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Report to the Senate Committee on Banking, Housing, and Urban Affairs 
and the House Committee on Financial Services:

November 2003:

PUBLIC ACCOUNTING FIRMS:

Required Study on the Potential Effects of Mandatory Audit Firm 
Rotation:

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-216] GAO-04-216:

GAO Highlights:

Highlights of GAO-04-216, a report to Senate Committee on Banking, 
Housing, and Urban Affairs and House Committee on Financial Services 

Why GAO Did This Study:

Following major failures in corporate financial reporting, the 
Sarbanes-Oxley Act of 2002 was enacted to protect investors through 
requirements intended to improve the accuracy and reliability of 
corporate disclosures and to restore investor confidence. The act 
included reforms intended to strengthen auditor independence and to 
improve audit quality. Mandatory audit firm rotation (setting a limit 
on the period of years a public accounting firm may audit a particular 
company’s financial statements) was considered as a reform to enhance 
auditor independence and audit quality during the congressional 
hearings that preceded the act, but it was not included in the act. 
The Congress decided that mandatory audit firm rotation needed further 
study and required GAO to study the potential effects of requiring 
rotation of the public accounting firms that audit public companies 
registered with the Securities and Exchange Commission.

What GAO Found:

The arguments for and against mandatory audit firm rotation concern 
whether the independence of a public accounting firm auditing a 
company's financial statements is adversely affected by a firm's long-
term relationship with the client and the desire to retain the client. 
Concerns about the potential effects of mandatory audit firm rotation 
include whether its intended benefits would outweigh the costs and the 
loss of company-specific knowledge gained by an audit firm through 
years of experience auditing the client. In addition, questions exist 
about whether the Sarbanes-Oxley Act requirements for reform will 
accomplish the intended benefits of mandatory audit firm rotation. 

In surveys conducted as part of our study, GAO found that almost all 
of the largest public accounting firms and Fortune 1000 publicly 
traded companies believe that the costs of mandatory audit firm 
rotation are likely to exceed the benefits. Most believe that the 
current requirements for audit partner rotation, auditor independence, 
and other reforms, when fully implemented, will sufficiently achieve 
the intended benefits of mandatory audit firm rotation. Moreover, in 
interviews with other stakeholders, including institutional investors, 
stock market regulators, bankers, accountants, and consumer advocacy 
groups, GAO found the views of these stakeholders to be consistent 
with the overall views of those who responded to its surveys.

GAO believes that mandatory audit firm rotation may not be the most 
efficient way to strengthen auditor independence and improve audit 
quality considering the additional financial costs and the loss of 
institutional knowledge of the public company’s previous auditor of 
record, as well as the current reforms being implemented. The 
potential benefits of mandatory audit firm rotation are harder to 
predict and quantify, though GAO is fairly certain that there will be 
additional costs. 

Several years’ experience with implementation of the Sarbanes-Oxley 
Act’s reforms is needed, GAO believes, before the full effect of the 
act’s requirements can be assessed. GAO therefore believes that the 
most prudent course of action at this time is for the Securities and 
Exchange Commission and the Public Company Accounting Oversight Board 
to monitor and evaluate the effectiveness of existing requirements for 
enhancing auditor independence and audit quality. 

GAO believes audit committees, with their increased responsibilities 
under the act, can also play an important role in ensuring auditor 
independence. To fulfill this role, audit committees must maintain 
independence and have adequate resources. Finally, for any system to 
function effectively, there must be incentives for parties to do the 
right thing, adequate transparency over what is being done, and 
appropriate accountability if the right things are not done. 

What GAO Recommends:

www.gao.gov/cgi-bin/getrpt?GAO-04-216.

To view the full product, including the scope and methodology, click 
on the link above. For more information, contact Jeanette M. Franzel 
at (202) 512-9471 or franzelj@gao.gov.

[End of section]

Contents:

Letter: 

Results in Brief: 

Background: 

Pros and Cons of Requiring Mandatory Audit Firm Rotation: 

Results of Our Surveys: 

Competition-Related Issues: 

Overall Views on Mandatory Audit Firm Rotation: 

Overall Views of Other Knowledgeable Individuals on Mandatory Audit 
Firm Rotation: 

Survey Groups Views on Implementing Mandatory Audit Firm Rotation if 
Required and Other Alternatives for Enhancing Audit Quality: 

Auditor Experience in Restatements of annual Financial Statements Filed 
with the SEC for 2001 and 2002: 

Experience of Foreign Countries with Mandatory Audit Firm Rotation: 

GAO Observations: 

Agency Comments and Our Evaluation: 

Appendixes:

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Implementation of Mandatory Audit Firm Rotation, if 
Required: 

Appendix III: Potential Value of Practices Other Than Mandatory Audit 
Firm Rotation for Enhancing Auditor Independence and Audit Quality: 

Appendix IV: Restatements of Annual Financial Statements for Fortune 
1000 Public Companies Due To Errors or Fraud: 

Appendix V: International Experience with Mandatory Audit Firm 
Rotation:

Appendix VI: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Staff Acknowledgments: 

Tables:

Table 1: Audit Committee Chairs' Reasons for Limiting Consideration to 
Only Big 4 Firms: 

Table 2: Public Accounting Firms' Population, Sample Sizes, and Survey 
Response Rates: 

Table 3: Public Company Chief Financial Officers' Population, Sample 
Sizes, and Survey Response Rates: 

Table 4: Public Company Audit Committee Chairs' Population, Sample 
Sizes, and Survey Response Rates: 

Table 5: Views on Potential Value of Other Practices for Enhancing 
Auditor Independence and Audit Quality: 

Table 6: Summary Results of the Fortune 1000 Public Companies That 
Changed Auditors: 

Table 7: Summary Results of the Fortune 1000 Public Companies That Did 
Not Change Auditors: 

Table 8: Summary of Net Dollar Effect of Restatements Due to Errors and 
Fraud: 

Figures:

Figure 1: Estimated Audit Firm Tenure for Fortune 1000 Public Companies: 

Figure 2: Tier 1 Firms: Value of Additional Procedures When Firm Has 
Less Knowledge and Experience with a Client: 

Figure 3: Fortune 1000 Public Companies' Belief That Additional or 
Enhanced Audit Procedures Would Affect the Risk of Not Detecting 
Material Misstatements: 

Figure 4: Views on How Mandatory Audit Firm Rotation Would Affect the 
Auditor's Potential to Deal with Material Financial Reporting Issues 
Appropriately: 

Figure 5: Expected Increase in Initial Year Audit Costs over Subsequent 
Year Audit Costs: 

Figure 6: Tier 1 Firms Expecting Additional Expected Marketing Costs 
under Mandatory Audit Firm Rotation Compared to Initial Year Audit 
Fees:	

Figure 7: Fortune 1000 Public Companies' Expected Selection Costs as a 
Percentage of Initial Year Audit Fees: 

Figure 8: Fortune 1000 Public Companies' Expected Support Costs as a 
Percentage of Initial Year Audit Fees: 

Figure 9: Support for Mandatory Audit Firm Rotation: 

Abbreviations: 

AICPA: American Institute of Certified Public Accountants:

CGAA: Co-ordinating Group on Audit and Accounting Issues:

CNMV: Comision Nacional del Mercaso de Valores:

CONSOB: Commissione Nazionale per le Societa e la Borsa:

CVM: Comissao de Valores Mobiliarios:

EDGAR: Electronic Data Gathering, Analysis, and Retrieval:

G-7: Group of Seven Industrialized Nations:

GAAP: generally accepted accounting principles:

GAAS: generally accepted auditing standards:

IOSCO: International Organization of Securities Commissions:

NIvRA: Royal Nederlands Instituut van Register Accountants:

NOvAA: Nederlandse Orde van Accountants-Administratieconsulenten:

OSFI: Office of the Superintendent of Financial Institutions:

PCAOB: Public Company Accounting Oversight Board:

POB: Public Oversight Board:

SEC: Securities and Exchange Commission:

SECPS: SEC Practice Section:

Letter November 21, 2003:

The Honorable Richard C. Shelby: 
Chairman: 
The Honorable Paul S. Sarbanes: 
Ranking Minority Member: 
Committee on Banking, Housing, and Urban Affairs: 
United States Senate:

The Honorable Michael G. Oxley: 
Chairman: 
The Honorable Barney Frank: 
Ranking Minority Member: 
Committee on Financial Services: 
House of Representatives:

Full, fair, and accurate reporting of financial information by public 
companies[Footnote 1] is critical to the effective functioning of the 
capital and credit markets in the United States. Federal securities 
laws and regulations require publicly owned companies to disclose 
financial information in a manner that accurately depicts the results 
of company activities and require that the companies' financial 
statements be audited by an independent public accountant. Although 
public company management is responsible for the company's financial 
statements, public confidence in the integrity of financial statements 
of publicly traded companies is enhanced by the audit process and 
independence of the auditor from the audit client.

Major failures in corporate financial reporting in recent years, 
including accountability breakdowns at Enron and WorldCom and other 
major corporations, that led to restatement of financial statements and 
bankruptcy adversely affected thousands of shareholders and employees. 
As a result, the Sarbanes-Oxley Act of 2002[Footnote 2] was enacted to 
protect investors by improving the accuracy and reliability of 
corporate disclosures. The act's requirements included reforms to 
strengthen corporate responsibility for financial reports and auditor 
independence and created the Public Company Accounting Oversight Board 
(PCAOB). The PCAOB has the responsibility to register and inspect 
public accounting firms that audit public companies, and the authority 
to investigate and discipline registered public accounting firms and to 
set auditing and related attestation, quality control, and auditor 
ethics and independence standards in connection with audits of public 
companies.

Senate report 107-205 that accompanied the Sarbanes-Oxley Act stated 
that in considering reforms to enhance auditor independence, some 
witnesses believed that mandatory audit firm rotation[Footnote 3] of 
public accounting firms was necessary to maintain the objectivity of 
audits, while other witnesses believed that public accounting firm 
rotation could be disruptive to the public company and the costs of 
mandatory audit firm rotation might outweigh the benefits. The Congress 
decided that mandatory audit firm rotation needed further study and 
required in Section 207 of the Sarbanes-Oxley Act that GAO study the 
issues. Specifically, we were asked to study the potential effects of 
requiring mandatory rotation of registered public accounting 
firms.[Footnote 4] To conduct our study, we did the following:

* Identified and reviewed research studies and other documents that 
addressed issues concerning auditor independence and audit quality 
associated with the length of a public accounting firm's tenure and the 
costs and benefits of mandatory audit firm rotation.

* Analyzed the issues we identified to (1) develop detailed 
questionnaires to obtain the views of public accounting firms and 
public company chief financial officers and their audit committee 
chairs of the issues associated with mandatory audit firm rotation, (2) 
hold discussions with officials of other interested stakeholders, such 
as institutional investors, federal banking regulators, U.S. stock 
exchanges, state boards of accountancy, the American Institute of 
Certified Public Accountants (AICPA), the Securities and Exchange 
Commission (SEC), and the PCAOB to obtain their views on the issues 
associated with mandatory audit firm rotation, and (3) obtain 
information from other countries on their experiences with mandatory 
audit firm rotation.

* Identified restatements of annual financial statements for Fortune 
1000 public companies due to errors or fraud that were reported to the 
SEC for years 2001 and 2002 through August 31, 2003, to (1) determine 
whether the restatement occurred after a change in the public 
companies' auditor of record, and (2) to obtain some insight into the 
value of a "fresh look" by a new auditor of record.

Our population of public accounting firms consisted of three tiers: 
Tier 1 firms included 92 public accounting firms that were members of 
the AICPA's self-regulatory program for audit quality that reported 
having 10 or more SEC clients in 2001 and 5 public accounting firms 
that were not members of the AICPA's self-regulatory program but had 10 
or more public company clients registered with the SEC in 
2001.[Footnote 5] Tier 2 firms included 604 public accounting firms 
that were members of the AICPA's self-regulatory program for audit 
quality that reported having 1 to 9 public company clients registered 
with the SEC in 2001.[Footnote 6] Tier 3 firms included 421 public 
accounting firms that were members of the AICPA's self-regulatory 
program for audit quality that reported having no public company 
clients registered with the SEC in 2001. We surveyed 100 percent of the 
97 Tier 1, firms and we administered our surveys to random samples of 
282 of the 604 Tier 2 firms and 237 of the 421 Tier 3 firms. We 
received responses from 74 of the 97 Tier 1 firms, or 76.3 
percent.[Footnote 7] Because of the more limited participation of Tier 
2 firms (85, or 30.1 percent) and Tier 3 firms (52, or 21.9 percent) in 
our survey, we are not projecting their responses to the population of 
these firms. The presentation of this report focuses on the responses 
from the Tier 1 firms, but any substantial differences in their overall 
views and those reported to us by either the Tier 2 or 3 firms that 
responded to our survey is discussed where applicable.

We also drew random samples of 330 of the Fortune 1000 public 
companies[Footnote 8] after removing 40 private companies from the 
list, 450 of the 14,887 other domestic companies and mutual funds, and 
391 of 2,141 foreign companies that make up the universe of the 17,988 
public companies that are registered with the SEC as of February 2003. 
For each of these three groups of public companies, we asked their 
chief financial officers and audit committee chairs to complete 
separate questionnaires.

Of the 330 Fortune 1000 public companies sampled, we received responses 
from 201, or 60.9 percent, of their chief financial officers and 191, 
or 57.9 percent, of their audit committee chairs.[Footnote 9] Because 
of limited participation of the other domestic companies and mutual 
funds (131, or 29.1 percent, of their chief financial officers and 96, 
or 21.3 percent, of their audit committee chairs) and the foreign 
public companies (99, or 25.3 percent, of their chief financial 
officers and 63, or 16.1 percent, of their audit committee chairs), we 
are not projecting their responses to the population of such companies. 
This report focuses on the responses from the Fortune 1000 public 
companies' chief financial officers and their audit committee chairs, 
but any substantial differences between their overall views and those 
reported to us by the other groups of public companies that responded 
to our surveys is discussed where applicable.

For additional information on our scope and methodology including 
details of our samples, response rates, and efforts to follow up with 
nonrespondents to our surveys, see appendix I. We conducted our work in 
Washington, D.C., between November 2002 and November 2003 in accordance 
with U.S. generally accepted government auditing standards.

A copy of each of our questionnaires, annotated to show in total the 
respondents' answers to each question for the Tier 1 firms and the 
Fortune 1000 public companies chief financial officers[Footnote 10] and 
their audit committee chairs, will be presented in a separate GAO 
report [Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-217] 
GAO-04-217) to be issued at a later date.

Results in Brief:

Nearly all Tier 1 firms and Fortune 1000 public companies and their 
audit committee chairs believed that the costs of mandatory audit firm 
rotation are likely to exceed the benefits. Also, most Tier 1 firms and 
Fortune 1000 public companies and their audit committee chairs believe 
that either the audit firm partner rotation requirements of the 
Sarbanes-Oxley Act as implemented by the SEC, or those partner rotation 
requirements coupled with other requirements of the Sarbanes-Oxley Act 
that concern auditor independence and audit quality, will sufficiently 
achieve the benefits of mandatory audit firm rotation when fully 
implemented. Our discussions with a number of other knowledgeable 
individuals in a variety of fields, such as institutional investment; 
regulation of the stock markets, the banking industry, and the 
accounting profession; and consumer advocacy, showed that most of the 
individuals we spoke with held views consistent with the overall views 
expressed by those who responded to our surveys.

Considering the arguments for and against mandatory audit firm rotation 
and the requirements of the Sarbanes-Oxley Act concerning auditor 
independence and audit quality, which are also intended to achieve the 
same type of benefits as mandatory audit firm rotation, we believe that 
more experience needs to be gained with the act's requirements. 
Therefore, the most prudent course at this time is for the SEC and the 
PCAOB to monitor and evaluate the effectiveness of the act's 
requirements to determine whether further revisions, including 
mandatory audit firm rotation, may be needed to enhance auditor 
independence and audit quality to protect the public interest.

Our research of studies concerning issues related to mandatory audit 
firm rotation showed the primary arguments relate to auditor 
independence, audit quality, audit cost, and competition-related issues 
for providing audit services. Regarding auditor independence and audit 
quality issues, our analysis of survey results of Tier 1 firms and 
Fortune 1000 public companies showed the following:

* The average length of the auditor of record's tenure, which 
proponents of mandatory audit firm rotation believe increases the risk 
that auditor independence and ultimately audit quality may be adversely 
affected, was about 22 years for Fortune 1000 public companies.

* About 79 percent of Tier 1 firms and Fortune 1000 public companies 
believe that changing audit firms increases the risk of an audit 
failure in the early years of the audit as the new auditor acquires the 
necessary knowledge of the company's operations, systems, and financial 
reporting practices and therefore may fail to detect a material 
financial reporting issue.

* Most Tier 1 firms and Fortune 1000 public companies believe that 
mandatory audit firm rotation would not have much effect on the 
pressures faced by the audit engagement partner in appropriately 
dealing with material financial reporting issues.

* About 59 percent of Tier 1 firms reported they would likely move 
their most knowledgeable and experienced audit staff as the end of the 
firm's tenure approached under mandatory audit firm rotation to attract 
or retain other clients, which they acknowledged would increase the 
risk of an audit failure.

Regarding audit costs, our survey results show that Tier 1 firms and 
Fortune 1000 public companies expect that mandatory audit firm rotation 
would lead to more costly audits.

* Nearly all Tier 1 firms estimated that initial year audit costs under 
mandatory audit firm rotation would increase by more than 20 percent 
over subsequent year costs to acquire the necessary knowledge of the 
public company and most of the Tier 1 firms estimated their marketing 
costs would also increase by at least more than 1 percent, which would 
be passed on to the public companies.

* Most Fortune 1000 public companies estimated that under mandatory 
audit firm rotation, they would incur auditor selection costs and 
additional auditor support costs totaling at least 17 percent or higher 
as a percentage of initial year audit fees.

Our check of audit fees and total company operating expenses reported 
by a selection of large and small public companies in 23 industries for 
the most recent fiscal year available found that for the large public 
companies selected, average audit fees represented approximately 0.04 
percent of company operating expenses and, for the small public 
companies selected, average audit fees represented approximately 0.08 
percent of company operating expenses. Based on estimates of possible 
increased audit-related costs from survey responses from Tier 1 firms 
and Fortune 1000 public companies, mandatory audit firm rotation could 
increase these audit-related costs from 43 percent to 128 percent of 
the recurring annual audit fees. This illustration is intended only to 
provide some insight into how, based on Tier 1 firms' and Fortune 1000 
public companies' responses, mandatory audit firm rotation may affect 
the initial year audit-related costs public companies may incur and is 
not intended to be representative.

Regarding competition-related effects of mandatory audit firm rotation, 
54 percent of Tier 1 firms believe mandatory audit firm rotation would 
decrease the number of firms willing and able to compete for audits of 
public companies and 83 percent of Tier 1 firms believe that the market 
share of public company audits would either become more concentrated in 
a small number of public accounting firms or would remain the same. As 
we have previously reported,[Footnote 11] the number of public 
accounting firms providing audit services to public companies is highly 
concentrated with the 4 largest firms auditing over 78 percent of all 
U.S. public companies and 99 percent of public company sales. Many 
Fortune 1000 public companies reported that they will only use a Big 4 
firm for a variety of reasons, including the capability of the firms to 
provide them audit services and the expectations of the capital markets 
that they will use Big 4 firms. Mandatory audit firm rotation would 
further decrease their choices for an auditor of record, and the 
Sarbanes-Oxley Act auditor independence requirements concerning 
prohibited nonaudit services may also further limit the public 
companies' choices for an auditor of record. Tier 1 firms expected that 
public companies in specialized industries, which in some industries 
currently have more limited choices for an auditor of record than other 
public companies, could be more affected by mandatory audit firm 
rotation than other public companies.

We believe that mandatory audit firm rotation may not be the most 
efficient way to enhance auditor independence and audit quality 
considering the additional financial costs and the loss of 
institutional knowledge of a public company's previous auditor of 
record. The potential benefits of mandatory audit firm rotation are 
harder to predict and quantify, though we are fairly certain that there 
will be additional costs. In addition, the current reforms being 
implemented may also provide some of the intended benefits of mandatory 
audit firm rotation. In that respect, mandatory audit firm rotation is 
not a panacea that totally removes the pressures on the auditors in 
appropriately resolving financial reporting issues that may materially 
affect the public companies' financial statements. These inherent 
pressures are likely to continue even if the term of the auditor is 
limited under any mandatory rotation process. Furthermore, most public 
companies will only use the Big 4 firms for audit services. Given this 
preference, these public companies may only have 1 or 2 real choices 
for auditor of record under any mandatory rotation system given the 
importance of industry expertise and the Sarbanes-Oxley Act's auditor 
independence requirements. However, over time a mandatory audit firm 
rotation requirement may result in more firms transitioning into 
additional industry sectors if the market for such audits has 
sufficient profit margins.

The Sarbanes-Oxley Act contains significant reforms aimed at enhancing 
auditor independence (e.g., additional partner rotation requirements 
and restrictions on providing nonaudit or consulting services) and 
audit quality (e.g., establishing the PCAOB and management and auditor 
reporting on internal controls over financial reporting) that are also 
intended to achieve the same type of benefits as mandatory audit firm 
rotation. The PCAOB's inspection program for registered public 
accounting firms could also provide an opportunity to provide a "fresh 
look", which would enhance auditor independence and audit quality 
through the program's inspection activities and also may provide new 
insights regarding (1) public companies' financial reporting practices 
that pose a high risk of issuing materially misstated financial 
statements for the audit committees to consider and (2) possibly either 
using the auditor of record or another firm to assist in reviewing 
these areas. However, it will take at least several years for the SEC 
and the PCAOB to gain sufficient experience with the effectiveness of 
the act in order to adequately evaluate whether further enhancements or 
revisions, including mandatory audit firm rotation, may be needed to 
further protect the public interest and to restore investor confidence. 
The current environment has greatly increased the pressures on public 
company management and auditors regarding honest, fair, and complete 
financial reporting, but it is uncertain if the current climate will be 
sustained over the long term. Rigorous enforcement of the act's 
requirements will undoubtedly be critical to its effectiveness.

