Risk & Compliance

I’ll Take Any New Regulation, Just Not This One

Critics of an auditor-rotation proposal suggest alternatives for improving audit quality, including proposals already on the PCAOB’s plate.
Sarah JohnsonMarch 22, 2012

If you don’t like one regulation, ask for another. That’s the tactic tried by critics of a Public Company Accounting Oversight Board (PCAOB) proposal that would require companies to switch audit firms every few years.

Those opposed to the PCAOB’s plans, which are in the very early stages and may not result in a rule, prodded the regulator this week to instead focus on other rulemaking in its pipeline, such as improving communications between audit committees and auditors, and expanding the audit reports included in companies’ annual reports. Those rules could lead to improved audit quality more effectively than mandatory audit rotation could, according to some panelists who participated in a two-day roundtable held by the accounting firms’ watchdog.

For example, the PCAOB could require that auditors publicly note whether they questioned management on alternative accounting methods, said one roundtable panelist. “Even the most honorable of management has enormous discretion in the numbers they put up,” said Roderick Hills, who chairs a governance program for the Center of Strategic and International Studies and formerly chaired the Securities and Exchange Commission.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

During the roundtable, the Center for Audit Quality reminded the PCAOB of a languishing proposal to require auditors to indicate whether a two-way communication is occurring between them and audit-committee members, and assess how well management communicates accounting issues to those members. The proposed rule would “encourage constructive dialogue between auditors and audit committees on significant audit and financial statement matters,” said CAQ executive director Cynthia Fornelli in written testimony. The proposal received mixed reviews and more than three dozen letters. In comparison, the rotation proposal has resulted in more than 625 letters, about 24% of them from CFOs.

Critics of auditor rotation, including CFOs and chairs of audit committees, are adamant that the proposal not move forward. They believe the mandate would lead to more costly audits during the transition period, limited choices among the Big Four firms favored by large companies, and a decrease in audit quality because the new accounting firm would need time to get up to speed. Those in favor cite the benefit of a “fresh set of eyes” and a move away from cozy management-auditor relationships.

As it is, critics claim, the Sarbanes-Oxley Act put enough safeguards in place by requiring companies to use new audit partners every five years. It also put the onus of choosing and retaining accounting firms on audit committees. Mandatory rotation would “usurp the role of the audit committee,” says Paul Chellgren, who chairs PNC Financial Services Group’s audit committee. Both PNC’s board and shareholders ratify its auditor ever year after an evaluation.

Audit committees are designed to provide a barrier between management and its accounting firms and also act as another set of eyes on company financials. And according to those who lead these committees, directors have significantly improved and embraced their role as overseers since Sarbox was enacted in 2002. “Audit committees have stepped up their game in the last 10 years,” said Catherine Lego, who chairs the audit committees of SanDisk and Lam Research.

In response to such claims, PCAOB board members said not all audit committees may have improved. “We have seen significant failures by audit committees to perform the kind of oversight you are talking about,” said Lewis Ferguson, a board member.

In fact, the PCAOB may be prompted by all this discussion to communicate more with audit committees, a suggestion repeated over the past two days. Lego suggested the PCAOB check in with clients’ audit committees before their inspections to get input. Other panelists said audit committees don’t get complete information from their accounting firms about PCAOB inspections.

Other suggestions raised during the roundtable included improving training for audit-committee members and requiring auditors to go through a request-for-proposal process on a regular basis. Former SEC chief accountant Donald Nicolaisen, who chairs Morgan Stanley’s and Verizon Communications’s audit committees, suggested the PCAOB resurrect a proposal that would require audit partners to include their names on audit reports, which the accounting industry has opposed vehemently. The PCAOB may also look into whether audit committees should disclose more information about their process for reviewing accounting firms in proxy statements.

Most of the panelists who are against auditor rotation said the mandate would be especially hard for multinationals, since they have more complex companies that would lose institutional knowledge through an auditor change. Some smaller companies may get a temporary reprieve if the board does move forward on auditor rotation. A bill colloquially known as the JOBS Act passed by the Senate today would give newly listed, emerging growth companies five years before they would have to comply with such a rule.