Audit Partner Rotation – Issue Brief Essay

Audit Partner Rotation – Issue Brief In response to the wave of corporate crises, the Sarbanes-Oxley Act includes a provision regarding mandatory audit partner rotation for firms auditing public companies. This should not be confused with audit firm rotation and it is important to make the distinction. The Act requires the lead audit partner and audit review partner (or concurring reviewer) to be rotated every five years on all public company audits. The Act requires a concurring review of all audits of issuers (as defined in the Act).

The focus of this document is audit partner rotation.However, it also discusses the circumstances in which audit partner rotation can be tantamount to audit firm rotation. A Reasoned Approach A reasoned, logical approach should be taken in considering imposing mandatory audit partner rotation at the state level. On January 28, 2003 the SEC adopted rules to effectuate the statutory requirement of audit partner rotation found in Sec. 203 of the Sarbanes-Oxley Act. In addition to the five-year rotation requirement of the lead and concurring audit partners, the rules also mandate a five-year “timeout” period after rotation.The rules, as adopted, specify that certain other significant audit partners will be subject to a seven-year rotation requirement with a two-year “timeout” period. The rule provides an alternative for firms with fewer than five public audit clients and fewer than ten partners.

The alternative requires the Public Company Accounting Oversight Board (PCAOB) to review all of the firm’s engagements subject to the rule at least once every three years. Further, the Sarbanes-Oxley Act requires the Government Accounting Office (GAO) to conduct a study of the effectiveness and implications of audit firm rotation.In a reasoned approach at the state level, it would not be logical to attempt to replicate what has already been done at the federal level regarding audit partner rotation.

It would also be logical to await the results of the GAO study regarding audit firm rotation before taking any action on that issue. The following is a discussion of several factors to consider which may provide a broader understanding of the implications of mandating audit partner rotation for firms auditing nonpublic entities. Audit Practice Considerations and the Public InterestAs noted above, the Sarbanes-Oxley Act requires the lead audit partner and audit review partner (or concurring reviewer) to be rotated every five years on all public company audits. Generally Accepted Auditing Standards, which apply to SEC and non-SEC engagements alike, do not require a concurring partner review. If the concurring partner review requirement were enacted for all engagements, sole practitioners would have to either give up their audit practice or outsource the concurring review function to another firm.In addition, for sole practitioners and small firms with a limited number of audit partners, adopting a mandatory audit partner rotation requirement would be tantamount to firm rotation. They could not meet the rotation requirement and would therefore have to give up the audit to another firm.

Because smaller audit firms would need to employ more professionals to meet the audit partner rotation mandate, many firms could cease providing audit services, thus eliminating competition and the cost and quality benefits associated with competition.Small businesses that employ these firms would be at a disadvantage either as a result of potentially higher costs of audit services (due to a reduced supply of auditors) or their total inability to engage an auditor because local firms may opt to eliminate audit services from their practices. Limiting the number of firms performing audits or imposing rules that inadvertently cause firm rotation is not in the public interest. Audit Quality It is clear that Congress believed that audit partner rotation was an important element to achieving a fresh look at the engagement for the audits of public companies.

In developing regulations pertaining to Sarbanes-Oxley, the SEC acknowledged that its partner rotation requirements needed to strike a balance between the need to achieve a fresh look at the engagement and a need for the audit engagement team to be composed of competent accountants. While audit partner rotation was mandated in Sarbanes-Oxley, there is no evidence that audit partner rotation will guarantee better audits. In fact, regarding the issue of firm rotation there are existing independent studies that conclude that audit firm rotation reduces audit quality and that the costs far outweigh the benefits.

Research conducted separately by the Public Oversight Board, the Commission on Auditors’ Responsibilities, and the National Commission on Fraudulent Financial Reporting found that audit failures are three times more likely in the first two years of a client/auditor relationship, and that there is a positive relationship between audit firm tenure and auditor competence. There is a substantial body of academic literature that indicates the direct relationship between the length of auditor tenure and the increased discovery of material financial statement errors.Knowledge of the client, its business and the environment it operates in is essential to audit quality. Without these, audit quality would decrease. It is clearly in the public’s interest to keep the most qualified partner on the job. Market and Economic Impact Requiring audit partner rotation for non-public companies could also have a direct impact on the cost of doing business, creating a more time consuming, less efficient, and therefore, more costly process for businesses.For instance, the periodic re-training of new auditors on the company’s policies and procedures can also be very costly, thus adding to the cost of the audit.

In fact, there are efficiencies gained over the long term by the audit team that can and many times do lead to cost savings. In its January 13, 2003 comment letter to the SEC on Strengthening the Commission’s Requirements Regarding Auditor Independence, the U. S. Small Business Administration’s (“SBA”) Office of Advocacy stated that “initial cost for new firms would rise, due to the need to familiarize auditors with the client firm’s industry and business practices. Their comment letter indicated they believed this increased cost to the auditing firm would result in increased cost to the audit consumer. Statistics indicate that only a relative few firms currently bid on audit requests now.

If mandatory audit partner rotation causes some firms to stop performing audits there will be even fewer firms bidding on audit requests. This consolidation of the market and therefore loss of competition will likely cause audit fees to increase.The potential reduction of firms performing audit services and the resulting increase in costs to small business by mandatory audit partner rotation is not in the public interest. Addressing Investor Risk Clients in the non-public business environment believe their current audit partner knows their business the best and can provide the best service.

The Sarbanes-Oxley Act was passed largely to protect public stakeholders, who have little direct contact with their company investments or management and are principally passive investors.Many of these stakeholders have a limited level of financial sophistication and little or no knowledge of the day-to-day operations or business practices at the organizations where they place their money. They need protection. In that environment, audit partner rotation makes sense. Conclusion In the non-public company environment the public is best served by not imposing regulations, such as mandatory audit partner rotation that has the potential to limit choices, decrease competition and thereby drive up costs.While the Small Business Administration’s comment letter to the SEC on Strengthening the Commission’s Requirements Regarding Auditor Independence focused on the need for a small firm exemption to public company audit partner rotation requirements, its comments can likewise apply to small firm audit partners of nonpublic entities.

“Advocacy is concerned that small issuers retaining the services of currently exempt small audit firms who decline to offer audit services to them may be forced to engage the services of a larger audit firm.Advocacy believes that this could result in significantly increased audit costs to audit consumers in two ways. First, initial costs for new firms would rise, due to the need to familiarize auditors with the client firm’s industry and business practices. Second, due to the effective elimination of smaller firms from the competitive market for audit services and the consolidation of the market, larger audit firms may gain some power over price, causing audit prices to rise.

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