We also believe that audit committees with their increased 
responsibilities under the Sarbanes-Oxley Act can play a very important 
role in enhancing auditor independence and audit quality. In that 
respect, the Conference Board Commission on Public Trust and Private 
Enterprise stated in its January 9, 2003, report that auditor rotation 
is a useful tool for building shareholder confidence in the integrity 
of the audit and of the company's financial statements. The commission 
advocated that audit committees should consider rotating audit firms 
when there are circumstances that could call into question the audit 
firm's independence from management. These circumstances included when 
(1) significant nonaudit services are provided by the auditor of record 
to the company (even if approved by the audit committee), (2) one or 
more former partners or managers of the audit firm are employed by the 
company, or (3) lengthy tenure of the auditor of record, such as over 
10 years--which our survey results show is prevalent at many Fortune 
1000 public companies. We believe audit committees that encounter these 
circumstances, at a minimum, need to be especially vigilant in the 
oversight of the auditor and in considering whether a "fresh look" 
(e.g., new auditor) is needed. We also believe that if audit committees 
regularly evaluated whether audit firm rotation would be beneficial, 
given the facts and circumstances of their companies' situation, and 
are actively involved in helping to ensure auditor independence and 
audit quality, many of the benefits of audit firm rotation could be 
realized at the initiative of the audit committees rather than through 
a mandatory rotation requirement.

In order to be effective, however, audit committees need to have access 
to adequate resources, including their own budgets, to be able to 
operate with the independence necessary to effectively perform their 
responsibilities under the Sarbanes-Oxley Act. Further, we believe that 
the audit committee's ability to operate independently is directly 
related to the independence of the public company's board of directors. 
It is not realistic to believe that an audit committee will 
unilaterally resolve financial reporting issues that materially affect 
a public company's financial statements without vetting those issues 
with the board of directors. Also, the ability of the board of 
directors to operate independently may also be affected in corporate 
governance structures where the public company's chief executive 
officer also serves as the chair of the board of directors. Like audit 
committees, boards of directors also need to be independent and have 
adequate resources and access to independent attorneys and other 
advisors when they believe it is appropriate. Finally, for any system 
to function effectively, there must be incentives for parties to do the 
right thing, adequate transparency to provide reasonable assurance that 
people will do the right thing, and appropriate accountability when 
people do not do the right thing.

This report makes no recommendations. We provided copies of a draft of 
this report to the SEC, AICPA, and PCAOB for their review. 
Representatives of the AICPA and the PCAOB provided technical comments, 
which we have incorporated where applicable. Representatives of the SEC 
had no comments.

Background:

Under federal securities laws, public companies are responsible for the 
preparation and content of financial statements that are complete, 
accurate, and presented in conformity with generally accepted 
accounting principles (GAAP). Financial statements, which disclose a 
company's financial position, stockholders' equity, results of 
operations, and cash flows, are an essential component of the 
disclosure system on which the U.S. capital and credit markets are 
based.

The Securities Exchange Act of 1934 requires that a public company's 
financial statements be audited by an independent public accountant. 
That statutory independent audit requirement in effect granted a 
franchise to the nation's public accountants, as an audit opinion on a 
public company's financial statements must be secured before an issuer 
of securities can go to market, have the securities listed on the 
nation's stock exchanges, or comply with the reporting requirements of 
the securities laws. As of February 2003, there were about 17,988 
public companies that were registered with the SEC and subject to the 
federal securities laws (15,847 domestic and 2,141 foreign public 
companies). Based on 2001 annual reports of public accounting firms 
submitted to the AICPA, about 700 public accounting firms that were 
members of the AICPA's former self-regulatory program for audit quality 
reported having approximately 15,000 public company clients registered 
with the SEC, of which the Big 4 public accounting firms[Footnote 12] 
had about 70 percent of these public company clients and another 88 
public accounting firms had about 20 percent of these public company 
clients. The other approximately 600 public accounting firms had the 
remaining 10 percent of the reported public company clients.

The independent public accountant's audit is critical in the financial 
reporting process because the audit subjects financial statements, 
which are management's responsibility, to scrutiny on behalf of 
shareholders and creditors to whom management is accountable. The 
auditor is the independent link between management and those who rely 
on the financial statements.

Ensuring auditor independence--both in fact and appearance--is a long-
standing issue. There has long been an arguably inherent conflict in 
the fact that an auditor is paid by the public company for which the 
audit was being performed. Various study groups over the past 20 years 
have considered the independence and objectivity of auditors as 
questions have arisen from (1) significant litigation involving 
auditors, (2) the auditor's performance of nonaudit services for audit 
clients, which prior to the Sarbanes-Oxley Act, had risen to 50 percent 
of total revenues on average for the large accounting firms,[Footnote 
13] (3) "opinion shopping" by clients, and (4) reports of public 
accountants advocating questionable client positions on accounting 
matters.

The major accountability breakdowns at Enron and WorldCom, and other 
failures in recent years such as Qwest, Tyco, Adelphia, Global 
Crossing, Waste Management, Micro Strategy, Superior Federal Savings 
Bank, and Xerox, led to the reforms contained in the Sarbanes-Oxley Act 
to enhance auditor independence and audit quality and to restore 
investor confidence in the nation's capital markets. To enhance auditor 
independence and audit quality, the act's reforms included:

* establishing the PCAOB, as an independent nongovernmental entity, to 
oversee the audit of public companies that are subject to the 
securities laws;

* making the PCAOB responsible for (1) establishing auditing and 
related attestation, quality control, ethics, and independence 
standards applicable to audits of public companies, (2) conducting 
inspections, investigations, and disciplinary proceedings of public 
accounting firms registered with the PCAOB, and (3) imposing 
appropriate sanctions;

* making the public company's audit committee responsible for the 
appointment, compensation, and oversight of the registered public 
accounting firm;

* requiring management and auditors' reports on internal control over 
financial reporting;

* prohibiting the registered public accounting firm from providing 
certain nonaudit services to a public company if the auditor is also 
providing audit services;

* requiring the audit committee to preapprove all audit and nonaudit 
services not otherwise prohibited;

* requiring mandatory rotation of lead and reviewing audit partners 
after they have provided audit services to a particular public company 
for 5 consecutive years; and:

* prohibiting the public accounting firm from providing audit services 
if the public company's chief financial officer, chief accounting 
officer, or any person serving in an equivalent position was employed 
by the firm and participated in the audit of the public company during 
the 1-year period preceding the date of starting the audit.

Mandatory audit firm rotation was also discussed in congressional 
hearings to enhance auditor independence and audit quality, but given 
the mixed views of various stakeholders, the Congress decided the 
effects of such a practice needed further study.

Pros and Cons of Requiring Mandatory Audit Firm Rotation:

Our review of research studies, technical articles, and other 
publications and documents showed that generally the arguments for and 
against mandatory audit firm rotation concern auditor independence, 
audit quality,[Footnote 14] and increased audit costs. A breakdown in 
auditor independence or audit quality can result in an audit failure 
and adversely affect those parties who rely on the fair presentation of 
the financial statements in conformity with GAAP.

Those who support mandatory audit firm rotation contend that pressures 
faced by the incumbent auditor to retain the audit client coupled with 
the auditor's comfort level with management developed over time can 
adversely affect the auditor's actions to appropriately deal with 
financial reporting issues that materially affect the company's 
financial statements. Those who oppose audit firm rotation contend that 
the new auditor's lack of knowledge of the company's operations, 
information systems that support the financial statements, and 
financial reporting practices and the time needed to acquire that 
knowledge increase the risk of an auditor not detecting financial 
reporting issues that could materially affect the company's financial 
statements in the initial years of the new auditor's tenure, resulting 
in financial statements that do not comply with GAAP.

In addition, those who oppose mandatory audit firm rotation believe 
that it will increase costs incurred by both the public accounting 
firms and the public companies. They believe the increased risk of an 
audit failure and the added costs of audit firm rotation outweigh the 
value of a periodic "fresh look" by a new public accounting firm. 
Conversely, those who support audit firm rotation believe the value of 
the "fresh look" to protect shareholders, creditors, and other parties 
who rely on the financial statements outweigh the added costs 
associated with mandatory firm rotation.

More recently, the Sarbanes-Oxley Act's requirements that concern 
auditor independence and audit quality have added to the mixed views 
about whether mandatory audit firm rotation should also be required to 
enhance auditor independence and audit quality.

Results of Our Surveys:

The results of our surveys show that while auditor tenure at Fortune 
1000 public companies averages 22 years, about 79 percent of Tier 
1[Footnote 15] firms and Fortune 1000 public companies[Footnote 16] are 
concerned that changing public accounting firms increases the risk of 
an audit failure in the initial years of the audit as the new auditor 
acquires the knowledge of a public company's operations, systems, and 
financial reporting practices. Further, many Fortune 1000 public 
companies will only use Big 4 public accounting firms and believe that 
the limited choices, that are likely to be further reduced by the 
auditor independence requirements of the Sarbanes-Oxley Act, coupled 
with the likely increased costs of financial statement audits and 
increased risk of an audit failure under mandatory audit firm rotation 
strongly argue against the need for mandatory rotation.

In addition, most Tier 1 firms and Fortune 1000 public companies 
believe that the pressures faced by the incumbent auditor to retain the 
client are not a significant factor adversely affecting the auditor 
appropriately dealing with financial reporting issues that may 
materially affect a public company's financial statements. Most Tier 1 
firms, and nearly all Fortune 1000 public companies, and their audit 
committee chairs believe that the Sarbanes-Oxley Act's requirements 
concerning auditor independence and audit quality, when fully 
implemented, will sufficiently achieve the intended benefits of 
mandatory audit firm rotation, and therefore, they believe it would be 
premature to impose mandatory audit firm rotation at this time.

Finally, about 50 percent of Tier 1 firms and 62 percent of Fortune 
1000 public companies stated that mandatory audit firm rotation would 
have no effect on the perception of auditor independence held by the 
capital markets and institutional investors. However, 65 percent of 
Fortune 1000 public companies reported that individual investors' 
perception of auditor independence would be increased, while the Tier 1 
firms had mixed views on the effect on individual investors' 
perceptions. At the same time, most Tier 1 firms reported that 
mandatory audit firm rotation may negatively affect audit assignment 
staffing, causing an increased risk of audit failures, and may create 
some confusion as currently a change in a public company's auditor of 
record sends a "red flag" signal as to why the change may have 
occurred. In contrast, most Fortune 1000 public companies did not 
believe scheduled changes in the auditor of record would result in a 
"red flag" signal.

Auditor of Record Tenure, Independence, and Audit Quality:

Currently, neither the SEC nor the PCAOB has set any regulatory limits 
on the length of time that a public accounting firm may function as the 
auditor of record for a public company. Based on the responses to our 
surveys, we estimate that about 99 percent of Fortune 1000 public 
companies and their audit committees currently do not have a public 
accounting firm rotation policy, although we estimate that about 4 
percent are considering such a policy. Unlimited tenure and related 
pressure on the public accounting firm and applicable partner 
responsible for providing audit services to the company to retain the 
client and the related continuing revenues are factors cited by those 
who support mandatory audit firm rotation. They believe that 
periodically having a new auditor will bring a "fresh look" to the 
public company's financial reporting and help the auditor appropriately 
deal with financial reporting issues since the auditor's tenure would 
be limited under mandatory audit firm rotation. Those who oppose 
mandatory audit firm rotation believe that changing auditors increases 
the risk of an audit failure during the initial years as the new 
auditor acquires the knowledge of the public company's operations, 
systems, and financial reporting practices.

The Conference Board's Commission on Public Trust and Private 
Enterprise[Footnote 17] in its January 9, 2003, report recommended that 
audit committees should consider rotating audit firms when there is a 
combination of circumstances that could call into question the audit 
firm's independence from management. The Commission believed that the 
existence of some or all of the following circumstances particularly 
merit consideration of rotation: (1) significant nonaudit services are 
provided by the auditor of record to the company--even if they have 
been approved by the audit committee, (2) one or more former partners 
or managers of the audit firm are employed by the company, or (3) the 
audit firm has been employed by the company for a substantial period of 
time, such as over 10 years.

To initially examine the issues surrounding the length of the auditors' 
tenure, we asked public companies and public accounting firms to 
provide information on the length of auditor tenure. According to our 
survey, Fortune 1000 public companies' average auditor tenure is 22 
years. Two contrasting factors greatly influence this 22-year average-
-the recent increased changes in auditors lowered the average and the 
long audit tenure period associated with approximately 10 percent of 
Fortune 1000 public companies raised the average. About 20 percent of 
the Fortune 1000 public companies had their current auditor of record 
for less than 3 years, a rate of change in auditors over the last 2 
years substantially greater than the nearly 3 percent annual change 
rate historically observed.[Footnote 18] This increased rate of auditor 
change was driven largely by the recent dissolution of Arthur Andersen 
LLP. More than 80 percent of Fortune 1000 public companies that changed 
auditors over the last 2 years did so to 
replace Andersen.[Footnote 19] Increasing the overall average audit 
tenure period for Fortune 1000 public companies were the approximately 
10 percent of public companies that had the same auditing firm for more 
than 50 years and have an average tenure period of more than 75 years. 
Excluding those Fortune 1000 public companies that have replaced 
Andersen in the last 2 years as well as those companies that had the 
same auditor of record for more than 50 years, the average for the 
remaining Fortune 1000 public companies is 19 years. See figure 1 for 
the Fortune 1000 public companies' estimated audit firm tenure.

Figure 1: Estimated Audit Firm Tenure for Fortune 1000 Public 
Companies:

[See PDF for image]

[End of figure]

An intended effect of mandatory audit firm rotation is to decrease the 
existing lengthy auditor tenure periods, thus lessening concerns about 
the firm's desire to retain a client adversely affecting auditor 
independence. About 97 percent of Fortune 1000 public companies 
expected that mandatory audit firm rotation would lower the number of 
consecutive years that a public accounting firm could serve as their 
auditor of record. The Fortune 1000 public companies were not given a 
possible limit on the number of years that a public accounting firm 
could serve as their auditor of record under mandatory audit firm 
rotation. Therefore, they reported their general belief that mandatory 
rotation would have the effect of decreasing auditor tenure based on 
their past experiences.

Impact of Auditor Knowledge and Experience on the Auditor's Detection 
of Misstatements:

Since the new auditor's knowledge and experience with auditing a public 
company after a change in auditors is a concern, we asked public 
accounting firms and public companies a number of questions about 
factors important to detecting material misstatements of financial 
statements. Tier 1 firms noted that a number of factors affect the 
auditor's ability to detect financial reporting issues that may 
indicate material misstatements in a public company's financial 
statements, including education, training, and experience; knowledge of 
GAAP and GAAS; experience with the company's industry; appropriate 
audit team staffing; effective risk assessment process for determining 
client acceptance; and knowledge of the client's operations, systems, 
and financial reporting practices.[Footnote 20] Although each of the 
above factors affects the quality of an audit, opponents of mandatory 
audit firm rotation focus on the increased risk of audit failure that 
may result from the new auditor's lack of specific knowledge of the 
client's operations, systems, and financial reporting practices. Based 
on the responses to our survey, we estimated that about 95 percent of 
Tier 1 firms would rate such specific knowledge as either of very great 
importance or great importance in the auditor's ability to detect 
financial reporting issues that may indicate material misstatements in 
a public company's financial statements.

GAAS require the auditor to obtain a sufficient knowledge of the 
client's operations, systems, and financial reporting practices to 
assess audit risk[Footnote 21] and to gather sufficient competent 
evidential matter. About 79 percent of Tier 1 firms and Fortune 1000 
public companies believed that the risk of an audit failure is higher 
in the early years of audit tenure as the new firm is more likely to 
not have fully developed and applied an in-depth understanding of the 
public company's operations and processes affecting financial 
reporting. More than 83 percent of Tier 1 firms and Fortune 1000 public 
companies that expressed a view stated that it generally takes 2 to 3 
years or more to become sufficiently familiar with the companies' 
operations and processes before the additional resources often needed 
to become knowledgeable are no longer needed. Tier 1 firms had mixed 
views about whether mandatory audit firm rotation (e.g., the "fresh 
look") would either increase, decrease or have no effect on the new 
auditor's likelihood of detecting financial reporting issues that may 
materially affect the financial statements that the previous auditor 
may not have detected. However, 50 percent of Fortune 1000 public 
companies reported that mandatory audit firm rotation would have no 
effect on the auditor's likelihood of detecting such financial 
reporting issues, while other Fortune 1000 public companies were 
generally split regarding whether mandatory audit firm rotation would 
either increase or decrease the auditor's likelihood of detecting such 
financial reporting issues.

As shown in figure 2, Tier 1 firms had mixed views of the value of 
additional audit procedures during the initial years of a new auditor's 
tenure, although 72 percent reported that additional audit procedures 
would be of at least some value in helping to reduce audit risk to an 
acceptable level.

Figure 2: Tier 1 Firms: Value of Additional Procedures When Firm Has 
Less Knowledge and Experience with a Client:

[See PDF for image]

[End of figure]

Most Fortune 1000 public companies believed such additional audit 
procedures would decrease audit risk, as shown in figure 3.

Figure 3: Fortune 1000 Public Companies' Belief That Additional or 
Enhanced Audit Procedures Would Affect the Risk of Not Detecting 
Material Misstatements:

[See PDF for image]

[End of figure]

The Tier 1 firms were also asked about the potential value of having 
enhanced access to key members of the previous audit team and its audit 
documentation to help reduce audit risk. The Tier 1 firms generally saw 
more potential value in having enhanced access to the previous audit 
team and its audit documentation than in performing additional audit 
procedures and verification of the public company's data during the 
initial years of the auditor's tenure. Nearly all of the Tier 1 firms 
believed that access to the previous audit team and its audit 
documentation could be accomplished under current GAAS.[Footnote 22]

Pressures Faced by Firms in Dealing with Financial Reporting Issues:

Proponents of mandatory audit firm rotation cite that pressures to 
retain the client can adversely affect the auditor's decision to 
appropriately deal with financial reporting issues when public company 
management is not supportive of the auditor's position on what is 
required by GAAP. They believe that mandatory audit firm rotation would 
serve as an incentive for the auditor to take the appropriate action 
since the auditor would know that tenure as auditor of record and the 
related revenues are for a limited term.[Footnote 23]

We asked public accounting firms and public companies based on their 
experiences whether the auditor's length of tenure is a factor in 
whether the auditor appropriately deals with material financial 
reporting issues and whether mandatory audit firm rotation would affect 
the pressures the firms face. About 69 percent of Tier 1 firms and 73 
percent of Fortune 1000 public companies do not believe that the risk 
of an audit failure increases due to the auditors' long-term 
relationship with the public companies' management under a long audit 
tenure and the auditors' desire to retain the clients. About 55 percent 
of the other Tier 1 firms[Footnote 24] and 65 percent of the other 
Fortune 1000 public companies[Footnote 25] were uncertain whether the 
risk of an audit failure would increase or decrease due to the 
auditors' long-term tenure.

About 71 percent of Tier 1 firms and 67 percent of Fortune 1000 public 
companies believe that pressure on the engagement partner to retain the 
client is currently small or not a factor in whether the auditor 
appropriately deals with financial reporting issues that may materially 
affect a public company's financial statements. However, 28 percent of 
Tier 1 firms and 33 percent of Fortune 1000 public companies believe 
such pressures are moderate or stronger. About 18 percent of Tier 1 
firms and Fortune 1000 public companies believed that under mandatory 
audit firm rotation, the pressures on the engagement partner would 
still be a moderate or stronger factor in retaining the audit client 
and in appropriately dealing with financial reporting issues. 
Therefore, based on these views, mandatory audit firm rotation would 
likely somewhat reduce the pressures on the engagement partner to 
retain the client. However, most Tier 1 firms and Fortune 1000 public 
companies generally considered these pressures to be small or not a 
factor in the auditor appropriately dealing with material financial 
reporting issues.

Tier 1 firms and Fortune 1000 public companies expressed similar views, 
that mandatory audit firm rotation would not significantly change the 
pressures on the engagement partner to retain the client as a factor in 
whether the engagement partner appropriately challenges overly 
aggressive/optimistic financial reporting[Footnote 26] by management.

As shown in figure 4, overall about 54 percent of Tier 1 firms and 71 
percent of Fortune 1000 public companies believe mandatory audit firm 
rotation overall would have no effect on the new auditor's potential 
for appropriately dealing with material financial reporting issues.

Figure 4: Views on How Mandatory Audit Firm Rotation Would Affect the 
Auditor's Potential to Deal with Material Financial Reporting Issues 
Appropriately:

[See PDF for image]

[End of figure]

The remaining Tier 1 firms are split between whether mandatory audit 
firm rotation would increase or decrease their potential to 
appropriately deal with material financial reporting issues. However, 
about 67 percent of the remaining Fortune 1000 public companies believe 
that mandatory audit firm rotation would increase the potential for the 
new auditor to deal appropriately with such financial reporting 
issues.[Footnote 27] In contrast, either with or without mandatory 
audit firm rotation, about 62 percent of Tier 1 firms and 63 percent of 
Fortune 1000 public companies believe the potential of a subsequent 
lawsuit, regulatory action, or both against the public accounting firm 
and its engagement partner is a moderate or stronger pressure for them 
to deal appropriately with financial reporting issues that may 
materially affect a public company's financial statements.

