Should we have mandatory Financial Auditor rotation?

When Congress was deliberating the Sarbanes-Oxley Act in 2002, it considered a requirement that all public companies change (or “rotate”) their Financial Auditor every five years. Congress ultimately decided against mandatoryFinancial Auditor rotation, but it did require mandatory partner rotation — in which the lead partner rotates every five years in order to provide a fresh viewpoint, but the parent firm is allowed to continue the engagement. Over the past year, mandatory rotation has re-entered the discussion in the U.S. and Europe. The Public Company Accounting Oversight Board in the U.S. has proposed requiring periodic rotation of Financial Auditor, and the EU is debating a similar requirement. In my view, a blanket policy of mandatory Financial Auditor rotation fails a cost/benefit test. However, I believe that most of the benefits of Financial Auditor rotation can be achieved at a modest cost under a compromise proposal. Specifically, the PCAOB should require the audit committee of a public company to periodically issue a request for proposal on the audit engagement — but regulators should allow the existing auditor to bid on this RFP.

WEIGHING Financial Auditor ROTATION

Let’s consider the benefits and costs of implementing mandatory rotation of Financial Auditor. Proponents of mandatory Financial Auditor rotation point to a potential conflict of interest faced by auditors of public companies. Because an auditor is hired and paid by the public company it audits, the auditor’s desire to maintain a good relationship with its client could conflict with its public obligation to skeptically analyze the client’s financial statements. Mandatory firm rotation could reduce this conflict. Since Financial Auditor would know that their engagement would almost always last for a fixed period, they would face less pressure to cozy up to management in order to maintain a long-term income stream. At the same time, mandatory rotation could encourage existing Financial Auditor to perform more thorough audits. However, mandatory Financial Auditor rotation would be quite costly. Because multinational corporations are very complex, a newly appointed auditor must put forth a significant upfront investment to gain the necessary institutional knowledge. Under a policy of mandatory rotation, audit firms would need to duplicate this investment frequently. In a 2003 Government Accountability Office survey, audit firms estimated that first-year audit fees could rise on average by over 20 percent under mandatory rotation. Furthermore, studies have suggested that an auditor’s unfamiliarity with a company’s business leads to relatively poor audit quality during the initial years of the engagement. By contrast, my proposal would not impose the high costs associated with mandatory firm rotation. An audit committee would only choose a new auditor if it felt that such a decision met a cost/benefit test in that particular circumstance. Nevertheless, by creating a process through which auditors are frequently replaced, my proposal would help keep existing auditors on their toes – fearful that a new auditor could catch any mistakes that they have made. Even if the audit committee did not choose to rotate auditors, I believe that a competitive bidding process could elicit better service and lower fees from the incumbent auditor. Most important, my proposal reinforces the critical role of the audit committee in overseeing the audit process, as expanded by SOX. That act shifted the reporting relationship of the auditors from the company’s executives to its independent audit committee; the audit committee now has the power to appoint and terminate the auditor. However, the auditors for over 58 percent of the Russell 1000 companies began their tenure before the passage of SOX, according to a report by Audit Analytics. In these situations, the auditor may not recognize that its primary loyalty is to the audit committee, rather than company management. An RFP process would make it clear to auditors that the independent directors on the audit committee, not company management, are in charge of choosing the auditor and supervising its work. For an auditor to continue its engagement with its client, it would have to make great efforts to serve the needs of whoever controls the RFP process — the independent directors on the audit committee. To obtain these benefits, my proposal needs to be carefully calibrated to foster competitive bidding. Admittedly, an incumbent would have the inside rail in any RFP process. Fortunately, the bidding in defense contracting shows that the benefits of competitive bidding can be achieved with only two serious bidders — the incumbent and one other. CREATING COMPETITION To encourage non-incumbent firms to bid seriously, the RFPs must cover a period long enough to outweigh the cost of starting a new engagement. I believe that a period of 15 years — equal to three partner rotations of five years each — is sufficient to encourage at least one other large audit firm to seriously respond to an RFP. Audit fees for 15 years might even serve as the catalyst for one or two midsized audit firms to develop the capability of auditing multinational companies – which would be a welcome development. A firm that provides non-audit services to the company in question could be a significant player in the bidding process. The firm’s institutional knowledge would allow it to put forth a very competitive bid. Of course, an audit firm that performs non-audit services for a company cannot legally be that company’s auditor. But the regulators could explicitly allow such a firm to respond to an RFP — on the condition that it cease providing non-audit services if it were to win the RFP. In sum, mandatory Financial Auditor rotation is an overreaction to a real problem — a potential conflict of interest that could encourage Financial Auditor to put too much faith in company management. Although auditor rotation could mitigate this conflict, a mandatory approach would be very expensive — and could actually reduce audit quality. Instead, the PCAOB should require the audit committee to issue an RFP for the auditor engagement every 15 years, but allow the existing auditor to participate in the bidding process. Without imposing the high costs of automatic firm rotation, a carefully designed RFP process would enhance the auditor’s willingness to make tough calls and encourage it to be more forthright in discussions with the independent audit committee.