Audit, Compliance and Risk Blog

Where Is the Regulator of Auditors of Public Companies?

Posted by Ron Pippin on Tue, Oct 09, 2012

auditor independenceThe Public Company Accounting Oversight Board (PCAOB) was created by the U.S. Congress as a result of passage of the Sarbanes-Oxley Act of 2002 (SOX). Some believe that the PCAOB has been sleeping, because its recent activity has not been very visible. But as discussed below, the board is addressing many complex and sometimes highly controversial changes to the auditing profession.

Background—How It All Started

The PCAOB was formed to oversee activities and regulate auditors of public companies that file financial statements with the Securities and Exchange Commission (SEC). Upon its formation in 2002, the board initially accepted as “interim standards” all the rules of the American Institute of Certified Public Accountants (AICPA), which oversees auditors of companies not subject to SEC oversight. Since that time, the PCAOB has been making changes and enhancements to the interim rules.

The latest currently effective rule issued by the board is Auditing Standard No. 15, Audit Evidence, issued on August 5, 2010. All rule changes, once finalized by the board, must be approved by the SEC before they are effective. Auditing Standard No. 16, Communications with Audit Committees, and Amendments to other PCAOB Standards, was issued on August 15, 2012, but it has not received SEC approval—a process that typically takes a few months to complete.

New Standards May Alter the Auditor-Client Relationship

Most of the standard-setting since the PCAOB was created in 2002 has been focused on adding the requirements for internal control reporting, clarifying risk assessment, and “tweaking” the interim standards. For the most part, auditors of public companies have not had to significantly adjust their audit procedures or the way they interact with their public-company clients, but that could soon change.

Probably the most controversial rule being considered by the PCAOB is the one concerning mandatory auditor rotation, as discussed below. However, the board is also:

  • developing rules that would change the verbiage in the auditor’s report; 

  • contemplating certain enhancements to “audit transparency,” including a requirement to disclose the name of the audit partner that supervised the audit and signed the auditor’s opinion; 

  • working on more detailed rules for audits of broker-dealers; and

  • considering standards that auditors must follow when auditing fair value measurements.

PCAOB Rulemaking, Due Process, and the “Concept Release” on Auditor Rotation

Whenever the PCAOB plans to issue a new rule or changes to its standards, the five-member board debates the merits of the rule change, receives input from its staff on how to develop the new or amended rule, and then issues a proposal. After the proposal is issued, stakeholders such as auditors, companies, and investor groups are encouraged to send comments to the board expressing their views on the proposal. The PCAOB, with help from its staff, considers the comments and whether to finalize the rule as proposed or change anything in the proposal. Any final rule is subject to SEC approval, although to date, the SEC has not made any significant changes to a final PCAOB auditing standard. All of these steps are typical of the due process required when any authority promulgates a new standard.

However, when the PCAOB is considering rule changes that may be controversial, it follows additional due process steps. For example, on August 16, 2011, the PCAOB issued for public comment a “concept release” titled Auditor Independence and Audit Firm Rotation. A concept release serves as a “trial balloon”—it discusses the topic without proposing any specific rules, but the board seeks input on the discussion in the release.

Specifics of the PCAOB Concept Release on Auditor Rotation

The suggestion that a company should periodically rotate its auditor has been around for years. Some argue that it increases auditor skepticism, strengthens a company’s internal controls, and enhances its corporate governance. However, the concept of auditor rotation is controversial because it would likely increase cost and some say lessen audit quality. Others believe that audit quality would increase.

The stated purpose of the PCAOB’s August 16, 2011, concept release on auditor rotation is to “solicit public comment on ways that auditor independence, objectivity and professional skepticism could be enhanced.” The concept release includes the following observation:

… a rotation requirement would aim directly at the basic conflict that, while inherent in the Securities Act of 1933, too often proves difficult for auditors to overcome. By ending a firm’s ability to turn each new engagement into a long-term income stream, mandatory firm rotation could fundamentally change the firm’s relationship with its audit client and might, as a result, significantly enhance the auditor’s ability to serve as an independent gatekeeper.

The PCAOB is seeking constituent views on 21 specific questions expressed in its concept release; for example, two such questions are:

  • Should different term lengths for different kinds of engagements be considered? If so, what characteristics, such as client size or industry, should this differentiation be based on?

  • Does audit effectiveness vary over an auditor’s tenure on a particular engagement? For example, are auditors either more or less effective at the beginning of a new client relationship? If there is a “learning curve” before auditors can become effective, generally how long is it, and does it vary significantly by client type?

Public Comment on the Concept Release, and What Will Happen Next

Now that the comment period on the PCAOB concept release on auditor rotation has expired, roundtable forums are progressing. The first such forum was held in March 2012, followed by a second one in June, with the third one scheduled for October 18, 2012. The PCAOB received nearly 700 letters of comment on this concept release—a typical proposal or release will generate less than 100 letters of comment.

The battleground is set and the outcome is unknown. Accounting firms and their clients are generally opposed, whereas investor groups are supportive of the concept. For example, Ernst & Young, one of the Big 4 accounting firms, concludes in its comment letter: "we do not believe further consideration of mandatory audit firm rotation is in the public interest.” KPMG, another Big 4 accounting firm, closes its comment letter as follows: “we believe that mandatory audit firm rotation could undermine the effectiveness of this architecture and present risks to audit quality as well as significant costs and practical problems for auditors and public companies.”

After the PCAOB finishes its roundtable forums, the board will likely decide whether to pursue a rule or drop the matter and look for other ways to increase auditor independence. Either way, no decisions are likely until 2013, and if the board does decide to propose such a rule, any final rule is likely not to be in effect until two to three years thereafter.

The concept release, comments letters, and access to other PCAOB material are available at its website


About the Author

Ron Pippin is an experienced CPA based in Wheaton, IL. His 40 plus year career includes being an audit partner in Arthur Andersen, a member of Andersen’s Professional Standards Group (“national office”) in Chicago, the Director of Financial Reporting for a Fortune 50 company and most recently, the editorial director of CCH’s Accounting Research Manager. Currently, Ron does independent writing and analysis together with accounting consultation on a variety of topics.

Tags: Corporate Governance, SEC, Accounting & Tax