Running head: Sarbanes-Oxley and Auditor Independence

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Sarbanes-Oxley and Auditor Independence David T. Michalkiewicz Auditing I Dr. Wendy Achilles Keiser University July 21, 2013

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Abstract The Sarbanes-Oxley Act of 2002 introduced two requirements aimed at reinforcing auditor independence. Those requirements are concurring partner review, and partner rotation. Under these requirements, all audits must be reviewed by a partner of equal or greater competence, who is independent of the audit team, and engagement partners and concurrent review partners must both be rotated every five years. These requirements help to assure that the conclusions arrived at by the engagement team are sound, and that auditor independence is not impaired by prolonged close proximity to the client. Yet audit failures, those audits where auditors failed to arrive at an opinion, still abound. James R. Doty, Chairman of the PCAOB, believes its because of reduced professional skepticism, due to impaired independence. Despite the best efforts of lawmakers and standard-setters, could it be that auditor independence is not being impaired by prolonged contact with the client, but by the audit firms, themselves?

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INTRODUCTION Two of the measures introduced by the Sarbanes-Oxley Act of 2002, aimed at promoting auditor independence, are the requirements for a concurring review of the audit by a second partner, and the periodic rotation of both the engagement partner, and the concurring review partner. Both of these measures are aimed at limiting the familiarity, between concerned parties, that comes from time spent working hand-in-hand. But do these measures really work, or is it possible that auditor independence is being impaired by their own firms (Doty, 2011)? ENGAGEMENT QUALITY REVIEW Sec. 103(a)(2)(A)(ii) of the Sarbanes-Oxley Act of 2002 states that the Board (the PCAOB) shall include, in its standards, requirements for a concurring or second partner review and approval of the audit report by a qualified individual other than the engagement partner. This is accomplished through Auditing Standard No. 7 (2009), which states An engagement quality review and concurring approval of issuance are required for each audit engagement and for each engagement to review interim financial information conducted pursuant to the standards of the Public Company Accounting Oversight Board (PCAOB), for the purpose of evaluating the judgments and conclusions reached by the engagement team and to determine whether to provide concurring approval of the report (AS No. 7). Engagement quality review allows a second set of eyes, independent of the audit team, to look over the data and conclusions, to determine if the final opinions were appropriately formed (Messier, Glover, & Prawitt, 2012, p. 594). As such, the concurrent reviewer must possess the same level of competency as the engagement partner and cannot have been involved with the engagement team during the execution of its duties, nor can they have been the engagement partner, for that particular client, during the preceding two years (AS No. 7, 2009).

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PARTNER ROTATION Sec. 203(j) of the Sarbanes-Oxley Act of 2002 establishes the requirements for the rotation of both the engagement partner, and the concurring review partner. It states 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. What this amounts to is that both the engagement partner, and the concurrent review partner, must be rotated every five years. SOUND REASONING The rotation of engagement and concurrent review partners is aimed at promoting auditor independence by preventing a familiarity, between concerned parties, that might pose a threat to the auditors independence, in both fact and/or appearance. This is summed up in AU Section 230.09, which states The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest (1972). Long nights and weekends spent working hand-in-hand can promote a familiarity that can color an auditors perception of a client, tainting his or her professional skepticism. Everyone wants to believe the best about someone that they like. In this respect, a friendly working relationship can become a hindrance. Such a relationship can give rise to situations allowing for the auditor to be influenced either by the client, or by the auditors own beliefs regarding the client. The requirements for partner rotation are aimed at mitigating this possibility.

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AUDIT FIRM ROTATION The PCAOB, in August of 2011, sought opinion on taking Sarbanes-Oxleys requirements one step further, to require the rotation of audit firms, after a set number of years (Public Company Accounting Oversight Board, 2011). However, such a thing has been steadfastly opposed by numerous entities, including the AICPA. The AICPAs response to the PCAOB Release cites research that indicates audit quality tends to improve rather than worsen with tenure, providing support to the expectation that there is a significant learning process for the auditor, i.e., an auditor needs time to get to know sufficiently well the business of the client and, consequently, audit quality tends to increase over time (American Institute of CPAs, 2011). Significant increases in cost and resources, which could place undue burden on clients and disrupt capital markets, are among the other reasons the AICPA has opposed audit firm rotation (AICPA). On July 8, 2013, the House of Representatives approved the Audit Integrity and Job Protection Act (Tysiac, 2013), an act which, if approved by the Senate, and signed into law by the President, would prevent the PCAOB from requiring the rotation of audit firms (H.R. 1564, 2013). EFFECTIVENESS OF ACTION James R. Doty, Chairman of the PCAOB, in his Keynote Address, on October 4, 2011, believes that hundreds of audit failures can be attributed to auditor skepticism, coming to ground in the bedrock of independence. In other words, auditors independence is being impaired, which lowers their professional skepticism. But is this impairment due to lengthy times spent under the employ of one client?

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Mr. Doty seems to believe that the impairment comes not from the auditors length of time in the employ of a certain client, but from pressures within the auditing firms, themselves (Doty, 2011). Mr. Doty points out that, in the first years of an engagement, auditing firms often charge reduced fees, in hopes of securing future revenue streams (Doty). These future revenues are put in danger if a client is displeased, often causing auditors to become less objective and more protective of the clients interests, for fear of losing those future revenues (Doty). CONCLUSION The measures introduced by the Sarbanes-Oxley Act of 2002 do what they can, in terms of mitigating the familiarity between auditor and client that would impair an auditors independence. However, the requirements for quality review and auditor rotation do very little towards alleviating the pressure from within the audit firm, itself, to retain the client and secure future earnings. Mr. Doty suggests that, if audit firms knew that their engagement with a client was to be for a finite number of years, this might be different. Unfortunately, if the Audit Integrity and Job Protection Act is signed into law, we will never know.

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References American Institute of CPAs. (2011, December 14). Re: Request for Public Comment: Concept Release on Auditor Independence and Audit Firm Rotation. Retrieved from http://pcaobus.org/Rules/Rulemaking/Docket037/413_AICPA.pdf AU Section 230.09 (1972, November). Retrieved from http://pcaobus.org/Standards/Auditing/Pages/AU230.aspx Doty, J. (2011, October 4). Keynote address: Which way next? Future thinking at the PCAOB. Retrieved from http://pcaobus.org/News/Speech/Pages/10042011_DotyNACD.aspx H.R. 1564: Audit integrity and Job Protection Act. Retrieved from http://www.govtrack.us/congress/bills/113/hr1564/text Messier, W., Glover, M., & Prawitt, D. (2012). Auditing and assurance services: A systematic approach (8th ed.). New York, NY: McGraw-Hill/Irwin Public Company Accounting Oversight Board. (2009, December 15). Auditing Standard No. 7 Engagement Quality Review. Retrieved from http://pcaobus.org/Standards/Auditing/Pages/Auditing_Standard_7.aspx Public Company Accounting Oversight Board. (2011, August 16). Concept Release on Auditor Independence and Audit Firm Rotation. Retrieved from http://pcaobus.org/Rules/Rulemaking/Docket037/Release_2011-006.pdf Sarbanes-Oxley Act of 2002. Retrieved from http://www.sec.gov/about/laws/soa2002.pdf Tysiac, K. (2013, July 8). Bill prohibiting mandatory audit firm rotation passes U.S. House. Retrieved from http://www.journalofaccountancy.com/News/20138294