Guarding the guards – The future of Audit?
There is a joke:
The CEO of a large company was looking for a new Auditor. This was put out to tender, and interviews were set. The CEO only had 1 question to the Auditors in the interview “What is 1 + 1?”
Audit Company 1: “2 of course”
Audit Company 2: “2 of course”
Audit Company 3: “Whatever you want it to be”
After the collapse of Lehman Brothers Holding and ensuing global financial crisis, auditors were blamed for contributing to the crisis by signing off on questionable accounting practices. Companies that collapsed or were bailed out by governments or other institutions had Auditors with very long tenures, and the insinuation was that due to the excessive long tenures these auditors (e.g. PricewaterhouseCoopers, KPMG, and Deloitte ) had become „Whatever you want it to be” partners rather than an independent, professional, cautious instance that ensured the company acted under correct governance.
Due to Audit failures, investors and regulators voiced concerns about the ability of auditors to prevent fraud and misstatements. One proposed response to these concerns was to make the rotation of audit firms mandatory for public companies. In April 2014, the European Parliament adopted a proposal requiring European-listed companies, banks, and financial institutions to appoint new audit firms at 10-year intervals. The term limits are expected to enhance audit firm independence, and therefore, increase audit quality.
In the USA, the Public Company Accounting Oversight Board (PCAOB) introduced a proposal mandating audit firm rotation. This proposal was y defeated after almost three years of debate when Congress passed a bill amending the Sarbanes-Oxley act of 2002. The amendment went as far as to prevent the PCAOB from requiring public companies to rotate their auditors.
The PCAOB chairman pledged to keep the project on its activity list and continue discussions on the matter. The logic behind these reforms is that auditors are the gatekeepers that preserve credibility in capital markets. They issue public reports on the reliability of financial information, and they make sure that the information contained in the reports reflects the truth. To trust these reports, investors need to be confident that auditors provide independent and unbiased certification.
Proponents of the mandatory audit firm rotation believe that a long-term engagement can lead auditors to become too aligned with the client and lose their objectivity.
Opponents of the policy (could these be large companies with powerful lobbyists?) argue that audit quality increases with longer tenure because of improved auditor expertise and superior knowledge about the client.
The Auditor debate is often pinned down to examining a trade-off between auditor independence and auditor competency, the two principal components of audit quality.
The rotation argument suggests that mandatory rotation provides the opportunity to interrupt the course of bad choices and hidden misbehaviours.
The Swiss Shareholders Association has up to now supported the concept of Auditor rotation in a rotation period less than the European 10 years.
There have been heated debates over the last decade as to what the best approach could be. The debate however has not been on a level playing field as special interest groups against Auditor Rotation have a lot of clout. There have been a number of studies looking at Auditor tenure vs the quality of the Audit Report, and these tend to support longer Auditor tenure.
However this still does not answer the “Whatever you want it to be” question, and apart from the causal link between long tenure and the 2008 Financial crisis, there do not seem to be any academic studies investigating Audit Tenure relating to company misbehaviour.
With all the major finance disasters and meltdowns, from Enron, the Financial Crisis, Bernie Madoff, Worldcom, Tyco, etc., the common factor, apart from misbehaving executives, was that all these companies had auditors who had become a part of the furniture.
One rationale that has been raised for greater Auditor autonomy is encapsulated in this thought: “There's a reason that students don't grade their own papers. There's a reason defendants don't sentence themselves. And there's a reason that companies should not self-control or investigate themselves either.
It is human nature to believe that corporate style misbehaviour we have seen in the past will not be repeated.
Perhaps the answer to ensure strong compliance and governance, needs to go further and remove the weak link in this cycle, that being the element of a company itself looking for the “Whatever you want it to be” auditor.
A solution might be to authorize a national regulator (e.g. FINMA) to assign Auditors to companies on a rotational and restricted time basis with exclusion for Audit companies who fall short of expected professionalism.
Such a system would offer an enhanced level of protection to parties involved.