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    Mandatory Audit Partner Rotation, Audit Quality, and Market...
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 15.0 International Matters, 15.03 Audit Partner Rotation 
    2845 Views, 6 Comments
    Title:
    Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan and Discussion of “Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan”
    Practical Implications:

    The adoption of mandatory partner rotation in many countries suggests that regulators believe that the benefits of rotation outweigh the costs and thus a policy of mandatory rotation enhances audit quality. The results of this study provide initial evidence of the effects of mandatory partner rotation on audit quality. Contrary to regulators’ beliefs, the findings do not support the assumption that audit partner rotation will lead to audit quality increases. One caveat to these findings is whether the findings will generalize to other countries with different regulatory and legal regimes.

    Citation:

    Chi, W., H. Huang, Y. Liao, and H. Xie. 2009. Mandatory audit partner rotation, audit quality, and market perception: Evidence from Taiwan. Contemporary Accounting Research 26 (2): 359-391. 

    Bamber, E.M., and L.S. Bamber. 2009. Discussion of “Mandatory audit partner rotation, audit quality, and market perception: Evidence from Taiwan”. Contemporary Accounting Research 26 (2): 393-402.

    Keywords:
    audit quality; audit partner rotation
    Purpose of the Study:

    The Sarbanes-Oxley Act of 2002 (SOX) reduced the period that an audit partner is allowed to serve a particular client from seven consecutive years (required by the AICPA since the 1970s) to five years. The assumption behind the mandatory rotation requirement is that rotating the audit partner will improve auditor independence and audit quality. Research on audit firm rotation in the U.S. suggests that longer audit firm tenure with a client increases audit quality.  Although, as Bamber and Bamber point out, the results of audit firm rotation may be different than audit partner rotation because the costs and benefits are quite different.  For example, in rotating audit firms, the new firm brings an entirely new audit team and a new audit methodology. In rotating an audit partner, many factors continue to be the same under the new partner (the team, the overall audit methodology, the firm’s history with the client, etc.). Due to the lack of audit partner data in the U.S., this study utilizes audit partner data from Taiwan to assess the effect of mandatory audit partner rotation on audit quality. More specifically, the authors address two primary issues:

    • The authors examine whether a sample of firms subject to mandatory rotation have higher audit quality as compared to three benchmarks: 1) a sample of firms not subject to mandatory rotation, 2) the mandatory sample in the year prior to adoption, and 3) a sample of firms with voluntary audit partner rotation.
    • The authors examine whether investors perceive higher audit quality for the firms subject to the mandatory rotation requirements relative to the three benchmark samples mentioned above.
    Design/Method/ Approach:

    The authors use data for publicly-listed firms in Taiwan from the 2004 Taiwan Economic Journal database.  Mandatory audit partner rotation became mandatory for firms listed on the two major stock exchanges in 2004.  For the 2004 firms, some companies had partners that were required to rotate off the engagement (firms subject to mandatory rotation in that year) whereas other companies did not have partners required to rotate as they had not been on the engagement long enough yet (a non-rotation sample). 

    Findings:
    • Audit quality is not significantly different when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of Taiwan firms not subject to mandatory rotation in 2004.  They also find no significant difference in audit quality when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of Taiwan firms whose audit partner voluntarily rotated in years before 2003.  
    • The audit quality provided by new partners for Taiwan firms subject to mandatory rotation in 2004 is lower than the audit quality of those same Taiwan firms one year earlier, when the audit was led by the prior partner.
    • The authors find that perceived audit quality is not significantly different when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of Taiwan firms not subject to mandatory rotation in 2004.  They also find no difference in perceived audit quality when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of those same Taiwan firms one year earlier.  They find that perceived audit quality is significantly higher for firms subject to mandatory rotation in 2004 compared to firms where audit partners voluntarily rotated prior to 2003. 
    Category:
    Independence & Ethics, International Matters
    Sub-category:
    Audit Firm Rotation, Audit Partner Rotation, Audit Firm Rotation
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    Comment

     

    • Robert E Jensen

      The PCAOB is Not Going to Give Up Until Audit Firm Rotation ---
      Resistance is Beginning to Look Futile in Spite of Overwhelming Opposition

      "PCAOB invites additional comments on audit firm rotation," by Ken Tysiac, Journal of Accountancy, June 26, 2012 ---
      http://journalofaccountancy.com/News/20125956.htm

      The PCAOB is soliciting further public comment on its concept release on auditor independence and mandatory audit firm rotation in anticipation of a public meeting on the issue Thursday in San Francisco.

      The comment period for the concept release was reopened Monday and will be extended through July 28. The release sought comment on how to enhance auditor independence, objectivity, and professional skepticism, and on mandatory audit firm rotation. Comments can be mailed to the PCAOB or emailed to comments@pcaobus.org.

      The PCAOB has already received more than 650 comment letters on the concept release, which was originally issued on Aug. 16, 2011. The AICPA sent a letter that supported the PCAOB’s overall goal of enhancing auditor independence, objectivity, and professional skepticism, but it urged the PCAOB to refrain from pursuing mandatory firm rotation because it “carries significant costs and possible unintended consequences that have the potential to hinder audit quality.”

      Panelists at the public meeting in San Francisco will include academics, investor advocates, audit committee chairmen, audit firm executives, and former regulators who are primarily based on the West Coast or in Asia. Former SEC Chairman Harold Williams and former SEC Chief Accountant Conrad Hewitt are among the former regulators on the panel. The meeting will be available via webcast at the PCAOB website.

      The PCAOB held a similar meeting March 21–22 in Washington, where some panelists offered alternatives to audit firm rotation that could improve auditor independence and objectivity.

       

      Jensen Comment
      Auditors for large CPA firms should think about ordering motor homes and customized buses for their families to live in after they manage to sell their homes.
      It might be better for auditors to look into divorces from spouses.

