Audit Firm Rotation As A Good Governance Practice For Non Profit Organizations

This article discusses audit firm rotation.

“The Exempt Organizations Division of the IRS had posted on the IRS web site a controversial document setting forth the Service’s view on what constitutes good governance practices for tax-exempt entities. Included in the document was the suggestion that audit firms be rotated on a regular basis, with five years as the suggested term. The American Institute of Certified Public Accountants (AICPA) protested the inclusion of this item in face-to-face meetings and in writing. Last month, the IRS dropped the document from its website, explaining that the new Form 990 sets forth the IRS’ current position on good governance practices which do not include the five-year rotation suggestion.”

The Argument For Audit Firm Rotation

This is another sad example of a professional organization placing the good of its members over the public interest. The AICPA has a long history of this type of advocacy. Why would the IRS recommended a five year audit rotation as a good governance practice for non profit organizations?

This second issue is subtle. Accountants are creatAudit rotation is designed to overcome two problems that can occur if an organization hires the same audit firm year in and year out. The first problem is that there is a tendency for audit firms to get too cozy with the management of the organizations they are assigned to audit. Personal and professional ties can easily impede auditor independence. Secondly, audit rotation provides the opportunity for the organization to be examined with a fresh pair of eyes.

This second issue is subtle. Accountants are creatures of habit and checklists. Things are done the same way as they were last year and often in a very mechanical and non critical manner. Many audit procedures and tests are numbingly mechanical and clerical and it is very easy to not view the audit process from a sufficiently critical and analytical point of view. Sometimes the most glaring internal control weaknesses can be overlooked simply because the auditors were not looking at the big picture but only concentrating on the minutia. A change in auditors guarantees that the organization in its entirety will get a fresh look and glaring internal control problems that may have been overlooked by the prior auditor may get picked up by the new one.

Of course CPA firms with long standing engagements with non profit organizations do not want to give up them up for obvious financial reasons. So these firms use their professional association, the AICPA, to advocate against the obvious good governance practice that is clearly in the public interest. Such cynicism is sadly the rule not the exception for most professional organizations.

The IRS also should share some of the blame for caving into the CPAs on this issue. But it probably was not the IRS staff that caved but the higher ups who were pressured from the Bush administration. Whenever there is a divergence between the private sector’s interests and the public’s interest you can pretty much count on the Bush administration siding with the private interests.

In any event the IRS had the right idea to begin with. Non profits should rotate their audit firms on a regular basis.

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Auditor Firm Rotation And Independence

Just this week (July 9,2013) the House of Representatives passed a bill that would prohibit the independent audit oversight committee from making auditor rotation for public companies mandatory. The justification for this move is that audit costs would increase. The opposing argument in favor of audit rotation is that you do not want auditors to get too cozy with the management of firms they audit and enforced rotation might prohibit. Also a periodic “fresh pair of eyes” may be helpful in detecting irregularities or improper accounting treatments, I believe that any increase in audit costs is offset by the benefits of rotation.

In addition the public oversight committee should prohibit audit firms from performing any non audit tax or advisory services. Finally it may even be a good idea for an independent board to assign auditors to firms rather than the current practice of having the companies hire their auditors. In this way auditors would have no incentive to subjugate their judgment to company management. Such is the current political and economic power of the big audit firms that these common sense proposals have little chance of being implemented. Only a rash of audit failures on the scale of the Enron debacle is likely to end this state of affairs.

For research on the impact of audit rotation on audit quality click here.
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