Well, the auditing profession appears to have finally hit the “bottom of the barrel.”  The demise of the respected Arthur Andersen firm in the wake of the Enron scandal was a huge disappointment.  And now PricewaterhouseCoopers (PwC) has failed us by not living up to the high standards set by its legacy firm.  For those of you too young to remember, Price Waterhouse & Co. was the Brooks Brothers of the accounting and auditing profession at one time.  As Mark Stevens in The Big Eight noted in 1981 (yes, over 30 years ago), Price worked hard “to retain its image as the gilt-edge CPA firm.”  My how times have changed!

So what happened?  On March 7, 2013, the Public Company Accounting Oversight Board (PCAOB ) reported that the PwC had failed to address certain audit related quality control criticisms levied at the firm in previous PCAOB inspection reports, not once but twice, first in March 25, 2009 and then again in August 12, 2010.  What makes this so interesting is that the issues raised in those previously issued reports would have remained “private” had PwC simply corrected the problems within 12 months of the reports’ issuance.  While this is not the first time that one of the Big Four has thumbed their noses at the PCAOB (Deloitte felt the PCAOB’s wrath in October 2011), it is surprising that “a leader in the profession” (and yes, those are PwC’s own words) has done so. You may recall that the Grumpies were not wild about this behavior the first time it happened.

Well, Lynn Turner, a former Chief Accountant of the U.S. Securities and Exchange Commission (SEC), in a recent email (March 7th) to his distribution list, has asked the million dollar question:

What kind of leaders are running the firms, what type of governance do they have, that provides that type of response to the regulator?

Just look at PwC’s response to the PCAOB in its March 7, 2013, Release No. 104-2013-054:

The Part II comments relate to some of the most complex, judgmental and evolving areas of auditing. Our actions relating to those areas, during the 12 months following issuance of the  comments and thereafter, have included providing our audit professionals with enhanced audit tools, training and additional technical guidance to promote more consistent audit execution. We believe that these efforts have been important positive contributors to audit quality at our firm. We are proud of our focus on continuous improvement and of the dedication and high quality audit work performed by our partners and other professionals.

Wow!  This hints at an admission by PwC that its highly paid auditors were not properly trained to audit publicly traded firms.  If this is indeed the case, we surely can’t overlook the ethical implications of a firm contracting to do work for which it was not qualified. This never would have happened at Price Waterhouse & Co. What really bothers this grumpy old accountant is that PwC just doesn’t get it. The old “we’ll try harder” language is just not acceptable.

Just look at a couple of the more glaring audit quality control problems plaguing PwC.  First, there is the supervision issue.  Apparently, some PwC engagement partners are spending miniscule amounts of time on their engagements (see PCAOB Release No. 104-2009-038A  page 23).  Remember, these are the same engagements that PwC (in responding to the PCAOB) indicated involved “some of the most complex, judgmental and evolving areas of auditing.”  How could PwC allow this to happen?

Particularly troubling is PwC’s “let them eat cake” attitude in addressing PCAOB concerns such as “failure to adequately challenge management assumptions, excessive reliance on management's responses to inquiries, and the failure to respond appropriately to potential issues identified during the audit.”  Apparently, PwC engagement teams view cumulative audit knowledge and experience (CAKE, a PwC acronym) as a “source of substantive assurance” in their audit model, which may have undervalued skepticism, supervision, and good old fashioned audit procedures (see PCAOB Release No. 104-2009-038A page 14).

And while I am on the topics, skepticism and supervision are NOT just about technical competency and/or having someone review your work.  Skepticism and supervision require competency, experience, judgment, and strength of character, traits typically found only in seasoned, grumpy old auditors…like engagement partners.  So, is it really surprising that the PCAOB found problems in these areas given the firm’s reduction in partner engagement time?

Also, let’s be clear on what the PCAOB really means by “quality control system.” This is the audit model itself…the activities and procedures used by an accounting and auditing firm to actually execute an audit.  So, when the PCAOB finds problems with how PwC audits estimates, fair value, and revenue recognition; evaluates controls; and uses specialists, it raises serious questions about how the firm’s business processes function. So, what PwC and its three other Big Four cronies really need is a new “audit model.” 

