Concept Release on Auditor Independence and Audit Firm Rotation

Thank you, Chairman Doty.

The concept release we are considering today is one part of the Board's comprehensive approach to, as you have said, improve the "relevance, credibility, and transparency of the audit by all available and effective means."[1] I strongly support that comprehensive approach and the issuance of this concept release in order to consider all alternatives.

A Comprehensive Approach to Global Concerns

Recently, we considered the relevance of the audit by focusing on the audit report and whether it can be made more useful by communicating more information. In that context, I noted that "investors want auditors to ask themselves what is it that, if they were investing in the company, they would want to know—and for the auditors then to highlight or provide that information." At that meeting, we discussed reasons that many investors believe their best interests would be served by changing the current three paragraph, largely boilerplate, binary, audit report to include, among other things, some of the same significant risks that auditors disclose to audit committees. And soon, I hope, we will consider a proposal that would provide much-needed transparency into the audits required to be conducted pursuant to the Board's standards, and specifically would provide information about who served as the engagement partner for each audit.

Today's topic, however, involves ways that auditor objectivity and professional skepticism could be enhanced, which begins with auditor independence. Investors expect that auditors, who are critical gatekeepers in the financial reporting system, will act on their behalf. That is what we are talking about today — how does the Board reinforce that auditors, under our watch, will act to protect investors?

As the concept release points out, an audit adds credibility to the financial reporting process only to the extent it is performed by an objective and independent third party with no interest in the financial success of the company and only when investors have confidence that the auditor was in fact independent.

For almost 40 years, professional auditing standards have stated that—

To be independent, the auditor must be intellectually honest; to be recognized as independent, he must be free from any obligation or interest in the client, its management, or its owners…. Independent auditors should not only be independent in fact; they should avoid situations that may lead outsiders to doubt their independence.[2]

The SEC has long recognized that—

… the capital formation process depends in large part on the confidence of investors in financial reporting…. Accordingly, … the auditor must be free to decide questions against his client's interests if his independent professional judgment compels that result. If the auditor is predisposed, or even appears predisposed, to blindly validate management's work rather than subjecting it to careful scrutiny, the ultimate result will be a diminution of public confidence in the profession and the integrity of the securities markets.[3]

In the words of the Board's Investor Advisory Group's Subcommittee on Global Networks and Audit Firm Governance:

the purpose of the audit is to provide investors (and audit committee members) confidence that an independent set of eyes have looked at the numbers reported by management and objectively, without bias, determined they can indeed be relied upon. If investors' confidence in that process is diminished or lost, the benefits of the audit (and its costs) are questioned.[4]

The European Commission, in October 2010, issued a "Green Paper" on "the role of the audit as well as the scope of the audit . . . in the general context of financial market regulatory reform." Among other things, the paper discusses possible ways to "reinforce the independence of auditors and address the conflicts of interest which are inherent in the current landscape . . . ."[5]

In discussing the future role, relevance and value of the audit, regulators and investors worldwide, as well as leaders within the profession, recognize that the status quo is not an option.

Auditor Independence

The drafters of the Sarbanes-Oxley Act recognized that independence is the bedrock upon which audit quality is built. The Act established the PCAOB "to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports," and it included several reforms designed to enhance auditor independence. For listed companies, it made independent audit committees—not management—responsible for hiring and firing the auditor and overseeing the engagement. Recognizing the risk to independence posed by the provision of non-audit services to audit clients, it prohibited certain of those non-audit services and required that the audit committee pre-approve all audit and non-audit services. And, noting "the strong benefits that accrue for the issuer and its shareholders when a new accountant ‘with fresh and skeptical eyes' evaluates the issuer periodically,"[6] it mandated audit partner rotation.

These reforms have clearly improved auditor independence and, along with it, audit quality. They have not, however, eliminated the strong incentives that lead some auditors to serve the interests of the company paying the bills rather than those of investors, to whom auditors owe "a public responsibility transcending any employment relationship with the client."[7] Further remedies may be necessary, and certainly deserve to be explored fully and publicly.

