Peeling away financial reporting issues one layer at a time

The PCAOB on the Auditor’s Reporting Model: Great Progress and More To Do

Why is it that shareholders of the largest public companies could pay around $80 million for their boilerplate audit reports, if the shareholders of smaller public companies pay only $80 thousand for exactly the same end product?

Or, why is it that the $80 million audit might have cost a small fraction of that (in real terms) 70 years ago, even though the verbiage of the auditor’s report has not fundamentally changed?

If you can’t think of a reason to be thankful for the Sarbanes-Oxley Act of 2002, I would ask you to consider the record of the PCAOB, a creation of S-OX.*  The mega accounting scandals at the turn of this century forced Congress to confront embarrassing facts about auditing profession’s longstanding status quo: (1) auditors were too close to their clients; (2) the profession did an inadequate job of sanctioning sub-standard practices; and (3) the auditing standards themselves were too weak.  In short, shareholders were not getting their money’s worth from audit services — to say the least.

Some would argue that, up to this point in time, the PCAOB has mainly earned its stripes by rigorous inspections of audit firms, and frank public exposure of the deficiencies uncovered.  But movement towards higher quality auditing standards has been slow, perhaps due to idealism and the predictable — shall we say, ‘lack of a shared vision’ — by entrenched special interests.

The topic of this post is a prime example. It has been five years since the PCAOB proposed to shed more light on what auditors actually do to earn $80 million dollars when the audit General Electric or BofA — to augment the standard boilerplate audit report language with additional disclosures that would be tailored to each specific audit engagement.  The most consequential provision would be to require that the auditor’s report contain information about “critical audit matters” — i.e., according to the SAG meeting briefing paper, “especially challenging, subjective, or complex auditor judgments.”

At our May PCAOB SAG meeting, we discussed (see the video here) the recently issued reproposal.  It withdraws the proposal for an auditor’s discussion and analysis, defers for additional study the reporting on other financial information, and tweaks the reporting of critical audit matters.  Although some of the discussion dealt with interesting technical issues regarding the latest tweaks, a number of general comments were made by investor advocates about how the PCAOB, if they could finally ram this one through the special interests, was on the verge of making real progress.  I also found comments from Phillip Johnson, former UK Deloitte partner in charge of audit quality and risk management, and Sir David Tweedie, former IASB chair, particularly enlightening.  Before I tell you what I had to say about the re-proposal, I would like to summarize their comments.

Phillip opened his remarks by stating that Europeans were concerned that the auditing profession was becoming irrelevant. As long as five years ago he had argued that auditors would have to re-invent what they were doing or face extinction.

But after three years of experience in the UK with a new international auditing reporting model that is similar to the PCAOB proposal, he has seen significant progress.  As an audit committee member himself, it has been interesting to see that the committee and the audit team members now seem to share a common purpose.   Perhaps most encouraging is that audit teams are taking more pride in their work, because of heightened interest in what they are doing, and appreciation of their professionalism.   Yet, we are not in new territory regarding what is being discussed between auditors and the audit committee.  The only substantive change is that the new auditor reporting model is letting shareholders in, to some extent at least, on the conversation.

Sir David (who by the way is the drollest and funniest accountant I have ever known) began by saying that this is the most important project the PCAOB has ever taken on.  The proposal goes beyond the mechanics of the audit, which has characterized PCAOB projects to-date, to the visible end of the audit.  An investor will, for the first time, be able to evaluate what the auditor is actually doing with respect to consequential matters of auditing management’s judgments.

In fact, Sir David seemed to find it ironic that there has been so much resistance from special interests, because in his view the end result of the PCAOB’s efforts will be to the benefit auditors.  The reason for the existence of the PCAOB is because people didn’t trust the audit — mainly he believes, because of the propensity for the auditor to become too close to the client.  In that respect, the expanded auditor’s report is a great defense for the auditor against those sorts of recriminations.

