A Push for Audit Quality Could Send Costs Higher

Regulators are coming down hard on audit firms during inspections of their work, which is likely to result in future audits that involve more scrutiny of judgments and estimates, more testing, and more documentation— all of which could drive costs higher.

Through its latest round of inspection reports and through its pursuit of new auditing standards, the Public Company Accounting Oversight Board is raising the bar for auditor performance, calling for more skepticism and more audit evidence. The latest batch of published inspection reports takes the largest firms to task for higher instances of audit failures and chides all of the Big 4 and other firms for sub-par work. The ratio of failed audits to the total number of audits inspected more than doubled at some firms and ranges from 20 percent to nearly 50 percent among the Big 4 and second-tier audit firms, like Grant Thornton and BDO USA.

Joe Carcello, director of the Corporate Governance Center at the University of Tennessee and a member of the PCAOB's Standing Advisory Group, says the PCAOB's criticisms seem to be focused on two broad areas. First, inspectors are looking for more audit procedures around anything that involves estimates or assumptions, such as fair-value measurements, impairments, allowances for doubtful accounts or loan losses, inventory obsolescence, pension assumptions, and others. Second, inspectors are looking for indications that auditors have applied a skeptical mindset to their work to truly challenge management's assertions.

“Often there's a perception by the board or inspectors that auditors are looking for evidence to support the client's numbers, so they are starting with the assumption that the number is right,” he says. Instead, the board wants to see evidence that auditors searched for the right number, whatever that number might be, he says. “You can see it not only in the auditing of estimates, but in many other areas of the audit.”

Theories vary on why the PCAOB is flagging more audits. It could be that the PCAOB is getting better at targeting audits that are likely to have problems and therefore finding more problems, or that inspectors are getting tougher on the audits they select for inspection, says Carcello. It's also possible audit performance has declined to some degree. “My guess is that it's some combination of those,” he says.

Whatever the cause, audit firms are gearing up to give regulators what they are demanding. “As a result of a combination of things—the PCAOB inspection reports, proposed rules and the concept release that are out there for debate, and our own continuous improvement process—we are doing a number of things differently,” says Robert Moritz, chairman and senior partner for PwC's U.S. operations. The PCAOB issued a controversial concept release last year exploring whether mandatory rotation of audit firms would inspire auditors to think and act more skeptically.

“If the work is being expanded particularly around high-risk areas, the ultimate fear is that the added burden on the external auditor will translate to increased costs.”

—Brian Christensen,

Managing Director,

Protiviti

PwC is getting more proactive in engaging with investors and audit committees, Moritz says, and the firm is investing in more staff. “We want to lessen the load on people to reduce stress and give them sufficient time to do a quality audit,” he says. The firm is also taking several other steps, including: investing in more training, assuring engagement teams understand the firm's audit methodology, gathering sufficient audit evidence, and absorbing the lessons learned through the inspection process to make auditing as efficient and effective as possible, he says.

Given the PCAOB's concern over the audit work on estimates, PwC is focusing more on how to assure consistency across the practice on how those numbers are audited. “We're getting specific around the kind of work that needs to be done and the documentation that is needed so it stands up to scrutiny,” he says.

Although inspectors have found more problems, Moritz doesn't believe that reflects a decline in audit quality. “I think it's a continuation of this journey that we are all on of sufficiently moving our game up to an even higher level,” he says. “The complexity around auditing and around accounting judgments has increased, and the level of sophistication around the inspection has increased. That all points to a more targeted effort. Where do we want to pay more attention? It's up to the firms to respond with the right remediation.”

That's what the PCAOB is expecting, according to board member Jeanette Franzel. As part of its quality control remediation process, the board expects firms to identify the root causes for audit failures and take appropriate steps to address them. "We carefully monitor and evaluate their efforts to do so, evaluate their specific remediation plans, and will continue to focus on these areas in future inspections," she says. 

ROLE OF THE AUDITOR

Below are observations from the CAQ's recent roundtable on the auditor's role:

Investors and other participants uniformly agreed that the audit is valuable and the current “pass-fail” report should be retained. Investors and a rating agency representative stated that a “clean” opinion on the financial statements and internal control over financial reporting provides investors with some “comfort” as it relates to other financial information provided by management. However, investors noted that financial statements are often used only as a “prescreen” because investors and analysts today rely on a range of quantitative information and financial models to make investment decisions, much of which is obtained from more current communications from management to investors outside of the historical annual report.

