Regulators Debate Solutions to Poor Audit Quality

Faced with a disturbing spike in audit failures in the aftermath of the financial crisis, America's top audit regulator, James Doty, has decided to poke a hornet's nest. 

Doty, chairman of the Public Company Accounting Oversight Board, is the driver of an initiative to determine whether mandatory rotation of audit firms would adequately shake up the audit profession and improve audit quality. And while his regulatory cohorts—at least those on this side of the Atlantic—agree with the idea of figuring out what causes audits to go wrong, they may not wish as much to provoke the ire of the industry. So far, Doty's fellow board members have agreed only to float the rotation idea and asked for input on whether it's the right answer.

The European Commission, on the other hand, is already a step further down the path, and is currently considering a measure to limit audit engagements to six years and prohibit audit firms from providing any non-audit services to their clients.

Here in the United States, the Securities and Exchange Commission is urging Doty and the PCAOB to put the brakes on mandatory rotation. Staff members at the SEC have told the PCAOB that it should do more work to figure out why audits fail before considering measures as radical as mandatory rotation. At a year-end national conference of the American Institute of Certified Public Accountants, SEC staffers practically directed the PCAOB to get a better handle on why audits fail and take a look at some rusty auditor performance standards before pulling the rug from under longstanding auditor-client relationships.

Brian Croteau, deputy chief accountant at the SEC, noted that the PCAOB has begun studying audit failures where they are uncovered in routine inspections to try to understand what went wrong, but the study is far from complete. “Thorough analysis of past inspections by those with sufficient details about the issues identified, including adequately understanding the root causes, is important to understanding the problems being addressed,” he said. It should be seen as a critical step in the “audit performance feedback loop” to inform future standard setting, he said.

PCAOB member Jay Hanson says the PCAOB has only in the past few years begun studying the root causes of audit failures. “For any given deficiency, there's probably a range of reasons,” he says. Auditors may face timing pressures, fee pressures, or a lack of competence or experience in a given area that would explain failures, he says. “There's only so much we can do from looking at the work papers,” he says. “The firms can probably do a lot better job in asking ‘what's the real reason you didn't do this?'”

The latest round of inspection reports for all the Big 4 firms reflect substantial increases in the number of failed audits, defined as any audit where a firm issued an opinion without adequate underlying support for that opinion. Doty has expressed concerned about the significant increase and warned audit firms to brace for what he expects to be even more failures in the next wave of reports. “While our 2011 inspection cycle is not yet complete, preliminary results show that the number of deficiencies identified continues to be high,” he said during remarks at the AICPA conference.

Of course, there are deficiencies, and then there are the kinds of audit failures that make investors furious—cases like MF Global or Lehman Brothers where audit firms issued clean opinions followed soon after by massive meltdowns that someone should have seen coming. Such debacles have stumped the PCAOB the most. Hanson said he has heard the “crystal clear message” from investors: They are angry that auditors aren't giving more early warnings or disclosures when there is reasonable doubt about a company's ability to remain in business as a going concern. “It is curious, but we are not having a lot of findings where auditors are deficient in that,” he said during the AICPA conference.

Too Close for Comfort

According to Doty, the root cause of today's audit problems stems, at least in part, from longstanding client relationships that make it difficult for auditors to think skeptically and act objectively. “These flaws were found at firms that are clearly comprised of highly competent and ethical professionals,” said Doty. “But too often, audit failures identified by PCAOB inspectors do not appear to be explainable by any lack of knowledge on the auditor's part about what steps are required in the circumstances.”

“While mandatory rotation may offer an imperfect solution and may pose implementation challenges, the one answer that is not acceptable to investors is a continuation of the status quo.”

—Barbara Roper,

Director of Investor Protection,

Consumer Federation of America

He challenged auditors to be honest about what's going wrong. “When you've found a potential problem in an engagement, do you think about how important retaining a client is to your own career or standing in your firm?” he asked. “If you don't think term limits would reduce the pressures that lurk, threatening to undermine your independence, then what would?”

Doty has some vocal investor advocates in his corner, like Barbara Roper, director of investor protection at the Consumer Federation of America. While acknowledging concerns about the disruptions that could occur with mandatory rotation, she says she's fed up with resistance to change. “While mandatory rotation may offer an imperfect solution and may pose implementation challenges, the one answer that is not acceptable to investors is a continuation of the status quo,” she wrote to the PCAOB.

Jim Kroeker, chief accountant at the SEC, didn't openly challenge Doty's view on mandatory rotation, but in remarks at the AICPA conference he steered the PCAOB's attention to some stale auditor performance standards. The PCAOB adopted AICPA standards as interim standards when the audit regulator was created under the Sarbanes-Oxley Act, but has updated only a fraction of them since. “I believe that improving the existing audit performance standards, coupled with the board's present inspection and enforcement programs, might be the most direct and effective way to positively impact audit quality,” he said.

KPMG COMMENTS

Below is an excerpt from KPMG's comment letter on mandatory auditor rotation:

We do not support mandatory audit firm rotation as it could potentially harm audit quality. The potential effect on audit quality should be the indispensable criterion for evaluating any proposed changes.

As the Board notes, the significant reforms put in place under the Sarbanes-Oxley Act (the “Act”) of 2002 “have enhanced auditor independence and along with it, the reliability of financial reporting.” The architecture created by the Act, which is comprised of independent oversight of the public auditing profession by both the Board and audit committees and rules limiting the tenure of all audit partners, provide powerful incentives for auditors to maintain the required independence in mental attitude when conducting audits. This architecture and set of incentives underpin the efforts of KPMG to reinforce in our people the critical need for independence, objectivity, and professional skepticism.

Some of the measures we support that would improve the existing architecture are summarized below. It is important to note that a number of these suggestions have already been implemented by many auditors and audit committees, but have not been consistently adopted across all public companies.

The auditor providing information to the audit committee that would enable it to better assess the auditor's objectivity and skepticism.

Developing best practices or protocols around auditor communications with the audit committees regarding Board inspections.

The auditor providing the audit committee with the audit plan for review, discussion, and approval.

The auditor providing information to the audit committee that would allow it to select and continuously review lead engagement partners.

The auditor providing all public company audit committees with information on the auditor's internal system of quality control as well as the result of any external reviews.

A more consistently robust audit committee report to shareholders.

Source: PCAOB.

He also called on audit committees to step up their game in the process of selecting and hiring auditors. “I suspect even the best audit committees can find ways to improve,” he said. “Audit committees should not forget their role over the appointment and compensation of auditors.”

Christian Peo, a professional accounting fellow at the SEC, also called on the audit firms to take a bigger role in identifying what goes wrong with audits. “Auditing firms have access to not only the findings of the PCAOB's inspections, but also of internal inspections and other ongoing internal monitoring and peer review results,” he said.

If Doty's floating of a controversial idea like mandatory rotation leads to a broader examination of why audits fail, that's a welcome move to audit quality advocates like Tim Leech, managing director at consulting firm Risk Oversight. “That's a drum I've been pounding for years, but nobody has been listening,” he says.

Leech says as much as audit firms bemoan the costs of litigating audit failures, they've come to accept it as a cost of doing business, and they pass that cost along in higher audit fees. “If you think of an audit as a product, can you imagine any industry accepting such high failure rates?” he asks. “The American auto industry didn't start producing better cars until it looked like the Japanese were going to wipe them out.” He says the audit profession needs a similar “total quality management” shake-up to make a meaningful improvement in audit quality and regain investor confidence. “We need to look at this process through a whole new lens,” he says.