Public Accounting Firms: Required Study on the Potential Effects
of Mandatory Audit Firm Rotation (21-NOV-03, GAO-04-216).
Following major failures in corporate financial reporting, the
Sarbanes-Oxley Act of 2002 was enacted to protect investors
through requirements intended to improve the accuracy and
reliability of corporate disclosures and to restore investor
confidence. The act included reforms intended to strengthen
auditor independence and to improve audit quality. Mandatory
audit firm rotation (setting a limit on the period of years a
public accounting firm may audit a particular company's financial
statements) was considered as a reform to enhance auditor
independence and audit quality during the congressional hearings
that preceded the act, but it was not included in the act. The
Congress decided that mandatory audit firm rotation needed
further study and required GAO to study the potential effects of
requiring rotation of the public accounting firms that audit
public companies registered with the Securities and Exchange
Commission.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-04-216
ACCNO: A08911
TITLE: Public Accounting Firms: Required Study on the Potential
Effects of Mandatory Audit Firm Rotation
DATE: 11/21/2003
SUBJECT: Audit oversight
Auditing procedures
Auditing standards
Corporate audits
Financial institutions
Financial records
Financial statement audits
Financial statements
Reporting requirements
Accounting procedures
Accounting standards
******************************************************************
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GAO-04-216
United States General Accounting Office
GAO Report to the Senate Committee on Banking, Housing, and Urban Affairs
and
the House Committee on Financial Services
November 2003
PUBLIC ACCOUNTING FIRMS
Required Study on the Potential Effects of Mandatory Audit Firm Rotation
a
GAO-04-216
Highlights of GAO-04-216, a report to Senate Committee on Banking,
Housing, and Urban Affairs and House Committee on Financial Services
Following major failures in corporate financial reporting, the
Sarbanes-Oxley Act of 2002 was enacted to protect investors through
requirements intended to improve the accuracy and reliability of corporate
disclosures and to restore investor confidence. The act included reforms
intended to strengthen auditor independence and to improve audit quality.
Mandatory audit firm rotation (setting a limit on the period of years a
public accounting firm may audit a particular company's financial
statements) was considered as a reform to enhance auditor independence and
audit quality during the congressional hearings that preceded the act, but
it was not included in the act. The Congress decided that mandatory audit
firm rotation needed further study and required GAO to study the potential
effects of requiring rotation of the public accounting firms that audit
public companies registered with the Securities and Exchange Commission.
www.gao.gov/cgi-bin/getrpt?GAO-04-216.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Jeanette M. Franzel at (202)
512-9471 or [email protected].
November 2003
PUBLIC ACCOUNTING FIRMS
Required Study on the Potential Effects of Mandatory Audit Firm Rotation
The arguments for and against mandatory audit firm rotation concern
whether the independence of a public accounting firm auditing a company's
financial statements is adversely affected by a firm's long-term
relationship with the client and the desire to retain the client. Concerns
about the potential effects of mandatory audit firm rotation include
whether its intended benefits would outweigh the costs and the loss of
company-specific knowledge gained by an audit firm through years of
experience auditing the client. In addition, questions exist about whether
the Sarbanes-Oxley Act requirements for reform will accomplish the
intended benefits of mandatory audit firm rotation.
In surveys conducted as part of our study, GAO found that almost all of
the largest public accounting firms and Fortune 1000 publicly traded
companies believe that the costs of mandatory audit firm rotation are
likely to exceed the benefits. Most believe that the current requirements
for audit partner rotation, auditor independence, and other reforms, when
fully implemented, will sufficiently achieve the intended benefits of
mandatory audit firm rotation. Moreover, in interviews with other
stakeholders, including institutional investors, stock market regulators,
bankers, accountants, and consumer advocacy groups, GAO found the views of
these stakeholders to be consistent with the overall views of those who
responded to its surveys.
GAO believes that mandatory audit firm rotation may not be the most
efficient way to strengthen auditor independence and improve audit quality
considering the additional financial costs and the loss of institutional
knowledge of the public company's previous auditor of record, as well as
the current reforms being implemented. The potential benefits of mandatory
audit firm rotation are harder to predict and quantify, though GAO is
fairly certain that there will be additional costs.
Several years' experience with implementation of the Sarbanes-Oxley Act's
reforms is needed, GAO believes, before the full effect of the act's
requirements can be assessed. GAO therefore believes that the most prudent
course of action at this time is for the Securities and Exchange
Commission and the Public Company Accounting Oversight Board to monitor
and evaluate the effectiveness of existing requirements for enhancing
auditor independence and audit quality.
GAO believes audit committees, with their increased responsibilities under
the act, can also play an important role in ensuring auditor independence.
To fulfill this role, audit committees must maintain independence and have
adequate resources. Finally, for any system to function effectively, there
must be incentives for parties to do the right thing, adequate
transparency over what is being done, and appropriate accountability if
the right things are not done.
Contents
Letter
Results in Brief
Background
Pros and Cons of Requiring Mandatory Audit Firm Rotation
Results of Our Surveys
Competition-Related Issues
Overall Views on Mandatory Audit Firm Rotation
Overall Views of Other Knowledgeable Individuals on Mandatory
Audit Firm Rotation
Survey Groups Views on Implementing Mandatory Audit Firm Rotation if
Required and Other Alternatives for Enhancing Audit Quality
Auditor Experience in Restatements of annual Financial Statements Filed
with the SEC for 2001 and 2002 Experience of Foreign Countries with
Mandatory Audit Firm
Rotation GAO Observations Agency Comments and Our Evaluation
1 5 10 13 14
33 37
40
44
46
48 49 52
Appendixes
Appendix I:
Appendix II:
Appendix III:
Appendix IV: Appendix V: Appendix VI:
Objectives, Scope, and Methodology
Implementation of Mandatory Audit Firm Rotation, if Required
Potential Value of Practices Other Than Mandatory Audit Firm Rotation for
Enhancing Auditor Independence and Audit Quality
Restatements of Annual Financial Statements for Fortune 1000 Public
Companies Due To Errors or Fraud
International Experience with Mandatory Audit Firm Rotation
GAO Contacts and Staff Acknowledgments
GAO Contacts
Staff Acknowledgments
54 72
75
78
83
91 91 91
Tables Table 1: Audit Committee Chairs' Reasons for Limiting
Consideration to Only Big 4 Firms 37
Table 2: Public Accounting Firms' Population, Sample Sizes, and
Survey Response Rates 62
Contents
Table 3: Public Company Chief Financial Officers' Population, Sample
Sizes, and Survey Response Rates 66 Table 4: Public Company Audit
Committee Chairs' Population, Sample Sizes, and Survey Response Rates 66
Table 5: Views on Potential Value of Other Practices for Enhancing Auditor
Independence and Audit Quality 77 Table 6: Summary Results of the Fortune
1000 Public Companies That Changed Auditors 79 Table 7: Summary Results of
the Fortune 1000 Public Companies That Did Not Change Auditors 79 Table 8:
Summary of Net Dollar Effect of Restatements Due to Errors and Fraud 82
Figures Figure 1: Figure 2: Figure 3:
Figure 4:
Figure 5: Figure 6:
Figure 7: Figure 8: Figure 9:
Estimated Audit Firm Tenure for Fortune 1000 Public
Companies 17
Tier 1 Firms: Value of Additional Procedures When Firm
Has Less Knowledge and Experience with a Client 20
Fortune 1000 Public Companies' Belief That Additional or
Enhanced Audit Procedures Would Affect the Risk of Not
Detecting Material Misstatements 21
Views on How Mandatory Audit Firm Rotation Would
Affect the Auditor's Potential to Deal with Material
Financial Reporting Issues Appropriately 24
Expected Increase in Initial Year Audit Costs over
Subsequent Year Audit Costs 28
Tier 1 Firms Expecting Additional Expected Marketing
Costs under Mandatory Audit Firm Rotation Compared to
Initial Year Audit Fees 30
Fortune 1000 Public Companies' Expected Selection
Costs as a Percentage of Initial Year Audit Fees 31
Fortune 1000 Public Companies' Expected Support Costs
as a Percentage of Initial Year Audit Fees 32
Support for Mandatory Audit Firm Rotation 40
Contents
Abbreviations
AICPA American Institute of Certified Public Accountants
CGAA Co-ordinating Group on Audit and Accounting Issues
CNMV Comision Nacional del Mercaso de Valores
CONSOB Commissione Nazionale per le Societa e la Borsa
CVM Comissao de Valores Mobiliarios
EDGAR Electronic Data Gathering, Analysis, and Retrieval
G-7 Group of Seven Industrialized Nations
GAAP generally accepted accounting principles
GAAS generally accepted auditing standards
IOSCO International Organization of Securities Commissions
NIvRA Royal Nederlands Instituut van Register Accountants
NOvAA Nederlandse Orde van Accountants-
Administratieconsulenten OSFI Office of the Superintendent of Financial
Institutions PCAOB Public Company Accounting Oversight Board POB Public
Oversight Board SEC Securities and Exchange Commission SECPS SEC Practice
Section
This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
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separately.
A
United States General Accounting Office Washington, D.C. 20548
November 21, 2003
The Honorable Richard C. Shelby
Chairman
The Honorable Paul S. Sarbanes
Ranking Minority Member
Committee on Banking, Housing, and Urban Affairs
United States Senate
The Honorable Michael G. Oxley
Chairman
The Honorable Barney Frank
Ranking Minority Member
Committee on Financial Services
House of Representatives
Full, fair, and accurate reporting of financial information by public
companies1 is critical to the effective functioning of the capital and
credit
markets in the United States. Federal securities laws and regulations
require publicly owned companies to disclose financial information in a
manner that accurately depicts the results of company activities and
require that the companies' financial statements be audited by an
independent public accountant. Although public company management is
responsible for the company's financial statements, public confidence in
the integrity of financial statements of publicly traded companies is
enhanced by the audit process and independence of the auditor from the
audit client.
Major failures in corporate financial reporting in recent years, including
accountability breakdowns at Enron and WorldCom and other major
corporations, that led to restatement of financial statements and
bankruptcy adversely affected thousands of shareholders and employees.
As a result, the Sarbanes-Oxley Act of 20022 was enacted to protect
investors by improving the accuracy and reliability of corporate
disclosures. The act's requirements included reforms to strengthen
1 For purposes of this report, public companies refers to issuers, the
securities of which are registered under 15 U.S.C. S: 78l, that are
required to file reports under 15 U.S.C. S: 780 (d), or that file or have
filed a registration statements that have not yet become effective under
the Securities Act of 1933.
2 Pub. L. No. 107-204, 116 Stat. 745.
corporate responsibility for financial reports and auditor independence
and created the Public Company Accounting Oversight Board (PCAOB). The
PCAOB has the responsibility to register and inspect public accounting
firms that audit public companies, and the authority to investigate and
discipline registered public accounting firms and to set auditing and
related attestation, quality control, and auditor ethics and independence
standards in connection with audits of public companies.
Senate report 107-205 that accompanied the Sarbanes-Oxley Act stated that
in considering reforms to enhance auditor independence, some witnesses
believed that mandatory audit firm rotation3 of public accounting firms
was necessary to maintain the objectivity of audits, while other witnesses
believed that public accounting firm rotation could be disruptive to the
public company and the costs of mandatory audit firm rotation might
outweigh the benefits. The Congress decided that mandatory audit firm
rotation needed further study and required in Section 207 of the
Sarbanes-Oxley Act that GAO study the issues. Specifically, we were asked
to study the potential effects of requiring mandatory rotation of
registered public accounting firms.4 To conduct our study, we did the
following:
o Identified and reviewed research studies and other documents that
addressed issues concerning auditor independence and audit quality
associated with the length of a public accounting firm's tenure and the
costs and benefits of mandatory audit firm rotation.
o Analyzed the issues we identified to (1) develop detailed
questionnaires to obtain the views of public accounting firms and public
company chief financial officers and their audit committee chairs of the
issues associated with mandatory audit firm rotation, (2) hold discussions
with officials of other interested stakeholders, such as institutional
investors, federal banking regulators, U.S. stock exchanges, state boards
of accountancy, the American Institute of Certified Public Accountants
3 Mandatory rotation is defined in the Sarbanes-Oxley Act as the
imposition of a limit on the period of years in which a particular public
accounting firm registered with the PCAOB may be the auditor of record for
a particular public company. For purposes of this report, the auditor of
record is the public accounting firm issuing an audit opinion of the
public company's financial statements.
4 Section 102 of the Sarbanes-Oxley Act requires public accounting firms
that want to audit public companies to register with the PCAOB and states
that it shall be unlawful for any person who is not a registered public
accounting firm to prepare, issue, or participate in the preparation or
issuance of any audit report with respect to any issuer.
(AICPA), the Securities and Exchange Commission (SEC), and the PCAOB to
obtain their views on the issues associated with mandatory audit firm
rotation, and (3) obtain information from other countries on their
experiences with mandatory audit firm rotation.
o Identified restatements of annual financial statements for Fortune 1000
public companies due to errors or fraud that were reported to the SEC for
years 2001 and 2002 through August 31, 2003, to (1) determine whether the
restatement occurred after a change in the public companies' auditor of
record, and (2) to obtain some insight into the value of a "fresh look" by
a new auditor of record.
Our population of public accounting firms consisted of three tiers: Tier 1
firms included 92 public accounting firms that were members of the AICPA's
self-regulatory program for audit quality that reported having 10 or more
SEC clients in 2001 and 5 public accounting firms that were not members of
the AICPA's self-regulatory program but had 10 or more public company
clients registered with the SEC in 2001.5 Tier 2 firms included 604 public
accounting firms that were members of the AICPA's self-regulatory program
for audit quality that reported having 1 to 9 public company clients
registered with the SEC in 2001.6 Tier 3 firms included 421 public
accounting firms that were members of the AICPA's self-regulatory program
for audit quality that reported having no public company clients
registered with the SEC in 2001. We surveyed 100 percent of the 97 Tier 1,
firms and we administered our surveys to random samples of 282 of the 604
Tier 2 firms and 237 of the 421 Tier 3 firms. We received responses from
74 of the 97 Tier 1 firms, or 76.3 percent.7 Because of the more limited
participation of Tier 2 firms (85, or 30.1 percent) and Tier 3 firms (52,
or 21.9 percent) in our survey, we are not projecting their responses to
the population of these firms. The presentation of this report focuses on
the
5 The 92 Tier 1 firms with 10 or more public company clients represented
about 90 percent of the total public company clients reported by member
firms in their 2001 annual reports to the AICPA's former self-regulatory
program for audit quality. Hereafter in this report, "Tier 1 firms" refers
to the 97 firms that had 10 or more public company clients.
6 The 604 Tier 2 firms with 1 to 9 public company clients in 2001
represented about 10 percent of the total public company clients reported
by member firms in their 2001 annual reports to the AICPA's former
self-regulatory program for audit quality.
7 Estimates of Tier 1 firms are subject to sampling errors of no more than
plus or minus 7 percentage points (95 percent confidence level) unless
otherwise noted, as well as to possible nonsampling errors generally found
in surveys.
responses from the Tier 1 firms, but any substantial differences in their
overall views and those reported to us by either the Tier 2 or 3 firms
that responded to our survey is discussed where applicable.
We also drew random samples of 330 of the Fortune 1000 public companies8
after removing 40 private companies from the list, 450 of the 14,887 other
domestic companies and mutual funds, and 391 of 2,141 foreign companies
that make up the universe of the 17,988 public companies that are
registered with the SEC as of February 2003. For each of these three
groups of public companies, we asked their chief financial officers and
audit committee chairs to complete separate questionnaires.
Of the 330 Fortune 1000 public companies sampled, we received responses
from 201, or 60.9 percent, of their chief financial officers and 191, or
57.9 percent, of their audit committee chairs.9 Because of limited
participation of the other domestic companies and mutual funds (131, or
29.1 percent, of their chief financial officers and 96, or 21.3 percent,
of their audit committee chairs) and the foreign public companies (99, or
25.3 percent, of their chief financial officers and 63, or 16.1 percent,
of their audit committee chairs), we are not projecting their responses to
the population of such companies. This report focuses on the responses
from the Fortune 1000 public companies' chief financial officers and their
audit committee chairs, but any substantial differences between their
overall views and those reported to us by the other groups of public
companies that responded to our surveys is discussed where applicable.
For additional information on our scope and methodology including details
of our samples, response rates, and efforts to follow up with
nonrespondents to our surveys, see appendix I. We conducted our work in
Washington, D.C., between November 2002 and November 2003 in accordance
with U.S. generally accepted government auditing standards.
8 We removed 40 private companies from the list of Fortune 1000 public
companies. Therefore, our population of Fortune 1000 public companies was
960.
9 The estimates from these surveys are subject to sampling errors of no
more than plus or minus 6 percentage points (95 percent confidence level)
unless otherwise noted, as well as to possible nonsampling errors
generally found in surveys.
A copy of each of our questionnaires, annotated to show in total the
respondents' answers to each question for the Tier 1 firms and the Fortune
1000 public companies chief financial officers10 and their audit committee
chairs, will be presented in a separate GAO report (GAO-04-217) to be
issued at a later date.
Results in Brief Nearly all Tier 1 firms and Fortune 1000 public companies
and their audit committee chairs believed that the costs of mandatory
audit firm rotation are likely to exceed the benefits. Also, most Tier 1
firms and Fortune 1000 public companies and their audit committee chairs
believe that either the audit firm partner rotation requirements of the
Sarbanes-Oxley Act as implemented by the SEC, or those partner rotation
requirements coupled with other requirements of the Sarbanes-Oxley Act
that concern auditor independence and audit quality, will sufficiently
achieve the benefits of mandatory audit firm rotation when fully
implemented. Our discussions with a number of other knowledgeable
individuals in a variety of fields, such as institutional investment;
regulation of the stock markets, the banking industry, and the accounting
profession; and consumer advocacy, showed that most of the individuals we
spoke with held views consistent with the overall views expressed by those
who responded to our surveys.
Considering the arguments for and against mandatory audit firm rotation
and the requirements of the Sarbanes-Oxley Act concerning auditor
independence and audit quality, which are also intended to achieve the
same type of benefits as mandatory audit firm rotation, we believe that
more experience needs to be gained with the act's requirements. Therefore,
the most prudent course at this time is for the SEC and the PCAOB to
monitor and evaluate the effectiveness of the act's requirements to
determine whether further revisions, including mandatory audit firm
rotation, may be needed to enhance auditor independence and audit quality
to protect the public interest.
Our research of studies concerning issues related to mandatory audit firm
rotation showed the primary arguments relate to auditor independence,
audit quality, audit cost, and competition-related issues for providing
audit services. Regarding auditor independence and audit quality issues,
our
10 Hereafter, "Fortune 1000 public companies" refers to their chief
financial officers.
analysis of survey results of Tier 1 firms and Fortune 1000 public
companies showed the following:
o The average length of the auditor of record's tenure, which proponents
of mandatory audit firm rotation believe increases the risk that auditor
independence and ultimately audit quality may be adversely affected, was
about 22 years for Fortune 1000 public companies.
o About 79 percent of Tier 1 firms and Fortune 1000 public companies
believe that changing audit firms increases the risk of an audit failure
in the early years of the audit as the new auditor acquires the necessary
knowledge of the company's operations, systems, and financial reporting
practices and therefore may fail to detect a material financial reporting
issue.
o Most Tier 1 firms and Fortune 1000 public companies believe that
mandatory audit firm rotation would not have much effect on the pressures
faced by the audit engagement partner in appropriately dealing with
material financial reporting issues.
o About 59 percent of Tier 1 firms reported they would likely move their
most knowledgeable and experienced audit staff as the end of the firm's
tenure approached under mandatory audit firm rotation to attract or retain
other clients, which they acknowledged would increase the risk of an audit
failure.
Regarding audit costs, our survey results show that Tier 1 firms and
Fortune 1000 public companies expect that mandatory audit firm rotation
would lead to more costly audits.
o Nearly all Tier 1 firms estimated that initial year audit costs under
mandatory audit firm rotation would increase by more than 20 percent over
subsequent year costs to acquire the necessary knowledge of the public
company and most of the Tier 1 firms estimated their marketing costs would
also increase by at least more than 1 percent, which would be passed on to
the public companies.
o Most Fortune 1000 public companies estimated that under mandatory audit
firm rotation, they would incur auditor selection costs and additional
auditor support costs totaling at least 17 percent or higher as a
percentage of initial year audit fees.
Our check of audit fees and total company operating expenses reported by a
selection of large and small public companies in 23 industries for the
most recent fiscal year available found that for the large public
companies selected, average audit fees represented approximately 0.04
percent of company operating expenses and, for the small public companies
selected, average audit fees represented approximately 0.08 percent of
company operating expenses. Based on estimates of possible increased
audit-related costs from survey responses from Tier 1 firms and Fortune
1000 public companies, mandatory audit firm rotation could increase these
auditrelated costs from 43 percent to 128 percent of the recurring annual
audit fees. This illustration is intended only to provide some insight
into how, based on Tier 1 firms' and Fortune 1000 public companies'
responses, mandatory audit firm rotation may affect the initial year
audit-related costs public companies may incur and is not intended to be
representative.
