PCAOB’s Proposed Mandatory Audit Firm Rotation Misses the Point

March 20th, 2012 | By

Last year, when the Public Company Accounting Oversight Board began soliciting comments on ways that auditor independence, objectivity and professional skepticism could be enhanced through mandatory audit firm rotation, NACD felt obligated to share our perspective. While NACD agrees with the PCAOB’s initiative to improve company audits, instituting a term-limit system may be the wrong approach. View NACD’s comment letter at www.NACDonline.org/CommentLetter2011.

As the only organization serving as the voice of the director, NACD is aware of the burdens that mandatory audit firm rotation places on boards and businesses alike. The turnover of audit firms could undermine the board’s duty to evaluate the firm’s work as required under the Sarbanes-Oxley Act of 2002.

Auditor rotation may accomplish the PCAOB’s intended goals but it has not yet shown this process to be cost effective nor has it shown that it would enhance financial reporting. On behalf of NACD’s nearly 12,000 members, we’ve submitted a comment letter to the PCAOB on this issue, outlining our five major issues with the proposal as drafted.

1. The board and audit committee are uniquely qualified to evaluate the work of an audit firm.

The board of directors, and more specifically the audit committee, is best positioned to judge the effectiveness of an auditor. An audit committee will possess the necessary objectivity to make this judgment. Furthermore, the committee will understand the most important aspects of a company’s strategy, financial reporting and internal controls. As such, along with the board, the audit committee is uniquely qualified to evaluate the work of an auditor and, if appropriate, to renew the auditor’s contract of engagement. Limiting the tenure of an auditor through mandatory firm rotation would infringe upon the committee.

2. The board and audit committee have a statutory responsibility for the oversight of auditors. Mandatory audit firm rotation supplants this authority.

Reducing the board’s options to keep an existing auditor runs counter to the spirit of existing law. Audit committees are directed to appoint, compensate and oversee the external auditor. These requirements came from the implementation of SOX. The act established qualifications for audit committee members and delegated specific responsibilities to protect the shareholders’ interest in accurate financial reporting.

Mandatory audit firm rotation would supplant the statutory responsibility and authority of audit committees to select the best auditor for a company and oversee its work. The authority of the board and its committees is at the heart of the corporate governance framework, and reducing that authority would result in weakened oversight and guidance directors provide for U.S. companies.

NACD believes change should occur based on the performance of the auditors—not an arbitrary timeline. Boards of directors should constantly assess the value an outside auditor is bringing to the company. When performance is lacking, a board of directors must step in and make a change. This type of assessment takes time and effort, but boards and audit committees are dedicated to the task.

3. Audit firm rotation is unnecessary for objectivity, since there is already a requirement for mandatory audit partner rotation —as well as rules for auditor independence.

Under current rules implemented under SOX, there is a requirement to rotate the lead partner in audits every five years, with a cooling off period of another five years. Having a new audit partner in charge ensures objectivity. In addition, the audit profession has spent years defining ever more stringent rules to define auditor independence. It would be difficult in this day and age to find a single auditor or audit firm with conflicts of interest in relation to the audited client. This regulatory framework already ensures the objectivity desired by proposed firm rotation, rendering firm rotation unnecessary. 

4. Developing an understanding of the company may take auditors years to develop and to deliver the maximum benefits.

On a practical level, mandatory rotation may also reduce the quality of an audit. It is common knowledge that quality audits are dependent upon the auditors’ understanding of the company. As an audit firm’s institutional knowledge of a company grows, so does its ability to identify critical issues. This understanding often takes years to develop.

5. Mandatory audit firm rotation is disruptive and costly, particularly in special situations.

Mandatory rotation forces a change that may not only be undesirable, but is disruptive and time-consuming. This is particularly true in times of corporate change. For example, a need to change auditors during M&A transactions, corporate financing or a change in management could prove daunting. A confluence of events such as this would greatly expand the cost and difficulty of the transaction or transition and potentially hamper an effective audit of the company. The time and resources required for management and audit committees to manage all of these transitions would be significant. Moreover, the additional work required for a new firm to get up to speed would add cost and possibly delay to the audit.

Call to action:  Please join me contacting the PCAOB to let your voice be known.

 

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