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PCAOB Floats Idea of Mandatory Audit Firm Rotation

James R. Doty, Chairman of the Public Company Accounting Oversight Board, recently addressed the SEC and Financial Reporting Institute 30th Annual Conference in Pasadena, California, speaking at length about the cultural challenges impeding auditor skepticism and independence. In particular, Doty expressed concern about the ways in which the current business of public accounting and maintaining client relationships may negatively affect audit quality:

One example of those counterweights may be found in the SEC rule that says an accountant will not be considered to have the necessary independence from its audit client if an audit partner earns or receives compensation based on selling non-audit services to the audit client.[citation omitted] The purpose of this rule is to keep auditors singularly focused on the quality of their audits and not on nurturing a relationship that will make management more receptive to cross-selling efforts.

 . . .

Enhancing the relevance of the auditor's report will do no good if we don't at the same time provide investors a sound basis for confidence in the audit. An audit has value to the public only to the extent that it is performed by a third party who is viewed as having no financial stake in the outcome.

Though not a new idea, Doty brought forth one potential solution the PCAOB may consider mandatory rotation of audit firms:

The PCAOB's efforts to address [auditor independence] problems through inspections and enforcement are ongoing. But considering the disturbing lack of skepticism we continue to see, and because of the fundamental importance of independence to the performance of quality audit work, the Board is prepared to consider all possible methods of addressing the problem of audit quality - including whether mandatory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client.

Based on the results of a widespread inspection effort, the PCAOB plans to issue a concept release exploring mandatory rotation of audit firms.

The PCAOB has now conducted annual inspections of the largest audit firms for eight years. Our inspectors have reviewed more than 2,800 engagements of such firms and discovered and analyzed hundreds of cases involving what they determined to be audit failures. We have conducted more than 1,500 inspections of smaller domestic firms and of non-U.S. firms. These include multiple inspections of hundreds of those firms. And our inspectors have identified hundreds more cases involving what they determined to be audit failures.

Based on this work, I believe it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against. I don't have a predetermined idea as to whether the PCAOB ultimately should adopt term limits. My only predilection is that the PCAOB deepen the analysis of how we can better insulate auditors from client pressure and shift their mindset to protecting the investing public.

As such, the Board plans to issue another concept release to explore whether there are other approaches we could take that could more systematically insulate auditors from the forces that pull them away from the necessary mindset.

We expect to issue this concept release around the same time that we issue the concept release on the auditor's reporting model, in order that they can be considered together in a holistic manner.

No doubt the concept release will generate much comment and controversy from and amongst the major audit firms, as well as public companies of all kinds.  

The full text of James Doty's June 2, 2011 address is available at:  http://pcaobus.org/News/Speech/Pages/06022011_DotyKeynoteAddress.aspx