Peeling away financial reporting issues one layer at a time

Audit Firm Term Limits: Nothing Else Left to Try

This post more or less (actually somewhat more, than less) mirrors my answers to questions posed by Matt Kelly, editor of Compliance Week in a recent podcasted interview. The subject was audit firm term limits, or mandatory audit firm rotation; and Matt had invited me to do this with him after reading my post on PCAOB chair Jim Doty's recent remarks.

Also, before I get started, I want to mention that in preparing for my interview with Matt I took the liberty of calling a couple of friends to elicit their views and bounce off ideas. Thanks to John Hufnagle and Gaylen Hansen for that.

On Changeover Costs

Assuming auditor rotation comes to pass (a big assumption, we know), what would the practical effects be for financial reporting or internal auditing executives? They'd face more complicated encounters with their auditors if new firms rotate in every few years, no?

In order to answer any question concerning incremental costs of auditor term limits, it would be helpful to know why average auditor tenure is currently so high. Is it purely because clients are seeking to avoid switching costs – such as more encounters with auditors to bring them up to speed on their client – or is it because even well-intentioned executives benefit from holding greater power over long-tenured auditors.

We also know that many executives complain that even long-tenured auditors impose significant switching costs on their clients, just because of the year-to-year turnover involving middle and lower staff. It could well be the case that auditor term limits might reduce that kind of turnover from changing assignments within the firm.

Whatever the ultimate answer to questions of changeover costs, I do agree that the PCAOB should be sensitive to these questions before any form of term limits are imposed, and I expect they will be. That's because term limits would be a fundamental change, and as I will describe later, there is virtually no chance that a political consensus can be achieved beforehand. If the PCAOB is going to move towards term limits, it's pretty safe to assume that they will move cautiously.

 

What's the Payback for Term Limits?

Would auditor rotation actually achieve the immediate goal of fewer audit failures?

That's a question that certainly goes to the heart of the issue, actually in two ways. First, there is the implicit premise to Matt's question: that the purpose of auditor rotation is to reduce the number of audit failures.

I would say that this is too narrow a specification of the problem. For one thing, it has already been well-publicized that in our earnings-obsessed business environment the executive suite denizens derive a large portion of their compensation, either directly or indirectly, from hitting earnings-based targets. In that environment, there is always the potential for a broad swath of shareholder value destruction should auditors subordinate their judgment to management. We probably wouldn't call that an audit failure, but it is a scourge nonetheless; there are billions of dollars of potential savings from term limits if it serves to curb excess executive compensation.

Second, we are debating this issue today, and the PCAOB is considering it, because of Lehman, AIG, Worldcom, Enron and a number of others mega-failures that contributed to severe disruptions in the economy as a whole. Audit failures below this level, even if they attracted the attention of the public, like Koss, are small potatoes compared to the potential savings if even one or two of the big ones could have been prevented by auditor term limits.

Auditor Incentives

More broadly, would a fresh set of eyes on the financial statements actually solve the problem of making audits more useful to investors? Or is this answer, audit rotation, somewhat separate from those larger concerns that audit reports aren't that useful anymore?

Actually, the beneficial effects of auditor rotation begin with the re-freshening of old eyes – the eyes of the incumbent auditor. In the fifth year of a 7-year relationship, will the incumbent auditor be feeling comfortable because it has worked smoothly with the client for five years, or will it feel uncomfortable because some yet-to-be-disclosed successor auditor will have every incentive to examine each page of the old working papers with a fine tooth comb?

But, to answer Matt's question more directly, and in the spirit of Jim Doty's "holistic approach," there are at least these three dimensions to the problem: auditor independence; the content and scope of the audit report; and the quality of the accounting standards on which the audited financial statements are based. With respect to the last one, some would say that the much of the problems at Lehman, Citigroup and WAMU is that these firms are not just too big to fail without severe fallout, but they are so complex that a reliable audit may not even be possible. How much of this problem is simply due to the fact that the accounting standards themselves are too darn complicated, counter-intuitive and oversaturated with abstractions that an auditor is simply in no position to evaluate? Answer: lots. And, don't kid yourself, IFRS is no better.

Politics, Politics, Politics

Do you think that the audit industry is going to mount a fight? What sort of battles are we looking at: titanic clashes or minor skirmishes?

Absolutely titanic. Doty's alluded to this in his speech when he mentioned that Congress considered adding term limits to the Sarbanes-Oxley Act in 2002. 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 for successor auditors pitted against predecessor auditors would have been, and still is, 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 too 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.

But, too be fair, I do see two political challenges to term limits. Perhaps the bigger of the two is that we don't have a lot of evidence that audit firm rotation is going to work. (But, that didn't stop Congress from enacting SOX 404.) The only country that has tried auditor term limits was Italy, but relative to the U.S., Italy is a country has less-developed capital markets, fewer investor protections and less effective enforcement mechanisms).

