Audit Firm Rotation?

Last month, Jay Hanson, a PCAOB (Public Company Accounting Oversight Board) member, stated at an AICPA Conference that implementation of a mandatory audit firm rotation was unlikely.  In a written statement presented at a CPAB roundtable in Houston in October, Hanson said that one obstacle to implementing mandatory auditor rotation was the absence of research proving a clear correlation between audit quality and auditor tenure.  A second… was a cost benefit analysis.

This is a topic that has been debated and hopefully will only remain as a debate (it would if I had my way.)  I am not a proponent of audit firm rotation.  I don’t see the benefit to the user of the financial statements.  The current system is not broken.  If auditing standards are properly followed, the system works fine.

Required firm rotation would be a costly proposition.  From a time perspective, the business’ financial team would have to be taken away from their normal daily routine to interview prospective audit firms.   They would then have to educate the new audit firm about their business and operations.  From an actual dollars and cents prospective, audit fees would increase.  Typically, audit firms will not charge for their initial “ramp up” time in learning the new client’s business, instead they write off this time as an expense of doing business and investing in a long-term relationship.  Required rotation would cause firms not to write this time off and thus pass it along to the new client.

The chances that firm rotation would find the fraud is not increased by having a new firm perform the audit. In fact, if a study was done, I think you would find just the opposite.  Anytime you learn something new there is always the chance of missing something until you become familiar with it.

The financial debacles are not an audit problem at all.  If someone wants to commit a crime they will do it and the chances an audit will find it are slim.  Unless I am testing 100% of all the transactions, there is a chance I will not select the one or two fraudulent transactions. Even the best controls can be circumvented and not be detected through an audit.

What we really have is the CPA being held out as a scape goat for all the financial debacles.  We obviously need better lobbyists.


1 reply

  1. With respect, sir, I think you’re missing the point. It’s not the cost to investors or finding fraud that matters here. What matters is the cost to INVESTORS. That, in turn, depends on the independence of the audit firm. The longer that firm is on its client’s payroll, the cozier the relationship gets.

    For example, if one looks at the public companies that have gotten in trouble–Enron, WorldCom, Adelphia, Sprint, Tyco, et al.–they have one thing in common: long-term relationships with their auditors. Worse, those audit firms are also allowed–wrongly, in my view–to provide tax and consulting services to their audit clients.

    In the wake of Enron’s collapse, Paul Volcker argued–correctly, in my view–that audit firms should provide one (1) service: auditing. Period. Nothing else–no tax stuff, no consulting stuff, nada. Zero. Zilch. He asserted–rightly, in my views–that audit firms provide valuable services and should be able to make a decent living as stand-alone firms that do nothing else.

    He was–and remains–right. The problem is that auditors seldom think in terms of delivering VALUE to clients. The most important objective becomes preserving the annuity aspect of the auditor-client relationship. Well, the annuity can lead to incest, which then gets really ugly. Before it does, however, the client can use its bargaining power to hold sway in situations where, with a truly independent audit firm that didn’t give a tinker’s damn about the annuity, it could not.

    Many years ago, I had breakfast one morning with a senior partner in a local accounting firm in El Paso. With his client’s permission, we talked about that client, which had been his client for over 25 years. I asked him my standard list of 35 questions. These are basic, easy questions. He said, “I don’t know” to 34 of them.

    PCAOB is on the right track. Audit-firm rotation needs to be mandatory. I support a ten-year relationship, max. That comports with the fine print of the 22nd Amendment to our Constitution. I also believe–strongly–that audit firms must be as pure as Caesar’s wife–no tax services, no consulting services, nothing but auditing. Once the firm gets out of the CFO’s hip pocket, Management Letters will begin to be worth the paper they’re written on. In 38 years as a financial professional (I’m a CPA, too), I’ve seen such Letters from exactly one (1) firm that was worth a damn. The rest of them were, in essence, focused on the client’s hairstyle while ignoring the fact that its feet were on fire.

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