A Case for Mandatory Auditor Rotation? Sharp-Eyed Students Have a Look

With comments due next month, the concept release on mandatory auditor rotation, issued by the Public Company Accounting Oversight Board on August 16 (here), provided an irresistible mid-term assignment for my class in Risk Management. 

It’s been stimulating this fall, to be with a group of students from the law and policy schools of the University of Chicago. We examine the sources of bias, misperception and flawed analysis in the behavior of those charged with governance and leadership – in business, politics and regulation. PCAOB chairman James Doty’s promotion and affection for auditor rotation was a natural.

Ask a group of inquisitive students to find the three central themes in an assignment, and collectively they will find all six – but in this exercise, their insights are on target.

First, in the venerable economics-oriented tradition of the U of C, where the words “opportunity cost” could be etched on a microchip installed in the frontal lobes of new arrivals, it’s no surprise that the PCAOB’s sketchy attitude toward the costs of rotation caught their attention. An example:

“The PCAOB’s proposed new rule and request for commentary seems to be based on a paucity of actual hard evidence and numbers.  (T)he trigger is …“financial scandals at Enron, WorldCom, and elsewhere,”… (but) the PCAOB does not attempt to estimate (even roughly) the costs of those failures, but they acknowledge that any increases in regulation will impose added cost to the financial system.  It might have been helpful for PCAOB to try to offer some way to balance the likely costs and benefits from alternative approaches.”

Going far beyond their skepticism about the doubtful extent of the PCAOB’s economic savvy, however, these samples of the observations of a classroom of curious students show their shared grasp of the agency’s pursuit of a preconceived agenda:

“By framing the issue as a problem with professional skepticism and objectivity, the release seems to ignore other possible explanations for auditing failures, even in the absence of any empirical evidence linking audit failures to the influences it believes is responsible.”

“It appears the conclusion has already been reached that errors and failures are a result of the relationship between the auditing firms and their clients, where relationships and failures are positively associated. This anchoring or early commitment to the source of the problem changes the entire frame of the argument…. The induction that because clients and auditors have long relationships, and there are issues, does not mean that there are issues because of the length of their relationship.”

“Failures of auditing accountability have not been decisively linked to auditing tenure.  There is something of a problem of absent evidence here—though the linkage might seem intuitive, there have not been reliable studies performed to examine alternate explanations.  Thus, the agency is reasoning from a lack of disconfirming evidence.”

“The primary flaw made in the Concept Release is an assumption of causality between audit company tenure and audit failure … likely induced by availability bias, confirmation bias and shortsighted shortcuts… Investigators see numerous longstanding relationships—this has led to an availability bias and confirmation bias—since longer relationships are a norm in this industry.”

“The WorldCom and Enron scandals are the “black swans” that … should be considered when creating policy decisions. However, it would be a mistake to believe that all swans are black because you have seen a black swan.” 

The well-observed “absence of evidence” is only the beginning, however, as put this way:

“The flaws of the Concept Release are not only limited to frame blindness; … the fact on which they relied are biased with the more common traps: anchoring, availability, representativeness, lack of evidence and confirmation bias.”

And the unproven issues of relating to competition and auditor choice were flagged:

“If the market for auditing services is not “competitive” in the economic sense, this should diminish the expectation that a policy of forced rotation would leave businesses with adequate substitutes available for each “round” of auditing.”

One student even got to a nuance on incentives that the PCAOB itself has breezed right on by – the flawed assumption that “Rotating auditors is preferred because an auditor would be incentivized to ‘clean up’ the books knowing another company would look at them when they took over.” Instead, “knowing they will be leaving…the auditing firm could be less incentivized to ‘clean up’ the books, as it would no longer be their responsibility.”

This last insight wanted only the next step, that a successor auditor under a rotation mandate would have no more incentive to raise issues with its predecessor than the other way around, since it will have inherited the obligation to resolve the issue and be responsible for it – the classic deterrent to quality that “If you raise a problem, then you become the problem.”

I could not conclude any better than as one student most pungently put it:

“The remedy (of mandatory rotation) comes not from informed research about the problem but from a formulaic dealing with problems of integrity and a Band-Aid based in biases.”

 

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Comments

[CJ]

Very interesting viewpoints. Please have your class put together a comment letter to submit to the PCAOB so those views can be shared with the Board.

[M Murray]

Thanks for the article - I wonder what your students would say to the profession's solution to regulation - peer review. Nearly all of the arguments made fit that issue as well. But the AICPA and state societies codified peer review into law in the Uniform CPA Licensing act. Hummmm....