With the amount of reliance that investors place upon the audited financial statements of publicly held companies, it is no surprise that regulators are constantly looking for ways to enhance the quality of the audit through auditor independence, objectivity and professional skepticism. Since the Sarbanes-Oxley Act was passed in 2002, the Public Company Accounting Oversight Board (PCAOB) has been responsible for overseeing, regulating, inspecting and disciplining accounting firms in their roles as auditors of public companies. In August of 2011, the PCAOB issued Concept Release No. 2011-006 to solicit public comment on ways to strengthen auditor independence, objectivity and professional skepticism. One possible approach that the PCAOB was seeking comments on in its Concept Release is mandatory audit firm rotation.
The idea of mandatory audit firm rotation is similar to that of the current requirement of the Securities and Exchange Commission (SEC) whereby audit partners periodically rotate for a "fresh look" at a company's financial statements. Such rotation should provide new insight into financial reporting areas that may pose a risk of material misstatement. However, mandatory audit firm rotation would require rotation of a company's audit firm as opposed to the current SEC rotation rules which require the lead and engagement quality review partners to rotate after five years and certain other partners associated with the audit to rotate after seven years, while the audit firm and the other members of the engagement team remain unchanged.
Mandatory audit firm rotation has gained some legislative support recently. In April of 2013, the European Parliament's Legal Affairs Committee approved a draft law that would require public entities to rotate audit firms every 14 years, with a potential extension to 25 years if certain safeguards are in place. However, this law has significant procedural hurdles to clear before becoming effective.
Advocates of mandatory audit firm rotation believe that setting a limit on the continuous stream of audit fees that an audit firm can receive from a single public company would significantly reduce the effects of management pressure on the audit firm and the partners involved, which would enhance the overall independence and objectivity of the audit.
Mandatory audit firm rotation is not a new concept. It has been studied in the past, most notably by the Government Accountability Office (GAO) in its November 2003 study Public Accounting Firms: Required Study on the Potential Effects of Mandatory Audit Firm Rotation, required by Congress as part of the Sarbanes-Oxley Act of 2002. Previous studies, including that of the GAO, concluded that the majority of public company executives and audit committees as well as the auditors of those public companies believe that the costs of a mandatory audit firm rotation far outweigh the advantages.
Critics of mandatory audit firm rotation believe that the costs of public company audits would increase significantly and that auditors would lose the institutional knowledge of a Company's business, processes, systems and risks that is developed over a period of time. Another issue is that not all audit firms have the same level of experience or expertise within the given industry in which a public company operates. Additionally, critics believe that audit firms would be more likely to rotate experienced and skilled staff off of the audit as the end of their tenure as auditors approached and move those staff to other engagements to retain or attract clients. These situations would likely result in an increased risk of audit failure and the issuance of materially misstated financial statements.
In response to the PCAOB's Concept Release, Representatives Robert Hurt from Virginia and Gregory Meeks from N.Y. introduced the Audit Integrity and Job Protection Act on April 15, 2013, The bill was passed July 9, 2013 by a vote of 321-62 by the Financial Services Committee of the House of Representatives and amends the Sarbanes-Oxley Act of 2002 to prohibit the PCAOB from requiring public companies to use specific auditors or requiring the use of different auditors on a rotating basis. Proponents of the bill argue that selecting a company's external auditor should be a decision made by a public company's board of directors and ratified by its shareholders, not a decision made by a regulator. The bill now goes to the Senate for a vote; if approved, it would then require approval by the president.
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