PCAOB Cracks Whip on Audit Quality

Regulators are pressuring auditors to do a better job with new measures intended to make auditors more cautious and more skeptical when reviewing clients’ financial statements.

The Public Company Accounting Oversight Board has adopted a new rule that instructs audit firms to take a closer look at their audit reports internally before issuing audit opinions. Even further, the board is floating an idea to require the lead partner on an audit engagement to sign the audit report in his or her own name, a subtle but significant change intended to drive audit quality.

The PCAOB approved Auditing Standard No. 7, Engagement Quality Review, to provide more specific requirements for how audit firms evaluate the significant judgments their teams make as well as the conclusions reached in preparing an audit report. The board’s goal is to increase the odds that a firm will catch any significant engagement deficiencies before it issues an audit opinion, and the PCAOB acknowledges that may mean more work.

Audit firms have long operated under a requirement to perform “concurring partner” reviews, where a partner who is not part of the engagement team looks over a company’s final audit opinion before it is issued. AS7 expands that requirement somewhat by giving the reviewing partner more specific instruction to evaluate judgments made and conclusions reached by the engagement team.

The PCAOB intends for AS7 to be effective for periods beginning on or after Dec. 15, 2009 (assuming the Securities and Exchange Commission approves it), which means it would apply to audits done in the spring of 2010.

Olson

PCAOB Chairman Mark Olson, who left his post July 31, said he became interested in beefing up the engagement quality review process in 2006 when he first took the job and met with inspections staff in regional offices. “As part of those meetings with inspectors, I would inquire as to which audit issues they found most problematic,” he said at a July 28 board meeting. “Among the most frequently mentioned issues of concern was the wide range in quality and rigor of the concurring partner or second partner reviews.”

“For the larger firms, the burden will be minimal as they have a number of quality control processes in place and can easily adapt to such a standard. Smaller firms will be impacted more directly.”

—Andy Gabor,

Director,

Morgan Franklin

The board first proposed the standard in February 2008, but heard many complaints that the language would essentially drive engagement quality reviewers to re-do the entire audit. The revised final standard “is not intended to become a second audit,” Olson said. Instead, it “appropriately focuses the review procedures on the areas of a particular audit that are more likely to have significant engagement deficiencies.”

Phil Wedemeyer, a partner with Grant Thornton and a member of the Auditing Standards Board at the American Institute of Certified Public Accountants, says it’s not clear whether the new standard will result in a noticeable increase in audit work. For firms that have been lax in performing the concurring partner review, perhaps so, he says.

“The new standard says if you use due professional care in doing the things that are in the standard, it will result in a quality review,” he adds. “That doesn’t represent a big difference in what we’ve always held ourselves to.”

Gabor

Andy Gabor, a director at audit and consulting firm Morgan Franklin, says the new standard likely will sting smaller firms more than large firms. “Any standard generates more documentation, more checklists to fill out by the auditors, and more overall diligence in the audit process,” he says. “For the larger firms, the burden will be minimal as they have a number of quality control processes in place and can easily adapt to such a standard. Smaller firms will be impacted more directly.”

The Sarbanes-Oxley Act has already ushered in a good deal of audit improvement, in Gabor’s view. He describes AS7 as “more of an incremental change in the same direction we have been surfing for some time.”

PCAOB STATEMENTS

The following excerpts are from the PCAOB chairman and member statements on the engagement quality review:

Beginning with the passage of the Sarbanes-Oxley Act in 2002, Wall Street and the public have come to better understand the vital role of the audit profession in this country and around the world. There is increased scrutiny of audit firms and the audit process by all stakeholders who have an interest in financial statements. While legitimate questions have been raised about the wisdom of requiring engagement signatures, my current belief is that the benefits from the increased transparency would outweigh any negatives. I see wisdom, however, in today’s initiative being a Concept Release and look forward to the Board benefiting from a robust and informative comment period at this time.

—Mark Olson,

Chairman,

PCAOB

First, commenters have been concerned that the EQR standard could inadvertently drive the engagement reviewer to, in effect, perform a re-audit. In its final form, Auditing Standard No. 7 focuses the reviewer on the engagement team’s significant judgments and on the team’s responses to the significant risks it identified. While this will require judgment and sophistication on the part of reviewers, the standard makes clear that they are responsible for evaluating how the engagement team identified and responded to risk, not for starting from scratch to assess risk independently. This should alleviate the concern that engagement quality review could turn into a re-audit.

