The benefits of mandatory auditor rotation.

Healey, Thomas J. ; Kim, Yu-Jin

THE RECENT DRUMROLL OF CORPORATE scandals has cast the spotlight on a glaring defect in traditional accounting practice: audit firms that get too cozy with the companies whose books they are supposed to review accurately and honestly. Public outrage over such scandals as Enron and WorldCom prompted last year's passage of the Sarbanes-Oxley Act, which includes a provision requiring audit firms to change every five years the person who is the lead audit partner or coordinating partner for each public company client. But the new law stops short of requiring the periodic changing of audit firms for each public company.

There is heated debate over the merits and shortcomings of such a practice, known as auditor rotation. In our opinion, although several valid arguments are marshaled against mandatory auditor rotation, they are far outnumbered by the potential benefits.

Perhaps the greatest of those benefits is the practice's usefulness in restoring badly shaken investor confidence in our financial accounting system. Indeed, the public's overall lack of faith in the corporate governance system, and in financial reporting in particular, must be overcome before individuals will truly become comfortable with long-term investing. A study of companies in Italy (where periodic audit firm rotation is mandatory) by Milan's Bocconi University found that the policy did seem to have a positive effect on improving public confidence in the corporate sector.

The specific benefits that would accrue to the public from auditor rotation fall into three general areas:

* Creation of an effective "peer review" system that discourages aggressive accounting practices while encouraging critical reviews upon each auditor turnover.

* Prevention of conflicts of interest that can easily arise from long-standing client relationships.

* Promotion of a more competitive market for audit firms, which would lead to higher quality audits.

In addition, the institution of mandatory rotation would alleviate the pressure on audit firms to separate non-audit businesses from their main practice, and also alleviate the pressure to monitor closely the migration of audit partners to CFO or other executive positions within their public company clients.

With Arthur Andersen stripped of its auditing role for the many major firms that were once among its blue chip clients, fresh sets of eyes will be scrutinizing numerous corporate financial records. This auditor turnover could be a very positive development, indeed, not only leading to the uncovering of additional audit irregularities, but helping to deter dishonest and fraudulent reporting in the future.

Start-up costs Auditor rotation has its detractors. They frequently cite the significant start-up costs--both monetary and non-monetary--to auditors, clients, and the public associated with audit firm turnover. Opponents also cite a diminution in audit quality that they claim would result from disrupting the ongoing relationship that typically provides an audit firm with comprehensive knowledge of its clients' businesses and operations. Indeed, the Bocconi University study in Italy showed that companies were more likely to be cautioned by regulators in the first year after appointing a new auditor than in any other year.

Leading the opposition to audit firm rotation is the accounting industry, whose members say they are fearful of the "staggering" up-front costs for new audits. A rough "back-of-the-envelope" calculation shows, however, that the costs of poor quality audits are far greater than the potential costs of auditor rotation. Morgan Stanley estimates the loss in market capitalization from the failures of just WorldCom, Tyco, Qwest, Enron, and Computer Associates to be $460 billion. Compare that to the $10 billion in audit revenues for the Big Five accounting firms in 2000. If rotation added 20 percent to their respective costs in each of the first two years, and turnover occurred every five years, then the annual cost could approximate $800 million--a small cost compared to the trillions of dollars of potential market damage from flawed audits.

Supporters of auditor rotation can also argue that nothing in the current Sarbanes-Oxley Act could have prevented debacles like Enron; mandatory audit firm rotation is the only practical, preventive mechanism. Stated John Biggs, chairman and CEO of financial services giant TIAA--CREF, which practices mandatory rotation:

 Consider the peer review aspects of mandatory
 rotation. Had rotation been in effect at Enron in
 1996, and had Arthur Andersen known that a
 new auditor would be appointed for 1997 and
 that the new auditor would do an exhaustive review of the former
 audit work papers, it is likely that Arthur Andersen would
 have assured that transactions and documentation were fully
 transparent. A thorough "real time" peer review would be
 truly effective. A strongly constituted, independent, and
 authorized regulatory board to oversee the auditing profession
 might also ask for a brief, signed peer review report from
 the new auditor. None of this would be costly unless there
 were troubles, as there were at Enron.

It can be argued that, if improved governance can prevent misrepresentation of public company performance, then the increased costs of rotation are more than economically justified. In testimony before a Senate committee, Biggs acknowledged that while periodic auditor rotation would likely be strongly opposed by accountants and their clients over the issue of costs, his own experience shows that the expenses can he effectively managed, and that they are well worth the long-term benefits.

Public confidence The outcome of the growing national debate over mandatory auditor rotation remains to be seen. What is clear, however, is that an immediate boost to investor confidence is urgently needed, and that an enforceable public policy like mandatory auditor rotation could be among the most powerful engines for change. In 1992, the American Institute of Certified Public Accountants issued a report contending that mandatory rotation was unnecessary because "growing public expectations, regulatory changes, and recent professional initiatives have all served to improve the auditing and financial reporting processes, as well as to create an environment for ongoing improvement without the undesirable consequences of mandatory rotation."

If only that had been the case!

Thomas J. Healey is a retired partner of Goldman Sachs and currently a senior fellow at Harvard University's Kennedy School of Government. He served as assistant secretary of the Treasury under President Ronald Reagan. He can be contacted by e-mail at [email protected].

Yu-Jin Kim is an MBA student at the Harvard Business School. She can be contacted by e-mail at [email protected].