The PCAOB will, from the outset of its studies and deliberations will face an uphill battle to get past the objections of the AICPA, without much hard data to support their argument. But, Doty seems to be ready for that. Few, except for AICPA shills will question the fact that there are fundamental problems with the ways that audits are currently being conducted, and that poor quality audits (and financial reporting in general) contributed to the financial crisis. Moreover, just about everything else, except for auditor term limits has been tried; and according to the findings of PCAOB inspectors, there are far too many audit failures, many of which could be explained by impaired independence.

The second challenge is determine whether term limits should be imposed on smaller issuers and smaller firms. For reasons stated above and others that are probably obvious, I think not.

In supporting audit term limits, my working assumptions are as follows: (1) fixing financial reporting rules so that financial statements can be audited reliably is a hopeless and frustrating goal that will elude regulators for another generation or more; (2) adding more verbiage around an inherently unreliable process will only smear more lipstick on the pig; and (3) every other device for loosening the bond between auditor and client has been tried and fallen far short of the mark. Therefore, audit term limits seems to be the only reasonable near-term response for breaking the vicious cycle of financial crises and erosion of public confidence in financial reporting.

8 Comments

  1. Reply DougT June 15, 2011

    Why do you assume that regulation can accomplish what the lack of competition leaves behind. Having newbie auditors every few years just makes it easier for management to “hide the bodies.”
    There are plenty of legal ways for managers to skirt the rules. Changing the guard too often just weakens the guard.
    I agree there are agency problems. But this seems likely to make them worse.

  2. Reply Bitter Audit Partner June 16, 2011

    Rotation is not the answer, and not really the problem. When I deal with an issue, I’m not thinking about the long relationship we have with the client; I’m thinking about my own license. The answer is really about who pays us and the circumstances under which we can get terminated. It really is that simple – a point that seems to be totally lost on academics and Doty.

  3. Reply Cubby June 17, 2011

    Great idea, a way to burden US companies with yet more costs of doing business that our foreign counterparts don’t have to deal with.
    In my experience as both auditor and preparer, the first year of an audit from a new firm is not only expensive (higher fees for sure, but internal client disruption is more costly) but also lower in quality. The quality of the audit (by which I mean how effectively it addresses the key financial statement risk areas) increases over the years as the team becomes more familiar with the company and its key risks.

  4. Reply older than the hills June 20, 2011

    I am a lawyer who has both sued and defended national accounting firms since 1973. The model is untenable. Firms make money by keeping clients happy and avoiding audits that bust the budget, but competition among firms keeps fees low. Audits become “risk-based” with less emphasis on substantive testing. Staff learn that the way to partner is to master “client handling” skills. Is it any surprise that the PCAOB found so many audit failures? It is not really true that we’ve tried everything else. The PSLRA, passed over Clinton’s veto in 1995, has basically eliminated private securities class actions against firms. The SEC’s enforcement program, two years after the Madoff disaster, is no more effective than before.
    Rotation is an attractive idea because it would likely put some iron in the partner’s and manager’s backbones, knowing that management cannot use the threat of replacement to deter a truly skeptical auditor from peeling away the onions.

  5. Reply Steve June 21, 2011

    The audit firms should not be allowed to provide other services (i.e., tax) to their audit clients. Period.
    The audit firms could never ever be independent if there are other significant financial interest involved with their clients.

  6. Reply Independent Accountant June 27, 2011

    Tom:
    I once favored mandatory CPA firm rotation. I haven’t for about 25 years. Why? What will happen as a practical matter? Every say 5-7 years Big 87654 firm A replaces Big 87654 Firm B. And? Is A going to “rat out” B or vice versa? CPA firm rotation is a solution in search of a problem.
    As for KPMG, didn’t it have a similar fiasco at National Student Marketing about 40 years ago?
    IA

  7. Reply File back taxes August 13, 2011

    Rotation might not be a bad thing. A fresh set of eyes can work and may even improve dialog with the client. Obviously, we need to try things out to see what works.

  8. Reply When will we learn... August 31, 2011

    I started my career as an auditor at a BigFirm and now I work for a regulating agency. The problem is the model; just as it is with the credit rating agencies. You can’t effectively audit your boss. Until we come up with a new model, all we are doing is wasting time and money by requiring more oversight and regulation – which will never be as effective as a truly independent hands-on audit by someone competent enough to do the work. The role of regulators needs to expand to become a better resource to companies and auditors in dealing with complex issues, and they need to be given the teeth to put incompetent auditors out of public practice – without having to jump through 1 million hoops to do it.

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