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SEC Insights - October 2011

 

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Audit Reform

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Audit ReformAudit reform has been a key topic at the Public Company Accounting Oversight Board (PCAOB) as of late, in part due to the ever-increasing investor concern of the reliability of the United States’ financial reporting system. In particular, the PCAOB is currently contemplating reform of the Auditor’s Reporting Model, the feasibility of mandatory audit firm rotation, and the possible disclosure of engagement partners and other audit participants.

On September 15, 2011, the PCAOB held a Roundtable Discussion regarding the possible expansion of current auditor responsibilities in the Auditor’s Reporting. In attendance were professionals from all constituents of the business community including investors, auditors, preparers, audit committee members, as well as other business professionals.The topics up for discussion included the possible addition of an Auditor’s Discussion & Analysis, a possible required and expanded use of the emphasis paragraph in the auditor’s report, clarification of the language used in the standard auditor’s report, and possible required auditor assurance on information outside of the financial statements.

The first topic brought to the table was the possibility of adding an “Auditor’s Discussion & Analysis” (“AD&A”) section to Companies’ annual 10-K filings. This addition would give investors and other financial statement users an opportunity to view financial statements “through the eyes of the auditor”.It would also give auditors a chance to discuss their significant findings during the audit including certain risk assessments, significant changes made to the financial statements during the audit, the auditor’s assessment of management’s significant estimates, and a discussion of the quality of accounting policies and practices employed by management. It was found, in a recent survey conducted by the CFA Institute, that 86% of investors said they would welcome an AD&A section to the current financial statement format. Investors believe this additional information would provide even more transparency to the current reporting model and enhance their decision-making process.On the other hand, preparers of financial statements feel that if additional disclosure is deemed necessary by the PCAOB, more standards should be issued requiring expanded disclosure by management and not by auditors.Their view is that an auditor cannot disclose anything management could not also disclose and auditors from the roundtable discussion concur with the preparers’ view.Preparers fear the AD&A could begin as a discussion of audit findings and eventually spiral into auditor analysis of operational and financial results, potentially violating independence. Auditors seem to mirror this sentiment, expressing that management should remain the source of financial information, and the auditor remain the provider of assurance on that information. Representatives from public accounting firms also expressed concern for potential confusion of financial statement users if the auditor and management discussions conflict. Another disadvantage of an AD&A section in addition to confusion is the comparability of audit reports from different audit firms would suffer with the added subjective analysis.

Similar to the Auditor’s Discussion & Analysis section, the PCAOB also raised the possibility of a required emphasis paragraph in the standard audit report.This additional paragraph would include discussion of all significant areas encountered during audit, including discussion of significant management judgments and estimates.In addition to discussing the key areas, the auditor could also be required to discuss key procedures performed to address these areas. Opponents of the emphasis paragraph, which include preparers and auditors, expressed concern regarding the understandability of audit terms by a financial statement user.The concern is if procedures are discussed, is it reasonable to assume that a knowledgeable user will understand the language and topics discussed by the auditor, or will this discussion cause more confusion than transparency?However, auditors and preparers at the roundtable seemed more in favor of the emphasis paragraph in lieu of an AD&A section. Prepares and auditors believe the AD&A section would give opportunity for the traditional roles to become blurred.With the emphasis paragraph, you are giving investors more insight but without going into extensive detail on a myriad of topics. Another advantage of the emphasis paragraph from the auditors’ point of view is the sizable difference in cost and time to prepare this paragraph versus an AD&A section.

In relation to the concern of adding an emphasis paragraph, comprehension of the language used in the standard auditor’s report is another primary concern brought up by the PCAOB. Items up for discussion include terms like “reasonable assurance”, auditor’s responsibility for fraud, auditor’s responsibility for financial disclosures, management’s responsibility for the preparation of the financial statements, auditor’s responsibility for information outside the financial statements, and auditor independence. One weakness of the current report language brought up at the roundtable was the point that auditors do provide assurance on information in the footnotes but that the Standard Auditor’s Report only names the financial statement titles and does not expressly name the footnotes as part of the financial statements audited. Conversely, the report does not mention anything regarding assurance on the Management Discussion & Analysis (MD&A) section, in which the auditor does not audit but only reviews for material discrepancies from the financial statements.Because neither the footnotes to the financial statements nor the MD&A section are expressly mentioned in the auditor’s report, users could mistakenly have a false sense of assurance on such information if they are under the impressions that that both sections are audited along with the financial statements. The overall belief at the roundtable discussion is that the benefits to users from these simple clarifications would greatly outweigh any additional costs and time incurred to implement the changes.

