By Anne Rosivach
Academics in accounting were well represented among the panelists at the third public meeting on auditor independence and audit firm rotation held October 18, 2012, at Rice University in Houston by the Public Company Accounting Oversight Board (PCAOB). Other speakers during the eight-hour meeting, who examined the PCAOB's 2011 concept release on ways to enhance auditor independence, objectivity, and professional skepticism, included investors, audit committee members, corporate officers, auditors, and other interested parties.
Speakers reviewed research on potential costs of mandatory auditor rotation, unintended consequences, and unconscious biases, among other topics. They offered a number of ideas about procedures the PCAOB could adopt that would enhance auditor independence and skepticism.
In his opening remarks, PCAOB Chairman James Doty said the basis of the Board's concern about auditor independence was that "PCAOB inspectors continue to find what is to me an unacceptable level of deficient audits. In addition, inspectors continue to find troubling suggestions of firms showing willingness to put management's short-term interest ahead of investors'." Doty said that the Board has received more than 600 comment letters on the comment release, primarily from auditors. Most counseled more time, more study, and more modest reforms than mandatory audit firm rotation.
Session One – Enhancing the Audit Committee's Independence from Management, and Possible Explanations for the Lack of Auditor Skepticism
Keynote speaker, Stephen A. Zeff, Herbert S. Autrey Professor of Accounting, Jones Graduate School of Business, Rice University, stated that the lack of skepticism resulted in part from accounting curricula that do not include courses that encourage professional skepticism. Zeff also faulted the relationship between the audit committee and the board of directors, a corporate governance issue, and the makeup of audit committees in many public companies. Zeff acknowledged that the PCAOB did not have jurisdiction over corporate governance issues or the selection of the audit committee.
A short-term remedy available to the PCAOB for the accounting education deficiencies would be for audit firms to require their audit partners and managers to take a specified minimum number of hours of continuing education each year on the economic and financial dimensions of the accounting for complex and novel financial transactions. Long term, Zeff said, the PCAOB, which awards accounting scholarships each year, could award those to students pursuing a course of study leading to professional skepticism.
Karen K. Nelson, Harmon Whittington Professor of Accounting, Jones Graduate School of Business, Rice University, raised issues that other speakers would address during the meeting:
- The four possible approaches to changes to an audit firm's tenure would be mandatory rotation, mandatory retention, a combination of the two, or the status quo.
- The costs of mandatory audit firm rotation are concentrated while the benefits are diffuse.
- A potential conflict of interest that could be inherent in the client-payer model.
- The enormous amount of proprietary data the PCAOB has on deficient audits that the Board could use to analyze auditor independence and skepticism issues.
Mark W. Nelson, Eleanora and George Landew Professor of Management and Professor of Accounting, S. C. Johnson Graduate School of Management, Cornell University, noted that one potential downside of audit firm rotation would be the loss of client- and industry-specific knowledge about the audit team. He also looked at potential benefits and unintended consequences:
- An approach to reduce the loss of client-specific knowledge associated with mandatory rotation could be to enhance predecessor/successor auditor communications, but enhanced communication could reduce the extent to which the successor auditor provides a fresh look.
- Another potential benefit of mandatory firm rotation is that it exposes the auditor to second-guessing by a successor auditor.
- A potential cost of mandatory firm rotation is that auditors may perceive little incentive to deal with smaller but escalating problems just prior to rotation.
Mark Nelson suggested that based on his research, at least some of the problem with skepticism might be caused by the way audit standards and procedures are written. Standards are written in positive terms. Auditors tend to plan more hours to a procedure when it is framed in negative terms; for example",determine whether client assumptions are not reasonable."
Throughout the meeting, other speakers would refer to Mark Nelson's description of mandatory rotation as "too blunt an instrument."
Session Three – Informational Dilemmas: A New Auditor Rotation Idea and "Too Complex to Depict?"
Henry T. C. Hu, Allan Shivers Chair in the Law of Banking and Finance, The University of Texas at Austin School of Law, discussed a recent publication in which he suggested that at some point, technology might provide a solution to some perceived deficiencies in the current financial disclosure model which relies on an intermediary to convey the reality of the company. In some cases, the intermediary may not understand complex financial innovation. If pure information becomes a reality, this combined with verbal or chart descriptions, may help to determine what is the auditor auditing and what is auditable.
Hu also suggested a mandatory firm rotation model where a firm could be retained for exemplary performance.
Robert T. Blakely, a member of several audit committees, and Kenneth Daly, President and Chief Executive Officer, National Association of Corporate Directors, emphasized the importance of the selection of the audit committee and their qualifications, and recommended continuing education for the audit committee.
