July 2013

In the past year, the issue of mandatory auditor rotation has been an active area of debate, both domestically and abroad.  The idea of mandatory auditor rotation has been around for years, but has consistently (and successfully) been opposed by the public accounting profession and its large clients.  While the European Union still shows signs of favoring such a policy, the idea has been significantly watered down in the United Kingdom and outright rejected in the United States.

Last fall, a European Commission proposal included mandatory auditor rotation after six years. A four-year period would be required before a firm could audit the same client again. Companies that opt for a voluntary joint audit would be allowed a nine-year period.  Just recently, a U.K. Commission stopped short of embracing the EU proposal, while still taking steps to improve competition.  British regulators proposed requiring large companies to put their auditing engagements out to bid every five years.  The U.K. Commission also would prohibit “big-four-only” clauses in loan documentation.

The proposed policy has getting far different treatment in the U.S.  Back in 2011, the Public Accounting and Oversight Board (“PCAOB” – the U.S. regulator of auditors of publicly-traded companies) issued a Concept Release on Auditor Independence and Audit Firm Rotation, seeking public comment on:

“ways that auditor independence, objectivity and professional skepticism could be enhanced. One possible approach on which the Board is seeking comment is mandatory audit firm rotation.”

The PCAOB provided the following rationale for mandatory auditor rotation:

“Proponents of such a requirement 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. …

[The PCAOB] remains concerned about both the frequency and the type of audit deficiencies it continues to find.…a rotation requirement would aim directly at the basic conflict that, while inherent in the Securities Act of 1933, too often proves difficult for auditors to overcome. By ending a firm’s ability to turn each new engagement into a long-term income stream, mandatory firm rotation could fundamentally change the firm’s relationship with its audit client and might, as a result, significantly enhance the auditor’s ability to serve as an independent gatekeeper.”

Audit firms are clearly motivated to keep clients under the current practice.  It is difficult to replace large clients if they leave after an auditor has taken a hard line on the propriety of financial reporting.  With the extremely low turnover of audit relationships, no wonder the public accounting firms are slow to upset their relationship with management.

This is especially true since many of the audit partners serving the largest companies have only one client.  If that one client is lost, the individual audit partner faces likely employment termination because there is little chance of obtaining sufficient new work to replace the lost client.  This places intense pressure on an individual audit partner whose entire livelihood depends on serving his only client.  While mandatory auditor rotation will not entirely change the pressure any professional has from a large client, the existence of other rotating relationships at least provides the possibility that an individual auditor who does the right thing will have a better chance to continue viable employment.

In response to this proposal, the Big Four came out fighting, spending record amounts.  According to a Reuters analysis of congressional disclosure reports, the four accounting powerhouses spent a combined $9.4 million last year on in-house and outside lobbyists, broken down as follows:

  • Deloitte $3.0 million
  • PricewaterhouseCoopers $2.7 million
  • Ernst & Young $2.2 million
  • KPMG $1.5 million

These firms and other critics contend that mandatory audit rotation increases costs substantially with no meaningful increase in audit quality.  There is no doubt that increased learning curve and other factors could lead to increased costs.  But for the audit firms cited above, self-interest is certainly a factor and a strong enough one to incentivize the associated spending.  Such efforts brought them domestic success.  Earlier this month, the House of Representatives approved a bill which outright prohibited the PCAOB from requiring mandatory audit firm rotation for public companies. This action was consistent with the recommendation of the AICPA, who subsequently issued a statement:

“In the absence of evidence that mandatory audit firm rotation would enhance audit quality, the House has sent regulators in the United States and Europe a clear message that the time has come to end the debate over rotation,” Melancon said. “In Europe, there is a misimpression that the continued consideration of the PCAOB’s concept release means that the U.S. is headed toward adoption of a mandatory firm rotation requirement. Today’s House vote will go a long way toward alleviating confusion and uncertainty for policy makers and stakeholders on both sides of the Atlantic.”

Fulcrum Inquiry is a licensed CPA firm that performs forensic accounting and fraud examinations.