Concept Release on Auditor Independence and Audit Firm Rotation

I support the concept release before the Board today because I hope it will trigger a wide-ranging discussion about auditor independence, objectivity, and professional skepticism. The release particularly invites comment on whether there should be mandatory audit firm rotation. I have serious doubts that mandatory rotation is a practical or cost-effective way of strengthening independence. However, with nearly nine years of inspections experience under our belts, the time is right to step back and thoughtfully examine whether we need to deploy new tools to promote independence.

Independence, objectivity, and professional skepticism give auditing its value and auditors their privileged place in our financial markets. Independence is a state of mind, not simply the state of being in compliance with a set of rules. As the Supreme Court has said, the auditor's public watchdog function demands "total independence from the client at all times and requires complete fidelity to the public trust."

Auditing is also a business. The professional imperative to maintain an independent attitude, and the economic imperative to maintain client relationships, can pull the auditor in opposite directions. Forcing a company, over the objections of its management, to change its financial reporting in a way that reduces earnings or indicates a weaker financial position may not seem like the best business development strategy. Further, an auditor/client relationship that spans decades might lead to a sense of partnership or mutual interest between the auditor and the client. These kinds of biases could be unconscious and unintended. But, if they exist, they can be corrosive of the independent mental attitude that auditing requires.

This problem is not new, and there are powerful forces built into public company auditing to foster and maintain independence. First and foremost, most auditors highly value their professionalism and their reputations. They recognize that their obligations to investors trump economic self-interest. There are countless cases in which auditors have insisted on compliance with the letter and spirit of the accounting and auditing standards or have exposed frauds. In addition, the SEC's independence rules, and the Board's standards, are designed to promote independence and skepticism. For the minority who are inclined to cut corners, there are criminal, civil, or administrative sanctions and monetary liability in appropriate cases.

The Sarbanes-Oxley Act included measures to strengthen independence. As a buffer against management pressure, the Act assigned responsibility for the relationship between a public company and its auditor to the independent audit committee. The Act also created the Board and gave it inspection, remediation, and enforcement authority over public company auditors. I believe that our work has significantly improved the quality of auditing. The real possibility that any public company engagement may become the subject of a rigorous PCAOB inspection, performed by experienced professionals with a deep commitment to the public interest, is an important counter-weight to the pressures that can undermine independence and professional skepticism.

In enacting the Sarbanes-Oxley law, Congress also directed the GAO to study the potential effects of firm rotation. In its November 2003 report, GAO concluded that "mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality, considering the costs of changing the auditor of record and the loss of auditor knowledge that is not carried forward to the new auditor."

GAO also noted, however, that the newly-created PCAOB was just beginning its work. Therefore, GAO observed, "the most prudent course" was for the SEC and PCAOB to monitor and evaluate the effectiveness of the Sarbanes-Oxley Act reforms and then consider whether additional steps should be taken to strengthen independence and protect the public interest.

Almost eight years have passed since the GAO report. The Board has conducted nearly 1,700 inspections and examined portions of more than 7,250 public company audits, including about 2,800 performed by the largest firms. We have accumulated a substantial body of data about what can go wrong in auditing. It makes sense to follow up on GAO's suggestion and use what we have learned to re-visit ways of enhancing auditor independence.

The concept release will kick off that review with a four-month public comment period and a 2012 public roundtable. As the debate about independence unfolds, there are three things that I hope the Board and the public will keep in mind.

  • First, there is a lot we don't know yet about what Board inspection findings might indicate regarding the connection between auditor tenure and specific audit deficiencies that appear to stem from a lack of professional skepticism.

    Not all audit breakdowns are the result of the auditor approaching his or her work with a pro-client bias. Lack of technical competence or experience, staffing or fee pressures, insufficient supervision, deficiencies in firm-wide audit methodologies, and a host of other problems unrelated to engagement tenure are often to blame. Generalizing from numbers of inspections findings and client tenure statistics to conclusions about whether tenure causes deficiencies is simplistic and misleading. It may be possible to draw relevant conclusions about the impact of tenure on audit quality from our inspections records, but the necessary analytical work has not yet been done.

  • Second, cost-benefit analysis should be central to this project, although the calculus will be complex.

    Firm rotation would not be cheap for American business. In GAO's survey, large firms estimated that, under rotation, first-year audit costs would increase by 20 percent, as a result of work associated with coming up to speed about a new client. Companies would also incur other, less easily measureable costs, such as the management time, effort, and distraction incident to changing auditors. And some studies suggest another cost: The risk that audit failure may be likely in the early years of a new engagement, as the incoming auditor moves up the learning curve with respect to the client and its financial reporting.

    Of course, the benefits of rotation could also be substantial. When lack of auditor independence leads to a blown audit, substantial costs may be inflicted on investors. If rotation would avoid those costs, even in only a small number of cases, it may be worth considering. But the Board should not impose the expense and burden associated with rotation on companies that raise capital in our markets unless the evidence is clear that the benefits will out-weigh the costs.

  • Third, if new regulatory measures are needed to enhance auditor independence, there may be effective alternatives that would not impose the economy-wide costs that would accompany mandatory firm rotation.

    One possibility might be to empower the SEC or the Board to require rotation on a case-by-case basis when a Board inspection finds that long tenure and lack of independence have intersected to result in an audit failure. Another possibility might be to impose special obligations on audit committees to justify the retention of the auditor after some period of time, such as 10 or 15 years.

I hope that those who comment on the concept release will not limit themselves to re-hashing the pros and cons of rotation. I urge commenters to instead think broadly about independence, objectivity, and professional skepticism and imaginatively about what the Board can do to strengthen those key attributes.

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The various Board members bring differing perspectives to this issue, and drafting a release that we could agree on his been a lengthy and painstaking process. I want to acknowledge the contributions of Marty Bauman, the Board's Chief Auditor, and Michael Gurbutt, Associate Chief Auditor. Helen Munter, Director of Registration and Inspections, Santina Rocca, Senior Adviser to the Director, and Gordon Seymour, the Board's General Counsel also played key roles. Above all, I want to thank Jake Lesser, Associate General Counsel, for his work. Jake is the principal draftsman of the concept release, and it is a tribute to his skill, eloquence, and legal sophistication — and most particularly to his patience.