How Mandatory Audit Firm Rotation May Affect Perception of Auditors' 
Independence:

Researchers have also raised questions about how the capital markets' 
and investors' current perceptions of auditor independence and audit 
quality would be affected by mandatory audit firm rotation. Under 
mandatory audit firm rotation, about 52 percent of Tier 1 firms and 
about 62 percent of Fortune 1000 public companies believed that the 
current perception of auditor independence held by capital markets and 
institutional investors would not be affected by requiring mandatory 
audit firm rotation while 34 percent of Tier 1 firms and about 38 
percent of Fortune 1000 public companies believed the perception of 
auditor independence would increase. However, about 65 percent of 
Fortune 1000 public companies believed that perception of auditors' 
independence held by individual investors would more likely increase 
under mandatory audit firm rotation while the Tier 1 firms had mixed 
views on the effect on individual investors. See the Overall Views of 
Other Knowledgeable Individuals on Mandatory Audit Firm Rotation 
section of the report for the results of our discussions with other 
knowledgeable individuals, including institutional investors, for 
their views on how mandatory audit firm rotation may affect their 
perception of auditor independence.

How Mandatory Audit Firm Rotation May Affect Audit Assignment Staffing:

Our research into the effects of mandatory audit firm rotation 
identified concerns about whether public accounting firms would move 
their most knowledgeable and experienced audit personnel from the 
current audit to other audits as the end of their tenure as auditor of 
record approached in order to attract or retain other clients. In 
response to our survey questions about whether mandatory audit firm 
rotation would affect assignment of audit staff, about 59 percent of 
Tier 1 firms indicated that they would likely move their most 
knowledgeable and experienced audit staff to other work to enhance the 
firm's ability to attract or retain other clients and another 28 
percent were undecided. Only about 13 percent of Tier 1 firms stated it 
was unlikely that an accounting firm would move staff to other work. Of 
the Tier 1 firms that stated they would likely move their most 
knowledgeable and experienced staff, 86 percent[Footnote 28] believe 
that moving these staff would increase the risk of an audit failure. 
About 92 percent of Fortune 1000 public companies also believed that by 
moving these audit staff, the risk of an audit failure would be 
increased.

How Mandatory Audit Firm Rotation May Affect Public Accounting Firms' 
Investment in Audit Tools:

Opponents of mandatory audit firm rotation expressed concern that 
limited audit tenure under mandatory rotation could cause public 
accounting firms to not invest in audit tools related to the 
effectiveness of auditing a specific client or industry. About 76 
percent of Tier 1 firms stated that their average audit tenure would 
likely decrease under mandatory audit firm rotation, and about 97 
percent of Fortune 1000 public companies expected the length of their 
auditors' tenure would decrease compared to their previous experience 
with changing auditors. In response to our survey questions about this 
possibility, about 64 percent of these Tier 1 firms said mandatory 
audit firm rotation would not likely decrease incentives to invest the 
resources needed to understand the client's operations and financial 
reporting practices in order to devise effective audit procedures and 
tools, while 36 percent said it would. Conversely, about 67 percent of 
Fortune 1000 public companies were concerned that mandatory audit firm 
rotation could negatively affect incentives for public accounting firms 
to invest in effective audit procedures and tools.

How Mandatory Audit Firm Rotation May Affect the Current "Red Flag" 
Signal to Investors When a Change in a Public Company's Auditor of 
Record Occurs:

Currently, when a change in the auditor of record occurs it acts as a 
"red flag" signal to investors to question why the change occurred and 
if the change may have occurred because of reasons related to the 
presentation of the public company's financial statements, such as 
differences in views of public company management and the auditor of 
record regarding financial reporting issues. Researchers have raised 
concerns that the "red flag" signal may be eliminated by mandatory 
audit firm rotation, as investors may not be able to distinguish a 
scheduled change from a nonscheduled change in a public company's 
auditor of record.

Regarding the "red flag" signal, most Tier 1 firms believed that 
mandatory audit firm rotation would not change the current reaction by 
investors to a change in the auditor of record, and therefore a "red 
flag" signal is likely to be perceived by investors for both scheduled 
and unscheduled changes in the public company's auditor of record. 
Several Tier 1 firms commented that users of financial statements would 
not be able to readily track scheduled rotations and therefore would be 
confused whether the change in auditors was scheduled or unscheduled. 
In contrast, most Fortune 1000 public companies believed that scheduled 
auditor changes under mandatory audit firm rotation would likely not 
produce a "red flag" signal and that the "red flag" signal for 
unscheduled changes in the auditor of record would be retained. Fortune 
1000 public companies did not provide any comments to further explain 
their beliefs. However, currently, public companies are required by SEC 
regulations to report changes in their auditor of record to the SEC. 
Therefore, public companies could use this reporting requirement to 
disclose whether the change in auditor of record under mandatory audit 
firm rotation was scheduled or unscheduled.

Potential Impact on Audit-Related Costs and Fees:

Opponents of mandatory audit firm rotation believe that the more 
frequent change in auditors likely to occur under mandatory audit firm 
rotation will result in the public accounting firms and ultimately 
public companies incurring increased costs for audits of financial 
statements. These costs include:

* marketing costs (the costs incurred by public accounting firms 
related to their efforts to acquire or retain financial statement audit 
clients),

* audit costs (the costs incurred by a public accounting firm to 
perform an audit of a public company's financial statements),

* audit fee (the amount a public accounting firm charges the public 
company to perform the financial statement audit),

* selection costs (the internal costs incurred by a public company in 
selecting a new public accounting firm as the public company's auditor 
of record), and:

* support costs (the internal costs incurred by a public company in 
supporting the public accounting firm's efforts to understand the 
public company's operations, systems, and financial reporting 
practices).

About 96 percent of Tier 1 firms stated that their initial year audit 
costs are likely to be more than in subsequent years in order to 
acquire the necessary knowledge during a first year audit of a public 
company's operations, systems, and financial reporting practices. 
Nearly all of these Tier 1 firms estimated initial year audit costs 
would be more than 20 percent higher than subsequent years' 
costs.[Footnote 29] Similar responses were received from Fortune 1000 
public companies. (See fig. 5.):

Figure 5: Expected Increase in Initial Year Audit Costs over Subsequent 
Year Audit Costs:

[See PDF for image]

[End of figure]

About 85 percent of Tier 1 firms stated that currently they are more 
likely to absorb their higher initial year audit costs than to pass 
them on to the public companies in the form of higher audit fees 
because of the firms' interest in retaining the audit client. However, 
about 87 percent said such costs would likely be passed on to the 
public companies during the more limited audit firm tenure period under 
mandatory rotation. Similarly, about 77 percent of Fortune 1000 public 
companies stated that currently when a change in the companies' auditor 
of record occurs, the additional initial year audit costs are likely to 
be absorbed by the public accounting firms. However, about 97 percent 
of the Fortune 1000 public companies expected the higher initial year 
audit costs would be passed on to them under mandatory audit firm 
rotation.

Comments received from a number of the Tier 1 firms indicated that 
currently initial years' audit costs are recovered from the public 
companies over the firms' tenure as auditor of record. However, the 
firms under mandatory audit firm rotation expected not to be able to 
recover the costs within a more limited tenure as auditor of record. 
Therefore, they would pass the costs on to the public companies through 
higher audit fees. Similarly, about 89 percent of Fortune 1000 public 
companies believed that mandatory audit firm rotation would lead to 
higher audit fees over time.[Footnote 30]

With the likely more frequent opportunities to compete for providing 
audit services to public companies under mandatory audit firm rotation, 
about 79 percent of Tier 1 firms expect to incur increased marketing 
costs associated with their efforts to acquire audit clients, and about 
79 percent of the Tier 1 firms expect to pass these costs on to the 
public companies through higher audit fees.

As shown in figure 6, most of the Tier 1 firms expecting higher 
marketing costs estimated that the cost would add at least more than 1 
percent to their initial year audit fees, and about 37 percent of these 
Tier 1 firms[Footnote 31] believed their additional marketing costs 
would be more than 10 percent of their initial year audit fees.

Figure 6: Tier 1 Firms Expecting Additional Expected Marketing Costs 
under Mandatory Audit Firm Rotation Compared to Initial Year Audit 
Fees:

[See PDF for image]

[End of figure]

A number of Tier 1 firms commented that they would have to spend more 
time marketing auditing services, including writing new proposals to 
compete for audit services. About 85 percent of Fortune 1000 public 
companies expected that public accounting firms would likely incur 
additional marketing costs under mandatory audit firm rotation, and 
about 92 percent of these Fortune 1000 public companies believed the 
costs would be passed on to them.

In addition to higher audit fees, nearly all Fortune 1000 public 
companies believed they would incur selection costs in hiring a new 
auditor of record under mandatory audit firm rotation. As shown in 
figure 7, most of those Fortune 1000 public companies expected the 
selection costs to be at least 6 percent or higher as a percentage of 
initial year audit fees.

Figure 7: Fortune 1000 Public Companies' Expected Selection Costs as a 
Percentage of Initial Year Audit Fees:

[See PDF for image]

[End of figure]

In addition, nearly all Fortune 1000 public companies expected to incur 
some additional initial year auditor support costs under mandatory 
audit firm rotation. As shown in figure 8, nearly all of those Fortune 
1000 public companies believed their additional support costs would be 
11 percent or higher as a percentage of initial year audit fees.

Figure 8: Fortune 1000 Public Companies' Expected Support Costs as a 
Percentage of Initial Year Audit Fees:

[See PDF for image]

[End of figure]

Tier 1 firms' views on the likelihood of public companies incurring 
selection costs and additional auditor support costs were similar to 
the views of Fortune 1000 public companies.

To provide some perspective on the possible impact of higher audit-
related costs (audit fees, company selection, and support cost) on 
public company operating costs, we analyzed financial reports filed 
with the SEC for a selection of large and small public companies for 
the most recent fiscal year available--one of each from 23 broad 
industry sectors, such as agriculture, manufacturing, and information 
services. Where available, for each industry sector, we selected a 
public company with annual revenues of more than $5 billion and a 
public company with annual revenues of less than $1 billion. The audit 
fees reported by the larger public companies we selected ranged from 
.007 percent to .11 percent of total operating costs 
and averaged .04 percent. The audit fees reported by the smaller public 
companies we selected ranged from 0.017 percent to 3.0 percent and 
averaged 0.08 percent.[Footnote 32]

Utilizing the predominant responses[Footnote 33] from Tier 1 firms, we 
estimate the additional first year audit costs following a change in 
auditor to likely range from 21 percent to 39 percent more than annual 
costs of recurring audits of the same client. In addition, we estimate 
the additional firm marketing costs under mandatory audit firm rotation 
to likely range from 6 percent to 11 percent of the firm's initial year 
audit fees. Based on the predominant responses from Fortune 1000 public 
companies, we also estimate the additional public company selection 
costs to range from 1 percent to 14 percent of the new auditor's 
initial year audit fees and possible additional public company support 
costs to range from 11 percent to 39 percent of the new auditor's 
initial year audit fees. Utilizing these ranges, we estimate that 
following a change in auditor under mandatory audit firm rotation, the 
possible additional first year audit-related costs could range from 43 
percent to 128 percent higher than the likely recurring audit costs had 
there been no change in auditor. We also calculated a weighted average 
percentage for each additional cost category using all responses from 
Tier 1 firms and Fortune 1000 public companies (as opposed to the 
predominant responses only). Using the resulting weighted averages for 
all responses, we calculated the potential additional first year audit-
related costs to be 102 percent higher than the likely recurring audit 
costs had there been no change in auditor. This illustration is 
intended only to provide insights into how Tier 1 firms and Fortune 
1000 public companies reported that mandatory audit firm rotation could 
affect the initial year audit costs and is not intended to be 
representative.

Competition-Related Issues:

Although mandatory audit firm rotation is generally considered by its 
proponents as a means of enhancing auditor independence and audit 
quality, mandatory rotation may also provide increased opportunities 
for some public accounting firms to compete to provide audit services 
to public companies. About 52 percent of Tier 1 firms believed that 
mandatory audit firm rotation would increase the opportunity to compete 
for public company audits and 30 percent were uncertain whether 
opportunities to compete to provide audit services would increase or 
decrease.

However, when asked how mandatory audit firm rotation would likely 
affect the number of firms actually willing and able to compete for 
public company audits, about 54 percent of Tier 1 firms said mandatory 
rotation would likely decrease the number of firms competing for audits 
of public companies, 14 percent expected an increase in the number of 
firms, and 22 percent expected no effect on the number of firms 
competing.

Although nearly all Tier 1 firms planned to register with the PCAOB to 
provide audit services to public companies,[Footnote 34] about 24 
percent of Tier 1 firms that currently provide audit services were 
uncertain whether they would continue to provide audit services to 
public companies if mandatory audit firm rotation were 
required.[Footnote 35] Firms in Tier 2 that responded to our survey 
showed more uncertainty regarding whether to register with the PCAOB, 
with about two-thirds planning to continue to provide audit services to 
public companies and most of the remaining respondents uncertain if 
they would continue to provide audit services to public 
companies.[Footnote 36] However, if mandatory audit firm rotation were 
required, 55 percent of the Tier 2 firms that responded to our survey 
that currently provide audit services to public companies were 
uncertain whether they would continue to provide the audit services to 
public companies, and another 12 percent said they would discontinue 
providing audit services to public companies.[Footnote 37]

The view of many Tier 1 firms that mandatory audit firm rotation may 
lead to fewer firms willing and able to compete for public company 
audits, which would lead to higher audit fees, should also be 
considered along with the results of our study of consolidation of the 
Big 8 firms into the current Big 4 firms.[Footnote 38] In that respect, 
we previously reported that the Big 4 audit over 78 percent of all U.S. 
public companies and 99 percent of public company annual sales. 
However, we found no empirical evidence of impaired competition. 
Further, we previously reported that smaller public accounting firms 
were unable to successfully compete for the audits of large national 
and multinational public companies because of factors such as lack of 
capacity and capital limitations.[Footnote 39]

About 83 percent of Tier 1 firms and 66 percent of Fortune 1000 public 
companies stated that under mandatory audit firm rotation, the market 
share of public company audits would either become more concentrated in 
a small number of larger public accounting firms or the already highly 
concentrated market share would remain about the same. About 44 percent 
of Tier 1 firms believed that incentives to create or maintain large 
firms would be increased while 32 percent believed mandatory audit firm 
rotation would have no effect on incentives to create or maintain large 
firms.

About 52 percent of Fortune 1000 public companies were at least 
somewhat concerned that the dissolution of Arthur Andersen LLP, 
resulting now in the Big 4 public accounting firms, would significantly 
limit the options their companies have in selecting a capable auditor 
of record. Under mandatory audit firm rotation, the number of Fortune 
1000 public companies expressing such concern increased to 79 percent.

About 48 percent of Tier 1 firms believed mandatory audit firm rotation 
would decrease the number of firms willing and able to compete for 
audits of public companies in specialized industries, while 29 percent 
of Tier 1 firms believed mandatory audit firm rotation would have no 
effect. As noted in our July 2003 report, we found that in certain 
specialized industries, the number of firms with expertise in auditing 
those industries can limit the number of choices such public companies 
have to two public accounting firms. Contributing to this situation is 
that many public companies will use only Big 4 firms for audit 
services. Also, public companies may have fewer choices in the future 
as auditor independence rules under the Sarbanes-Oxley Act prohibiting 
the auditor of record from also providing certain nonaudit services 
could further reduce the number of eligible auditors. In that respect, 
mandatory audit firm rotation would further affect the number of 
eligible auditors. For example, if a public company in a specialized 
industry has only three or four choices for its auditor of record, the 
current auditor of record is not eligible to repeat as auditor of 
record under mandatory audit firm rotation, and another firm is not 
eligible because it provided prohibited nonaudit services that affect 
auditor independence to the public company, then the number of eligible 
firms would be reduced to one or two firms.

About 35 percent of Fortune 1000 public companies were at least 
somewhat concerned that the Sarbanes-Oxley Act auditor independence 
requirements would significantly limit their options in selecting a 
capable auditor of record. However, 53 percent of Fortune 1000 public 
companies expressed such concern if mandatory audit firm rotation were 
required.

The Sarbanes-Oxley Act requires the audit committee to hire, 
compensate, and oversee the public accounting firm serving as auditor 
of record for the public company. About 92 percent of the Fortune 1000 
audit committee chairs stated that their public companies currently use 
Big 4 firms as auditor of record, and 94 percent of those that do 
stated that they would not realistically consider using non-Big 4 firms 
as the public companies' auditor of record. Table 1 provides reasons 
given by the audit committee chairs for only using Big 4 firms and the 
importance of those reasons to them.

Table 1: Audit Committee Chairs' Reasons for Limiting Consideration to 
Only Big 4 Firms:

Numbers in percentages.

Expectations of the capital markets; Very great importance: 48; Great 
importance: 34; Moderate: importance: 14; Some importance: 1; Little or 
no importance: 3; Don't know: 0.

Public company geographic/global operations; Very great importance: 53; 
Great importance: 27; Moderate: importance: 10; Some importance: 4; 
Little or no importance: 6; Don't know: 0.

Public company operations require specialized industry skills/
knowledge; Very great importance: 39; Great importance: 36; Moderate: 
importance: 18; Some importance: 6; Little or no importance: 1; Don't 
know: 0.

Public company contractual obligations (e.g. with banks or lenders); 
Very great importance: 15; Great importance: 28; Moderate: importance: 
25; Some importance: 5; Little or no importance: 20; Don't know: 7.

Requirement of the public company's board of directors; Very great 
importance: 23; Great importance: 35; Moderate: importance: 19; Some 
importance: 7; Little or no importance: 13; Don't know: 3.

Sufficiency of audit firm resources; Very great importance: 68; Great 
importance: 26; Moderate: importance: 4; Some importance: 2; Little or 
no importance: 0; Don't know: 0.

Audit firm's name and reputation; Very great importance: 35; Great 
importance: 41; Moderate: importance: 18; Some importance: 4; Little or 
no importance: 2; Don't know: 0.

Source: GAO analysis of survey data.

[End of table]

Although the Sarbanes-Oxley Act now makes the audit committee 
responsible for hiring the public company's auditor of record, 96 
percent of Fortune 1000 public companies currently using Big 4 firms 
also stated that they would not realistically consider using non-Big 4 
firms as the companies' auditor of record. They generally gave the same 
reasons as the audit committee chairs.

Overall Views on Mandatory Audit Firm Rotation:

In our surveys, we asked public accounting firms, public companies, and 
their audit committee chairs to provide their overall views on the 
potential costs and benefits that may result under mandatory audit firm 
rotation. About 85 percent of Tier 1 firms, 92 percent of Fortune 1000 
public companies, and 89 percent of Fortune 1000 audit committee chairs 
believed that costs are likely to exceed benefits.

Our surveys also requested views whether the Sarbanes-Oxley Act auditor 
independence and related audit quality requirements could also achieve 
the intended benefits of mandatory audit firm rotation. The act, as 
implemented by SEC rules, requires the mandatory rotation of both lead 
and reviewing audit engagement partners after 5 years and after 7 years 
for other partners with significant involvement in the audit 
engagement. Other related provisions of the act concerning auditor 
independence and audit quality include prohibiting the auditor of 
record from also providing certain nonaudit services, requiring audit 
committee preapproval of audit and nonaudit services not otherwise 
prohibited and related public disclosures, establishing certain auditor 
reporting requirements to the audit committee, requiring time 
restrictions before certain auditors could be hired by the client as 
employees, expanding audit committee responsibilities, and 
establishing the PCAOB as an independent nongovernmental entity 
overseeing registered public accounting firms in the audit of public 
companies.

About 66 percent of Tier 1 firms believe the audit partner rotation 
requirements sufficiently achieve the intended benefits of a "fresh 
look" of mandatory audit firm rotation. Another 27 percent of the Tier 
1 firms believe that the audit partner rotation requirements may not be 
as effective as mandatory audit firm rotation in achieving the intended 
benefits of a "fresh look," but is a better choice given the higher 
cost of mandatory audit firm rotation. Fortune 1000 public companies 
and audit committee chairs responding to our survey expressed similar 
views.

We asked those Tier 1 firms and Fortune 1000 public companies and their 
audit committee chairs who did not believe that the partner rotation 
requirement by itself sufficiently achieved the intended benefits of 
mandatory audit firm rotation to consider the auditor independence, 
audit quality, and partner rotation requirements of the Sarbanes-Oxley 
Act as implemented by SEC rules and their views on whether these 
requirements in total would likely achieve the intended benefits of 
mandatory audit firm rotation when fully implemented. About 25 
percent[Footnote 40] of these Tier 1 firms believed these requirements 
of the Sarbanes-Oxley Act, when fully implemented, would sufficiently 
achieve the intended benefits of mandatory audit firm rotation, while 
63 percent[Footnote 41] believed these requirements would only somewhat 
or minimally achieve the intended benefits of mandatory audit firm 
rotation when fully implemented. Conversely, 76 percent[Footnote 42] of 
Fortune 1000 public companies and 72 percent[Footnote 43] of their 
audit committee chairs believed these requirements would sufficiently 
achieve the intended benefits of mandatory audit firm rotation. 
Combining the responses to the above two questions for those who 
believed either the partner rotation requirements or the partner 
rotation requirements coupled with the other Sarbanes-Oxley Act auditor 
independence and audit quality requirements would sufficiently achieve 
the benefits of mandatory audit firm rotation shows that about 75 
percent of the Tier 1 firms, 95 percent of Fortune 1000 public 
companies, and about 92 percent of the audit committee chairs believe 
these requirements, when fully implemented, would sufficiently achieve 
the benefits of mandatory audit firm rotation.

