April 17, 2018

Auditor Rotation: Is the Concept Coming Back?

We haven’t heard much about auditor rotation since the PCAOB’s concept release about that topic in 2011. That concept release didn’t go too far due to controversy. But at GE, proxy advisors appear to be taking a closer look at the company’s longstanding relationship with its auditor. Here’s the intro from Cydney Posner’s blog (also see this WSJ article):

It’s certainly a rare event, but both ISS and Glass Lewis have recommended voting against a proposal to ratify the appointment of GE’s auditor, KPMG at the GE annual shareholders meeting. Most often, the issue of auditor ratification is not very controversial—in fact, it’s usually so tame that it’s one of the few matters at annual shareholders meetings considered “routine” (for purposes of allowing brokers to vote without instructions from the beneficial owners of the shares). Are we witnessing the beginning of a new trend?

In its analysis justifying its negative recommendation, ISS observed that the SEC is currently investigating GE’s revenue recognition practices and internal controls related to long-term service agreements, as well as a $9.5 billion increase in future policy benefit reserves for the GE’s insurance operations. ISS also cites commentators who suggested that GE and its auditors “must have or should have been aware of the issues—particularly the increasing insurance liabilities—for years.” These accounting issues, together with KPMG’s issuance of unqualified reports on the financial statements, were the basis of the recommendation by ISS against ratification of the auditors. Not to mention that KPMG has been GE’s auditor for a long time—by a “long time,” I mean 109 years! And notwithstanding major changes in the management team, ISS observed, the board, stressing the benefits of auditor tenure, still reappointed KPMG.

In addition, ISS also saw no discussion in the proxy statement regarding how or whether the board took into account KPMG’s role in GE’s two accounting problems or any other regulatory issues involving KPMG, including auditor independence allegations (which both ISS and GL indicate were alleged to involve GE) that KPMG settled with the SEC in 2014 or the indictments in 2018 of KPMG employees.

Glass Lewis also indicated that it usually supports management’s choice of auditor except when GL believes the auditor’s “independence or audit integrity has been compromised.” In its analysis, GL raised the same concerns as ISS regarding the SEC investigation of GE and problems at KPMG, noting in particular the large increase in fees to KPMG in the prior year, as well as its long tenure as GE’s auditor, which has “thrown KPMG’s effectiveness and relationship with the Company into question.”

Also note this article which highlights how the new changes to the audit report include disclosure of the length of an auditor’s tenure at that company. The article notes: “At the time of writing, 21 of the Dow 30 companies had released their annual reports (those with Dec. 31 year-ends). The average auditor tenure at those companies was 66 years.”

Why Aren’t We Getting High Quality Audits?

Here’s commentary from former SEC Chief Accountant Lynn Turner: This recent Compliance Week blog (and this Financial Times article) review the 2017 inspection results from the International Forum of Independent Audit Regulators. I’m left with these questions:

1. Why have audit regulators such as the PCAOB – which has now been in business for 15+ years – been unable to improve the quality of audits to high-quality?

2. Why is the goal to have 71% of audits comply with professional standards? Do investors really have to pay for audits when 29% are found to be defective?

3. Does this system even work? The regulators very rarely fine an auditor for deficient work. And auditors have a conflict of interest since they’re paid by the company being audited.

4. How can the IFIAR manage and inspect for quality – when their report says they’re having a difficult time figuring out how to measure it? Perhaps that’s the reason over one in every four audits is deficient.

The inconsistency among IFIAR member findings is also concerning. Those who conducted fewer inspections were much more likely to find a significant failure to satisfy audit standard requirements. There was a 62% finding rate for members inspecting 20 or fewer audits – a 46% finding rate for members inspecting 21-40 – and a 30% finding rate for members inspecting 41 or more.

The two areas with the highest rate & greatest number of findings were:

Accounting Estimates: most findings related to failure to assess the reasonableness of assumptions

Internal Control Testing: most commonly, auditors failed to obtain sufficient persuasive evidence to support reliance on manual controls. The next most common finding was that auditors failed to sufficiently test controls over – or the accuracy & completeness of – data or reports produced by management

“You Get What You Pay For”: Audit Fee Pressure Lowers Audit Quality?

There’s some concern among audit firms that they’re being required to “do more with less.” Rigorous work is required to comply with Sarbanes-Oxley and other regulations – but clients are looking for ways to reduce or maintain fee levels. As a consequence, 80% of firms have seen a reduction in the profitability of audit services.

Studies are starting to show that this fee pressure is negatively impacting audit quality. This latest white paper finds that there’s a higher rate of misstatements among firms that are shifting their focus to more profitable non-audit services. Interestingly, the analysis also shows that the decline in audit quality is more common at large audit offices than small ones.

Some people in our community are wondering whether this information will affect auditor regulations and shareholder ratification votes. I’m not holding my breath – this study just confirms what many people have been observing for decades, and shareholders seem to ignore audit fee info.

Liz Dunshee