State Board Report

April 2012

The first of what may be several public meetings on auditor independence and audit firm rotation was held by the Public Company Accounting Oversight Board on March 21-22 in Washington, D.C. Opinions expressed about the PCAOB’s concept release ranged from investor groups endorsing mandatory rotation of audit firms after a set period, to former SEC Chair Roderick Hills stating: “Do not surrender the audit committee to the bureaucracy of mandatory rotation.” PCAOB Chairman James Doty began the public meeting by stating: “The discussion will focus on ways to insulate the audit process from the pressure to maintain a long-term relationship with the audit client, pressure that could affect how an auditor approaches tough decisions on an audit.” While speakers did not make unexpected comments, as many had previously provided written comments to the PCAOB’s concept release, Mr. Doty felt these presentations were “important to have them on public record.” Many recommendations were made that the PCAOB members said they would consider.

Former SEC Chairman Harvey Pitt recommended, rather than having all firms be forced to switch after a designated time, leaving it up to the audit committee to make the determination whether a change is needed, and the PCAOB could articulate the determinants for a firm’s retention. “Nothing will eliminate all future fraudulent reports,” Mr. Pitt observed, but, he added “we must constantly strive to improve financial reporting.”

Similarly, Robert Pozen of the Harvard Business School suggested: “The PCAOB could require the audit committee of every publicly traded company to hold a RFP process for its auditor at least once in any designated period, such as 10 to 20 years. The existing audit firm would be allowed to submit a proposal in response to the RFP and be chosen by the audit committee if it determined that the existing audit firm would likely perform the highest quality audit relative to costs over the designated period.”

Mandatory rotation of audit firms is “a very blunt instrument,” Donald T. Nicolaisen, former SEC chief accountant, observed. Recognizing that there are legal limits as to what the PCAOB can disclose about a particular firm, he suggested, “perhaps there are limited situations where the PCAOB could meet with an audit committee of a particular company to indicate that the PCAOB has significant concerns about an audit relationship.” He commended the PCAOB for steps it has taken to have the audit partner sign the opinion, stronger enforcement, better training, and he said he would welcome dialog between audit committees and the PCAOB.

CALPERS (the California Public Employees’ Retirement System) has developed its own principles that call for holding competitive bidding for auditors every five years, explained Mary Hartman Morris, CALPERS investment officer. Ms. Morris, Damon Silvers of the AFL-CIO and Edward J. Durkins of the United Brotherhood of Carpenters all endorsed the mandatory audit firm rotation concept. Mr. Silvers observed that over the last ten years we have seen the “diminishing relevance of financial reporting,” which became clear with the financial crisis of 2008. He believes that firm rotation was contemplated when the Sarbanes-Oxley Act was created.

Working on a seven-year cycle, TIAA-CREF made rotations among the big audit firms and did not see a 20 percent increase in audit costs that some have projected, John Biggs, former chairman and CEO of TIAA-CREF stated. He suggested that disclosure in the proxy statement of the audit firm’s tenure would be a good thing, and real-time firm audits would be very useful, but he said that mandatory firm rotation would be at the top of his list to improve audit quality.

Many of the speakers acknowledged that the capabilities of audit committees vary. Audit committees are not equipped to do the job of determining whether audit firms should be replaced, according to John C. Bogle, founder of The Vanguard Group. “They have the responsibility, but not enough knowledge.” He recommended that audit committees have their own staff. The system used in Norway, where shareholders are included in the auditor selection process, was suggested by Mr. Bogle. He maintains that accountants don’t want to offend their actual clients or their potential clients, which is why the audit committee should be strengthened with its own staff, and why shareholders need to stand up for their rights.

Proctor & Gamble employs all of the Big Four firms, P&G Senior Vice President Valarie L. Sheppard told the PCAOB. It employs one of the firms to be its auditor and the others to provide consulting services. Over 900 people are involved in P&G’s audit work worldwide. With mandatory rotation P&G would have to decide at least a year in advance of the rotation which of the firms it would need to drop as a consultant, so that firm could take over the role of auditor. Ms. Sheppard reported P&G believes mandatory rotation would be disruptive, add significant costs, and would not result in improvement of audit quality. Speakers from Entergy Corporation and Goodyear Tire & Rubber agreed with P&G. Darren Wells, Goodyear Executive Vice President and CFO, observed that no regulation could force the minority of auditors who do not abide by professional standards to do so. Theodore Bunting, Jr., Entergy senior vice president stated: “Any additional information brought to the audit committee can only help. But the decision [to change auditor] should be made by the audit committee.”

While Arthur Levitt, former SEC Chairman, commended the PCAOB for “taking on an issue that will be opposed by much of the business community,” he commented that, “The JOBS Act is a much greater threat” to the lowering of standards [see story on page 5]. He advised that the PCAOB can’t afford to “dilute the value of the audit committee,” but he did not believe that mandatory rotation would hurt the audit committee’s morale.

“Auditors are in the business of noticing when something is wrong. If they don’t see that, why do we pay them?” Max Bazerman, of Harvard Business School, stated. As an example, he pointed to the Madoff feeder funds’ accountants who had an incentive not to notice a problem with Madoff ‘s reports. Professor Bazerman told the PCAOB that current institutions prevent auditor independence as the auditors have the incentive to keep being hired, which biases the way they interpret data. Dr. Bazerman recommended that auditors be hired under contracts that specify there will be a change of auditors at the end of the contract. The staff should not be able to move to the successor auditor and the staff should be barred from working for the client. During the term of the contract, Professor Bazerman explained, the audit firm could only be fired if the PCAOB agreed that the firm had shown it was incompetent.

Financial statement insurance was recommended by Jack Ciesielski, president of R.G. Associates, Inc. He commended the PCAOB for challenging the status quo on behalf of investors, but he thought audit firm rotation could work counter to investor interests. “The client/payer relationship is the root cause,” of the situation and there needs to be a change in the model for audit payment, Mr. Ciesielski explained. His solution is to have the insurance industry guarantee the usability of financial reporting. He admitted this would be a change going beyond the PCAOB’s authority, but he feels the PCAOB is the right regulatory body “to tee this up.”

Improving the strength of the audit committee was recommended by Arnold Wright of Northeastern University. He agreed that following the Sarbanes-Oxley Act there were dramatic improvements in the audit committees’ power and diligence, but a “passive role seems somewhat common,” Professor Wright said. He believes that the social or business ties that audit committee members may have to management threaten their independence. Based on research findings, he made four suggestions: Audit committees should fulfill their role of being the primary party in hiring the outside auditor. Audit committees can act as an ally of audit firms and should resolve audit disputes. Audit committee members should avoid social relationships with outside auditors or management. Companies should seek audit committee members who have industry expertise.

“We do believe the status quo is not an option,” PricewaterhouseCoopers Chairman Robert E. Moritz told the PCAOB meeting. He reported that 92 percent of PWC audit staff reported they had to have a “difficult conversation” with clients in the past two years. “You don’t hear about the good audits,” he observed.

The written responses to the PCAOB’s concept paper can be found on its website, as well as an archived Webcast of the two-day meeting. A NASBA representative has been asked to participate in a future forum the PCAOB will hold on this topic.

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