How to Put More Distance Between Banks and Their Auditors

Mandatory rotation of a company's external auditors is not a popular idea among the audit firms or their clients.

The Public Company Accounting Oversight Board, the audit industry regulator, sought input last week from investors, auditors, academics and former regulators on a controversial "concept release" on the idea. More than 45 speakers gave their opinions of various ways to put rotation into practice. All of the suggestions made were intended to improve auditor independence, professional skepticism and, hopefully, audit quality.

PCAOB Chairman Jim Doty opened the meetings this week with the admission that fixed term limits for auditor relationships "would significantly alter the status quo." That is an understatement. The PCAOB received more than 600 comment letters, almost all in opposition to mandatory rotation.

Audit committee members object to such mandates because of the perceived cost. They also accuse the PCAOB of trying to usurp the enhanced role and responsibilities delegated to audit committees by the Sarbanes-Oxley Act. Audit firm CEOs say mandatory rotation would distract them from audit quality assurance and force the partners to focus on responding to constant requests for proposals and marketing activities. The auditor firms would rather collect oligopolistic fees from a government-mandated franchise without having to compete or justify those fees.

Some company representatives claim they would have to spend too much time and money getting new auditors up to speed on company culture and complex customized systems. Academics and former regulators, politically sensitive when in doubt, are divided on the advantages and disadvantages of mandatory auditor swaps.

Data firm Audit Analytics says that about 175 companies in the S&P 500 have used the same auditor for 25 years or more. The average tenure for audit firms at the top 100 U.S. companies by market cap is 28 years and 20 of those companies used the same auditor for 50 years or more.

Inertia is in evidence among the largest banks. In 2010, Citigroup (or rather the U.S. Treasury, which still owned 27% of the bank’s stock at the time), reappointed KPMG to its 41st consecutive year as auditor. JP Morgan Chase and Bank of America have both been using PricewaterhouseCoopers for a while, since 1965 and 1958 respectively. KPMG has been working with Wells Fargo since 1931.

And cozy ties between auditor and audited have an inglorious history. Consider that Ernst & Young had audited Lehman Brothers since before it was spun off from American Express in 1994, right up until the investment bank failed in 2008. Three of four chief financial officers at Lehman Brothers since 2000 were Ernst & Young alumni, including David Goldfarb, a former senior partner of the audit firm, who as Lehman’s CFO concoted the infamous Repo 105 balance sheet window-dressing technique.

But I'm not in favor of mandatory auditor rotation, in particular for the big banks. That's not because it costs too much or disrupts the company. Good corporate governance costs money and that’s a cost of doing good business.

Upsetting the relationships between banks and their auditors is, unfortunately, very disruptive to audit firms because of independence requirements. Rotation may force an audit firm to move all accounts, lines of credit, and other funding facilities to another bank. SEC rules prevent auditors from doing business with the bank that holds partner and firm money.

Moreover, I oppose mandatory auditor rotation because it's too much like term limits for elected officials. Both allow abdication of the responsibility for booting bad actors. And it’s an exercise in futility. Companies would be forced to move their audit from one potentially corruptible audit firm to another.

One of the speakers at the PCAOB forum last week, James Alexander, the head of equity Research at M&G Investment Management (a division of the U.K. life and pensions company Prudential PLC), said the implied guarantee by sovereigns for the too-big-to-fail banks means investors already depend more on regulators than audits to reassure them banks are safe and sound. In essence, for some banks, "audits don’t matter."

Large banks went down the drain during the crisis with no warning or "going concern" qualification from the auditors prior to the failure, bailout, or nationalization. In the U.K., the CEOs of the four largest audit firms told the House of Lords that they held back on "going concern" qualifications for failing banks because the auditors were told the government would bail out the banks.

The PCAOB’s inspection findings, as well as those of international counterparts such as the U.K.’s Financial Services Authority, show clearly and repeatedly that more needs to be done to ensure audit quality and protect investors. Inspection reports say deficiencies in professional skepticism are causing audit firms to have persistent quality problems. Investors could use an independent set of fresh eyes to warn them of issues before regulators have to get involved.

In my opinion, audit committees, regulators, and plaintiffs must follow and enforce rules already on the books that charge the audit committees with hiring and firing auditors. That includes booting an auditor that's not doing the job when it allows executives to put banks at risk of failure for their own enrichment.

Several speakers proposed a sensible compromise. Audit committees could be forced to put the audit out to competitive bid every seven to 10 years or so, with a "comply or explain" regime that requires disclosure about the decision to switch firms or retain the incumbent. That would likely push audit committees, and the CFOs and CEOs who inappropriately influence them at times, out of their comfort zone. Audit firms may even quit more often when company executives try to bully them rather than rolling over and playing dead. It’s always better to walk out on your own terms than be kicked out.

Francine McKenna writes the blog re: The Auditors, about the Big Four accounting firms. She worked in consulting, professional services, accounting and financial management for more than 25 years.