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June 17, 2011

I don’t often use the word “wow” in the title of an article in these newsletters. The last time I did was in January 2010 when the IRS Commissioner announced in a speech to the New York State Bar Association that certain corporate taxpayers will be required to disclose in their annual tax return their uncertain tax positions. Most readers will concur that that was a “wow” moment.

Well, I think we have another one. This time it was a speech from James R. Doty, Chairman of the Public Company Accounting Oversight Board (PCAOB), delivered on June 2, during the 30th Annual SEC and Financial Reporting Institute Conference. In his speech, Chairman Doty sounded more than a little  frustrated with audit firms.

The Problems

Chairman Doty focused on three problems:

  1. “Despite existing independence rules, auditors still too often approach the audit with an inappropriate mindset.”
  2. “We hear that auditors are often less than forthcoming with audit committees that try to elicit information about [PCAOB] inspection results.”
  3. “Investors are left with the impression that the signing firm performed all the procedures described in the audit report. That is generally not the case.”

Doty provided examples of infractions that, in his words, happen “too often.” He said that PCAOB staff have identified “hundreds of audit failures,” that the PCAOB sees a “disturbing lack of skepticism” and that often “the examples are galling.” Doty isn’t asking for heads, yet, but rather is providing all of us with a warning that things have to change.

The Issues

Independence

“Despite existing independence rules, auditors still too often approach the audit with an inappropriate mindset.”

Chairman Doty cited instances in which audit firms bent rules, ignored evidence or set out to change standards to please the audit client — bringing them to factual conclusions that the PCAOB deemed inaccurate or plainly wrong. He suggested that the root cause of these audit failures is a lack of skepticism on the part of the audit team. Instead, the audit team often has an “inappropriate mindset,” stemming from a belief that they are paid to increase revenues from the client rather than conduct a quality audit. Doty cited examples of partner evaluations to support his contention that audit partners are either unaware of or “simply unconcerned” about rules that require their independence.

In light of what he called a disturbing lack of skepticism and the fundamental importance of auditor independence, Doty dusted off an old proposal to require auditor rotation. Clearly, the PCAOB has been thinking about this possibility for some time. Even though Doty proclaimed that the PCAOB has not “predetermined that rotation should be implemented,” he nonetheless cited the substantive work conducted by the PCAOB over the past eight years, involving thousands of inspections where “hundreds” of audit failures were uncovered. Citing this body of work, Doty concluded that it is “incumbent on the PCAOB to take up the debate about firm tenure.”

Telling the Audit Committee the Truth

“We hear that auditors are often less than forthcoming with audit committees that try to elicit information about [PCAOB] inspection results.”

This part of the Chairman’s speech detailed instances in which the PCAOB believes that auditors were less than candid with audit committees. Doty said that too often PCAOB concerns are explained away as a mere difference of professional opinion or a lack of documentation to support the appropriateness of an item in the financial statements. In fact, Doty said that in the opinion of his staff, the problem is that the firm has “failed to perform an audit that provides what the audit committee contracted for and what investors deserve — reasonable assurance about whether the financial statements are free of material misstatement.” Doty stopped short of calling some audit firms liars. Instead, he said their explanations to audit committees are “at odds with reality.” Doty didn’t disclose what specific proposals are being studied to address this situation. He cited the law requiring that the details and results of an inspection not be made public. He merely said that we will hear more on this subject in the near future. Perhaps he will suggest that a change in the law is necessary, or that audit committees need to include a clause in their engagement letters requiring the audit firm to disclose the specifics of any affected client’s inspection. We will have to wait and see.

Audit Transparency

“Investors are left with the impression that the signing firm performed all the procedures described in the audit report. That is generally not the case.”

Here, Chairman Doty reminded us that the PCAOB issued a concept paper two years ago that would require the audit partner to sign the audit opinion of his/her clients. The view was that identifying the partner by name and requiring him/her to personally sign the audit opinion would underscore that the PCAOB considers the partner — not just his/her firm — responsible for the accuracy and appropriateness of the audit opinion. Doty said that the PCAOB has received many thoughtful comments and that now is the time to consider them all and develop a compromise.