      Teaching Case on PCAOB Proposal to Rotate Auditing Firms

      From The Wall Street Journal Accounting Weekly Review on August 19, 2011

      Curbs on Auditor Terms Explored
      by: Michael Rapoport
      Aug 17, 2011
      Click here to view the full article on WSJ.com
       

      TOPICS: Audit Committee, Audit Firms, Audit Quality, Auditing, Auditing Services, Auditor Changes, Auditor Independence, Public Accounting, Public Accounting Firms

      SUMMARY: "The [Public Company Accounting Oversight Board (PCAOB)] voted Tuesday to explore whether companies should have to change their outside auditors every several years, with the aim of improving audit quality and auditors' independence from their clients."

      CLASSROOM APPLICATION: The article is useful in an auditing class to introduce the process of engaging auditors, auditor rotation, professional skepticism, and the PCAOB.

      QUESTIONS: 
      1. (Introductory) What is the Public Company Accounting Oversight Board (PCAOB)? What is this entity proposing with regard to the engagement of CPAs performing audits of financial statements?

      2. (Advanced) Who engages a certified public accountant to provide an audit opinion on annual financial statements?

      3. (Advanced) Define the term "professional skepticism" in performing an audit. According to the article, what evidence exists that auditors may have difficulty maintaining professional skepticism on audit engagements?

      4. (Advanced) What are the negative points related to the PCAOB proposal? How could those problems lead to difficulty in accomplishing the goals of an audit just as a lack of professional skepticism might do?
       

      Reviewed By: Judy Beckman, University of Rhode Island
       

      "Curbs on Auditor Terms Explored," by: Michael Rapoport, The Wall Street Journal, August 17, 2011 ---
      http://professional.wsj.com/article/SB10001424053111903480904576512351445912480.html?mod=djem_jiewr_AC_domainid

      The U.S. government's auditing regulator voted Tuesday to explore whether companies should have to change their outside auditors every several years, with the aim of improving audit quality and auditors' independence from their clients.

      The move by the Public Company Accounting Oversight Board is the first step toward requiring auditor "term limits" that could break up client-auditor relationships that have lasted decades or even more than a century in some cases.

      Supporters say the move would help alleviate coziness between audit firms and clients that could lead an auditor to be not as skeptical as it should be in questioning a company's books. Critics say it would increase costs to companies as a new auditor gets up to speed and would deprive companies of a longstanding auditor's institutional knowledge.

      Investors "would be better positioned and the capital markets would be better served if we could increase the skepticism of auditors," said Joseph Carcello, a University of Tennessee professor who serves on two advisory boards that counsel the auditing watchdog. "This is one proposal that may get us there."

      The consideration of mandatory audit-firm rotation is still in its early stages. The board is accepting public comments on rotation, and soliciting input on other audit-independence ideas, until Dec. 14. It plans to hold a public discussion next March on the possibility of rotation. Any move to require rotation would be subject to approval by the Securities and Exchange Commission.

      Board Chairman James Doty said it is important to explore audit-firm rotation as a move that might help counter the pressures, incentives and mindset that might lead a longstanding auditor to go easy on a client.

      "For example, when we see auditors marketing themselves to potential clients as 'a partner in supporting and helping' the client 'achieve its goals,' it's hard not to question whether their mindset might have contributed to some of these audit failures," Mr. Doty said at the board's meeting Tuesday.

      Michael Gallagher, a managing partner at PricewaterhouseCoopers LLP, said in a statement that PwC wants to discuss how to improve audit quality, but "we are not supportive of mandatory audit-firm rotation." The firm believes the move could have "negative consequences"—for example, he said, it limits the discretion of a company's audit committee in choosing the auditor it believes is best suited to that company's needs.

      Mandatory rotation or any other new requirements should "meet the objective of improving audit quality," and making sure any benefits of new rules are worth the costs "should be central to the project," said Cindy Fornelli, executive director of the Center for Audit Quality, an accounting-industry group.

      Audit-firm rotation has been proposed before, notably in the discussions after the Enron Corp. and WorldCom Inc. accounting scandals that led to passage of the Sarbanes-Oxley corporate-overhaul law in 2002. In that case, Congress ultimately said the General Accounting Office—as the Government Accountability Office was known at the time—should study the issue, and the GAO, amid opposition from accounting firms and their clients, said rotation "may not be the most efficient way" to improve audit quality and auditor independence.

      But the GAO also said regulators could consider further auditor-independence steps after they had had time to evaluate the effectiveness of Sarbanes-Oxley's overhauls. Members of the auditing oversight board said the timing is appropriate now, since the board has inspected accounting firms for several years and uncovered hundreds of audit failures, indicating auditor independence may still be a problem.

      Continued in article

      Jensen Comment
      How some AECM actives vote, to date, on proposals to have mandatory rotation of audit firms of public company clients as long as the rotations are not too often (nothing less than 5-7 years between required rotations). Note that this is rotation between firms and not just the present rules for rotating auditors within one auditing firm assigned to a particular client.


      Tom Selling (Yes)


      Bob Jensen (No)

      Doty's initiative probably has epsilon chance of eventually happening in the near future. It ain't going to happen until more Andersen type audits happen that once again threaten the very foundation of securities markets --- when investors commence abandoning the securities markets in droves because of distrust of audited financial statements.


      Personally, I think there are better ways around the auditor independence issue than rotating audits between Big Four firms. Firstly, there are many huge international clients such that fixed costs of taking on a new huge client are enormous. Deloitte found this out when it had to bring over 600 new auditors to Washington DC when KPMG was fired from the audit of Fannie Mae and Deloitte took on the responsibility.