Regarding competition-related effects of mandatory audit firm rotation, 54
percent of Tier 1 firms believe mandatory audit firm rotation would
decrease the number of firms willing and able to compete for audits of
public companies and 83 percent of Tier 1 firms believe that the market
share of public company audits would either become more concentrated in a
small number of public accounting firms or would remain the same. As we
have previously reported,11 the number of public accounting firms
providing audit services to public companies is highly concentrated with
the 4 largest firms auditing over 78 percent of all U.S. public companies
and 99 percent of public company sales. Many Fortune 1000 public companies
reported that they will only use a Big 4 firm for a variety of reasons,
including the capability of the firms to provide them audit services and
the expectations of the capital markets that they will use Big 4 firms.
Mandatory audit firm rotation would further decrease their choices for an
auditor of record, and the Sarbanes-Oxley Act auditor independence
requirements concerning prohibited nonaudit services may also further
limit the public companies' choices for an auditor of record. Tier 1 firms
expected that public companies in specialized industries, which in some
industries currently have more limited choices for an auditor of record
than other public companies, could be more affected by mandatory audit
firm rotation than other public companies.
11 U.S. General Accounting Office, Public Accounting Firms: Mandated Study
on Consolidation and Competition, GAO-03-864 (Washington, D.C.: July 30,
2003).
We believe that mandatory audit firm rotation may not be the most
efficient way to enhance auditor independence and audit quality
considering the additional financial costs and the loss of institutional
knowledge of a public company's previous auditor of record. The potential
benefits of mandatory audit firm rotation are harder to predict and
quantify, though we are fairly certain that there will be additional
costs. In addition, the current reforms being implemented may also provide
some of the intended benefits of mandatory audit firm rotation. In that
respect, mandatory audit firm rotation is not a panacea that totally
removes the pressures on the auditors in appropriately resolving financial
reporting issues that may materially affect the public companies'
financial statements. These inherent pressures are likely to continue even
if the term of the auditor is limited under any mandatory rotation
process. Furthermore, most public companies will only use the Big 4 firms
for audit services. Given this preference, these public companies may only
have 1 or 2 real choices for auditor of record under any mandatory
rotation system given the importance of industry expertise and the
Sarbanes-Oxley Act's auditor independence requirements. However, over time
a mandatory audit firm rotation requirement may result in more firms
transitioning into additional industry sectors if the market for such
audits has sufficient profit margins.
The Sarbanes-Oxley Act contains significant reforms aimed at enhancing
auditor independence (e.g., additional partner rotation requirements and
restrictions on providing nonaudit or consulting services) and audit
quality (e.g., establishing the PCAOB and management and auditor reporting
on internal controls over financial reporting) that are also intended to
achieve the same type of benefits as mandatory audit firm rotation. The
PCAOB's inspection program for registered public accounting firms could
also provide an opportunity to provide a "fresh look", which would enhance
auditor independence and audit quality through the program's inspection
activities and also may provide new insights regarding (1) public
companies' financial reporting practices that pose a high risk of issuing
materially misstated financial statements for the audit committees to
consider and (2) possibly either using the auditor of record or another
firm to assist in reviewing these areas. However, it will take at least
several years for the SEC and the PCAOB to gain sufficient experience with
the effectiveness of the act in order to adequately evaluate whether
further enhancements or revisions, including mandatory audit firm
rotation, may be needed to further protect the public interest and to
restore investor confidence. The current environment has greatly increased
the pressures on public company management and auditors regarding honest,
fair, and complete financial reporting, but it is uncertain if the current
climate will
be sustained over the long term. Rigorous enforcement of the act's
requirements will undoubtedly be critical to its effectiveness.
We also believe that audit committees with their increased
responsibilities under the Sarbanes-Oxley Act can play a very important
role in enhancing auditor independence and audit quality. In that respect,
the Conference Board Commission on Public Trust and Private Enterprise
stated in its January 9, 2003, report that auditor rotation is a useful
tool for building shareholder confidence in the integrity of the audit and
of the company's financial statements. The commission advocated that audit
committees should consider rotating audit firms when there are
circumstances that could call into question the audit firm's independence
from management. These circumstances included when (1) significant
nonaudit services are provided by the auditor of record to the company
(even if approved by the audit committee), (2) one or more former partners
or managers of the audit firm are employed by the company, or (3) lengthy
tenure of the auditor of record, such as over 10 years-which our survey
results show is prevalent at many Fortune 1000 public companies. We
believe audit committees that encounter these circumstances, at a minimum,
need to be especially vigilant in the oversight of the auditor and in
considering whether a "fresh look" (e.g., new auditor) is needed. We also
believe that if audit committees regularly evaluated whether audit firm
rotation would be beneficial, given the facts and circumstances of their
companies' situation, and are actively involved in helping to ensure
auditor independence and audit quality, many of the benefits of audit firm
rotation could be realized at the initiative of the audit committees
rather than through a mandatory rotation requirement.
In order to be effective, however, audit committees need to have access to
adequate resources, including their own budgets, to be able to operate
with the independence necessary to effectively perform their
responsibilities under the Sarbanes-Oxley Act. Further, we believe that
the audit committee's ability to operate independently is directly related
to the independence of the public company's board of directors. It is not
realistic to believe that an audit committee will unilaterally resolve
financial reporting issues that materially affect a public company's
financial statements without vetting those issues with the board of
directors. Also, the ability of the board of directors to operate
independently may also be affected in corporate governance structures
where the public company's chief executive officer also serves as the
chair of the board of directors. Like audit committees, boards of
directors also need to be independent and have adequate resources and
access to independent attorneys and other
advisors when they believe it is appropriate. Finally, for any system to
function effectively, there must be incentives for parties to do the right
thing, adequate transparency to provide reasonable assurance that people
will do the right thing, and appropriate accountability when people do not
do the right thing.
This report makes no recommendations. We provided copies of a draft of
this report to the SEC, AICPA, and PCAOB for their review. Representatives
of the AICPA and the PCAOB provided technical comments, which we have
incorporated where applicable. Representatives of the SEC had no comments.
Background Under federal securities laws, public companies are responsible
for the preparation and content of financial statements that are complete,
accurate, and presented in conformity with generally accepted accounting
principles (GAAP). Financial statements, which disclose a company's
financial position, stockholders' equity, results of operations, and cash
flows, are an essential component of the disclosure system on which the
U.S. capital and credit markets are based.
The Securities Exchange Act of 1934 requires that a public company's
financial statements be audited by an independent public accountant. That
statutory independent audit requirement in effect granted a franchise to
the nation's public accountants, as an audit opinion on a public company's
financial statements must be secured before an issuer of securities can go
to market, have the securities listed on the nation's stock exchanges, or
comply with the reporting requirements of the securities laws. As of
February 2003, there were about 17,988 public companies that were
registered with the SEC and subject to the federal securities laws (15,847
domestic and 2,141 foreign public companies). Based on 2001 annual reports
of public accounting firms submitted to the AICPA, about 700 public
accounting firms that were members of the AICPA's former selfregulatory
program for audit quality reported having approximately 15,000 public
company clients registered with the SEC, of which the Big 4 public
accounting firms12 had about 70 percent of these public company clients
and another 88 public accounting firms had about 20 percent of these
12 PricewaterhouseCoopers LLP, Ernst & Young LLP, Deloitte & Touche LLP, and
KPMG LLP.
public company clients. The other approximately 600 public accounting
firms had the remaining 10 percent of the reported public company clients.
The independent public accountant's audit is critical in the financial
reporting process because the audit subjects financial statements, which
are management's responsibility, to scrutiny on behalf of shareholders and
creditors to whom management is accountable. The auditor is the
independent link between management and those who rely on the financial
statements.
Ensuring auditor independence-both in fact and appearance-is a
longstanding issue. There has long been an arguably inherent conflict in
the fact that an auditor is paid by the public company for which the audit
was being performed. Various study groups over the past 20 years have
considered the independence and objectivity of auditors as questions have
arisen from (1) significant litigation involving auditors, (2) the
auditor's performance of nonaudit services for audit clients, which prior
to the Sarbanes-Oxley Act, had risen to 50 percent of total revenues on
average for the large accounting firms,13 (3) "opinion shopping" by
clients, and (4) reports of public accountants advocating questionable
client positions on accounting matters.
The major accountability breakdowns at Enron and WorldCom, and other
failures in recent years such as Qwest, Tyco, Adelphia, Global Crossing,
Waste Management, Micro Strategy, Superior Federal Savings Bank, and
Xerox, led to the reforms contained in the Sarbanes-Oxley Act to enhance
auditor independence and audit quality and to restore investor confidence
in the nation's capital markets. To enhance auditor independence and audit
quality, the act's reforms included
o establishing the PCAOB, as an independent nongovernmental entity, to
oversee the audit of public companies that are subject to the securities
laws;
o making the PCAOB responsible for (1) establishing auditing and related
attestation, quality control, ethics, and independence standards
applicable to audits of public companies, (2) conducting inspections,
investigations, and disciplinary proceedings of public accounting firms
registered with the PCAOB, and (3) imposing appropriate sanctions;
13 Senate Report 107-205, at 14 (2002).
o making the public company's audit committee responsible for the
appointment, compensation, and oversight of the registered public
accounting firm;
o requiring management and auditors' reports on internal control over
financial reporting;
o prohibiting the registered public accounting firm from providing
certain nonaudit services to a public company if the auditor is also
providing audit services;
o requiring the audit committee to preapprove all audit and nonaudit
services not otherwise prohibited;
o requiring mandatory rotation of lead and reviewing audit partners after
they have provided audit services to a particular public company for 5
consecutive years; and
o prohibiting the public accounting firm from providing audit services if
the public company's chief financial officer, chief accounting officer, or
any person serving in an equivalent position was employed by the firm and
participated in the audit of the public company during the 1-year period
preceding the date of starting the audit.
Mandatory audit firm rotation was also discussed in congressional hearings
to enhance auditor independence and audit quality, but given the mixed
views of various stakeholders, the Congress decided the effects of such a
practice needed further study.
Pros and Cons of Requiring Mandatory Audit Firm Rotation
Our review of research studies, technical articles, and other publications
and documents showed that generally the arguments for and against
mandatory audit firm rotation concern auditor independence, audit
quality,14 and increased audit costs. A breakdown in auditor independence
or audit quality can result in an audit failure and adversely affect those
parties who rely on the fair presentation of the financial statements in
conformity with GAAP.
Those who support mandatory audit firm rotation contend that pressures
faced by the incumbent auditor to retain the audit client coupled with the
auditor's comfort level with management developed over time can adversely
affect the auditor's actions to appropriately deal with financial
reporting issues that materially affect the company's financial
statements. Those who oppose audit firm rotation contend that the new
auditor's lack of knowledge of the company's operations, information
systems that support the financial statements, and financial reporting
practices and the time needed to acquire that knowledge increase the risk
of an auditor not detecting financial reporting issues that could
materially affect the company's financial statements in the initial years
of the new auditor's tenure, resulting in financial statements that do not
comply with GAAP.
In addition, those who oppose mandatory audit firm rotation believe that
it will increase costs incurred by both the public accounting firms and
the public companies. They believe the increased risk of an audit failure
and the added costs of audit firm rotation outweigh the value of a
periodic "fresh look" by a new public accounting firm. Conversely, those
who support audit firm rotation believe the value of the "fresh look" to
protect shareholders, creditors, and other parties who rely on the
financial
14 Audit quality as used in this report refers to the auditor conducting
the audit in accordance with generally accepted auditing standards (GAAS)
to provide reasonable assurance that the audited financial statements and
related disclosures are (1) presented in conformity with GAAP and (2) are
not materially misstated whether due to errors or fraud. This definition
assumes that reasonable third parties with knowledge of the relevant facts
and circumstances would have concluded that the audit was conducted in
accordance with GAAS and that, within the requirements of GAAS, the
auditor appropriately detected and then dealt with known material
misstatements by (1) ensuring that appropriate adjustments, related
disclosures, and other changes were made to the financial statements to
prevent them from being materially misstated, (2) modifying the auditor's
opinion on the financial statements if appropriate adjustments and other
changes were not made, or (3) if warranted, resigning as the public
company's auditor of record and reporting the reason for the resignation
to the SEC.
statements outweigh the added costs associated with mandatory firm
rotation.
More recently, the Sarbanes-Oxley Act's requirements that concern auditor
independence and audit quality have added to the mixed views about whether
mandatory audit firm rotation should also be required to enhance auditor
independence and audit quality.
Results of Our Surveys The results of our surveys show that while auditor
tenure at Fortune 1000 public companies averages 22 years, about 79
percent of Tier 115 firms and Fortune 1000 public companies16 are
concerned that changing public accounting firms increases the risk of an
audit failure in the initial years of the audit as the new auditor
acquires the knowledge of a public company's operations, systems, and
financial reporting practices. Further, many Fortune 1000 public companies
will only use Big 4 public accounting firms and believe that the limited
choices, that are likely to be further reduced by the auditor independence
requirements of the Sarbanes-Oxley Act, coupled with the likely increased
costs of financial statement audits and increased risk of an audit failure
under mandatory audit firm rotation strongly argue against the need for
mandatory rotation.
In addition, most Tier 1 firms and Fortune 1000 public companies believe
that the pressures faced by the incumbent auditor to retain the client are
not a significant factor adversely affecting the auditor appropriately
dealing with financial reporting issues that may materially affect a
public company's financial statements. Most Tier 1 firms, and nearly all
Fortune 1000 public companies, and their audit committee chairs believe
that the Sarbanes-Oxley Act's requirements concerning auditor independence
and audit quality, when fully implemented, will sufficiently achieve the
intended benefits of mandatory audit firm rotation, and therefore, they
believe it would be premature to impose mandatory audit firm rotation at
this time.
Finally, about 50 percent of Tier 1 firms and 62 percent of Fortune 1000
public companies stated that mandatory audit firm rotation would have no
15 Hereafter, the presentation of our detailed Tier 1 firm survey results
represent estimated projections to their population.
16 Hereafter, the presentation of our detailed Fortune 1000 public
companies' and their audit committee chairs' survey results represent
estimated projections to their populations.
effect on the perception of auditor independence held by the capital
markets and institutional investors. However, 65 percent of Fortune 1000
public companies reported that individual investors' perception of auditor
independence would be increased, while the Tier 1 firms had mixed views on
the effect on individual investors' perceptions. At the same time, most
Tier 1 firms reported that mandatory audit firm rotation may negatively
affect audit assignment staffing, causing an increased risk of audit
failures, and may create some confusion as currently a change in a public
company's auditor of record sends a "red flag" signal as to why the change
may have occurred. In contrast, most Fortune 1000 public companies did not
believe scheduled changes in the auditor of record would result in a "red
flag" signal.
Auditor of Record Tenure, Independence, and Audit Quality
Currently, neither the SEC nor the PCAOB has set any regulatory limits on
the length of time that a public accounting firm may function as the
auditor of record for a public company. Based on the responses to our
surveys, we estimate that about 99 percent of Fortune 1000 public
companies and their audit committees currently do not have a public
accounting firm rotation policy, although we estimate that about 4 percent
are considering such a policy. Unlimited tenure and related pressure on
the public accounting firm and applicable partner responsible for
providing audit services to the company to retain the client and the
related continuing revenues are factors cited by those who support
mandatory audit firm rotation. They believe that periodically having a new
auditor will bring a "fresh look" to the public company's financial
reporting and help the auditor appropriately deal with financial reporting
issues since the auditor's tenure would be limited under mandatory audit
firm rotation. Those who oppose mandatory audit firm rotation believe that
changing auditors increases the risk of an audit failure during the
initial years as the new auditor acquires the knowledge of the public
company's operations, systems, and financial reporting practices.
The Conference Board's Commission on Public Trust and Private Enterprise17
in its January 9, 2003, report recommended that audit committees should
consider rotating audit firms when there is a combination of circumstances
that could call into question the audit firm's independence from
management. The Commission believed that the existence of some or all of
the following circumstances particularly merit consideration of rotation:
(1) significant nonaudit services are provided by the auditor of record to
the company-even if they have been approved by the audit committee, (2)
one or more former partners or managers of the audit firm are employed by
the company, or (3) the audit firm has been employed by the company for a
substantial period of time, such as over 10 years.
To initially examine the issues surrounding the length of the auditors'
tenure, we asked public companies and public accounting firms to provide
information on the length of auditor tenure. According to our survey,
Fortune 1000 public companies' average auditor tenure is 22 years. Two
contrasting factors greatly influence this 22-year average-the recent
increased changes in auditors lowered the average and the long audit
tenure period associated with approximately 10 percent of Fortune 1000
public companies raised the average. About 20 percent of the Fortune 1000
public companies had their current auditor of record for less than 3
years, a rate of change in auditors over the last 2 years substantially
greater than the nearly 3 percent annual change rate historically
observed.18 This increased rate of auditor change was driven largely by
the recent dissolution of Arthur Andersen LLP. More than 80 percent of
Fortune 1000 public companies that changed auditors over the last 2 years
did so to
17 The Conference Board is a not-for-profit organization that conducts
conferences, makes forecasts and assesses trends, publishes information
and analysis, and brings executives together to learn from one another.
The Conference Board formed the commission to address the circumstances
that led to the recent corporate scandals and subsequent decline of
confidence in U.S. capital markets. The commission included former senior
federal government officials, such as a former Chairman of the Board of
Governors of the Federal Reserve System, former Chairman of the SEC, and
former Comptroller General; a state government official responsible for
the state's retirement system; a former U.S. senator; various private
sector executives holding senior positions of responsibility; and a
college professor.
18 R. Doogar (University of Illinois, Urbana-Champaign) and R. Easley and
D. Ricchiute (University of Notre Dame), "Switching Costs, Audit Firm
Market Shares and Merger Profitability," (Nov. 20, 2001), which was
discussed in GAO-03-864, cited a level of 2.7 percent annual client
switching of auditors based on prior research the authors performed using
1981-1997 Compustat data.
replace Andersen.19 Increasing the overall average audit tenure period for
Fortune 1000 public companies were the approximately 10 percent of public
companies that had the same auditing firm for more than 50 years and have
an average tenure period of more than 75 years. Excluding those Fortune
1000 public companies that have replaced Andersen in the last 2 years as
well as those companies that had the same auditor of record for more than
50 years, the average for the remaining Fortune 1000 public companies is
19 years. See figure 1 for the Fortune 1000 public companies' estimated
audit firm tenure.
Figure 1: Estimated Audit Firm Tenure for Fortune 1000 Public Companies
Percentage 100
25
22 22
20
15
10
5
0 1-2 3-10 11-20 21-30 31-40 41-50 50 or more
Years
Source: GAO analysis of survey data.
An intended effect of mandatory audit firm rotation is to decrease the
existing lengthy auditor tenure periods, thus lessening concerns about the
firm's desire to retain a client adversely affecting auditor independence.
19 The Fortune 1000 public companies that hired a new audit firm to
replace Andersen over the last 2 years reported that Andersen had served
as their companies' auditor of record for an average of 26 years.
About 97 percent of Fortune 1000 public companies expected that mandatory
audit firm rotation would lower the number of consecutive years that a
public accounting firm could serve as their auditor of record. The Fortune
1000 public companies were not given a possible limit on the number of
years that a public accounting firm could serve as their auditor of record
under mandatory audit firm rotation. Therefore, they reported their
general belief that mandatory rotation would have the effect of decreasing
auditor tenure based on their past experiences.
Impact of Auditor Knowledge and Experience on the Auditor's Detection of
Misstatements
Since the new auditor's knowledge and experience with auditing a public
company after a change in auditors is a concern, we asked public
accounting firms and public companies a number of questions about factors
important to detecting material misstatements of financial statements.
Tier 1 firms noted that a number of factors affect the auditor's ability
to detect financial reporting issues that may indicate material
misstatements in a public company's financial statements, including
education, training, and experience; knowledge of GAAP and GAAS;
experience with the company's industry; appropriate audit team staffing;
effective risk assessment process for determining client acceptance; and
knowledge of the client's operations, systems, and financial reporting
practices.20 Although each of the above factors affects the quality of an
audit, opponents of mandatory audit firm rotation focus on the increased
risk of audit failure that may result from the new auditor's lack of
specific knowledge of the client's operations, systems, and financial
reporting practices. Based on the responses to our survey, we estimated
that about 95 percent of Tier 1 firms would rate such specific knowledge
as either of very great importance or great importance in the auditor's
ability to detect financial reporting issues that may indicate material
misstatements in a public company's financial statements.
