Tenure disclosure puts new pressure on audit committees

Audit reports are beginning to carry some new information meant to make them more informative to investors, including a reference to just how long the same audit firm has been auditing each public company’s books.

Audit experts are advising audit committees to take it for what it’s worth—a piece of information that’s noteworthy, but doesn’t necessarily mean anything all by itself. “It’s a reference point in the overall consideration of audit committee oversight, selection, and retention of the audit relationship,” said Wes Bricker, chief accountant at the Securities and Exchange Commission, at a recent accounting conference.

The Public Company Accounting Oversight Board finalized a new standard in 2017 that requires auditors to include a great deal of new information in audit reports. Most significantly, auditors are required to disclose and describe the “critical audit matters” that surfaced during an audit—those areas involving material accounts or disclosures that proved most difficult in the audit because they involved challenging, subjective, or complex auditor judgments.

CAM disclosures are not, however, required right away. The PCAOB wanted to allow time for audit firms and their clients to work out a plan for how to comply, so CAM disclosures are not required for large accelerated filers until mid 2019 and for all other companies until 2020.

More immediately, the new audit report format now includes a disclosure by audit firms regarding how long they have served as the auditor on each engagement. Although an increasing number of audit committees are voluntarily disclosing the tenure in their proxy statements, the PCAOB required the disclosure by auditors in their audit reports.

The PCAOB requirement standardizes the metric and makes it more accessible to all investors, said Bricker. “You don’t have to pay for it if the auditor knows it and includes it in the report,” he said.

“Tenure itself should not be much of a factor in retention decisions. The important thing is to have a robust auditor evaluation process in place.”
Dan Goelzer, Partner, Baker McKenzie

So that leaves audit committees now to decide what to do with that information. Obviously, audit committees know how long they’ve engaged their own auditor, so the disclosure doesn’t tell them anything new with respect to their own engagement. It does produce an opportunity for an audit committee to know how long its peer companies or chief competitors have engaged the same firm or how long the company’s own auditor has served on other engagements.

Debate still rages over whether a long-tenured auditor is a good thing or a bad thing for audit quality. On the one hand, an auditor who has served many consecutive years on an audit is in the best position to understand the company, its business, its processes, and controls and, therefore, perform the most robust risk assessments and the most efficient audit.

On the other hand, skeptics say long tenures can be linked to a kind of coziness between audit leadership and management, which can lead to complacency. Former PCAOB Chairman James Doty tried but failed to lead a charge for term limits on audit engagements, which would have produced a system of mandatory rotation.

Recent academic research suggests auditor independence should be a concern for companies that have engaged the same audit firm for long periods of time. A study out of Baruch College suggests a kind of “economic bonding” between Big 4 firms and companies they’ve audited for many years, which magnifies over the length of the relationship.

Rulemaking background

In 2008, the U.S. Department of the Treasury's Advisory Committee on the Auditing Profession issued its final report recommending, among other things, that the PCAOB "consider improvements to the auditor's standard reporting model."
In 2010 and 2011, PCAOB staff conducted outreach to investors, auditors, preparers of financial statements, audit committee members, and other interested parties to seek their views on potential changes to the auditor's report.
In March 2011, the staff presented its findings to the Board at an open meeting.
In June 2011, the Board issued a concept release to seek public comment on potential changes to the auditor's reporting model. The Board received 155 comment letters.
In September 2011, the Board held a public meeting to obtain insight from a diverse group of investors and other financial statement users, preparers of financial statements, audit committee members, and auditors on the alternatives presented in the concept release.
In August 2013, the Board proposed for public comment the auditor reporting standard that would have required auditors to include a discussion of critical audit matters specific to the audit. The Board received 248 comment letters.
In April 2014, the Board held a public meeting to discuss the proposed standard and comments received and obtain further input on the 2013 proposal.
In May 2016, the Board reproposed for public comment the auditor reporting standard. The Board received 88 comment letters.
Source: PCAOB

Big 4 firms tend to charge more and do less once the firm becomes entrenched on an engagement, the study says. “Big 4 audit firms charge a sizable tenure-linked fee premium,” the study says, even as “less audit effort is needed” over time. Earlier research also has raised concerns about the timeliness of error corrections under long-tenured auditors.

There are plenty of public companies that have engaged the same audit firm for decades, according to the latest study. The average tenure for the first 21 companies listed in the Dow 30 is 66 years, the study says. A database prepared by Audit Analytics shows nearly 20 public companies have had the same audit firm for 100 years or longer, and nearly 200 have had the same firm performing the audit for 50 years or longer. More than 850 companies have engaged the same firm for at least 20 years or longer.

That puts the onus on audit committees to determine whether the company is benefitting or not from a longstanding relationship with the firm. And the new disclosure puts it front and center before investors, which may serve to heighten pressure on audit committees, says Kevin Caulfield, managing director at Navigant Consulting. “Because it’s disclosed now, it’s a chance for audit committees to take that second look to think about are we still getting quality audits from this auditor,” he says.

A lengthy tenure is not a reason to boot the auditor, but rather a reason to give the audit relationship a careful look, says Dan Goelzer, a partner at law firm Baker McKenzie and a former member and acting chair of the PCAOB. “Tenure itself should not be much of a factor in retention decisions,” he says. “The important thing is to have a robust auditor evaluation process in place.”

Fred Lipman, a partner at law firm Blank Rome, says he sees the disclosure requirement as “apparently intended to produce shareholder pressure” on audit committees with lengthy auditor tenures to hire a new  firm. “Audit committees should resist this pressure and focus more on the quality of the audit partner and audit team,” he says.

Doug Carmichael, accounting professor at Baruch and former chief auditor at the PCAOB, says audit committees with a long-tenured auditor should consider a number of indicators of audit quality to help them determine if the audit is suffering as a result of that long tenure. He advises audit committees to study PCAOB inspection reports and PCAOB enforcement actions, for example, to get a sense of the nature of concerns raised at the firm and whether they might be factors on the company’s own audit.

“What’s the trend in nature and frequency of deficiencies found?” Carmichael says. “Any PCAOB enforcement actions against firm partners or the firm? Or reports that the firm failed to correct overall deficiencies in quality controls after one year? Negative information from these inquiries would be a good reason to begin the process of changing auditors.”

It’s a bit of a balancing act for audit committees, says Mike Scanlon, a partner at law firm Gibson Dunn & Crutcher. They must be sensitive to the risks that might be associated with long-tenured auditors, but they also want to assure they have an auditor who is adequately familiar with the company’s systems, processes, and operations. “It’s a balancing they undertake and consider in deciding whether to retain the auditor or move to a different auditor,” he says.