Peeling away financial reporting issues one layer at a time

PCAOB Shifts into High Gear under Jim Doty

Lots of "rethinking" has been going on of late. There's a new SEC staff paper rethinking how to take IFRS adoption/convergence off life support; and the FASB and IASB are rethinking how much they can give away to special interests regarding capitalized costs and onerous contracts in their revenue recognition project.

But, new PCAOB chair, Jim Doty's recent speech, "Rethinking the Relevance, Credibility and Transparency of Audits is what I'll be writing about — if only because once in a great while I need to write encouraging thoughts on the future of financial reporting. Most refreshingly, not once did Doty even remotely indicate that US auditing standards should be 'converged' with international standards. That sets him apart from all too many policy makers, who are obsessed with devolving US financial reporting into something palatable to the whims and vicissitudes of the European Union, China, and each and every Third World country.

Doty took pains to emphasize that he remains open to all suggestions; but the fact remains that PCAOB inspectors have uncovered far too many problems, in far too many audits, to conclude that something short of broad-based change is called for:

"We need a holistic approach to addressing the cultural challenges inherent in auditing, based on a deep, fact-based analysis of the problem. By a 'holistic approach,' I mean addressing relevance, credibility, and transparency of the audit by all available and effective means."

As John Hufnagle summarized it in his blog, Doty's PCAOB is considering reforms on several fronts. I have re-arranged them to reflect my own priorities, in descending order:

  • Strengthening the "independence" rules (perhaps by mandating periodic audit firm rotation)
  • Enhancing the auditor's report;
  • Adding required communications to audit committees about the results and processes of PCAOB inspections;
  • Adding a requirement that the engagement partner, in addition to the firm, should sign the auditor's report.

Independence: Shall We Continue to Play Make-Believe?

I'm going to focus on independence; and frankly, Doty didn't start out as I would have liked (although he ended in a good place):

"To perform their role properly — to assure that reported financial and economic successes are not illusory — auditors must approach their jobs with independence and skepticism. They cannot allow themselves to be caught up in their audit clients' business goals. How do we instill those necessary traits in auditors? This may be the most important auditing question of our time."[Emphasis supplied]

In other words, once upon a time, auditors were selfless professionals who could be relied upon to subjugate their individual interests for the greater good. Somehow, as the world changed in bad ways, auditors' "traits" changed with it. Someday, hopefully, a prince will come to make the world the wonderful place it once was, and to give the auditors their "necessary traits" back.

Obviously, I don't believe those halcyon days ever really existed, except perhaps in popular myth. The notion that the rest of society should trust a profession as a whole (or its individual members) to have the integrity to subjugate personal interests for the greater good (particularly when the stakes are high) is an antiquated false premise upon which the entire system of financial reporting has been built — and which surely no one seriously believes in anymore. Yet, it is precisely the notion from which the auditing profession has profited greatly and is now desperately clinging to for dear life.

As much as it pains me to say it, Doty is probably acting wisely by choosing to avoid a frontal assault on the concept of an independent audit, even if he thinks, as I do, that independence is a myth. The apparent strategy is to leave the myth intact while focusing on making changes to the reality to effectively bust it without actually saying so.

* * * *

"The PCAOB has now conducted annual inspections of the largest audit firms for eight years. Our inspectors have reviewed more than 2,800 engagements of such firms and discovered and analyzed hundreds of cases involving what they determined to be audit failures. We have conducted more than 1,500 inspections of smaller domestic firms and of non-U.S. firms. These include multiple inspections of hundreds of those firms. And our inspectors have identified hundreds more cases involving what they determined to be audit failures.

Based on this work, I believe it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against. I don't have a predetermined idea as to whether the PCAOB ultimately should adopt term limits. My only predilection is that the PCAOB deepen the analysis of how we can better insulate auditors from client pressure and shift their mindset to protecting the investing public.

As such, the Board plans to issue another concept release to explore whether there are other approaches we could take that could more systematically insulate auditors from the forces that pull them away from the necessary mindset. [Emphasis supplied]

Here again, Doty is taking a more prudent tack by introducing mandatory audit firm rotation (i.e., "term limits") without immediately embracing it, or comparing it to other alternatives. But, similar to the independence myth, if the PCAOB can be left to an unfettered and objective judgment, it will find that every other idea for "insulating auditors" except for mandatory audit firm rotation will run the risk of being ineffective. Everything else is more going through the motions: more rote disclosures, and more procedural charades.

