Former SEC Chairs on Auditor Rotation

The U.S. Senate Committee on Banking, Housing and Urban Affairs, on Tuesday, February 12, 2002, held an oversight hearing on “Accounting and Investor Protection Issues Raised by Enron and Other Public Companies.”  Eventually, the Sarbanes-Oxley Act of 2002 was passed by both houses of Congress and signed into law by President George W. Bush.  A key part of the legislation is the creation of the Public Company Accounting Oversight Board (PCAOB).

In the months leading up to passage, several hearings were held including one on February 12, 2002, in which four previous SEC chairs–Arthur Levitt, Harold Williams, Richard Breeden, Roderick Hills–testified.  Jim Hamilton of the Jim Hamilton’s World of Securities Regulation blog reminds us, in “Views of Former SEC Chairs on Auditor Rotation Relevant as PCAOB and European Commission Consider the Concept,” of ideas that didn’t make it into Sarbanes-Oxley.

Three of the former chairmen spoke up in favor of auditor rotation.  Despite this support, the decision was made in 2002 not to require auditor rotation.  We now have another crisis in 2008 and again auditors are criticized for failing to require solid numbers in corporate financial reports.  Perhaps it is time to try it.  I don’t think it would hurt.

Here is what each of the former chairmen has to say.

Arthur Levitt, Jr.

Arthur Levitt, SEC Chairman from 1993-2000, spoke on auditor independence issues at the hearing. He said,

Let me turn briefly to probably the most urgent area of reform. Like no other, the accounting profession has been handed an invaluable, but fragile, franchise. From this Federal mandate to certify financial statements, the profession has prospered greatly. But as an edict for the public good, this franchise is only as valuable as the public service it provides, and as fragile as the public confidence that gives it life.

It’s well past time to recognize that the accounting profession’s independence has been compromised …

I also propose that serious consideration be given to requiring companies to change their audit firm – not just the partners — every 5-7 years to ensure that fresh and skeptical eyes are always looking at the numbers.

In 2011, the PCAOB and the European Union are considering just this issue.

Harold M. Williams

Harold Williams, SEC  Chairman from 1977-1981, also spoke on auditor independence.  He said,

The American Institute of Certified Public Accountants begins its code of conduct with the statement “The distinguishing mark of a profession is acceptance of its responsibility to the public.” Indeed, the profession’s auditing responsibility is a quasi-public one, deeply infused with the public interest. This raises critical issues. Can an auditor be independent when his client is paying the bill? Can the auditor withstand pressure from the client? …

Williams said the answers are no and no.  Williams continued, going a half-step further than Levitt,

I would urge the Commission to consider a requirement that a public company retain its auditor for a fixed term with no right to terminate. This could be for five years or perhaps the Biblical seven. After that fixed term, the corporation would be required to change auditors. As a consequence of such a requirement, the auditor would be assured of the assignment and, therefore, would not be threatened with the loss of the client and could exercise truly independent judgment. Under such a system the client would lose its ability to threaten to change auditors if in its judgment the assigned audit team was inadequate.

This is a terrific suggestion, and could very well result in a more independent auditor.  Currently, audit firms ditch troublesome clients instead of remaining on assignment, showing backbone, and issuing qualified or adverse auditor opinions.

Richard Breeden

Richard C. Breeden, SEC Chairman from 1989-1993, spoke about the critical role of auditors.  He said,

Accountants play a unique role as the scorekeepers of the market economy. While companies in the U.S. don’t have to employ a law firm, an underwriter, or other types of professionals, federal law requires a publicly traded company to hire an independent accounting firm to perform an annual audit. In addition to this shared federal monopoly, more than a hundred million investors in the U.S. depend on audited financial statements to make investment decisions. This imbues accounting firms with a high level of public trust, and also explains why there is a strong federal interest in how well the accounting system functions …

Though restricting the unhealthy pressure of auditor consulting makes sense, this step alone is not a magic bullet that will fix the deeper problems of the system …  One means of insulating the audit firms from the pressure of keeping the audit engagement would be to provide for mandatory limits on audit engagements to a specified period of time, such as 5-7 years.

Roderick Hills

Roderick M. Hills, SEC Chairman from 1975-1977, speaks primarily about empowering the board’s audit committee with sufficient authority and power to protect audit firms from the pressures of corporate management.  With respect to auditor rotation, he says,

Forcing a change of auditors can only lower the quality of audits and increase their costs. The longer an auditor is with a company the more it learns about its personnel, its business and its intrinsic values. To change every several years will simply create a merry-go-round of mediocrity.

An effective audit committee can mandate a rotation of partners in the same firm that can achieve the same result as changing firms.

In summary, he opposes auditor rotation.

What do you think?  Is the counsel of four former chairmen of the SEC more timely in 2011 than it was in 2002?

Debit and credit – – David Albrecht