What audit rule changes mean for investors

In late 2017, U.S. regulators finalized changes to the audit report that prefaces company financial statements. Not all changes took effect for 2018 annual reports, but already the differences are noticeable.

Audit tenure

For audits conducted after Dec. 15, 2017, the auditors’ report to shareholders must disclose how long they have been engaged by the company. The results are quite surprising. At the time of writing, 21 of the Dow 30 companies had released their annual reports (those with Dec. 31 year-ends). The average auditor tenure at those companies was 66 years. In some cases, the auditor had been with the company for so long they weren’t sure when the relationship had started (see table below). To check your U.S. holdings, the length of an auditor’s tenure can be found under the signature on the audit report (also known as the audit opinion).

The concern for investors is that lengthy audit tenures can lead to lazy auditors, or auditors that willfully turn a blind eye to management that is stretching accounting rules. In the aftermath of the Enron and WorldCom accounting scandals in the early 2000s, and again after the financial crisis in 2008, the U.S. considered the idea of mandatory auditor rotations to force companies to switch audit firms after a certain number of years. This never caught on because of pushback from both auditors and companies.

By contrast, EU laws require auditors to rotate at least every 20 years, and for the contract to be tendered out every decade. Disclosure of audit tenure length only recently became standard, however, so it will take time for many long-in-the-tooth engagements to disappear.

Where is Canada?

While Canada is preparing to introduce new regulations for audit reports similar to those in the U.S., one notable difference will be the lack of a requirement to disclose the length of audit tenure.

Despite the current lack of a disclosure requirement for Canadian public companies, the audit tenure of some cross-listed firms is known as a result of U.S.-mandated disclosures. Manulife Financial, for instance, has engaged Ernst & Young for 113 years. While that supercentenarian feat might be the Canadian record, nobody can say for sure due to current regulations.

Pushback against regulation

Both auditors and companies tend to lobby against major regulatory changes such as mandatory audit rotations. They argue it would make for lower-quality audits and increase the likelihood of undetected fraud, and that national competitiveness and investor protection are their primary concerns. But auditor rotation can also be costly to companies, as new auditors would spend longer delving into more issues. Further, a competitive bidding environment for audit services would likely lead to lower auditor profitability in the long run.

Auditors have argued for years that there is no proof that audit rotations work. Such proof is tough to establish when no jurisdictions have required it for long. While that might change with future evidence from the EU, compelling data (published in a March 2017 article in The Accounting Review) exists today that audit quality is improved by rotating audit partners.

Changing up the major partners responsible for an audit leads to more financial restatements and higher write-downs of impaired assets. It’s arguable that changing firms would lead to even more fresh opinions.

This is especially important for industries and companies where management’s judgment can have a significant impact on financial statements. Major areas of concern include the valuation of real estate and infrastructure assets, lengthy construction contracts, significant mergers and acquisitions, and notable intangible assets, to name a few.

Advisors can well understand the benefits of bringing a new set of eyes to a stale investment portfolio. They should similarly take notice of audit relationships that are well past their best before dates.

Longest auditor relationships in Dow 30 (companies reported so far)

Company	Auditor	Since
DowDuPont	Deloitte	1905
General Electric	KPMG	1909
Johnson & Johnson	PWC	at least 1920
Coca-Cola	E&Y	1921
Goldman Sachs	PWC	1922

Sources: Accountability Research; company reports