Members of the PCAOB:
This letter contains our comments on the Board’s Concept Release # 006-2011 on Auditor Independence and Audit Firm Rotation. The comments and recommendations within are presented on behalf of the National Association of Corporate Directors (NACD), a national nonprofit organization of nearly 13,000 corporate director members. I have served as president and CEO of NACD since 2007, and was previously a public company auditor for 33 years.
After much study of this Concept Release, including recent member surveys and focus group discussions among audit committee chairs, NACD has concluded the following:
- The corporate director community shares the PCAOB’s view that external auditor independence, objectivity and skepticism are critical objectives to pursue. NACD supports a rigorous process led by the audit committee, endorsed by the board, and communicated to shareholders.
- Mandatory audit firm rotation is not an effective way to achieve that objective. The audit committee has a statutory responsibility for the external audit relationship, and we see no evidence that a requirement for mandatory audit firm rotation will increase the quality of financial reporting and therefore investor confidence.
- There is an alternative solution that audit committees have suggested and NACD presents in this letter. It is a solution in which boards own and execute a rigorous process for oversight, act on the results as necessary, and proactively communicate the process and outcomes to shareholders.
The Role of the Board in Relation to the Issuer’s External Auditor
In today’s public company boardroom, members of the audit committee come to the table with a significant stake in the effectiveness of the external auditor. Under the Sarbanes-Oxley Act of 2002, the audit committee is directly responsible for the appointment, compensation and oversight of the external auditor. NYSE and NASDAQ requirements call for the audit committee to hire and fire the outside auditor.
This post is excerpted from NACD CEO Kenneth Daly’s prepared testimony to the PCAOB.
NACD sees no evidence—either in our annual research or in our education programs for thousands of directors per year—that audit committees are unclear about their statutory responsibility with regard to the external auditor. Nor do they believe that responsibility would be better performed by others.
The audit committee should decide if and when to change the auditor in the best interests of the company, its financial reporting and the audit risk presented. Removing that authority from the audit committee could result in an undue weakening of the oversight and guidance that directors provide to U.S. companies.
Furthermore, our members believe substituting a mandatory requirement for better oversight seems unlikely to give investors a measure of comfort. In a survey of audit committee members we conducted in June of 2012, a full 94 percent of respondents did not believe mandatory rotation would make a significant impact on shareholder confidence and value.
Our discussions with some investor groups about the value of mandatory audit firm rotation have yielded mixed opinions. We will continue to collaborate with these groups to try to better understand their thinking and to gauge their reaction to enhanced proxy reports by audit committees on the matter of auditor evaluation. (See item I below.)
The Process by Which Boards Oversee Auditor Independence, Objectivity and Skepticism
NACD knows that boards are using the auditor evaluation processes as a primary tool for providing oversight of auditor performance and to make decisions about auditor retention or rotation.
Statistically, our research from the survey conducted in June 2012 shows that:
- More than 90 percent of NACD members have a defined process to regularly evaluate the performance of the independent auditor.
- The vast majority of them (80%) include criteria for determining whether to re-appoint or select a new audit firm.
- Seventy-six percent of respondents told us that the audit committee also involves the full board in auditor evaluation, providing access to the evaluation and opportunities to “weigh in.”
A Plan for Improving Rigor and Transparency in the Board’s Oversight of the External Auditor
NACD has determined that the auditor evaluation process is a key element of effective oversight for auditor independence, objectivity and skepticism. We have also determined that more rigor and transparency of the auditor evaluation process is both welcome and achievable by the boards of public issuers. This sentiment is shared by many of our members, our national board of directors and our advisory council of audit committee chairs who serve on the boards of Fortune 500 companies.
To that end, NACD suggests a three-pronged approach to robust oversight of auditor independence, objectivity and skepticism such that the board continues to have decision-making responsibility for the selection and rotation of the external auditor.
I. Rigorous Evaluation Process
As the first and most critical component of a plan for effective oversight, NACD has been working with a coalition of leading organizations to develop a tool to assist audit committees in performing an annual evaluation of the auditor.
The evaluation tool is scalable, and it specifically includes an evaluation of the auditor’s independence, objectivity and skepticism.
As a next step, we are exploring methods by which audit committees can enhance their communication to shareholders about their process for evaluation and oversight, including their use of this tool.
II. New Standards and Tools From the PCAOB
New issuances from the PCAOB comprise a second component of effective oversight for auditor independence, objectivity and skepticism.
- Newly adopted AS 16 appropriately updates the substantive matters auditors should discuss with audit committees about issues raised during and the results of the audit, including the quality of the company’s accounting. NACD is now urging our constituency to participate fully in the substance of the auditor/audit committee discussion, while at the same time assessing the quality of the auditor’s communications. For example, we are delivering an interactive webinar on AS 16 to our members, sponsored by the Center for Audit Quality (CAQ), to help audit committees understand the context of the standard as well as the expectations.
- In this regard, we are also appreciative of the PCAOB’s recent release of information for audit committees on the PCAOB’s inspection process. It provides an overview of the inspection process and report, as well as good insights for audit committees on how to discuss and digest the contents of those reports.
Coupled with a rigorous board process of external auditor evaluation, these PCAOB issuances provide a stronger platform for audit committee oversight of auditor independence, objectivity, and skepticism.
III. Director Education and Awareness
Audit committees take their responsibilities seriously. As a third component of effective oversight, NACD promotes the sharing of leading practices between audit committees and continues to provide educational and informative resources for directors and boards.
Our educational efforts address the range of audit committee responsibilities—from the oversight of the auditor’s performance, to financial reporting and the need to employ a healthy dose of skepticism in their work.
In a new development, we have rolled out the first of a five-part series of webinars on skepticism. The first module is titled “The etiquette and ethics of skepticism.” It informs members of the financial reporting supply chain about how to be skeptical without creating a chilling or punitive environment—including the audit committee, management, and the internal and external auditors. This is one of the tools we’re developing for boards in collaboration with Financial Executives International, The Institute of Internal Auditors and the CAQ to aid in the detection and deterrence of fraud.
We at NACD believe that audit committees can do a better job of communicating with shareholders about how they fulfill their oversight responsibilities for the external auditor’s performance.
We are dedicated to encouraging more transparency and want to explore ways that audit committees can provide more information, both within and separate from the audit committee report in the proxy. In fact, the use of the tool, Audit Committee Annual Evaluation of the External Auditor, could lead to enhanced proxy reporting.
We have concluded that mandatory audit firm rotation is unlikely to improve financial reporting, and that audit committees should retain the responsibility for oversight of the external auditor.
I suggest instead that we work with boards and shareholders on this issue. Let’s agree on enhancements to the audit committee’s process of evaluation and oversight, and better clarify how the audit committee communicates that process back to shareholders. The attached auditor assessment tool provides a framework, and NACD and our coalition are committed to educating and supporting directors on how to use it effectively.