Over the years, many alternatives have been considered to further strengthen auditor independence. For example, prominent individuals such as Paul Volcker and Michel Barnier, the European Commissioner for Internal Market and Service, have suggested at various times consideration of "audit-only" firms. Under this concept, in exchange for the statutory franchise given to the audit profession, auditing firms would perform only accounting and audit related services and not provide non-audit services. Others have suggested lengthening the list of prohibited non-audited services. And it has also been suggested that the mandatory tendering of audit contracts could be required at regular intervals.

While some of these or other alternatives may merit further consideration, they do not address the fundamental conflict of interest inherent in the system. The auditor is paid by the company that he or she audits. And, as a natural and inevitable result of that arrangement, auditors know that if they push management too hard, they risk losing the fee not just for the current audit but, potentially, the fees for an unlimited number of audits in the future. In essence, they risk losing an annuity.

Audit Firm Rotation

During the debates that led to the Act, Congress considered mitigating this conflict by requiring auditing firms to rotate off an engagement after a certain number of years. In the end, however, the Act did not require audit firm rotation but, instead, directed the GAO to study it. The GAO concluded, essentially, that the reforms that were included in the Act should be given time to work and that rotation could, if necessary, be revisited again by the Board and the SEC.

I agree that the time has come to revisit the issue of audit firm rotation in the context of exploring all available options for enhancing auditor independence, objectivity and professional skepticism.

The inspection findings of the PCAOB, as well as those of our international counterparts, indicate that more must be done in these areas. As is clear from the Board's Concept Release, inspectors have raised numerous concerns about professional skepticism in their inspections of both large and small firms, and these concerns are cited too often to ignore. For example, in one recent case, an inspection report stated that:

[t]he lack of professional skepticism appears to stem from the [f]irm's culture that allows, or tolerates, audit approaches that do not consistently emphasize the need for an appropriate level of critical analysis and collection of objective evidence.

Another report cited:

[n]umerous instances…in which the [f]irm's personnel did not appear to be willing to sufficiently challenge or critically evaluate management's assertions, analyses, or accounting practices.

Still another report found that:

[t]he audit partners and senior managers may have a bias toward accepting management's perspective, rather than developing an independent view or challenging management's conclusions.

As I have indicated, these are not isolated instances.

International inspectors in the last several years have reported similar issues, with regulators from Australia, Canada, Germany, the Netherlands, Singapore, Switzerland and the United Kingdom citing deficiencies in professional skepticism as persistent problems at audit firms.

For example, The Canadian Public Accountability Board "found several examples of overreliance on management representations" and noted that "[w]hile some reliance on management is inherent in any audit, there is a higher risk of inappropriately reducing professional skepticism in instances where there is greater familiarity or comfort with the reporting issuer and its historical accounting policies and practices."[8] The United Kingdom's Audit Inspection Unit found that "[f]irms sometimes approach the audit of highly judgmental balances by seeking to obtain evidence that corroborates rather than challenges the judgments made by their clients."[9] The Netherlands Authority for the Financial Markets stated that it found weaknesses in 29 of the 46 audits it reviewed and identified "insufficient professional scepticism exercised by the external auditor" as one of the causes of these weaknesses.[10]

As was the case during the Sarbanes-Oxley debate, some investors and other interested parties have begun calling for the enhancement of auditor independence through mandatory firm rotation. At the most recent meeting of the Board's Investor Advisory Group, one of the IAG's working groups recommended that the Board "undertake a project to establish periodic mandatory rotation of the auditor, for example every ten years."[11] At a previous meeting, IAG member Meredith Williams, Executive Director of the Colorado Public Employment Retirement Association, expressed his belief that there would be "huge, huge value" in rotation[12]. And at least one leader of the profession, asking "who wants to be the partner to lose an audit client who has been with the firm for 20 years?" suggested in a recent op-ed piece that "we need to take a close look at the length of time an auditor can remain in office."[13]

Recently, Michel Barnier, in a speech to the Federation of European Accountants, argued that "independence must be the watchword of the profession and our first concern is the quality and credibility of auditing." He also said:

When many companies use the same audit firm decade after decade — or for more than a century — that damages the profession… we need to consider the benefits of making it obligatory to change auditing firms after a certain time period. We have to find the right balance between changing too often, which would damage the quality of the audit, and ensuring auditors' independence.[14]

Others have made serious arguments against requiring rotation, including arguments about costs, unique challenges for audits of multinational companies, and disruptive implementation challenges. We have a responsibility to carefully consider all of the arguments for and against firm rotation in a transparent, open process.