Michelle Edkins, Managing Director, Global Head of Corporate Governance and Responsible Investment, BlackRock, addressed the selection process for audit committee members: "We believe that board independence generally is improved by a formal and transparent appointment process driven by the nominating and governance committee (or equivalent) of independent directors."
Session Five – European Commission Proposals for the Reform of the EU Audit Market
Nathalie Berger, Head of Unit, Audit and Credit Rating Agencies, European Commission, brought the panel up to date on actions taken or considered in Europe with respect to mandatory rotation and mandatory retendering.
In her prepared statement Berger wrote",To mitigate the risk of any potential conflict of interest due to a familiarity threat, the proposals on audit policy before the European parliament require all public-interest entities to change their auditor every six years in cases where one auditor has performed the statutory audit, and every nine years in cases where two auditors have carried out the audit."
"Currently, Italy is the only Member State of the European Union that requires mandatory audit firm rotation. In Italy, public-interest entities are obliged to change their auditors every nine years."
The Financial Reporting Council (FRC) in the United Kingdom has called on the top 350 companies on the London Stock Exchange to put the external audit contract out to tender at least every ten years - or explain to shareholders why its actions are consistent with principles of good governance.
Other proposals before the European parliament are:
- Mandatory rotation
- Prohibition of "Big 4 only contractual clauses"
- Prohibition of the provision of certain non-audit services
- Pure audit firms
Berger said that mandatory rotation had substantial support from members, but "pure audit firms" had little support.
Other new ideas are a European passport for audit firms and a European quality certificate.
Corporate officers and other interested parties offered differing views on the concept release in later sessions. Academic speakers and others analyzed potential costs of mandatory auditor rotation using various different data-based analyses and found small increases in costs that could be outweighed by the benefits of a superior audit.
Patrick T. Mulva, Vice President and Controller, ExxonMobil Corporation, presented a very strong challenge to the concept of audit firm rotation when he said that the PCAOB had not provided empirical evidence to support the theory that mandatory rotation of audit firms would enhance independence and professional skepticism.
Along with T. Cory Bleuer, Vice President, Controller and Chief Accounting Officer, BMC Software, Inc.; and Daniel J. Cancelmi, Chief Financial Officer, Tenet Healthcare Corporation, Mulva applauded the PCAOB for the very important influence on audit quality brought about by its efforts so far. The corporate officers all spoke to changes in the rigor of audits and changes in the performance of auditors, including greater involvement by the audit partner and by the national offices of the firms.
The corporate officers suggested some meaningful changes the PCAOB could make in the future to strengthen its oversight, and they proposed the PCAOB consider:
- Greater transparency with results
- Stronger disciplinary actions
- Greater communication with audit committees (all three support the proposed AS 16)
- Improved auditor training
Robert A. Prentice, Interim Chair and Professor, Business, Government and Society Department, McCombs School of Business, The University of Texas at Austin; and Erik F. Gerding, Associate Professor of Law, University of Colorado Law School, discussed the concept of psychological biases that can subvert independence, even without an auditor's conscious awareness.
Prentice stated that "the self-serving bias does not universally adversely affect every single decision made by every single person. However, it is a strong, systematic, and pervasive influence." Prentice applauded provisions in the AICPA's Code of Professional Conduct that recognize this influence and attempt to minimize its impact by preventing auditors from entering into financial, employment, consulting, and other arrangements that would create conflicts of interest.
Gerding addressed some of the legal challenges the Board could face in taking tougher action. He suggested that the Board should also take the disciplining effects of auditor reputation seriously, and take steps to publicize in greater detail the Board findings of the results of inspection, investigation, and disciplinary hearings. "Although Congress restricted the ability of the Board to disclose publicly inspection reports and disciplinary proceedings, it did not prohibit disclosure outright", he said.
Gerding recommended that the "Board should consider first imposing audit rotation on a case-by-case basis rather than a broadly applicable rule", to avoid the risk of legal challenge.
W. David Rook, Partner-in-Charge, Firm Assurance and Advisory Services, Weaver and Tidwell, LLP, pointed out that the concept release could have a big impact on smaller issuers that might not even have an audit committee. Rook said that mandatory retendering could consume an enormous amount of resources.
Cynthia M. Fornelli, Executive Director, Center for Audit Quality, and Rook discussed the need for firms and the PCAOB to perform root cause analysis. Fornelli expressed concern about a downward pressure on fees and suggested that mandatory retendering could increase that downward pressure.
In closing, referring to the comment letters, Doty said that "numerosity should not determine this issue." He thanked panelists for their data-based analyses and comments about the possibility of a structural problem and for their suggestions about hand-off procedures and potential costs. Doty said that the Board will have to review the consequences of mandatory rotation",think about not having it too blunt an instrument."