Most Tier 1 firms and Fortune 1000 public companies and their audit 
committee chairs believe the Sarbanes-Oxley Act auditor independence 
and audit quality requirements, when fully implemented, would 
sufficiently achieve the benefits of mandatory audit firm rotation, and 
most of these groups when asked their overall opinion on mandatory 
audit firm rotation did not support mandatory rotation.[Footnote 44] A 
minority within these groups supports the concept of mandatory audit 
firm rotation, but believes more time is needed to evaluate the 
effectiveness of the various Sarbanes-Oxley Act requirements for 
enhancing auditor independence and audit quality. (See fig. 9.):

Figure 9: Support for Mandatory Audit Firm Rotation:

[See PDF for image]

[End of figure]

Overall Views of Other Knowledgeable Individuals on Mandatory Audit 
Firm Rotation:

As part of our review, we spoke to a number of knowledgeable 
individuals to obtain their views on mandatory audit firm rotation to 
provide additional perspective on issues addressed in the survey. These 
individuals had experience in a variety of fields, such as 
institutional investment; regulation of the stock markets, the banking 
industry, and the accounting profession; and consumer advocacy. 
Generally, the views expressed by these knowledgeable individuals were 
consistent with the overall views expressed by survey 
respondents.[Footnote 45] Most did not favor implementing a requirement 
for mandatory audit firm rotation at this time because they believe the 
costs of implementing such a requirement outweigh the benefits and 
greater experience with implementing the requirements of the Sarbanes-
Oxley Act should be gained prior to adding new requirements.

Many individuals acknowledged that conceptually, audit firm rotation 
could provide certain benefits in the areas of auditor independence and 
audit quality. For example, audit firm rotation may increase the 
perception of auditor independence because long-term relationships 
between the auditor of record and the client that could undermine 
independence would not likely develop under the limited term as auditor 
of record. Some individuals also believe that under mandatory audit 
firm rotation, the auditor might be less likely to succumb to 
management pressure to accept questionable accounting practices because 
the incentive to keep the client is gone and another audit firm would 
be looking at the firm's work in the future. Some also believed that 
audit quality may also be increased through a change in auditors 
because a new auditor of record would provide a "fresh look" at an 
entity's financial reporting practices and accounting policies. In 
addition, some individuals noted that mandatory audit firm rotation 
might cause a company to reexamine its audit needs and seek more 
knowledgeable and experienced audit firm personnel when negotiating for 
a new auditor of record.

The individuals we spoke to, however, acknowledged a number of 
practical concerns related to mandatory audit firm rotation, one of the 
most important being the limited number of audit firms available from 
which to choose. For example, some companies, especially those with 
geographically diverse operations or those operating in certain 
industries, may be somewhat limited in the choice of auditing firms 
capable of performing the audit. Not all audit firms have offices or 
staff located in all the geographic areas, whether domestically or 
internationally, where the clients conduct their operations, nor do all 
audit firms have personnel with certain industry knowledge to be able 
to perform audits of clients that operate in specific environments.

Similar to the views of Fortune 1000 public companies and audit 
committee chairs, individuals we spoke to noted that large companies 
are often limited to choices among the Big 4 firms. In some cases, the 
choices are further restricted because the accounting profession has 
become segmented by industry, and a lack of industry-specific knowledge 
may preclude some firms from performing the audits. For a company that 
is limited to use of Big 4 firms, it was viewed that selection may also 
be restricted because an audit firm providing certain nonaudit services 
or serving as a company's internal auditor is prohibited by 
independence rules from also serving as that company's auditor of 
record. In some cases, a company may also be limited in its choice of 
firms if an audit firm audits one of the company's major competitors 
and the public company decides not to use that firm as its auditor of 
record.

With regard to the use of a Big 4 firm, some individuals believe that 
although a new auditor provides a "fresh look" at an audit engagement, 
the Big 4 audit firms have somewhat similar cultures and methodologies 
for performing audits, and as a result, the benefit of a "fresh look" 
is more limited today than it was in the past when the firms had 
different cultures and employed a greater variety of methodologies.

Many individuals we spoke with also noted that when a change in auditor 
of record occurs, a learning curve, which can last a year or more, 
exists while the new auditor becomes familiar with the client's 
operations, thus increasing the audit risk associated with the 
engagement. Although a new auditor provides a "fresh look" for the 
audit, concern was raised that a new auditor may challenge the previous 
auditor's judgments in an overly aggressive manner because the new 
auditor is not familiar with the client's operations or accounting 
policies, and this poses a problem for the public company because the 
previous auditor is not present to explain the rationale for those 
judgments. It was viewed that in some cases, these are matters of 
professional judgment rather than actual errors and that such a 
situation could result in increased tension between the client and new 
auditor of record.

Some individuals we spoke with expressed concern that if mandatory 
audit firm rotation were implemented, the audit firm may rotate its 
most qualified staff off the engagement during the later years of audit 
tenure because the audit firm might focus its resources on obtaining or 
providing services to new clients. These individuals believe that such 
a practice would increase audit risk, as did most Tier 1 firms and 
Fortune 1000 public companies. Some individuals also expressed concern 
that toward the end of audit tenure, an audit firm might shift its 
attention to marketing nonaudit services the firm could provide when it 
was no longer the auditor of record, which may be counter to the 
intended benefits of mandatory audit firm rotation.

Individuals we spoke with also noted other implementation issues with 
mandatory audit firm rotation. For example, they viewed mandatory audit 
firm rotation as increasing costs to a company, not only in terms of 
higher audit fees but also in additional selection and support costs. 
In particular, many individuals we spoke with, as did most Tier 1 firms 
and Fortune 1000 public companies, believed that when a company rotates 
auditors, a certain amount of disruption occurs and the company spends 
a significant amount of resources--both financial and human--educating 
the new auditor about company operations and accounting matters. 
Individuals we spoke with expressed concern not only that these 
additional audit, selection, and support costs are ultimately passed on 
to shareholders but also that audit committees may lose control of 
selecting the best auditors to provide the best quality to shareholders 
since the incumbent firm would not be eligible to compete to provide 
audit services for some period of time.

Some individuals we spoke with noted that they have already observed a 
heightened sense of corporate responsibility and better corporate 
governance as a result of a change in behavior brought about by the 
large corporate failures in recent years. Overall, the majority of 
knowledgeable individuals we spoke with believe that a requirement for 
mandatory audit firm rotation should not be implemented at this 
time.[Footnote 46] However, some individuals suggested that regulators 
could require a change in the auditor of record as an enforcement 
action if conditions warrant such a measure. Most individuals we spoke 
with believe that the cost of requiring mandatory audit firm rotation 
would exceed the benefits because of the various practical concerns 
noted. Rather, these individuals believe that greater experience with 
the existing provisions of the Sarbanes-Oxley Act should be gained and 
the results assessed before the need for the mandatory audit firm 
rotation is considered. Many individuals we spoke with believe that 
individual Sarbanes-Oxley Act provisions, such as audit firm partner 
rotation and the increased responsibilities of the audit committee, are 
not a substitute for mandatory audit firm rotation, but taken 
collectively, they could accomplish many of the same intended benefits 
of mandatory audit firm rotation to improve auditor independence and 
audit quality. For example, some individuals believe that the existing 
Sarbanes-Oxley Act provisions related to audit committees have already 
resulted in more time spent on audit committee activities and greater 
contact and frequency of meetings with auditors. These individuals 
commented that audit committees now ask more questions of auditors 
because of a 
heightened sense of accountability for the performance, accuracy, 
reliability, and integrity of everything the independent auditors are 
doing.

Survey Groups Views on Implementing Mandatory Audit Firm Rotation if 
Required and Other Alternatives for Enhancing Audit Quality:

If mandatory audit firm rotation were required a number of implementing 
factors affecting the structure of the requirement would need to be 
decided by policy makers (e.g., the Congress and regulators). The 
following provides the views of Tier 1 firms, Fortune 1000 public 
companies, and their audit committee chairs on certain implementing 
factors, regardless of whether they supported mandatory audit firm 
rotation.

* Most believed that the auditor of record's tenure should be limited 
to either 5 to 7 years or 8 to 10 years.

* Nearly all believed that when the incumbent auditor of record is 
replaced, the public accounting firm should not be permitted to compete 
for audit services for either 3 or 4 years or 5 to 7 years.

* Nearly all believed that the audit committee should be permitted to 
terminate the business relationship with the auditor of record at any 
time if it is dissatisfied with the firm's performance. Likewise, most 
believed that the public accounting firm should be able to terminate 
its relationship with the audit committee/public company at any time if 
it is dissatisfied with the working relationship.

* Nearly all believed that implementation of mandatory audit firm 
rotation should be staggered on a reasonable basis to avoid a 
significant number of public companies changing auditors 
simultaneously.

* Most Tier 1 firms believed that mandatory audit firm rotation should 
not be applied uniformly to all public companies regardless of their 
nature or size. In contrast, most Fortune 1000 public companies and 
their audit committee chairs believed mandatory audit firm rotation 
should be applied to all public companies regardless of nature or size. 
However, most other domestic and mutual fund companies that responded 
to our survey believed mandatory audit firm rotation should not be 
applied uniformly, and their audit committee chairs who responded to 
our survey were split on the subject.

* The Tier 1 firms and Fortune 1000 audit committee chairs who believed 
that mandatory audit firm rotation should not be applied uniformly more 
frequently selected the larger public companies rather than the smaller 
public companies to be subject to mandatory audit firm rotation. 
However, Fortune 1000 public companies were divided on their selection 
of sizes of public companies that should be subject to mandatory audit 
firm rotation.

See appendix II for additional details of the responses.

Our research of studies, other documents, and survey development 
activities concerning issues related to mandatory audit firm rotation 
identified the following other practices for potentially enhancing 
auditor independence and audit quality:

* the audit committee periodically holding an open competition for 
providing audit services,

* requiring audit managers to periodically rotate off the engagement 
for providing audit services to the public company,

* the audit committee periodically obtaining the services of a public 
accounting firm to assist it in overseeing the financial statement 
audit or to conduct a forensic audit in areas of the public company's 
financial statement process that present a risk of fraudulent financial 
reporting, and:

* the audit committee hiring the auditor of record on a noncancelable 
multiyear basis in which only the public accounting firm could 
terminate the business relationship for cause during the contract 
period.

Although many Tier 1 firms, Fortune 1000 public companies, and their 
audit committee chairs saw some benefit in each of the alternative 
practices, in general, they most frequently reported that the 
alternative practices would have limited or little benefit. The most 
notable exception involved the practice in which an audit committee 
would hire an auditor of record on a noncancelable multiyear basis, for 
which most Fortune 1000 public companies and their audit committee 
chairs reported that the practice would have no benefit. (See table 5 
in app. III.):

Regarding practices other than mandatory audit firm rotation that may 
have potential value to enhance auditor independence and audit quality, 
the Sarbanes-Oxley Act provides the PCAOB with the authority to set 
auditing and related attestation, ethics, independence, and quality 
control standards for registered public accounting firms and for 
conducting inspections to determine compliance of each registered 
public accounting firm with the rules of the PCAOB, the SEC, or 
professional standards in connection with the performance of audits, 
the issuance of audit reports, and related matters involving public 
companies. In that respect, the PCAOB's inspection program for 
registered public accounting firms could also provide the PCAOB with 
the opportunity to provide a "fresh look" at the auditor of record's 
performance regarding auditor independence and audit quality. For 
example, the inspections could include factors potentially affecting 
auditor independence, such as length of the auditor's tenure, partners 
or managers of the audit firm who recently left the firm and are now 
employed by the public company in financial reporting roles, and 
nonaudit services provided by the auditor of record, as suggested by 
the Conference Board Commission on Public Trust and Private Enterprise 
in its January 9, 2003, report. Also, the inspections could consider 
the auditor's work in high-risk areas of the public company's 
operations and related financial reporting. Further, the inspections 
can serve to provide some degree of transparency of their overall 
results and enforcement of PCAOB and SEC requirements that may be 
useful for audit committees to consider.

Auditor Experience in Restatements of annual Financial Statements Filed 
with the SEC for 2001 and 2002:

With the dissolution of Arthur Andersen LLP in 2002, Tier 1 firms 
reported replacing Anderson, as auditor of record, for more than 1,200 
public company clients since December 31, 2001. Such volume of change 
in auditors provided an unprecedented opportunity to gain some actual 
experience with the potential value of the "fresh look" provided by a 
new auditor. Since many of these public companies had to replace 
Andersen as their auditor of record during 2002, the number of changes 
in their auditor of record effectively represented a partial form of 
mandatory audit firm rotation. We identified all annual restatements of 
financial statements filed on a Form 10-KA and any annual restatements 
included in an annual Form 10K filing with the SEC by Fortune 1000 
public companies for 2001 and 2002 through August 31, 2003, and focused 
on which restatements were attributable to errors or fraud where the 
previous financial statements did not comply with GAAP and identified 
whether there was a change in the auditor of record.

We found that 28, or 2.9 percent, of the 960 Fortune 1000 public 
companies changed their auditor of record during 2001, and 204, or 21.3 
percent, of the companies changed their auditor during 2002. The 
significant increase from 2001 through 2002 was primarily due to the 
dissolution of Andersen. Our analysis showed that the Fortune 1000 
public companies filed 43 restatements during those 2 years that were 
due to errors or fraud. The financial statements affected ranged from 
years 1997 to 2002. The misstatement rates of these public companies' 
previously issued statements of net income ranged from a 6.7 percent 
overstatement of net income for 2000 to a 37.0 percent understatement 
of net loss for 2001.

The restatement rates due to errors or fraud among the 43 Fortune 1000 
public companies that changed their auditor of record were 10.7 percent 
in 2001 and 3.9 percent in 2002 compared to restatement rates of 2.5 
percent in 2001 and 1.2 percent in 2002 for companies that did not 
change auditors. Although the data indicate that the overall 
restatement rate is approximately 4.5 times higher for 2001 and 3.25 
times higher for 2002 for the companies that changed their auditor of 
record as compared to those companies that did not change auditors, 
caution should be taken as further analysis would be needed to 
determine whether the restatements are associated with the "fresh look" 
attributed to mandatory audit firm rotation. In that respect, for the 
majority of the restatements, the public information filed with the SEC 
and included in the SEC's Electronic Data Gathering, Analysis, and 
Retrieval (EDGAR) system did not provide sufficient information to 
determine whether company management, the auditor of record, or 
regulators identified the error or fraud, and in those cases in which 
there was a change in the auditor of record, whether the predecessor 
auditor or the successor auditor identified the problem and whether it 
was identified before or after the change in auditor of record. Also, 
the recent corporate financial reporting failures have greatly 
increased the pressures on company management and their auditors 
regarding honest, fair, and complete financial reporting. See appendix 
IV for additional details of our analysis.

Regarding further analysis to determine whether restatements are 
associated with the "fresh look," we believe such additional future 
research could potentially add value to better predict the benefits of 
mandatory audit firm rotation and the future need for mandatory audit 
firm rotation. See the observations section of this report for our 
views on mandatory audit firm rotation considering the Sarbanes-Oxley 
Act's requirements for enhancing auditor independence and audit quality 
and other factors to consider in evaluating the need for mandatory 
audit firm rotation.

Experience of Foreign Countries with Mandatory Audit Firm Rotation:

To obtain other countries' current or previous experience with or 
consideration of mandatory audit firm rotation, we surveyed the 
securities regulators of the Group of Seven Industrialized Nations (G-
7), which included the United Kingdom, Germany, France, Japan, Canada, 
and Italy. In addition to the G-7 countries' securities regulators, we 
also surveyed the following members of the International Organization 
of Securities Commissions (IOSCO)[Footnote 47]: Australia, Austria, 
Belgium, Brazil, China, Hong Kong, Luxembourg, Mexico, the Netherlands, 
Singapore, Spain, Sweden, and Switzerland.[Footnote 48] The IOSCO 
members represent these foreign countries' organizations with duties 
and responsibilities which are similar to the SEC in the United States. 
We received responses from 11 of the 19 countries' securities 
regulators surveyed.

Italy and Brazil reported having mandatory audit firm rotation for 
public companies, and Singapore reported the requirement for banks that 
are incorporated in Singapore. Austria also reported that beginning in 
2004, mandatory audit firm rotation will be required for the auditor of 
record of public companies. Spain and Canada reported that they 
previously had mandatory audit firm rotation requirements. Generally, 
reasons reported for requiring mandatory audit firm rotation related to 
auditor independence, audit quality, or increased competition for 
providing audit services. Reasons for abandoning the requirements for 
mandatory audit firm rotation related to its lack of cost-
effectiveness, cost, and having achieved the objective of increased 
competition for audit services. Many of the survey respondents also 
reported either requiring or considering audit partner rotation 
requirements that are similar to the requirements of the Sarbanes-Oxley 
Act. See appendix V for additional information on the survey 
respondents' experiences and consideration of mandatory audit firm 
rotation and audit partner rotation.

GAO Observations:

The Sarbanes-Oxley Act contains significant reforms intended to enhance 
auditor independence and audit quality, which are viewed by the groups 
of stakeholders we surveyed or held discussions with as likely to 
sufficiently achieve the same intended benefits as mandatory audit firm 
rotation when fully implemented. In that respect, the SEC's regulations 
to implement the auditor independence and audit quality requirements of 
the act have only recently been issued, and the PCAOB is in the process 
of implementing its inspection program. Therefore, we believe it will 
take at least several years to gain some experience with the 
effectiveness of the act's requirements concerning auditor independence 
and audit quality.

We believe that it is critical for both the SEC and the PCAOB, through 
its oversight and enforcement programs, to formally monitor the 
effectiveness of the regulations and programs intended to implement the 
Sarbanes-Oxley Act. This information will be valuable in considering 
whether changes, including mandatory audit firm rotation, may be needed 
to further protect the public interest. We noted that survey responses 
from Tier 1 firms show that the potential for lawsuits or regulatory 
action is a major incentive for the firms to appropriately deal with 
public company management in resolving financial reporting issues. We 
believe that the SEC's and PCAOB's rigorous enforcement of regulations 
and other requirements will be critical to the effectiveness of the 
act's requirements.

It is clear that the likely additional costs associated with mandatory 
rotation have influenced the views of Tier 1 firms and Fortune 1000 
public companies and their audit committee chairs to not support 
mandatory rotation. However, we believe that these additional costs 
need to be balanced with the need to protect the public interest, 
especially considering the recent significant accountability 
breakdowns and their impact on investors and other interested parties. 
Although expecting to have zero financial reporting/audit failures is 
not a realistic expectation, Enron, WorldCom, and others have recently 
demonstrated that a single financial reporting/audit failure of a major 
public company can have significant consequences to shareholders and 
other interested parties. We believe it is fairly certain that 
mandatory audit firm rotation would result in selection costs and 
additional support costs for public companies. Also, most Tier 1 firms 
and Fortune 1000 public companies believe that mandatory audit firm 
rotation would also result in higher audit fees, primarily due to 
higher initial years' audit costs.

If public accounting firms under mandatory audit firm rotation have (1) 
a shorter tenure as auditor of record to recover higher initial year 
audit costs and (2) fewer opportunities to also sell nonaudit services 
due to the Sarbanes-Oxley Act requirements concerning prohibited 
nonaudit services, then we believe it is reasonable to assume, as 
public accounting firms and public companies have done, that the higher 
initial year audit costs associated with a new auditor are likely to be 
passed on to the public companies, along with increased marketing 
costs. However, competition among public accounting firms for providing 
audit services should to some extent also affect audit fees. Therefore, 
we believe it is uncertain at this time how these dynamics would play 
out in the market for audit services and their effect on audit fees 
over the long term. However, if intensive price competition were to 
occur, the expected benefits of mandatory audit firm rotation could be 
adversely affected if audit quality suffers due to audit fees that do 
not support an appropriate level of audit work.

We believe that mandatory audit firm rotation may not be the most 
efficient way to enhance auditor independence and audit quality, 
considering the costs of changing the auditor of record and the loss of 
auditor knowledge that is not carried forward to the new auditor. We 
also believe that the potential benefits of mandatory audit firm 
rotation are harder to predict and quantify while we are fairly certain 
there will be additional costs. In that respect, mandatory audit firm 
rotation is not a panacea that totally removes pressures on the auditor 
in appropriately resolving financial reporting issues that may 
materially affect the public companies' financial statements. Those 
pressures are likely to continue even if the term of the auditor is 
limited under any mandatory rotation process. Furthermore, most public 
companies will only use the Big 4 firms for their auditor of record for 
a variety of reasons, including the firms' having sufficient industry 
knowledge and resources to audit their companies and expectations of 
the capital markets to use Big 4 firms. These public companies may only 
have 1 or 2 choices for their auditor of record under any mandatory 
rotation system. However, over time a mandatory audit firm rotation 
requirement may result in more firms transitioning into additional 
industry sectors if the market for such audits has sufficient profit 
margins.

The current environment has greatly increased the pressures from 
regulators and investors on public company management and public 
accounting firms to have financial statements issued by public 
companies that comply with GAAP and provide full disclosure. These 
pressures and the reforms of the Sarbanes-Oxley Act provide incentives 
to have financial reporting that is honest, fair, and complete and that 
serves the public interest. If such reporting is widely and 
consistently achieved then the likelihood of the "fresh look" serving 
to identify financial reporting issues that may materially affect 
financial statements that were either overlooked or not appropriately 
dealt with by the previous auditor of record will be reduced. However, 
it is uncertain at this time if the current climate and pressures for 
accurate and complete financial reporting and for restoring public 
trust will be sustained over the long term.

