Auditor independence: mandatory auditor rotation and the increased burden for audit committees

May 2013 | SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD

Financier Worldwide Magazine

The role of independent committees of a board of directors, such as the audit committee, the compensation committee, the nominating and governance committee, and perhaps a risk management committee, is becoming increasingly important as significant responsibilities shift to the board of directors. As part of this evolution, the audit committee, which was the first committee whose independence was mandated, continues to be the committee whose role is evolving most rapidly and on which requirements are imposed. In addition to regulation and oversight by the SEC, public company financial statements, and thus the audit committee, are affected by rulemaking of the Public Company Accounting Oversight Board (PCAOB). The PCAOB’s recent proposals and rulemaking with regard to auditor independence suggest increasing responsibility for the audit committee. Along with this increasing responsibility, increasing exposure will result, and the need for independent counsel for the audit committee will intensify.

Background

Since its creation, the PCAOB has conducted hundreds of inspections of registered public accounting firms, observing, in many instances, a lack of the independence, objectivity and professional scepticism required of an independent auditor. As a result of these findings, on 16 August 2011, the PCAOB issued a ‘Concept Release’ to solicit public comment on methods to: (i) enhance auditor independence; (ii) increase objectivity and professional scepticism; and (iii) generally increase or promote audit quality. One of the methods proposed in the Concept Release is mandatory auditor rotation.

To date, the Sarbanes-Oxley Act of 2002 has provided the bulk of the guidance of auditor independence. In drafting the Sarbanes-Oxley Act of 2002, Congress considered, but stopped short of implementing, mandatory auditor rotation. Most notably, Sarbanes-Oxley established the audit committee, rather than management, as the party responsible for hiring the independent auditor and overseeing the engagement. Sarbanes-Oxley also requires mandatory rotation of the lead audit partner by prohibiting the same partner from performing audit services for an issuer for more than five consecutive fiscal years. Based on the language in the Concept Release, it appears that the PCAOB believes Sarbanes-Oxley did not complete the task of assuring auditor independence.

The PCAOB is not alone. Auditor independence has become an international concern. The European Commission has proposed legislation mandating audit firm rotation every six years, which is currently before the European Parliament and Counsel of Member States, with some action expected in the near future. The Canadian Public Accountability Board is currently reviewing a requirement for a ‘mandatory comprehensive review’ of independent auditors to be performed by independent audit committees and the UK has proposed an auditor review process and a mandatory ‘retender’ on a 10 year cycle.

Despite the proposals moving forward elsewhere, the PCAOB’s proposals have been the focus of significant debate. In response to the Concept Release, the PCAOB has received nearly 700 comment letters, many focused on the proposal of mandatory auditor rotation, and has conducted roundtable discussions in Washington, DC, San Francisco and Houston for the purpose of gaining additional insight from both panel members and participants. Opinions have spanned the spectrum. During the third roundtable meeting in October 2012, an academic panel introduced research suggesting that mandatory auditor rotation would enhance independence. One panel member, an associate professor of accounting at the University of Kansas, provided information indicating that long-term relationships between auditors and public companies increased the likelihood the company would receive a clean audit opinion and that auditors with longstanding relationships are less likely to raise issues the longer their tenure continues. Information was also presented reflecting that in countries where mandatory auditor rotation is in effect, earnings management is less evident.

On the other hand, the President and CEO of the National Association of Corporate Directors expressed the views of his organisation in support of an alternative to mandatory auditor rotation, suggesting that the audit committee should “own and execute” a risk process for oversight of the auditors and should communicate not only the process but also the outcome to shareholders. Along these lines, Larry Rittenberg, an Emeritus Professor of Accounting at the University of Wisconsin and former chairman of the Committee of Sponsoring Organizations (COSO), suggested that the performance of external auditors could be improved by requiring the audit committee to give more focus to accounting issues and to communicate with independent auditors, as well as requiring the auditor to rotate more frequently its non-partner staff.

Members of the five-member PCAOB board appear to be divided in their support for the proposals, as well. While Chairman Doty has expressed support for mandatory auditor rotation, other PCAOB board members have shared concerns. At the American Institute of Certified Public Accountants (AICPA) Regulatory Conference, PCAOB board member Jay Hanson indicated that he does not believe the board has sufficient evidence to support mandatory auditor rotation, noting that the JOBS Act of 2012 requires that any PCAOB standard must be implemented with evidence that reflects the benefits of the standard justify the cost of the new standard. The cost benefit analysis would require a study that analysed the link between tenure and audit independence, audit failures and deficiencies which, according to Hanson, has not been presented. Somewhat less specific, PCAOB board member Jeanette Franzel informed the AICPA that, in her view, the PCAOB is in the process of rethinking the Concept Release and will be seeking other methods to improve independence and the quality of audits.

