Friday, June 03, 2011

PCAOB Plans Concept Releases on Audit Report and Auditor Independence

The PCAOB plans to issue several policy documents over the next two months to foster a broad debate and research about ways to enhance both the relevance and credibility of the outside audits of company financial statements and provide investors with a better understanding of what an audit is through enhanced transparency, said PCAOB Chairman James Doty. In remarks at the SEC and Financial Reporting Institute 30th Annual Conference, he said that the Board plans on long comment periods to allow for evidence-gathering and research, and will hold public roundtables to explore issues through discussion. In order to perform their role properly, emphasized the PCAOB Chair, auditors must approach their jobs with independence and skepticism and not allow themselves to be caught up in their audit clients' business goals. Instilling these traits in auditors may be the most important auditing question of our time, he said.

Auditor independence rules are a counterweights to the fact that auditors are paid by the clients they are charged with policing. One example of those counterweights may be found in the SEC regulation that says an accountant will not be considered to have the necessary independence from its audit client if an audit partner earns or receives compensation based on selling non-audit services to the audit client. The purpose of this regulation is to keep auditors singularly focused on the quality of their audits and not on nurturing a relationship that will make management more receptive to cross-selling efforts. Chairman Doty called for an holistic approach to address the cultural challenges inherent in auditing, which means addressing relevance, credibility, and transparency of the audit by all available and effective means.

Given the current investor discontent with the current auditor's report, which provides only a pass-fail opinion, and which is viewed as of limited relevance, the PCAOB is developing a concept release on several alternatives for changing the auditor's reporting model, which the Board expects to issue this month. According to the Chair, the concept release will lay out a broad range of options, including more insight into procedures already included in the audit, for example, areas of disclosure the auditors already review.

While the PCAOB's efforts to address auditor independence problems through inspections and enforcement are ongoing, noted the Chair, the Board is prepared to consider all possible methods of addressing the problem of audit quality, including whether mandatory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client. The PCAOB will take up the debate about audit firm tenure and examine it, he pledged, with rigorous analysis and the weight of evidence in support and against. The Chairman does not have a predetermined idea as to whether the PCAOB ultimately should adopt term limits. His only predilection is that the PCAOB deepen the analysis of how the Board can better insulate auditors from client pressure and shift their mindset to protecting the investing public.

The Board plans to issue another concept release to explore whether there are other approaches it could take that could more systematically insulate auditors from the forces that pull them away from the necessary mindset. This concept release will come out around the same time as the concept release on the auditor's reporting model so that they can be considered together in a holistic manner.

The Board also wants to enhance audit committees' understanding of its inspection process. Like other regulatory examination processes in the world of financial and securities regulation, said the Chair, the details and results of any particular PCAOB inspection are, by law, largely nonpublic, which prevents the Board from disclosing to an audit committee any concerns about its auditor, and possibly its audit. To a great extent, he allowed, that information void can be filled by an auditor's candid discussion with an audit committee about an inspection. But the Board is hearing that auditors are often less than forthcoming with audit committees that try to elicit information about inspection results.

While he recognizes that audit firms may approach such audit committee discussions with caution so as not to waive any privilege the firm might have, Chairman Doty said that caution does not explain other more troubling assertions by firms, such as that a particular audit deficiency cited by PCAOB inspectors is based on nothing more than incomplete documentation; or that it reflects merely a difference of professional judgment within a range of reasonable judgments. He emphasized that an audit committee armed with a proper understanding of Board process would recognize that those kinds of assertions are seriously suspect. The Chair said that those assertions are, without exception, directly at odds with the considered collective conclusion of a group of very experienced auditors on the inspection staff.

Such a conclusion means that, in a concrete, identifiable respect that is not reducible to a mere difference in professional judgment, the inspections staff has determined that the firm failed to perform an audit that provides what the audit committee contracted for and what investors deserve, which is reasonable assurance about whether the financial statements are free of material misstatement.
In addition, in response to deficiencies cited by inspectors, firms often represent that they have complied with applicable standards governing an auditor's conduct with regard to post-opinion indications of possible deficiencies. Typically, the representation is that the firm has taken necessary follow-up steps and determined that it can support its previously issued opinion. Too often, however, noted Chairman Doty, that representation seems at odds with reality as it appears to the inspection staff.

The PCAOB can neither open its inspection files to audit committees nor compel auditors to disclose inspection information to them. But it can and should help audit committees be better informed about Board processes and better equipped to engage with their auditors about inspections without settling for responses that distort the significance of inspection results.

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