Auditor Rotation Proposal Just More Spin

The U.S. audit regulator, the PCAOB, met yesterday in an open meeting to approve a concept release for study, again, of the potential advantages and disadvantages of mandatory audit firm rotation to improve audit integrity, auditor independence, and the quality of audit opinions.

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  1. Throughout the period of review, examination, and introspection on the causes and solutions to the latest financial crisis, the auditors have stayed well above the fray. They've never been called to testify before Congress like they were in the U.K. at the House of Lords

    They've only recently started to show up as defendants in subprime, credit crisis, and financial crisis related lawsuits, although some key cases were settled early in the process. They escaped any mention in the Dodd-Frank reform bill. And they've continued to benefit from the chaos, and extra work by grabbing lucrative contracts with government and staying on board as auditors of some of the most troubled companies such as AIG, Bank of America, Citgroup, and GM.

    Compared to the ratings agencies, the auditors have gotten away with murder.

    The PCAOB, the auditing regulator that emerged from the last scandal, Enron, and its legislation, Sarbanes-Oxley, is starting to rattle their cage however.

    The regulator is now looking at the inspection record the auditors have accumulated since Sarbanes-Oxley and it's littered with audit failure.

    In congressional testimony earlier this year, the Board's Chairman explained that:

    "Although the PCAOB's 2010 inspection reporting cycle is not yet complete, so far PCAOB inspectors have continued to identify significant deficiencies related to the valuation of complex financial instruments, inappropriate use of substantive analytical procedures, reliance on entity level controls without adequate evaluation of whether those processes actually function as effective controls, and several other issues. PCAOB inspectors have also identified more issues than in prior years. In any event, the Board is troubled by the volume of significant deficiencies, especially in areas identified in prior inspections. The PCAOB is working on several initiatives to drive improvements in audit quality."

  2. The PCAOB defines "audit failure" as, "a failure to obtain reasonable assurance about whether the financial statements are free of material misstatement. That does not mean that the financial statements are, in fact, materially misstated. Rather, it means that the inspection staff has determined that, because of an identified error or omission, the firm failed to fulfill its fundamental responsibility in the audit -- to obtain reasonable assurance about whether the financial statements are free of material misstatement. 

    In other words, investors were relying on an opinion on the financial statements that, when issued, was not supported by sufficient appropriate evidence."


    By that definition, they've documented a whole lot of failure over the last several years.


    The PCAOB thinks it's time to look at audit firm rotation  - audit partner rotation was implemented under Sarbanes-Oxley in 2002 as a compromise - as a way to improve auditor independence. Some of the problems the regulator sees with audits are a lack of auditor professional skepticism and an inappropriate focus on building and maintaining the client relationship with the company management rather than on performing a public duty for shareholders.


    So the PCAOB has asked for public comment and plans to study the issue further.

  3. I'm against the auditor rotation proposal but not for the same reasons the audit firms are. They cite cost, disruption to clients, and even higher vulnerability to fraud.


    I'm against an auditor rotation proposal because it's just more of the same old, same old. 

  4. And audit firm rotation does not resolve the fundamental, "inherent conflict" that was mentioned so often during the PCAOB's open meeting:  

    The auditors are paid directly by the companies they pass judgment on.

    That's the same conflict ratings agencies have. The ratings agencies were vilified as crisis culprits for allowing worthless mortgage securities to spread throughout the banking system. They have also been stripped recently of their exclusive, monopolistic government franchise to produce required ratings.

    That's not to say that long, close auditor-company relationships don't obviously result in close, deep personal relationships, potential bias, loss of independence and objectivity, and even possibly collusion and complicity in achieving common goals - to keep the companies alive.

    Just look at some of the banks and bailout recipients from the crisis and their auditor relationships:

    Citigroup and KPMG - 41+ years
    AIG and PwC - 35+ years including being sued by shareholders multiple times and settling
    Lehman and Ernst & Young - As far back as 1975 with Shearson Lehman American Express
    GM and Deloitte - 90+ years including being sued by shareholders and a bankruptcy

  5. Some companies go through voluntary auditor rotation and periodic re-tendering. Other than the government agencies and pension plans that mandate this to prevent corruption and cronyism, I'm skeptical of the "good governance" excuse. In this economic environment, companies have the upper hand on vendors, including the "independent" audit and squeeze them to reduce fees or threaten to replace them.


    We should view the wholesale auditor changes that occurred during the first few years after Sarbanes-Oxley was passed in 2002 with a grain of salt. After the non-voluntary changes for Arthur Andersen clients, most of the rest were fraught with conflict and controversy. 

  6. The auditor change numbers PCAOB Chairman Doty quoted during the open meeting yesterday were post-Sarbanes fallout. Auditors were afraid of inspections and new liability and started reversing their position on long standing issues. They were afraid to answer for them during inspections. The Navistar debacle is an example of that. 


    So is the firing of Hank Greenberg from AIG. 

    Many auditors were fired or forced to resign over rising Sarbanes-Oxley fees and some companies switched from Big 4 to next tier, some multiple times, chasing lower fees and an auditor that would go easier on them. 

    The Koss scandal is an example of a closely held "public" company trying to get away from Sarbanes-Oxley requirements and the fees. They switched from PwC who insisted on doing Sarbanes-Oxley work to Grant Thornton who did not (They are so small they were subject to the ongoing SOx exemption debate.) Koss got substantially lower fees. Their Director of Accounting stole $35+ million based on non-existent internal controls.

    Given the complacency of the PCAOB until now to push back hard on auditors for repeat deficiencies, I'd conclude the auditors had nothing to worry about.

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