GAAS require the auditor to obtain a sufficient knowledge of the client's
operations, systems, and financial reporting practices to assess audit
risk21 and to gather sufficient competent evidential matter. About 79
percent of
20 Although not specifically listed in our applicable survey question,
several Tier 1 firms commented that public company management's integrity,
honesty, and cooperation is of very great or great importance in the
auditor's ability to detect material financial reporting issues.
21 GAAS define audit risk as the risk that an auditor may unknowingly fail
to appropriately modify his or her opinion on financial statements that
are materially misstated.
Tier 1 firms and Fortune 1000 public companies believed that the risk of
an audit failure is higher in the early years of audit tenure as the new
firm is more likely to not have fully developed and applied an in-depth
understanding of the public company's operations and processes affecting
financial reporting. More than 83 percent of Tier 1 firms and Fortune 1000
public companies that expressed a view stated that it generally takes 2 to
3 years or more to become sufficiently familiar with the companies'
operations and processes before the additional resources often needed to
become knowledgeable are no longer needed. Tier 1 firms had mixed views
about whether mandatory audit firm rotation (e.g., the "fresh look") would
either increase, decrease or have no effect on the new auditor's
likelihood of detecting financial reporting issues that may materially
affect the financial statements that the previous auditor may not have
detected. However, 50 percent of Fortune 1000 public companies reported
that mandatory audit firm rotation would have no effect on the auditor's
likelihood of detecting such financial reporting issues, while other
Fortune 1000 public companies were generally split regarding whether
mandatory audit firm rotation would either increase or decrease the
auditor's likelihood of detecting such financial reporting issues.
As shown in figure 2, Tier 1 firms had mixed views of the value of
additional audit procedures during the initial years of a new auditor's
tenure, although 72 percent reported that additional audit procedures
would be of at least some value in helping to reduce audit risk to an
acceptable level.
Figure 2: Tier 1 Firms: Value of Additional Procedures When Firm Has Less
Knowledge and Experience with a Client
Value of additional procedures
Very great value
Great value
Moderate value
Some value 25
Little or no value
Don't know
0 5 10152025 100 Percentage
Source: GAO analysis of survey data.
Most Fortune 1000 public companies believed such additional audit
procedures would decrease audit risk, as shown in figure 3.
Figure 3: Fortune 1000 Public Companies' Belief That Additional or
Enhanced Audit Procedures Would Affect the Risk of Not Detecting Material
Misstatements 3%
No basis to evaluate
Likely increase risk
Neither increase or decrease risk
Decrease risk
The Tier 1 firms were also asked about the potential value of having
enhanced access to key members of the previous audit team and its audit
documentation to help reduce audit risk. The Tier 1 firms generally saw
more potential value in having enhanced access to the previous audit team
and its audit documentation than in performing additional audit procedures
and verification of the public company's data during the initial years of
the auditor's tenure. Nearly all of the Tier 1 firms believed that access
to the previous audit team and its audit documentation could be
accomplished under current GAAS.22
22 Several Tier 1 firms commented that cooperation of the predecessor
public accounting firm is a barrier to full access of the firm's audit
documentation and indicated that this is an area that the PCAOB may need
to address.
Pressures Faced by Firms in Dealing with Financial Reporting Issues
Proponents of mandatory audit firm rotation cite that pressures to retain
the client can adversely affect the auditor's decision to appropriately
deal with financial reporting issues when public company management is not
supportive of the auditor's position on what is required by GAAP. They
believe that mandatory audit firm rotation would serve as an incentive for
the auditor to take the appropriate action since the auditor would know
that tenure as auditor of record and the related revenues are for a
limited term.23
We asked public accounting firms and public companies based on their
experiences whether the auditor's length of tenure is a factor in whether
the auditor appropriately deals with material financial reporting issues
and whether mandatory audit firm rotation would affect the pressures the
firms face. About 69 percent of Tier 1 firms and 73 percent of Fortune
1000 public companies do not believe that the risk of an audit failure
increases due to the auditors' long-term relationship with the public
companies' management under a long audit tenure and the auditors' desire
to retain the clients. About 55 percent of the other Tier 1 firms24 and 65
percent of the other Fortune 1000 public companies25 were uncertain
whether the risk of an audit failure would increase or decrease due to the
auditors' long-term tenure.
About 71 percent of Tier 1 firms and 67 percent of Fortune 1000 public
companies believe that pressure on the engagement partner to retain the
client is currently small or not a factor in whether the auditor
appropriately deals with financial reporting issues that may materially
affect a public company's financial statements. However, 28 percent of
Tier 1 firms and 33 percent of Fortune 1000 public companies believe such
pressures are moderate or stronger. About 18 percent of Tier 1 firms and
Fortune 1000 public companies believed that under mandatory audit firm
rotation, the pressures on the engagement partner would still be a
moderate or stronger
23 Although mandatory audit firm rotation would likely set a limit on the
number of consecutive years the public accounting firm could serve as the
company's auditor of record, it may also provide that the business
relationship could be terminated by either party during that time.
24 The 95 percent confidence interval surrounding this estimate ranges
from 41 percent to 62 percent.
25 The 95 percent confidence interval surrounding this estimate ranges
from 51 percent to 77 percent.
factor in retaining the audit client and in appropriately dealing with
financial reporting issues. Therefore, based on these views, mandatory
audit firm rotation would likely somewhat reduce the pressures on the
engagement partner to retain the client. However, most Tier 1 firms and
Fortune 1000 public companies generally considered these pressures to be
small or not a factor in the auditor appropriately dealing with material
financial reporting issues.
Tier 1 firms and Fortune 1000 public companies expressed similar views,
that mandatory audit firm rotation would not significantly change the
pressures on the engagement partner to retain the client as a factor in
whether the engagement partner appropriately challenges overly
aggressive/optimistic financial reporting26 by management.
As shown in figure 4, overall about 54 percent of Tier 1 firms and 71
percent of Fortune 1000 public companies believe mandatory audit firm
rotation overall would have no effect on the new auditor's potential for
appropriately dealing with material financial reporting issues.
26 GAAP are subject to interpretation by public company management and
underlying concepts of GAAP may be applied to transactions of a public
company that are not specifically addressed by GAAP. The auditor may
encounter situations in which public company management aggressively or
optimistically applies the concepts of GAAP to achieve a certain result
that arguably may not reflect the economic substance of the transactions
while public company management believes such financial reporting complies
with GAAP.
Figure 4: Views on How Mandatory Audit Firm Rotation Would Affect the
Auditor's Potential to Deal with Material Financial Reporting Issues
Appropriately
Auditor's potential
Increase potential
Neither increase or decrease potential 71
Decrease potential
No basis to evaluate
0 10 20 30 40 50 60 70 80100 Percentage
Tier 1 firms
Fortune 1000 public companies
Source: GAO analysis of survey data.
The remaining Tier 1 firms are split between whether mandatory audit firm
rotation would increase or decrease their potential to appropriately deal
with material financial reporting issues. However, about 67 percent of the
remaining Fortune 1000 public companies believe that mandatory audit firm
rotation would increase the potential for the new auditor to deal
appropriately with such financial reporting issues.27 In contrast, either
with or without mandatory audit firm rotation, about 62 percent of Tier 1
firms and 63 percent of Fortune 1000 public companies believe the
potential of a subsequent lawsuit, regulatory action, or both against the
public accounting firm and its engagement partner is a moderate or
stronger pressure for them to deal appropriately with financial reporting
issues that may materially affect a public company's financial statements.
27 The 95 percent confidence interval surrounding this estimate ranges
from 54 percent to 79 percent.
How Mandatory Audit Firm Rotation May Affect Perception of Auditors'
Independence
Researchers have also raised questions about how the capital markets' and
investors' current perceptions of auditor independence and audit quality
would be affected by mandatory audit firm rotation. Under mandatory audit
firm rotation, about 52 percent of Tier 1 firms and about 62 percent of
Fortune 1000 public companies believed that the current perception of
auditor independence held by capital markets and institutional investors
would not be affected by requiring mandatory audit firm rotation while 34
percent of Tier 1 firms and about 38 percent of Fortune 1000 public
companies believed the perception of auditor independence would increase.
However, about 65 percent of Fortune 1000 public companies believed that
perception of auditors' independence held by individual investors would
more likely increase under mandatory audit firm rotation while the Tier 1
firms had mixed views on the effect on individual investors. See the
Overall Views of Other Knowledgeable Individuals on Mandatory Audit Firm
Rotation section of the report for the results of our discussions with
other knowledgeable individuals, including institutional investors, for
their views on how mandatory audit firm rotation may affect their
perception of auditor independence.
How Mandatory Audit Firm Rotation May Affect Audit Assignment Staffing
Our research into the effects of mandatory audit firm rotation identified
concerns about whether public accounting firms would move their most
knowledgeable and experienced audit personnel from the current audit to
other audits as the end of their tenure as auditor of record approached in
order to attract or retain other clients. In response to our survey
questions about whether mandatory audit firm rotation would affect
assignment of audit staff, about 59 percent of Tier 1 firms indicated that
they would likely move their most knowledgeable and experienced audit
staff to other work to enhance the firm's ability to attract or retain
other clients and another 28 percent were undecided. Only about 13 percent
of Tier 1 firms stated it was unlikely that an accounting firm would move
staff to other work. Of the Tier 1 firms that stated they would likely
move their most knowledgeable and experienced staff, 86 percent28 believe
that moving these staff would increase the risk of an audit failure. About
92 percent of Fortune 1000 public companies also believed that by moving
these audit staff, the risk of an audit failure would be increased.
28 The 95 percent confidence interval surrounding this estimate ranges
from 77 percent to 90 percent.
How Mandatory Audit Firm Rotation May Affect Public Accounting Firms'
Investment in Audit Tools
Opponents of mandatory audit firm rotation expressed concern that limited
audit tenure under mandatory rotation could cause public accounting firms
to not invest in audit tools related to the effectiveness of auditing a
specific client or industry. About 76 percent of Tier 1 firms stated that
their average audit tenure would likely decrease under mandatory audit
firm rotation, and about 97 percent of Fortune 1000 public companies
expected the length of their auditors' tenure would decrease compared to
their previous experience with changing auditors. In response to our
survey questions about this possibility, about 64 percent of these Tier 1
firms said mandatory audit firm rotation would not likely decrease
incentives to invest the resources needed to understand the client's
operations and financial reporting practices in order to devise effective
audit procedures and tools, while 36 percent said it would. Conversely,
about 67 percent of Fortune 1000 public companies were concerned that
mandatory audit firm rotation could negatively affect incentives for
public accounting firms to invest in effective audit procedures and tools.
How Mandatory Audit Firm Rotation May Affect the Current "Red Flag" Signal
to Investors When a Change in a Public Company's Auditor of Record Occurs
Currently, when a change in the auditor of record occurs it acts as a "red
flag" signal to investors to question why the change occurred and if the
change may have occurred because of reasons related to the presentation of
the public company's financial statements, such as differences in views of
public company management and the auditor of record regarding financial
reporting issues. Researchers have raised concerns that the "red flag"
signal may be eliminated by mandatory audit firm rotation, as investors
may not be able to distinguish a scheduled change from a nonscheduled
change in a public company's auditor of record.
Regarding the "red flag" signal, most Tier 1 firms believed that mandatory
audit firm rotation would not change the current reaction by investors to
a change in the auditor of record, and therefore a "red flag" signal is
likely to be perceived by investors for both scheduled and unscheduled
changes in the public company's auditor of record. Several Tier 1 firms
commented that users of financial statements would not be able to readily
track scheduled rotations and therefore would be confused whether the
change in auditors was scheduled or unscheduled. In contrast, most Fortune
1000 public companies believed that scheduled auditor changes under
mandatory audit firm rotation would likely not produce a "red flag" signal
and that the "red flag" signal for unscheduled changes in the auditor of
record would be retained. Fortune 1000 public companies did not provide
any comments to further explain their beliefs. However, currently, public
companies are required by SEC regulations to report changes in their
auditor of record to the SEC. Therefore, public companies could use this
reporting requirement to disclose whether the change in auditor of record
under mandatory audit firm rotation was scheduled or unscheduled.
Potential Impact on Audit-Related Costs and Fees
Opponents of mandatory audit firm rotation believe that the more frequent
change in auditors likely to occur under mandatory audit firm rotation
will result in the public accounting firms and ultimately public companies
incurring increased costs for audits of financial statements. These costs
include
o marketing costs (the costs incurred by public accounting firms related
to their efforts to acquire or retain financial statement audit clients),
o audit costs (the costs incurred by a public accounting firm to perform
an audit of a public company's financial statements),
o audit fee (the amount a public accounting firm charges the public
company to perform the financial statement audit),
o selection costs (the internal costs incurred by a public company in
selecting a new public accounting firm as the public company's auditor of
record), and
o support costs (the internal costs incurred by a public company in
supporting the public accounting firm's efforts to understand the public
company's operations, systems, and financial reporting practices).
About 96 percent of Tier 1 firms stated that their initial year audit
costs are likely to be more than in subsequent years in order to acquire
the necessary knowledge during a first year audit of a public company's
operations, systems, and financial reporting practices. Nearly all of
these Tier 1 firms estimated initial year audit costs would be more than
20 percent higher than subsequent years' costs.29 Similar responses were
received from Fortune 1000 public companies. (See fig. 5.)
29 Several Tier 1 firms commented that mandatory audit firm rotation could
also result in costs to relocate staff given the unpredictability of where
new audit clients would be located and increased costs for education and
training of staff.
Figure 5: Expected Increase in Initial Year Audit Costs over Subsequent
Year Audit Costs
Increase in initial year audit costs
More than 50 percent
More than 40 percent but less than 50 percent
More than 30 percent but less than 40 percent
More than 20 percent but less than 30 percent 49
More than 10 percent but less than 20 percent
10 percent or less
No basis or experience
0 10 20 30 40 50100
Percentage
Fortune 1000 public companies
Tier 1 firms
Source: GAO analysis of survey data.
About 85 percent of Tier 1 firms stated that currently they are more
likely to absorb their higher initial year audit costs than to pass them
on to the public companies in the form of higher audit fees because of the
firms' interest in retaining the audit client. However, about 87 percent
said such costs would likely be passed on to the public companies during
the more limited audit firm tenure period under mandatory rotation.
Similarly, about 77 percent of Fortune 1000 public companies stated that
currently when a change in the companies' auditor of record occurs, the
additional initial year audit costs are likely to be absorbed by the
public accounting firms. However, about 97 percent of the Fortune 1000
public companies expected the higher initial year audit costs would be
passed on to them under mandatory audit firm rotation.
Comments received from a number of the Tier 1 firms indicated that
currently initial years' audit costs are recovered from the public
companies over the firms' tenure as auditor of record. However, the firms
under mandatory audit firm rotation expected not to be able to recover the
costs within a more limited tenure as auditor of record. Therefore, they
would pass the costs on to the public companies through higher audit fees.
Similarly, about 89 percent of Fortune 1000 public companies believed that
mandatory audit firm rotation would lead to higher audit fees over time.
30
With the likely more frequent opportunities to compete for providing audit
services to public companies under mandatory audit firm rotation, about 79
percent of Tier 1 firms expect to incur increased marketing costs
associated with their efforts to acquire audit clients, and about 79
percent of the Tier 1 firms expect to pass these costs on to the public
companies through higher audit fees.
As shown in figure 6, most of the Tier 1 firms expecting higher marketing
costs estimated that the cost would add at least more than 1 percent to
their initial year audit fees, and about 37 percent of these Tier 1
firms31 believed their additional marketing costs would be more than 10
percent of their initial year audit fees.
30 Many Fortune 1000 public companies commented that mandatory audit firm
rotation would lead to higher audit fees as the public accounting firms
would want to recoup their additional costs within the limited time as
auditor of record that would be established under mandatory audit firm
rotation. Also, they stated there would be no incentive for the public
accounting firms to absorb the additional costs since mandatory audit firm
rotation would preclude long-term business relationships as the auditor of
record.
31 The 95 percent confidence interval for the estimate of these Tier 1
firms that expect more than a 10 percent increase ranges from 29 percent
to 45 percent. Also, as shown in figure 6, the 95 percent confidence
interval for the estimate of Tier 1 firms who have no basis or experience
to estimate what their increase would be ranges from 15 percent to 27
percent.
Figure 6: Tier 1 Firms Expecting Additional Expected Marketing Costs under
Mandatory Audit Firm Rotation Compared to Initial Year Audit Fees
2%
Less than 1 percent
More than 1 percent
No basis or experience
More than 5 percent
More than 10 percent
A number of Tier 1 firms commented that they would have to spend more time
marketing auditing services, including writing new proposals to compete
for audit services. About 85 percent of Fortune 1000 public companies
expected that public accounting firms would likely incur additional
marketing costs under mandatory audit firm rotation, and about 92 percent
of these Fortune 1000 public companies believed the costs would be passed
on to them.
In addition to higher audit fees, nearly all Fortune 1000 public companies
believed they would incur selection costs in hiring a new auditor of
record under mandatory audit firm rotation. As shown in figure 7, most of
those Fortune 1000 public companies expected the selection costs to be at
least 6 percent or higher as a percentage of initial year audit fees.
Figure 7: Fortune 1000 Public Companies' Expected Selection Costs as a
Percentage of Initial Year Audit Fees
Likely selection costs
20 percent or more
More than 15 percent but less than 20 percent
More than 10 percent but less than 15 percent
More than 5 percent but less than 10 percent 23
Less than 5 percent 23
None
No basis to know
0 5 101520
Percentage
Source: GAO analysis of survey data.
In addition, nearly all Fortune 1000 public companies expected to incur
some additional initial year auditor support costs under mandatory audit
firm rotation. As shown in figure 8, nearly all of those Fortune 1000
public companies believed their additional support costs would be 11
percent or higher as a percentage of initial year audit fees.
Figure 8: Fortune 1000 Public Companies' Expected Support Costs as a
Percentage of Initial Year Audit Fees
Support costs
50 percent or more
More than 40 percent but less than 50 percent
More than 30 percent but less than 40 percent
More than 20 percent 28but less than 30 percent
More than 10 percent but less than 20 percent
Less than 10 percent
No basis to estimate
0 5 10 15 20 25 30100 Percentage
Source: GAO analysis of survey data.
Tier 1 firms' views on the likelihood of public companies incurring
selection costs and additional auditor support costs were similar to the
views of Fortune 1000 public companies.
To provide some perspective on the possible impact of higher audit-related
costs (audit fees, company selection, and support cost) on public company
operating costs, we analyzed financial reports filed with the SEC for a
selection of large and small public companies for the most recent fiscal
year available-one of each from 23 broad industry sectors, such as
agriculture, manufacturing, and information services. Where available, for
each industry sector, we selected a public company with annual revenues of
more than $5 billion and a public company with annual revenues of less
than $1 billion. The audit fees reported by the larger public companies we
selected ranged from .007 percent to .11 percent of total operating costs
and averaged .04 percent. The audit fees reported by the smaller public
companies we selected ranged from 0.017 percent to 3.0 percent and
averaged 0.08 percent.32
Utilizing the predominant responses33 from Tier 1 firms, we estimate the
additional first year audit costs following a change in auditor to likely
range from 21 percent to 39 percent more than annual costs of recurring
audits of the same client. In addition, we estimate the additional firm
marketing costs under mandatory audit firm rotation to likely range from 6
percent to 11 percent of the firm's initial year audit fees. Based on the
predominant responses from Fortune 1000 public companies, we also estimate
the additional public company selection costs to range from 1 percent to
14 percent of the new auditor's initial year audit fees and possible
additional public company support costs to range from 11 percent to 39
percent of the new auditor's initial year audit fees. Utilizing these
ranges, we estimate that following a change in auditor under mandatory
audit firm rotation, the possible additional first year audit-related
costs could range from 43 percent to 128 percent higher than the likely
recurring audit costs had there been no change in auditor. We also
calculated a weighted average percentage for each additional cost category
using all responses from Tier 1 firms and Fortune 1000 public companies
(as opposed to the predominant responses only). Using the resulting
weighted averages for all responses, we calculated the potential
additional first year audit-related costs to be 102 percent higher than
the likely recurring audit costs had there been no change in auditor. This
illustration is intended only to provide insights into how Tier 1 firms
and Fortune 1000 public companies reported that mandatory audit firm
rotation could affect the initial year audit costs and is not intended to
be representative.
Competition-Related Issues
Although mandatory audit firm rotation is generally considered by its
proponents as a means of enhancing auditor independence and audit quality,
mandatory rotation may also provide increased opportunities for
32 The public company annual reports for the most recent fiscal year
available (either 2002 or 2003) did not disclose any auditor selection or
support costs that the companies may have incurred.
