US audit firm rotation alternatives emerge in hearings

Alternative solutions to mandatory audit firm rotation for US public companies emerged Thursday in the second of two days of hearings in Washington on enhancing the independence, objectivity and professional scepticism of external auditors.

Harvard Business School senior lecturer Robert Pozen proposed to the US Public Company Accounting Oversight Board what he called a “modified version of rotation” where audit committees would be required to periodically send requests for proposals to audit firms.

Under Pozen’s plan, the existing auditor would be allowed to bid for the engagement, and could be chosen if the audit committee determined that it remains the best option.

“I would assume that over 80% of the time, the existing auditor would be chosen,” said Pozen, a senior fellow at the Brookings Institution who several years ago led a US Securities and Exchange Commission (SEC) advisory committee on improvements to financial reporting. “And that’s OK. . .because then they would have heightened sensitivity to who they’re serving, which is the independent audit committee.”

Jack Ciesielski, president of Maryland-based investment adviser R.G. Associates, proposed a new model where financial statement issuers would purchase financial statement insurance that covers investors against losses resulting from financial reporting misrepresentations.

“You can think of it as a guarantee by the insurance company that the financial statements are fit for use by investors,” Ciesielski said.

The PCAOB on Aug. 16 issued a concept release asking for comment on whether audit firm rotation would improve the independence, objectivity and professional scepticism involved in audits.

Firm rotation also has been an issue overseas, as the European Commission in November proposed limiting to six years, with some exceptions, the period during which an external audit firm can perform audits for public companies.

On Wednesday, panellists’ proposals included a “comply or explain” model similar to that used in the UK, and audit firm rotation for only the largest public companies.

On Thursday, audit committee members speaking at the hearing opposed audit rotation and said their oversight has improved significantly since the US Congress passed the Sarbanes-Oxley Act of 2002, which created the PCAOB to regulate public-company auditors and mandated a number of reforms to enhance corporate responsibility and financial disclosures.

Former SEC Chief Accountant Donald Nicolaisen, who chairs three audit committees, called the mandatory rotation solution a “blunt instrument.”

“It essentially throws out the good to deal with what are perceived to be bad situations, situations where auditors are not independent, and may well result in unintended consequences ,” Nicolaisen said.

During an earlier session, PCAOB members challenged other audit committee members who oppose mandatory firm rotation.

“I do get the impression from this panel that virtually the status quo is fine,” said PCAOB member Steve Harris. “And the leaders in the profession and investors would all tell us, the status quo is not an option. There ought to be change.”

Richard Roedel, Lorillard Inc.’s audit committee chairman, said there is room for improvement even though a sound structure is in place to deal with the issues being debated in the hearings.

Catherine Lego, who chairs two audit committees, said the PCAOB and National Association of Corporate Directors could come up with best practices that audit committee members, particularly new ones, could follow in order to best serve the interests of shareholders.

“I would appreciate discussion with the PCAOB prior to the review,” Lego said. “There are things I would love another set of eyes to look at, specifically the judgement items. . . .I don’t think every audit committee works at the level it could work. . . .There are a lot of people who don’t know what to do. They are poorly trained for their role.”

Ciesielski, who proposed the financial statement insurance model, does not favour mandatory rotation, but two other investor representatives who spoke with him did. Mia Martinez, speaking on behalf of the Black Economic Council, Latino Business Chamber of Greater Los Angeles and National Asian American Coalition, called for mandatory rotation every six years, particularly for Fortune 1000 companies.

Audit committee members were joined by business leaders in opposing mandatory rotation. The discussion became heated when PCAOB Chairman James Doty confronted David Hirschmann of the US Chamber of Commerce and Center for Capital Markets Competitiveness over a Center comment letter that said the PCAOB was overstepping its authority and considering the mandatory rotation solution without looking at the full range of possible options.

“If the focus of the board is to find which form of mandatory audit rotation is the best form, then we urge you to take a step back from that,” Hirschmann replied. “We urge you to abandon that. If the focus is instead to really engage in a constructive discussion about how to strengthen auditor quality, strengthen independence, then count us as full-in partners. But let’s define the problem we’re trying to solve.”

Doty replied that the concept release was designed to elicit ideas of the kind that panellists provided during the hearings.

—Ken Tysiac (ktysiac@aicpa.org) is a CGMA Magazine senior editor.