      Secondly the cost of dismantling after the loss of a huge client are enormous, especially in a local office that's responsible for most of the audit of a large client. Did KPMG have to ship over 600 auditors out of Washington DC when it was fired from the Fannie Mae audit?


      Thirdly, if there are only four firms that can really take on the largest clients in the world, the advantages of rotation are minimal, and "random rotation" is a bad joke. In this case I like Jim's carousel metaphor.
       

      Jim Peterson (No) ---
      http://www.jamesrpeterson.com/home/2011/08/mandatory-auditor-rotation-the-pcaob-sails-off-th-charts.html


      Francine Mckenna (No) ---
      http://retheauditors.com/2011/08/15/dear-pcaob-my-response-to-your-request-for-comments/

      Bob,
      You make excellent points about firm specialization (Jim P. did too from a country perspective) and the lack of true geographic mobility of staff even within the United States. There's the licensing issues and local taxes to deal with too. If an auditor works in another state they have to be licensed and pay local income taxes and head taxes like in NYC, Ohio, some cities, etc. It's a nightmare. They'd rather layoff staff if they lose a big client in NYC as Deloitte did during crisis (lost Bear Stearns and Merrill Lynch) and hire new cheaper grads in midwest or west for those new clients. Practices are run locally, rewards are dished out on local office results primarily, and partners protect their teams and won't pay another partner for their staff especially if they are higher paid and require travel.

      Francine


      Francine has a recent summary of her reactions to various PCAOB proposals and to some recent court decisions involving audit firms as defendants ---
      http://retheauditors.com/2011/08/15/dear-pcaob-my-response-to-your-request-for-comments/

      As I recall virtually all commentators on the AECM have been opposed to having the public sector (read that government) takeover private sector auditing. One exception has been David Albrecht who said that he favors government auditing but he did not elaborate on why the government would do a better job in the best interests of investors.
       

      Bob Jensen's threads on audit firm rotation are at
      http://www.trinity.edu/rjensen/Fraud001c.htm#Rotation

      The Saga of Auditor Professionalism and Independence ---
      http://www.trinity.edu/rjensen/Fraud001c.htm

       

    • Robert E Jensen

      The PCAOB is Not Going to Give Up Until Audit Firm Rotation ---
      Resistance is Beginning to Look Futile in Spite of Overwhelming Opposition

      "PCAOB invites additional comments on audit firm rotation," by Ken Tysiac, Journal of Accountancy, June 26, 2012 ---
      http://journalofaccountancy.com/News/20125956.htm

      The PCAOB is soliciting further public comment on its concept release on auditor independence and mandatory audit firm rotation in anticipation of a public meeting on the issue Thursday in San Francisco.

      The comment period for the concept release was reopened Monday and will be extended through July 28. The release sought comment on how to enhance auditor independence, objectivity, and professional skepticism, and on mandatory audit firm rotation. Comments can be mailed to the PCAOB or emailed to comments@pcaobus.org.

      The PCAOB has already received more than 650 comment letters on the concept release, which was originally issued on Aug. 16, 2011. The AICPA sent a letter that supported the PCAOB’s overall goal of enhancing auditor independence, objectivity, and professional skepticism, but it urged the PCAOB to refrain from pursuing mandatory firm rotation because it “carries significant costs and possible unintended consequences that have the potential to hinder audit quality.”

      Panelists at the public meeting in San Francisco will include academics, investor advocates, audit committee chairmen, audit firm executives, and former regulators who are primarily based on the West Coast or in Asia. Former SEC Chairman Harold Williams and former SEC Chief Accountant Conrad Hewitt are among the former regulators on the panel. The meeting will be available via webcast at the PCAOB website.

      The PCAOB held a similar meeting March 21–22 in Washington, where some panelists offered alternatives to audit firm rotation that could improve auditor independence and objectivity.

       

      Jensen Comment
      Auditors for large CPA firms should think about ordering motor homes and customized buses for their families to live in after they manage to sell their homes.
      It might be better for auditors to look into divorces from spouses.

      Teaching Case on PCAOB Proposal to Rotate Auditing Firms

      From The Wall Street Journal Accounting Weekly Review on August 19, 2011

      Curbs on Auditor Terms Explored
      by: Michael Rapoport
      Aug 17, 2011
      Click here to view the full article on WSJ.com
       

      TOPICS: Audit Committee, Audit Firms, Audit Quality, Auditing, Auditing Services, Auditor Changes, Auditor Independence, Public Accounting, Public Accounting Firms

      SUMMARY: "The [Public Company Accounting Oversight Board (PCAOB)] voted Tuesday to explore whether companies should have to change their outside auditors every several years, with the aim of improving audit quality and auditors' independence from their clients."

      CLASSROOM APPLICATION: The article is useful in an auditing class to introduce the process of engaging auditors, auditor rotation, professional skepticism, and the PCAOB.

      QUESTIONS: 
      1. (Introductory) What is the Public Company Accounting Oversight Board (PCAOB)? What is this entity proposing with regard to the engagement of CPAs performing audits of financial statements?

      2. (Advanced) Who engages a certified public accountant to provide an audit opinion on annual financial statements?

      3. (Advanced) Define the term "professional skepticism" in performing an audit. According to the article, what evidence exists that auditors may have difficulty maintaining professional skepticism on audit engagements?

      4. (Advanced) What are the negative points related to the PCAOB proposal? How could those problems lead to difficulty in accomplishing the goals of an audit just as a lack of professional skepticism might do?
       

      Reviewed By: Judy Beckman, University of Rhode Island
       

      "Curbs on Auditor Terms Explored," by: Michael Rapoport, The Wall Street Journal, August 17, 2011 ---
      http://professional.wsj.com/article/SB10001424053111903480904576512351445912480.html?mod=djem_jiewr_AC_domainid

      The U.S. government's auditing regulator voted Tuesday to explore whether companies should have to change their outside auditors every several years, with the aim of improving audit quality and auditors' independence from their clients.

