Peeling away financial reporting issues one layer at a time

Would Someone Please Audit the Auditor?

Auditors are not priests, immune to the temptations of the material world.  Many of us have come to realize that even priests are not priests. 

Granted, the mindset may have been different in 1933.  That’s when representatives of the accounting profession were able to convince Congress that government involvement in audits would not be necessary, and it was not even necessary to "audit the auditors."  The public could rely on the "conscience" of auditors to do the job right.  As Bill Cosby’s Noah said to God, "Right." 

Could mandatory audit firm rotation have prevented at least some of the major accounting scandals?  Would it have been more effective, and less costly, than SOX 404?  Guess what I think. 

Enron, Tyco, Kmart, Xerox.  Whichever accounting scandal you can name, pre- or post-SOX, the odds are that culpable auditors had been at the same trough for decades.  In 2003, the GAO reported that average tenure of auditors to the Fortune 1000 was 22 years.  From my personal experience, it is not uncommon to find the same auditor retained by a firm for more than 40 years.   How would you like to be a first-year  partner-in-charge, and to be put between the rock that has been one of your firm’s biggest clients for decades, and the hard place that is their material violations of GAAP?  If you’re lucky, they’ll fit you with a muzzle and give you an offer you can’t refuse–like a transfer to Finland.  In fact, that’s what KPMG’s head did to the irksome partner who was questioning Xerox’s management over their many fraudulent accounting techniques. 

The theory behind mandatory audit firm rotation is that successor auditors would have a strong economic incentive to perform a thorough initial review of their new clients, so as to avoid exposure for restatements occurring on their watch. The really interesting part is the incentives it gives to the predecessor auditor, who expects the successor to be as strict as a drill sergeant inspecting the barracks on his first visit.  Mandatory firm rotation makes too much sense, and perhaps now that we have evidence on the costs and efficacy of SOX 404, it may be time to reconsider it. 

I say ‘reconsider’, because I believe that Paul Sarbanes, the Democratic Senator from Maryland, placed mandatory audit firm rotation at the foundation of the bill he first envisaged.  It was vigorously opposed by the AICPA (the accounting counterpart of the National Rifle Association); for successor auditors pitted against predecessor auditors would have been their worst nightmare come true. 

Into the breach stepped Michael Oxley, a Republican Representative from the state of Ohio and well-known supporter of the accounting profession. Oxley was also the Financial Services Committee Chair in the House. Using the largely unsubstantiated argument that audit firm rotation would be far to costly, most of the burdensome responsibilities on corporations in the Act — CEO/CFO certification, SOX 404, new board and audit committee requirements, to name a few — were added by Oxley in exchange for giving the ax to mandatory audit firm rotation.  The happy ending for the AICPA was that not only could they avoid auditors auditing auditors, SOX 404 gave them a windfall in the form of new services for which they could charge an arm and a leg.   

The costs of SOX 404 have been absurd, and there is a lot of evidence that they will not abate without regulatory changes.  In their fifth annual study of corporate governance compliance costs, the law firm of Foley & Lardner report that although internal SOX 404 compliance cost  declined slightly in 2006, total  out-of-pocket costs associated with Sarbanes-Oxley compliance showed a double-digit percentage increase for companies both large and small.   Would you be surprised to know  that the largest area of cost increase was external audit fees?  I didn’t think so. 

The combination of SOX and consolidation/attrition of the Big Eight down to the Final Four has created what one congressional witness characterized as the biggest windfall to audit partners in history.  The great irony is that instead of mandatory audit firm rotation, we now have mandatory loyalty to current auditors.

1 Comment

  1. Reply Okwuagbala Emmanuel May 25, 2011

    There is need for cost benefit analysis of mandatory rotation of auditors to know if the benefit out weigh the cost which I am now researching.

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