How to Win an Auditor Beauty Contest: Taking Advantage of Auditor Changes

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by Bruce Mann

More companies are giving serious attention to the auditor selection process than ever before, opening the door for firms to compete for assignments on a more level playing field. The days when management was able to pick its favorite auditor without oversight from the board or audit committee have passed. First it was the demise of Arthur Andersen that forced many companies to interview for new auditors. Then the other shoe dropped - Congress passed the Sarbanes-Oxley Act, both empowering the audit committee and putting a heavy burden on its members to take direct responsibility for the appointment, compensation and oversight of the outside auditors. No longer can auditors be selected by and report to management.

The Sarbanes-Oxley Act not only requires that public companies have independent audit committees that oversee the activities of their auditors, but provides that this responsibility applies to private companies the moment they file a registration statement for an initial public offering. In the past, the selection of auditors by private companies was based more on the comfort that corporate founders and senior management felt with accounting firms that they had previously worked with than on a comprehensive interview or analysis of available firms. However, no private company wants to delay its IPO while it locates independent directors to serve on an audit committee and satisfies those directors that its relationship with its auditors is in compliance with what is required. Thus, the old boy's network approach in which auditors for private companies were picked by management and never subjected to independent review before the IPO, and independent directors were brought on board just prior to the public offering, will have to change. A record of active audit committee participation in the auditor selection process even before the IPO will help assure compliance with the new corporate responsibility standards under Sarbanes-Oxley.

In this new environment, the obligation of audit committees to review the qualifications of the outside auditors doesn't end once an auditor has been selected. Not only is the duty of oversight an ongoing obligation, but under the newly-proposed New York Stock Exchange corporate governance rule proposals, the audit committees of NYSE-listed companies must consider whether, in order to assure continuing auditor independence, there should be regular rotation of the audit firm rather than just of the lead audit partner as required by the Sarbanes-Oxley Act.

The requirement that all audit and non-audit services be preapproved by the audit committee will not eliminate the practice of companies seeking stockholder ratification of the appointment of their independent auditors. While not legally required, seeking such ratification is common practice and is required as a condition of engagement by a number of independent audit firms. The new audit committee oversight responsibility will prevent corporations from asking stockholders for ratification unless the audit committee has taken affirmative steps to satisfy itself that the firm should be appointed for the current year.

In the face of these new obligations, audit committees can no longer blindly accept management's recommendations in either the initial selection process or the decision to reappoint the existing auditors for another year. Those committees that don't choose their auditors with care and conduct beauty contests when considering auditor selection or replacement will be vulnerable to attack. A well documented decision making process in which auditors are asked to differentiate themselves from other candidates will become the rule rather than the exception.

Unfortunately, there are no clear standards for choosing an auditor. Neither the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees appointed by the NYSE and NASD, nor Congress in adopting the Sarbanes-Oxley Act, nor the SEC have established criteria for auditor selection.

Forget about the slick brochures with pretty pictures an mushy marketing material that have been the staple of beauty contest presentations in the past. The audit committee will need to document why you have been chosen as the company's auditor. Hard facts and targeted presentations that can become part of the record supporting your choice are now essential.

Because there are no clear standards for auditor selection, you should be prepared to answer the questions audit committees will be focusing on during the interview process, and should be ready to emphasize those skills you have that will cause you to stand out from the pack in the beauty contest. In making your case to the Audit Committee, your presentation should respond to the following questions:

  1. Relevant experience. What similar companies do you audit in terms of the nature, scope, and issues you expect to encounter in this company's audit? Who and where are your firm's employees who specialize in the accounting issues of its industry and are they readily available to you? What do you consider the major audit risks of the industry?
  2. Familiarity with the Company. Have you reviewed the company's recent SEC filings and do you agree with the financial presentation and description of its significant accounting policies? How does its financial reporting practices compare to its competitors? Where are the company's practices more conservative or aggressive than its competitors? What do you consider its major audit risks?
  3. Conflicts with other audit clients. Do the company's financial statement presentation and significant accounting policies conflict with those of similar companies you audit? If so, would these conflicts create a problem for you in issuing an opinion on its financial statements? Do you perform audit or non-audit services for any of its competitors? If so, what procedures do you have in place to preserve confidences? Would the same team work on engagements for this company and any of its competitors?
  4. Advice on emerging issues. How active are you in alerting your audit clients to emerging issues and potential changes in accounting principles or auditing standards? You should plan to provide the audit committee with copies of all materials, newsletters, etc. you have distributed to your audit clients during the past two years.
  5. Personnel. Who would actually work on the audit? What are the backgrounds and industry experience of the proposed audit partner, the audit manager and the audit partners at other significant company locations, both domestic and foreign? What are your policies on training and rotation of audit personnel? How do you raise and dispose of questions about decisions of the company's financial staff in preparing its financial statements? You should be prepared to offer the audit committee the opportunity to interview the proposed audit team members to assess both their experience and their ability to work compatibly with the company's financial personnel while maintaining their independence and objectivity.
  6. Other services offered. What additional non-audit and management advisory support services do you offer? What are your policies on providing these services to your audit clients and how are they priced? Do you provide seminars on accounting, auditing and regulatory issues for your audit clients?
  7. Other financial interests. What are your policies on investments by your personnel in companies that you audit and their competitors? You should plan to provide the audit committee with copies of your code of business conduct and conflict, investment and other policies that could affect the relationship between your personnel and the company.
  8. Audit costs. What fee structure would you propose? Are you prepared to absorb the start-up costs that are involved in changing auditors, including your initial review of the company's system of internal controls, meetings with executives and financial personnel and visits to its facilities to familiarize yourselves with the its business? If not, what do you estimate those costs will be and are you willing to cap them? What do you estimate the fee will be for regular audit services, will you cap that fee, and what is included in those services? What can the company do to reduce its audit costs without diminishing audit effectiveness?
  9. The audit plan. Have you formed any opinions on what tests of the company's accounting records will be required and what the scope of the audit will be? What is your approach to quarterly reviews? If you have reviewed significant transactions during a quarterly review, can the company go forward with confidence that the transaction will not be reversed at year-end? You should be prepared to provide the audit committee with a sample audit plan for a comparable company.

These questions are not meant to be a template to be used indiscriminately in presenting the case to the audit committee for your selection as the company's independent auditor. Each company has its unique issues and concerns which should be reflected in making your presentation and in the questions asked by the members of the audit committee during the interview process. However, demonstrating your ability to answer these questions will not only help you establish why your firm should be the one selected, but will aid in establishing the record of diligence critical to members of the audit committee.

Bruce Mann is a partner of Morrison & Foerster LLP, based in its San Francisco office. Mr. Mann has over 40 years experience advising corporate clients, both as a lawyer and an investment banker.

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