Regarding the need for mandatory audit firm rotation, we believe the 
most prudent course at this time is for the SEC and the PCAOB to 
monitor and evaluate the effectiveness of the Sarbanes-Oxley Act's 
requirements for enhancing auditor independence and audit quality, and 
ultimately restoring investor confidence. In that respect, the PCAOB's 
inspection program for registered public accounting firms could also 
provide an opportunity to provide a "fresh look," which would enhance 
auditor independence and audit quality through the program's inspection 
activities, and may provide new insights regarding (1) public 
companies' financial reporting practices that pose a high risk of 
issuing materially misstated financial statements for the audit 
committees to consider and (2) possibly either using the auditor of 
record or another firm to assist in reviewing these areas. In addition, 
future research on the potential benefits of mandatory audit firm 
rotation as suggested by our analysis of restatements of financial 
statements may also be valuable to consider along with the evaluations 
of the effectiveness of the Sarbanes-Oxley Act.

Further, we also believe that currently audit committees, with their 
increased responsibilities under the Sarbanes-Oxley Act, can play a 
very important role in enhancing auditor independence and audit 
quality. In that respect, the Conference Board Commission on Public 
Trust and Private Enterprise in its January 9, 2003, report stated that 
auditor rotation is a useful tool for building shareholder confidence 
in the integrity of the audit and of the company's financial 
statements. The commission advocated that audit committees consider 
rotating audit firms when there are circumstances that could call into 
question the audit firm's independence from management. The 
circumstances that merited consideration included when (1) significant 
nonaudit services are provided to the company by the auditor of record 
(even if they have been approved by the audit committee), (2) one or 
more former partners or managers of the audit firm are employed by the 
company, or (3) lengthy tenure of the auditor of record, such as over 
10 years--which our survey results show is prevalent at many Fortune 
1000 public companies. In such cases, we believe audit committees need 
to be especially vigilant in the oversight of the auditor and in 
considering whether a "fresh look" is warranted. We also believe that 
if audit committees regularly evaluate whether audit firm rotation 
would be beneficial, given the facts and circumstances of their 
companies' situation, and are actively involved in helping to ensure 
audit independence and audit quality, many of the intended benefits of 
audit firm rotation could be realized at the initiative of the audit 
committee rather than through a mandatory requirement.

However, audit committees need to have access to adequate resources, 
including their own budgets, to be able to operate with the 
independence necessary to effectively perform their responsibilities 
under the Sarbanes-Oxley Act. Further, we believe that an audit 
committee's ability to operate independently is directly related to the 
independence of the public company's board of directors. It is not 
realistic to believe that audit committees will unilaterally resolve 
financial reporting issues that materially affect a public company's 
financial statements without vetting those issues with the board of 
directors. Also, the ability of the board of directors to operate 
independently may also be affected in corporate governance structures 
where the public company's chief executive officer also serves as the 
chair of the board of directors. Like audit committees, boards of 
directors also need to be independent and to have adequate resources 
and access to independent attorneys and other advisors when they 
believe it is appropriate. Finally, for any system to function 
effectively, there must be incentives for parties to do the right 
thing, adequate transparency to provide reasonable assurance that 
people will do the right thing, and appropriate accountability when 
people do not do the right thing.

Agency Comments and Our Evaluation:

We provided copies of a draft of this report to the SEC, AICPA, and 
PCAOB for their review. Representatives of the AICPA and the PCAOB 
provided technical comments, which we have incorporated where 
applicable. Representatives of the SEC had no comments.

We are sending copies of this report to the Chairman and Ranking 
Minority Member of the House Committee on Energy and Commerce. We are 
also sending copies of this report to the Chairman of the Securities 
and Exchange Commission, the Chairman of the Public Company Accounting 
Oversight Board, and other interested parties. This report will also be 
available at no charge on GAO's Web site at [Hyperlink, http://
www.gao.gov] http://www.gao.gov.

If you or your staffs have any questions concerning this report, please 
contact me at (202) 512-9471 or John J. Reilly, Jr., Assistant 
Director, at (202) 512-9517. Key contributors are acknowledged in 
appendix VI.

Signed by:

Jeanette M. Franzel: 
Director, Financial Management and Assurance:

[End of section]

Appendixes: 

[End of section]

Appendix I: Objectives, Scope, and Methodology:

As mandated by Section 207 of the Sarbanes-Oxley Act of 2002[Footnote 
49] and as agreed with your staff, to perform our study and review of 
the potential effects of requiring mandatory rotation of registered 
public accounting firms, we:

1. identified and reviewed research studies and related literature that 
addressed issues concerning auditor independence and audit quality 
associated with the length of a public accounting firm's tenure and the 
costs and benefits of mandatory audit firm rotation;

2. Analyzed the issues we identified to:

* develop detailed questionnaires to obtain the views of public 
accounting firms and public company chief financial officers and their 
audit committee chairs on the potential effects of mandatory audit firm 
rotation,

* hold discussions with officials of other interested stakeholders, 
such as institutional investors, federal banking regulators, U.S. stock 
exchanges, state boards of accountancy, the American Institute of 
Certified Public Accountants (AICPA), the Securities and Exchange 
Commission (SEC), and the Public Company Accounting Oversight Board 
(PCAOB), to obtain their views on the issues associated with mandatory 
audit firm rotation, and:

* obtain information from other countries on their experiences with 
mandatory audit firm rotation; and:

3. identified restatements of annual 2001 and 2002 financial statements 
of Fortune 1000 public companies due to errors or fraud that were 
reported to the SEC during 2002 and 2003 through August 31, 2003, to:

* determine whether the restatement occurred before or after a change 
in the public companies' auditor of record, and:

* test the value of the "fresh look" commonly attributed to mandatory 
audit firm rotation.

We conducted our work in Washington, D.C., between November 2002 and 
November 2003 in accordance with U.S. generally accepted government 
auditing standards.

Identifying Research Studies Concerning Auditor Independence and Audit 
Quality:

To identify existing research related to mandatory audit firm rotation, 
we utilized several methods including general Internet searches, 
requests from the AICPA library, the AICPA's Web site [Hyperlink, 
http://www.aicpa.org] (www.aicpa.org), the American Accounting 
Association's Web site [Hyperlink, http://accounting.rutgers.edu/
raw/aaa/] (http://accounting.rutgers.edu/raw/aaa/), the SEC's Web site 
[Hyperlink, http://www.sec.gov] (www.sec.gov), requests from GAO's 
internal library resources, and suggestions provided by communities of 
interest. Also, many studies were identified through bibliographies of 
previously identified research. We used the following keywords in our 
searches: "mandatory audit firm rotation," "mandatory auditor 
rotation," "compulsory audit firm rotation," "compulsory auditor 
rotation," "auditor rotation," "auditor change(s)," and "auditor 
switching.":

We identified a total of 80 studies, articles, position papers, and 
reports from our searches. We then applied the following criteria to 
these studies. We focused on studies that (1) were mostly published no 
earlier than 1980, (2) contained some original data analyses, and (3) 
focused on some aspect of mandatory audit firm rotation. Using these 
criteria, 27 studies were subjected to further methodological review to 
evaluate the design and approach of the studies, the quality of the 
data used, and the reasonableness of the studies' conclusions and to 
determine if any limitations of a study were of sufficient severity to 
call into question the reasonableness of the conclusion. We eliminated 
10 of these studies because they were actually position papers or 
literature summaries, and did not include any original data analyses. 
One additional study was eliminated because of fundamental 
methodological flaws.

Of the remaining 16 studies that were subjected to a high-level 
methodological review, 7 have major caveats that should be considered 
along with the results of the studies, while the other 9 have some more 
minor methodological limitations, such as limited application to the 
subject; limited data availability; or insufficient information on 
issues including choice of samples, response rates, and nonresponse 
analyses. In developing the survey instruments covering issues 
concerning auditor independence and audit quality associated with the 
length of a public accounting firm's tenure and the costs and benefits 
of mandatory audit firm rotation, we primarily used the studies from 
among this latter group of 9 as listed below.

The Relationship of Audit Failures and Audit Tenure, by Jeffrey 
Casterella of Colorado State University, W. Robert Knechel of 
University of Florida and University of Auckland, and Paul Walker of 
the University of Virginia, November 2002.

Auditor Rotation and Retention Rules: A Theoretical Analysis (Rotation 
Rules), by Eric C. Weber of Northwestern University, June 1998.

Audit-Firm Tenure and the Quality of Financial Reports, by Van E. 
Johnson of Georgia State University, Inder K. Khurana of the University 
of Missouri-Columbia, and J. Kenneth Reynolds of Louisiana State 
University, Winter 2002.

"The Effects of Auditor Change on Audit Fees: Tests of Price Cutting 
and Price Recovery", The Accounting Review, by D.T. Simon, and J.R. 
Francis, April 1988.

"Does Auditor Quality and Tenure Matter to Investors?" Evidence from 
the Bond Market. Sattar Mansi of Virginia Polytechnic Institute, 
William F. Maxwell of University of Arizona, and Darius P. Miller of 
Kelley School of Business, February 2003 paper under revision for the 
Journal of Accounting Research.

An Analysis of Restatement Matters: Rules, Errors, Ethics, for the Five 
Years Ended December 31, 2002, The Huron Consulting Group, January 
2003.

The Commission on Auditors' Responsibilities: Report of Tentative 
Conclusions, The Cohen Commission (an independent commission 
established by the AICPA), 1977. (Limited to Section 9, "Maintaining 
the Independence of Auditors, Rotation of Auditors").

"Audit Fees and Auditor Change; An Investigation of the Persistence of 
Fee Reduction by Type of Change", Journal of Business Finance and 
Accounting, by A. Gregory, and P. Collier, January 1996.

"Auditor Changes and Tendering: UK Interview Evidence", Accounting, 
Auditing and Accountability Journal, v11n1, V. Beattie, and S. 
Fearnley, 1998.

Obtaining the Views of Public Accounting Firms and Public Company Chief 
Financial Officers and Their Audit Committee Chairs on Mandatory Audit 
Firm Rotation:

We analyzed the issues identified from our review of studies, articles, 
position papers, and reports to develop an understanding of the 
background and related advantages and disadvantages of mandatory audit 
firm rotation. We developed three separate survey instruments 
incorporating a variety of issues related to auditor independence, 
audit quality, mandatory audit firm rotation and the potential effects 
on audit costs, audit fees, audit quality, audit risk, and competition 
that may arise with a mandatory audit firm rotation requirement. In 
addition, these survey instruments solicited views on the impact of 
specific provisions of the Sarbanes-Oxley Act intended to enhance 
auditor independence and audit quality, other practices for enhancing 
audit quality, views on implementing mandatory audit firm rotation, and 
overall opinions on requiring mandatory audit firm rotation.

We performed field tests of the survey instruments to help ensure that 
the survey questions would be understandable to different groups of 
respondents, eliminate factual inaccuracies, and obtain feedback and 
recommendations to improve the surveys. We took the feedback and 
comments we received into consideration in developing our final survey 
instruments. Specifically, during March and April of 2003, we performed 
field tests of the survey instrument for public accounting firms with 
eight different public accounting firms, including two of the Big 4 
firms, two national firms, and four regional or local firms. During May 
2003, we conducted field tests of the survey instrument for public 
company chief financial officers with four public companies, including 
two Fortune 1000 companies and two commercial banks not included in the 
Fortune 1000. We tailored the survey instrument for public company 
audit committee chairpersons by incorporating the feedback and comments 
we received from the chief financial officers during the field tests we 
performed with public companies.

Surveys of Public Accounting Firms:

Section 207 of the Sarbanes-Oxley Act mandated that GAO study the 
potential effects of mandatory audit firm rotation of registered public 
accounting firms, referring to public accounting firms that would be 
registered with the new PCAOB. During the January 2003 time frame when 
we were framing the population, since the PCAOB was in the process of 
getting organized and becoming operational, there were no public 
accounting firms registered with the PCAOB at that time.[Footnote 50] 
Therefore, we coordinated with the AICPA to establish a population of 
public accounting firms that would most likely register with the PCAOB. 
The AICPA provided a complete list of the more than 1,100 public 
accounting firms that were registered with the AICPA's Securities and 
Exchange Commission Practice Section (SECPS)[Footnote 51] as of January 
2003. Prior to the restructuring of the SECPS, AICPA bylaws required 
that all members that engage in the practice of public accounting with 
a firm auditing one or more SEC clients join the SECPS. Public 
accounting firms that did not have any SEC clients could join the SECPS 
voluntarily. Based on the information submitted in their 2001 annual 
reports, these SECPS member firms collectively had nearly 15,000 SEC 
clients.[Footnote 52] Therefore, the public accounting firms registered 
with the SECPS at that time were used to frame an alternative source of 
public accounting firms that perform audits of issuers registered with 
the SEC.

Based on the AICPA-provided SECPS membership list and the number of SEC 
clients reported in these SECPS member firms' 2001 annual reports, of 
1,117 SECPS members, 696 firms had 1 or more SEC clients and 421 firms 
were SECPS members but did not audit any public companies. The 696 
members of the SECPS collectively audited 14,928 of the 17,956 issuers 
registered with the SEC. Since approximately 3,000 issuers were audited 
by public accounting firms that were not members of the SECPS, we 
obtained a list from the SEC that included the names of over 1,000 
public accounting firms that performed the audits of public companies 
registered with the SEC. We compared the 696 SECPS member firms to all 
of the public accounting firms that were included in the SEC's list in 
order to identify the non-SECPS member public accounting firms, which 
were mainly consisted of foreign public accounting firms or domestic 
firms that are not AICPA members. Since the PCAOB has indicated that it 
will not exempt foreign public accounting firms that audit issuers 
registered with the SEC from registering with the PCAOB, we included 
non-SECPS member public accounting firms that reported to the SEC that 
they had 10 or more SEC clients in the population.

Stratification of Public Accounting Firm Population:

In order to identify differences in views on the potential effects of 
mandatory audit firm rotation for respondents that vary based on the 
size of the public accounting firm, location (e.g., domestic versus 
foreign firms) and other factors, we stratified the population into 
three tiers based on the number of SEC clients reported to the SECPS in 
the SECPS member firms' 2001 annual reports and the aforementioned SEC 
data for non-SECPS member public accounting firms:

1. Tier 1 firms: 92 SECPS member and 5 non-SECPS public accounting 
firms that had 10 or more 2001 SEC clients in 2001,

2. Tier 2 firms: 604 SECPS member firms that had from 1 to 9, 2001 SEC 
clients in 2001, and:

3. Tier 3 firms: 421 SECPS member firms that reported having no SEC 
clients.

The basis for selecting public accounting firms with 10 or more SEC 
clients was twofold. First, the 92 SECPS member firms included in Tier 
1 collectively had approximately 90 percent of all of the SEC clients 
reported to the SECPS in the member firms' 2001 annual reports. Second, 
the public accounting firms with 10 or more SEC clients were viewed to 
collectively have the most experience and knowledge about changing 
auditors for public company clients and accordingly were considered to 
have a great interest in the potential effects of mandatory audit firm 
rotation. Tier 2 was established because the 604 SECPS member firms 
with 1 to 9 SEC clients comprises approximately 10 percent of the total 
SEC clients reported to the the SECPS in member firms' 2001 annual 
reports and were also considered to have a great interest in, as well 
as important views on, the potential effects of mandatory audit firm 
rotation based on their experience and knowledge of being auditors for 
public companies. Lastly, we included the 421 SECPS member public 
accounting firms that had no SEC clients in Tier 3 of our population in 
order to determine if there would be greater or less interest in 
providing financial statement audit services to public companies if 
mandatory audit firm rotation were required. We requested that the 
public accounting firms' chief executive officers or managing partners, 
or their designated representatives, complete the survey.

Method of Administration:

In order to conduct our survey, we selected a 100 percent certainty 
sample of Tier 1 public accounting firms consisted of all 92 SECPS 
member firms and all 5 non-SECPS member firms. In addition, we selected 
separate random samples from each of the two remaining strata. We 
created two separate Web sites for the public accounting firm surveys. 
The top tier firms were surveyed independently of the second and third 
tiers because the Tier 1 survey was administered jointly with another 
study dealing with consolidation of major public accounting firms since 
1989 as mandated by Section 701 of the Sarbanes-Oxley Act.[Footnote 53] 
The survey for the Tier 2 and Tier 3 firms, which dealt only with the 
potential effects of mandatory audit firm rotation, was created at a 
separate Web site. A unique password and user ID was assigned to each 
selected public accounting firm in our sample to facilitate completion 
of the survey online. The surveys were made available to the Tier 1 
firms during the week of May 27, 2003, and the surveys to the Tier 2 
and Tier 3 firms were made available during the week of June 12, 2003. 
Both survey Web sites remained open until September 2003. Responses to 
surveys completed online were automatically stored on GAO's Web sites. 
From August through September 2003, we performed follow-up efforts to 
increase the overall response rates by telephoning the selected public 
accounting firms that had not completed the survey, and requested that 
they take advantage of the opportunity to express their views on this 
important issue by doing so.

Lastly, in order to gain knowledge about whether the views of the Tier 
1 public accounting firms that did not complete our survey were 
materially different from the overall views of the Tier 1 public 
accounting firms that completed our survey, we asked the following key 
questions of those public accounting firms that did not complete our 
survey and that we contacted during our telephone follow-up efforts. 
Specifically, we asked whether their firms believed the benefits of 
mandatory audit firm rotation would exceed the costs of implementing 
such a requirement and whether their firms would support requiring 
mandatory audit firm rotation. As more fully described in the body of 
this report, the overall views expressed by the Tier 1 public 
accounting firms that completed our survey generally indicated that the 
costs of mandatory audit firm rotation would exceed the benefits and 
that their firms were not in favor of supporting such a requirement. 
The views of the Tier 1 public accounting firms that did not complete 
our survey and that we contacted in our telephone follow-up efforts 
were generally consistent with the overall views of the Tier 1 public 
accounting firms that completed our survey.

Public Accounting Firm Survey Results:

As disclosed in our survey instruments, all survey results were to be 
compiled and presented in summary form only as part of our report, and 
we will not release individually identifiable data from these surveys, 
unless compelled by law or required to do so by the Congress. We 
received responses from 74 of the 97 Tier 1 firms, or 76.3 
percent.[Footnote 54] Because of the more limited participation of Tier 
2 firms (85, or 30.1 percent) and Tier 3 firms (52, or 21.9 percent) in 
our survey, we are not projecting their responses to the population of 
firms in these tiers. The presentation of this report focuses on the 
responses from the Tier 1 firms, but any substantial differences in 
their overall views and those reported to us by either Tier 2 or 3 
firms are discussed where applicable.

Table 2 summarizes the population, sample sizes, and overall responses 
received for all three tiers of public accounting firms surveyed on the 
potential effects of mandatory audit firm rotation.

Table 2: Public Accounting Firms' Population, Sample Sizes, and Survey 
Response Rates:

Population size; Tier 1 firms: 97; Tier 2 firms: 604; Tier 3 firms: 
421; Totals: 1,122.

Sample size; Tier 1 firms: 97; Tier 2 firms: 282; Tier 3 firms: 237; 
Totals: 616.

Total responses; Tier 1 firms: 74; Tier 2 firms: 85; Tier 3 firms: 52; 
Totals: 211.

Response rate; Tier 1 firms: 76.3%; Tier 2 firms: 30.1%; Tier 3 firms: 
21.9%.

Source: GAO survey data.

[End of table]

Surveys of Public Company Chief Financial Officers and Audit Committee 
Chairs:

As a part of fulfilling our objective to study the potential effects of 
mandatory audit firm rotation, we obtained the views on the advantages 
and disadvantages and related costs and benefits from a random sample 
of chief financial officers and audit committee chairs of public 
companies registered with the SEC. We solicited the views of chief 
financial officers of public companies because they were considered to 
be very knowledgeable about the issues involving financial statement 
audits of public companies. We also solicited the views of audit 
committee chairs because under the Sarbanes-Oxley Act, the audit 
committee has expanded responsibilities for monitoring and overseeing 
public companies' financial reporting and the financial statement audit 
process. We obtained such views by administering a survey to randomly 
selected samples of public company chief financial officers and their 
audit committee chairs.

Section 207 of the Sarbanes-Oxley Act defines "mandatory rotation" as 
the imposition of a limit on the period of years for which a particular 
registered public accounting firm may be the auditor of record for a 
particular issuer. Therefore, in framing the population from which we 
planned to draw our sample of public companies, we researched what the 
definition of an "issuer" is with the SEC, with GAO's General Counsel, 
and the AICPA's SECPS. The primary purpose of conducting this research 
was to determine whether mutual funds (or mutual fund complexes) and 
other types of investment companies such as investment trusts, should 
be included in the population. Based on discussions with the Director 
of the SEC's Office of Investment Management, mutual funds and 
investment trusts are issuers that are required to file periodic 
reports with the SEC under the Securities Exchange Act of 1934 or the 
Investment Company Act of 1940. Also, officials in the SEC's Office of 
Investment Management indicated that there are nearly 10,000 individual 
mutual funds grouped into 877 mutual fund complexes (also known as 
families). A mutual fund complex is responsible for hiring the auditor 
of record, either collectively or individually, for the individual 
mutual funds that are included in the family or complex. As such, 
investment trusts and the 877 mutual fund complexes were included in 
our population for the purpose of administering our survey.