Doty also said he expects to address a concern about multinational companies. He explained that often, non-U.S. affiliates of large audit firms conduct portions of these audits abroad. Users of the financial reports need to understand that the signing audit firm has not necessarily performed all the procedures described in the audit report, and that the PCAOB might not have conducted inspections of these audit affiliates.

The Solutions

It remains to be seen whether the solution is auditor rotation, a change in the law governing the confidentiality of PCAOB inspections, or a requirement for audit partners to sign their names to audit reports. It is hard to imagine the big audit firms letting this process take on a life of its own. The PCAOB is addressing three issues, not one. It must expect that this will make it difficult for its opponents to sweep them all away.

The issues — independence, audit committee disclosures and audit transparency — seem to be listed in order of importance. In his speech, Doty devoted twice as many words to the issue of independence as he did to audit committee disclosures, which in turn was twice as long as audit transparency. Also, Doty’s recommendations became more general as the speech progressed. And the issues seem to be listed (whether by design or not) in the order that the PCAOB expects the greatest push-back. Clearly, audit firms and clients will weigh in most heavily against auditor rotation. Audit committees and client management will probably favor more disclosure, and they probably couldn’t care less if the audit partner has to sign his or her John Hancock on the audit report.

We too have noticed recently that audit firms have been agreeing to perform certain tax services that they would have declined just a couple of years ago due to audit independence. We also know that one national audit firm is on a recruiting binge for tax partners. Part of the lure dangled in front of these candidates is that this firm finds itself with a substantially smaller portion of tax work devoted to audit clients, as compared with their peers. They view this as an opportunity to grow their practice substantially.

We have also seen numerous instances where audit firms boldly discount tax work for their audit clients as a means of keeping out other accounting firms, law firms and others. Or they raise the prospect of their client paying twice for the same work: first, when the client secures the work from a competitor of the audit firm, and second, when the audit firm says it has to audit the work closely during the ASC 740 portion of its audit engagement. 

We are also concerned about the impact of auditor rotation. It seems like a one-size-fits-all solution that may not be warranted for all publicly traded companies. Specifically, we have tracked the degree to which companies retain their audit firm for tax work. This information is readily available from each company’s annual proxy statement. Many firms have actively worked to reduce the tax services they receive from their audit firm. In 2009, for example, 146 companies in the Fortune 500 received little or no tax work from their audit firm. In 2002, the earliest year for which this data exists, only 84 companies could make such a claim. Also, between 2002 and 2009, tax fees as a percent of audit fees declined from 40 percent to 11 percent.

To mandate auditor rotation on all public companies — and assuming that rotation amounts to a big headache for corporate America — seems to penalize the good along with the bad. Perhaps rotation need not be mandated for all public companies, just for those where the PCAOB finds the kind of problems noted in the Chairman’s speech. Or it could be mandated if the public company fails to reduce its non-audit spend with the audit firm to a specified minimal level.

Alvarez & Marsal Taxand Says:

If Chairman Doty is looking for a legacy, auditor rotation should do it, and we expect PCAOB staff to push hard for this approach. Transition and phase-in will be the details they will focus on. The big audit firms will resist mightily. Academic studies will emerge indicating that the cost of audits will increase substantially. Other studies will foretell of many potential restatements, as replacement auditors will become conservative and demand that balance sheets be scrubbed clean of conveniently ignored problems of the past.

We make no prediction about the outcome, other than to say that the speech that unveiled the supercharged rotation concept, in spite of all the superlatives, is couched in terms of debate and compromise. So our guess is that the PCAOB is looking for effective alternatives. Perhaps mandatory, but selective, rotation will work. However this works out, I believe we are in for another “wow” summer.

For More Information on this Topic, Contact:

Robert Filip
Managing Director, Seattle
206-664-8910
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Gregory Gunderson
Managing Director, Dallas
214-438-8410
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Paul Helderman
Managing Director, New York
212-763-9760
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Charles Henderson
Managing Director, Atlanta
404-720-5226
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Sean Menendez
Managing Director, Miami
305-704-6688
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