As you may recall, a financial statement audit opinion is supposed to certify that a company’s reports comply with generally accepted accounting principles (GAAP).  Complicating matters is the fact that GAAP has become so “complex” and “judgmental” (and those are PwC’s own words) that the current audit model (essentially unchanged for 75 years) may no longer be useful.  Evidence that today’s GAAP is wreaking havoc among auditors can be found in another PCAOB report (Release No. 2013-001) dated February 25, 2013 which summarizes results for inspections conducted in 2007-2010 of 578 audit firms involving 1801 audits.  Just look at some of the problem audit areas identified by the PCAOB…these again are all significantly judgment focused: revenue recognition, fair value measurement, business combinations and related intangibles, and estimates.  So, as the Financial Accounting Standards Board (FASB) makes it headlong rush into fair value reporting and abandons two key qualitative characteristics of financial reporting, faithful representation and verifiability (discussed in Concept Statement No. 8), it just may be a major contributor to poor quality auditing by promulgating accounting rules that are filled with measurement error and impossible to verify.  Yes, FASB may be killing the auditing profession!
Some of the FASB’s finest work surfaces at the heart of the auditors’ problems: software transactions, multiple-deliverables, gross vs. net. (see PCAOB Release No. 2013-001 pages 11 and 12).  Yes, the some of the very same issues that the grumpies have been harping about for several years. The complexity of such transactions begs for accounting experience, and it is sheer lunacy to expect junior auditors (those with less than five years of diverse experience) to deal with these transactions.  
Then there is fair value accounting, the centerpiece of the FASB’s standard-setting for the past decade.  When it comes to assessing controls and substantively auditing assumptions and valuation models (see PCAOB Release No. 2013-001 page 17), today’s auditors seem to fail miserably at both junior and senior levels.  Again, we must ask why?  Despite all of the firms’ assertions, audit staffs simply haven’t been trained adequately in the accounting and auditing of these transactions.  Heck, in most cases, the clients don’t understand them either.  And who gave us the accounting that motivated (or in some cases encouraged) these transactions…the FASB!
Then there is the FASB’s stubborn commitment to goodwill and asset impairment testing.  If management doesn’t know why it paid an excess purchase price for an acquisition, can you really expect an auditor to ascertain the veracity of recorded goodwill amounts?  Why does FASB continues to play this goodwill game?  Could it be that mandating goodwill write-offs at the date of an acquisition might stifle M&A activity, since manager overpayments would be exposed to investors?  But does this really matter since research shows that most acquisitions fail to achieve their strategic goals thus rendering recorded goodwill meaningless?  Bottom line…how do you expect inadequately supervised (and often junior) auditors to audit client assumptions and estimates for assets that have no tangible existence?  The auditor has been set up to fail…by FASB!
Next, there is the issue of analytical procedures (see PCAOB Release No. 2013-001 page 32).  In the old days (when I was a junior auditor), analytical procedures resided in the domain of experienced auditors (i.e., audit seniors and above). Today, junior accountants many of whom are not even trained in fundamental financial statement analysis are commonly tasked with evaluating management explanations.  The situation is so pathetic in fact that all too often juniors fill their analytical working papers with such trite phrases as “appears reasonable, pass further work,” when additional work is in fact needed.
Then, there is the inability of today’s auditors to assess fraud risk (see PCAOB Release No. 2013-001 page 35).  With so little audit work being done by seasoned, experienced auditors, this deficiency is not unexpected.  Junior auditors would not recognize a fraud today if it jumped up and smacked them in the face.  Even in my old audit days, we laughed about giving junior auditors that old task “review the general ledger for significant/unusual transactions.”  Without experience and business sense, the young auditor will always fail in this task.
But am I suggesting that the Big Four may NOT be THE problem?  Of course not, they represent themselves as being competent to audit, so they must suffer the consequences if they don’t comply with PCAOB standards. Moreover, the Big Four are simply “reaping what they have sown.” PwC et al. may actually be getting what they deserve, since they lobbied mightily for many of the judgmental GAAP standards we now have (including the adoption of international financial reporting standards).  And why did the large accounting and auditing firms promote such accounting rules?  While they will never admit it, in part to reduce their legal liability for bad audits…after all it’s harder to be sued (and lose) when auditing a client’s estimates or judgments.  Unfortunately for them, however, the PCAOB has unmasked their shoddy auditing of judgment related accounting areas. The big accounting firms simply can’t audit the “new accounting” because they use an outdated audit model driven by antiquated staffing mixes which ignore the importance of experience and wisdom. And if inadequate partner supervision time is not a big enough problem for these firms, their relatively young mandatory retirement ages rob them of the talent they most need to audit subjective accounting issues…the senior folks who actually have experience, insights, and judgment.
So, what’s the solution?  First, dump the current cast of FASB (and IASB) characters and replace them with some practicing grumpy old accountants (that excludes Ed and me of course) who take the qualitative characteristics of useful financial information (Chapter 3, FASB Concept Statement No. 8) seriously, and who will restore such concepts as faithful representation and verifiability to the standard setting process.  The notion of relying on and/or auditing management estimates and assumptions given today’s increasingly subjective accounting is simply ludicrous.

Second, the PCAOB must move the auditing profession away from its historical audit pyramid where relatively inexperienced and inadequately trained “grunts” labor long hours to make their audit partners wealthy.  That may have worked when business transactions were much simpler, local, and slower paced.  But with today’s transaction complexity, speed, and globalization, what we need to have for quality audits is senior manager and partner time…not rookie time.  The tired, old, audit pyramid needs to be scrapped and should have gone the way of rolodexes, printed encyclopedias, phone books, film, bank deposit slips, and answering machines…AWAY.

Finally, the auditing profession must stop forcing their elder statesmen (those over 60) into retirement.  By forcing these early departures, these firms are throwing away one of (if not THE) most valuable assets that they have….experience.

So, while it brings tears to this grumpy old accountant’s eyes to see the demise of what I remember as such a great firm, PwC and the other large accounting firms are getting exactly what they deserve for promoting bad accounting standards: impossible to audit balance sheets!


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


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AuthorAnthony Catanach