We obtained lists of public company issuers from the SEC in developing 
the population as follows: The SEC's Office of Corporation Finance 
provided a list of 17,079 public companies from the SEC's Electronic 
Data Gathering, Analysis, and Retrieval (EDGAR) system. This list 
included registrants that were listed as current issuers registered 
with the SEC as of February 2003 and included 14,938 domestic public 
companies (including investment trusts) and 2,141 foreign public 
companies (i.e., companies that are domiciled outside of the United 
States but are registered with the SEC). Our comparison of this SEC 
list to a separate list of Fortune 1000 companies identified an 
additional 32 public companies that were added to the original list of 
17,079, bringing the total population to an adjusted total of 17,111. 
As noted above, we also obtained a complete list of 877 mutual fund 
complexes from the SEC that included current issuers registered with 
the SEC's Office of Investment Management. Therefore, the population of 
public company issuers as of February 2003 totaled 17,988, consisted of 
17,111 public companies and 877 mutual fund complexes.

Stratification of Chief Financial Officer and Audit Committee Chair 
Population:

In order to identify differences in views on the potential effects of 
mandatory audit firm rotation based on differences in company industry, 
size, or geographic location, we stratified the population into the 
following three strata: (1) domestic Fortune 1000 companies, (2) other 
(non-Fortune 1000) domestic companies and mutual fund complexes, and 
(3) foreign companies.

Fortune 1000 stratum: Based on Fortune's list of the Fortune 1000 as of 
March 2003, we identified 960 public companies in the Fortune 1000; the 
remaining 40 companies were privately owned. Since private companies 
are not subject to SEC rules or the Sarbanes-Oxley Act's provisions, 
these 40 companies were not included in the stratum. We used the file 
provided by the SEC listing the 17,079 domestic and foreign public 
companies to extract a separate stratum of the 960 public companies in 
the Fortune 1000. In addition, in comparing Fortune's list of the 
Fortune 1000 to the SEC's listing of public companies, we identified 32 
additional companies that were included in the Fortune 1000 but which 
were not included in the SEC list. In connection with framing the 
Fortune 1000 stratum, we added these 32 companies to the list of 
domestic and foreign public companies provided to us by the SEC to 
ensure that it was complete.

Foreign company stratum: Using the "state code" identifier included in 
the adjusted SEC list of 17,111 domestic and foreign public companies, 
we extracted a separate stratum of 2,141 foreign companies.

Other domestic companies and mutual fund complexes stratum: After 
extracting the 960 domestic Fortune 1000 public companies and the 2,141 
foreign public companies from the adjusted SEC list of 17,111 domestic 
and foreign public companies, a separate stratum of 14,010 non-Fortune 
1000 public companies was created from the SEC file representing the 
"other domestic" public companies. These 14,010 other domestic public 
companies (which included investment trusts) were combined with the 877 
mutual fund complexes provided by the SEC's Office of Investment 
Management to create a total population for this stratum of 14,887.

Method of Administration:

In order to conduct these surveys, we selected a separate random sample 
from each of the three public company strata. We mailed a survey 
package to the chief financial officer of each public company issuer 
included in our sample. This survey package provided the chief 
financial officer with the option of completing the enclosed hard copy 
of the survey and returning it in the mail to our Atlanta Field Office 
or of completing the survey online. We created a Web site with the 
public company survey for the chief financial officers. A unique 
password and user ID was assigned to each selected company in our 
sample of companies to facilitate completion of the survey online. In 
addition, a separate survey directed to the chair of the audit 
committee (or head of an equivalent body) was included in the mail 
survey package. The chief financial officer was asked to forward this 
survey to the audit committee chair. The survey for the public company 
audit committee chairs was not made available online. As such, these 
surveys could only be completed on hard copy and returned to our 
Atlanta Field Office. The survey packages were mailed to all 1,171 
public companies in June 2003. The survey Web site for public company 
chief financial officers remained open until September 2003. The cutoff 
date for accepting mailed surveys from public company chief financial 
officers and audit committee chairs was September 2003. Responses to 
surveys completed online were automatically stored into GAO's Web 
sites, and mailed survey responses of chief financial officers and 
audit committee chairs were entered into a separate compilation 
database by GAO contractor personnel who were hired to perform such 
data inputting. From August through September 2003, we also performed 
follow-up efforts to increase the overall response rates by telephoning 
public company chief financial officers, who had not completed or 
returned the survey, and requesting that the chief financial officer 
and the audit committee chair complete our survey and return it to us.

Public Company Survey Results:

As disclosed in our surveys, all survey results were to be compiled and 
presented in summary form only as part of our report, and we will not 
release individually identifiable data from these surveys, unless 
compelled by law or required to do so by the Congress. Of the 330 
Fortune 1000 public companies sampled, we received responses from 201, 
or 60.9 percent, of their chief financial officers and 191, or 57.9 
percent, of their audit committee chairs.[Footnote 55] Because of 
limited participation of the other domestic companies and mutual funds 
(131, or 29.1 percent, of their chief financial officers and 96, or 
21.3 percent, of their audit committee chairs) and the foreign public 
companies (99, or 25.3 percent, of their chief financial officers and 
63, or 16.1 percent, of their audit committee chairs), we are not 
projecting their responses to the population of companies in these 
strata. The presentation of this report focuses on the responses from 
the Fortune 1000 public companies' chief financial officers and their 
audit committee chairs, but any substantial differences in their 
overall views and those reported to us by the other groups of public 
companies we surveyed is discussed where applicable.

Tables 3 and 4 summarize the population, sample size, and survey 
responses received for all three strata of public company chief 
financial officers and their audit committee chairs surveyed on the 
potential effects of mandatory audit firm rotation.

Table 3: Public Company Chief Financial Officers' Population, Sample 
Sizes, and Survey Response Rates:

Population size; Fortune 1000 companies: 960; Domestic public 
companies and mutual funds: 14,887; Foreign public companies: 2,141; 
Totals: 17,988.

Sample size; Fortune 1000 companies: 330; Domestic public companies 
and mutual funds: 450; Foreign public companies: 391; Totals: 
1,171.

Total responses; Fortune 1000 companies: 201; Domestic public 
companies and mutual funds: 131; Foreign public companies: 99; 
Totals: 431.

Response rate; Fortune 1000 companies: 60.9%; Domestic public 
companies and mutual funds: 29.1%; Foreign public companies: 25.3%.

Source: GAO survey data.

[End of table]

Table 4: Public Company Audit Committee Chairs' Population, Sample 
Sizes, and Survey Response Rates:

Population size; Fortune 1000 companies: 960; Domestic public 
companies and mutual funds: 14,887; Foreign public companies: 2,141; 
Totals: 17,988.

Sample size; Fortune 1000 companies: 330; Domestic public companies 
and mutual funds: 450; Foreign public companies: 391; Totals: 
1,171.

Total responses; Fortune 1000 companies: 191; Domestic public 
companies and mutual funds: 96; Foreign public companies: 63; 
Totals: 350.

Response rate; Fortune 1000 companies: 57.9%; Domestic public 
companies and mutual funds: 21.3%; Foreign public companies: 16.1%.

Source: GAO survey data.

[End of table]

Additional Survey Considerations:

We initially requested information from all 97 Tier 1 firms (firms with 
10 or more SEC clients). We received responses from 74 of them. We 
conducted follow-up with a limited number of the nonrespondents and did 
not find substantive differences between the respondents and the 
nonrespondents on key questions related to mandatory audit firm 
rotation. We requested information from 330 Fortune 1000 public 
companies and their audit committee chairs and received 201 and 191 
responses from them, respectively. While we did not conduct follow-up 
with the nonrespondents from our surveys of Fortune 1000 public 
companies and their audit committee chairs, we had no reason to believe 
that respondents and nonrespondents to our original samples from these 
strata would substantively differ on issues related to mandatory audit 
firm rotation. Therefore, we analyzed respondent data from the Tier 1 
and Fortune 1000 public companies and their audit committees as 
probability samples from these respective populations.

Survey results based on probability samples are subject to sampling 
error. Each of the three samples (Tier 1 and Fortune 1000 public 
companies and their audit committee chairs) is only one of a large 
number of samples we might have drawn from the respective populations. 
Since each sample could have provided different estimates, we express 
our confidence in the precision of our three particular samples' 
results as 95 percent confidence intervals. These are intervals that 
would contain the actual population values for 95 percent of the 
samples we could have drawn. As a result, we are 95 percent confident 
that each of the confidence intervals in this report will include the 
true values in the respective study populations. All percentage 
estimates from the survey of Tier 1 firms have sampling errors not 
exceeding +/-7 percentage points unless otherwise noted. All percentage 
estimates from the surveys of Fortune 1000 public companies and their 
audit committee chairs have sampling errors not exceeding +/-6 
percentage points unless otherwise noted. Also, estimated percentages 
for subgroups of Tier 1 firms and Fortune 1000 public companies and 
their audit committee chairs often have sampling errors exceeding these 
thresholds, which are noted where they are reported. In addition, all 
numerical estimates other than percentages have sampling errors of not 
more than +/-14 percent of the value of those numerical estimates.

Despite our judgment that respondents and nonrespondents do not differ 
on issues related to mandatory audit firm rotation, our survey 
estimates may nevertheless contain errors to the extent that there 
truly are differences between these groups on issues related to this 
topic.

The practical difficulties of conducting any survey also introduce 
other types of nonsampling errors. Differences in how a particular 
question is interpreted and differences in the sources of information 
available to respondents can also be sources of nonsampling errors. We 
included steps in both the data collection and data analysis stages to 
minimize such nonsampling errors. These steps included developing our 
survey questions with the aid of our survey specialists, conducting 
pretests of the public accounting firm and public company questions and 
questionnaires, verifying computer analysis by an independent analyst, 
and double verification of survey data entry where applicable.

Discussions Held with Officials of Other Interested Stakeholders:

To supplement the responses to our survey, we identified other 
knowledgeable individuals associated with a broad range of communities 
of interest and conducted telephone or in-person discussions to obtain 
their views on mandatory audit firm rotation. The communities of 
interest included significant institutional investors (pension funds, 
mutual funds, and insurance companies), self-regulatory organizations 
(such as stock exchanges), consumer advocacy groups, regulators (state 
boards of accountancy, banking regulators), the AICPA, the SEC, the 
PCAOB, and recognized experts in corporate governance.

The questions for these discussions were based on key questions from 
the surveys for public accounting firms and public companies. The 
results of the discussions were compiled and presented in summary form 
only as part of our report, and we will not release individually 
identifiable data from these discussions, unless compelled by law or 
required to do so by the Congress.

Obtaining Information from Other Countries on Their Experiences with 
Mandatory Audit Firm Rotation:

In order to obtain other countries' current or previous experience with 
or consideration of mandatory audit firm rotation, we administered 
surveys to the securities regulators of the Group of Seven 
Industrialized Nations (G-7), which included the United Kingdom, 
Germany, France, Japan, Canada, and Italy. In addition to the G-7 
countries' securities regulators, we also administered surveys to the 
following members of the International Organization of Securities 
Commissions (IOSCO)[Footnote 56]: Australia, Austria, Belgium, Brazil, 
China, Hong Kong, Luxembourg, Mexico, the Netherlands, Singapore, 
Spain, Sweden, and Switzerland. The IOSCO members represent these 
foreign countries' organizations with duties and responsibilities 
similar to those of the SEC in the United States.

We administered the surveys to these foreign countries' securities 
regulators in December 2002. From July and through October 2003, we 
performed follow-up efforts to increase the overall response rates by 
sending e-mail messages to the foreign countries' securities regulators 
in our sample who had not completed the survey and requested that they 
do so. We received responses from 11 of the 19 countries' securities 
regulators surveyed.

Identifying Restatements of Annual Financial Statements for Fortune 
1000 Public Companies due to Errors or Fraud:

To obtain some insight into the potential value of the "fresh look" 
provided by a new auditor of record, we analyzed the rate of annual 
financial statement restatements reported to the SEC by Fortune 1000 
public companies during 2002 and 2003 through August 31, 2003. We 
particularly focused on restatements for 2001 and 2002 and compared the 
financial statement restatement rates of those Fortune 1000 public 
companies that changed their auditor of record to those of Fortune 1000 
public companies that did not change their auditor of record during 
this period.

In connection with performing this analysis, we separately tracked the 
Fortune 1000 public companies that changed auditors from the public 
companies that did not change auditors during 2001 and 2002. Financial 
statement restatements filed for changes in accounting principles or 
changes in organizational business structure (e.g., stock splits, 
mergers and acquisitions), reclassifications, or to compliance with SEC 
reporting requirements are not necessarily indications of compromised 
audit quality or auditor independence. However, financial statement 
restatements due to errors or fraud raise doubt about the integrity of 
management's financial reporting practices, the quality of the audit, 
or the auditor's independence. Therefore, the focus of our analysis was 
on annual financial statement restatements (hereinafter referred to as 
"restatements") due to errors or fraud. Since not all restatements are 
indications of errors or fraud, we 
reviewed Form 10-KAs[Footnote 57] (amended 10-K filings), Form 8-Ks, 
and any related SEC enforcement actions to determine if the 
restatements were due to errors or fraud. The primary purpose of this 
test was to determine whether the rate of restatements due to errors or 
fraud of companies that changed auditors was higher or lower than the 
rate of restatements due to errors or fraud of companies that did not 
change auditors.

For each of the Fortune 1000 companies, we searched SEC's EDGAR system 
for Form 10-KA filings submitted to the SEC during 2002 and 2003 
through August 31, 2003, that amended either 2001 or 2002 financial 
statements to identify annual financial statement restatements. We 
determined if there had been a change in auditor from 2001 through 2002 
by reviewing the name of the auditor of record on the audit opinion 
included in the Form 10-KA filed for 2001 and 2002, and also noted what 
type of audit opinion was issued on the 2001 and 2002 financial 
statements. This allowed us to identify the restatements associated 
with Fortune 1000 public companies that changed auditors and the 
restatements of Fortune 1000 public companies that did not change 
auditors. We compared the level of restatements for Fortune 1000 public 
companies that changed auditors to the level of restatements of Fortune 
1000 public companies that did not change auditors.

For each of the restatements identified above, we reviewed underlying 
Form 10-KA (amended 10-K filings), Form 8-Ks, and any related SEC 
enforcement actions to quantify the dollar effect of the restatements 
and to determine if the restatements were due to errors or fraud. We 
differentiated restatements caused by errors or fraud from restatements 
caused by changes that were not indications of compromised audit 
quality or auditor independence, such as changes in accounting 
principles, mergers, stock splits, and reclassifications using 
appropriate classification criteria. In addition, we attempted to 
ascertain from the above sources whether company management, the 
predecessor auditor, or the successor auditor identified the error or 
fraud, and where applicable, whether it was identified before or after 
the change in auditor.

After categorizing the 2001 and 2002 Fortune 1000 public companies' 
annual financial statement restatements and annual financial statement 
filings into (1) companies that did not change auditors and filed a 
restatement, (2) companies that did not change auditors and did not 
file a restatement, (3) companies that changed auditors and filed a 
restatement, and (4) companies that changed auditors and did not file a 
restatement, we compared the rates of restatements among and between 
these groups.

[End of section]

Appendix II: Implementation of Mandatory Audit Firm Rotation, if 
Required:

If mandatory audit firm rotation were required, a number of 
implementing factors affecting the structure of the requirement would 
need to be decided. As a component of our surveys of public accounting 
firms, public companies, and their audit committee chairs, we asked 
them to provide their views on various implementing factors, regardless 
of whether they supported mandatory audit firm rotation, including:

* the limit on the incumbent firm's audit tenure period,

* the "cooling off" period before the incumbent firm could again 
compete to provide audit services to the public company,

* under what circumstances either the audit committee or the public 
accounting firm could terminate the relationship for providing audit 
services,

* whether mandatory audit firm rotation should be implemented on a 
staggered basis, and:

* whether mandatory audit firm rotation should be required for audits 
of all public companies, and if not, to which public companies should 
it be applied.

Time Limit on the Auditor of Record's Tenure:

Regarding the limit on the auditor of record's tenure under mandatory 
audit firm rotation, about 47 percent of Tier 1 firms stated that the 
limit should be 8 to 10 years. Fortune 1000 chief financial officers 
and audit committee chairs selected 8 to 10 years about as often as 5 
to 7 years as the limit on the auditor of record's tenure. Tiers 2 and 
3 firms and other public companies' audit committee chairs that 
responded to our surveys generally favored an audit tenure of 5 to 7 
years.

Time Limit Before the Auditor of Record Could Compete to Provide Audit 
Services to the Public Company Previously Audited:

Most Tier 1 firms and Fortune 1000 public company chief financial 
officers and their audit committee chairs believed the "cooling off" 
period under mandatory audit firm rotation should be 3 or 4 years 
before the auditor of record could again compete to provide audit 
services to the public company previously audited.

Circumstances When the Audit Committee or the Auditor of Record Could 
Terminate the Business Relationship Providing Audit Services:

Nearly all Tier 1 firms and Fortune 1000 public company chief financial 
officers and their audit committee chairs stated that the audit 
committee under mandatory audit firm rotation should be permitted to 
terminate the auditor of record at any time if it is dissatisfied with 
the public accounting firm's performance or working relationship. Most 
Tier 1 firms and Fortune 1000 public company chief financial officers 
and their audit committee chairs also believed that the auditor of 
record should be able to terminate its relationship with the audit 
committee/public company at any time if the public accounting firm is 
dissatisfied with the working relationship.

Period for Implementing Mandatory Audit Firm Rotation:

Nearly all Tier 1 firms and Fortune 1000 public company chief financial 
officers and their audit committee chairs believed that mandatory audit 
firm rotation should be implemented over a period of years (staggered) 
to avoid a significant number of public companies changing auditors 
simultaneously.

Public Companies for Which Auditor of Record Should Be Subject to 
Mandatory Audit Firm Rotation:

About 70 percent of Tier 1 firms believed that mandatory audit firm 
rotation should not be applied uniformly for audits of all public 
companies regardless of their nature or size. In contrast, about 81 
percent of Fortune 1000 public companies and 65 percent of their audit 
committee chairs believed that mandatory audit firm rotation should be 
applied uniformly for audits of all public companies regardless of the 
nature or size. Most chief financial officers of other domestic and 
mutual fund public companies who responded to our survey believe 
mandatory audit firm rotation should be applied uniformly, and their 
audit committee chairs were split on the subject. Comments that we 
received from many of the Tier 1 firms, Fortune 1000 public companies, 
and their audit committee chairs that supported requiring that 
mandatory audit firm rotation be applied uniformly generally took the 
view that there should be a level playing field and that the benefits 
and the costs of mandatory audit firm rotation should be applied to all 
public companies. In contrast, those who commented opposing requiring 
mandatory audit firm rotation for all public companies generally took 
the view that the smaller public companies are less complex and the 
costs of mandatory audit firm rotation would be more burdensome for the 
smaller companies.

We asked those public accounting firms and public company chief 
financial officers and their audit committee chairs who believed 
mandatory audit firm rotation should not be applied uniformly to all 
public companies to select by company nature and size to which 
companies mandatory audit firm rotation should apply. Tier 1 firms and 
Fortune 1000 audit committee chairs more frequently selected the larger 
public companies. However, Fortune 1000 chief financial officers were 
about evenly split in their views regardless of the size of the public 
company. Chief financial officers and their audit committee chairs of 
other domestic and mutual fund public companies, as well as foreign 
public company chief financial officers and their audit committee 
chairs, who responded to our survey more frequently selected the larger 
public companies.

[End of section]

Appendix III: Potential Value of Practices Other Than Mandatory Audit 
Firm Rotation for Enhancing Auditor Independence and Audit Quality:

We asked public accounting firms, public companies' chief financial 
officers, and their audit committee chairs to provide their views on 
the potential value of the various following alternative practices we 
identified through our research and other inquiries made in developing 
our surveys versus the value of other than mandatory audit firm 
rotation for enhancing auditor independence and audit quality.

* The audit committee periodically holding an open competition for 
providing audit services: Having the audit committee periodically hold 
an open competition for public accounting firms to serve as the public 
company's auditor of record, in which the incumbent auditor of record 
could also compete, could potentially enhance auditor independence and 
audit quality by letting the incumbent firm know that it does not have 
unlimited tenure as the auditor of record and a lock on the associated 
revenues, and that another firm may be selected to provide a "fresh 
look" at the company's financial reporting process, practices, and 
financial statements. Also, the public company has an opportunity to 
see the quality of personnel that another public accounting firm could 
provide. However, the public company will incur some costs in holding 
such a competition and, if another firm is selected, may incur 
additional initial years' audit fees and will have additional auditor 
support costs to assist the new auditor of record in understanding the 
company's operations, systems, and financial reporting practices.

* Requiring audit managers to periodically rotate off the engagement 
for providing audit services to the public company: Audit manager is a 
senior position reporting to the engagement audit partner with 
responsibility for assisting the engagement audit partner in planning, 
conducting, and reporting on the audit of the public company's 
financial statements. Larger audits will likely have multiple audit 
managers and audit partners participating in the audit. Conceptually, 
periodically changing audit managers brings a "fresh look" to the audit 
assignment and the associated potential benefits. However, there is an 
associated learning curve that is likely to cause both the public 
accounting firm and the public company to incur some additional costs. 
Some public accounting firms commented that this practice already 
occurs as a result of career enhancement policies and practices of the 
firms.

* The audit committee periodically obtaining the services of a public 
accounting firm to assist it in overseeing the financial statement 
audit or to conduct a forensic audit in areas of the public company's 
financial reporting process that present a risk of fraudulent financial 
reporting: Overseeing the auditor of record's conduct of the financial 
statement audit is a significant responsibility that is especially 
challenging depending on the size and complexity of a public company. 
Having another public accounting firm as needed to assist the audit 
committee brings a "fresh look" to help the audit committee understand 
the public company's operations, systems, and financial reporting 
practices and the underlying internal controls and risks. Also, as 
areas are identified that may have greater risk of fraudulent financial 
reporting, the audit committee may wish to have a public accounting 
firm conduct a forensic audit to provide both a "fresh look" and a more 
penetrating audit of transactions and related internal controls and 
financial reporting practices in areas of high risk. Additional costs 
will be incurred by the audit committee, and some degree of 
coordination and cooperation of the incumbent audit firm will be 
necessary, which will also add to the audit committee's 
responsibilities.

