October 22, 2012
PCAOB Considers Mandatory Auditor Rotation
Posted by Erik Gerding

On Thursday, I travelled to Houston and gave a statement before the Public Company Accounting Oversight Board in a roundtable hearing, as the PCAOB considers whether to impose a mandatory auditor rotation rule. In using its new inspection powers, the PCAOB has found worrying evidence of auditors compromising their independence, objectivity, and professional skepticism (see the PCAOB’s concept release soliciting public feedback).

This problem and whether mandatory auditor rotation is an appropriate solution present a bramble bush of questions that have solicited a great deal of comments (you can see the statements at the Houston roundtable (including my own) here); the PCAOB also held roundtables previously in Washington, D.C. and San Francisco).

For me, the roundtable represented an opportunity to revisit some of the legal scholarship on audit failure that deserves renewed attention, even as public attention has shifted from Enron/SOX to “Subprime”/Dodd-Frank. Let me highlight the works of two scholars in particular.

First, Sean O’Connor (Univ. of Washington) authored a great series of articles that examined “the creation” of the problem of auditor independence. In one work, O’Connor looks at how certain accountants pushed for, and Congress created, requirements for mandatory “independent” auditing of issuer financial statements in public offerings (the ’33 Act) and in periodic reporting (the ’34 Act). Professor O’Connor looks at how the New Deal Congress imported much of these requirements from provisions in Britain’s Companies Act but without considering key differences in status and governance between chartered accountants in Britain versus the accounting industry in the United States. Moreover, Congress failed to spell out what makes auditors “independent.” This omission left the job to the SEC and resulted in Boards and not shareholders selecting and paying auditors. In a later work, O’Connor looks at how these legal requirements and the “issuer pays” model mean that true auditor independence will always be elusive. His work parallels work in other scholarship on gatekeepers (for example, Frank Partnoy’s theory of how “regulatory licenses” endow credit rating agencies with government-granted oligopoly power that undermines their effective gatekeeping). O’Connor presents a fairly radical set of solutions, including ending the ’34 Act (but not the ’33 Act) statutory requirements for independent audits and giving shareholders control of auditor selection.

Bill Bratton (Penn) had a second and different spin on the problem of auditor independence. He agrees that the issuer-pays model fundamentally compromises auditor independence. But, he argues that making auditors responsive to shareholders is problematic, as different groups of shareholders have radically different investing interests and time horizons. This article represents part of a series of articles by Bratton on the “dark side” of shareholder value and the downsides of shareholder primacy. Instead of making auditors beholden to shareholder, Bratton recommends strengthening the fidelity of auditors to accounting rules. Less radical than O’Connor’s suggestions, Bratton’s proposal raises a number of questions, including whether fidelity to rules can provide adequate discipline of audit firms without a third-party strenuously enforcing those rules on behalf of shareholders, whether professional and social norms provide a meaningful disciplining device for auditors, and, most vexing, how effective can rules be when industry wields a powerful hand in writing them.

Both sets of works deserve renewed scrutiny as the problems of auditor independence persist.

Accounting, Enron, Legal Scholarship, Securities | Bookmark

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