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No-Fuss Audit Rotation Alternatives Floated

Mandatory audit rotation is anathema to many CFOs. But some new alternative approaches could take the heat out of the debate.
Kathleen Hoffelder, CFO.com | US
July 25, 2012

Almost 10 years after the U.S. General Accounting Office (GAO) first studied whether to require mandatory audit rotation, the idea is still causing corporate executives' blood to boil. But new approaches and a revised look at some old alternatives just might calm their nerves.

Instead of having a mandatory requirement to change auditors in the way the Public Company Accounting Oversight Board's (PCAOB) concept release would, Peter Bible, partner-in-charge of the public companies group of audit and accounting firm EisnerAmper notes that a kind of tenure-based approach might be more acceptable to industry participants.

Auditors, for one, might do a better job, he says, if they were required to perform for a certain number of years, such as a 6-year or 10-year term, and couldn't be fired without the approval of a regulator. This, he says, would eliminate the pressures auditors sometimes face when they feel they have to go along with a company (who is paying the bill) or when they believe a company might put out a bid for another auditor.

"It takes a lot of the human nature side of it off the table," he adds. "If you really want to make it so the auditors are independent, then make it so the auditors can't be fired."

Others have suggested that a way to get around auditor rotation is to rotate the actuaries who analyze and forecast a company's financial risks with statistics instead. While this may not be appropriate for all organizations - and only certain types of organizations, such as life insurers and pension funds, even use actuaries - the idea makes sense to Robin Madsen, CFO at California State Teachers' Retirement System (CalSTRS).

"We're very reliant on our actuaries," said Madsen at a PCAOB meeting in June. "We have established [a program] where we hire another actuarial firm to come in and audit the work of our actuaries to see if they can replicate it within reasonable tolerances."

Although there are no standards that require rotation of actuaries currently, Madsen believes using this kind of approach could be a useful alternative to rotating auditors. "The actuaries actually sign their opinions with their names. There's just a difference in the standards of practice [between actuaries and auditors]," she said.

Another approach, having a third party hire a company's auditor (unlike the current practice of audit committees selecting audit firms), may be making a comeback. Michael Doron, an assistant professor at California State University at Northridge, examined the concept in a paper dated last month, explaining that the third-party audit-payer idea is still being considered by various industry participants. He says the idea actually dates back to the 1933 Senate hearings on the Securities Act.

A 2010 European Commission green paper on audit policy discussed the concept, saying at that time the idea could be "relevant for the audit of the financial statements of large companies and/or systemic financial institutions."

At a meeting last March, then-PCAOB chairman James Doty discussed having a third-party payer or insurance fund pay for a company's audit. The idea is still one of many being reviewed in the comment period, which ends July 28, according to a PCAOB spokesperson.

But a sticking point with any kind of third-party format for auditing is how much government intervention should be allowed. The U.S. government's hand in the auditor process is not typically welcomed, cautions EisnerAmper's Peter Bible. More governmental pressure on audits "could go down a slippery slope," he says. "Before you know it, your auditors are government employees." Instead, he notes that having a private-sector self-regulatory organization, independent of the government, in charge of such a third-party payer model would appease industry executives and could potentially work well with regulators.

So why are so many alternatives needed? Companies have routinely balked at mandating auditor rotation, contending that the Sarbanes-Oxley Act of 2002 has enough checks and balances in place already to allow for the accuracy and reliability of corporate disclosures. Under Sarbox, companies are required to switch the lead partner of their audit firms every five years.

David Eaton, vice president of proxy research at proxy advisory Glass, Lewis & Co., noted at the PCAOB meeting last month that the "independence and objectivity of auditors has improved over the past decade," which makes the rotation idea less necessary.

Some companies have even started rotating auditors on their own. Small companies already rotate auditors faster than the general population, according to Bible. Thus, they are likely not to be as disturbed by the proposed mandatory rotation requirements, he says.

Larger companies, on the other hand, should incur the biggest expenses in getting new auditors up to speed in any rotation change. That's because they have the most to adjust to in terms of staffing and IT systems. Online audit tracker Audit Analytics notes in a report this month that "changes in auditing standards require additional work in the areas of fraud detection, understanding the business and fair-value consideration."


Brian Fox, founder and chief marketing officer of Confirmation.com, an electronic audit-confirmation service, says costs to a firm can be extremely high if fraud goes undetected in all steps of the audit process. At the same time, in his view, most fraudsters would not be in favor of rotation, since companies that have the same auditors for two decades or more would be prone to fraud. "The PCAOB challenge is how can we have the least negative impact for honest auditors and have the most impact on catching criminals," he adds.

To others, however, the benefits in rotating an auditor can outweigh the costs. CalSTRS's Madsen acknowledged at the PCAOB meeting that while she believes it is expensive to rotate auditors, just receiving a "new set of eyes" from using a new audit firm could provide unforeseen benefits. Yet even though the retirement system recently switched auditors, it's opposed to mandatory rotation in general, reasoning that it should be a matter of choice.

The case against mandatory audit rotation, however, is well established. In its study dating back to 2003, the GAO said at that time that mandatory audit-firm rotation may not be the most efficient way to strengthen auditor independence and improve audit quality.

The PCAOB does not expect further action on the audit-rotation proposal until next year. More public meetings could still take place before then, says the oversight group'sspokesperson.




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