      The move by the Public Company Accounting Oversight Board is the first step toward requiring auditor "term limits" that could break up client-auditor relationships that have lasted decades or even more than a century in some cases.

      Supporters say the move would help alleviate coziness between audit firms and clients that could lead an auditor to be not as skeptical as it should be in questioning a company's books. Critics say it would increase costs to companies as a new auditor gets up to speed and would deprive companies of a longstanding auditor's institutional knowledge.

      Investors "would be better positioned and the capital markets would be better served if we could increase the skepticism of auditors," said Joseph Carcello, a University of Tennessee professor who serves on two advisory boards that counsel the auditing watchdog. "This is one proposal that may get us there."

      The consideration of mandatory audit-firm rotation is still in its early stages. The board is accepting public comments on rotation, and soliciting input on other audit-independence ideas, until Dec. 14. It plans to hold a public discussion next March on the possibility of rotation. Any move to require rotation would be subject to approval by the Securities and Exchange Commission.

      Board Chairman James Doty said it is important to explore audit-firm rotation as a move that might help counter the pressures, incentives and mindset that might lead a longstanding auditor to go easy on a client.

      "For example, when we see auditors marketing themselves to potential clients as 'a partner in supporting and helping' the client 'achieve its goals,' it's hard not to question whether their mindset might have contributed to some of these audit failures," Mr. Doty said at the board's meeting Tuesday.

      Michael Gallagher, a managing partner at PricewaterhouseCoopers LLP, said in a statement that PwC wants to discuss how to improve audit quality, but "we are not supportive of mandatory audit-firm rotation." The firm believes the move could have "negative consequences"—for example, he said, it limits the discretion of a company's audit committee in choosing the auditor it believes is best suited to that company's needs.

      Mandatory rotation or any other new requirements should "meet the objective of improving audit quality," and making sure any benefits of new rules are worth the costs "should be central to the project," said Cindy Fornelli, executive director of the Center for Audit Quality, an accounting-industry group.

      Audit-firm rotation has been proposed before, notably in the discussions after the Enron Corp. and WorldCom Inc. accounting scandals that led to passage of the Sarbanes-Oxley corporate-overhaul law in 2002. In that case, Congress ultimately said the General Accounting Office—as the Government Accountability Office was known at the time—should study the issue, and the GAO, amid opposition from accounting firms and their clients, said rotation "may not be the most efficient way" to improve audit quality and auditor independence.

      But the GAO also said regulators could consider further auditor-independence steps after they had had time to evaluate the effectiveness of Sarbanes-Oxley's overhauls. Members of the auditing oversight board said the timing is appropriate now, since the board has inspected accounting firms for several years and uncovered hundreds of audit failures, indicating auditor independence may still be a problem.

      Continued in article

      Jensen Comment
      How some AECM actives vote, to date, on proposals to have mandatory rotation of audit firms of public company clients as long as the rotations are not too often (nothing less than 5-7 years between required rotations). Note that this is rotation between firms and not just the present rules for rotating auditors within one auditing firm assigned to a particular client.


      Tom Selling (Yes)


      Bob Jensen (No)

      Doty's initiative probably has epsilon chance of eventually happening in the near future. It ain't going to happen until more Andersen type audits happen that once again threaten the very foundation of securities markets --- when investors commence abandoning the securities markets in droves because of distrust of audited financial statements.


      Personally, I think there are better ways around the auditor independence issue than rotating audits between Big Four firms. Firstly, there are many huge international clients such that fixed costs of taking on a new huge client are enormous. Deloitte found this out when it had to bring over 600 new auditors to Washington DC when KPMG was fired from the audit of Fannie Mae and Deloitte took on the responsibility.


      Secondly the cost of dismantling after the loss of a huge client are enormous, especially in a local office that's responsible for most of the audit of a large client. Did KPMG have to ship over 600 auditors out of Washington DC when it was fired from the Fannie Mae audit?


      Thirdly, if there are only four firms that can really take on the largest clients in the world, the advantages of rotation are minimal, and "random rotation" is a bad joke. In this case I like Jim's carousel metaphor.
       

      Jim Peterson (No) ---
      http://www.jamesrpeterson.com/home/2011/08/mandatory-auditor-rotation-the-pcaob-sails-off-th-charts.html


      Francine Mckenna (No) ---
      http://retheauditors.com/2011/08/15/dear-pcaob-my-response-to-your-request-for-comments/

      Bob,
      You make excellent points about firm specialization (Jim P. did too from a country perspective) and the lack of true geographic mobility of staff even within the United States. There's the licensing issues and local taxes to deal with too. If an auditor works in another state they have to be licensed and pay local income taxes and head taxes like in NYC, Ohio, some cities, etc. It's a nightmare. They'd rather layoff staff if they lose a big client in NYC as Deloitte did during crisis (lost Bear Stearns and Merrill Lynch) and hire new cheaper grads in midwest or west for those new clients. Practices are run locally, rewards are dished out on local office results primarily, and partners protect their teams and won't pay another partner for their staff especially if they are higher paid and require travel.

      Francine


      Francine has a recent summary of her reactions to various PCAOB proposals and to some recent court decisions involving audit firms as defendants ---
      http://retheauditors.com/2011/08/15/dear-pcaob-my-response-to-your-request-for-comments/

      As I recall virtually all commentators on the AECM have been opposed to having the public sector (read that government) takeover private sector auditing. One exception has been David Albrecht who said that he favors government auditing but he did not elaborate on why the government would do a better job in the best interests of investors.
       

