Keeping Corporate Managements Honest; The key is to switch the allegiance of the auditor to independent directors on company boards

August 19, 2013, 7:15 p.m. ET

Keeping Corporate Managements Honest

The key is to switch the allegiance of the auditor to independent directors on company boards.

ROBERT C. POZEN

In a rare burst of bipartisanship, the House of Representatives last month voted 321 to 62 to stop a government board from forcing public companies to change auditors every six or seven years. This requirement was floated by the Public Company Accounting Oversight Board, which suggested that term limits would bolster the independence of auditors.

An overwhelming number of congressmen rejected this requirement as too costly, and they passed an amendment to the 2002 Sarbanes-Oxley corporate-accounting law that would prohibit the board from adopting such mandatory rotation.Keeping auditors independent of management interference remains an important goal, but there is a better and less expensive way to achieve it. The key is to switch the allegiance of the auditor from the management of a public company to the board of directors’ audit committee that must be composed entirely of independent, or outside, directors.

Instead of mandatory rotation, I’d suggest that the audit committees of public companies be required, at least once every 15 years, to issue a request for proposals (RFP) for auditors to bid for the company’s audit business. The current audit firm would be permitted to submit a proposal explaining why it should be retained. The independent directors on the audit committee would then choose the company’s auditor for the next 15 years, based on a cost-benefit analysis of competing bids.

A newly appointed auditor must put forth a substantial investment to get up to speed on the complexities of a large public company. These costs, which are likely to be passed on to the company, would be incurred every six or seven years under mandatory auditor rotation. Under the RFP approach, the costs would occur at most every 15 years. In practice, the committee is likely to change auditors only if the benefits would exceed the transition costs.

The RFP process itself would confer most of the benefits sought by advocates of mandatory auditor rotation. The likelihood that auditors will become too cozy with company management is reduced when they owe their continued tenure to independent directors.

They will have an incentive to tell the audit committee about all the significant accounting judgments embedded in the company’s financial statements—especially borderline accounting issues. If they fail to do so, they may lose their contract. The possibility of another firm reviewing its work papers will make the current auditor more reluctant to bend the rules for management.

I recognize that under the approach I’m advocating the current auditor likely will be retained much of the time. There is nothing wrong with this if the current auditor is doing a good job at a reasonable fee. Nevertheless, the RFP requirement still would promote competition.

At present, the Big Four accounting firms—PriceWaterhouseCoopers, Ernst & Young, KPMG and Deloitte—have a virtual oligopoly over the audit business of the global companies in the Fortune 100 and FTSE 100. Since it is almost impossible for a middle-size firm to break into this oligopoly, they have little incentive to expand their resources to do so.

An RFP process would lead some middle-size firms to build the capacity to audit a large global company. As a practical matter, such capacity building is likely to start in specialized areas like biotech or oil.

Congress has sent a strong message to the Public Company Accounting Oversight Board against mandatory audit rotation. On the other hand, if the board simply required the audit committee of public companies to issue a RFP every 15 years, the regulator could achieve most of the benefits of mandatory auditor rotation at a much lower cost. These RFPs would increase the number of firms qualified to perform audits of the larger public companies.

Mr. Pozen, a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution, is the author of “Extreme Productivity: Boost Your Results, Reduce Your Hours” (HarperBusiness, 2012).