33 We established the various ranges used for this analysis based on our
analysis of the responses from Tier 1 firms and Fortune 1000 public
companies. In establishing the ranges, we used survey responses consisting
of the predominant responses (at least 68 percent) of those received.
some public accounting firms to compete to provide audit services to
public companies. About 52 percent of Tier 1 firms believed that mandatory
audit firm rotation would increase the opportunity to compete for public
company audits and 30 percent were uncertain whether opportunities to
compete to provide audit services would increase or decrease.
However, when asked how mandatory audit firm rotation would likely affect
the number of firms actually willing and able to compete for public
company audits, about 54 percent of Tier 1 firms said mandatory rotation
would likely decrease the number of firms competing for audits of public
companies, 14 percent expected an increase in the number of firms, and 22
percent expected no effect on the number of firms competing.
Although nearly all Tier 1 firms planned to register with the PCAOB to
provide audit services to public companies,34 about 24 percent of Tier 1
firms that currently provide audit services were uncertain whether they
would continue to provide audit services to public companies if mandatory
audit firm rotation were required.35 Firms in Tier 2 that responded to our
survey showed more uncertainty regarding whether to register with the
PCAOB, with about two-thirds planning to continue to provide audit
services to public companies and most of the remaining respondents
uncertain if they would continue to provide audit services to public
companies.36 However, if mandatory audit firm rotation were required, 55
percent of the Tier 2 firms that responded to our survey that currently
provide audit services to public companies were uncertain whether they
would continue to provide the audit services to public companies, and
another 12 percent said they would discontinue providing audit services to
public companies.37
34 As of October 22, 2003, 89 percent of those Tier 1 firms that responded
to our survey have registered with the PCAOB or have applications pending.
35 In total, these Tier 1 firms that were uncertain whether they would
continue to provide audit services to public companies if mandatory audit
firm rotation were required audit 586 public companies.
36 As of October 22, 2003, 80 percent of these Tier 2 firms that responded
to our survey have registered with the PCAOB or have applications pending.
37 In total, these Tier 2 firms that would discontinue providing audit
services to public companies if mandatory audit firm rotation were
required audit 154 public companies.
The view of many Tier 1 firms that mandatory audit firm rotation may lead
to fewer firms willing and able to compete for public company audits,
which would lead to higher audit fees, should also be considered along
with the results of our study of consolidation of the Big 8 firms into the
current Big 4 firms.38 In that respect, we previously reported that the
Big 4 audit over 78 percent of all U.S. public companies and 99 percent of
public company annual sales. However, we found no empirical evidence of
impaired competition. Further, we previously reported that smaller public
accounting firms were unable to successfully compete for the audits of
large national and multinational public companies because of factors such
as lack of capacity and capital limitations.39
About 83 percent of Tier 1 firms and 66 percent of Fortune 1000 public
companies stated that under mandatory audit firm rotation, the market
share of public company audits would either become more concentrated in a
small number of larger public accounting firms or the already highly
concentrated market share would remain about the same. About 44 percent of
Tier 1 firms believed that incentives to create or maintain large firms
would be increased while 32 percent believed mandatory audit firm rotation
would have no effect on incentives to create or maintain large firms.
About 52 percent of Fortune 1000 public companies were at least somewhat
concerned that the dissolution of Arthur Andersen LLP, resulting now in
the Big 4 public accounting firms, would significantly limit the options
their companies have in selecting a capable auditor of record. Under
mandatory audit firm rotation, the number of Fortune 1000 public companies
expressing such concern increased to 79 percent.
About 48 percent of Tier 1 firms believed mandatory audit firm rotation
would decrease the number of firms willing and able to compete for audits
of public companies in specialized industries, while 29 percent of Tier 1
firms believed mandatory audit firm rotation would have no effect. As
noted in our July 2003 report, we found that in certain specialized
industries, the number of firms with expertise in auditing those
industries
38 GAO-03-864.
39 A number of Tier 1 firms responding to our survey on mandatory audit
firm rotation commented that the increased costs likely to be incurred by
the firms under mandatory audit firm rotation could result in many smaller
firms being unable to compete or absorb the increased costs, resulting in
smaller firms leaving the market for providing audit services.
can limit the number of choices such public companies have to two public
accounting firms. Contributing to this situation is that many public
companies will use only Big 4 firms for audit services. Also, public
companies may have fewer choices in the future as auditor independence
rules under the Sarbanes-Oxley Act prohibiting the auditor of record from
also providing certain nonaudit services could further reduce the number
of eligible auditors. In that respect, mandatory audit firm rotation would
further affect the number of eligible auditors. For example, if a public
company in a specialized industry has only three or four choices for its
auditor of record, the current auditor of record is not eligible to repeat
as auditor of record under mandatory audit firm rotation, and another firm
is not eligible because it provided prohibited nonaudit services that
affect auditor independence to the public company, then the number of
eligible firms would be reduced to one or two firms.
About 35 percent of Fortune 1000 public companies were at least somewhat
concerned that the Sarbanes-Oxley Act auditor independence requirements
would significantly limit their options in selecting a capable auditor of
record. However, 53 percent of Fortune 1000 public companies expressed
such concern if mandatory audit firm rotation were required.
The Sarbanes-Oxley Act requires the audit committee to hire, compensate,
and oversee the public accounting firm serving as auditor of record for
the public company. About 92 percent of the Fortune 1000 audit committee
chairs stated that their public companies currently use Big 4 firms as
auditor of record, and 94 percent of those that do stated that they would
not realistically consider using non-Big 4 firms as the public companies'
auditor of record. Table 1 provides reasons given by the audit committee
chairs for only using Big 4 firms and the importance of those reasons to
them.
Table 1: Audit Committee Chairs' Reasons for Limiting Consideration to
Only Big 4 Firms
Numbers in percentages
Reasons for limiting consideration to only Big 4
Very great Great Moderate Some Little or no Don't
firms
importance importance importance importance importance know
Expectations of the capital markets 48 34 14 1 3
Public company geographic/global operations 53 27 10 4 6
Public company operations require specialized
industry skills/knowledge 39 36 18 6 1
Public company contractual obligations (e.g. with
banks or lenders) 15 28 25 5 20
Requirement of the public company's board of
directors 23 35 19 7 13
Sufficiency of audit firm resources 68 26 4 2 0
Audit firm's name and reputation 35 41 18 4 2
Source: GAO analysis of survey data.
Although the Sarbanes-Oxley Act now makes the audit committee responsible
for hiring the public company's auditor of record, 96 percent of Fortune
1000 public companies currently using Big 4 firms also stated that they
would not realistically consider using non-Big 4 firms as the companies'
auditor of record. They generally gave the same reasons as the audit
committee chairs.
Overall Views on Mandatory Audit Firm Rotation
In our surveys, we asked public accounting firms, public companies, and
their audit committee chairs to provide their overall views on the
potential costs and benefits that may result under mandatory audit firm
rotation. About 85 percent of Tier 1 firms, 92 percent of Fortune 1000
public companies, and 89 percent of Fortune 1000 audit committee chairs
believed that costs are likely to exceed benefits.
Our surveys also requested views whether the Sarbanes-Oxley Act auditor
independence and related audit quality requirements could also achieve the
intended benefits of mandatory audit firm rotation. The act, as
implemented by SEC rules, requires the mandatory rotation of both lead and
reviewing audit engagement partners after 5 years and after 7 years for
other partners with significant involvement in the audit engagement. Other
related provisions of the act concerning auditor independence and audit
quality include prohibiting the auditor of record from also providing
certain nonaudit services, requiring audit committee preapproval of audit
and
nonaudit services not otherwise prohibited and related public disclosures,
establishing certain auditor reporting requirements to the audit
committee, requiring time restrictions before certain auditors could be
hired by the client as employees, expanding audit committee
responsibilities, and establishing the PCAOB as an independent
nongovernmental entity overseeing registered public accounting firms in
the audit of public companies.
About 66 percent of Tier 1 firms believe the audit partner rotation
requirements sufficiently achieve the intended benefits of a "fresh look"
of mandatory audit firm rotation. Another 27 percent of the Tier 1 firms
believe that the audit partner rotation requirements may not be as
effective as mandatory audit firm rotation in achieving the intended
benefits of a "fresh look," but is a better choice given the higher cost
of mandatory audit firm rotation. Fortune 1000 public companies and audit
committee chairs responding to our survey expressed similar views.
We asked those Tier 1 firms and Fortune 1000 public companies and their
audit committee chairs who did not believe that the partner rotation
requirement by itself sufficiently achieved the intended benefits of
mandatory audit firm rotation to consider the auditor independence, audit
quality, and partner rotation requirements of the Sarbanes-Oxley Act as
implemented by SEC rules and their views on whether these requirements in
total would likely achieve the intended benefits of mandatory audit firm
rotation when fully implemented. About 25 percent40 of these Tier 1 firms
believed these requirements of the Sarbanes-Oxley Act, when fully
implemented, would sufficiently achieve the intended benefits of mandatory
audit firm rotation, while 63 percent41 believed these requirements would
only somewhat or minimally achieve the intended benefits of mandatory
audit firm rotation when fully implemented. Conversely, 76 percent42 of
Fortune 1000 public companies and 72 percent43
40 The 95 percent confidence interval surrounding this estimate ranges
from 17 percent to 39 percent.
41 The 95 percent confidence interval surrounding this estimate ranges
from 48 percent to 72 percent.
42 The 95 percent confidence interval surrounding this estimate ranges
from 62 percent to 86 percent.
43 The 95 percent confidence interval surrounding this estimate ranges
from 58 percent to 84 percent.
of their audit committee chairs believed these requirements would
sufficiently achieve the intended benefits of mandatory audit firm
rotation. Combining the responses to the above two questions for those who
believed either the partner rotation requirements or the partner rotation
requirements coupled with the other Sarbanes-Oxley Act auditor
independence and audit quality requirements would sufficiently achieve the
benefits of mandatory audit firm rotation shows that about 75 percent of
the Tier 1 firms, 95 percent of Fortune 1000 public companies, and about
92 percent of the audit committee chairs believe these requirements, when
fully implemented, would sufficiently achieve the benefits of mandatory
audit firm rotation.
Most Tier 1 firms and Fortune 1000 public companies and their audit
committee chairs believe the Sarbanes-Oxley Act auditor independence and
audit quality requirements, when fully implemented, would sufficiently
achieve the benefits of mandatory audit firm rotation, and most of these
groups when asked their overall opinion on mandatory audit firm rotation
did not support mandatory rotation.44 A minority within these groups
supports the concept of mandatory audit firm rotation, but believes more
time is needed to evaluate the effectiveness of the various Sarbanes-Oxley
Act requirements for enhancing auditor independence and audit quality.
(See fig. 9.)
44 Comments from a number of the Tier 1 firms primarily reiterated their
previously stated views regarding the costs and benefits of mandatory
audit firm rotation and that the SEC's recent audit partner rotation
requirements better balance the need for a "fresh look" without
eliminating the auditor of record's institutional knowledge of the client.
They also reiterated that the Sarbanes-Oxley Act should be given time to
work and rebuild investors' confidence. Similar comments were received
from many of the Fortune 1000 public companies' chief financial officers
and their audit committee chairs who also stressed the additional costs of
mandatory audit firm rotation.
Figure 9: Support for Mandatory Audit Firm Rotation
Percentage 100
90
90
88
As part of our review, we spoke to a number of knowledgeable individuals
to obtain their views on mandatory audit firm rotation to provide
additional perspective on issues addressed in the survey. These
individuals had experience in a variety of fields, such as institutional
investment; regulation of the stock markets, the banking industry, and the
accounting profession; and consumer advocacy. Generally, the views
expressed by these knowledgeable individuals were consistent with the
overall views expressed by survey respondents.45 Most did not favor
implementing a requirement for mandatory audit firm rotation at this time
because they
45 SEC and PCAOB officials informed us that they have not taken a position
on the merits of mandatory audit firm rotation.
80
70
60
50
40
30
20
10 0 Supports Supports concept
but more time is needed with Sarbanes-Oxley requirements
Does not support
Other
Support for mandatory audit firm rotation
Tier 1 firms Fortune 1000 public companies Fortune 1000 audit committees
Source: GAO analysis of survey data.
Overall Views of Other Knowledgeable Individuals on Mandatory Audit Firm
Rotation
believe the costs of implementing such a requirement outweigh the benefits
and greater experience with implementing the requirements of the
Sarbanes-Oxley Act should be gained prior to adding new requirements.
Many individuals acknowledged that conceptually, audit firm rotation could
provide certain benefits in the areas of auditor independence and audit
quality. For example, audit firm rotation may increase the perception of
auditor independence because long-term relationships between the auditor
of record and the client that could undermine independence would not
likely develop under the limited term as auditor of record. Some
individuals also believe that under mandatory audit firm rotation, the
auditor might be less likely to succumb to management pressure to accept
questionable accounting practices because the incentive to keep the client
is gone and another audit firm would be looking at the firm's work in the
future. Some also believed that audit quality may also be increased
through a change in auditors because a new auditor of record would provide
a "fresh look" at an entity's financial reporting practices and accounting
policies. In addition, some individuals noted that mandatory audit firm
rotation might cause a company to reexamine its audit needs and seek more
knowledgeable and experienced audit firm personnel when negotiating for a
new auditor of record.
The individuals we spoke to, however, acknowledged a number of practical
concerns related to mandatory audit firm rotation, one of the most
important being the limited number of audit firms available from which to
choose. For example, some companies, especially those with geographically
diverse operations or those operating in certain industries, may be
somewhat limited in the choice of auditing firms capable of performing the
audit. Not all audit firms have offices or staff located in all the
geographic areas, whether domestically or internationally, where the
clients conduct their operations, nor do all audit firms have personnel
with certain industry knowledge to be able to perform audits of clients
that operate in specific environments.
Similar to the views of Fortune 1000 public companies and audit committee
chairs, individuals we spoke to noted that large companies are often
limited to choices among the Big 4 firms. In some cases, the choices are
further restricted because the accounting profession has become segmented
by industry, and a lack of industry-specific knowledge may preclude some
firms from performing the audits. For a company that is limited to use of
Big 4 firms, it was viewed that selection may also be restricted because
an audit firm providing certain nonaudit services or
serving as a company's internal auditor is prohibited by independence
rules from also serving as that company's auditor of record. In some
cases, a company may also be limited in its choice of firms if an audit
firm audits one of the company's major competitors and the public company
decides not to use that firm as its auditor of record.
With regard to the use of a Big 4 firm, some individuals believe that
although a new auditor provides a "fresh look" at an audit engagement, the
Big 4 audit firms have somewhat similar cultures and methodologies for
performing audits, and as a result, the benefit of a "fresh look" is more
limited today than it was in the past when the firms had different
cultures and employed a greater variety of methodologies.
Many individuals we spoke with also noted that when a change in auditor of
record occurs, a learning curve, which can last a year or more, exists
while the new auditor becomes familiar with the client's operations, thus
increasing the audit risk associated with the engagement. Although a new
auditor provides a "fresh look" for the audit, concern was raised that a
new auditor may challenge the previous auditor's judgments in an overly
aggressive manner because the new auditor is not familiar with the
client's operations or accounting policies, and this poses a problem for
the public company because the previous auditor is not present to explain
the rationale for those judgments. It was viewed that in some cases, these
are matters of professional judgment rather than actual errors and that
such a situation could result in increased tension between the client and
new auditor of record.
Some individuals we spoke with expressed concern that if mandatory audit
firm rotation were implemented, the audit firm may rotate its most
qualified staff off the engagement during the later years of audit tenure
because the audit firm might focus its resources on obtaining or providing
services to new clients. These individuals believe that such a practice
would increase audit risk, as did most Tier 1 firms and Fortune 1000
public companies. Some individuals also expressed concern that toward the
end of audit tenure, an audit firm might shift its attention to marketing
nonaudit services the firm could provide when it was no longer the auditor
of record, which may be counter to the intended benefits of mandatory
audit firm rotation.
Individuals we spoke with also noted other implementation issues with
mandatory audit firm rotation. For example, they viewed mandatory audit
firm rotation as increasing costs to a company, not only in terms of
higher
audit fees but also in additional selection and support costs. In
particular, many individuals we spoke with, as did most Tier 1 firms and
Fortune 1000 public companies, believed that when a company rotates
auditors, a certain amount of disruption occurs and the company spends a
significant amount of resources-both financial and human-educating the new
auditor about company operations and accounting matters. Individuals we
spoke with expressed concern not only that these additional audit,
selection, and support costs are ultimately passed on to shareholders but
also that audit committees may lose control of selecting the best auditors
to provide the best quality to shareholders since the incumbent firm would
not be eligible to compete to provide audit services for some period of
time.
Some individuals we spoke with noted that they have already observed a
heightened sense of corporate responsibility and better corporate
governance as a result of a change in behavior brought about by the large
corporate failures in recent years. Overall, the majority of knowledgeable
individuals we spoke with believe that a requirement for mandatory audit
firm rotation should not be implemented at this time.46 However, some
individuals suggested that regulators could require a change in the
auditor of record as an enforcement action if conditions warrant such a
measure. Most individuals we spoke with believe that the cost of requiring
mandatory audit firm rotation would exceed the benefits because of the
various practical concerns noted. Rather, these individuals believe that
greater experience with the existing provisions of the Sarbanes-Oxley Act
should be gained and the results assessed before the need for the
mandatory audit firm rotation is considered. Many individuals we spoke
with believe that individual Sarbanes-Oxley Act provisions, such as audit
firm partner rotation and the increased responsibilities of the audit
committee, are not a substitute for mandatory audit firm rotation, but
taken collectively, they could accomplish many of the same intended
benefits of mandatory audit firm rotation to improve auditor independence
and audit quality. For example, some individuals believe that the existing
Sarbanes-Oxley Act provisions related to audit committees have already
resulted in more time spent on audit committee activities and greater
contact and frequency of meetings with auditors. These individuals
commented that audit committees now ask more questions of auditors because
of a
46 Individuals we spoke with that generally supported mandatory audit firm
rotation included representatives of entities that currently have
mandatory audit firm rotation policies, a consumer advocacy group, two
individuals associated with oversight of the accounting profession, an
individual knowledgeable in the regulation of public companies, and an
expert in corporate governance.
heightened sense of accountability for the performance, accuracy,
reliability, and integrity of everything the independent auditors are
doing.
Survey Groups Views on Implementing Mandatory Audit Firm Rotation if
Required and Other Alternatives for Enhancing Audit Quality
If mandatory audit firm rotation were required a number of implementing
factors affecting the structure of the requirement would need to be
decided by policy makers (e.g., the Congress and regulators). The
following provides the views of Tier 1 firms, Fortune 1000 public
companies, and their audit committee chairs on certain implementing
factors, regardless of whether they supported mandatory audit firm
rotation.
o Most believed that the auditor of record's tenure should be limited to
either 5 to 7 years or 8 to 10 years.
o Nearly all believed that when the incumbent auditor of record is
replaced, the public accounting firm should not be permitted to compete
for audit services for either 3 or 4 years or 5 to 7 years.
o Nearly all believed that the audit committee should be permitted to
terminate the business relationship with the auditor of record at any time
if it is dissatisfied with the firm's performance. Likewise, most believed
that the public accounting firm should be able to terminate its
relationship with the audit committee/public company at any time if it is
dissatisfied with the working relationship.
o Nearly all believed that implementation of mandatory audit firm
rotation should be staggered on a reasonable basis to avoid a significant
number of public companies changing auditors simultaneously.
o Most Tier 1 firms believed that mandatory audit firm rotation should
not be applied uniformly to all public companies regardless of their
nature or size. In contrast, most Fortune 1000 public companies and their
audit committee chairs believed mandatory audit firm rotation should be
applied to all public companies regardless of nature or size. However,
most other domestic and mutual fund companies that responded to our survey
believed mandatory audit firm rotation should not be applied uniformly,
and their audit committee chairs who responded to our survey were split on
the subject.
o The Tier 1 firms and Fortune 1000 audit committee chairs who believed
that mandatory audit firm rotation should not be applied uniformly more
frequently selected the larger public companies rather than the
smaller public companies to be subject to mandatory audit firm rotation.
However, Fortune 1000 public companies were divided on their selection of
sizes of public companies that should be subject to mandatory audit firm
rotation.
See appendix II for additional details of the responses.
Our research of studies, other documents, and survey development
activities concerning issues related to mandatory audit firm rotation
identified the following other practices for potentially enhancing auditor
independence and audit quality:
o the audit committee periodically holding an open competition for
providing audit services,
o requiring audit managers to periodically rotate off the engagement for
providing audit services to the public company,
o the audit committee periodically obtaining the services of a public
accounting firm to assist it in overseeing the financial statement audit
or to conduct a forensic audit in areas of the public company's financial
statement process that present a risk of fraudulent financial reporting,
and
o the audit committee hiring the auditor of record on a noncancelable
multiyear basis in which only the public accounting firm could terminate
the business relationship for cause during the contract period.