The challenge before us to is to act responsibly and practically to promote greater independence, objectivity, and professional skepticism in the audits of public companies, and to ensure that an auditor's primary focus and allegiance is to the investor. I look forward to reading the comment letters for ideas and recommendations on cost-effective ways to fulfill that responsibility.

Finally, I commend you, Mr. Chairman, for your leadership in bringing this issue before the Board, and for your willingness to take a fresh and comprehensive look at the numerous issues facing the profession and to consider various alternatives for addressing them.

I would also like to thank our Chief Auditor, Marty Baumann, and his staff, Michael Gurbutt; Gordon Seymour and Jacob Lesser from the Office of General Counsel; and Helen Munter and Santina Rocca from the Division of Registration and Inspections for their hard work on this project.

Thank you, Mr. Chairman.

[1] James R. Doty, “Rethinking the Relevance, Credibility and Transparency of Audits”, SEC and Financial Reporting Institute, 30th Annual Conference, USC Marshall School of Business, Leventhal School of Accounting (June 2, 2011) available at .

[2] AU sec. 220, Independence (November 1972).

[3] SEC, Accounting Series Release No. 296 (August 27, 1981).

[4] Memorandum by the PCAOB Investor Advisory Group Subcommittee on Global Networks and Audit Firm Governance, at 8, (March 16, 2011) available at

[5] European Commission, Green Paper: Audit Policy Lessons From the Crisis 11 (October 13, 2010), available at

[6] S. Rep. 107-205, at 21 (2002).

[7] U.S. v. Arthur Young & Co., 465 U.S. 805, 817-18 (1984) (emphasis in original).

[8] Canadian Public Accountability Board, Enhancing Audit Quality: Report on the 2010 Inspections of the Quality of Audits Conducted by Public Accounting Firms 11 (April 2011).

[9] See U.K. Audit Inspection Unit, 2009/10 Annual Report 4 (July 21, 2010) (stating that "[a]uditors should exercise greater professional scepticism particularly when reviewing management's judgments relating to fair values and the impairment of goodwill and other intangibles and future cash flows relevant to the consideration of going concern"); see also U.K. Financial Reporting Council, Effective Company Stewardship: Enhancing Corporate Reporting and Audit 14 (2011) (stating that "[t]he FRC is particularly keen to ensure that the right environment is created for increased auditor scepticism when assessing material assumptions and estimates"). In its most recent annual report, the U.K Audit Inspection Unit noted that its "findings continue to identify the need for firms to ensure that both partners and staff exercise appropriate professional scepticism, particularly in respect of key areas of audit judgment such as the valuation of assets and the impairment of goodwill and other intangible assets." U.K. Audit Inspection Unit, 2010/11 Annual Report 6 (July 19, 2011).

[10] Netherlands Authority for the Financial Markets, Report on General Findings Regarding Audit Quality and Quality Control Monitoring 10 (Sept. 1, 2010).

[11] Memorandum by the PCAOB Investor Advisory Group Subcommittee on Global Networks and Audit Firm Governance, at 12, (March 16, 2011) available at

[12] See Comments of Meredith Williams, IAG Meeting (May 4, 2010), available at

[13] Paul Raleigh, Managing Partner, Grant Thornton, “We Have to Train Financial Watchdogs to Bark More,” Irish Independent, July 24, 2011.

[14] Michel Barnier, Speech at Meeting of the Federation of European Accountants (June 2011) available at

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