Considering a Change in Auditors?
May 23, 2016
Many nonprofits have audit firm rotation polices requiring a change in audit firms—not just audit partners—every few years, most typically every five years. Some call for rotation in as little as every three years. Policies such as these have become the norm only in the past dozen years or so. Why is this, and does it make sense?
The rise of audit partner or audit firm rotation policies, in large part, is attributable to the Sarbanes-Oxley Act of 2002. Curiously, with the exception of two very narrow provisions of the act dealing with document destruction and whistleblower policies, the act does not apply to nonprofits unless a nonprofit is also an issuer of publicly traded securities or has filed as a registrant to issue such securities under the Securities Exchange Act of 1934 or the Securities Act of 1933, respectively. So, if the Sarbanes-Oxley Act doesn’t apply to nonprofits, why have so many adopted its audit partner rotation policy, or going even further, turned the policy into one of audit firm rotation?
This article looks back at the act, the effects it has had—intended or otherwise—on the relationships between nonprofits and their auditors since its passage, and offers considerations for nonprofits when evaluating their own policies.
Recent Origins of Rotation Policies as “Best Practice”
Why was the Sarbanes-Oxley Act enacted in the first place? Originally called “The Public Company Accounting Reform and Investor Protection Act" in the Senate, and “The Corporate and Auditing Accountability and Responsibility Act" in the House, the names go a long way in telling the story. In 2002, investors were reeling from a series of corporate scandals the likes of Enron, WorldCom, and Tyco. Determined to put an end to the fraud, and to increase accountability and transparency in financial accounting and reporting, Congress passed the act in July of that year.
The act is broad, sweeping, and comprehensive—so much so that it is well beyond the scope of this article, which focuses on a single provision contained in the act.
Never was the act intended to apply to nonpublic entities such as private businesses, nonprofit organizations, governments, or municipalities. Nonetheless, as the provisions of the act became better known and more widely understood after its passage, the merits of adopting some of its provisions began to make sense to managers and directors of nonpublic entities, and some of those provisions have evolved into “best practices” over time.
Perhaps the most ubiquitous of these “best practices” is that which has generally become to be referred to as “auditor rotation.” This broad term encompasses both audit partner rotation and audit firm rotation.
Sarbanes-Oxley Does Not Prescribe Audit Firm Rotation
Contrary to widespread misconception, the Sarbanes-Oxley Act doesn’t require rotation of audit firms. Section 203 of the act – Audit Partner Rotation, reads:
It shall be unlawful for a registered public accounting firm to provide audit services to an issuer if the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the audit, has performed audit services for that issuer in each of the 5 previous fiscal years of that issuer.
The general concept is that swapping out the audit partner periodically will disrupt the slow creep of unnoticed or inadvertent inattention, complacency, or over-familiarity on the part of the audit partner, as well as more sinister possibilities such as collusion, impaired independence, or even active participation in fraudulent financial reporting or theft. This line of reasoning ascribes little or no significance to other factors that could mitigate those risks, such as changes in the reviewing partner, changes in other members of the audit team, and quality assurance measures undertaken by the firm.
Unintended Consequences Possible with Audit Firm Rotation
Audit firm rotation, on the other hand, is far more severe, tantamount to throwing out both the baby and the bath water. With audit firm rotation, disruption with a capital “D” occurs, and affects everything, often to the detriment of the nonprofit. A study of auditor tenure conducted by professors at the University of Richmond and Texas A&M International University concluded:
The results do not support the arguments of those who propose mandatory auditor rotation and suggest that, contrary to the concerns expressed by the SEC, there is an inverse relationship between auditor tenure and audit reporting failures.
Another study conducted by professors at Georgia State University, the University of Missouri-Columbia, and Louisiana State University, concluded:
. . . we find that relative to medium audit-firm tenures of four to eight years, short audit-firm tenures of two to three years are associated with lower-quality financial reports. In contrast, we find no evidence of reduced financial-reporting quality for longer audit-firm tenures of nine or more years. Overall, our results provide empirical evidence pertinent to the recurring debate regarding mandatory audit-firm rotation—a debate that has, to date, relied on anecdotal evidence and isolated cases.
The AICPA opposes mandatory audit firm rotation, citing the often costly and unintended consequences that may result. Instead, the AICPA recommends the strengthening of audit committees and encourages them to be more proactive in their interactions with and supervision of the auditors.
How to Get the Best of Both Worlds
nonprofits can increase the effectiveness of the audit firm relationship and audit quality, while also directing targeted responses to specific areas of concern by doing the following:
- If you have an audit firm rotation policy, consider changing it to an audit partner rotation policy.
- If your audit firm rotation policy is less than five years, and you don’t want to change it to an audit partner rotation policy, consider increasing the rotation term to a minimum of five years—studies suggest even longer periods of time make the most sense.
- Consider the positive effects of changes in the composition of the audit team. If those changes aren’t occurring naturally because of normal staff progression and/or turnover, consider discussing specific changes with your audit partner.
- Consider asking your audit partner to have a second partner participate in planning the current-year engagement, and/or reviewing the audit work before issuance of the financial statements.
- Don’t just blindly adhere to your rotation policy. Evaluate whether or not, all things considered, rotation makes sense at the time the policy calls for it, and also consider whether specific circumstances dictate the wisdom of making a change before then.
- Engage in brainstorming sessions with your audit team. Specific concerns can be addressed and incorporated into the annual audit process, or as custom-designed procedures performed separately. For example, if you are concerned about internal controls surrounding a particular transaction stream, or the process followed to determine the proper recording of a particular type of transaction, you can work with your auditors to develop procedures to select and test a sample of transactions to determine that the appropriate controls are in place and functioning as designed. This type of customized approach can be applied on a rotating or as-needed basis, and provides a nearly infinite ability to address any nonprofit’s unique needs over time.
- Keep it fresh—keep it evolving. Remember, nothing stays the same. Challenge yourself and your auditors to change the mix, take a fresh approach, and be responsive to changes in your organization, personnel, the business and legal environment, business practices, accounting standards, etc. The world won’t stop changing; nor should you or your auditors.