Although many Tier 1 firms, Fortune 1000 public companies, and their audit
committee chairs saw some benefit in each of the alternative practices, in
general, they most frequently reported that the alternative practices
would have limited or little benefit. The most notable exception involved
the practice in which an audit committee would hire an auditor of record
on a noncancelable multiyear basis, for which most Fortune 1000 public
companies and their audit committee chairs reported that the practice
would have no benefit. (See table 5 in app. III.)
Regarding practices other than mandatory audit firm rotation that may have
potential value to enhance auditor independence and audit quality, the
Sarbanes-Oxley Act provides the PCAOB with the authority to set auditing
and related attestation, ethics, independence, and quality control
standards for registered public accounting firms and for conducting
inspections to
determine compliance of each registered public accounting firm with the
rules of the PCAOB, the SEC, or professional standards in connection with
the performance of audits, the issuance of audit reports, and related
matters involving public companies. In that respect, the PCAOB's
inspection program for registered public accounting firms could also
provide the PCAOB with the opportunity to provide a "fresh look" at the
auditor of record's performance regarding auditor independence and audit
quality. For example, the inspections could include factors potentially
affecting auditor independence, such as length of the auditor's tenure,
partners or managers of the audit firm who recently left the firm and are
now employed by the public company in financial reporting roles, and
nonaudit services provided by the auditor of record, as suggested by the
Conference Board Commission on Public Trust and Private Enterprise in its
January 9, 2003, report. Also, the inspections could consider the
auditor's work in high-risk areas of the public company's operations and
related financial reporting. Further, the inspections can serve to provide
some degree of transparency of their overall results and enforcement of
PCAOB and SEC requirements that may be useful for audit committees to
consider.
Auditor Experience in Restatements of annual Financial Statements Filed
with the SEC for 2001 and 2002
With the dissolution of Arthur Andersen LLP in 2002, Tier 1 firms reported
replacing Anderson, as auditor of record, for more than 1,200 public
company clients since December 31, 2001. Such volume of change in auditors
provided an unprecedented opportunity to gain some actual experience with
the potential value of the "fresh look" provided by a new auditor. Since
many of these public companies had to replace Andersen as their auditor of
record during 2002, the number of changes in their auditor of record
effectively represented a partial form of mandatory audit firm rotation.
We identified all annual restatements of financial statements filed on a
Form 10-KA and any annual restatements included in an annual Form 10K
filing with the SEC by Fortune 1000 public companies for 2001 and 2002
through August 31, 2003, and focused on which restatements were
attributable to errors or fraud where the previous financial statements
did not comply with GAAP and identified whether there was a change in the
auditor of record.
We found that 28, or 2.9 percent, of the 960 Fortune 1000 public companies
changed their auditor of record during 2001, and 204, or 21.3 percent, of
the companies changed their auditor during 2002. The significant increase
from 2001 through 2002 was primarily due to the dissolution of Andersen.
Our analysis showed that the Fortune 1000 public companies filed 43
restatements during those 2 years that were due to errors or fraud. The
financial statements affected ranged from years 1997 to 2002. The
misstatement rates of these public companies' previously issued statements
of net income ranged from a 6.7 percent overstatement of net income for
2000 to a 37.0 percent understatement of net loss for 2001.
The restatement rates due to errors or fraud among the 43 Fortune 1000
public companies that changed their auditor of record were 10.7 percent in
2001 and 3.9 percent in 2002 compared to restatement rates of 2.5 percent
in 2001 and 1.2 percent in 2002 for companies that did not change
auditors. Although the data indicate that the overall restatement rate is
approximately 4.5 times higher for 2001 and 3.25 times higher for 2002 for
the companies that changed their auditor of record as compared to those
companies that did not change auditors, caution should be taken as further
analysis would be needed to determine whether the restatements are
associated with the "fresh look" attributed to mandatory audit firm
rotation. In that respect, for the majority of the restatements, the
public information filed with the SEC and included in the SEC's Electronic
Data Gathering, Analysis, and Retrieval (EDGAR) system did not provide
sufficient information to determine whether company management, the
auditor of record, or regulators identified the error or fraud, and in
those cases in which there was a change in the auditor of record, whether
the predecessor auditor or the successor auditor identified the problem
and whether it was identified before or after the change in auditor of
record. Also, the recent corporate financial reporting failures have
greatly increased the pressures on company management and their auditors
regarding honest, fair, and complete financial reporting. See appendix IV
for additional details of our analysis.
Regarding further analysis to determine whether restatements are
associated with the "fresh look," we believe such additional future
research could potentially add value to better predict the benefits of
mandatory audit firm rotation and the future need for mandatory audit firm
rotation. See the observations section of this report for our views on
mandatory audit firm rotation considering the Sarbanes-Oxley Act's
requirements for enhancing auditor independence and audit quality and
other factors to consider in evaluating the need for mandatory audit firm
rotation.
Experience of Foreign Countries with Mandatory Audit Firm Rotation
To obtain other countries' current or previous experience with or
consideration of mandatory audit firm rotation, we surveyed the securities
regulators of the Group of Seven Industrialized Nations (G-7), which
included the United Kingdom, Germany, France, Japan, Canada, and Italy. In
addition to the G-7 countries' securities regulators, we also surveyed the
following members of the International Organization of Securities
Commissions (IOSCO)47: Australia, Austria, Belgium, Brazil, China, Hong
Kong, Luxembourg, Mexico, the Netherlands, Singapore, Spain, Sweden, and
Switzerland.48 The IOSCO members represent these foreign countries'
organizations with duties and responsibilities which are similar to the
SEC in the United States. We received responses from 11 of the 19
countries' securities regulators surveyed.
Italy and Brazil reported having mandatory audit firm rotation for public
companies, and Singapore reported the requirement for banks that are
incorporated in Singapore. Austria also reported that beginning in 2004,
mandatory audit firm rotation will be required for the auditor of record
of public companies. Spain and Canada reported that they previously had
mandatory audit firm rotation requirements. Generally, reasons reported
for requiring mandatory audit firm rotation related to auditor
independence, audit quality, or increased competition for providing audit
services. Reasons for abandoning the requirements for mandatory audit firm
rotation related to its lack of cost-effectiveness, cost, and having
achieved the objective of increased competition for audit services. Many
of the survey respondents also reported either requiring or considering
audit partner rotation requirements that are similar to the requirements
of the Sarbanes-Oxley Act. See appendix V for additional information on
the survey respondents' experiences and consideration of mandatory audit
firm rotation and audit partner rotation.
47 IOSCO is an international association of securities regulators that was
created in 1983 to promote high standards of regulation in order to
maintain just, efficient, and sound markets, promote the development of
domestic markets, establish standards and an effective surveillance of
international securities transactions, and promote the integrity of the
markets by a rigorous application of the standards and by effective
enforcement against offenses.
48 Based on our review of literature concerning mandatory audit firm
rotation, we found that Saudi Arabia was identified as presently requiring
mandatory audit firm rotation of public companies. While Saudi Arabia is
not an IOSCO member, we attempted to administer our survey to the Saudi
Arabian Monetary Authority, Saudi Arabia's financial supervisory
authority, but did not receive a response.
GAO Observations The Sarbanes-Oxley Act contains significant reforms
intended to enhance auditor independence and audit quality, which are
viewed by the groups of stakeholders we surveyed or held discussions with
as likely to sufficiently achieve the same intended benefits as mandatory
audit firm rotation when fully implemented. In that respect, the SEC's
regulations to implement the auditor independence and audit quality
requirements of the act have only recently been issued, and the PCAOB is
in the process of implementing its inspection program. Therefore, we
believe it will take at least several years to gain some experience with
the effectiveness of the act's requirements concerning auditor
independence and audit quality.
We believe that it is critical for both the SEC and the PCAOB, through its
oversight and enforcement programs, to formally monitor the effectiveness
of the regulations and programs intended to implement the Sarbanes-Oxley
Act. This information will be valuable in considering whether changes,
including mandatory audit firm rotation, may be needed to further protect
the public interest. We noted that survey responses from Tier 1 firms show
that the potential for lawsuits or regulatory action is a major incentive
for the firms to appropriately deal with public company management in
resolving financial reporting issues. We believe that the SEC's and
PCAOB's rigorous enforcement of regulations and other requirements will be
critical to the effectiveness of the act's requirements.
It is clear that the likely additional costs associated with mandatory
rotation have influenced the views of Tier 1 firms and Fortune 1000 public
companies and their audit committee chairs to not support mandatory
rotation. However, we believe that these additional costs need to be
balanced with the need to protect the public interest, especially
considering the recent significant accountability breakdowns and their
impact on investors and other interested parties. Although expecting to
have zero financial reporting/audit failures is not a realistic
expectation, Enron, WorldCom, and others have recently demonstrated that a
single financial reporting/audit failure of a major public company can
have significant consequences to shareholders and other interested
parties. We believe it is fairly certain that mandatory audit firm
rotation would result in selection costs and additional support costs for
public companies. Also, most Tier 1 firms and Fortune 1000 public
companies believe that mandatory audit firm rotation would also result in
higher audit fees, primarily due to higher initial years' audit costs.
If public accounting firms under mandatory audit firm rotation have (1) a
shorter tenure as auditor of record to recover higher initial year audit
costs and (2) fewer opportunities to also sell nonaudit services due to
the Sarbanes-Oxley Act requirements concerning prohibited nonaudit
services, then we believe it is reasonable to assume, as public accounting
firms and public companies have done, that the higher initial year audit
costs associated with a new auditor are likely to be passed on to the
public companies, along with increased marketing costs. However,
competition among public accounting firms for providing audit services
should to some extent also affect audit fees. Therefore, we believe it is
uncertain at this time how these dynamics would play out in the market for
audit services and their effect on audit fees over the long term. However,
if intensive price competition were to occur, the expected benefits of
mandatory audit firm rotation could be adversely affected if audit quality
suffers due to audit fees that do not support an appropriate level of
audit work.
We believe that mandatory audit firm rotation may not be the most
efficient way to enhance auditor independence and audit quality,
considering the costs of changing the auditor of record and the loss of
auditor knowledge that is not carried forward to the new auditor. We also
believe that the potential benefits of mandatory audit firm rotation are
harder to predict and quantify while we are fairly certain there will be
additional costs. In that respect, mandatory audit firm rotation is not a
panacea that totally removes pressures on the auditor in appropriately
resolving financial reporting issues that may materially affect the public
companies' financial statements. Those pressures are likely to continue
even if the term of the auditor is limited under any mandatory rotation
process. Furthermore, most public companies will only use the Big 4 firms
for their auditor of record for a variety of reasons, including the firms'
having sufficient industry knowledge and resources to audit their
companies and expectations of the capital markets to use Big 4 firms.
These public companies may only have 1 or 2 choices for their auditor of
record under any mandatory rotation system. However, over time a mandatory
audit firm rotation requirement may result in more firms transitioning
into additional industry sectors if the market for such audits has
sufficient profit margins.
The current environment has greatly increased the pressures from
regulators and investors on public company management and public
accounting firms to have financial statements issued by public companies
that comply with GAAP and provide full disclosure. These pressures and the
reforms of the Sarbanes-Oxley Act provide incentives to have financial
reporting that is honest, fair, and complete and that serves the public
interest. If such reporting is widely and consistently achieved then the
likelihood of the "fresh look" serving to identify financial reporting
issues that may materially affect financial statements that were either
overlooked or not appropriately dealt with by the previous auditor of
record will be reduced. However, it is uncertain at this time if the
current climate and pressures for accurate and complete financial
reporting and for restoring public trust will be sustained over the long
term.
Regarding the need for mandatory audit firm rotation, we believe the most
prudent course at this time is for the SEC and the PCAOB to monitor and
evaluate the effectiveness of the Sarbanes-Oxley Act's requirements for
enhancing auditor independence and audit quality, and ultimately restoring
investor confidence. In that respect, the PCAOB's inspection program for
registered public accounting firms could also provide an opportunity to
provide a "fresh look," which would enhance auditor independence and audit
quality through the program's inspection activities, and may provide new
insights regarding (1) public companies' financial reporting practices
that pose a high risk of issuing materially misstated financial statements
for the audit committees to consider and (2) possibly either using the
auditor of record or another firm to assist in reviewing these areas. In
addition, future research on the potential benefits of mandatory audit
firm rotation as suggested by our analysis of restatements of financial
statements may also be valuable to consider along with the evaluations of
the effectiveness of the Sarbanes-Oxley Act.
Further, we also believe that currently audit committees, with their
increased responsibilities under the Sarbanes-Oxley Act, can play a very
important role in enhancing auditor independence and audit quality. In
that respect, the Conference Board Commission on Public Trust and Private
Enterprise in its January 9, 2003, report stated that auditor rotation is
a useful tool for building shareholder confidence in the integrity of the
audit and of the company's financial statements. The commission advocated
that audit committees consider rotating audit firms when there are
circumstances that could call into question the audit firm's independence
from management. The circumstances that merited consideration included
when (1) significant nonaudit services are provided to the company by the
auditor of record (even if they have been approved by the audit
committee), (2) one or more former partners or managers of the audit firm
are employed by the company, or (3) lengthy tenure of the auditor of
record, such as over 10 years-which our survey results show is prevalent
at many Fortune 1000 public companies. In such cases, we believe audit
committees need to be especially vigilant in the oversight of the auditor
and in considering whether a "fresh look" is warranted. We also believe
that if audit committees regularly evaluate whether audit firm rotation
would be beneficial, given the facts and circumstances of their companies'
situation, and are actively involved in helping to ensure audit
independence and audit quality, many of the intended benefits of audit
firm rotation could be realized at the initiative of the audit committee
rather than through a mandatory requirement.
However, audit committees need to have access to adequate resources,
including their own budgets, to be able to operate with the independence
necessary to effectively perform their responsibilities under the
Sarbanes-Oxley Act. Further, we believe that an audit committee's ability
to operate independently is directly related to the independence of the
public company's board of directors. It is not realistic to believe that
audit committees will unilaterally resolve financial reporting issues that
materially affect a public company's financial statements without vetting
those issues with the board of directors. Also, the ability of the board
of directors to operate independently may also be affected in corporate
governance structures where the public company's chief executive officer
also serves as the chair of the board of directors. Like audit committees,
boards of directors also need to be independent and to have adequate
resources and access to independent attorneys and other advisors when they
believe it is appropriate. Finally, for any system to function
effectively, there must be incentives for parties to do the right thing,
adequate transparency to provide reasonable assurance that people will do
the right thing, and appropriate accountability when people do not do the
right thing.
Agency Comments and We provided copies of a draft of this report to the
SEC, AICPA, and PCAOB for their review. Representatives of the AICPA and
the PCAOB provided
Our Evaluation technical comments, which we have incorporated where
applicable. Representatives of the SEC had no comments.
We are sending copies of this report to the Chairman and Ranking Minority
Member of the House Committee on Energy and Commerce. We are also sending
copies of this report to the Chairman of the Securities and Exchange
Commission, the Chairman of the Public Company Accounting
Oversight Board, and other interested parties. This report will also be
available at no charge on GAO's Web site at http://www.gao.gov.
If you or your staffs have any questions concerning this report, please
contact me at (202) 512-9471 or John J. Reilly, Jr., Assistant Director,
at
(202) 512-9517. Key contributors are acknowledged in appendix VI.
Jeanette M. Franzel
Director, Financial Management and Assurance
Appendix I
Objectives, Scope, and Methodology
As mandated by Section 207 of the Sarbanes-Oxley Act of 20021 and as
agreed with your staff, to perform our study and review of the potential
effects of requiring mandatory rotation of registered public accounting
firms, we
1. identified and reviewed research studies and related literature that
addressed issues concerning auditor independence and audit quality
associated with the length of a public accounting firm's tenure and the
costs and benefits of mandatory audit firm rotation;
2. analyzed the issues we identified to
o develop detailed questionnaires to obtain the views of public
accounting firms and public company chief financial officers and their
audit committee chairs on the potential effects of mandatory audit firm
rotation,
o hold discussions with officials of other interested stakeholders, such
as institutional investors, federal banking regulators, U.S. stock
exchanges, state boards of accountancy, the American Institute of
Certified Public Accountants (AICPA), the Securities and Exchange
Commission (SEC), and the Public Company Accounting Oversight Board
(PCAOB), to obtain their views on the issues associated with mandatory
audit firm rotation, and
o obtain information from other countries on their experiences with
mandatory audit firm rotation; and
3. identified restatements of annual 2001 and 2002 financial statements of
Fortune 1000 public companies due to errors or fraud that were reported to
the SEC during 2002 and 2003 through August 31, 2003, to
o determine whether the restatement occurred before or after a change in
the public companies' auditor of record, and
o test the value of the "fresh look" commonly attributed to mandatory
audit firm rotation.
1 Pub. L. No. 107-204, 116 Stat. 745, 775.
Appendix I
Objectives, Scope, and Methodology
We conducted our work in Washington, D.C., between November 2002 and
November 2003 in accordance with U.S. generally accepted government
auditing standards.
Identifying Research Studies Concerning Auditor Independence and Audit
Quality
To identify existing research related to mandatory audit firm rotation, we
utilized several methods including general Internet searches, requests
from the AICPA library, the AICPA's Web site (www.aicpa.org), the American
Accounting Association's Web site
(http://accounting.rutgers.edu/raw/aaa/), the SEC's Web site
(www.sec.gov), requests from GAO's internal library resources, and
suggestions provided by communities of interest. Also, many studies were
identified through bibliographies of previously identified research. We
used the following keywords in our searches: "mandatory audit firm
rotation," "mandatory auditor rotation," "compulsory audit firm rotation,"
"compulsory auditor rotation," "auditor rotation," "auditor change(s),"
and "auditor switching."
We identified a total of 80 studies, articles, position papers, and
reports from our searches. We then applied the following criteria to these
studies. We focused on studies that (1) were mostly published no earlier
than 1980, (2) contained some original data analyses, and (3) focused on
some aspect of mandatory audit firm rotation. Using these criteria, 27
studies were subjected to further methodological review to evaluate the
design and approach of the studies, the quality of the data used, and the
reasonableness of the studies' conclusions and to determine if any
limitations of a study were of sufficient severity to call into question
the reasonableness of the conclusion. We eliminated 10 of these studies
because they were actually position papers or literature summaries, and
did not include any original data analyses. One additional study was
eliminated because of fundamental methodological flaws.
Of the remaining 16 studies that were subjected to a high-level
methodological review, 7 have major caveats that should be considered
along with the results of the studies, while the other 9 have some more
minor methodological limitations, such as limited application to the
subject; limited data availability; or insufficient information on issues
including choice of samples, response rates, and nonresponse analyses. In
developing the survey instruments covering issues concerning auditor
independence and audit quality associated with the length of a public
accounting firm's tenure and the costs and benefits of mandatory audit
firm rotation, we primarily used the studies from among this latter group
of 9 as listed below.
Appendix I
Objectives, Scope, and Methodology
The Relationship of Audit Failures and Audit Tenure, by Jeffrey Casterella
of Colorado State University, W. Robert Knechel of University of Florida
and University of Auckland, and Paul Walker of the University of Virginia,
November 2002.
Auditor Rotation and Retention Rules: A Theoretical Analysis (Rotation
Rules), by Eric C. Weber of Northwestern University, June 1998.
Audit-Firm Tenure and the Quality of Financial Reports, by Van E. Johnson
of Georgia State University, Inder K. Khurana of the University of
Missouri-Columbia, and J. Kenneth Reynolds of Louisiana State University,
Winter 2002.
"The Effects of Auditor Change on Audit Fees: Tests of Price Cutting and
Price Recovery", The Accounting Review, by D.T. Simon, and J.R. Francis,
April 1988.
"Does Auditor Quality and Tenure Matter to Investors?" Evidence from the
Bond Market. Sattar Mansi of Virginia Polytechnic Institute, William F.
Maxwell of University of Arizona, and Darius P. Miller of Kelley School of
Business, February 2003 paper under revision for the Journal of Accounting
Research.
An Analysis of Restatement Matters: Rules, Errors, Ethics, for the Five
Years Ended December 31, 2002, The Huron Consulting Group, January 2003.
The Commission on Auditors' Responsibilities: Report of Tentative
Conclusions, The Cohen Commission (an independent commission established
by the AICPA), 1977. (Limited to Section 9, "Maintaining the Independence
of Auditors, Rotation of Auditors").
"Audit Fees and Auditor Change; An Investigation of the Persistence of Fee
Reduction by Type of Change", Journal of Business Finance and Accounting,
by A. Gregory, and P. Collier, January 1996.
"Auditor Changes and Tendering: UK Interview Evidence", Accounting,
Auditing and Accountability Journal, v11n1, V. Beattie, and S. Fearnley,
1998.
