Mandatory Audit Firm Rotation: Regulatory Sit ‘n’ Spin

Posted on by Greg Kyte

It's been about a year since the PCAOB crapped out Release No. 2011-006, "Concept Release on Auditor Independence and Audit Firm Rotation." Some people in the profession think the PCAOB has no real intention of mandating audit firm rotation; rather, these professional skeptics believe the PCAOB just brought it up to appear relevant.

The PCAOB started the release by downplaying the controversial part, stating its purpose was "to solicit public comment on ways that auditor independence, objectivity and professional skepticism could be enhanced." And then adding, "One possible approach on which the board is seeking comment is mandatory audit firm rotation." Kinda like after the 8th grade skating party, when you were talking to Dana, the cute girl from science class, and said, "I think it would be cool to get to know you better. One possible way to achieve that outcome is for you to show me your boobies." 
 
Then in March, PCAOB Chairman James Doty said: 
The board, of course, has not proposed mandatory audit firm rotation. Rather … the PCAOB is engaged in a deep and wide-ranging public dialogue about ways to enhance the independence, objectivity and professional skepticism of public company auditors.
No, Dana, I didn't ask you to show me your boobies. I just said that it was one of the many, wide-ranging possibilities of how we could get to know each other a little better. Jeesh, whore.
 
Personally, I think an audit firm rotation mandate would be impotent regulatory BS. However, partners who are afraid of it are being stupid. Like a lot of other regulation, mandatory rotation could be used to justify higher fees, and if firms aggressively market themselves, they could capture new business that has been locked down for decades. If the game is played shrewdly, crafty partners and marketing teams could rotate in more clients than they have to rotate out. But chances are, if you are on the lower half of the corporate totem pole, mandatory rotation would suck donk. Staff would suffer under increased pressure and increased hours with no upside other than maybe being able to convince themselves that they have a skosh more job security. 
 
But one thing that everyone can enjoy throughout this public dialogue is watching important people say stupid shit. My favorite comes from C. Brian Fox, founder of Confirmation.com:
What would a fraudster say about audit firm rotation? The answer is obvious; a fraudster would be whole-heartedly against it. […] If I were a fraudster, I’d have written the PCAOB not just one comment letter against audit firm rotation, I’d have written four letters using four different company names and letterheads since anyone can copy and paste legitimate company logos using the Internet. 
Not only does Mr. Fox express his support for mandatory rotation, he implies that if you are against it, you should be in jail. It's also nice to see that he's perfected his exposure-draft-ballot-stuffing technique.
 
Steven Thomas, partner at Thomas, Alexander, Forrester LLP, said:
I ask an auditor what the P in CPA means and they don’t know it stands for public. […] The auditors don’t have an incentive to act in the public interest. They only have an incentive to act in their financial interest. We need to change the incentives. Auditor rotation is good, but you can’t put another fox in the henhouse. We have to change the incentives, particularly for audit committees.
I thought it stood for "profiteering." Now I'm no farmer, but I do feel that regulations should be enacted to criminalize the act of putting a second fox into a henhouse that already contains one or more foxes. However, I also believe that mandatory henhouse rotation won't solve anyone's fox problem. 
 
But let's talk about incentives. If you want people to act outside of their financial interest, then financial incentives are off the table. That leaves cookies and good feelings. Of course, all Jeff Skilling really needed was a snickerdoodle and a hug.
 
Former SEC chairman Harold Williams supports mandatory rotation but isn't sure it will "produce the desired result of breaking up the oligopoly of the Big Four." Who ever stated that as a desired result? No one. Just like no one ever stated "putting H&R Block out of business" as a desired result of tax return preparer registration (even though we all thought it). Breaking the oligopoly of the Big 4 may be a desired result for Moss Adams and Grant Thornton, but it seems like Harry's the only one saying it out loud, and he definitely didn't get it from the PCAOB's concept release.
 
Possibly the most cathartic moment in the public discourse was when Rep. Scott Garrett, R-N.J., chairman of the House Capital Markets and Government Sponsored Enterprises Subcommittee, said:
I think it is important to remind the PCAOB that it is not a policy-making entity; Congress and this committee are the policy-makers. … I am very concerned about some of the recent activist proposals put forth by the PCAOB.
It's kind of fun to watch the PCAOB get bitch-slapped by a congressional subcommittee that I've never heard of before.

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(UPDATE 2) PCAOB Gives Ernst & Young Manager the Charlie Rangel Treatment

~ Update includes statement from Ernst & Young.

~Update 2 includes statement from Claudius Modesti, PCAOB Director of Enforcement and Investigations

Today in obscure accounting oversight board enforcement actions, an Ernst & Young Manager in the Boston office was censured by the PCAOB for repeated violations oy to Cooperate with Inspectors, and Auditing Standard No. 3 (“AS3”), Audit Documentation.


The violations occurred when 27 year-old Jacqueline Higgins “(1) added documents to the working papers without indicating the dates that documents were added to the working papers, the names of the persons preparing the additional documentation, and the reason for adding the documentation months after the documentation completion date; and (2) removed a document from the working
papers after the documentation completion date.”

