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Sunday, August 30, 2015

The Continued Debate Regarding Mandatory Auditor Rotation


It’s been four years since the Public Company Accounting Oversight Board (PCAOB) published Concept Release No. 2011-006, Auditor Independence and Audit Firm Rotation, which proposed mandatory audit firm rotation every few years. Regulators had hoped to improve audit quality and strengthen investor protections by setting term limits. But the PCAOB tabled this proposal in 2013 after it was met with almost unanimous opposition from auditors, public companies and corporate directors.

Now, as the PCAOB considers another proposal that would require public companies to disclose the duration of their relationships with auditors, a recent study challenges the theory that periodic rotation keeps auditors on their toes.

Why regulators want to impose term limits
Some investor advocates and regulators believe auditor-client relationships, once they last more than a few years, undermine an audit firm’s independence and lull auditors into complacency. They argue that long-term ties cause auditors to accept a client’s questionable decisions to protect the revenue from the client. Term limits are seen as a means toward breaking this pattern and giving auditors freedom to challenge a company when its accounting practices are questionable.

Accounting firms, public companies and audit committee members oppose term limits because they say it will drive up costs, disrupt business activities and do nothing for audit quality. These groups were very vocal when the PCAOB proposed mandatory auditor rotation in 2011, sending more than 600 comment letters to the board expressing opposition to term limits.

How researchers challenged the benefits of mandatory auditor rotation
A recent experiment using decision-making gamesmanship supports the opponents’ viewpoint. It found that auditors are less independent when faced with questionable accounting decisions if they’re forced to rotate every few years. Mandatory auditor rotation improves audit quality when an auditor believes the client is honest, but the effect is reversed when an auditor thinks that the client is dishonest, according to the academic research paper published in the July-August 2015 issue of the American Accounting Association’s Accounting Review.

“Professional skepticism requirements are intended to elevate auditors’ skepticism of their clients and, ultimately, audit quality. This benefit disappears and even reverses when auditors rotate. That is, rotation and a skeptical mind-set interact to the detriment of audit effort and financial reporting quality.… Regulators appear not to have considered that the frame auditors use to evaluate management representations can vary between assuming potential honesty to assuming potential dishonesty,” the study said.

Auditors, knowing that they will not be in a long-term engagement with a client, are “likely to perceive themselves to be less competent in evaluating the honesty or dishonesty of the [corporate] manager relative to auditors who do not rotate,” the paper said. “Rotating auditors would find it difficult to garner psychological support for the probability of manager dishonesty, leading them to be less likely to choose high levels of audit effort than non-rotating auditors.”

The findings are based on a lab experiment by behavioral researchers at the University of Mississippi, the University of Illinois at Urbana-Champaign and the University of Massachusetts in Amherst. For purposes of the experiment, researchers equated “professional skepticism” to an auditor’s view that the client is dishonest.

How the PCAOB hopes to achieve a compromise
As a compromise between auditor rotation advocates and opponents, regulators have been considering adding a disclosure requirement. In August 2013, the PCAOB published Release No. 2013-005, Proposed Auditing Standards on The Auditor’s Report; The Auditor’s Responsibilities Regarding Other Information; and Related Amendments. This proposal would require companies to disclose in the audit report the length of time the accounting firm has been auditing the company.

Two years later, however, the board’s disclosure proposal is still under review. Audit firms and companies continue to argue that there’s no clear link between tenure and audit quality, so the proposal serves only to add to “disclosure overload” in public companies’ annual reports. In their view, the information may be best dealt with by audit committees, who have oversight of auditors, and audit committees are the purview of the Securities and Exchange Commission (SEC).

Interestingly, one member of the SEC’s Advisory Committee on Small and Emerging Companies, Richard Leza, still believes there’s a strong link between auditor rotation and audit quality. He recently called mandatory audit firm rotation “a very good thing.” His comments during a telephone meeting in July were surprising, because they came as the advisory panel was discussing a recommendation to exempt smaller companies (with less than $250 million in public float) from any term limit rules and disclosures, along with other regulatory breaks.

Why it’s OK to stick with your current audit firm
High quality audits benefit everyone who relies on audited financial statements. But is there a disconnect between mandatory auditor rotation and improved audit quality? The answer could be “yes” in cases of suspected wrongdoing, according to recent academic research.

Fine-tuned professional skepticism and procedural due diligence are important ingredients for high quality audits. But research shows that auditors who suspect dishonest behavior don’t necessarily become less skeptical or diligent just because they’ve worked for the same client for many years.

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