Audit Firms Told to Step Up Their Scrutiny

Auditing firms are feeling heat from regulators to look harder for the root causes of financial reporting failures and to assure they are not cutting corners on quality because of pressure from corporate clients over fees.

Daniel Goelzer, acting chairman of the Public Company Accounting Oversight Board, gave a stern warning to audit firms earlier this month at a conference of the American Institute of Certified Public Accountants. “It's been widely reported that [corporate] audit committees are expecting auditors to share in the economic pain that companies are feeling, by agreeing to fee reductions,” he said. The PCAOB, however, will be watching to see whether that pressure tempts audit firms to ease up on the rigor of audits.

Inspectors will be looking for any sign that audit deficiencies can be linked to reduced fees, Goelzer said. Martin Baumann, chief auditor of the PCAOB, said he's hopeful auditors aren't cutting the number of hours they spend on audits “unless they are doing so because of an identifiable decrease in audit risk or other commensurate changes in circumstances.”

Auditors struggling with how to perform a high-quality audit while under pressure to reduce fees should discuss the issue frankly with their client's audit committee and be prepared to make tough choices, said Brian Croteau, deputy chief accountant at the Securities and Exchange Commission. “Ultimately, the auditor has a responsibility to determine whether to accept an engagement or continue an engagement if it is not able to perform a high quality audit,” he said.

James Kroeker, chief accountant at the SEC, suggested auditors shouldn't even consider curtailing necessary audit work as a way of coping with falling revenue. “It's probably not a popular message, but it seems like the variable in that equation would be other things—like partner compensation—as opposed to audit quality,” he said. “The variable can't be audit quality.”

The PCAOB's focus on fee pressure is part of the board's push to move beyond merely identifying audit failures, Goelzer said; the goal is to pinpoint why the audit failures occur. “Firms, particularly the largest, need to be out in front of the board on this effort,” he said. “That may require some firms to change the way they manage their practices or to develop stronger tools to exert control over how individual auditors approach their work.”

“I often wonder whether a change to our collective vocabulary could be as fundamental to strengthening auditor independence as any rule or other reminder.”

—James Kroeker,

Chief Accountant,

Securities and Exchange Commission

William Gassel, deputy director of large firm inspections at the PCAOB, said the regulator has been working with major audit firms for more than a year to drill deeper into audit failures and determine why they occur. The firms are performing their own root-cause analyses, he said, based on PCAOB findings, their own internal findings, peer reviews and other evidence. “We're finding … it's one of those things where you get out of it what you put into it,” he said.

Gassel said the firms themselves are in the best position to do such deep analysis, because they know the audit workload and operations much more than the PCAOB or its inspectors. But inspectors will take that dive in 2011 to get a better sense for why audit failures occur, he said. “We're working to make suggestions of potential needed action that, at a minimum, a firm should take in response to an inspection report,” he said.

Regulators are watching for audit problems around mortgages, Baumann said, especially documentation around modifications and foreclosures. “Auditors should be aware that the potential risks and costs associated with these activities could have implications for audits of financial statements or of internal controls over financial reporting,” he said.

Other Issues

Baumann also stressed that auditors should take a fresh look at their audit of internal controls, and assure that it reflects any changes within the company and its business environment in the past year. The PCAOB has noticed that material weaknesses seem to be reported in connection with restatements rather than before them, making the weaknesses a lagging (rather than leading) indicator of control problems. “In many cases a material weakness likely existed before the restatement, but unfortunately the ICFR audits are often not identifying them,” he said.

A MATTER OF TRUST

In the following excerpt SEC Chief Accountant James Kroeker remarks on ensuring trustworthy audits:

In my remarks, I would like to focus us today on the importance of the public trust. As it relates to the role of each of us as members of the accounting profession, public trust includes the confidence that the numbers the investing public receives are accurate, unbiased, and subject to examination by a truly independent and objective 3rd party. But there is a lot packed into that idea, including some very fundamental questions like:

When faced with a difficult decision, does the public trust that auditors are acting in the best interest of the shareholders and not acting as defenders of management's conclusions?? 

Does the public trust that accountants are faithfully applying the requirements of GAAP rather than trying to find creative ways to engineer around the next FASB pronouncement?? 

Does the public trust that the comments given to standard-setting bodies on their proposals are given in the spirit of improving the transparency and integrity of the body of accounting or auditing literature? ? 

Does the public trust accounting professionals to tell them about bad news in as transparent and robust a manner as they would if they were reporting good news?? 

Does the public trust that leaders of the accounting profession are guided first by a sense of responsibility to the public?

As we all know, building trust takes time, and maintaining trust requires continuous attention. Conversely, once trust is weakened, it is often very difficult to rebuild. Further, once trust is weakened, it has a tendency to foster suspicion even in the absence of a specific incident. As we all know, it takes only a few “bad actors” or a few “bad actions” to begin to chisel away at the valuable reputation of the profession.

Thus, I would like to challenge each of you to continue to do all that you can to:

(1) Improve the objectivity and integrity required of us as professionals;

(2) Continue to identify strong leaders in this profession who have a clear record of acting the interest of investors and the public, and

(3) Explore ways that we as professionals may be able to show leadership in enhancing trust.

Source

SEC Chief Accountant James Kroeker.

Baumann mentioned one more concern that is on the PCAOB's radar: auditor independence. “We are aware of the increase in non-audit services at many firms,” he said. “We're working closely with our inspections division to consider whether the nature or extent of these non-audit services could impact auditor independence and require action on our part.” Baumann said the board doesn't have any rulemaking on its agenda at the moment, but the issue is under study to determine if rules might be necessary.

The big push on auditors is driven in part by some unhappiness at the SEC over the recent results of a Center for Audit Quality poll of “Main Street” investors. The CAQ's annual survey found only three-quarters of investors have any confidence in capital markets at all, and not many of them have faith in auditors to protect their interests. When asked who does a good job of protecting investors, respondents named regulators, brokers, and even “none of the above” ahead of auditors.

“Those are not stellar results,” said Mike Starr, a newly appointed deputy chief accountant at the SEC assigned to try to spot emerging trends or problems before they become crises. “Auditors ranked fourth with 16 percent, just slightly ahead of journalists. We would like to see that percentage higher.”

Kroeker implored auditors to think more about the investor as their client rather than the company whose financial statements and internal controls are under review as a way to help rebuild investor trust. “I often wonder whether a change to our collective vocabulary could be as fundamental to strengthening auditor independence as any rule or other reminder,” he said. “Don't use the word ‘client' to refer to management of companies under audit.”

That doesn't mean auditors should become adversaries to management, but it would help dispel any notion that auditors are advocates for the management of the companies they audit. On that note, he too had a word of caution for audit firms that may be trying to rebuild consulting practices. “I trust that the profession will not need to re-learn lessons of the past on the serious, adverse effects of under-investing in the quality or failing to strictly maintain the independence of their audit process,” he warned. “I am likewise hopeful that if significant investments are being made to pursue other lines of business within a ‘multi-disciplinary' firm, the potential impact on public trust and public perception of the audit practice is being considered.”