooperman's Valuation & Forensic Services practice in the New Jersey / New York City area. His work encompasses valuations for litigation support, marital dissolution, shareholder disputes, estate and gift tax, intangible asset valuation, purchase price allocation and financial reporting.