      Bob Jensen's threads on audit firm rotation are at
      http://www.trinity.edu/rjensen/Fraud001c.htm#Rotation

      The Saga of Auditor Professionalism and Independence ---
      http://www.trinity.edu/rjensen/Fraud001c.htm

       

    • Robert E Jensen

      PCAOB "Time Bomb" says Bloomberg's Jonathon Weil
      "Bigger, Stronger, Faster: The PCAOB After The Supreme Court Ruling," by Francine McKenna, re:TheAuditors, June 26, 2012 ---
      http://retheauditors.com/2010/06/26/bigger-stronger-faster-the-pcaob-after-the-supreme-court-ruling/

      Bob Jensen's threads on auditing professionalism and independence ---
      http://www.trinity.edu/rjensen/Fraud001c.htm

    • Robert E Jensen

      LIBOR --- http://en.wikipedia.org/wiki/Libor

      Barclays --- http://en.wikipedia.org/wiki/Barclays

      Questions
      Why are US. towns & states, labor unions, and other investors suing U.K.'s Barclays and other U.K. banks for LIBOR manipulation?
      Why do PwC auditors need more caffeine?

      Answer
      Many of their returns on investments in things like pension funds were diminished by U.K. bank conspiracies to manipulate LIBOR. And millions of interest rate swaps based upon LIBOR underlyings (notionals in the trillions) did not have fair and just settlements. What a huge mess going on while PwC and other Big Four auditing firms slept!!!

      "Barclays Manipulates LIBOR While Auditor PwC Snoozes," by Francine McKenna, Forbes, July 2, 2012 ---
      http://www.forbes.com/sites/francinemckenna/2012/07/02/barclays-manipulates-libor-while-auditor-pwc-snoozes/

      Bob Jensen's threads on banks and traders that are rotten to the core ---
      http://www.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking

      Bob Jensen's threads on the woes of PwC are at
      http://www.trinity.edu/rjensen/Fraud001.htm

    • Robert E Jensen

      A few surprises of professors coming out in favor of audit firm rotation
      "PCAOB Hears Evidence Favoring Auditor Rotation," by Tammy Whitehouse, Compliance Week, October 18, 2012 ---
      http://www.complianceweek.com/pcaob-hears-evidence-favoring-auditor-rotation/article/264288/

      Audit research experts have presented the Public Company Accounting Oversight Board with evidence they say demonstrates auditor rotation leads to better audit quality.

      During its Houston roundtable to discuss whether mandatory rotation would improve audit quality, Scott Whisenant, an associate professor of accounting at the University of Kansas, reviewed a variety of academic studies for the board that suggest rotation would produce benefits the board is seeking. He noted much of the protest around mandatory rotation has focused on costs, but few studies have focused on possible benefits because rotation is practiced in only a handful of countries.

      The results of a 2000 study suggest, he said, that long-term auditor client relationships significantly increase the likelihood of an unqualified opinion, which raises questions about audit quality. The exception, however, is the last year of the relationship, when the likelihood of an unqualified opinion drops. “In this final year, the auditors finally drop the hammer down on clients,” Whisenant said, knowing they are about to surrender the job to a successor firm that will no doubt review their work.

      Whisenant said his own more recent research with another coauthor suggests that in countries where rotation is practiced there's evidence of less earnings management, less managing to meet earnings targets, and more timely recognition of losses. The study concludes the quality of audit markets improves after the enactment of rotation, he says, and evidence suggests that concerns about any disruption or difficulty of transition to a new audit firm are more than offset by benefits. “Depending on the statistics we investigated, the benefit to audit quality of adopting rotation rules appears to be larger by a factor of at least two, and in some cases more, than the cost of audit quality erosion at the forced rotation of audit engagements,” he said.

      Stephen Zeff, accounting professor at Rice University, told the PCAOB auditors have become more commercial and less professional over the past several decades, driven there by an education process that preaches memorization of standards more than critical thinking and an allowance for auditors to develop business relationships with their clients. Karen Nelson, another accounting professor from Rice, said her review of academic research suggests auditors working under the present model are more likely to issue a report biased toward management than under practically any other arrangement  that would involve mandates on rotation or retention.

      PCAOB Chairman James Doty praised the “extraordinary array of views” presented by the academics. “This is where we we wanted to get to with the concept release,” he said, where the board could begin to digest empirical evidence that would suggest what regulatory regime is most likely to produce objective, professional, skeptical audits. The webcast archive of the Houston roundtable will be available on the PCAOB website.

       

      Jensen Comment
      A few of my AECM friends have repeatedly argued for audit firm rotation, including Tom Selling and David Albrecht. Now it turns out that some other professors mentioned above are coming out of the woodwork in favor of such rotation as well.

      It would seem that the PCAOB wants audit firm rotation so badly that, in spite of the overwhelmingly negative comments received in various invitations to comment, the Board just keeps coming back for more support in favor of rotation..

      I'm on record as being against it for various important reasons. One is cost since there are so many costs of gearing up for a first-time audit, especially a large multinational client with offices and factories spread about the world. I can't imagine the cost of gearing up for a first time audit of GM, GE, Exxon-Mobil, etc. Second, the new costs will be added to pressures on audit firms by the PCAOB to conduct more costly audits, including much more detailed testing ---
      http://pcaobus.org/Inspections/Reports/Pages/default.aspx

      It's naive to assume that clients will remain passive and simply cough up the millions or tens of millions of dollars added in rotation-based fees billed by their auditors. Instead, get ready for intense lobbying in Washington DC to overturn any PCOAB audit firm rotation mandate and more intense lobbying to overturn SarBox legislation that created the PCAOB in the first place. I think that attention given to the audit firm rotation issue may merely be a pretense by the PCAOB in an effort to scare audit firms and raise added concerns about audit independence. Does the PCAOB really want to go toe-to-toe with Corporate America as well as companies headquartered around the world who listed on the NYSE?

