United States: PCAOB Issues Concept Release Soliciting Comments On Mandatory Audit Firm Rotation

The Public Company Accounting Oversight Board (the "PCAOB" or "Board") has issued a concept release soliciting comment on whether the PCAOB should require the mandatory rotation of accounting firms that audit public companies.¹ While the PCAOB also invited comments on other measures that might enhance auditor independence, objectivity and professional skepticism, the Release's primary focus is to revive a public discussion of the potential advantages and disadvantages of requiring public company auditors to rotate off engagements after some period of time.

Recognizing the significant issues raised in the Release, the PCAOB stated that it will accept comments through December 14, 2011. The Board also announced that it will convene a public roundtable to discuss the Release in March 2012. The information gathered by the PCAOB during this process may lead to a specific rulemaking proposal in the future. This memorandum describes the reasons asserted by the PCAOB for revisiting the issue of mandatory firm rotation; identifies the key issues on which the Board has solicited comment in the Release; and highlights several points that interested parties may wish to consider in deciding whether to comment.

Background on Audit Firm Rotation

The concept of mandatory audit firm rotation is not new. To the contrary, it has been considered by legislators and regulators on several occasions since the 1970s.² The debate stems from the indisputable fact that an accounting firm is paid by its audit client to render an audit report on the client's financial statements, but at the same time is expected to be independent and objective. In the eyes of some observers, there is an inherent tension in this approach that can lead firms to view an audit engagement as a long-term revenue stream, to the potential detriment of investors who are looking to firms to identify and highlight problems.

The PCAOB is sensitive to such criticisms. It notes in the Release that proponents of mandatory rotation believe that "setting a limit on the continuous stream of audit fees that an auditor may receive from one client would free the auditor, to a significant degree, from the effects of management pressure and offer an opportunity for a fresh look at the company's financial reporting."³ The Board also observes that some who favor mandatory rotation believe that potential pressures on auditors to satisfy management would be replaced by a heightened sensitivity if their audit work stands to be scrutinized in the future by a competitor, thereby providing an added incentive for firms to perform high-quality audits.

At the same time, the PCAOB acknowledges that opponents of mandatory rotation believe that forcing U.S. issuers to change auditors would result in disruption and higher costs during a period of economic weakness and increased global competition. The Release also points out that, according to earlier studies, audit quality may actually suffer in the early years of a new engagement, as the new auditor climbs a steep learning curve. Opponents of mandatory rotation also argue that mandatory rotation would fail to recognize that there may be a limited number of qualified successors, since some accounting firms have unique strengths in certain industries or countries, or that some businesses might engage in "opinion shopping" when evaluating replacement auditors.⁴ In addition, the only realistic replacement choice for some companies may currently be providing important non-audit services that would be prohibited if that firm were to take over the audit.

Congress considered such competing arguments in 2002, while debating the Sarbanes-Oxley Act. At that time, Congress chose not to mandate the rotation of firms, instead requiring firms to rotate lead engagement and concurring review partners every five years.⁵ It also directed the General Accountability Office (the "GAO") to conduct a study and report on the potential effects of mandatory firm rotation. The GAO's report, published in 2003, concluded that mandatory firm rotation "may not be the most efficient way to enhance auditor independence and audit quality."⁶ The GAO also found that it would take several years for the SEC and the Board "to gain sufficient experience" with the reforms enacted under Sarbanes-Oxley to "adequately evaluate whether further enhancements or revisions, including mandatory audit firm rotation, may be needed to further protect the public interest and to restore investor confidence."⁷

Results of the PCAOB's Inspection Program

The PCAOB has now conducted inspections of registered public accounting firms for eight years. According to the Release, the Board believes that the time is ripe to revisit whether changes are needed to bolster auditor independence and, in particular, whether mandatory audit firm rotation would be an effective counterweight to what PCAOB Chairman James R. Doty recently characterized as "the fundamental conflict of the audit client paying the auditor."⁸

In the Release, the PCAOB states that Sarbanes-Oxley has made "a significant, positive difference in the quality of public company auditing."⁹ However, the Board professes to be troubled by the continued frequency and nature of audit deficiencies identified by its examiners during the inspection process. To illustrate this concern, the Release includes several excerpts from inspection reports, where PCAOB inspectors found that auditors had demonstrated a bias toward management's perspective and failed to develop an independent view; placed excessive reliance on management's responses to the audit team's inquiries; or failed to sufficiently challenge or evaluate management's assumptions and conclusions. The PCAOB recognized that such deficiencies did not necessarily result from a lack of objectivity or professional skepticism. However, it expressed concern that many audit deficiencies may reflect situations where an auditor failed to place the interests of investors ahead of those of management, possibly as a result of unconscious biases.

