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.