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 Issuance of a Concept Release on Auditor Independence and Audit Firm Rotation

DATE: Aug. 16, 2011
SPEAKER: James R. Doty, Chairman
EVENT: PCAOB Open Board Meeting
LOCATION: Washington, DC

I believe that the long association of the largest audit firms with their major audit clients is an issue that must be addressed in order to fulfill the mission of the PCAOB. One cannot talk about audit quality without discussing independence, skepticism and objectivity. Any serious discussion of these qualities must take into account the fundamental conflict of the audit client paying the auditor. That leads to consideration of firm rotation as a counterweight to that conflict.

There are, of course, considerable implementation challenges associated with mandatory rotation. The concept release invites study and consideration of whether there are ways to mitigate those challenges. But the reason to consider the concept is to resolve the question to which the discussion of independence, skepticism and objectivity always seems to return. That is the central question of this concept release:

will term limits, set at some appropriate length, with due regard for implementation complexities, reduce the pressures auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets?

The idea of audit firm term limits is not new. The debate ebbs and flows, but the contending solutions languish unresolved. In fact, the very size, complexity, and systemic risk found in today's issuer population supports the need for reconsideration of audit firm rotation at this time.

With this release, I hope to challenge critics and proponents alike to do their homework, come forward with facts, and add meaningful depth to the discussion, in order that we might reach resolution.

The PCAOB has conducted inspections of audit engagements for more than eight years. Our daily work is to gain insight into audit practices that formerly could be gleaned only on an ad hoc basis through government investigations and litigation. Since the PCAOB began its work, our inspectors have identified hundreds of audit failures. We have published summaries of what was wrong about each engagement in the public portion of our periodic inspection reports. Though the recitations are dry, both the PCAOB and the firms recognize the seriousness of these shortcomings.

To ascertain why those failures have occurred, we consider surrounding circumstances. We look for common themes. We try to infer root causes. For example, when we see auditors marketing themselves to potential clients as "a partner in supporting and helping" the client "achieve its goals," it's hard not to question whether their mindset might have contributed to some of these audit failures. I note that audit regulators in other countries have published similar findings and expressed similar concerns about weaknesses in auditor skepticism.

But inspectors' reviews typically stop at the work papers. And, even with the time and resources needed to investigate more deeply, we cannot directly see into the minds of the people who make up the engagement team.

The fact that our inspections cannot always link a specific failure to an absence of objectivity in the auditor's mindset does not establish that the auditor was unaffected by the pressures and incentives inherent in the system. To the contrary, our experience teaches that those pressures and incentives are powerful and pervasive. The public is aware of those pressures and incentives. They may well have eroded public confidence in audits. This is why it is important to consider ways better to protect auditor independence.

I do not suggest that term limits would provide a talisman to eliminate all inappropriate influences on auditors. But the concept release intends to drive the analysis beyond the conventional wisdom, which often stops with the assumption that term limits would mean little or no improvements in audits and higher fees.

To be sure, when auditors change, there may be a learning curve for the new auditors. But consider this: according to the research firm Glass Lewis, between 2003 and 2006, more than 6,500 public companies, or nearly 52 percent of all public companies, voluntarily changed their auditors. How did auditors and companies manage those changes? What did auditors, and the audit committees that oversee them, do to make sure the new auditors were in a position to provide reasonable assurance in the early years of an engagement? This experience should inform the responses of preparers and auditors to this concept release. The learning curve, and cost-based issues involved in changing audit firms, cannot be fairly described as uncharted waters.

We want the public to have ample time to consider this matter and form reasoned and supported responses. And we will have a roundtable meeting next March to discuss the information and views we receive. I look forward to the comments and discussion.

 

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