Appendix I
Objectives, Scope, and Methodology
Obtaining the Views of Public Accounting Firms and Public Company Chief
Financial Officers and Their Audit Committee Chairs on Mandatory Audit
Firm Rotation
We analyzed the issues identified from our review of studies, articles,
position papers, and reports to develop an understanding of the background
and related advantages and disadvantages of mandatory audit firm rotation.
We developed three separate survey instruments incorporating a variety of
issues related to auditor independence, audit quality, mandatory audit
firm rotation and the potential effects on audit costs, audit fees, audit
quality, audit risk, and competition that may arise with a mandatory audit
firm rotation requirement. In addition, these survey instruments solicited
views on the impact of specific provisions of the Sarbanes-Oxley Act
intended to enhance auditor independence and audit quality, other
practices for enhancing audit quality, views on implementing mandatory
audit firm rotation, and overall opinions on requiring mandatory audit
firm rotation.
We performed field tests of the survey instruments to help ensure that the
survey questions would be understandable to different groups of
respondents, eliminate factual inaccuracies, and obtain feedback and
recommendations to improve the surveys. We took the feedback and comments
we received into consideration in developing our final survey instruments.
Specifically, during March and April of 2003, we performed field tests of
the survey instrument for public accounting firms with eight different
public accounting firms, including two of the Big 4 firms, two national
firms, and four regional or local firms. During May 2003, we conducted
field tests of the survey instrument for public company chief financial
officers with four public companies, including two Fortune 1000 companies
and two commercial banks not included in the Fortune 1000. We tailored the
survey instrument for public company audit committee chairpersons by
incorporating the feedback and comments we received from the chief
financial officers during the field tests we performed with public
companies.
Appendix I
Objectives, Scope, and Methodology
Surveys of Public Accounting Firms
Section 207 of the Sarbanes-Oxley Act mandated that GAO study the
potential effects of mandatory audit firm rotation of registered public
accounting firms, referring to public accounting firms that would be
registered with the new PCAOB. During the January 2003 time frame when we
were framing the population, since the PCAOB was in the process of getting
organized and becoming operational, there were no public accounting firms
registered with the PCAOB at that time.2 Therefore, we coordinated with
the AICPA to establish a population of public accounting firms that would
most likely register with the PCAOB. The AICPA provided a complete list of
the more than 1,100 public accounting firms that were registered with the
AICPA's Securities and Exchange Commission Practice Section (SECPS)3 as of
January 2003. Prior to the restructuring of the SECPS, AICPA bylaws
required that all members that engage in the practice of public accounting
with a firm auditing one or more SEC clients join the SECPS. Public
accounting firms that did not have any SEC clients could join the SECPS
voluntarily. Based on the information submitted in their 2001 annual
reports, these SECPS member firms collectively had nearly 15,000 SEC
clients.4 Therefore, the public accounting firms registered with the SECPS
at that time were used to frame an alternative source of public accounting
firms that perform audits of issuers registered with the SEC.
Based on the AICPA-provided SECPS membership list and the number of SEC
clients reported in these SECPS member firms' 2001 annual reports, of
1,117 SECPS members, 696 firms had 1 or more SEC clients and 421 firms
were SECPS members but did not audit any public companies. The 696
2 The PCAOB established the process for public accounting firms to
register with the PCAOB starting in April 2003, with public accounting
firms having an initial opportunity to register with the PCAOB no later
than October 22, 2003. As of October 22, 2003, according to the PCAOB,
there were 598 public accounting firms registered with the PCAOB and 55
public accounting firms that had applications pending the PCAOB's review.
3 The AICPA's SECPS was a part of the former self-regulatory system. SECPS
was overseen by the former Public Oversight Board (POB), which represented
the public interest on all matters affecting public confidence in the
integrity of the audit process. The SECPS required AICPA member accounting
firms registered with the SECPS to subject their professional practices to
peer review and oversight by the POB and SEC. The AICPA recently announced
a new voluntary membership called the Center for Public Company Audit
Firms that restructures and replaces the SECPS, which had several of its
functions absorbed into the PCAOB.
4 According to SEC records, there were nearly 18,000 issuers registered
with the SEC as of February 2003.
Appendix I
Objectives, Scope, and Methodology
members of the SECPS collectively audited 14,928 of the 17,956 issuers
registered with the SEC. Since approximately 3,000 issuers were audited by
public accounting firms that were not members of the SECPS, we obtained a
list from the SEC that included the names of over 1,000 public accounting
firms that performed the audits of public companies registered with the
SEC. We compared the 696 SECPS member firms to all of the public
accounting firms that were included in the SEC's list in order to identify
the non-SECPS member public accounting firms, which were mainly consisted
of foreign public accounting firms or domestic firms that are not AICPA
members. Since the PCAOB has indicated that it will not exempt foreign
public accounting firms that audit issuers registered with the SEC from
registering with the PCAOB, we included non-SECPS member public accounting
firms that reported to the SEC that they had 10 or more SEC clients in the
population.
Stratification of Public Accounting Firm Population
In order to identify differences in views on the potential effects of
mandatory audit firm rotation for respondents that vary based on the size
of the public accounting firm, location (e.g., domestic versus foreign
firms) and other factors, we stratified the population into three tiers
based on the number of SEC clients reported to the SECPS in the SECPS
member firms' 2001 annual reports and the aforementioned SEC data for
non-SECPS member public accounting firms:
1. Tier 1 firms: 92 SECPS member and 5 non-SECPS public accounting firms
that had 10 or more 2001 SEC clients in 2001,
2. Tier 2 firms: 604 SECPS member firms that had from 1 to 9, 2001 SEC
clients in 2001, and
3. Tier 3 firms: 421 SECPS member firms that reported having no SEC
clients.
The basis for selecting public accounting firms with 10 or more SEC
clients was twofold. First, the 92 SECPS member firms included in Tier 1
collectively had approximately 90 percent of all of the SEC clients
reported to the SECPS in the member firms' 2001 annual reports. Second,
the public accounting firms with 10 or more SEC clients were viewed to
collectively have the most experience and knowledge about changing
auditors for public company clients and accordingly were considered to
have a great interest in the potential effects of mandatory audit firm
rotation. Tier 2 was established because the 604 SECPS member firms with 1
to 9 SEC clients
Appendix I
Objectives, Scope, and Methodology
comprises approximately 10 percent of the total SEC clients reported to
the the SECPS in member firms' 2001 annual reports and were also
considered to have a great interest in, as well as important views on, the
potential effects of mandatory audit firm rotation based on their
experience and knowledge of being auditors for public companies. Lastly,
we included the 421 SECPS member public accounting firms that had no SEC
clients in Tier 3 of our population in order to determine if there would
be greater or less interest in providing financial statement audit
services to public companies if mandatory audit firm rotation were
required. We requested that the public accounting firms' chief executive
officers or managing partners, or their designated representatives,
complete the survey.
Method of Administration In order to conduct our survey, we selected a 100
percent certainty sample of Tier 1 public accounting firms consisted of
all 92 SECPS member firms and all 5 non-SECPS member firms. In addition,
we selected separate random samples from each of the two remaining strata.
We created two separate Web sites for the public accounting firm surveys.
The top tier firms were surveyed independently of the second and third
tiers because the Tier 1 survey was administered jointly with another
study dealing with consolidation of major public accounting firms since
1989 as mandated by Section 701 of the Sarbanes-Oxley Act.5 The survey for
the Tier 2 and Tier 3 firms, which dealt only with the potential effects
of mandatory audit firm rotation, was created at a separate Web site. A
unique password and user ID was assigned to each selected public
accounting firm in our sample to facilitate completion of the survey
online. The surveys were made available to the Tier 1 firms during the
week of May 27, 2003, and the surveys to the Tier 2 and Tier 3 firms were
made available during the week of June 12, 2003. Both survey Web sites
remained open until September 2003. Responses to surveys completed online
were automatically stored on GAO's Web sites. From August through
September 2003, we performed follow-up efforts to increase the overall
response rates by telephoning the selected public accounting firms that
had not completed the survey, and requested that they take advantage of
the opportunity to express their views on this important issue by doing
so.
Lastly, in order to gain knowledge about whether the views of the Tier 1
public accounting firms that did not complete our survey were materially
5 U.S. General Accounting Office, Public Accounting Firms: Mandated Study
on Consolidation and Competition, GAO-03-864 (Washington, D.C.: July 30,
2003).
Appendix I
Objectives, Scope, and Methodology
different from the overall views of the Tier 1 public accounting firms
that completed our survey, we asked the following key questions of those
public accounting firms that did not complete our survey and that we
contacted during our telephone follow-up efforts. Specifically, we asked
whether their firms believed the benefits of mandatory audit firm rotation
would exceed the costs of implementing such a requirement and whether
their firms would support requiring mandatory audit firm rotation. As more
fully described in the body of this report, the overall views expressed by
the Tier 1 public accounting firms that completed our survey generally
indicated that the costs of mandatory audit firm rotation would exceed the
benefits and that their firms were not in favor of supporting such a
requirement. The views of the Tier 1 public accounting firms that did not
complete our survey and that we contacted in our telephone follow-up
efforts were generally consistent with the overall views of the Tier 1
public accounting firms that completed our survey.
Public Accounting Firm Survey Results
As disclosed in our survey instruments, all survey results were to be
compiled and presented in summary form only as part of our report, and we
will not release individually identifiable data from these surveys, unless
compelled by law or required to do so by the Congress. We received
responses from 74 of the 97 Tier 1 firms, or 76.3 percent.6 Because of the
more limited participation of Tier 2 firms (85, or 30.1 percent) and Tier
3 firms (52, or 21.9 percent) in our survey, we are not projecting their
responses to the population of firms in these tiers. The presentation of
this report focuses on the responses from the Tier 1 firms, but any
substantial differences in their overall views and those reported to us by
either Tier 2 or 3 firms are discussed where applicable.
Table 2 summarizes the population, sample sizes, and overall responses
received for all three tiers of public accounting firms surveyed on the
potential effects of mandatory audit firm rotation.
6 Estimates of Tier 1 firms are subject to sampling errors of no more than
plus or minus 7 percentage points (95 percent confidence level) unless
otherwise noted, as well as to possible nonsampling errors generally found
in surveys.
Appendix I
Objectives, Scope, and Methodology
Table 2: Public Accounting Firms' Population, Sample Sizes, and Survey
Response Rates
Tier 1 firms Tier 2 firms Tier 3 firms Totals
Population size 97 604 421 1,122
Sample size 97 282 237
Total responses 74 85 52
Response rate 76.3% 30.1% 21.9% - --
Source: GAO survey
data.
Surveys of Public Company Chief Financial Officers and Audit Committee
Chairs
As a part of fulfilling our objective to study the potential effects of
mandatory audit firm rotation, we obtained the views on the advantages and
disadvantages and related costs and benefits from a random sample of chief
financial officers and audit committee chairs of public companies
registered with the SEC. We solicited the views of chief financial
officers of public companies because they were considered to be very
knowledgeable about the issues involving financial statement audits of
public companies. We also solicited the views of audit committee chairs
because under the Sarbanes-Oxley Act, the audit committee has expanded
responsibilities for monitoring and overseeing public companies' financial
reporting and the financial statement audit process. We obtained such
views by administering a survey to randomly selected samples of public
company chief financial officers and their audit committee chairs.
Section 207 of the Sarbanes-Oxley Act defines "mandatory rotation" as the
imposition of a limit on the period of years for which a particular
registered public accounting firm may be the auditor of record for a
particular issuer. Therefore, in framing the population from which we
planned to draw our sample of public companies, we researched what the
definition of an "issuer" is with the SEC, with GAO's General Counsel, and
the AICPA's SECPS. The primary purpose of conducting this research was to
determine whether mutual funds (or mutual fund complexes) and other types
of investment companies such as investment trusts, should be included in
the population. Based on discussions with the Director of the SEC's Office
of Investment Management, mutual funds and investment trusts are issuers
that are required to file periodic reports with the SEC under the
Securities Exchange Act of 1934 or the Investment Company Act of 1940.
Also, officials in the SEC's Office of Investment Management indicated
that there are nearly 10,000 individual mutual funds grouped into 877
mutual fund complexes (also known as families). A mutual fund complex is
Appendix I
Objectives, Scope, and Methodology
responsible for hiring the auditor of record, either collectively or
individually, for the individual mutual funds that are included in the
family or complex. As such, investment trusts and the 877 mutual fund
complexes were included in our population for the purpose of administering
our survey.
We obtained lists of public company issuers from the SEC in developing the
population as follows: The SEC's Office of Corporation Finance provided a
list of 17,079 public companies from the SEC's Electronic Data Gathering,
Analysis, and Retrieval (EDGAR) system. This list included registrants
that were listed as current issuers registered with the SEC as of February
2003 and included 14,938 domestic public companies (including investment
trusts) and 2,141 foreign public companies (i.e., companies that are
domiciled outside of the United States but are registered with the SEC).
Our comparison of this SEC list to a separate list of Fortune 1000
companies identified an additional 32 public companies that were added to
the original list of 17,079, bringing the total population to an adjusted
total of 17,111. As noted above, we also obtained a complete list of 877
mutual fund complexes from the SEC that included current issuers
registered with the SEC's Office of Investment Management. Therefore, the
population of public company issuers as of February 2003 totaled 17,988,
consisted of 17,111 public companies and 877 mutual fund complexes.
Stratification of Chief Financial Officer and Audit Committee Chair
Population
In order to identify differences in views on the potential effects of
mandatory audit firm rotation based on differences in company industry,
size, or geographic location, we stratified the population into the
following three strata: (1) domestic Fortune 1000 companies, (2) other
(non-Fortune 1000) domestic companies and mutual fund complexes, and (3)
foreign companies.
Fortune 1000 stratum: Based on Fortune's list of the Fortune 1000 as of
March 2003, we identified 960 public companies in the Fortune 1000; the
remaining 40 companies were privately owned. Since private companies are
not subject to SEC rules or the Sarbanes-Oxley Act's provisions, these 40
companies were not included in the stratum. We used the file provided by
the SEC listing the 17,079 domestic and foreign public companies to
extract a separate stratum of the 960 public companies in the Fortune
1000. In addition, in comparing Fortune's list of the Fortune 1000 to the
SEC's listing of public companies, we identified 32 additional companies
that were included in the Fortune 1000 but which were not included in the
SEC list. In connection with framing the Fortune 1000 stratum, we added
these
Appendix I
Objectives, Scope, and Methodology
32 companies to the list of domestic and foreign public companies provided
to us by the SEC to ensure that it was complete.
Foreign company stratum: Using the "state code" identifier included in the
adjusted SEC list of 17,111 domestic and foreign public companies, we
extracted a separate stratum of 2,141 foreign companies.
Other domestic companies and mutual fund complexes stratum: After
extracting the 960 domestic Fortune 1000 public companies and the 2,141
foreign public companies from the adjusted SEC list of 17,111 domestic and
foreign public companies, a separate stratum of 14,010 non-Fortune 1000
public companies was created from the SEC file representing the "other
domestic" public companies. These 14,010 other domestic public companies
(which included investment trusts) were combined with the 877 mutual fund
complexes provided by the SEC's Office of Investment Management to create
a total population for this stratum of 14,887.
Method of Administration In order to conduct these surveys, we selected a
separate random sample from each of the three public company strata. We
mailed a survey package to the chief financial officer of each public
company issuer included in our sample. This survey package provided the
chief financial officer with the option of completing the enclosed hard
copy of the survey and returning it in the mail to our Atlanta Field
Office or of completing the survey online. We created a Web site with the
public company survey for the chief financial officers. A unique password
and user ID was assigned to each selected company in our sample of
companies to facilitate completion of the survey online. In addition, a
separate survey directed to the chair of the audit committee (or head of
an equivalent body) was included in the mail survey package. The chief
financial officer was asked to forward this survey to the audit committee
chair. The survey for the public company audit committee chairs was not
made available online. As such, these surveys could only be completed on
hard copy and returned to our Atlanta Field Office. The survey packages
were mailed to all 1,171 public companies in June 2003. The survey Web
site for public company chief financial officers remained open until
September 2003. The cutoff date for accepting mailed surveys from public
company chief financial officers and audit committee chairs was September
2003. Responses to surveys completed online were automatically stored into
GAO's Web sites, and mailed survey responses of chief financial officers
and audit committee chairs were entered into a separate compilation
database by GAO contractor personnel who were hired to perform such data
inputting. From
Appendix I
Objectives, Scope, and Methodology
August through September 2003, we also performed follow-up efforts to
increase the overall response rates by telephoning public company chief
financial officers, who had not completed or returned the survey, and
requesting that the chief financial officer and the audit committee chair
complete our survey and return it to us.
Public Company Survey Results
As disclosed in our surveys, all survey results were to be compiled and
presented in summary form only as part of our report, and we will not
release individually identifiable data from these surveys, unless
compelled by law or required to do so by the Congress. Of the 330 Fortune
1000 public companies sampled, we received responses from 201, or 60.9
percent, of their chief financial officers and 191, or 57.9 percent, of
their audit committee chairs.7 Because of limited participation of the
other domestic companies and mutual funds (131, or 29.1 percent, of their
chief financial officers and 96, or 21.3 percent, of their audit committee
chairs) and the foreign public companies (99, or 25.3 percent, of their
chief financial officers and 63, or 16.1 percent, of their audit committee
chairs), we are not projecting their responses to the population of
companies in these strata. The presentation of this report focuses on the
responses from the Fortune 1000 public companies' chief financial officers
and their audit committee chairs, but any substantial differences in their
overall views and those reported to us by the other groups of public
companies we surveyed is discussed where applicable.
Tables 3 and 4 summarize the population, sample size, and survey responses
received for all three strata of public company chief financial officers
and their audit committee chairs surveyed on the potential effects of
mandatory audit firm rotation.
7 The estimates from these surveys are subject to sampling errors of no
more than plus or minus 6 percentage points (95 percent confidence level)
unless otherwise noted, as well as to possible nonsampling errors
generally found in surveys.
Appendix I
Objectives, Scope, and Methodology
Table 3: Public Company Chief Financial Officers' Population, Sample
Sizes, and Survey Response Rates
Domestic public Fortune 1000 companies and Foreign public companies mutual
funds companies Totals
Population size 960 14,887 2,141 17,988
Sample size 330 450 391 1,171
Total responses 201 131 99
Response rate 60.9% 29.1% 25.3% - --
Source: GAO survey data.
Table 4: Public Company Audit Committee Chairs' Population, Sample Sizes,
and Survey Response Rates
Domestic public Fortune 1000 companies and Foreign public companies mutual
funds companies Totals
Population size 960 14,887 2,141 17,988
Sample size 330 450 391 1,171
Total responses 191 96 63
Response rate 57.9% 21.3% 16.1% - --
Source: GAO survey data.
Additional Survey Considerations
We initially requested information from all 97 Tier 1 firms (firms with 10
or more SEC clients). We received responses from 74 of them. We conducted
follow-up with a limited number of the nonrespondents and did not find
substantive differences between the respondents and the nonrespondents on
key questions related to mandatory audit firm rotation. We requested
information from 330 Fortune 1000 public companies and their audit
committee chairs and received 201 and 191 responses from them,
respectively. While we did not conduct follow-up with the nonrespondents
from our surveys of Fortune 1000 public companies and their audit
committee chairs, we had no reason to believe that respondents and
nonrespondents to our original samples from these strata would
substantively differ on issues related to mandatory audit firm rotation.
Therefore, we analyzed respondent data from the Tier 1 and Fortune 1000
public companies and their audit committees as probability samples from
these respective populations.
Appendix I
Objectives, Scope, and Methodology
Survey results based on probability samples are subject to sampling error.
Each of the three samples (Tier 1 and Fortune 1000 public companies and
their audit committee chairs) is only one of a large number of samples we
might have drawn from the respective populations. Since each sample could
have provided different estimates, we express our confidence in the
precision of our three particular samples' results as 95 percent
confidence intervals. These are intervals that would contain the actual
population values for 95 percent of the samples we could have drawn. As a
result, we are 95 percent confident that each of the confidence intervals
in this report will include the true values in the respective study
populations. All percentage estimates from the survey of Tier 1 firms have
sampling errors not exceeding +/- 7 percentage points unless otherwise
noted. All percentage estimates from the surveys of Fortune 1000 public
companies and their audit committee chairs have sampling errors not
exceeding +/- 6 percentage points unless otherwise noted. Also, estimated
percentages for subgroups of Tier 1 firms and Fortune 1000 public
companies and their audit committee chairs often have sampling errors
exceeding these thresholds, which are noted where they are reported. In
addition, all numerical estimates other than percentages have sampling
errors of not more than +/-14 percent of the value of those numerical
estimates.
Despite our judgment that respondents and nonrespondents do not differ on
issues related to mandatory audit firm rotation, our survey estimates may
nevertheless contain errors to the extent that there truly are differences
between these groups on issues related to this topic.