But, the proposal is “not the end of it.”   Foreshadowing my own remarks, Sir David opined that there are plenty of other things that investors might like to see in the auditor’s report.

My Own Two Cents

I, too, think that the proposal is a great start to providing real information to users through the audit report.  If finalized,  it will constitute a significant achievement by the Board.  Nonetheless, there is still more work to do.

First, I believe that an area of critical audit matters (CAMs) that merits special attention in a new standard is the selection of accounting treatments from non-authoritative GAAP.  My concern is partly in regard to the advent of the FASB Accounting Standards Codification, which modified the protocol set forth by Generally Accepted Auditing Standards regarding the selection of accounting treatments from non-authoritative GAAP.

For example, it is now more likely that the selection of a non-authoritative GAAP treatment for a transaction might not be consistent with statements of the FASB’s own Statements of Financial Accounting Concepts.  This is because the concepts statements, for some inexplicable reason, no longer rank higher than that great safety-in-numbers defense known as “industry practice.”  This is potentially very dangerous, so it would seem to me that the PCAOB should restore specific guidance to auditors – perhaps via illustrative examples of when the selection of a non-authoritative accounting treatment should become a CAM; and how it should be discussed, especially when there is a conflict between management’s chosen accounting treatment and general concepts.

Second, I understand why, but nonetheless hoped that the changes made would be more comprehensive regarding other aspects of the auditors report. I have specifically in mind by the Board’s choosing not to re-consider the language in the opinion paragraph, which in my opinion contains highly ambiguous, and consequently misleading terminology regarding the “fairness” of the financial statements.

The inconsistent and often misleading use of “fairly presented” language in financial reporting is a monster pet peeve of mine.  To begin to see why, kindly consider these 5 brief situations:

  1. The standard auditors report states (and I paraphrase) that the financial statements are presented fairly in accordance with GAAP
  2. The accounting historian Steve Zeff, writes that 70 years ago, the leadership of Arthur Andersen decided that it should be principled, even if accounting rules were not.  In their view, financial statements did not produce a “fair presentation” when they used accounting treatments that were, in its judgement, not appropriate, even if they were “generally accepted”.  For examples, additional disclosure beyond what was required might be necessary to prevent the financial statements from being misleading. Consequently, Andersen’s unqualified opinion language was modified to state that the financial statements were  “presented fairly and in accordance with GAAP.”
  3. The CEO and CFO certifications called for by S-OX and SEC rules require the signatories to affirm that the  “financial statements are fairly presented in all material respects” – without referring to GAAP.
  4. AICPA reporting standards require the term “fairly presented” for seemingly any unqualified auditor’s report on financial statements, regardless of the basis of accounting.  For example, financial statements presented on a tax basis would also constitute a “fair presentation” of financial statements according to the AICPA.
  5. No compentent economist would assert that a time series of financial data unadjusted for inflation could ever constitute a fair presentation of past events.   Yet, no matter how much inflation distorts financial results, they are, according to the auditor’s report, always somehow “fairly presented.”

So, what does “fairly presented in accordance with GAAP” mean – even as a term of art?  I am aware that the PCAOB has a highly technical explanation of what “fairly presented” is supposed to mean in its auditing standards, but with all due respect it sheds virtually no light on the credibility issue that I am concerned about.  When communicating to investors, all the words used in the auditor’s report should mean something to them.

In so many other respects, the auditor report proposal by the PCAOB has done a commendable job in specifying requirements for information about CAMs that can be expressed without resorting to arcane terms of art.

As Sir David said, there is more to be done.  I also happen to know that he regards “fair presentation” (its UK counterpart is “true and fair”) to be the foundational concept for high quality financial reporting.  As such, it must be used with great care. Yet, its current function in the audit report is merely aggrandisement — puffery, pure and simple.

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*I am a member of the Standing Advisory Group of the PCAOB.  All of the opinions I express in this post are my own.

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