      Equally important in my mind is what rotation will do to the quality and skills of auditors on the job. First there is the inevitable relocation that will come from shifting from a huge client headquartered in one city to another big client headquartered thousands of miles away. Even with medium-sized clients in smaller cities there will be inevitable stresses of having to uproot families and move. For example, after giving up an audit of USAA in San Antonio hundreds of auditors may have to move to Dallas, Houston, NYC, Washington DC or who knows where.

      I'm not alone. A raft of other highly respected professors claim the following ---
      http://pcaobus.org/Rules/Rulemaking/Docket037/041_Karim_Jamal.pdf

      We understand and affirm the importance of auditor independence, objectivity and scepticism for the proper functioning of the U.S. capital market and are supportive of the PCAOB’s desire to enhance the actual and perceived independence of auditors. However, academic research on the topic suggests that adopting a system of audit firm rotation will not help the U.S. economy achieve these worthy goals. Instead, such a change may impair auditor independence, weaken audit expertise and undermine corporate governance.

      We organize our response below in terms of impact on objectivity (especially opinion shopping), and development of expertise. We note that many of the views expressed in our letter are influenced by a detailed research study conducted by Fiolleau et al. (2010) on how companies currently choose auditors. A copy of this study is publicly available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1535074. Of course, any such study is limited in its generalizability. In particular, Fiolleau et al. (2010) examines cases where audit committee’s have voluntarily chosen to seek competing bids from auditors. However, we think the studies’ observations are suggestive of what is likely to happen on an economy-wide basis if PCAOB were to mandate periodic rotation of audit firms. Some of our other comments are based on other research evidence, which we cite.

      Selection and appointment of auditors by their clients is a major source of concerns about real and perceived independence and objectivity of the auditors. Since the PCAOB seems to be unwilling to deal with this root cause of the independence problem at this time, other reforms are being sought. No audit can be perfect, and the quality of audit is determined not only by independence but also by many other factors—such as the quality of accounting standards, accounting education, auditor expertise, audit committees, corporate governance, auditor discipline, liability, and a host of other institutional features of the audit environment. The focus of PCAOB should be to provide the best audit quality, and not to fixate on any subset of such determinants of audit quality. Our reading of existing research leads us to conclude that, in spite of its superficial appeal, audit firm rotation is a bad policy choice on all relevant dimensions. We explain our reasons below.

      Rotation and Auditor Objectivity
      |
      The most appealing and common sense intuition underlying auditor rotation is that it promotes objectivity by refreshing the personnel (or firm) who are not tied down by judgments, compromises, and personal relationships of the past. A new auditor brings a fresh set of eyes, and has the opportunity to raise issues that have been overlooked or settled in the past. Research experiments show that new auditors are better able to identify issues, alter their judgments, and bring issues up for discussion when they are not personally committed to prior decisions (see article by Tan on p. 113-35 in Spring 1995 issue of Journal of Accounting Research).

      Our first observation on this rationale for firm rotation is that familiarity arises between individuals (e.g., the audit partner and the CFO) not firms, so most of the benefit from taking a “fresh look” can be obtained more simply by rotating the partner and or other senior personnel on the audit team (e.g., audit manager). Since the policy of partner rotation is already in place, audit firm rotation is unlikely to add any significant marginal benefit, especially when the considerable costs of firm rotation are taken into account. The GAO’s (2003) study on mandatory audit firm rotation estimated increased initial audit costs of more than 20% (some studies in Europe suggest 40%) and this did not include costs incurred by the audit committee and management to conduct the tendering process.

      Our second observation from the research study by Fiolleau et al. (2010) is that although the auditors are supposedly appointed by the audit committee of the client company, management plays a significant role in the process, and may even dominate it for all practical purposes. This means that a mandate for audit firm rotation will force the incumbent and potential auditors into a “beauty contest” every few years. The market power of the audit firms is so much weaker than the power of their clients that, at the time of bidding for engagement, the former compete among themselves to convince the management / audit committee of their potential clients of their commitment, service, and responsiveness. Each hiring exercise becomes an opportunity for opinion shopping by clients, lowballing of audit fees and demonstrations of loyalty and relationship-building by the auditors. Many of the auditor behaviours that the rotation proposal is intended to discourage get exacerbated when the audit firm enters into a beauty contest (bidding war) to get an audit engagement.

      A third observation from the Fiolleau et al., (2010) study is that, with only four large international firms, the audit market is highly concentrated. Most large clients already receive one service or another from every one of the four firms. If one of these accounting firms audits the client, the other three often provide it a host of advisory services in tax, valuations etc. This perpetual engagement and pre-existing relationships of most large companies with all four audit firms implies that there is only limited opportunity for mandatory rotation to bring about a “fresh look.”A large corporation would have to deliberately avoid business engagement with one Big 4 firm, to have at least one firm who would meet current independence rules and have the expertise needed to conduct the audit. The PCAOB proposal is likely to yield little by way of benefits and incur the additional harm associated with increased frequency of “beauty contests.”

      Rotation and Auditor Expertise
      There is compelling evidence that audit firm rotation will impair auditor expertise. PCAOB’s concept paper indicates awareness that the auditor is most vulnerable to missing fraud in a new engagement (see also St Pierre and Anderson on p 242-63 in Vol 59(2), 1984 issue of The Accounting Review). A variety of studies (e.g., Myers et al., on p 779-799 in Vol 78, July 2003 issue of The Accounting Review) show that the quality of accounting numbers improves with increases in auditor tenure. The most compelling force disciplining accounting accruals is auditor industry expertise (see Craswell et al., on p 297-322 in December 1995 issue of Journal of Accounting and Economics). While academic evidence is seldom conclusive, the weight of evidence suggests that a policy of mandatory auditor rotation undermines expertise formation and will impair audit quality. The thrust of Generally Accepted Accounting Principles (GAAP) is increasingly oriented to having management communicate to investors how they operate the business. Auditors’ understanding of the substance of client business would be undermined if they are rotated out every few years. The Fiolleau et al (2010) study reveals that even the four largest audit firm’s lack depth of expertise in serving large corporate clients across all industries outside the main business centres such as New York, Toronto, London, and Tokyo. For clients with headquarters located in smaller cities, finding industry specialists in the local offices can be a significant challenge.

