Tuesday, December 09, 2014

PCAOB Chair Says Stronger Audits Will Enhance Capital Formation

[This story previously appeared in Securities Regulation Daily.]

By Jacquelyn Lumb

In remarks at the Chamber of Commerce conference on the future of financial reporting, PCAOB Chair James Doty expressed his view that enhancing the relevance of reliability of audits is critical to returning capital providers to long-term funding. To overcome short-term investment strategies and what Doty called the tyranny of the quarterly earnings call, he called for a stronger audit to provide greater confidence that auditors are looking out for investors.

Non-audit services. Doty also talked about the increase in non-audit services. If the current trend continues, he said within 10 years, audits may account for less than 20 percent of the revenue of the global, networked accounting firms. He also noted that all audit firms provide the same audit report in which the engagement partner is anonymous, so there is little competition based on quality. It is not even clear from the audit report how much of the audit was performed by the firm that signs the opinion, he added.

Audit deficiencies. Doty said that the largest accounting firm and many of the smaller firms are capable of high quality auditing, but the rate of problems found by PCAOB inspectors suggests that all of these firms could miss a material misstatement. He reported that out of 219 audits by the four largest firms that were selected for review in the 2013 inspection cycle, the opinions in 85 should not have been issued. He added that the Board’s results are fairly consistent with international results. Doty said these circumstances suggest the need for a deeper examination of how firms can improve audit quality.

Doty believes the Sarbanes-Oxley Act triggered a cultural change in auditors’ view of their accountability. The more audits the Board inspects, the more problems get fixed, and the better the auditor’s execution, he said.

PCAOB initiatives. Doty reviewed some of the Board’s long-term initiatives aimed at avoiding audit deficiencies, including the greater use of economic analysis in its standard setting initiatives, providing support to audit committees, and increasing audit transparency by disclosing the name of the engagement partner and other firms that participated in an audit. If the market knows where and by whom an audit was performed, Doty said it creates an incentive to assure quality.

Naming the engagement partner. Doty noted that auditors in many jurisdictions have grown accustomed to signing audit reports. With the recent adoption of the requirement by the IAASB, reporting the engagement partner’s name will become the norm. The U.S. will likely be the only country in the top 20 financial markets that does not require the disclosure, he advised. Doty also cited recent studies which found that disclosure of the engagement partner’s name makes a difference to the investing public and the markets.

The Board is considering whether the engagement partner’s signature serves a materially greater benefit than simple disclosure. Disclosure may provide the information the public wants without increasing litigation risk, he noted. Doty hopes the Board will adopt a final standard soon.

Auditor’s report. With respect to the Board’s disclosure project on the auditor’s reporting model, Doty said the initiative benefits from the ability to review experiences abroad. Readers of the new U.K. audit reports have applauded some of the results and criticized the boilerplate approach of others, which provides an incentive to compete based on quality, according to Doty.

He said the enhanced U.K. audit reports are the leading edge of a significant wave of change in the audit profession. The International Auditing and Assurance Standards Board recently approved a standard to require enhanced auditor reporting, including key audit matters, which will affect more than 100 jurisdictions. The European Parliament also adopted a broad package of audit reforms, including expanded audit reports. Doty said the Board will study these reforms and adopt elements from the best of them.

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