The practical difficulties of conducting any survey also introduce other
types of nonsampling errors. Differences in how a particular question is
interpreted and differences in the sources of information available to
respondents can also be sources of nonsampling errors. We included steps
in both the data collection and data analysis stages to minimize such
nonsampling errors. These steps included developing our survey questions
with the aid of our survey specialists, conducting pretests of the public
accounting firm and public company questions and questionnaires, verifying
computer analysis by an independent analyst, and double verification of
survey data entry where applicable.
Discussions Held with To supplement the responses to our survey, we
identified other Officials of Other Interested knowledgeable individuals
associated with a broad range of communities Stakeholders of interest and
conducted telephone or in-person discussions to obtain
their views on mandatory audit firm rotation. The communities of interest
Appendix I
Objectives, Scope, and Methodology
included significant institutional investors (pension funds, mutual funds,
and insurance companies), self-regulatory organizations (such as stock
exchanges), consumer advocacy groups, regulators (state boards of
accountancy, banking regulators), the AICPA, the SEC, the PCAOB, and
recognized experts in corporate governance.
The questions for these discussions were based on key questions from the
surveys for public accounting firms and public companies. The results of
the discussions were compiled and presented in summary form only as part
of our report, and we will not release individually identifiable data from
these discussions, unless compelled by law or required to do so by the
Congress.
Obtaining Information from Other Countries on Their Experiences with
Mandatory Audit Firm Rotation
In order to obtain other countries' current or previous experience with or
consideration of mandatory audit firm rotation, we administered surveys to
the securities regulators of the Group of Seven Industrialized Nations
(G7), which included the United Kingdom, Germany, France, Japan, Canada,
and Italy. In addition to the G-7 countries' securities regulators, we
also administered surveys to the following members of the International
Organization of Securities Commissions (IOSCO)8: Australia, Austria,
Belgium, Brazil, China, Hong Kong, Luxembourg, Mexico, the Netherlands,
Singapore, Spain, Sweden, and Switzerland. The IOSCO members represent
these foreign countries' organizations with duties and responsibilities
similar to those of the SEC in the United States.
We administered the surveys to these foreign countries' securities
regulators in December 2002. From July and through October 2003, we
performed follow-up efforts to increase the overall response rates by
sending e-mail messages to the foreign countries' securities regulators in
our sample who had not completed the survey and requested that they do so.
We received responses from 11 of the 19 countries' securities regulators
surveyed.
8 IOSCO is an international association of securities regulators that was
created in 1983 to promote high standards of regulation in order to
maintain just, efficient, and sound markets; promote the development of
domestic markets; establish standards and an effective surveillance of
international securities transactions; and promote the integrity of the
markets by rigorously applying the standards and by effectively enforcing
them.
Appendix I
Objectives, Scope, and Methodology
Identifying Restatements of Annual Financial Statements for Fortune 1000
Public Companies due to Errors or Fraud
To obtain some insight into the potential value of the "fresh look"
provided by a new auditor of record, we analyzed the rate of annual
financial statement restatements reported to the SEC by Fortune 1000
public companies during 2002 and 2003 through August 31, 2003. We
particularly focused on restatements for 2001 and 2002 and compared the
financial statement restatement rates of those Fortune 1000 public
companies that changed their auditor of record to those of Fortune 1000
public companies that did not change their auditor of record during this
period.
In connection with performing this analysis, we separately tracked the
Fortune 1000 public companies that changed auditors from the public
companies that did not change auditors during 2001 and 2002. Financial
statement restatements filed for changes in accounting principles or
changes in organizational business structure (e.g., stock splits, mergers
and acquisitions), reclassifications, or to compliance with SEC reporting
requirements are not necessarily indications of compromised audit quality
or auditor independence. However, financial statement restatements due to
errors or fraud raise doubt about the integrity of management's financial
reporting practices, the quality of the audit, or the auditor's
independence. Therefore, the focus of our analysis was on annual financial
statement restatements (hereinafter referred to as "restatements") due to
errors or fraud. Since not all restatements are indications of errors or
fraud, we
Appendix I
Objectives, Scope, and Methodology
reviewed Form 10-KAs9 (amended 10-K filings), Form 8-Ks, and any related
SEC enforcement actions to determine if the restatements were due to
errors or fraud. The primary purpose of this test was to determine whether
the rate of restatements due to errors or fraud of companies that changed
auditors was higher or lower than the rate of restatements due to errors
or fraud of companies that did not change auditors.
For each of the Fortune 1000 companies, we searched SEC's EDGAR system for
Form 10-KA filings submitted to the SEC during 2002 and 2003 through
August 31, 2003, that amended either 2001 or 2002 financial statements to
identify annual financial statement restatements. We determined if there
had been a change in auditor from 2001 through 2002 by reviewing the name
of the auditor of record on the audit opinion included in the Form 10-KA
filed for 2001 and 2002, and also noted what type of audit opinion was
issued on the 2001 and 2002 financial statements. This allowed us to
identify the restatements associated with Fortune 1000 public companies
that changed auditors and the restatements of Fortune 1000 public
companies that did not change auditors. We compared the level of
restatements for Fortune 1000 public companies that changed auditors to
the level of restatements of Fortune 1000 public companies that did not
change auditors.
9 We focused on Form 10-KA filings because they include the actual
restatements of previously issued annual financial statements included in
the original Form 10-K. While amended quarterly filings (Form 10-QA) and
Form 8-K filings may include disclosures of a public company's intention
to restate previously issued annual financial statements, we did not
consider Form 10-QA or Form 8-K filings for the purpose of identifying
restatements of annual financial statements. Public companies may announce
via a Form 10-Q or a Form 8-K that the company is going to restate in the
near future, but then not file restated financial statements with the SEC
because it may file for bankruptcy or become delisted. Therefore, we
intentionally limited our review of the SEC's EDGAR system to identifying
restatements of annual financial statements that were filed with the SEC
during 2002 and 2003 through August 31, 2003. However, we also identified
annual restatements of those Fortune 1000 public companies that included
restatements in their annual Form 10-K filings. In addition, some public
companies (such as Freddie Mac, WorldCom, Qwest, and Enron) and their
auditors may still be in the process of determining the required
adjustments and developing appropriate disclosures before they can file
the restatement of previously issued annual financial statements via Form
10-KA to the SEC. Lastly, since we reviewed the Form 10-KA filings for
2002 that had been submitted to the SEC through August 31, 2003, the
results of our analysis reflect restatements that have been submitted to
the SEC through that date and therefore do not include or reflect
restatements that may be filed in the future by any public companies that
plan to restate previously issued financial statements or any public
companies that may not yet be aware of a need to restate previously issued
annual financial statements.
Appendix I
Objectives, Scope, and Methodology
For each of the restatements identified above, we reviewed underlying Form
10-KA (amended 10-K filings), Form 8-Ks, and any related SEC enforcement
actions to quantify the dollar effect of the restatements and to determine
if the restatements were due to errors or fraud. We differentiated
restatements caused by errors or fraud from restatements caused by changes
that were not indications of compromised audit quality or auditor
independence, such as changes in accounting principles, mergers, stock
splits, and reclassifications using appropriate classification criteria.
In addition, we attempted to ascertain from the above sources whether
company management, the predecessor auditor, or the successor auditor
identified the error or fraud, and where applicable, whether it was
identified before or after the change in auditor.
After categorizing the 2001 and 2002 Fortune 1000 public companies' annual
financial statement restatements and annual financial statement filings
into (1) companies that did not change auditors and filed a restatement,
(2) companies that did not change auditors and did not file a restatement,
(3) companies that changed auditors and filed a restatement, and (4)
companies that changed auditors and did not file a restatement, we
compared the rates of restatements among and between these groups.
Appendix II
Implementation of Mandatory Audit Firm Rotation, if Required
If mandatory audit firm rotation were required, a number of implementing
factors affecting the structure of the requirement would need to be
decided. As a component of our surveys of public accounting firms, public
companies, and their audit committee chairs, we asked them to provide
their views on various implementing factors, regardless of whether they
supported mandatory audit firm rotation, including
o the limit on the incumbent firm's audit tenure period,
o the "cooling off" period before the incumbent firm could again compete
to provide audit services to the public company,
o under what circumstances either the audit committee or the public
accounting firm could terminate the relationship for providing audit
services,
o whether mandatory audit firm rotation should be implemented on a
staggered basis, and
o whether mandatory audit firm rotation should be required for audits of
all public companies, and if not, to which public companies should it be
applied.
Time Limit on the Auditor of Regarding the limit on the auditor of
record's tenure under mandatory audit
Record's Tenure firm rotation, about 47 percent of Tier 1 firms stated
that the limit should be 8 to 10 years. Fortune 1000 chief financial
officers and audit committee chairs selected 8 to 10 years about as often
as 5 to 7 years as the limit on the auditor of record's tenure. Tiers 2
and 3 firms and other public companies' audit committee chairs that
responded to our surveys generally favored an audit tenure of 5 to 7
years.
Time Limit Before the Most Tier 1 firms and Fortune 1000 public company
chief financial officers Auditor of Record Could and their audit committee
chairs believed the "cooling off" period under Compete to Provide Audit
mandatory audit firm rotation should be 3 or 4 years before the auditor of
record could again compete to provide audit services to the publicServices
to the Public company previously audited. Company Previously
Audited
Appendix II
Implementation of Mandatory Audit Firm
Rotation, if Required
Circumstances When the Audit Committee or the Auditor of Record Could
Terminate the Business Relationship Providing Audit Services
Nearly all Tier 1 firms and Fortune 1000 public company chief financial
officers and their audit committee chairs stated that the audit committee
under mandatory audit firm rotation should be permitted to terminate the
auditor of record at any time if it is dissatisfied with the public
accounting firm's performance or working relationship. Most Tier 1 firms
and Fortune 1000 public company chief financial officers and their audit
committee chairs also believed that the auditor of record should be able
to terminate its relationship with the audit committee/public company at
any time if the public accounting firm is dissatisfied with the working
relationship.
Period for Implementing Nearly all Tier 1 firms and Fortune 1000 public
company chief financial Mandatory Audit Firm officers and their audit
committee chairs believed that mandatory audit Rotation firm rotation
should be implemented over a period of years (staggered) to
avoid a significant number of public companies changing auditors
simultaneously.
Public Companies for Which Auditor of Record Should Be Subject to
Mandatory Audit Firm Rotation
About 70 percent of Tier 1 firms believed that mandatory audit firm
rotation should not be applied uniformly for audits of all public
companies regardless of their nature or size. In contrast, about 81
percent of Fortune 1000 public companies and 65 percent of their audit
committee chairs believed that mandatory audit firm rotation should be
applied uniformly for audits of all public companies regardless of the
nature or size. Most chief financial officers of other domestic and mutual
fund public companies who responded to our survey believe mandatory audit
firm rotation should be applied uniformly, and their audit committee
chairs were split on the subject. Comments that we received from many of
the Tier 1 firms, Fortune 1000 public companies, and their audit committee
chairs that supported requiring that mandatory audit firm rotation be
applied uniformly generally took the view that there should be a level
playing field and that the benefits and the costs of mandatory audit firm
rotation should be applied to all public companies. In contrast, those who
commented opposing requiring mandatory audit firm rotation for all public
companies generally took the view that the smaller public companies are
less complex and the costs of mandatory audit firm rotation would be more
burdensome for the smaller companies.
We asked those public accounting firms and public company chief financial
officers and their audit committee chairs who believed mandatory audit
firm rotation should not be applied uniformly to all public companies to
Appendix II
Implementation of Mandatory Audit Firm
Rotation, if Required
select by company nature and size to which companies mandatory audit firm
rotation should apply. Tier 1 firms and Fortune 1000 audit committee
chairs more frequently selected the larger public companies. However,
Fortune 1000 chief financial officers were about evenly split in their
views regardless of the size of the public company. Chief financial
officers and their audit committee chairs of other domestic and mutual
fund public companies, as well as foreign public company chief financial
officers and their audit committee chairs, who responded to our survey
more frequently selected the larger public companies.
Appendix III
Potential Value of Practices Other Than Mandatory Audit Firm Rotation for
Enhancing Auditor Independence and Audit Quality
We asked public accounting firms, public companies' chief financial
officers, and their audit committee chairs to provide their views on the
potential value of the various following alternative practices we
identified through our research and other inquiries made in developing our
surveys versus the value of other than mandatory audit firm rotation for
enhancing auditor independence and audit quality.
o The audit committee periodically holding an open competition for
providing audit services: Having the audit committee periodically hold an
open competition for public accounting firms to serve as the public
company's auditor of record, in which the incumbent auditor of record
could also compete, could potentially enhance auditor independence and
audit quality by letting the incumbent firm know that it does not have
unlimited tenure as the auditor of record and a lock on the associated
revenues, and that another firm may be selected to provide a "fresh look"
at the company's financial reporting process, practices, and financial
statements. Also, the public company has an opportunity to see the quality
of personnel that another public accounting firm could provide. However,
the public company will incur some costs in holding such a competition
and, if another firm is selected, may incur additional initial years'
audit fees and will have additional auditor support costs to assist the
new auditor of record in understanding the company's operations, systems,
and financial reporting practices.
o Requiring audit managers to periodically rotate off the engagement for
providing audit services to the public company: Audit manager is a senior
position reporting to the engagement audit partner with responsibility for
assisting the engagement audit partner in planning, conducting, and
reporting on the audit of the public company's financial statements.
Larger audits will likely have multiple audit managers and audit partners
participating in the audit. Conceptually, periodically changing audit
managers brings a "fresh look" to the audit assignment and the associated
potential benefits. However, there is an associated learning curve that is
likely to cause both the public accounting firm and the public company to
incur some additional costs. Some public accounting firms commented that
this practice already occurs as a result of career enhancement policies
and practices of the firms.
o The audit committee periodically obtaining the services of a public
accounting firm to assist it in overseeing the financial statement audit
or to conduct a forensic audit in areas of the public company's financial
reporting process that present a risk of fraudulent financial
Appendix III
Potential Value of Practices Other Than
Mandatory Audit Firm Rotation for
Enhancing Auditor Independence and Audit
Quality
reporting: Overseeing the auditor of record's conduct of the financial
statement audit is a significant responsibility that is especially
challenging depending on the size and complexity of a public company.
Having another public accounting firm as needed to assist the audit
committee brings a "fresh look" to help the audit committee understand the
public company's operations, systems, and financial reporting practices
and the underlying internal controls and risks. Also, as areas are
identified that may have greater risk of fraudulent financial reporting,
the audit committee may wish to have a public accounting firm conduct a
forensic audit to provide both a "fresh look" and a more penetrating audit
of transactions and related internal controls and financial reporting
practices in areas of high risk. Additional costs will be incurred by the
audit committee, and some degree of coordination and cooperation of the
incumbent audit firm will be necessary, which will also add to the audit
committee's responsibilities.
o Requiring that the auditor of record be hired on a noncancelable
multiyear basis, although the public accounting firm could terminate the
relationship for cause during the contract period: Having the audit
committee hire the auditor of record on a multiyear basis that only the
auditor of record can cancel potentially enhances auditor independence and
audit quality by assisting the auditor in dealing with any pressures from
management in appropriately dealing with financial reporting practices
that may materially affect the financial statements. However, this
practice takes away flexibility of the audit committee to replace the
auditor of record within the period of the contract should the audit
committee be dissatisfied with the auditor of record's performance.
Although many Tier 1 firms, Fortune 1000 public companies, and their audit
committee chairs saw some benefit in each of the alternative practices, in
general, they most frequently reported that the alternative practices
would have limited or little benefit. The most notable exception involved
the practice in which audit committee would hire the auditor of record on
a noncancelable multiyear basis, for which most Fortune 1000 public
companies and their audit committee chairs reported that the practice
would have no benefit. (See table 5.)
Appendix III
Potential Value of Practices Other Than
Mandatory Audit Firm Rotation for
Enhancing Auditor Independence and Audit
Quality
Table 5: Views on Potential Value of Other Practices for Enhancing Auditor
Independence and Audit Quality
Numbers in percentages
Significant or very Limited or positive benefit little benefit No benefit
Practice 1: Audit committee periodically holding open competition for
providing audit services
Tier 1 firms 11 44
Fortune 1000 public companies 11 53
Fortune 1000 audit committee chairs 23 53
Practice 2: Requiring periodic rotation of audit managers
Tier 1 firms 14 57
Fortune 1000 public companies 24 48
Fortune 1000 audit committee chairs 42 46
Practice 3: Audit committee periodically obtaining service of a public
accounting firm to assist in overseeing the financial statement audit
Tier 1 firms 20 53
Fortune 1000 public companies 10 42
Fortune 1000 audit committee chairs 13 59
Practice 4: Audit committee periodically obtaining service of a
public
accounting firm to conduct a forensic audit
Tier 1 firms 30 46
Fortune 1000 public companies 13 50
Fortune 1000 audit committee chairs 19 61 20
Practice 5: Audit committee hiring auditor of record on a
noncancelable
multiyear basis
Tier 1 firms 22 48 30
Fortune 1000 public companies 5 34 61
Fortune 1000 audit committee chairs 6 37 57
Source: GAO analysis of survey data.
Appendix IV
Restatements of Annual Financial Statements for Fortune 1000 Public
Companies Due To Errors or Fraud
To obtain some insight into the potential value of the "fresh look"
provided by a new auditor of record, we analyzed the rate of annual
financial statement restatements reported to the Securities and Exchange
Commission (SEC) by Fortune 1000 public companies during 2002 and 2003
through August 31, 2003. We particularly focused on restatements for 2001
and 2002 and compared the financial statement restatement rates of those
Fortune 1000 public companies that changed their auditor of record to
those Fortune 1000 public companies that did not change their auditor of
record during this period.
Historically, only about 3 percent of public companies change auditors in
any given year.1 However, we observed that 2.9 percent (28 out of 9602) of
the Fortune 1000 public companies changed auditors during 2001 and 21.3
percent (204 out of 960) of the Fortune 1000 public companies changed
auditors during 2002. The significant increase from 2001 through 2002 was
primarily due to the dissolution of Arthur Andersen LLP in 2002, which was
caused, in part, by its criminal indictment for obstruction of justice
stemming from its role as auditor of Enron Corporation. Since many of
these public companies had to replace Andersen as their auditor of record
during 2002, the number of changes in their auditor of record effectively
represented a partial form of mandatory audit firm rotation.
Tables 6 and 7 summarize the occurrence of the reported Fortune 1000
public companies' restatement filings.
1 R. Doogar (University of Illinois, Urbana-Champaign) and R. Easley and
D. Ricchiute (University of Notre Dame), "Switching Costs, Audit Firm
Market Shares and Merger Profitability," (Nov. 20, 2001), which was
discussed in GAO-03-864, cited a level of 2.7 percent annual client
switching of auditors based on prior research the authors performed using
1981-1997 Compustat data.
2 We identified 960 public companies included in the Fortune 1000 for the
purpose of developing our sampling approach for administering the public
company surveys, that is, in framing the upper stratum of the population
universe.
Appendix IV Restatements of Annual Financial Statements for Fortune 1000
Public Companies Due To Errors or Fraud
Table 6: Summary Results of the Fortune 1000 Public Companies That Changed
Auditors
Number of companies with restatements due to 2001 2002
Rules based changes 0 0
Errors 3 7
Fraud 0 1
Restatements related to companies that changed auditors 3
Fortune 1000 public companies that changed auditors 28 204
Restatement rate for companies that changed auditors 10.7% 3.9%
Source: GAO analysis of restatements.
Table 7: Summary Results of the Fortune 1000 Public Companies That Did Not
Change Auditors
Number of companies with restatements due to 2001 2002
Rules based changes 2 1
Errors 21 8
Fraud 2 1
Restatements related to companies that did not change 25
auditors
Fortune 1000 public companies that did not change auditors 932 756
Restatement rate for companies that did not change auditors 2.7% 1.3%
Source: GAO analysis of restatements.
The combined restatement rates from tables 6 and 7 for all Fortune 1000
public companies, including those that changed auditors and those that
retained their auditor of record, was 2.9 percent in 2001 (28 restatements
out of the 960 Fortune 1000 public companies) and 1.9 percent in 2002 (18
restatements out of the 960 Fortune 1000 public companies). The overall
restatement rates are higher in 2001 than the comparable levels of
restatements observed in 2002. This may be due to the fact that our
analysis was limited to restatements submitted to the SEC on Form 10-KA
filings for 2001 and 2002 through August 31, 2003. Some of the Fortune
1000 public companies that had not filed restatements with the SEC as of
August 31, 2003, may still do so in the future. Additionally, because some
companies may require considerable amounts of time and effort to unravel
complex accounting and financial reporting issues (e.g., WorldCom, which
is in the process of working its way out of bankruptcy proceedings, and
the Federal Home Loan Mortgage Corporation, better known as Freddie Mac,
which is working to restate 3 years of previously issued financial
Appendix IV Restatements of Annual Financial Statements for Fortune 1000
Public Companies Due To Errors or Fraud
statements), it is reasonable to expect that additional restatements will
be included in Form 10-KAs or other filings that had not been submitted to
the SEC as of August 31, 2003.