      Improving Audit Quality
      Audit quality is not just an attribute of the auditor alone. The nature of Generally Accepted Accounting Principles (GAAP) is also a major determinant of audit quality. Over the recent decades, the Financial Accounting Standards Board (FASB) has set standards that de-emphasize

      verifiability in favour of the mark-to-market valuation, no matter how illiquid the market may be. It has also adopted a practice of writing detailed standards in its attempt to close loopholes but ends up creating new ones. Exploitation of the Repo 105 rules by financial service firms during the recent crisis is a good example. This type of standards place auditors in a very difficult position vis-à-vis corporate management. The shift in GAAP towards the so-called “fair value accounting” is a major factor undermining audit quality.

      Importance of Audit Resignation as a Signal
      When financial press reports that company X audited by firm Y for the past twenty years has changed its auditor, investors get a valuable and informative warning signal that draws close scrutiny by the investment and regulatory communities. PCAOB’s mandatory rotation proposal will eliminate this signal by making auditor changes a matter of routine, deserving little attention or scrutiny, and thus undermine the quality of audit.

      Transfer of Audit Resources from Verification to Marketing
      The PCAOB proposal, by eliminating all long-term client-auditor relationships, will induce audit firms to devote even greater resources to marketing themselves to potential clients. These resources can only come from cutting back on the substantive work of verification during the course of their audits or by raising audit fees. Individuals in the audit firm will find their presentation and marketing skills becoming more valuable relative to their technical accounting and auditing skills.

      Confusion and Unintended Consequences from Too Many Initiatives
      Auditors now face a very complex economic and social environment. There are economic incentives to be responsive to management but these have to be balanced with incentives emanating from audit committees, concurring review partners, national office reviews, litigation, GAAP and industry practice, and PCAOB reviews. In some countries two audit firms jointly conduct an audit making it difficult for any single audit firm to have consistency in its audits across countries as complex co-ordination is required across audit firms. Fraud cases like Parmalat are thought to have avoided detection due to lack of continuity of the auditor and presence of multiple audit firms. Adding more agents and incentives into this mix serves to create a very complex incentive structure, interpersonal friction and potential for unintended consequences as accountability and authority get distributed across a variety of agents. This increases moral hazard and the potential for confusion. Adding one more firm rotation requirement on top is not just a free good that improves the system. Too much complexity makes the audit process more vulnerable to systemic failure.

      Conclusion
      Audit firm rotation is a bad policy prescription especially in an environment where auditors are appointed by board audit committees who often are significantly influenced by management. The potential benefits of rotation will be exceeded by the harm associated with the “beauty contest” that takes place to appoint a new auditor. Rotation actually impairs audit quality by promoting more frequent opinion shopping and lowballing. Rotation also impairs audit expertise, eliminates a valuable signal of auditor change, and shifts even more resources from substantive audit work to marketing of audit services.

      Most of the benefits of rotation can be realized by rotating the engagement partners. Because of limited depth of expertise, we suggest rotating engagement partners every ten years. Given the limited independence of most audit committees from the management, PCAOB’s goal of improving audit quality through firm rotation is beyond its reach. Pressing the FASB/IASB to pay greater attention to verifiability of financial reports would be a more effective avenue to improve audit quality.

      Signed,

      Tracey C. Ball, FCA ICD.D

      Executive Vice President & CFO Canadian Western Bank Group (TSX:CWB)

      Rozina Kassam,CA

      CFO, COMMERCIAL SOLUTIONS INC. (TSX:CSA)

      Jonathan Glover, PhD

      Professor of Accounting, Carnegie Mellon University

      Karim Jamal, FCA, PhD

      Chartered Accountants Distinguished Chair Professor, University of Alberta

      Ken Kouri FCA

      Retired Partner Kouri Berezan Heinrichs, CA

      D. Brad Paterson, CMA

      CFO, Wave Front Technology Solutions (TSX (V): WEE)

      Suresh Radhakrishnan, PhD

      Professor of Accounting, University of Texas at Dallas

      Shyam Sunder, PhD

      James L. Frank Professor of Accounting, Economics and Finance, Yale University

       

      The very best prospects for becoming accounting majors may be turned off by the gypsy-living prospects of becoming career CPA auditors. The very best seniors and managers and even partners on a particular audit may take up other job offers rather than uproot spouses and children to relocate as Sundowners ---
      http://en.wikipedia.org/wiki/The_Sundowners

      There are many, many more very responsible concerns raised in the overwhelmingly negative responses received by the PCAOB --
      http://pcaobus.org/Rules/Rulemaking/Pages/Docket037.aspx

      In particular read Response 35 (James L. Fuehrmeyer, Jr.) and Response 29 (Dennis R. Beresford) at
      http://pcaobus.org/Rules/Rulemaking/Pages/Docket037Comments.aspx

       

    • Robert E Jensen

      Stephen Zeff, accounting professor at Rice University, told the PCAOB auditors have become more commercial and less professional over the past several decades, driven there by an education process that preaches memorization of standards more than critical thinking and an allowance for auditors to develop business relationships with their clients.
      Tammy Whitehouse, Compliance Week, October 18, 2012 ---
      http://www.complianceweek.com/pcaob-hears-evidence-favoring-auditor-rotation/article/264288/

      "Bad Grades Are Rising for Auditors," by Floyd Norris, The New York Times, August 23, 2012 ---
      http://www.nytimes.com/2012/08/24/business/bad-grades-rising-at-audit-firms.html?pagewanted=all&_r=0

      Are audits getting worse? Or are the inspectors getting pickier?

