Is it time to revise 8-K rules on auditor changes? Announcing an auditor change can raise red flags, even though such concerns may be unwarranted. In this era of increasing transparency, 8-Ks that also include the reasons for change can allay negative assumptions.

For nearly three decades, negative perceptions have been associated with the act of a public company changing its auditor. The general assumption was that organizations make such a move in order to gain a more favorable opinion or escape a problem. What began in the 1970s--with a system for reporting auditor changes through 8-K filings--still persists today, distorting the opinions of analysts, ratings agencies, investors and others involved in the capital markets.

While required 8-K disclosures have evolved over time to provide expanded information about auditor changes, the persistence of negative perceptions raises several questions:

1. What predisposes capital markets influencers to resist auditor change?

2. How did misperceptions develop?

3. What needs to be done to allow companies to change auditors more freely--whether changing from one Big Four to another, from a Big Four to a mid-tier firm or from one mid-tier firm to another?

4. What needs to be done to provide investors and analysts with more complete information and transparency in assessing a change in auditors?

With these concerns in mind, it may be time to seriously reconsider the disclosure process.

Shaping Perceptions of Auditor Change

It is not difficult to understand how concerns about auditor changes developed. When first addressed by the Securities and Exchange Commission (SEC) as a means to curtail opinion shopping, Form 8-K filings were required only when there was a disagreement between a company and its auditors. As a result, changes were continually associated with problems in a company's financial statements, whether these problems were real or just perceived.

In 1988, the SEC updated these rules, requiring all companies to report auditor changes, as well as if there had been a disagreement between a company and an audit firm or if one of four "reportable events" had occurred. The change expanded the auditor change disclosure requirements. But the only required disclosures were negative, despite the fact that some positive reasons for an auditor change did and do exist--such as changing to work with a firm that specializes in your industry or market segment, getting better service from your firm or getting a better value for fees.

Thus, over time, an auditor change has become a "red flag" that problems may exist with a company's financial statements, making many companies reluctant to change firms--even if they would be changing for the right reasons.

"There is a lot that is good about current 8-K filing requirements, but I do believe it would be helpful if reasons for an auditor change were provided in all circumstances," says Greg Jonas, managing director of Moody's Investors Service. "Whenever companies change auditors, questions are raised as to why; some reasons people are relaxed about, while other reasons are concerning, so when you don't know--positive or negative--it's difficult to react appropriately."

The Sarbanes-Oxley Effect

In passing the Sarbanes-Oxley Act of 2002, Congress ushered in a new regulatory environment. The legislation included expanded independence requirements and thorough evaluations of internal controls, which fundamentally changed the relationships between public companies, audit committees and the external auditor.

Implementing these changes proved to be somewhat of a challenge. Companies found themselves reconsidering each step of their internal controls processes; auditors checked and doubled-checked work for fear of lawsuits; and tasks were now divided among more people and firms to assure independence. Finding the right answers was no longer easy, and costs associated with Sarbanes-Oxley requirements continued to surge.

Yet, due in part to the post-Sarbanes-Oxley audit environment, companies began to reconsider their audit firm choices--related to the best combination of technical expertise, client service, geographic reach and value for fees--despite misperceptions that still existed. Indeed, since 2003, more than 3,200 auditor dismissals have occurred (see table on this page).

Further evidence of this change can be found in the support shown by media and regulatory leaders regarding the need for auditor reviews. Among those to express concern is former Public Company Accounting Oversight Board (PCAOB) Chairman William McDonough, who, in an exit interview with The Wall Street Journal last fall, said his agency now encouraged issuers to "really look for an audit firm that makes sense for them. There's been a sort of a notion that rating agencies and maybe your lenders will think it's particularly spiffy if you're a small or medium-sized company and you deal with a Big Four firm. Frankly, I don't think that makes a whole lot of sense."

The topic of auditor concentration was addressed further in May 2005, when a group of 53 leaders gathered in New York City for an American Assembly meeting. The group comprised representatives from the regulatory, accounting, financial, legal, academic, investment banking and journalistic arenas, as well as corporate board members and audit committee chairs.

Among the results, assembly participants agreed that firms outside the Big Four could play a larger role in auditing public companies, but sometimes real, as well as artificial, barriers prevent companies from changing audit firms--particularly when changing to a firm outside the Big Four. Misperceptions among some market influencers, who effectively prevent companies from choosing mid-tier auditors, was noted as a significant barrier, and representatives conceded such perceptions were, to some extent, unwarranted.

Change Not Necessarily a 'Red Flag'

Fortunately, some companies are not only reassessing and changing their auditor relationships to better suit their organization, but they are also proactively addressing misperceptions in the market associated with this decision.

Notably, 11 percent more companies disclosed the circumstances for auditor changes in 2004 than in 2003, when they were not required to do so. The most-often cited voluntary disclosures included the following reasons:

* The new auditor was better suited to the company's size.

* The new auditor was more knowledgeable about the company's industry or operations.

* The new auditor was closer to the company's operation.