The last topic up for discussion at the PCAOB roundtable was auditor assurance responsibilities on other information.As discussed in the previous paragraph, it is possible users of financial statements could be misguided as to the level of assurance provided by auditors on other information outside the financial statements.The PCAOB is proposing required assurance on other information such as MD&A non-GAAP information, and earnings reports released by companies.The purpose of this additional assurance would be to provide users with a higher level of confidence on all information provided by management. Currently, auditors are only responsible to review the MD&A section and to consider whether the information discussed is materially inconsistent with the financial statements. Proponents of additional assurance on MD&A believe that auditors should be more involved in this section to make sure liquidity analysis and other similar elements are included in order to improve the quality of the information provided. An interesting point brought forth by an investor at the roundtable is the importance of earnings releases to investor decisions. Investors believe that earnings releases are more extensive, more timely, and ultimately more influential in investor decision-making than a companies’ annual 10-K reports. Because of the significance of earnings reports to the investor community, the question was raised as to why so much focus is placed on the 10-K report and yet no assurance is required for earnings releases. Auditors are receptive to performing the extra procedures to provide this additional assurance, but there is a fear that they will eventually be asked to offer expertise on a variety of information and the role of the auditor could morph into an “uber monitor” of companies, providing assurance on everything to an excessive degree, which neither auditors nor management want.

All comments on the Concept Release regarding the Auditor’s Reporting Model were due September 30 and no final decisions have been made as of the date of this article.

In addition to the discussion of expanding the role of the auditor in financial reporting, the PCAOB released a Concept Statement in August to discuss proposed reform regarding audit firm rotation. The driving factor of this proposed reform is the constant request from investors and users of financial statements to enhance auditor independence, objectivity, and professional skepticism in financial reporting. Major downfalls of mandatory audit rotation identified in a General Accounting Office (GAO) study in November 2003 were the additional costs and the loss of knowledge of the public company’s auditor. At that time, the benefits were too unpredictable to suggest mandatory rotation reform so the GAO decided to monitor the effects of the Sarbanes-Oxley Act and revisit audit firm rotation in the future. The PCAOB has now decided to revisit this proposed reform.When considering this reform, a key question the PCAOB is contemplating is whether audit deficiencies are mainly due to independence issues or can be attributed to other issues.One suggestion included in the concept release was for audit committees to become more vigilant in identifying when the auditor is becoming too close and to regularly evaluate and consider whether auditor change is necessary. A potential model for audit firm rotation is not yet settled and the PCAOB is currently welcoming comments in order to evaluate the possible need for this reform. A recent article in the CPA Journal discussed the possible inadvertent downfalls of mandatory audit reform which include management taking advantage of new and unfamiliar auditors, increased costs and inefficiencies, and a possible decrease in audit quality due to lack of motivation on the audit firm side from knowing they will eventually lose the client regardless of the quality of the audit work performed. Audit firms might result to performing a “good enough” quality audit in order to save costs in response to the increased cost of constantly engaging new clients. In a recent article in Accounting Today, Jeffrey Weiner, the managing partner of accounting firm Marcum LLP, expressed his views on the possible reform in the following statement

“As one of the nation’s leading SEC audit firms serving middle-market companies, Marcum is concerned about the PCAOB’s announcement that they intend to revisit mandatory auditor rotation.There are not many PCAOB-registered audit firms qualified to meet the unique needs and partner-level attention required by America’s mid- and large-cap companies. Mandating ‘term limits’ for audit firms will lead to higher upfront costs for companies due to the time required to screen new firms as well as for the firm selected to get up to speed with a company’s operations/financial systems and to create new audit files. In addition, for the largest SEC registrants, the independence issue will reduce the number of firms available for rotation. There may not really be as many choices of firms as the numbers might suggest. Marcum believes that any effort at mandating audit firm rotation should undergo a thorough cost-benefit analysis weighing the benefits of perceived greater independence and objectivity against the costs of switching.”

The most recent PCAOB proposal was released on October 11 regarding the possible required disclosure of engagement partners and other audit participants in the audit report. This proposed amendment would require the disclosure of names of engagement partners and other participants in audit engagements in the audit report. Other participants disclosed would include other audit firms and other parties not employed by the audit firm, who participated in the engagement. The purpose of this additional disclosure is again, greater transparency for financial statement users.The board is currently accepting comments on this proposal through January 9, 2012.

The future of the auditor’s role remains to be seen. However, the desire for greater transparency and more assurance, expressed by investors and users of financial statements, suggest a future of more standards, more disclosures, and more auditor responsibility.
 
 
 
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