Should Auditors Rotate Every 109 Years?

Independence. Integrity. Objectivity. Professional skepticism. These concepts are bedrock principles of audit quality.

As audit failures continue to plague the accounting profession, the Contributing Columnists of the AAA Public Interest Section offer different perspectives about preserving these principles.

During the next few weeks, a number of our Columnists will present an online conversation about this critical issue. Steven Mintz will kick off our series (below) by addressing GE’s recent travails while raising the suggestion of auditor rotation. Sri Ramamoorti, Michael Kraten, and others will then approach the issue from different directions.

Why are we utilizing our blog in this manner? We are showcasing our perspectives in order to generate interest in our midyear meeting. If you would like to present your own work about accounting and the public interest, please keep in mind that the manuscript submission deadline is Monday, January 14, 2019.

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We are delighted to publish this “opinion piece” by Dr. Steven Mintz, a frequent contributor to our social media blog. As always, when you read his contribution, we ask that you keep in mind that the opinions expressed therein are those of the author. They do not represent the position of the AAA or of any other party.

A new rule adopted by the U.S. Securities and Exchange Commission requires disclosure of the tenure of a public company’s external auditor in the annual report. KPMG recently reported that it has audited GE since 1909. This raises the question whether there should be mandatory audit firm rotation after some period of service. Right now, other than the tenure disclosure, there are no requirements for mandatory audit firm rotation.

The fact that KPMG has audited GE for 109 years is coming under greater scrutiny, given that the SEC disclosed on January 24, 2018 that it was beginning an investigation of the company’s accounting practices. The regulators are investigating a $6.2 billion insurance loss from GE Capital, the troubled financial service business that the company is trying to wind down.

The SEC is also looking into “revenue recognition and controls” for the company’s long-term service agreements including insurance reserves. GE restated its 2016 and 2017 quarterly numbers to reflect new accounting standards. The company lost $9.8 billion in a single recent quarter. With the company’s stock down more than 40 percent during a recent twelve month period, the uncertainty of the accounting investigation raises troubling questions.

The obvious question is: Where were the auditors during the accounting scandals? The answer is: Nowhere To Be Found. In fact, two shareholder watchdog groups – Glass-Lewis and Institutional Shareholder Services — urged shareholders not to ratify KPMG as GE’s auditor at the company’s annual shareholders meeting last April. GE shareholders approved KPMG for another year, but only after overcoming substantial opposition in the wake of GE’s accounting issues. Only 65 percent of shareholders supported GE, an historically low percentage of support. Last year 94 percent of shareholders supported GE.

Let’s examine the potential costs and benefits of auditor rotation. The costs should be obvious. There is a learning curve during which time the audit may not be as efficient and increase the costs to the client. Moreover, a relationship of trust between the audit firm and client builds up over several years and any forced rotation may make it more difficult to build trust simply because of the lesser passage of time. In that regard, GE defended its decision to stick with KPMG, noting that the benefits of a “long-tenured auditor” include “deep expertise” and “familiarity” with the company’s vast business empire. GE also highlighted “independence controls” on KPMG, including “thorough” oversight from the board’s audit committee and requirements that the lead partner be rotated every five years.*

The benefits of forced rotation are subtler. After a period of service (say, 20 years), the auditors may become too complacent and close to the client, creating a familiarity threat to independence. Audit independence and objectivity may fall by the way side. And conflicts of interest may develop over time, making it more difficult for auditors to exercise professional skepticism in gathering and evaluating financial data to ensure that the financial statements do not contain any material misstatements.

The benefits of auditor rotation may also include getting a fresh look at the company’s accounting methods and financial reporting techniques. The new firm may not be biased by past audits, and may critically challenge accounting techniques that smooth net income or create earnings to meet or exceed financial analysts’ earnings consensus estimates. Glass-Lewis chimed in when it wrote to GE shareholders, saying that GE shareholders must beware that “a long-tenured auditor can become too close with a client,” while a new auditor can “uncover problems previously unidentified.”*

The accounting profession contends that the mandatory rotation of principal audit partners sufficiently protects the public interest and builds in the “fresh look” critics are looking for. The Sarbanes-Oxley Act created a five-year auditor requirement. The SEC enforces it through the Public Company Accounting Oversight Board (PCAOB). Critics contend that this is not enough, and that mandatory audit firm rotation is necessary to compensate for years of influence by audit clients over their auditors.

The key factor in evaluating the net benefits of mandatory audit firm rotation is the public interest. The problem is there hasn’t been sufficient research on this issue because the mandatory partner rotation requirement under Sarbanes-Oxley is relatively recent, and less time has gone by since the European Union first required a 10 to 20 year firm rotation.

I have a different perspective. The PCAOB conducts inspections of public company audits every year or so. Why can’t the PCAOB look at the retention issue based on noted deficiencies in audits examined? It’s true that the Board may not look at the same client each year. Still, some kind of overall evaluation of the ethics of the firms, based on audit inspections, might add value to the process of determining when audit firms should be rotated. Noted deficiencies such as a lack of independence, integrity, objectivity, and professional skepticism, the bedrocks of audit quality, should raise questions in the minds of shareholders about whether a firm should be rotated.

The presence of these factors suggests ethical failures in the audits. By making the evaluations public so that shareholders can consider them in their annual retention votes, the firms may take the noted failures more seriously. This may not be the perfect solution, but it does begin the process of holding audit firms accountable for their audits by having meaningful consequences for repeated failures in ethics, and it protects the public interest.

* Source: Matt Egan, GE pressured to fire auditor after 109 years. April 24, 2018.