The timeline goes like this: E&Y was given notice by the PCAOB that an inspection of the unknown company’s audit was being performed on March 30, 2010 and the partner, senior manager and manager on the engagement were given notice on March 31, 2010. The inspection fieldwork was set to begin on April 19, 2010.

On April 5th, the three Ernsters began preparing for the inspection and that’s when problems started cropping up which led to more trouble. The order has the details:

First, Respondent reported to the Engagement Partner and the Senior Manager that a “Review Procedures Memorandum” was missing from the external working papers. The Engagement Partner and the Senior Manager directed Respondent to create and print out the missing document, and to backdate the document to November 30, 2009. The Engagement Partner and the Senior Manager directed Respondent to backdate her sign-off on this working paper to November 30, 2009, and to add this document to the external working papers.

17. Second, Respondent reported to the Engagement Partner that the tie-out of the financial statements contained in the external working papers was performed upon a pre-final set of financial statements. The Engagement Partner directed Respondent to remove this document from the external working papers, and to replace it with a newly created document which tied-out the final financial statements, and which the Engagement Partner directed Respondent to backdate to November 2009.

18. Third, Respondent reported to the Engagement Partner that the Average Forward Foreign Currency Contracts Calculation (“A3a Working Paper”) was missing from the external working papers. The Engagement Partner directed Respondent to gather the missing document, backdate it to November 2009, and add it to the external working papers.

19. Finally, Respondent reported to the Senior Manager that three checklists were missing from the external working papers. The Senior Manager directed Respondent to assemble the missing checklists as a single document (“HH6.8 Working Paper”) and to backdate her sign-off on this working paper to November 2009. The Senior Manager directed Respondent to add the document to the external working papers. The Senior Manager and Respondent reported to the Engagement Partner the facts and circumstances related to the creation of the HH6.8 Working Paper, and the Engagement Partner took no steps to cause the document to be properly dated, or to have it removed from the external working papers.

So those are the wonky details. Where this particular story is most interesting (in our opinion) is that Ms Higgins was, prior to this little mishap, on the fast track. According to the order, she graduated in May of 2005 and started with E&Y in September. She was promoted to senior associate in October of 2007 and then promoted to manager in October of 2009. Now, perhaps she was an audit-savant or perhaps not but in just over four years, she was a manager, which is a much quicker pace than usual.

Granted, she was still under the supervision of the senior manager and partner on the engagement but a young manager nevertheless. Now, you might be asking yourself, “what about the senior manager and partner? Are they getting their wrists slapped?” Conventional wisdom tell us, “absofuckinglutely” but the PCAOB isn’t saying. We were told by a spokesperson that the Board cannot comment on any other action related to this case.

As far as what a censure by the PCAOB actually entails, we were told that “It is an official reprimand from the PCAOB.” Some might call it a wrist slap but we’re damn sure you don’t want that in your file when you’re 27 years old. The action also states that Ms. Higgins was removed from the engagement in July 2010 and “at that time Higgins ceased participating in issuer audit engagements.”

Messages with E&Y spokesperson Charles Perkins and A message left with an attorney for Ms. Higgins were not immediately returned.

Ernst & Young has issued the following statement:

Our firm policy clearly prohibits persons from supplementing audit workpapers in circumstances like those described in the disciplinary order. When we determined that firm policy had been violated, we put the three individuals involved on administrative leave and subsequently separated the partner and senior manager. We have advised the PCAOB of these facts and have cooperated fully with the PCAOB throughout its investigation of this matter.

Based on the above, you might conclude that more disciplinary action will be coming from the PCAOB but like we said, they’re not talking.

UPDATE 2 – circa 3:30 pm: Claudius Modesti, PCAOB Director of Enforcement and Investigations, explained the seemingly light punishment in an email to Going Concern:

As to the censure, under the facts and circumstances, the censure is appropriate given Higgins’ relatively junior position on the audit team and her overall role in the conduct. We also considered the fact that she settled the matter without requiring the Board to commence litigation, which would have been nonpublic as required by the Sarbanes-Oxley Act.”

It was then explained to us that the PCAOB has never explained a disciplinary action in this way: “We also considered the fact that she settled the matter without requiring the Board to commence litigation, which would have been nonpublic as required by the Sarbanes-Oxley Act.”

If that’s not quite clear, consider this: It is significant because, had Ms Higgins acted in the alternative (i.e. not settled), litigation would have been necessary and no one outside of the PCAOB, Higgins, her lawyers and E&Y would have known about the proceedings. Granted, it’s fairly common for lighter disciplinary action to result from a settlement but it also makes sense from a PR perspective (not to mention, transparency and investor protection) if the PCAOB can actually announce that they are taking action against people who break the rules. Part of the challenge the Board has faced is convincing anyone that they have teeth.

It will be interesting now to see if the senior manager and partner follow the same track as Ms. Higgins and how the PCAOB will respond to their cooperation (or lack thereof).

Jacqueline a Higgins CPA[1]