The Release does not assert, much less seek to establish, that mandatory firm rotation would address these concerns. Indeed, the PCAOB notes that a preliminary analysis of its inspection data "appears to show no correlation between auditor tenure and number of comments in PCAOB inspection reports."¹⁰ Given the PCAOB's characterization of its analysis as "preliminary," and the lengthy comment period provided for by the Release, it is likely that the PCAOB will continue to analyze findings from its inspection program in the coming months. This extended period provides an opportunity for interested parties to submit comments for the PCAOB to consider, while leaving open the possibility that the PCAOB may ultimately draw conclusions from inspection findings that it has not yet identified.

Significant Questions Posed in the Release

The Release affirms the PCAOB's view that it is again appropriate to "explore" the idea of mandatory audit firm rotation. Recent public statements by individual members of the PCAOB, however, suggest varying levels of enthusiasm for changing the current rules. For example, Chairman Doty has implied that, at a minimum, he believes that mandatory firm rotation warrants serious consideration,¹¹ while Board Members Daniel L. Goelzer and Jay D. Hanson have flagged concerns about the potential costs associated with a change and the need to proceed with caution.¹²

The Board seeks comments generally as to whether mandatory audit firm rotation would enhance the objectivity of audit firms and their willingness to stand firm in the face of client pressure. In addition, the PCAOB has posed a number of specific questions in two different sections of the Release. The first set of questions generally speaks to whether the Board should propose a mandatory firm rotation requirement and includes, for example, the following questions:

• Does the current "audit client-payor" model create a fundamental conflict of interest and, if so, would mandatory audit firm rotation eliminate or significantly mitigate that conflict?
• What are the advantages, disadvantages and potential unintended consequences of mandatory audit firm rotation?
• What are the costs of audit firm rotation and how can those costs be mitigated?
• To what extent have some audit committees already adopted policies that provide for the periodic rotation of the outside auditors and what are the experiences of those audit committees that have implemented such policies?
• Are there alternatives to audit firm rotation that would meaningfully enhance auditor independence, objectivity and professional skepticism?
• Rather than pursue potential proposals to require firm rotation, should the PCAOB seek to address its concerns regarding independence through its current inspection programs or, at a minimum, allow more time to evaluate the impact of recent additions to the Board's auditing standards?¹³

The second set of questions essentially assumes that the PCAOB will move forward with a proposal to require firm rotation, and seeks input as how such rules should be structured. Among the questions posed in this section of the Release are:

• What is an appropriate rotation period and, in particular, what would be the advantages and disadvantages associated with requiring rotation after periods of 10 years or greater?
• Should the PCAOB require rotation for all audits, for only larger clients that are issuers, or for some other subset of audit clients?
• What would be the significant transition and implementation issues associated with mandatory firm rotation, including (1) the impact on competition for audit engagements; (2) the impact on the market for providing non-audit services to clients; (3) the ability and capacity of firms to staff new engagements appropriately; (4) whether multinational audits would pose unique challenges; and (5) if the early years of a new engagement pose a higher audit risk, how that risk can be mitigated.

Important Points to Consider in Evaluating the Release

The Release identifies many questions that public companies, their auditors, investors and other interested parties may wish to address. As they consider the Release, the following issues may also merit consideration:

Does the PCAOB have the legal authority to require mandatory audit firm rotation without further legislation? In enacting the Sarbanes-Oxley Act, Congress decided to require audit partner, but not audit firm, rotation. The Release appears to assume that, because Congress also gave the PCAOB authority to establish professional standards in Sarbanes-Oxley, the Board can require mandatory firm rotation.

The Board's authority to impose such a requirement through new rules, however, is not entirely clear. Indeed, a contrary view would be that Congress intended to reserve unto itself the power to impose such a requirement, as evidenced by the fact that it directed the GAO to report back to Congress, and not to the SEC or PCAOB, on the issues associated with mandatory firm rotation. The PCAOB presumably believes that Section 103(a) of Sarbanes-Oxley represents a grant of broad authority to the Board to adopt professional standards for registered public accounting firms. However, the Board has noted that any new firm rotation requirement would enhance auditor independence, and Section 103(b) of Sarbanes-Oxley speaks directly to the Board's standard-setting activities relating to independence. That section provides only that "[t]he Board shall establish such rules as may be necessary or appropriate in the public interest or for the protection of investors, to implement, or as authorized under, title II of this Act." It is not clear that any audit firm rotation requirement adopted by the PCAOB would fall within this grant of authority, since Title II of the Act merely authorizes the PCAOB to add to the list of prohibited non-audit services included in Section 201 of the Act and to exempt firms and issuers from such restrictions.

