August 26, 2011

The Reliability, Role, and Relevance of the Audit: A Turning Point

By Ariana Sewell - Assurance Services and Sharnika Viswakula, Supervisor - Assurance Services

The Reliability, Role, and Relevance of the Audit: A Turning Point

On May 5, 2011, the 10th Annual Financial Reporting Conference was held at Baruch College in New York. The conference was an opportunity for communication between business and accounting executives and policy setters from the Public Company Accounting Oversight Board (PCAOB), U.S. Securities and Exchange Commission, and the Financial Accounting Standards Board. The Chairman of the PCAOB, James R. Doty, gave the keynote address titled, “The Reliability, Role, and Relevance of Audit: A Turning Point”. The speech focused on the importance of auditors, the problems and risks of the profession, and steps that the PCAOB is taking to lessen those risks.

Doty emphasized the fact that the American public believes that financial and economic data is reliable in this country and that auditors and audits are important to financial and economic communities. Ensuring that reports are honest is an integral part of keeping the system trustworthy. Doty highlighted three of the many risks and forces working against this trust. First, is the fact that the auditors are “hired and fired” by the engaging company. The Sarbanes Oxley Act’s reforms have shifted the decision of the “hiring and firing” of auditors from management to audit committee members. Doty points out that the audit committee, like management, may see their decision making role as one of negotiating the lowest fee over seeking auditor objectivity and independence from management. Second, all public companies are required to obtain an audit by law. As result of this, auditors do not have a “natural incentive” to customize reports to specific investor needs. Third, is the environment that auditors work in. External conflicts of interest arise, such as whether or not the going concern assumption is valid. Audit committees compensated with stock can also cause conflict. According to Doty, these three forces discourage the profession from innovating to meet public expectations, which is an honest opinion. The scopes of audits have not changed even though investors’ expectations have changed, especially since the financial crisis.

Doty stated that “there is no silver bullet to address these challenges”. However, the PCAOB is taking initiatives to reduce the risks created by these conflicts and confront incentives that impair investor protection. As European policy makers are facing the same issues, they also contribute ideas to what function audits serve and base them on lessons learned from the financial crisis. One of the ideas that surfaced amongst the European Commission and the U.K.’s House of Lords’ Select Committee on Economic Affairs (Lords’) is reversing some of the past consolidating efforts and breaking up the Big Four. While the Lords’ focused mainly on the failure of audits to warn of the impending financial crisis, there was also a conclusion made that “there is inevitably a connection between the assessment of the Big Four’s performance and the question…of market concentration”.

As an answer to this idea, Doty says that multinational firms are necessary to audit large, multinational companies and “governments should regulate such firms, not cripple them”. Firms at present compete on price and client service, not on investor protection; some auditors even question if the quality of the audit is of value to their corporate clients. To face this problem and focus on competition, the PCAOB expects to issue a concept release which may result in the first substantial changes in decades which could hold auditors to higher standards.

Doty then spoke directly about the initiatives to be taken by the PCAOB to “meet the public’s demand for more and better information from auditors”. Under Sarbanes-Oxley, all investigations and disciplinary proceedings of the PCAOB are kept confidential, unless consent is given by the respondents. The PCAOB has asked Congress to change this law, as it prohibits the public from gaining confidence in the Board’s oversight and denies any benefit from the deterrent effect on other entities. It also denies auditors the access to these proceedings in a timely manner. Doty made it clear that improving standards is not meant to “trap” auditors. “We write standards so that expectations are clear,” he stated.

Doty also stated that inspection by the PCAOB is a “key warning tool” and while many of the findings are confidential except to the firm being inspected, the significance should not be downplayed by auditors and audit committees should question auditors who try to do so. The PCAOB is now taking initiatives to improve communication between audit committees and auditors, improve audits of fair value measurements, and improve communication and quality control among firms in global networks engaged in multinational audits. Speaking on the oversight of multinational audits, Doty addressed the fact that, “for many large, multinational companies, a significant portion of the audit may be conducted abroad”. Companies assume that because the opinion is signed by the networked firm, the audit is of high quality. That is not always true. During inspection, the PCAOB has often found errors in work of affiliated firms whose work are signed off by principal auditors without proper review.

In order to improve global quality control, the PCAOB intends to enhance scrutiny of inspection and has joined forces with U.K. and Swiss authorities to perform inspections, while also working to reach similar agreements with European authorities. They are also engaging in discussion with Chinese authorities, as the number of Chinese companies seeking access to capital in U.S. securities markets grows. “U.S. markets continue to be attractive for companies that have their major operations in China. It is critical that investors in these companies are afforded the investor protections that attach to U.S. markets.”

As interests in American markets grow, it is up to auditors and the regulation of government to keep the American market protected and investors honestly informed. By focusing on issues raised by the financial crisis and making changes based on those issues, the protection of investors can grow and continue. Doty made it clear this is the intention of the PCAOB and that changes are being made to ensure it.