Should auditor rotation be a mandatory practice in light of recent regulatory updates? Studies have shown that audit failures are three times more likely in the first two years of an auditor/client relationship. Further, the Public Company Accounting Oversight Board, (inspecting independent financial statement audit quality on an annual basis) found that the seven largest CPA firms in the U.S. incurred audit deficiencies ranging from 23% to 42% of the engagements inspected during 2011. This is in effect, a 1 in 3 audit failure rate regardless of how long the firm has been engaged with the client company.
Background
In 2011, the PCAOB issued a concept release to solicit public feedback on ways to enhance auditor independence, objectivity, and professional skepticism primarily through mandatory rotation of audit firms. The suggested rotation would limit the number of years (suggested to be 10) for which a firm could serve as the auditor of a publicly traded company. The release said that at the time, the average audit firm tenure for the top 500 U.S. public companies was approximately 21 years. The public comment period was extended twice since its release and most recently was closed on November 19, 2012. Currently, the PCAOB is analyzing comments received for further consideration of the proposal. Although this proposed rule is only intended for SEC registrants, the private sector often looks to public company oversight for best practice recommendations.
Proponents
Proponents of mandatory auditor rotation primarily believe that setting a limit on the firm’s recurring audit fee from a client would allow the auditor to focus more on the company’s financial reporting as opposed to managing the audit team’s efficiency and budget. Further, given that a firm knows at inception that it will eventually lose the client, the auditor may think twice before compromising its independence and risking the firm’s reputation to preserve the client relationship.
Opponents
Opponents to the proposal have continually expressed concerns about the high costs of changing auditors for the companies themselves. In addition, opponents cite academic research indicating that audit quality suffers after an auditor rotation, as high as threefold in the first two years.
Fiscal Impact
The AICPA’s letter to the PCAOB cited that according to the Government Accountability Office, “in the first year, mandatory firm rotation could result in increased audit costs of more than 20%.” In 2012, we issued a report finding that of 350 total public companies analyzed, audit fees continued to decline during 2011. In addition, 14 companies switched audit firms during that time and as a result, their average audit fee decreased ~$100,000 (7%). Although these findings indicate decreasing costs to companies, specifically upon an auditor switch, perhaps it is a result of the current economic squeeze impacting the audit firms and their intended “investment” in the future client relationship.
The Verdict on Auditor Rotation
Fair arguments exists on both sides of the table; however, the PCAOB has received negative feedback in overwhelming fashion – to the tune of more than 650 letters for which more than 90% have been estimated to be in opposition of the proposal.
