Rotating audit firms might cause more harm than good.
By George G. Johnson
For years, there has been debate about whether or not organizations, including nonprofits, should adopt mandatory audit firm rotation practices in order to prevent auditing firms from compromising their independence and becoming too comfortable with a client. There is concern that familiarity between an auditor and client may foster a stale relationship, leading to complacency in the audit work.
While these are legitimate concerns, many groups, including the American Institute of Certified Public Accountants (AICPA), the Securities and Exchange Commission (SEC), the United States General Accounting Office (GAO), as well as academics, have studied mandatory audit firm rotation and oppose its practice since there has been a lack of evidence showing any sort of associated benefits.
In fact, studies by the Public Oversight Board (POB) have shown that audits are actually three times more likely to fail during the first two years of a relationship between an auditor and a new firm. This is a result due to the lack of tenure of the audit firm and the competence in which the audit is conducted. Each time a new auditor begins working with an organization, there is a necessary introductory phase where open communication is less likely to take place because of a lack of familiarity between the two parties.
Additionally, an auditor must be able to determine when a client is not revealing all available information, which naturally comes from the knowledge gained in a long-term relationship with the client and its management team. By working with the same client over an extended period of time, a certain amount of institutional knowledge is gained, making it much easier to detect fraud.
Another pitfall that may happen as a result of mandatory audit firm rotation is a lame duck auditing session. There is more of a chance for complacency to set in knowing that a relationship is about to expire. CPA firms have indicated that they would likely remove their most experienced partners from an audit in its final year of an engagement so that they can focus their work for more established clients. With less experience on a lame duck audit team, the probability of an error occurring in the audit process is significantly increased.
Naturally, the client also gains a certain level of comfort working and communicating with auditors over time. Subconsciously, we don’t communicate as openly with others when there is less familiarity in a relationship. Clients are much more likely to share information and communicate any potential problems.
Mandatory audit firm rotation also incurs an increase in cost. Auditors need to spend a substantial amount of billable time simply learning the organization’s culture, accounting systems, processes, people, industry, and associated risks in order to perform an accurate audit. This goes for both the audit firm and the organization.
The time spent during the “getting-to-know-you” period could also affect the auditor’s ability to report information in a timely manner, as resources and time are being dedicated to learning about the new client. Experts feel that it takes at least two years for auditors and clients to get on the same page in terms or sharing all critical information that should be understood during an audit.
To address the concern of auditor independence, professionals in the accounting industry already feel that auditing committees have the appropriate amount of control and influence when it comes to maintaining independence. Audit committees and, additionally, the Public Company Accounting Oversight Board (PCAOB), have a responsibility to oversee auditors and mandatory audit firm rotation could potentially diminish their influence.
If an organization does require some form of rotation, they should consider rotation of auditing staff within the firm they are already working with. This will ensure that the audit will be done with fresh set of eyes without losing any of the institutional knowledge that has been built up over time.
The overwhelming majority of organizations and academics familiar with accounting and the auditing process oppose mandatory audit firm rotation policies because of the lack of evidence showing any improvement that may stem from rotation. Studies have shown that audits are much more likely to fail in the first two years of engagement with a new auditing firm. When you factor in augmented costs with the increased failure rate, there really is no rational reason to institute mandatory audit firm rotation practices.
George G. Johnson, CPA, is the managing director for certified public accounting and professional services firm George Johnson & Company.