BY ROBERT C. POZEN
not mandatory rotation
When Congress Was deliberating
the sarbanes-oxley act in 2002, it considered a requirement that all public companies
change (or “rotate”) their audit firm every five
years. Congress ultimately decided against
mandatory firm 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 audit firms, and the eU is
debating a similar requirement.
in my view, a blanket policy of mandatory
firm rotation fails a cost/benefit test. however, i believe that most of the benefits of 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.
let’s consider the benefits and costs of implementing mandatory rotation of audit firms.
Proponents of mandatory 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 auditors 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
auditors to perform more thorough audits.
however, mandatory auditor rotation
would be quite costly. because multinational
corporations are very complex, a newly ap-
pointed 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 of-
fice 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 im-
pose the high costs associated with manda-
tory 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 par-
ticular circumstance. nevertheless, by cre-
ating 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 com-
mittee 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 rela-
tionship of the auditors from the company’s
executives to its independent audit commit-
tee; 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.
Robert C. Pozen is the former chairman of
MFS Investment Management, and also
serves as a senior lecturer at the Harvard
Business School and a senior research fellow at the Brookings Institution.
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.
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 re-
spond to an rFP. audit fees for 15 years might
even serve as the catalyst for one or two mid-
sized 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 signifi-
cant player in the bidding process. The firm’s
institutional knowledge would allow it to put
forth a very competitive bid. of course, an au-
dit firm that performs non-audit services for
a company cannot legally be that company’s
auditor. but the regulators could explicitly al-
low 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 auditor rotation is an
overreaction to a real problem — a potential
conflict of interest that could encourage audi-
tors to put too much faith in company man-
agement. although auditor rotation could
mitigate this conflict, a mandatory approach
would be very expensive — and could actu-
ally reduce audit quality.
“I warned you that it would be a working vacation.”
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