Mandatory Auditor Rotation -- PCAOB Chairman Doty Takes an Old Idea Out for Another Spin

Say this for Jim Doty, the new chairman of the American audit regulator – he is willing to pack his bags and go on the speaking circuit. Following his May 5 gig in New York (here), where he flagged the prospect of a re-visited approach to the standard auditor’s report (my thoughts here), the PCAOB head was off to California on June 2 (here).

There he promised “a holistic approach to addressing the cultural challenges inherent in auditing” – a notion whose meaning will emerge in time, out from behind the sloganeering of “addressing relevance, credibility, and transparency of the audit by all available and effective means”(emphasis his).  

His one specific is to drag back out, yet again, the question, “whether mandatory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client.”

As Doty at least has the candor to concede, “the idea of a regulatory limit on auditor tenure is not new.” It was not new when examined in 1977, as Doty cites – back when audit choices included eight large firms and a real middle tier – nor yet again in the post-Andersen era of the Sarbanes-Oxley law of 2002.

But – unlike fine wines or monumental architecture, which will mellow and improve with age – a bad idea does not acquire respectability with the passage of time.

Since the proponents of rotation are undeterred by the only available evidence -- namely the experience of Italy, where both mandatory rotation and divided responsibility between two audit firms were part of the context of the debacle of Parmalat – two other arguments should bear:

First, the feasibility of rotation clashes with the reality of global concentration. The Big Four now have a virtual lock on large-company assurance; as the risk management leaders of the surviving mid-tier firms would admit (if only off the record, and despite the public posturing of their leaders), the smaller firms could not take over the audit of a global-scale bank or airline or manufacturer or service enterprise, if handed the job on a no-bid silver platter.

The consequence – again with focus on the world’s largest companies where both the risks and the concentration are greatest – is the absence of auditor choice imposed by the constraints of service delivery under the shibboleth of independence.

That is, a large company, engaging one Big Four firm for its audit, will disqualify another that is used for consulting services, and a third that provides financial and transactional advice.

Then comes into play the factor usually omitted from discussion, namely the uneven distribution of expertise around the large world economies. Consider the varied market-leading significance of KPMG in Germany, Ernst & Young in France, Deloitte in Spain or PwC in the UK or Switzerland. A global-scale company requires audit services in all of those countries, and US rotation requirements would be viral in application -- but shortcomings in available industry competence and geographic coverage would constrain alternative choices. Enforced rotation would confront severe dislocations, amounting in effect to unachievable demands.

The second branch of the two-fold parochialism seemingly behind the recurring advocacy for rotation is that it somehow favors an improved mind-set of auditor skepticism.

As if the assurance function had ever reflected the kind of innocent, pre-lapsarian virtue ascribed by the proponents of “independence.”

History is to the contrary. Since its invention in the Victorian 1850’s by Mr. Deloitte and his counter-parts, professional assurance has been under the direct engagement – and payment – by the owner-managers, who until then had selected “auditors” from among their own, surely-interested ranks.

The nascent profession, together with its clients, saw off the proposal of nationalized government audit in the 1860’s in England, and did so again in the US in the 1930’s. Over an unmodified 160-year history of “client pays,” the full-service firms’ economic incentives to satisfy those paying clients’ audit needs have been at least arguably no more than for a firm deriving no revenue at all from ancillary services.

So the intellectual stability of the entire structure of appearance-based independence restrictions and limitations on the scope of permissible services resembles nothing else than an elaborate edifice built on the shifting fragility of a sandbar.

I’m therefore obliged to take issue with the enthusiasm of the commentators on Doty’s speech – not least, my blogging colleague the usually insightful Tom Selling, who in the Accounting Onion proffers applause and pride at Doty’s tone and plan of action.

In the park around the corner from my house is a decades-old carousel – beloved by hordes of small children who for one euro can circle in safety astride old-fashioned wooden horses, stabbing and grasping at the rings held out by the grizzled operator of the ancient apparatus.

The metaphor extends. There is no more adult substance to Doty’s spin on mandatory auditor rotation than there is to the revolving fantasy of an antique and anachronistic merry-go-round.

 

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Comments

[Elliot Kamlet]

Interesting article today in the CFO Journal of the Wall Street Journal. It seems that Apple lets out its audit for re-bidding every 5 years and switches auditors.
Why are fees high enough that a competitor with the same cost structure can come in for less? The only logical answers I can think of is that the current auditor simply raises fees all the time even above the required level. Also, the new auditor is hoping to grab some other business for itself. But how does the new auditor learn the ins and outs of the business so quickly that it can afford to underbid the established auditor?
Sarbanes Oxley might be the answer. Since an auditor may no longer perform advising work for an audit client, most multi-national companies employ 2-3 of the Big 4 in different capacities. They all must learn the ins and outs of the company. When they begin an audit, they already have a great deal of knowledge about the company.

[Robert F. Kelley]

"Mandatory rotation of auditors" along with "independence" lie together in the murky pool of contemplation {def. the action of looking at something for a long time} never to be revived. Absolute salvation for auditing will be real-time auditing with access by lenders and investors.