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PCAOB Resurrects Audit-Firm-Rotation Debate

Investors cite concerns about auditor independence in the wake of the financial crisis.
David M. Katz, | US
August 19, 2011

In a move likely to have many finance chiefs groaning, the Public Company Accounting Oversight Board has put the notion of mandatory rotation of audit firms squarely on the regulatory agenda again. Earlier this week, the PCAOB issued a concept release seeking public comment on how to boost auditor independence from clients, with audit firm rotation the principal method mentioned.

The idea of forcing audit firms and companies to sever their ties after a given period - ten years is the most frequently contemplated duration - has been bandied about since the 1970s. Most recently, it came up in Congressional debates preceding passage of the 2002 Sarbanes-Oxley Act. After a 2003 study by what was the General Accountability Office (then called the General Accounting Office) found that more experience with Sarbox was needed before contemplating mandatory rotation, the issue has remained dormant - until now.

Why has the board decided to reawaken debate?  "In more than eight years of conducting inspections, the PCAOB has identified hundreds of audit failures by the largest firms, each of which are technically capable of the highest quality audits," PCAOB Chairman James Doty said in a statement prepared for CFO. "On these facts, it behooves us to re-evaluate whether audit firm term limits are necessary to preserve auditors' independence from their clients."

The current impetus, though, appears to have come from investors. On March 16, at a meeting of the PCAOB's Investor Advisory Group, some members of the IAG urged the board to consider mandatory firm rotation "in the context of lessons learned from the financial crisis," according to the concept release.

These investors said that "key to concern over [auditor] independence was the level of 'coziness' the firm had with the management of the company being audited." They also noted that "[m]any of the auditors of the large companies involved in the financial crisis ... had long running audit relationships with those companies."

The working group recommended that the board "undertake a project to establish periodic mandatory rotation of the auditor, for example every ten years."

For their part, however, individual PCAOB members expressed skepticism about the notion. "I have serious doubts that mandatory rotation is a practical or cost-effective way of strengthening independence," board member Daniel Goelzer said, for example.

To many CFOs, mandatory rotation has represented substantial new costs and the risk of poorer audits. In a survey of public accounting firms and public company CFO and their companies' audit committee chairs on which its 2003 report was based, the GAO found that 79% of larger audit firms and Fortune 1000 companies that responded believed that changing audit firms boosts the risk of an audit failure in the early years of the audit.

Nearly all of the larger audit firms that responded estimated that initial year audit costs would increase by more than 20%.