Peeling away financial reporting issues one layer at a time

Rays of Sunlight to Shine on Audits — and Auditability

Yesterday was a very good day for investors! The SEC finally approved PCAOB rules that will make a lot more information public about what actually went down during the audit.

It is certainly fair to say that the new model for the audit report is of historic significance.   And of the new items, by far the most significant is the disclosures about “critical audit matters.”   These are defined as matters that: (1) were communicated to the audit committee (as already required by other PCAOB AS 1301; (2) relate to material accounts or disclosures; and most notably, (3) involved especially challenging, subjective, or complex auditor judgment.

Even though I can’t recall a single instance where the SEC failed to approve a finalized PCAOB rule, I was concerned about the prospects for this one.   Normally, one would think that the SEC would be closely monitoring the PCAOB’s rulemaking docket and providing feedback.  Nobody should want egg on their face, right?  But a number of factors had me concerned that this one would fail: strong resistance from the Accounting Establishment, including the former white-shoe law firm of the new SEC chair Jay Clayton; a prolonged period for deliberations; a depleted Commission with only three votes instead of the normal five, and two of which who are ‘conservatives.’

But, thankfully, and to the credit of these three commissioners, the support by investor interests ultimately held sway. Investors have long complained that, despite the large sums paid to auditors out of shareholders’ pockets, the output of the standard auditor’s report is opague and invariant.  Moreover, the indications I am aware of from the UK’s experience with similar rules  have been largely positive.

The resistance to the PCAOB rule was spearheaded by the U.S. Chamber of Commerce. Their arguments boiled down to these: CAM disclosures are not relevant information for investor decision making; they would result in increased litigation costs to the detriment of investors; they would quickly devolve into boilerplate;  and they would chill communications between the auditor and the issuer’s audit committee.

I write this post, because I wonder whether all of the above might be the least of their concerns.

The Elephant in the Room

It strikes me that there are two other reasons for the strenuous opposition.  They remain unexpressed, I believe, because to do otherwise would make salient important questions about the business model that the audit industry is built on — specifically, the amount of value added from attestations of the ‘reasonableness’ of management’s judgments.

The first unexpressed reason is that the CAM discussion in the auditor’s report will make it more apparent than ever that quality financial statements rest on the shaky foundation of a great many judgments made by the issuer’s management.  These judgments purport to be unbiased even though management invariably has a direct financial interest in the financial statements themselves.

The second reason is related, and more to the point: fulsome description of the CAMs will raise questions in the minds of investors about the actual effectiveness of auditors as gatekeepers guarding against biased judgment, i.e., the actual auditability of present-day accounting standards.

To illustrate, below is a brief excerpt from the very lengthy audit report for Rolls Royce prepared under the new U.K. rules in 2013.  The CAM disclosed in this excerpt has to do with use of percentage of completion accounting for very complex contracts over a very sophisticated, dynamic and highly-engineered product line:

“The risk:  The amount of revenue and profit recognised in a year on the sale of engines and aftermarket services is dependent, inter alia, on the assessment of the percentage of completion of long-term aftermarket contracts and the forecast cost profile of each arrangement…

Our response:  We tested the controls designed and applied by the Group to provide assurance that the estimates used in assessing revenue and cost profiles are appropriate and that the resulting estimated cumulative profit on such contracts is accurately reflected in the financial statements.  We challenged the appropriateness [i.e., ‘reasonableness’?] of these estimates for each programme and assessed whether or not the estimates showed any evidence of management bias.  Our challenge was based on our assessment of the historical accuracy of the Group’s estimates in previous periods and an assessment of the consistency of assumptions across programmes, detailed discussions and assessments of the achievability of the Group’s plans to reduce life-cylce costs and an analysis of the impact of these plans on forecast cost profiles taking account contingencies and analysis of the impact of known technical issues on cost forecasts….” [emphasis supplied]

I will freely admit that I am not an auditor.  But, as a long-time educator, I have to say that there is very little in our curriculum that prepares our students to perform this kind of work.  To attest to the reasonableness of these particular accounting estimates, they would have to put themselves in the shoes of an airplane engine manufacturing executive — or in analogous circumstances, the CEO of a SIFI financial institution.

My students may start their careers by being competent to perform certain tasks, but they will never be aerospace — or even financial — engineers.  As the above excerpt from auditor’s report implies, the auditors heavily relied on management’s historic track record, internal controls (somewhat spotty as it turned out), and management’s representations.  All of which is dicey enough in the best of circumstances, but when current events call into question the relevance of past estimates (the 2008 financial crisis as one example, or a dip in the demand for airplane engines) this kind of discussion could take on quite a different tone, and could add to the perception that auditors are not worth the fees they are paid to act as financial accounting gatekeepers.

The elephant in the room, unspoken by the Chamber, et. al., is the threat to the auditing brand when auditors must answer these questions before the investing public — as opposed to just the subset of the CEO’s loyal friends who serve on the audit committee.  (This generously assumes that the right questions are even asked in the first place.)  Investors may come to perceive, and rightly so in my view, that there is a whole lot of stuff for which auditors are unable to provide reasonable assurance.

One thing I have learned in the past few years is how deeply auditors have come to resent PCAOB inspections of their work, and the humiliating publicity that can come with them.  Yet, the objective of those inspections is merely to hold the auditor to standards of the profession, irrespective of how effective or ineffective those standards might be.  Now, on top of those inspections, CAM disclosures likely will publicly raise important questions about whether auditors can competently attest to whether management’s judgements are even in the ballpark of ‘reasonable’ under even the most favorable of circumstances.  I, for one, look forward to the discussion.

Will Enhanced Auditability Come with Enhanced Transparency?

In his published remarks accompanying SEC approval, Chair Clayton stated:

“I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships — with Main Street investors ending up in a worse position than they were before.

I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward …”

I respectfully suggest that, in addition to assiduously monitoring the application of the new PCAOB rules, the Commission is bound to learn from the new disclosures that the financial reporting model as a whole merits a fresh look.

If the enhanced transparency of the audit process does not lead to improved financial accounting standards that produce auditable financial statements, then an historic opportunity will have been wasted.

1 Comment

  1. Reply K. K Raman October 27, 2017

    Hello, I was wondering whether you had a post on PCAOB rule relating to disclosure of engagement partner?

    Pl. let me know (w date of posting) or email me the post. Thanks!

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