To what extent should the PCAOB be expected to weigh the relative costs and benefits of mandatory audit firm rotation? In the Release, the PCAOB refers to the need to weigh the potential costs and benefits of mandatory audit firm rotation carefully, particularly in light of the current economic environment. The Release does not include, however, a detailed or meaningful cost/benefit analysis. Instead, the limited discussion of costs and benefits in the Release is constrained by the PCAOB's current lack of empirical and reliable data on a number of key issues.

For example, according to the GAO's 2003 report, large accounting firms estimated that a rotation requirement would increase audit costs in the initial year of an engagement by approximately 20 percent. The PCAOB does not yet appear to be in a position to confirm or refute that estimate. Moreover, the PCAOB is still seeking input on other potential costs associated with mandatory firm rotation, including the impact on registrants' financial reporting staffs and the impact on the costs associated with the provision of non-audit services. In addition, by its own admission, the PCAOB's preliminary analysis of its inspection data does not provide clear support for a conclusion that firm rotation would enhance auditor independence or audit quality.¹⁴ It may be difficult for the Board to approve an independence requirement that would significantly increase costs without demonstrating that it would provide a clear benefit.

In the D.C. Circuit's recent decision in Business Roundtable and Chamber of Commerce v. SEC,¹⁵ the court invalidated an SEC rule that required public companies to provide shareholders with information about shareholder-nominated candidates for boards of directors. It did so on the grounds that the SEC had failed to apprise itself of the economic consequences of the rule, as required by Section 3(f) of the Exchange Act.¹⁶ The PCAOB likely is mindful of that recent decision, even if the Board does not appear to believe that it is subject to the same requirements.¹⁷ Given that (1) the SEC would be subject to Section 3(f) if it were to propose mandatory audit firm rotation and (2) the SEC would be required to approve any rules on mandatory firm rotation adopted by the PCAOB, there is, at a minimum, a strong policy argument that the PCAOB should conduct a thorough analysis of the effects that a firm rotation requirement would have on "efficiency, competition, and capital formation" before adopting any such rule.

What are the practical difficulties and unintended consequences that could result from a mandatory firm rotation requirement? In the Release, the PCAOB acknowledges that a change to current rules might inadvertently have a negative impact on audit quality. However, the Release only identifies some of the potential issues that audit firms and other interested parties may wish to comment upon.

For example, the Release notes that prior studies have identified a greater risk of audit deficiencies in the first two years of a new audit engagement, but does not devote much attention to exploring what might occur during the last two years, before a mandatory rotation. For example, would firms' staffing and resource decisions tend to favor newer engagements that have been identified as higher risk, to the detriment of older engagements that are already staffed with seasoned engagement teams? In addition, under what circumstances could or would a firm that is currently providing prohibited non-audit services to an issuer take on a new audit engagement? Moreover, could such a firm begin planning for the audit or providing audit-related services before all prohibited non-audit services ceased, even if the firm was in the process of winding down those services? Such issues would surely need to be addressed if the Board continues to pursue the idea of mandatory firm rotation.

The Release also implies that audit firm rotation would increase competition among firms for audit engagements, and thereby benefit investors by lowering costs, but would such greater competition ultimately raise or lower the bar for audit quality? Moreover, would costs actually decline, since companies often review their audit costs regularly? Although difficult to address in the context of an open-ended release that does not include a specific rulemaking proposal, firms and other interested parties may wish to highlight what they believe to be any unintended consequences of a mandatory firm rotation requirement that might undermine the PCAOB's stated objectives, as well as any steps that could be taken to mitigate such concerns.

To what extent are recent changes to the PCAOB's auditing standards likely to address some of the Board's professed concerns with audit quality? In recent years, the PCAOB has adopted several new standards aimed at improving audit quality, including new requirements for "engagement quality reviews" by a second partner and expanded standards designed to improve the ability of auditors to detect material misstatements in financial statements.¹⁸ These standards are relatively new, however, with some being applied for the first time only in connection with audits for the current fiscal year. The Board has invited comments on whether it should wait and evaluate the impact of these initiatives before devoting significant resources to exploring whether mandatory firm rotation could be accomplished in a cost-effective manner. The PCAOB may be particularly interested in comments from audit firms and other interested parties as to whether these enhancements stand to improve audit quality and potentially alleviate the need for any firm rotation requirement. The PCAOB also would likely be interested in comments from companies that have recently switched audit firms.