* Requiring that the auditor of record be hired on a noncancelable 
multiyear basis, although the public accounting firm could terminate 
the relationship for cause during the contract period: Having the audit 
committee hire the auditor of record on a multiyear basis that only the 
auditor of record can cancel potentially enhances auditor independence 
and audit quality by assisting the auditor in dealing with any 
pressures from management in appropriately dealing with financial 
reporting practices that may materially affect the financial 
statements. However, this practice takes away flexibility of the audit 
committee to replace the auditor of record within the period of the 
contract should the audit committee be dissatisfied with the auditor of 
record's performance.

Although many Tier 1 firms, Fortune 1000 public companies, and their 
audit committee chairs saw some benefit in each of the alternative 
practices, in general, they most frequently reported that the 
alternative practices would have limited or little benefit. The most 
notable exception involved the practice in which audit committee would 
hire the auditor of record on a noncancelable multiyear basis, for 
which most Fortune 1000 public companies and their audit committee 
chairs reported that the practice would have no benefit. (See table 
5.):

Table 5: Views on Potential Value of Other Practices for Enhancing 
Auditor Independence and Audit Quality:

Numbers in percentages.

Practice 1: Audit committee periodically holding open competition for 
providing audit services: 

Tier 1 firms; Significant or very positive benefit: 11; Limited or 
little benefit: 44; No benefit: 45.

Fortune 1000 public companies; Significant or very positive benefit: 
11; Limited or little benefit: 53; No benefit: 36.

Fortune 1000 audit committee chairs; Significant or very positive 
benefit: 23; Limited or little benefit: 53; No benefit: 24.

Practice 2: Requiring periodic rotation of audit managers: 

Tier 1 firms; Significant or very positive benefit: 14; Limited or 
little benefit: 57; No benefit: 29.

Fortune 1000 public companies; Significant or very positive benefit: 
24; Limited or little benefit: 48; No benefit: 28.

Fortune 1000 audit committee chairs; Significant or very positive 
benefit: 42; Limited or little benefit: 46; No benefit: 12.

Practice 3: Audit committee periodically obtaining service of a public 
accounting firm to assist in overseeing the financial statement audit: 

Tier 1 firms; Significant or very positive benefit: 20; Limited or 
little benefit: 53; No benefit: 27.

Fortune 1000 public companies; Significant or very positive benefit: 
10; Limited or little benefit: 42; No benefit: 48.

Fortune 1000 audit committee chairs; Significant or very positive 
benefit: 13; Limited or little benefit: 59; No benefit: 28.

Practice 4: Audit committee periodically obtaining service of a public 
accounting firm to conduct a forensic audit: 

Tier 1 firms; Significant or very positive benefit: 30; Limited or 
little benefit: 46; No benefit: 24.

Fortune 1000 public companies; Significant or very positive benefit: 
13; Limited or little benefit: 50; No benefit: 37.

Fortune 1000 audit committee chairs; Significant or very positive 
benefit: 19; Limited or little benefit: 61; No benefit: 20.

Practice 5: Audit committee hiring auditor of record on a noncancelable 
multiyear basis: 

Tier 1 firms; Significant or very positive benefit: 22; Limited or 
little benefit: 48; No benefit: 30.

Fortune 1000 public companies; Significant or very positive benefit: 5; 
Limited or little benefit: 34; No benefit: 61.

Fortune 1000 audit committee chairs; Significant or very positive 
benefit: 6; Limited or little benefit: 37; No benefit: 57.

Source: GAO analysis of survey data.

[End of table]

[End of section]

Appendix IV: Restatements of Annual Financial Statements for Fortune 
1000 Public Companies Due To Errors or Fraud:

To obtain some insight into the potential value of the "fresh look" 
provided by a new auditor of record, we analyzed the rate of annual 
financial statement restatements reported to the Securities and 
Exchange Commission (SEC) by Fortune 1000 public companies during 2002 
and 2003 through August 31, 2003. We particularly focused on 
restatements for 2001 and 2002 and compared the financial statement 
restatement rates of those Fortune 1000 public companies that changed 
their auditor of record to those Fortune 1000 public companies that did 
not change their auditor of record during this period.

Historically, only about 3 percent of public companies change auditors 
in any given year.[Footnote 58] However, we observed that 2.9 percent 
(28 out of 960[Footnote 59]) of the Fortune 1000 public companies 
changed auditors during 2001 and 21.3 percent (204 out of 960) of the 
Fortune 1000 public companies changed auditors during 2002. The 
significant increase from 2001 through 2002 was primarily due to the 
dissolution of Arthur Andersen LLP in 2002, which was caused, in part, 
by its criminal indictment for obstruction of justice stemming from its 
role as auditor of Enron Corporation. Since many of these public 
companies had to replace Andersen as their auditor of record during 
2002, the number of changes in their auditor of record effectively 
represented a partial form of mandatory audit firm rotation.

Tables 6 and 7 summarize the occurrence of the reported Fortune 1000 
public companies' restatement filings.

Table 6: Summary Results of the Fortune 1000 Public Companies That 
Changed Auditors:

Number of companies with restatements due to: Rules based changes; 
2001: 0; 2002: 0; Errors; 2001: 3; 2002: 7; Fraud; 2001: 0; 2002: 1.

Number of companies with restatements due to: Restatements related to 
companies that changed auditors; 2001: 3; 2002: 8.

Number of companies with restatements due to: Fortune 1000 public 
companies that changed auditors; 2001: 28; 2002: 204.

Number of companies with restatements due to: Restatement rate for 
companies that changed auditors; 2001: 10.7%; 2002: 3.9%.

Source: GAO analysis of restatements.

[End of table]

Table 7: Summary Results of the Fortune 1000 Public Companies That Did 
Not Change Auditors:

Number of companies with restatements due to: Rules based changes; 
2001: 2; 2002: 1; Errors; 2001: 21; 2002: 8; Fraud; 2001: 2; 2002: 1.

Number of companies with restatements due to: Restatements related to 
companies that did not change auditors; 2001: 25; 2002: 10.

Number of companies with restatements due to: Fortune 1000 public 
companies that did not change auditors; 2001: 932; 2002: 756.

Number of companies with restatements due to: Restatement rate for 
companies that did not change auditors; 2001: 2.7%; 2002: 1.3%.

Source: GAO analysis of restatements.

[End of table]

The combined restatement rates from tables 6 and 7 for all Fortune 1000 
public companies, including those that changed auditors and those that 
retained their auditor of record, was 2.9 percent in 2001 (28 
restatements out of the 960 Fortune 1000 public companies) and 1.9 
percent in 2002 (18 restatements out of the 960 Fortune 1000 public 
companies). The overall restatement rates are higher in 2001 than the 
comparable levels of restatements observed in 2002. This may be due to 
the fact that our analysis was limited to restatements submitted to the 
SEC on Form 10-KA filings for 2001 and 2002 through August 31, 2003. 
Some of the Fortune 1000 public companies that had not filed 
restatements with the SEC as of August 31, 2003, may still do so in the 
future. Additionally, because some companies may require considerable 
amounts of time and effort to unravel complex accounting and financial 
reporting issues (e.g., WorldCom, which is in the process of working 
its way out of bankruptcy proceedings, and the Federal Home Loan 
Mortgage Corporation, better known as Freddie Mac, which is working to 
restate 3 years of previously issued financial statements), it is 
reasonable to expect that additional restatements will be included in 
Form 10-KAs or other filings that had not been submitted to the SEC as 
of August 31, 2003.

Financial statement restatements filed for changes in accounting 
principles or changes in organizational business structure (e.g., stock 
splits, mergers and acquisitions), reclassifications, or compliance 
with SEC reporting requirements, referred to as "rules based changes," 
are not necessarily indications of compromised audit quality or auditor 
independence. However, financial statement restatements due to errors 
or fraud raise doubt about the integrity of management's financial 
reporting practices, the quality of the audits, and the auditor's 
independence. Therefore, the following focus of our analysis was on 
annual financial statement restatements (hereinafter referred to as 
"restatements") due to errors or fraud.

The rate of restatement due to errors or fraud for Fortune 1000 public 
companies that changed auditors were 10.7 percent in 2001 and 3.9 
percent in 2002 compared to restatement rates due to errors or fraud of 
2.5 percent in 2001 and 1.2 percent in 2002 for companies that did not 
change auditors. Although the data indicate that the overall 
restatement rate is approximately four[Footnote 60] times higher in 
2001 and three times higher in 2002[Footnote 61] for those Fortune 1000 
public companies that changed auditors than for those companies that 
did not change auditors, caution should be exercised as further 
analysis would be needed in order to determine whether the restatements 
are associated with the "fresh look" of the new auditor attributed to 
mandatory audit firm rotation. In that respect, in some cases we were 
able to determine from our review of the Form 10-KAs, any related Form 
8-Ks, and the results of Internet news searches, that the restatements 
were identified as a result of an SEC investigation or an enforcement 
action. However, for the majority of the restatements we identified, 
the information included in the SEC's EDGAR system did not provide 
sufficient information to ascertain whether company management, and in 
those cases where there was a change in auditor, the predecessor 
auditor, or the successor auditor identified the error or fraud and 
whether it was identified before or after the change in auditor. Also, 
the recent corporate financial reporting failures have greatly 
increased the pressures on management and auditors regarding honest, 
fair, and complete financial reporting.

Effect of Restatements Due to Errors or Fraud:

The phrase in an auditor's unqualified opinion, "present fairly, in all 
material respects, in conformity with generally accepted accounting 
principles," indicates the auditor's belief that the financial 
statements taken as a whole are not materially misstated. An auditor 
plans an audit to obtain reasonable assurance of detecting 
misstatements that could be large enough, individually or in the 
aggregate, to be quantitatively material to the financial 
statements.[Footnote 62] Financial statements are materially misstated 
when they contain misstatements the effect of which, individually or in 
the aggregate, is important enough to cause them not to be presented 
fairly, in all material respects, in conformity with generally accepted 
accounting principles. As previously noted, misstatements can result 
from errors or fraud. As defined in Financial Accounting Standards 
Board Statement of Financial Concepts No. 2, materiality represents the 
magnitude of an omission or misstatement of an item in a financial 
report that, in light of surrounding circumstances, makes it probable 
that the judgment of a reasonable person relying on the information 
would have been changed or influenced by the inclusion or correction of 
the item.

Table 8 summarizes the net dollar effect of the restatements due to 
errors or fraud on the reported net income (loss) of all 43 companies' 
previously issued annual financial statements for the fiscal years, 
calendar years, or both ended from 1997 through 2002.[Footnote 63]

Table 8: Summary of Net Dollar Effect of Restatements Due to Errors and 
Fraud:

Dollars in millions.

Net effect of restatements; 1997: ($69.2); 1998: ($71.2); 1999: 
($1,387.0); 2000: ($821.4); 2001: ($456.3); 2002: ($124.8).

Net income (loss), previously reported; 1997: $337.4; 1998: $316.4; 
1999: $11,054.7; 2000: $12,234.2; 2001: ($1,234.4); 2002: ($640.2).

Misstatement rate; 1997: (20.5)%; 1998: (22.5)%; 1999: (12.5)%; 2000: 
(6.7)%; 2001: (37.0)%; 2002: (19.5)%.

Source: GAO analysis of restatements.

[End of table]

The misstatement rates associated with these 43 companies' previously 
issued statements of net income (loss), which ranged from a 6.7 percent 
overstatement of net income (loss) for 2000 to a 37.0 percent 
understatement of net income (loss) for 2001, would clearly be 
considered material enough to have affected the fair presentation of 
the results of operations included in these 43 companies' financial 
statements. Accordingly, it is probable that the judgment of a 
reasonable person relying on the information included in these 
companies' previously issued financial statements would have been 
changed or influenced by the inclusion of omitted information or 
correction of misstated items due to errors or fraud.

[End of section]

Appendix V: International Experience with Mandatory Audit Firm 
Rotation:

Italy:

Italy has required mandatory audit firm rotation of listed companies 
since 1975 in which the audit engagement may be retendered (recompeting 
for providing audit services) every 3 years and the same public 
accounting firm may serve as the auditor of record for a maximum of 9 
years. In addition, there is a minimum time lag of 3 years before the 
predecessor auditor can return. The mandatory audit firm rotation 
requirement was intended to safeguard the independence of public 
accounting firms. In a meeting with IOSCO Standing Committee one 
member, the Italian representative from Commissione Nazionale per le 
Societa e la Borsa (CONSOB), the Italian securities regulator, 
indicated that Italy's experience with mandatory audit firm rotation 
has been a good one, noting that mandatory audit firm rotation gives 
the appearance of independence, which is considered very important to 
maintaining investor confidence. However, it was also noted that there 
have been negative impacts, when after 3 years, there is fee pressure 
by the listed company on the audit firm that contributes to reduced 
audit fees. In responding to our survey, CONSOB's representative 
indicated that there has been a progressive reduction in audit fees, 
which has given rise to concern over audit firms' ability to maintain 
adequate levels of audit services and quality control.

Research in Italy[Footnote 64] concludes that mandatory audit firm 
rotation carries significant threats to audit quality from competitive 
pressures. However, the CONSOB raised concerns about the study's 
methodology, accuracy, data used, and appropriateness of the 
conclusions. Our review of the executive summary of the study also 
identified potential limitations on the reliability of data used and 
methodological concerns that created uncertainties about the study's 
conclusions.[Footnote 65] Italy has also considered partner rotation; 
however, because Italy is currently considering reducing the maximum 
auditor tenure from 9 years to 6 years, partner rotation has not been 
given further consideration.

Brazil:

Brazil enacted a mandatory audit firm rotation requirement in May 1999 
with a 5-year maximum term and minimum time lag of 3 years before the 
predecessor auditor of record can return. The Comissao de Valores 
Mobiliarios (CVM), which is the Brazilian Securities Commission, 
indicated that the primary reason mandatory audit firm rotation was 
enacted was to strengthen audit supervision following accounting fraud 
at two banks (Banco Economico and Banco Nacional). Brazil does not have 
a partner rotation requirement, as the CVM believes that the 
requirement of rotating audit firms is stronger than changing partners 
within firms. However, as a component of its mandatory audit firm 
rotation requirement, Brazil prohibits an individual auditor who 
changes audit firms to audit the same corporations previously audited.

Singapore:

Starting in March 2002, the Monetary Authority of Singapore stipulated 
that banks incorporated in Singapore should not appoint the same public 
accounting firm for more than 5 consecutive financial years. However, 
this requirement does not apply to foreign banks operating in 
Singapore. Banks incorporated in Singapore that have had the same 
public accounting firm for more than 5 years have until 2006 to change 
their audit firms. While a "time out" period is not stipulated, banks 
incorporated in Singapore shall not, except with the prior written 
approval of the Monetary Authority of Singapore, appoint the same audit 
firm for more than 5 consecutive years. In addition, listed companies 
are required under the Listing Rules of the Singapore Exchange to 
rotate audit partners-in-charge every 5 years.

The primary reason Singapore instituted mandatory audit firm rotation 
for local banks was to promote the independence and effectiveness of 
external audits. In addition, mandatory audit firm rotation for local 
banks was cited by Singapore's officials as a measure to help (1) 
safeguard against public accounting firms having an excessive focus on 
maintaining long-term commercial relationships with the banks they 
audit, which could make the firms too committed or beholden to the 
banks, (2) maintain the professionalism of audit firms--where with 
long-term relationships, audit firms run the risk of compromising their 
objectivity by identifying too closely with the banks' practices and 
cultures, and (3) bring a fresh perspective to the audit process--where 
with long-term relationships, public accounting firms might become less 
alert to subtle but important changes in the bank's circumstances.

Austria:

In Austria, Austrian Commercial Law will require mandatory audit firm 
rotation every 6 years to strengthen the quality of audits and to 
enhance auditor independence by limiting the time of doing business 
between the audited company and its auditor of record. The 6-year 
mandatory audit firm rotation requirement will become effective from 
the beginning of the year 2004, and there will be a minimum time lag of 
1 year before the predecessor auditor of record can return. Austria 
does not have a partner rotation requirement; however, anyone who 
serves as the audit partner of a public company for 6 consecutive years 
will not be allowed to continue to serve in that capacity by becoming 
employed by the company's successor auditor.

United Kingdom:

In January 2003, the United Kingdom adopted the recommendations of the 
Co-ordinating Group on Audit and Accounting Issues (CGAA)[Footnote 66] 
to strengthen the audit partner rotation requirements by reducing the 
maximum period for rotation of the lead audit partner from 7 years to 5 
years. The United Kingdom also adopted CGAA's recommendation to limit 
the maximum period for rotation of the other key audit partners to 7 
years. According to the CGAA report, the rotation of the audit 
engagement partner has been a requirement in the United Kingdom for 
many years, and the United Kingdom concluded that the requirements for 
the rotation of audit partners played an important role in upholding 
auditor independence.

With respect to the issue of mandatory audit firm rotation, the United 
Kingdom supports CGAA's recommendations, which concluded that the 
balance of advantage is against requiring the mandatory rotation of 
audit firms. The primary arguments against mandatory audit firm 
rotation, as cited in the CGAA report, include the possible negative 
effects on audit quality and effectiveness in the first years following 
a change, the substantial costs resulting from a requirement to switch 
auditors regularly, the lack of strong evidence of a positive impact on 
audit quality, the potential difficulty or impossibility of identifying 
a willing and able audit firm that can accept the audit without 
violating independence requirements in a concentrated listed company 
audit market, and competitive implications of such a requirement. 
However, CGAA also recommended that audit committees should consider 
changing their auditor of record when the audit tenure is from 15 years 
to 20 years.

France:

In France, audit partner rotation had been required since 1998 by the 
French Code of Ethics of the accounting profession. However, the 
requirement was not enforceable because the Code of Ethics had not 
specified any maximum length for mandatory rotation of audit partners. 
In August 2003, France promulgated the French Act on Strengthening of 
Financial Security, which makes it illegal for an audit partner to sign 
more than six annual audit reports. The main requirement that serves as 
an alternative to mandatory audit firm rotation is the French 
requirement of having two firms engaged in the audit of entities 
issuing consolidated financial statements, which has been a requirement 
since 1985 and has been reincluded in the August 2003 promulgation of 
the French Act on Strengthening of Financial Security. According to the 
Deputy Chief Accountant of the Commission des Operations de Bourse, 
mandatory audit firm rotation is not required in France primarily 
because of concern over the potential impairment of audit quality due 
to the new auditor's lack of knowledge of the company's operations.

Spain:

The Comision Nacional del Mercaso de Valores (CNMV)--the agency in 
charge of supervising and inspecting the Spanish stock markets and the 
activities of all the participants in those markets--indicated that 
from 1989 through 1995, Spain had a mandatory audit firm rotation 
requirement with a maximum audit term of 9 years, which included 
mandatory retendering every 3 years. The main objectives of this former 
requirement were to enhance auditors' independence and promotion of 
fair competition. However, in 1995, the Spanish "Company Law" and the 
Spanish "Audit Law" were amended, effectively eliminating the mandatory 
audit firm rotation requirement, by allowing that "after the expiration 
of the initial period (minimum 3 years, maximum 9 years), the same 
auditor could be re-hired by the shareholders on an annual basis." The 
Director of the CNMV indicated that the 9-year mandatory audit firm 
rotation requirement was abandoned since the main objective of 
increased competition among audit firms had been achieved and because 
of listed companies' increased training costs incurred with a complete 
new team of auditors from a new public accounting firm. In November 
2002, the Spanish "Audit Law" was amended to introduce a new 
requirement under which "all audit-engaged team" members (including 
audit partners, managers, supervisors, and junior staff) have to rotate 
every 7 years in certain types of companies, which include all listed 
companies, companies subject to public supervision, and companies with 
annual revenues over 30 million euros.

The Netherlands:

In January 2003, the Royal Nederlands Instituut van Register 
Accountants (NIvRA) and Nederlandse Orde van Accountants-
Administratieconsulenten (NOvAA) of the Netherlands, which are the 
bodies that represent the accounting profession in the Netherlands and 
are responsible for the qualifications and regulation of the accounting 
profession, adopted the recommendation of CGAA to strengthen the audit 
partner rotation requirements by reducing the maximum period for 
rotation of the engagement audit partner from 7 years to 5 years and to 
limit the maximum period for rotation of the other key audit partners 
to 7 years. The adoption of these measures by both NIvRA and NOvAA made 
these requirements a part of the code of conduct for auditors. A 
representative of the Netherlands Authority for the Financial Markets 
indicated that the Dutch government is in the process of promulgating 
these audit partner rotation regulations into law, where the 
requirement will only apply to public interest entities.

Japan:

In Japan, the Amended Certified Public Accountant Law was passed in May 
2003, and beginning on April 1, 2004, audit partners and reviewing 
partners will be prohibited from being engaged in auditing the same 
listed company over a period of 7 consecutive years. Mandatory audit 
firm rotation has never been required in Japan, and public companies 
have never been encouraged to voluntarily pursue audit firm rotation. 
While Japan agreed with the December 2002 report issued by the 
Subcommittee on Regulations of Certified Public Accountants of the 
Financial System Council that mandatory audit firm rotation will need 
further consideration in the future, Japan's securities regulator 
stated that mandatory audit firm rotation was not supported because of 
the concerns that it (1) may cause confusion given the concentration of 
audit business held by large public accounting firms, (2) is not 
required in other major countries other than Italy, (3) may 
significantly lower the quality of audits due to the need to arrange 
newly organized audits, and (4) would result in greater cost of 
implementation under the current concentration of audit business held 
by large public accounting firms.