Given the opposition to mandatory auditor rotation, both by the public and members of the PCAOB board, it has been suggested that the PCAOB may abandon the mandatory rotation requirement and consider instead requiring audit committees (fully independent of and operating without influence of management) to periodically, and perhaps annually, prepare and furnish a formal evaluation of the functions of its existing auditor, giving effect to the quality of their audit services, the degree of scepticism and objectivity shown by the auditor, the nature of the non-audit services they provide, the influence those services could have on independence, and in general, the relationship with and involvement of management in the audit process. This evaluation will be used to justify retention or replacement of the auditor.

Given the amount of time and effort the PCAOB has exerted on the question of auditor independence, and the PCAOB’s comments regarding its experience in connection with 10 years of inspections of registered public accounting firms, it appears likely that the PCAOB will propose new and additional requirements within the next six to nine months.

What to expect

Audit committees should expect significant additional burdens and responsibilities regarding auditor independence. Although it is possible that the PCAOB will impose mandatory auditor rotation for public issuers, it seems more likely the PCAOB will adopt the Canadian approach or portions of the UK approach (for FTSE 350 companies) and task the audit committee with detailed reporting obligations on, and formal evaluations of, the independent auditor. Such reports will likely be made part of a public company’s periodic reporting requirements, and require the audit committee to provide the rationale and support for its decision either to retain or to replace the issuer’s independent auditor.

Such a comprehensive review by the audit committee, coupled with preparing and publishing a formal evaluation, will, at a minimum, require the audit committee to probe the degree of scepticism and objectivity reflected by the auditor (independent from any management influence), the relationship between auditors or members of the audit firm and management (or board of directors), the nature of non-audit services provided by the audit firm, and the influence those services could have on auditor independence. Reviews may also be required to address any perceived issues. For example, a significant complaint that has risen to the PCAOB level, and also is being addressed by the Financial Accounting Standards Board (FASB), relates to valuations and estimates of management used in connection with financial statement preparation, and the degree and nature of the auditor’s examination and analysis of such vital audit functions. By installing a comprehensive review requirement, the audit committee would be tasked with ensuring that the auditor thoroughly examined such valuations and estimates.

What to do

To comply with the anticipated requirements, audit committees should consider engaging independent counsel to assist and guide the audit committee, without influence from management or others. Generally, audit committees operate without a staff independent of management, but the nature of these reports would prohibit the audit committee from looking to management for assistance with the evaluation and reporting process. Engaging independent counsel to serve as the audit committee’s staff for this purpose would allow the audit committee to fulfil its responsibilities, but it would also provide the audit committee with assurances that the review and report adhere to prevailing best practices. For example, the PCAOB’s periodic inspection reports reflect increasing deficiencies on the part of audit firms. By monitoring the inspection reports, independent counsel could assist the audit committee with establishing an appropriate scope for the ongoing review and evaluation process, as well how the matters in recent inspection reports should be addressed in the published report.

While the impending regulations are likely to task the audit committee with reporting obligations, as the methods to ensure auditor independence continue to be debated, it is likely that the audit committee’s responsibilities will be more onerous in the future. Some have suggested that audit committees will be tasked with ongoing responsibilities throughout the audit process, including the engagement of the independent audit firm, designing the scope of the audit, planning the audit process and periodically meeting with auditors and evaluating the audit, and quarterly reviews, on a continuing basis. Independent counsel to the audit committee could serve to fulfil many of these obligations.

Conclusion

As the role of the audit committee evolves, audit committee members should engage independent counsel to ensure the committee meets both existing and new requirements and that members meet their fiduciary obligations. The role of independent counsel to the audit committee should be tailored to fit the individual company. For example, at a minimum, independent counsel can be engaged to periodically educate the committee on new PCAOB and FASB standards. Alternatively, independent counsel can serve as the audit committee’s staff, not only educating the committee on the standards, but ensuring compliance with those standards by outlining plans for approval, assisting with implementation and interfacing with the internal auditors. There are many other options in between. While the scope of an engagement will vary to meet a committee’s needs, as the responsibilities and thus exposure of the audit committee continues to grow, having independent counsel will become increasingly valuable and, in many instances, necessary.

Bill Floyd is senior counsel and Amanda Leech is an associate at McKenna Long & Aldridge LLP. Mr Floyd can be contacted on +1 (404) 527 4010 or by email: wlf@mckennalong.com. Ms Leech can be contacted on +1 (404) 527 4163 or by email: aleech@mckennalong.com.

Bill Floyd and Amanda Leech

McKenna Long & Aldridge LLP