* A change in company control or management led to a new auditor.

* The incumbent auditor merged with another CPA firm.

* The audit partner from the incumbent firm had joined a different audit firm.

* The incumbent auditor chose not to register with the PCAOB.

In all of the above scenarios, the auditor change resulted from a business decision made by the board of directors and management for the benefit of the company and its shareholders. Thus, one may conclude, audit firm changes are not always--and should not be automatically perceived as--red flags, but rather as "yellow flags," identifying an event that should be analyzed more closely before judging its significance. And, further analysis may reveal the audit firm change is a "green flag" signaling a positive event resulting from proactive management.

Revising 8-K Rules for Reporting Audit Firm Changes

Although public acceptance of audit firm changes is improving, reform of the current 8-K disclosure rules would further increase the level of transparency surrounding audit firm changes and assure that communications between the new audit firm and its predecessor allow for the highest standards of accountability.

"Most of the 8-K disclosures that I've reviewed have not provided significant information regarding the underlying reasons and circumstances for the auditor change," says Neri Bukspan of Standard & Poor's. "When you look at an auditor change and the sensitivity of the relationship, it's important to know if a successor auditor could succeed where the predecessor auditor could not."

In one circumstance, he adds, the change could result from something as simple as a business reason, such as optimizing costs or service provided, while in another it could be the level of transparency in the reporting. "Further, knowing this information provides insight to both the auditor in learning what to overcome and the value to provide the user in details as to the audit's quality, as well as the management and board's posture as it relates to the financial reporting oversight process," says Bukspan.

Revising 8-K rules to require disclosure by both companies and audit firms and to require more open discussions between the successor and predecessor firms would benefit the capital markets by:

* Highlighting acceptable business reasons for changing audit firms, rather than focusing only on management problems and other negative implications;

* Reducing the risk that investors and analysts will misinterpret an auditor change by eliminating ambiguity in the related filings;

* Providing context for audit firm review by revealing reasons why other companies choose to change auditors;

* Promoting competition among audit firms to retain current clients and win new business, thus improving technology, client service and other firm offerings; and

* Preventing inconsistencies and sensitive areas from being overlooked by requiring open communications and full disclosure between the successor and predecessor.

Lynn Turner, managing director of research for Glass Lewis & Co., says, "Being aware of an auditor change and its reasoning provides investors with valuable information, allowing them to make a more informed decision regarding the company." He says that not providing any reason "gives investors a reason to wonder and worry about what happened." Following a study on auditor turnover he conducted in 2004, titled Auditor Turnover Gains Momentum, Turner believes the SEC should implement stronger rules, making disclosure of the reasons for an auditor change mandatory in all circumstances.

Tom Weirich, a professor of accounting at Central Michigan University, who conducted the study along with Turner, says there are different reasons why an auditor would resign or why a company would ask its auditor to leave. "Knowing this information," he says, "would be beneficial to investors and stockholders, as well as third parties in general."

What Can Be Done Now?

The system for reporting auditor changes simply does not meet the needs of the current audit environment, in which changes have become much more frequent. Reasons for all company dismissals of auditors and for all auditor resignations or not standing for reappointment should be required by the SEC to support transparency and responsibility in the investment community.

The appropriate match between a company and its external audit firm is simply too important to be controlled by concerns over misperceptions in the market--particularly when misperceptions can be so easily overcome through improved disclosure.

Although no reforms are yet in place, companies can still take steps towards improving the current audit environment by resisting the temptation to become complacent in their audit provider. That is, companies need to step back and think about their size, complexity, industry focus, market segment and geographic footprint, as well as the level of service (attention, responsiveness and access) they want from their audit firm.

Following their review, the company may find that its current audit firm is the best choice, and the board and management may take comfort in knowing they upheld their responsibility to investors. On the other hand, the company may find another firm better suited to its current needs. Then, the company should feel comfortable making the decision to change audit firms and documenting the rationale in its 8-K filing.

Finally, increasing transparency about auditor changes avoids misunderstandings and often replaces "red flags" with "green flags" of approval in the investment community.

Cono Fusco is a Managing Partner of Strategic Relationships for Grant Thornton LLP and can be reached at [e-mail] or 212.624.5230.

RELATED ARTICLE: takeaways

* 8-K filings were originally required by the SEC to indicate change due to a disagreement between a company and its auditors; revised requirements in 1998 expanded disclosure, but only for negative reasons.

* Sarbanes-Oxley has driven companies to reconsider audit firm choices, and more changes have occurred for business reasons: technical expertise, service, value and geographic reach.

* Since 2003, more than 3,200 auditor dismissals have occurred; PCAOB members also support change.

* Reforming current 8-K disclosures rules would increase the level of transparency surrounding audit firm changes.

Trends in Auditor Changes

              2001  2002  2003  2004  2005

Resignations   191   312   510   587   565
Dismissals     902   912   957  1149  1108
Total         1093  1224  1467  1736  1673

Source: Public Accounting Report, Jan. 17, 2005, and later data
extracted from AuditAnalytics