Canada:

There are currently no Canadian requirements for mandatory audit firm 
rotation. However, mandatory audit firm rotation was included in 
banking legislation shortly after the 1923 failure of the Home Bank and 
up to the December 1991 revision of the Bank Act. The Bank Act required 
that two firms audit a chartered bank, but that the same two firms 
could not perform more than two consecutive audits. As a result, one of 
the two firms would have to rotate off the audit for a minimum of 2 
years.

According to Canadian officials, in practice this requirement was 
implemented in two different ways. Some banks appointed a panel of 
three audit firms with one of the three firms being a permanent auditor 
while the other two firms rotated every 2 years. Other banks appointed 
a panel of three audit firms and rotated among the three firms. 
Generally, the firm that was in its "off year" did not completely step 
away from the audit of the bank and would maintain at least a watch on 
developments in the bank's business and financial reporting to ensure 
that it was knowledgeable enough to step back in when it rotated on 
again.

One of the primary benefits of the system was believed to be that the 
use of two firms facilitated an independent review of the loan 
portfolio. This new perspective was generally considered to be a useful 
safeguard, and it was believed that the second firm would not bring 
with it an element of additional cost. The rotation element of the 
system was considered to bring with it an additional element of 
security by ensuring that issues were reviewed regularly by auditors 
with a fresh perspective, thus minimizing the risk of a problem 
festering because an issue was decided on and not reevaluated.

Since the 1923 failure of the Home Bank, the dual auditor requirement 
with mandatory audit firm rotation for one of the two audit firms every 
2 years was in place for over 60 years and was considered to be one of 
the key safeguards in the bank governance system. However, in 1985 two 
regional banks in the province of Alberta failed despite the existence 
of the dual auditor system. A subsequent government inquiry into the 
failures found that the Office of the Inspector General of Banks, now 
the Office of the Superintendent of Financial Institutions (OSFI), 
heavily relied on the external auditors and recommended the need for 
some direct examination by the supervisor of the quality of banks' loan 
portfolios. Until 1991, only Canadian banks were required to rotate 
their auditor of record. In 1991, in line with a push for harmonized 
supervision, banking legislation was amended to reduce the requirement 
to one audit firm, and the mandatory audit firm rotation requirement 
was abandoned with the revision of the Bank Act. According to Canadian 
officials, one of the reasons for the abandonment was that many argued 
that the cost was not matched by the benefits and it was noted that 
Canada seemed to be largely alone in the world imposing such a system. 
There were few strong advocates for retaining the system, but questions 
were raised as to whether it was in fact a valuable element of 
protecting the safety and soundness of the banking system.

Mandatory audit firm rotation is not currently being considered in 
Canada. Instead, as of July 2003, mandatory rotation of audit partners 
for all public companies was being considered by Canada's securities 
regulator, supported by a new model of independent oversight and 
inspection of auditors of public companies. The accounting profession, 
through the Public Interest and Integrity Committee of the Canadian 
Institute of Chartered Accountants and in collaboration with provincial 
institutes, is considering developing an updated independence standard 
that considers certain requirements of the Sarbanes-Oxley Act for 
Canadian application to listed financial institutions regulated by 
OSFI. This independence standard will focus on mandatory rotation of 
the engagement partner rather than the firm auditing a listed 
enterprise regulated by OSFI, as well as other key members of the firm 
involved with the audit. According to Canadian officials, extending 
this requirement to nonlisted financial institutions is under 
consideration but the outcome will not be known for some time.

Germany:

In Germany, according to the German Commercial Code, a qualified 
auditor or certified accounting firm, beginning with annual financial 
statements issued after December 31, 2001, may not be an auditor of a 
stock corporation that has issued officially listed shares if it 
employs a certified accountant who has signed the certification 
concerning the examination of the annual financial statements or the 
consolidated financial statements of the corporation more than six 
times in the 10 years prior to the fiscal year to be examined. 
According to German officials, the principle of audit partner rotation 
has proven to be successful, and there are no plans to switch to a 
model based on mandatory audit firm rotation because the purpose of 
guaranteeing an independent audit of the financial statements of a 
company can be efficiently achieved by audit partner rotation. However, 
in order to improve investor protection and company integrity, 
Germany's federal government published a 10-point paper, which included 
a planned amendment to the corresponding Commercial Code regulations to 
shorten the period of time after which an auditor of record must rotate 
to every 5 years and to include all responsible audit partners in the 
rotation requirement.

[End of section]

Appendix VI: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

Jeanette M. Franzel, (202) 512-9471 John J. Reilly, Jr., (202) 512-
9517:

Staff Acknowledgments:

In addition to those individuals named above, William E. Boutboul, 
Cheryl E. Clark, Robert W. Gramling, Wilfred B. Holloway, Michael C. 
Hrapsky, Catherine M. Hurley, Charles E. Norfleet, Judy K. Pagano, 
Sidney H. Schwartz, Jason O. Strange, Partricia A. Summers, and Walter 
K. Vance made key contributions to this report.

(194346):

FOOTNOTES

[1] For purposes of this report, public companies refers to issuers, 
the securities of which are registered under 15 U.S.C. § 78l, that are 
required to file reports under 15 U.S.C. § 780 (d), or that file or 
have filed a registration statements that have not yet become effective 
under the Securities Act of 1933.

[2] Pub. L. No. 107-204, 116 Stat. 745.

[3] Mandatory rotation is defined in the Sarbanes-Oxley Act as the 
imposition of a limit on the period of years in which a particular 
public accounting firm registered with the PCAOB may be the auditor of 
record for a particular public company. For purposes of this report, 
the auditor of record is the public accounting firm issuing an audit 
opinion of the public company's financial statements.

[4] Section 102 of the Sarbanes-Oxley Act requires public accounting 
firms that want to audit public companies to register with the PCAOB 
and states that it shall be unlawful for any person who is not a 
registered public accounting firm to prepare, issue, or participate in 
the preparation or issuance of any audit report with respect to any 
issuer.

[5] The 92 Tier 1 firms with 10 or more public company clients 
represented about 90 percent of the total public company clients 
reported by member firms in their 2001 annual reports to the AICPA's 
former self-regulatory program for audit quality. Hereafter in this 
report, "Tier 1 firms" refers to the 97 firms that had 10 or more 
public company clients.

[6] The 604 Tier 2 firms with 1 to 9 public company clients in 2001 
represented about 10 percent of the total public company clients 
reported by member firms in their 2001 annual reports to the AICPA's 
former self-regulatory program for audit quality.

[7] Estimates of Tier 1 firms are subject to sampling errors of no more 
than plus or minus 7 percentage points (95 percent confidence level) 
unless otherwise noted, as well as to possible nonsampling errors 
generally found in surveys.

[8] We removed 40 private companies from the list of Fortune 1000 
public companies. Therefore, our population of Fortune 1000 public 
companies was 960. 

[9] The estimates from these surveys are subject to sampling errors of 
no more than plus or minus 6 percentage points (95 percent confidence 
level) unless otherwise noted, as well as to possible nonsampling 
errors generally found in surveys. 

[10] Hereafter, "Fortune 1000 public companies" refers to their chief 
financial officers.

[11] U.S. General Accounting Office, Public Accounting Firms: Mandated 
Study on Consolidation and Competition, GAO-03-864 (Washington, D.C.: 
July 30, 2003).

[12] PricewaterhouseCoopers LLP, Ernst & Young LLP, Deloitte & Touche 
LLP, and KPMG LLP.

[13] Senate Report 107-205, at 14 (2002).

[14] Audit quality as used in this report refers to the auditor 
conducting the audit in accordance with generally accepted auditing 
standards (GAAS) to provide reasonable assurance that the audited 
financial statements and related disclosures are (1) presented in 
conformity with GAAP and (2) are not materially misstated whether due 
to errors or fraud. This definition assumes that reasonable third 
parties with knowledge of the relevant facts and circumstances would 
have concluded that the audit was conducted in accordance with GAAS and 
that, within the requirements of GAAS, the auditor appropriately 
detected and then dealt with known material misstatements by (1) 
ensuring that appropriate adjustments, related disclosures, and other 
changes were made to the financial statements to prevent them from 
being materially misstated, (2) modifying the auditor's opinion on the 
financial statements if appropriate adjustments and other changes were 
not made, or (3) if warranted, resigning as the public company's 
auditor of record and reporting the reason for the resignation to the 
SEC. 

[15] Hereafter, the presentation of our detailed Tier 1 firm survey 
results represent estimated projections to their population.

[16] Hereafter, the presentation of our detailed Fortune 1000 public 
companies' and their audit committee chairs' survey results represent 
estimated projections to their populations.

[17] The Conference Board is a not-for-profit organization that 
conducts conferences, makes forecasts and assesses trends, publishes 
information and analysis, and brings executives together to learn from 
one another. The Conference Board formed the commission to address the 
circumstances that led to the recent corporate scandals and subsequent 
decline of confidence in U.S. capital markets. The commission included 
former senior federal government officials, such as a former Chairman 
of the Board of Governors of the Federal Reserve System, former 
Chairman of the SEC, and former Comptroller General; a state government 
official responsible for the state's retirement system; a former U.S. 
senator; various private sector executives holding senior positions of 
responsibility; and a college professor.

[18] R. Doogar (University of Illinois, Urbana-Champaign) and R. Easley 
and D. Ricchiute (University of Notre Dame), "Switching Costs, Audit 
Firm Market Shares and Merger Profitability," (Nov. 20, 2001), which 
was discussed in GAO-03-864, cited a level of 2.7 percent annual client 
switching of auditors based on prior research the authors performed 
using 1981-1997 Compustat data.

[19] The Fortune 1000 public companies that hired a new audit firm to 
replace Andersen over the last 2 years reported that Andersen had 
served as their companies' auditor of record for an average of 26 
years.

[20] Although not specifically listed in our applicable survey 
question, several Tier 1 firms commented that public company 
management's integrity, honesty, and cooperation is of very great or 
great importance in the auditor's ability to detect material financial 
reporting issues.

[21] GAAS define audit risk as the risk that an auditor may unknowingly 
fail to appropriately modify his or her opinion on financial statements 
that are materially misstated.

[22] Several Tier 1 firms commented that cooperation of the predecessor 
public accounting firm is a barrier to full access of the firm's audit 
documentation and indicated that this is an area that the PCAOB may 
need to address.

[23] Although mandatory audit firm rotation would likely set a limit on 
the number of consecutive years the public accounting firm could serve 
as the company's auditor of record, it may also provide that the 
business relationship could be terminated by either party during that 
time.

[24] The 95 percent confidence interval surrounding this estimate 
ranges from 41 percent to 62 percent.

[25] The 95 percent confidence interval surrounding this estimate 
ranges from 51 percent to 77 percent.

[26] GAAP are subject to interpretation by public company management 
and underlying concepts of GAAP may be applied to transactions of a 
public company that are not specifically addressed by GAAP. The auditor 
may encounter situations in which public company management 
aggressively or optimistically applies the concepts of GAAP to achieve 
a certain result that arguably may not reflect the economic substance 
of the transactions while public company management believes such 
financial reporting complies with GAAP.

[27] The 95 percent confidence interval surrounding this estimate 
ranges from 54 percent to 79 percent.

[28] The 95 percent confidence interval surrounding this estimate 
ranges from 77 percent to 90 percent.

[29] Several Tier 1 firms commented that mandatory audit firm rotation 
could also result in costs to relocate staff given the unpredictability 
of where new audit clients would be located and increased costs for 
education and training of staff.

[30] Many Fortune 1000 public companies commented that mandatory audit 
firm rotation would lead to higher audit fees as the public accounting 
firms would want to recoup their additional costs within the limited 
time as auditor of record that would be established under mandatory 
audit firm rotation. Also, they stated there would be no incentive for 
the public accounting firms to absorb the additional costs since 
mandatory audit firm rotation would preclude long-term business 
relationships as the auditor of record.

[31] The 95 percent confidence interval for the estimate of these Tier 
1 firms that expect more than a 10 percent increase ranges from 29 
percent to 45 percent. Also, as shown in figure 6, the 95 percent 
confidence interval for the estimate of Tier 1 firms who have no basis 
or experience to estimate what their increase would be ranges from 15 
percent to 27 percent.

[32] The public company annual reports for the most recent fiscal year 
available (either 2002 or 2003) did not disclose any auditor selection 
or support costs that the companies may have incurred.

[33] We established the various ranges used for this analysis based on 
our analysis of the responses from Tier 1 firms and Fortune 1000 public 
companies. In establishing the ranges, we used survey responses 
consisting of the predominant responses (at least 68 percent) of those 
received.

[34] As of October 22, 2003, 89 percent of those Tier 1 firms that 
responded to our survey have registered with the PCAOB or have 
applications pending.

[35] In total, these Tier 1 firms that were uncertain whether they 
would continue to provide audit services to public companies if 
mandatory audit firm rotation were required audit 586 public companies.

[36] As of October 22, 2003, 80 percent of these Tier 2 firms that 
responded to our survey have registered with the PCAOB or have 
applications pending.

[37] In total, these Tier 2 firms that would discontinue providing 
audit services to public companies if mandatory audit firm rotation 
were required audit 154 public companies.

[38] GAO-03-864.

[39] A number of Tier 1 firms responding to our survey on mandatory 
audit firm rotation commented that the increased costs likely to be 
incurred by the firms under mandatory audit firm rotation could result 
in many smaller firms being unable to compete or absorb the increased 
costs, resulting in smaller firms leaving the market for providing 
audit services.

[40] The 95 percent confidence interval surrounding this estimate 
ranges from 17 percent to 39 percent.

[41] The 95 percent confidence interval surrounding this estimate 
ranges from 48 percent to 72 percent.

[42] The 95 percent confidence interval surrounding this estimate 
ranges from 62 percent to 86 percent.

[43] The 95 percent confidence interval surrounding this estimate 
ranges from 58 percent to 84 percent.

[44] Comments from a number of the Tier 1 firms primarily reiterated 
their previously stated views regarding the costs and benefits of 
mandatory audit firm rotation and that the SEC's recent audit partner 
rotation requirements better balance the need for a "fresh look" 
without eliminating the auditor of record's institutional knowledge of 
the client. They also reiterated that the Sarbanes-Oxley Act should be 
given time to work and rebuild investors' confidence. Similar comments 
were received from many of the Fortune 1000 public companies' chief 
financial officers and their audit committee chairs who also stressed 
the additional costs of mandatory audit firm rotation.

[45] SEC and PCAOB officials informed us that they have not taken a 
position on the merits of mandatory audit firm rotation.

[46] Individuals we spoke with that generally supported mandatory audit 
firm rotation included representatives of entities that currently have 
mandatory audit firm rotation policies, a consumer advocacy group, two 
individuals associated with oversight of the accounting profession, an 
individual knowledgeable in the regulation of public companies, and an 
expert in corporate governance.

[47] IOSCO is an international association of securities regulators 
that was created in 1983 to promote high standards of regulation in 
order to maintain just, efficient, and sound markets, promote the 
development of domestic markets, establish standards and an effective 
surveillance of international securities transactions, and promote the 
integrity of the markets by a rigorous application of the standards and 
by effective enforcement against offenses.

[48] Based on our review of literature concerning mandatory audit firm 
rotation, we found that Saudi Arabia was identified as presently 
requiring mandatory audit firm rotation of public companies. While 
Saudi Arabia is not an IOSCO member, we attempted to administer our 
survey to the Saudi Arabian Monetary Authority, Saudi Arabia's 
financial supervisory authority, but did not receive a response.

[49] Pub. L. No. 107-204, 116 Stat. 745, 775.

[50] The PCAOB established the process for public accounting firms to 
register with the PCAOB starting in April 2003, with public accounting 
firms having an initial opportunity to register with the PCAOB no later 
than October 22, 2003. As of October 22, 2003, according to the PCAOB, 
there were 598 public accounting firms registered with the PCAOB and 55 
public accounting firms that had applications pending the PCAOB's 
review.

[51] The AICPA's SECPS was a part of the former self-regulatory system. 
SECPS was overseen by the former Public Oversight Board (POB), which 
represented the public interest on all matters affecting public 
confidence in the integrity of the audit process. The SECPS required 
AICPA member accounting firms registered with the SECPS to subject 
their professional practices to peer review and oversight by the POB 
and SEC. The AICPA recently announced a new voluntary membership called 
the Center for Public Company Audit Firms that restructures and 
replaces the SECPS, which had several of its functions absorbed into 
the PCAOB. 

[52] According to SEC records, there were nearly 18,000 issuers 
registered with the SEC as of February 2003.

[53] U.S. General Accounting Office, Public Accounting Firms: Mandated 
Study on Consolidation and Competition, GAO-03-864 (Washington, D.C.: 
July 30, 2003).

[54] Estimates of Tier 1 firms are subject to sampling errors of no 
more than plus or minus 7 percentage points (95 percent confidence 
level) unless otherwise noted, as well as to possible nonsampling 
errors generally found in surveys.

[55] The estimates from these surveys are subject to sampling errors of 
no more than plus or minus 6 percentage points (95 percent confidence 
level) unless otherwise noted, as well as to possible nonsampling 
errors generally found in surveys. 

[56] IOSCO is an international association of securities regulators 
that was created in 1983 to promote high standards of regulation in 
order to maintain just, efficient, and sound markets; promote the 
development of domestic markets; establish standards and an effective 
surveillance of international securities transactions; and promote the 
integrity of the markets by rigorously applying the standards and by 
effectively enforcing them. 

[57] We focused on Form 10-KA filings because they include the actual 
restatements of previously issued annual financial statements included 
in the original Form 10-K. While amended quarterly filings (Form 10-QA) 
and Form 8-K filings may include disclosures of a public company's 
intention to restate previously issued annual financial statements, we 
did not consider Form 10-QA or Form 8-K filings for the purpose of 
identifying restatements of annual financial statements. Public 
companies may announce via a Form 10-Q or a Form 8-K that the company 
is going to restate in the near future, but then not file restated 
financial statements with the SEC because it may file for bankruptcy or 
become delisted. Therefore, we intentionally limited our review of the 
SEC's EDGAR system to identifying restatements of annual financial 
statements that were filed with the SEC during 2002 and 2003 through 
August 31, 2003. However, we also identified annual restatements of 
those Fortune 1000 public companies that included restatements in their 
annual Form 10-K filings. In addition, some public companies (such as 
Freddie Mac, WorldCom, Qwest, and Enron) and their auditors may still 
be in the process of determining the required adjustments and 
developing appropriate disclosures before they can file the restatement 
of previously issued annual financial statements via Form 10-KA to the 
SEC. Lastly, since we reviewed the Form 10-KA filings for 2002 that had 
been submitted to the SEC through August 31, 2003, the results of our 
analysis reflect restatements that have been submitted to the SEC 
through that date and therefore do not include or reflect restatements 
that may be filed in the future by any public companies that plan to 
restate previously issued financial statements or any public companies 
that may not yet be aware of a need to restate previously issued annual 
financial statements.

[58] R. Doogar (University of Illinois, Urbana-Champaign) and R. Easley 
and D. Ricchiute (University of Notre Dame), "Switching Costs, Audit 
Firm Market Shares and Merger Profitability," (Nov. 20, 2001), which 
was discussed in GAO-03-864, cited a level of 2.7 percent annual client 
switching of auditors based on prior research the authors performed 
using 1981-1997 Compustat data. 

[59] We identified 960 public companies included in the Fortune 1000 
for the purpose of developing our sampling approach for administering 
the public company surveys, that is, in framing the upper stratum of 
the population universe.

[60] The 10.7 percent rate of restatements due to errors or fraud of 
the Fortune 1000 public companies that changed auditors in 2001 was 
approximately 4.25 times higher than the 2.5 percent rate of 
restatements due to errors or fraud of the Fortune 1000 public 
companies that did not change auditors.

[61] The 3.9 percent rate of restatements due to errors or fraud of the 
Fortune 1000 public companies that changed auditors in 2002 was 
approximately 3.25 times higher than the 1.2 percent rate of 
restatements due to errors or fraud of the Fortune 1000 public 
companies that did not change auditors.

[62] Although the auditor should be alert for misstatements that could 
be qualitatively material, it ordinarily is not practical to design 
procedures to detect them. Section 326 of the AICPA's Statement on 
Auditing Standards states that "an auditor typically works within 
economic limits; his or her opinion, to be economically useful, must be 
formed within a reasonable length of time and at reasonable cost."

[63] The restatement of one of the 43 companies that submitted 
restatements due to errors or fraud related to financial statements 
that were originally issued in 1995. However, we were unable to 
quantify the dollar effect of the restatements associated with these 
financial statements because the SEC's EDGAR system did not include 
financial statements filed prior to 1997.

[64] SDA Universita Bocconi Corporate Finance and Real Estate 
Department and Administration and Control Department, The Impact of 
Mandatory Audit Rotation on Audit Quality and on Audit Pricing: The 
Case Of Italy (Executive Summary).

[65] The authors of the SDA Universita Bocconi study did not respond to 
our request to provide us additional information about the reliability 
of data that were used and the methodological approach. 

[66] The CGAA was established by the Chancellor of the Exchequer and 
the Secretary of State for Trade and Industry to ensure that there is a 
coordinated and comprehensive work program for individual regulators to 
review the United Kingdom's current regulatory arrangements for 
statutory audit and financial reporting, avoiding any unnecessary 
overlap; commission additional work or reviews if judged appropriate; 
and reach a view on the adequacy of the proposals, and, if appropriate, 
make specific recommendations.

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