With respect to the financial statement audit, several investors thought that auditors could “convey more” about the highest risk areas of financial statements, which might be done through, for example, an emphasis of a matter paragraph in the audit report, to add credibility to the report (although preparers and attorneys commented that the cost of additional work and legal risks of providing this information might outweigh any benefit).

Participants strongly believed that the auditor's role should be limited to attesting to information provided by management and that auditors should not provide their own “impressions” or views regarding the quality of a company's accounting policies and practices. Audit committee members, preparers, attorneys and auditors thought that such analysis would “compete” with management's disclosures and ultimately shift the responsibility for accounting and disclosure away from management to the auditor. These “dueling” disclosures could also have the potential to confuse investors. Moreover, even if the disclosures were consistent the result would be additional redundancies, that would be time consuming and costly for the auditor to prepare due to the number of reviews that would be necessary prior to issuance.

Participants thought investors would benefit from auditor association with certain areas of the annual report outside of the audited financial statements to provide investors additional assurance on matters they view as most important to their understanding of a company's financial performance and future prospects. Several investors suggested that they would appreciate some level of assurance around certain other financial and non-financial information used to analyze a company (e.g., disclosures in press releases, key performance indicators, and non-GAAP measures) and whether risks are appropriately described. However, given the limited discussion time, participants were not able to identify specific types of information or the levels of assurance that would be appropriate. Also, some participants thought that less sophisticated investors may not be aware that auditors currently provide some value by reading other information provided outside of the audited financial statements for consistency with the audited financial statements.

Participants acknowledged that some information may not be “auditable” or would require substantial additional work before the auditor could issue some type of report (i.e., areas not currently examined as part of the audits of the financial statements and internal control over financial reporting). Also, audit committee chairs, former CEOs, attorneys, academics and investors thought that at present auditors may not have access to the appropriate information, or lack the necessary skill-set or experience to form an opinion on such information (e.g., business model, certain types of forward-looking information). Preparers and board members thought that analysts already fill this role. Academics noted that auditor review of these disclosures is not covered by current auditing standards, not tested in the CPA examination, and is not taught in universities.

Source: Center for Audit Quality.

At Grant Thornton, Trent Gazzaway says companies will see more audit work in the areas most often criticized in PCAOB reports. “In general, companies can expect an increased level of detail transaction testing going forward,” says the national managing partner for audit services. As an example, auditors likely will be selecting a larger sample of revenue transactions to test throughout the year. “They might also expect an increased level of testing and documentation around internal control and judgments and estimates, including fair value,” he says.

Deloitte & Touche says it is mobilizing as well. In a written statement, Stephen Van Arsdell, CEO and chief quality officer, says the firm is enhancing its risk-based audit methodology, which requires customized audit plans and more professional judgment and skepticism. It is also establishing new policies to increase the frequency of required consultations to the firm's subject-matter experts, and it is investing in more training. Additionally, the firm is modifying its performance criteria for admitting new partners and evaluating and promoting professional staff, focusing on “high-quality audits that serve the interests of the investing public” as the “central criteria.”

Higher Audit Costs?

The word in the field is that audit firms across the board are intensifying their focus on high-risk areas in response to PCAOB activity, says Brian Christensen, managing director at consulting firm Protiviti. “If the work is being expanded particularly around high-risk areas, the ultimate fear is that the added burden on the external auditor will translate to increased costs,” he says.

Gazzaway says it's possible. “It's reasonable to expect an impact on audit fees as the cost and effort to deliver audits continues to increase across the profession,” he says.

Dennis Beresford, a director and audit committee member for several public companies and a former chairman of the Financial Accounting Standards Board, says he hasn't seen any meaningful change in audit costs yet. “Given the continuing weak economy, I think firms have kept their hourly rates fairly flat,” he says. “But if particular circumstances call for increased hours, those costs will be passed on to the client. And if PCAOB requirements mandate more hours in all cases, that will almost certainly result in higher audit costs.”

Scott Showalter, accounting professor for North Carolina State University and a former KPMG partner, says he hasn't heard discussion about increased audit costs. “But I think it is clear, the various firm-wide changes the firms make in response to the inspection results do add costs to the delivery of the audit,” he says. “Whether the firm decides to pass those increased costs on to the clients is a business decision each firm makes.”