      Those would seem to be two possible explanations of a trend that looks very bad.

      This week the Public Company Accounting Oversight Board reported that in recent months it had reviewed audits of 23 brokerage firms. Not a single one of them was deemed acceptable.

      The names of the firms doing the audits were not disclosed, and many of them were very small firms, as opposed to the major firms that audit most public companies.

      But the trends at the big firms are not promising either. They are subject to annual reviews by the board, but until 2009 those inspections did not disclose the proportion of audits reviewed that were deemed to be defective. Among the Big Four — Deloitte & Touche, PricewaterhouseCoopers, KPMG and Ernst & Young — the board found something wrong in nearly one in six audits it reviewed that year. A year later, the proportion had doubled to one in three. The 2011 inspections have yet to be released, so we don’t know if things got better or worse.

      This is not strictly a Big Four problem. The next four firms, all much smaller but auditing a substantial number of public companies, scored a little worse.

      Some of the reaction to the report on brokerage audits was harsh.

      “If any other businesses, such as manufacturing or software companies, had such high failure rates in their products, they would go out of business,” said Lynn E. Turner, a former partner in Coopers & Lybrand, a predecessor of PricewaterhouseCoopers, and a former chief accountant for the Securities and Exchange Commission. He then referred to the Yugo, a car from the former Yugoslavia that gained a reputation for very poor quality, and that soon vanished from showrooms.

      In fact, the comparison to car manufacturers helps to show why it is so hard for the market to sort out whether audits are done well. The quality of a car will become clear after it is driven for a while, and consumers will notice.

      But if an auditor does no work at all and just signs on the dotted line before pocketing the fee, that fact may never become public. If the company’s books were actually pristine, so that a good audit would have uncovered no problems, nothing is likely to surface to demonstrate how bad the audit was, unless someone inspects the work that was done.

      Given that reality, it seems amazing that the auditing industry was able to escape any real oversight until 2002, when the Sarbanes-Oxley Act established the accounting oversight board. Until then, the only reviews of auditing were “peer reviews,” administered by the American Institute of Certified Public Accountants, in which one firm checked up on another. Few problems were ever found.

      The board began work in 2003, and fairly quickly found problems. In the first year of reviews, it noticed that one company had overstated its current assets, making it look better. It then checked other companies and found that the error was widespread, involving customers of each of the Big Four. A round of restatements followed.

      The 2010 reports — the most recent available and the ones with the high level of deficient audits — concerned audits of 2009 financial statements. Inspectors focused on financial companies, and zeroed in on the willingness of auditors to accept valuations of complex securities without determining whether the valuation methods used were reasonable.

      That year, 2009, was also the year that politicians put heavy pressure on the Financial Accounting Standards Board, which sets accounting rules, to relax rules on marking securities to market value. At a public hearing in March, Robert H. Herz, then the chairman of the standards board, was excoriated by members of the House of Representatives capital markets subcommittee for issuing rules that made the banks look worse than they deserved to look. FASB (pronounced FASS-bee) soon relaxed the rules, and auditors were expected to assure compliance with those newly eased rules.

      Some accountants privately speculate that some of the lapses found by oversight board auditors could have been influenced by the pressure not to make banks, already in trouble, look worse than was necessary.

      In its inspections of the audits of 23 brokerage firms, many of the auditing lapses found by the board dealt with the failure of the auditing firms to do enough work, at least in the inspector’s view, to justify a conclusion that the numbers were correct. In 15 of the 23 audits cited in this week’s report, “firms did not perform sufficient procedures to test the occurrence, accuracy and completeness of revenue.” In six of the nine audits where the auditor had to deal with how much securities were worth, “firms did not perform sufficient procedures to test the valuation.”

      That is different from saying that the auditor reached the wrong conclusion.

      In the 2010 inspection of PricewaterhouseCoopers, auditors were found to have missed significant errors in how one company accounted for derivative securities it owned. The board inspectors cited no other errors in financial statements, but in 27 of the PWC audits — out of 71 reviewed — the auditors failed to perform work that the board thought should have been done.

      Those 71 audits were not chosen at random.

      “Our approach is risk-based on two different bases,” Jay Hanson, the only board member with extensive experience in auditing public companies, said in an interview. He said the board sought out the riskiest clients at each firm, and then paid attention to what it knew about different offices of the firm. It might even choose to look at work done by a specific partner whose previous work had been deemed subpar.

      “We are going into areas where we think there could be problems,” he said. Presumably a review of audits chosen randomly would find fewer problems.

      The Big Four firm that has gotten the most negative reviews is Deloitte & Touche. Under the law, the accounting board does not disclose negative conclusions regarding a firm’s quality control systems unless the firm fails to address those problems within a year. Last fall, Deloitte became the only major firm that has had such a review released.

      This summer, Deloitte gained another unfortunate distinction. The system of peer reviews still functions, with reviewers looking at audits of private companies that are not subject to review by the oversight board. Deloitte’s review, by Ernst & Young, concluded that the firm had not done enough work on some audits, and said that after the reviewers pointed out problems, Deloitte did more work and a client company had to restate its financial statements.

      Deloitte received a grade of “pass with deficiency.” That had never before happened to a major firm.

      Deloitte declined to discuss that review with me, but provided a statement saying, “Deloitte is proud of the significant investments and hard work we have put into raising the bar on audit quality and we are confident those efforts are having a positive impact. Audit quality has been and continues to be our No. 1 priority.”

      It is hard to imagine any firm saying otherwise, which makes such assertions less than fully persuasive.

      Continued in article