Perhaps, Doty, may yet find a way to give audit firm rotation a silver lining. For example, if auditor objectivity could be controlled, it may make sense that auditors should be allowed to pitch other services that dovetail with the audit. A holistic approach to improving audit quality could lead to recognition that mandatory audit firm rotation, while creating restrictions, could also create new opportunities for auditors — so long as there are clear limits on when, what, and how much non-audit services would be appropriate to take on.

Remaining Concerns: Too Much Said in Some Ways, and Not Enough in Others

Overall, Doty's speech sets the tone, and establishes a plan for action, that is the kind of effort I applaud and am proud to observe. Yet, I do have concerns with the holistic approach. One the good side, there will be so many proposals put out for comment that some of it surely has to stick. But, will it be the right stuff? One scenario I fear is that the PCAOB will be forced by political pressures to settle for changes that will make a great press release, but will fail to address the systemic problems.

But, it's nice, for once, to feel that investor advocates don't have to beat their heads against every wall in Washington.

3 Comments

  1. Reply Steve June 6, 2011

    How could audit firms be independent while trying to sell other more profitable services (e.g., tax, consulting) to the companies they audit?
    This is the fundamental question that the new PCAOB chair and Congress should address.

  2. Reply KPO'M June 7, 2011

    I think part of the issue is that the PCAOB’s rulemaking, until recently, has been very slow, and their inspections process haphazard. All we get are reports that list a bunch of individual issues at each firm, but no way to compare the firms or conclude on the severity of each issue.
    It hasn’t done much to address the “check-the-box” culture of audits (which often breeds a forest-for-the-trees issue). Perhaps the PCAOB needs to use a statistical method of sampling audit engagements for inspection, and come up with criteria with which to grade and/or rank audit firms. We do it with restaurant inspections. Why not with audit firm inspections?

  3. Reply Superheater June 9, 2011

    Tom, I’m not sure why you find this encouraging.
    Whatever his position, Jim Doty is a lawyer, not an accountant. He chairs an organization where the sole qualification for the majority of its board is to be unqualified. Of course, that requirement-was arguably nothing but an insidious takeover of (a part of) accountancy by lawyers. Having heard a speech to Washington lawyers on C-Span in November 2002 open with a joke that SOX was the securities attorneys full employment act, I think it was just that.
    Are we to expect lawyers, with their compulsive disputatiousness to provide effective regulation with clarity and finality-or just more and more regulations and revisions, ala the IRS? Moreover, lawyers have influenced auditing for decades prior to SOX without clear public benefit but with increasing legal billings.
    If regulation by “outsiders” is such a good idea, let’s create a federal legal oversight board required to have a majority of non-lawyers on its board. Can you imagine an accountant lecturing lawyers on their public responsibilities or reforming their profession? It’s not like lawyers are absent from the annals of Enron.
    Whatever the problems of professional self-policing, the idea that government is a better solution defies the evidence. Indeed, the PCAOB’s “superior”, the SEC, was cited by the GAO for ACCOUNTING problems (again), had a widespread employee pornography scandal and spends inordinate effort considering and promoting IFRS. Of course, they snagged Martha Stewart, but ignored (ignored, not missed) Bernie Madoff.
    The PCAOB is apparently here to stay, but what has it accomplished? Has it reformed auditing? No. Made it more effective or efficient? No. Produced great new standards? No. Stopped corporate implosions (in part) caused by accounting failures? No. If they found widespread fraud at a BIG 4 could they issue a “death penalty”? No.
    We can only hope something will spur future lawmakers to reconsider Peekaboo’s propriety and utility- as happened with the Interstate Commerce Commission-and treat it similarly.
    As for the speech, it contains nothing new. Montgomery (and other largely forgotten giants) ceaselessly enjoined their peers to be diligent. So there was a good old days-when real practitioners-not sinecured bureaucrats- enjoined their peers to do the “right thing”. (See Mike Brewster’s “Unaccountable”).

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