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SEC Insights - October 2013

 

U.S. House of Representatives Blocks Mandatory Auditor Rotation

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With applause from many public companies, investors and auditors nationwide, the “Audit Integrity and Job Protection Act” (the “Act”) 1 was passed by the US House of Representative on Monday, July 8, 2013 with a 321-62 vote.2 If it becomes law, the Act will amend the Sarbanes-Oxley Act (“Sarbanes-Oxley”) by limiting the Public Company Accounting Oversight Board’s (“PCAOB” or the “Board”) authority by prohibiting the Board from either requiring a specific registered public accounting firm to audit a particular issuer, or to require that such audits be conducted for an issuer by different registered public accounting firms on a rotating basis.

Back in 2002 when Sarbanes-Oxley was enacted, the PCAOB was created to protect the interests of the public. In order to fulfill this role, the PCAOB was granted authority to set standards and rules as deemed necessary or appropriate. In addition to the creation of the PCAOB, Title II of Sarbanes-Oxley implemented standards to regulate auditor independence.3 These independence standards included the prohibition of providing non-audit services and mandatory audit partner rotation. Although the PCAOB and independence standards of Sarbanes-Oxley have resulted in increased audit fees and other costs to public companies, many think that the standards clearly resulted in improved audit quality.

With respect to mandatory audit firm rotation, Sarbanes-Oxley did not produce a complete cost-benefit analysis. Rather, Section 207 states that the US Comptroller General was required to conduct a study and produce a report within one year on the potential advantages and disadvantages of mandatory audit firm rotation. A year later, the report issued by the General Accounting Office (“GAO”) concluded that “mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality.”4 The GAO report did not issue a final conclusion on the matter because the GAO believed more information was necessary regarding the effectiveness of the PCAOB and the overall implementation of Sarbanes-Oxley.

In August 2011, the PCAOB revived the matter and issued a concept release requesting comments from the public on how to improve auditor independence, objectivity and professional skepticism with regards to public company audits.5 In this concept release, the PCAOB suggested that mandatory audit firm rotation would be a viable solution to increasing audit quality. The concept release describes numerous audit deficiencies noted by the Board in which auditors placed too much reliance on management responses and representations and failed to obtain corroborating evidence or to sufficiently challenge management’s assumptions. This lack of professional skepticism, the PCAOB argues, is a result of the relationships between management and the auditors that have developed over years of recurring engagements.

The need for professional skepticism and independence is no doubt essential in audits. Professional skepticism is defined by the Auditing Standards as “an attitude that includes a questioning mind and a critical assessment of audit evidence.”6 Despite its importance in auditing, professional skepticism is not tangible and therefore is difficult to substantiate and document in audit workpapers. The PCAOB acknowledges this limitation, yet insists that many of the audit failures identified point clearly to a lack of professional skepticism.

Mandatory audit firm rotation, the Board believes, would improve professional skepticism as the recurring relationship between management and auditor would be severed. Many, including audit committee members of large corporations, private investors and CPAs, using their own professional skepticism, have challenged the Board on this concept. After its concept release in 2011, the Board received over 600 comment letters, most of which were not in favor of the proposal and only a few in support of the idea of mandatory audit firm rotation. Those opposed to the idea reasoned that mandatory audit firm rotation would unnecessarily disrupt business activities and significantly increase costs to public companies. Moreover, responders cited that mandatory audit firm rotation would likely increase the risk of audit failure and decrease audit quality instead of enhancing it, specifically in the first few years after rotation. This is because the lack of familiarity with the client in the early years of an engagement adds to the potential risk of audit failure as the new auditors need to acquaint themselves with the client’s industry, internal procedures and general history, among other factors. These are but a few of the numerous responses sent to the PCAOB opposing its concept release on mandatory audit firm rotation.7

Although it seems that mandatory audit firm rotation is not practical nor is it worthwhile, the fact remains that the Board continues to identify many audit deficiencies which should be addressed. In December 2012, in preparation for the audit season, the PCAOB issued a Practice Alert on “Maintaining and Applying Professional Skepticism in Audits.”8 In this publication, the PCAOB discusses the impediments to applying professional skepticism, as well as ways to promote it. In summary, professional skepticism is an attitude that each individual auditor needs to cultivate, as well as a tone and culture of the audit firm in general. Through implementing strong quality control systems with multiple levels of review and employing and training strong auditors, audit firms can be successful, as the Board notes in the Practice Alert, in enhancing audit quality.

The Practice Alert is simply a reminder to auditors of the responsibility they already carry. It contains similar ideas and information as the concept release from 2011 regarding mandatory audit firm rotation and cites similar audit deficiencies noted in PCAOB reviews. The Board ends this Practice Alert stating that “the PCAOB also is continuing to explore whether additional actions might meaningfully enhance auditors’ professional skepticism.”9

With the passage of the Audit Integrity and Job Protection Act in early July 2013, mandating audit firm rotation will likely not be the meaningful solution to improving audit quality. Although the Act still has a journey to the Senate for approval and then to be signed into law by the President, the general public response against mandatory audit firm rotation has been presented to the Board. Meanwhile, the Board appears to have conceded on the issue and developed a compromise on mandatory audit firm rotation. On August 13, 2013, the PCAOB proposed a new auditing standard to enhance the auditor’s report. The proposed auditor’s report would include, among other elements, a disclosure of the auditor’s tenure with the client. [[1] http://pcaobus.org/News/Releases/Pages/08132013_OpenMeeting.aspx1].To our knowledge, there have not been any studies, nor has it been proven that there is a relationship between auditor longevity and audit quality.The inclusion of such information potentially implies such a relationship.Although the PCAOB believes that this will allow the reader to make his or her own determination of the possible impact of a recurring relationship between auditor and client on the financial statements or lack thereof, others believe that given the lack of any demonstrated relationship, the information is as potentially misleading as helpful.

1 H.R. 1564 of the 113th Congress, available at http://docs.house.gov/billsthisweek/20130708/BILLS-113HR1564-SUS.pdf

2 http://clerk.house.gov/evs/2013/roll306.xml

3 Sarbanes-Oxley Act of 2002 (Public Law 107-204) of the 107th Congress, available at http://www.sec.gov/about/laws/soa2002.pdf

4 U.S. General Accounting Office, Required Study on the Potential Effects of Mandatory Audit Firm Rotation, available at http://www.gao.gov/new.items/d04216.pdf

5 PCAOB Release No. 2011-006, Concept release on Auditor Independence and Audit Firm Rotation, available at http://pcaobus.org/Rules/Rulesmaking/Docket037/Release_2011-006.pdf

6 Statement on Auditing Standards, AU Section 230, Due Professional Care in the Performance of Work, section .07, available at http://pcaobus.org/Standards/Auditing/Pages/AU230.aspx

7 http://pcaobus.org/Rules/Rulemaking/Pages/Docket037Comments.aspx, as quoted in Compliance Week (see below footnote 8)

8 PCAOB Staff Audit Practice Alert No. 10, available at http://pcaobus.org/Standards/QandA/12-04-2012_SAPA_10.pdf

9 ibid

John Schuyler contributed to this article.

 
 
 
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