An Intermediate Approach to the Auditor Rotation Issue

In March, the Public Company Accounting Oversight Board (PCAOB) held hearings about whether to require public companies to change (or “rotate”) their external auditor periodically. Similarly, the European Union has proposed mandatory auditor rotation every six or 12 years.

Mandatory auditor rotation is designed to address a potential conflict of interest between a public company and its auditor. 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 duty to rigorously question the client’s financial statements.

Advocates of mandatory rotation generally object to the historic coziness between auditors and the management of public companies: the auditors of almost 36 percent of all companies in the Russell 1000 have held that position for 21 years or more. These advocates cite two specific benefits of replacing the auditor every five or 10 years: a term limit for an auditor’s engagement with a company would decrease the auditor’s incentive to ingratiate itself with management, and furthermore, mandatory rotation would keep the current auditor on its toes, since it would fear that a new auditor would expose any previous errors or omissions.

On the other hand, public companies have vigorously argued that the benefits of mandatory rotation are outweighed by its costs. Because multinational corporations are very complex, an auditor must develop company specific knowledge to fully understand the company’s finances. Mandatory rotation would quickly erode this institutional knowledge, reducing audit quality and increasing costs.

In addition, critics point out that mandatory rotation undermines the role of the audit committee/a> in overseeing the audit process, as expanded by the Sarbanes Oxley Act. That Act made the auditor report to the independent audit committee, which now has the power to appoint and terminate the auditor.

Given these competing arguments, I favor a compromise proposal requiring the independent audit committee to periodically issue a request for proposal (RFP) for the audit engagement, but allowing the existing auditor to bid on the RFP. This proposal would reap most of the benefits of auditor rotation without imposing many of the costs.

Even if the existing auditor usually wins the RFP, the bidding process raises the probability that the audit committee would appoint a new auditor. This would encourage the existing auditor to maintain its professional skepticism more vigilantly. The existing auditor would be worried that any deficiencies in its audits would be discovered if a new auditor were subsequently engaged.

Yet an RFP requirement would not impose large costs on a public company from switching its auditor every five or 10 years. The existing auditor would be replaced only if the audit committee decided that this change met a cost/benefit test in the context of that particular company.

Most importantly, an RFP process would reinforce the critical role of the independent audit committee in the eyes of the external auditor, especially one with a longstanding relationship to the same company. The RFP process would make it clear that the independent directors on the audit committee, not company management, were in charge of choosing the auditor and supervising its work.

Nevertheless, commentators are likely to raise three practical questions about this RFP proposal.

1. How often should the audit committee be required to issue a RFP?

In my view, the answer is every 15 years. This period would allow an audit firm enough time to gain the expertise it needed to understand the complexities of a global company. This period would also be long enough to warrant a serious effort by other large audit firms in responding to these RFPs. Audit fees for 15 years might even persuade one or two middle-size audit firms to develop the capability of auditing multinational companies.

2. Will there be enough firms bidding on the RFP other than the existing auditor?

Even if only one firm other than the existing auditor responds to the RFP, that should be sufficient to obtain most of the benefits of a competitive bidding process, as shown by the bidding for many large defense contracts. Of course, audit firms cannot perform both audit and non-audit services for the same public company. But the regulators could allow any qualified firm to respond to a RFP as long as the firm stopped the non-audit services if it won the RFP for the audit.

3. Will the RFP process make audit firms more likely to fold on tough accounting issues?

With a periodic RFP process, the auditor would make great efforts to serve the needs of the audit committee, not company management. Thus, the RFP process would make the existing auditor to be more responsive to the audit committee — exactly what we want. With the RFP process in mind, the auditor would be more likely to alert the audit committee to close questions on financial reporting and possible areas of debate with company management.

In short, mandatory audit rotation as a blanket rule is probably not cost effective. Instead, the PCAOB should require the audit committee to issue a RFP for the auditor engagement every 15 years, but allow the existing auditor to participate in the bidding process. This process would enhance the auditor’s willingness to make tough calls and reinforce its primary allegiance to the audit committee.