By issuing the Release, the PCAOB sought to reinvigorate public debate regarding the relative merits of mandatory audit firm rotation. The range of questions posed in the Release suggests that the Board both recognizes the significance of the issues raised by mandatory firm rotation and plans to explore those issues in depth. Comments provided in response to the Board's questions, including those that provide empirical data or relevant experiences involving audit firm rotation, can be expected to play a vital role in the Board's consideration of whether mandatory audit firm rotation would meaningfully enhance auditor independence, objectivity and professional skepticism.

Footnotes

1 See Concept Release on Auditor Independence and Audit Firm Rotation; Notice of Roundtable, PCAOB Release 2011-006 (Aug. 16, 2011) (the "Release").

2 See, e.g., STAFF OF SUBCOMM. ON REPORTS, ACCOUNTING AND MANAGEMENT OF THE S. COMM. ON GOVERNMENT OPERATIONS, 95th Cong., THE ACCOUNTING ESTABLISHMENT 21 (Comm. Print 1977); AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, THE COMMISSION ON AUDITORS' RESPONSIBILITIES: REPORT, CONCLUSIONS, AND RECOMMENDATIONS 108-109 (1978); SEC, OFFICE OF THE CHIEF ACCOUNTANT, STAFF REPORT ON AUDITOR INDEPENDENCE 52-54 (1994); Accounting Reform and Investor Protection Issues Raised by Enron and Other Companies: Hearings Before the S. Comm. on Banking, Housing and Urban Affairs, 107th Cong. 15, 17, 24, 51, 52, 65, 76, 84, 220, 249, 347-348, 821, 990, 1079, and 1122 (2002).

3 Release at 2.

4 Release at 11, 13-14.

5 See Section 203 of the Sarbanes-Oxley Act (adding new Section 10A(j) to the Exchange Act); Strengthening the Commission's Requirements Regarding Auditor Independence, Securities Act Release No. 8,183 (Jan. 28, 2003) (adopting final rules implementing, among other things, Section 203 of the Sarbanes-Oxley Act).

6 U.S. GEN. ACCOUNTING OFFICE, GAO-04-216, PUBLIC ACCOUNTING FIRMS: REQUIRED STUDY ON THE POTENTIAL EFFECTS OF MANDATORY AUDIT FIRM ROTATION 8 (2003).

7 Id. at 5.

8 James R. Doty, Remarks at PCAOB Open Board Meeting (Aug. 16, 2011) ("Doty Remarks").

9 Release at 2.

10 Release at 16.

11 See Doty Remarks ("I believe that the long association of the largest audit firms with their major audit clients is an issue that must be addressed in order to fulfill the mission of the PCAOB.").

12 See Daniel L. Goelzer, Remarks at PCAOB Open Board Meeting (Aug. 16, 2011) ("I have serious doubts that mandatory rotation is a practical or cost-effective way of strengthening independence."); Jay D. Hanson, Remarks at PCAOB Open Board Meeting (Aug. 16, 2011) ("I believe that we should proceed cautiously down this path.").

13 See, e.g., Auditing Standards Related to the Auditor's Assessment of and Response to Risk and Related Amendments to PCAOB Standards, PCAOB Release No. 2010-004 (Aug. 5, 2010) (adopting eight auditing standards and related amendments designed to enhance the effectiveness of the auditor's assessment of and response to the risks of material misstatement in an audit); Auditing Standard No. 7 — Engagement Quality Review and Conforming Amendment to the Board's Interim Quality Control Standards, PCAOB Release No. 2009-004 (July 28, 2009) (adopting an engagement quality review standard).

14 Release at 16.

15 647 F.3d 1144 (D.C. Cir. 2011).

16 See Section 3(f) of the Exchange Act (stating that "[w]henever pursuant to this title the Commission is engaged in rulemaking, or in the review of a rule of a self-regulatory organization, and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation."). The decision also held that the SEC failed to comply with Section 2(c) of the Investment Company Act of 1940, which requires a similar determination regarding the economic impact of new rules.

17 Instead, the Board provides the SEC with a summary of the Board's view of the burden on competition when submitting a final rule for Commission approval. While this summary may comply with Section 19 of the Exchange Act, which governs proposed rule changes submitted by the PCAOB, the Business Roundtable decision suggests that Section 3(f) requires a more robust assessment of the economic effects of a new rule.

18 See supra note 13.

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