Second, the standard that the reviewer must meet in determining whether to provide concurring approval has been a major source of debate. Understandably, reviewers are sensitive to the criterion against which the Board, the SEC, and potentially the courts will measure their work. Under Auditing Standard No. 7, the reviewer may provide concurring approval only if, after performing the required review with “due professional care,” he or she is not aware of a significant engagement deficiency. This tethers the reviewer’s responsibility to his or her performance of the procedures required in the standard, rather than to a free-floating obligation not to concur if he or she “knows or should know” any fact that makes concurrence inappropriate. Further, the concept of acting with due professional care has long been embedded in auditing and should be familiar to the profession.

Third, the extent and nature of the documentation that the reviewer must create to memorialize his or her work has been a major concern. Auditing Standard No. 7 invokes the same principle that governs the audit team’s work paper documentation: The EQR documentation must be sufficient to enable an experienced auditor, having no previous connection with the engagement, to understand the procedures performed by the reviewer. The adopting release makes clear that this requirement is not intended to cause the reviewer’s documentation to duplicate the audit work papers. For example, if the reviewer raises an issue with the engagement team, the reviewer’s documentation only needs to reflect that discussion if it is necessary to an understanding of his work and if it is not fully reflected in the engagement work papers.

I believe that AS No. 7 strikes the right balance in addressing these and other difficult issues that the two comment periods have exposed. The burden will now fall to our inspections staff to monitor how the standard works in practice and how it affects audit quality.

—Daniel Goelzer,

Board Member,

PCAOB

Thank you, Mr. Chairman. I support the adoption of Auditing Standard No. 7—the Board’s Engagement Quality Review (EQR) Standard. As I said when this standard was re-proposed last March, Congress had the investing public in mind when it directed the PCAOB to require a second-partner review for every audit of a U.S. public company under section 103(a)(2)(A)(ii)of the Sarbanes-Oxley Act.

I believe that the requirements of this standard make important improvements to our existing interim standard, and that with the adoption of this standard, the quality of the EQR process will improve substantially. I also am confident that, given time, the number of concerns related to poorly performed second-partner reviews identified during our inspection process will diminish. In short, the EQR Standard will give investors added confidence in the quality of the audits of financial statements filed with the SEC.

—Steven Harris,

Board Member,

PCAOB

Source

Public Company Accounting Oversight Board.

Goelzer

PCAOB member Dan Goelzer, who became acting chairman on Aug. 1, said AS7 in its final form strikes the right balance between calling for more rigor in the internal review, and not commanding a second audit or excessive documentation. “The burden will now fall to our inspections staff to monitor how the standard works in practice and how it affects audit quality,” he said.

Sign on the Line

In addition to the review standard, the PCAOB issued a concept release mapping out an idea to require the engagement partner on an audit team to sign the audit report in his or her own name. Currently, audit reports carry only the firm’s name, not the individual who led the audit engagement. The board and other signature advocates have drawn a parallel to the SOX requirement for corporate officers to certify financial statements.

The board believes a signature requirement would improve audit quality by increasing the engagement partner’s sense of accountability to users of financial statements, and increase transparency about who is responsible for performing the audit. Both would give engagement partners reason to use a little more care in overseeing and finalizing an audit, the board said in its concept release.

The PCAOB’s Standing Advisory Group has debated the issue several times, and investor advocates are vocal in their call for a signature. The Treasury Department’s Advisory Committee on the Auditing Profession also recommended a signature requirement in its final report on how to make the auditing profession more sustainable, and the European Union already requires the engagement partner to sign the report.

Auditors, however, are squeamish. They wonder whether it will increase their personal liability, cause weary auditors to throw in the towel and retire, or discourage younger auditors from ascending to the engagement partner ranks.

“It implies that it is just that partner who has responsibility for the quality of the audit and the ultimate conclusion,” Wedemeyer says. “That signature really is the product of a lot of other people involved in the engagement who have a portion of the responsibility for the engagement.”

Bedard

Jean Bedard, an accounting professor at Bentley University who has studied audit issues and advocated for a signature requirement, says most research suggests auditors would behave differently if required to sign the audit report by name. If that’s true, they likely would exercise more conservative judgments, perform more audit procedures, take more time, and produce more documentation, she says.

“It seems these are the likely outcomes of a more diligent approach,” she says. “So, in sum, if the policy does have its intended effect of increasing partners’ diligence, it is unlikely to be fee-neutral.”