Financial statement restatements filed for changes in accounting
principles or changes in organizational business structure (e.g., stock
splits, mergers and acquisitions), reclassifications, or compliance with
SEC reporting requirements, referred to as "rules based changes," are not
necessarily indications of compromised audit quality or auditor
independence. However, financial statement restatements due to errors or
fraud raise doubt about the integrity of management's financial reporting
practices, the quality of the audits, and the auditor's independence.
Therefore, the following focus of our analysis was on annual financial
statement restatements (hereinafter referred to as "restatements") due to
errors or fraud.
The rate of restatement due to errors or fraud for Fortune 1000 public
companies that changed auditors were 10.7 percent in 2001 and 3.9 percent
in 2002 compared to restatement rates due to errors or fraud of 2.5
percent in 2001 and 1.2 percent in 2002 for companies that did not change
auditors. Although the data indicate that the overall restatement rate is
approximately four3 times higher in 2001 and three times higher in 20024
for those Fortune 1000 public companies that changed auditors than for
those companies that did not change auditors, caution should be exercised
as further analysis would be needed in order to determine whether the
restatements are associated with the "fresh look" of the new auditor
attributed to mandatory audit firm rotation. In that respect, in some
cases we were able to determine from our review of the Form 10-KAs, any
related Form 8-Ks, and the results of Internet news searches, that the
restatements were identified as a result of an SEC investigation or an
enforcement action. However, for the majority of the restatements we
identified, the information included in the SEC's EDGAR system did not
provide sufficient information to ascertain whether company management,
and in those
3 The 10.7 percent rate of restatements due to errors or fraud of the
Fortune 1000 public companies that changed auditors in 2001 was
approximately 4.25 times higher than the 2.5 percent rate of restatements
due to errors or fraud of the Fortune 1000 public companies that did not
change auditors.
4 The 3.9 percent rate of restatements due to errors or fraud of the
Fortune 1000 public companies that changed auditors in 2002 was
approximately 3.25 times higher than the 1.2 percent rate of restatements
due to errors or fraud of the Fortune 1000 public companies that did not
change auditors.
Appendix IV Restatements of Annual Financial Statements for Fortune 1000 Public
Companies Due To Errors or Fraud
cases where there was a change in auditor, the predecessor auditor, or the
successor auditor identified the error or fraud and whether it was
identified before or after the change in auditor. Also, the recent
corporate financial reporting failures have greatly increased the
pressures on management and auditors regarding honest, fair, and complete
financial reporting.
Effect of Restatements Due to Errors or Fraud
The phrase in an auditor's unqualified opinion, "present fairly, in all
material respects, in conformity with generally accepted accounting
principles," indicates the auditor's belief that the financial statements
taken as a whole are not materially misstated. An auditor plans an audit
to obtain reasonable assurance of detecting misstatements that could be
large enough, individually or in the aggregate, to be quantitatively
material to the financial statements.5 Financial statements are materially
misstated when they contain misstatements the effect of which,
individually or in the aggregate, is important enough to cause them not to
be presented fairly, in all material respects, in conformity with
generally accepted accounting principles. As previously noted,
misstatements can result from errors or fraud. As defined in Financial
Accounting Standards Board Statement of Financial Concepts No. 2,
materiality represents the magnitude of an omission or misstatement of an
item in a financial report that, in light of surrounding circumstances,
makes it probable that the judgment of a reasonable person relying on the
information would have been changed or influenced by the inclusion or
correction of the item.
Table 8 summarizes the net dollar effect of the restatements due to errors
or fraud on the reported net income (loss) of all 43 companies' previously
issued annual financial statements for the fiscal years, calendar years,
or both ended from 1997 through 2002.6
5 Although the auditor should be alert for misstatements that could be
qualitatively material, it ordinarily is not practical to design
procedures to detect them. Section 326 of the AICPA's Statement on
Auditing Standards states that "an auditor typically works within economic
limits; his or her opinion, to be economically useful, must be formed
within a reasonable length of time and at reasonable cost."
6 The restatement of one of the 43 companies that submitted restatements
due to errors or fraud related to financial statements that were
originally issued in 1995. However, we were unable to quantify the dollar
effect of the restatements associated with these financial statements
because the SEC's EDGAR system did not include financial statements filed
prior to 1997.
Appendix IV Restatements of Annual Financial Statements for Fortune 1000 Public
Companies Due To Errors or Fraud
Table 8: Summary of Net Dollar Effect of Restatements Due to Errors and Fraud
Dollars in millions
1997 1998 1999 2000 2001
Net effect of ($69.2) ($71.2) ($1,387.0) ($821.4) ($456.3) ($124.8)
restatements
Net income
(loss),
previously $337.4 $316.4 $11,054.7 $12,234.2 ($1,234.4) ($640.2)
reported
Misstatement rate (20.5)% (22.5)% (12.5)% (6.7)% (37.0)% (19.5)%
Source: GAO analysis of restatements.
The misstatement rates associated with these 43 companies' previously
issued statements of net income (loss), which ranged from a 6.7 percent
overstatement of net income (loss) for 2000 to a 37.0 percent
understatement of net income (loss) for 2001, would clearly be considered
material enough to have affected the fair presentation of the results of
operations included in these 43 companies' financial statements.
Accordingly, it is probable that the judgment of a reasonable person
relying on the information included in these companies' previously issued
financial statements would have been changed or influenced by the
inclusion of omitted information or correction of misstated items due to
errors or fraud.
Appendix V
International Experience with Mandatory Audit Firm Rotation
Italy Italy has required mandatory audit firm rotation of listed companies
since 1975 in which the audit engagement may be retendered (recompeting
for providing audit services) every 3 years and the same public accounting
firm may serve as the auditor of record for a maximum of 9 years. In
addition, there is a minimum time lag of 3 years before the predecessor
auditor can return. The mandatory audit firm rotation requirement was
intended to safeguard the independence of public accounting firms. In a
meeting with IOSCO Standing Committee one member, the Italian
representative from Commissione Nazionale per le Societa e la Borsa
(CONSOB), the Italian securities regulator, indicated that Italy's
experience with mandatory audit firm rotation has been a good one, noting
that mandatory audit firm rotation gives the appearance of independence,
which is considered very important to maintaining investor confidence.
However, it was also noted that there have been negative impacts, when
after 3 years, there is fee pressure by the listed company on the audit
firm that contributes to reduced audit fees. In responding to our survey,
CONSOB's representative indicated that there has been a progressive
reduction in audit fees, which has given rise to concern over audit firms'
ability to maintain adequate levels of audit services and quality control.
Research in Italy1 concludes that mandatory audit firm rotation carries
significant threats to audit quality from competitive pressures. However,
the CONSOB raised concerns about the study's methodology, accuracy, data
used, and appropriateness of the conclusions. Our review of the executive
summary of the study also identified potential limitations on the
reliability of data used and methodological concerns that created
uncertainties about the study's conclusions.2 Italy has also considered
partner rotation; however, because Italy is currently considering reducing
the maximum auditor tenure from 9 years to 6 years, partner rotation has
not been given further consideration.
1 SDA Universita Bocconi Corporate Finance and Real Estate Department and
Administration and Control Department, The Impact of Mandatory Audit
Rotation on Audit Quality and on Audit Pricing: The Case Of Italy
(Executive Summary).
2 The authors of the SDA Universita Bocconi study did not respond to our
request to provide us additional information about the reliability of data
that were used and the methodological approach.
Appendix V
International Experience with Mandatory
Audit Firm Rotation
Brazil Brazil enacted a mandatory audit firm rotation requirement in May
1999 with a 5-year maximum term and minimum time lag of 3 years before the
predecessor auditor of record can return. The Comissao de Valores
Mobiliarios (CVM), which is the Brazilian Securities Commission, indicated
that the primary reason mandatory audit firm rotation was enacted was to
strengthen audit supervision following accounting fraud at two banks
(Banco Economico and Banco Nacional). Brazil does not have a partner
rotation requirement, as the CVM believes that the requirement of rotating
audit firms is stronger than changing partners within firms. However, as a
component of its mandatory audit firm rotation requirement, Brazil
prohibits an individual auditor who changes audit firms to audit the same
corporations previously audited.
Singapore Starting in March 2002, the Monetary Authority of Singapore
stipulated that banks incorporated in Singapore should not appoint the
same public accounting firm for more than 5 consecutive financial years.
However, this requirement does not apply to foreign banks operating in
Singapore. Banks incorporated in Singapore that have had the same public
accounting firm for more than 5 years have until 2006 to change their
audit firms. While a "time out" period is not stipulated, banks
incorporated in Singapore shall not, except with the prior written
approval of the Monetary Authority of Singapore, appoint the same audit
firm for more than 5 consecutive years. In addition, listed companies are
required under the Listing Rules of the Singapore Exchange to rotate audit
partners-in-charge every 5 years.
The primary reason Singapore instituted mandatory audit firm rotation for
local banks was to promote the independence and effectiveness of external
audits. In addition, mandatory audit firm rotation for local banks was
cited by Singapore's officials as a measure to help (1) safeguard against
public accounting firms having an excessive focus on maintaining long-term
commercial relationships with the banks they audit, which could make the
firms too committed or beholden to the banks, (2) maintain the
professionalism of audit firms-where with long-term relationships, audit
firms run the risk of compromising their objectivity by identifying too
closely with the banks' practices and cultures, and (3) bring a fresh
perspective to the audit process-where with long-term relationships,
public accounting firms might become less alert to subtle but important
changes in the bank's circumstances.
Appendix V
International Experience with Mandatory
Audit Firm Rotation
Austria In Austria, Austrian Commercial Law will require mandatory audit
firm rotation every 6 years to strengthen the quality of audits and to
enhance auditor independence by limiting the time of doing business
between the audited company and its auditor of record. The 6-year
mandatory audit firm rotation requirement will become effective from the
beginning of the year 2004, and there will be a minimum time lag of 1 year
before the predecessor auditor of record can return. Austria does not have
a partner rotation requirement; however, anyone who serves as the audit
partner of a public company for 6 consecutive years will not be allowed to
continue to serve in that capacity by becoming employed by the company's
successor auditor.
United Kingdom In January 2003, the United Kingdom adopted the
recommendations of the Co-ordinating Group on Audit and Accounting Issues
(CGAA)3 to strengthen the audit partner rotation requirements by reducing
the maximum period for rotation of the lead audit partner from 7 years to
5 years. The United Kingdom also adopted CGAA's recommendation to limit
the maximum period for rotation of the other key audit partners to 7
years. According to the CGAA report, the rotation of the audit engagement
partner has been a requirement in the United Kingdom for many years, and
the United Kingdom concluded that the requirements for the rotation of
audit partners played an important role in upholding auditor independence.
With respect to the issue of mandatory audit firm rotation, the United
Kingdom supports CGAA's recommendations, which concluded that the balance
of advantage is against requiring the mandatory rotation of audit firms.
The primary arguments against mandatory audit firm rotation, as cited in
the CGAA report, include the possible negative effects on audit quality
and effectiveness in the first years following a change, the substantial
costs resulting from a requirement to switch auditors regularly, the lack
of strong evidence of a positive impact on audit quality, the potential
difficulty or impossibility of identifying a willing and able audit firm
that can accept the audit without violating independence requirements
3 The CGAA was established by the Chancellor of the Exchequer and the
Secretary of State for Trade and Industry to ensure that there is a
coordinated and comprehensive work program for individual regulators to
review the United Kingdom's current regulatory arrangements for statutory
audit and financial reporting, avoiding any unnecessary overlap;
commission additional work or reviews if judged appropriate; and reach a
view on the adequacy of the proposals, and, if appropriate, make specific
recommendations.
Appendix V
International Experience with Mandatory
Audit Firm Rotation
in a concentrated listed company audit market, and competitive
implications of such a requirement. However, CGAA also recommended that
audit committees should consider changing their auditor of record when the
audit tenure is from 15 years to 20 years.
France In France, audit partner rotation had been required since 1998 by
the French Code of Ethics of the accounting profession. However, the
requirement was not enforceable because the Code of Ethics had not
specified any maximum length for mandatory rotation of audit partners. In
August 2003, France promulgated the French Act on Strengthening of
Financial Security, which makes it illegal for an audit partner to sign
more than six annual audit reports. The main requirement that serves as an
alternative to mandatory audit firm rotation is the French requirement of
having two firms engaged in the audit of entities issuing consolidated
financial statements, which has been a requirement since 1985 and has been
reincluded in the August 2003 promulgation of the French Act on
Strengthening of Financial Security. According to the Deputy Chief
Accountant of the Commission des Operations de Bourse, mandatory audit
firm rotation is not required in France primarily because of concern over
the potential impairment of audit quality due to the new auditor's lack of
knowledge of the company's operations.
Spain The Comision Nacional del Mercaso de Valores (CNMV)-the agency in
charge of supervising and inspecting the Spanish stock markets and the
activities of all the participants in those markets-indicated that from
1989 through 1995, Spain had a mandatory audit firm rotation requirement
with a maximum audit term of 9 years, which included mandatory retendering
every 3 years. The main objectives of this former requirement were to
enhance auditors' independence and promotion of fair competition. However,
in 1995, the Spanish "Company Law" and the Spanish "Audit Law" were
amended, effectively eliminating the mandatory audit firm rotation
requirement, by allowing that "after the expiration of the initial period
(minimum 3 years, maximum 9 years), the same auditor could be re-hired by
the shareholders on an annual basis." The Director of the CNMV indicated
that the 9-year mandatory audit firm rotation requirement was abandoned
since the main objective of increased competition among audit firms had
been achieved and because of listed companies' increased training costs
incurred with a complete new team of auditors from a new public accounting
firm. In November 2002, the Spanish "Audit Law" was amended to introduce a
new requirement under which "all audit-engaged
Appendix V
International Experience with Mandatory
Audit Firm Rotation
team" members (including audit partners, managers, supervisors, and junior
staff) have to rotate every 7 years in certain types of companies, which
include all listed companies, companies subject to public supervision, and
companies with annual revenues over 30 million euros.
The Netherlands In January 2003, the Royal Nederlands Instituut van
Register Accountants (NIvRA) and Nederlandse Orde van
Accountants-Administratieconsulenten (NOvAA) of the Netherlands, which are
the bodies that represent the accounting profession in the Netherlands and
are responsible for the qualifications and regulation of the accounting
profession, adopted the recommendation of CGAA to strengthen the audit
partner rotation requirements by reducing the maximum period for rotation
of the engagement audit partner from 7 years to 5 years and to limit the
maximum period for rotation of the other key audit partners to 7 years.
The adoption of these measures by both NIvRA and NOvAA made these
requirements a part of the code of conduct for auditors. A representative
of the Netherlands Authority for the Financial Markets indicated that the
Dutch government is in the process of promulgating these audit partner
rotation regulations into law, where the requirement will only apply to
public interest entities.
Japan In Japan, the Amended Certified Public Accountant Law was passed in
May 2003, and beginning on April 1, 2004, audit partners and reviewing
partners will be prohibited from being engaged in auditing the same listed
company over a period of 7 consecutive years. Mandatory audit firm
rotation has never been required in Japan, and public companies have never
been encouraged to voluntarily pursue audit firm rotation. While Japan
agreed with the December 2002 report issued by the Subcommittee on
Regulations of Certified Public Accountants of the Financial System
Council that mandatory audit firm rotation will need further consideration
in the future, Japan's securities regulator stated that mandatory audit
firm rotation was not supported because of the concerns that it (1) may
cause confusion given the concentration of audit business held by large
public accounting firms, (2) is not required in other major countries
other than Italy, (3) may significantly lower the quality of audits due to
the need to arrange newly organized audits, and (4) would result in
greater cost of implementation under the current concentration of audit
business held by large public accounting firms.
Appendix V
International Experience with Mandatory
Audit Firm Rotation
Canada There are currently no Canadian requirements for mandatory audit
firm rotation. However, mandatory audit firm rotation was included in
banking legislation shortly after the 1923 failure of the Home Bank and up
to the December 1991 revision of the Bank Act. The Bank Act required that
two firms audit a chartered bank, but that the same two firms could not
perform more than two consecutive audits. As a result, one of the two
firms would have to rotate off the audit for a minimum of 2 years.
According to Canadian officials, in practice this requirement was
implemented in two different ways. Some banks appointed a panel of three
audit firms with one of the three firms being a permanent auditor while
the other two firms rotated every 2 years. Other banks appointed a panel
of three audit firms and rotated among the three firms. Generally, the
firm that was in its "off year" did not completely step away from the
audit of the bank and would maintain at least a watch on developments in
the bank's business and financial reporting to ensure that it was
knowledgeable enough to step back in when it rotated on again.
One of the primary benefits of the system was believed to be that the use
of two firms facilitated an independent review of the loan portfolio. This
new perspective was generally considered to be a useful safeguard, and it
was believed that the second firm would not bring with it an element of
additional cost. The rotation element of the system was considered to
bring with it an additional element of security by ensuring that issues
were reviewed regularly by auditors with a fresh perspective, thus
minimizing the risk of a problem festering because an issue was decided on
and not reevaluated.
Since the 1923 failure of the Home Bank, the dual auditor requirement with
mandatory audit firm rotation for one of the two audit firms every 2 years
was in place for over 60 years and was considered to be one of the key
safeguards in the bank governance system. However, in 1985 two regional
banks in the province of Alberta failed despite the existence of the dual
auditor system. A subsequent government inquiry into the failures found
that the Office of the Inspector General of Banks, now the Office of the
Superintendent of Financial Institutions (OSFI), heavily relied on the
external auditors and recommended the need for some direct examination by
the supervisor of the quality of banks' loan portfolios. Until 1991, only
Canadian banks were required to rotate their auditor of record. In 1991,
in line with a push for harmonized supervision, banking legislation was
amended to reduce the requirement to one audit firm, and the mandatory
audit firm rotation requirement was abandoned with the revision of the
Appendix V
International Experience with Mandatory
Audit Firm Rotation
Bank Act. According to Canadian officials, one of the reasons for the
abandonment was that many argued that the cost was not matched by the
benefits and it was noted that Canada seemed to be largely alone in the
world imposing such a system. There were few strong advocates for
retaining the system, but questions were raised as to whether it was in
fact a valuable element of protecting the safety and soundness of the
banking system.
Mandatory audit firm rotation is not currently being considered in Canada.
Instead, as of July 2003, mandatory rotation of audit partners for all
public companies was being considered by Canada's securities regulator,
supported by a new model of independent oversight and inspection of
auditors of public companies. The accounting profession, through the
Public Interest and Integrity Committee of the Canadian Institute of
Chartered Accountants and in collaboration with provincial institutes, is
considering developing an updated independence standard that considers
certain requirements of the Sarbanes-Oxley Act for Canadian application to
listed financial institutions regulated by OSFI. This independence
standard will focus on mandatory rotation of the engagement partner rather
than the firm auditing a listed enterprise regulated by OSFI, as well as
other key members of the firm involved with the audit. According to
Canadian officials, extending this requirement to nonlisted financial
institutions is under consideration but the outcome will not be known for
some time.
Germany In Germany, according to the German Commercial Code, a qualified
auditor or certified accounting firm, beginning with annual financial
statements issued after December 31, 2001, may not be an auditor of a
stock corporation that has issued officially listed shares if it employs a
certified accountant who has signed the certification concerning the
examination of the annual financial statements or the consolidated
financial statements of the corporation more than six times in the 10
years prior to the fiscal year to be examined. According to German
officials, the principle of audit partner rotation has proven to be
successful, and there are no plans to switch to a model based on mandatory
audit firm rotation because the purpose of guaranteeing an independent
audit of the financial statements of a company can be efficiently achieved
by audit partner rotation. However, in order to improve investor
protection and company integrity, Germany's federal government published a
10-point paper, which included a planned amendment to the corresponding
Commercial Code regulations to shorten the period of time after which an
auditor of record must rotate
Appendix V
International Experience with Mandatory
Audit Firm Rotation
to every 5 years and to include all responsible audit partners in the
rotation requirement.
Appendix VI
GAO Contacts and Staff Acknowledgments
GAO Contacts Jeanette M. Franzel, (202) 512-9471 John J. Reilly, Jr.,
(202) 512-9517
Staff Acknowledgments
(194346)
In addition to those individuals named above, William E. Boutboul,
Cheryl E. Clark, Robert W. Gramling, Wilfred B. Holloway,
Michael C. Hrapsky, Catherine M. Hurley, Charles E. Norfleet,
Judy K. Pagano, Sidney H. Schwartz, Jason O. Strange,
Partricia A. Summers, and Walter K. Vance made key contributions to this
report.
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