Before you get too excited about the “new and improved” audit report showcased in Michael Rapoport’s recent article titled “How to Make an Audit Report Useful,” I thought a reality check just might be in order.  While the intentions of the Public Company Accounting Oversight Board (PCAOB) and International Auditing and Assurance Standards Board (IAASB) are no doubt honorable in proposing changes to today’s audit report, expanding the report with more accounting jargon is simply not the answer.  

Both the PCAOB and IAASB argue that a new report is needed to better meet investor information needs.  But this begs the question…exactly why are investors clamoring for more information from the auditors about their work?  The answer is simple: audits of publicly traded companies are increasingly becoming suspect as accounting restatements become the norm, and large audit failures far too common.  And it doesn’t help investors when three of the Big Four auditors (BFA) are so deficient in their practices that the PCAOB “sanctions” them by releasing their complete inspection reports.

And if you think that this Grumpy Old Accountant is being too harsh, let’s review some of the “improvements” highlighted in Michael Rapoport’s Wall Street Journal mock-up.

First of all, is it really necessary to define what constitutes a set of financial statements in an audit report?  Hasn’t it always been a fundamental assumption that readers of financial statements have some basic level of financial acumen?  When was that abandoned?  If the “investor” is truly this ignorant, the rest of this “new report” is going to be meaningless.

Next, why are we allowing the BFA to use this new report as a tool to limit their legal liability for doing a poor job?  Consider the following examples/sections:   

  • Stating that the financial statements are the responsibility of company management is uninformative.  If not management, then whom?
  • Also, is it really necessary (and informative) for auditors to clarify their responsibilities, and aren’t they supposed to perform in compliance with the auditing standards? 
  • Do definitions for such terms as “reasonable assurance” and “material misstatements” really belong in the audit report?  The audit report is not an educational tool, but rather an opinion on the quality of a company’s financial statements.

The text associated with the above disclosures serves one and only one purpose: to limit the auditor’s legal liability when audit failures occur.  To assert that these litanies might have any information content for the investor is ridiculous.

Now, there are a couple of sections in this “new report” that actually aren’t bad, but if auditors were really delivering high quality audits, they wouldn’t be needed either.  For example:

  • Information on the conduct of the audit does have some value, particularly given today’s declining audit quality.  But just look at what is being proposed for this section…this is rubbish!  Investors could care less about the organizational structure of accounting firms, or their revenue generation abilities.  Why not tell us about engagement team composition and experience, engagement hours per staffing level, etc.  
  • Similarly, information on audit scope and emphasis could be informative.  But should an investor really have to worry about how the auditors do their jobs?  Why can’t we rely on the auditors’ judgment, professionalism, and ethical behavior to deliver a reliable audit report?

And then there is the “assessment of risks” section.  While this sounds like a nice addition, let’s be realistic.  Are the BFA really going to add any incremental information beyond what is already being reported by a company in the required risk disclosures in the management discussion and analysis (MD&A) section of the 10-K?  I really doubt it…and then there is the other issue.  Do you really think the BFAs will say anything bad about the client that pays their bill?  As for “other audit reports,” why bother?  Auditors are struggling with the basic audit as it is…do we really need more unreliable reports?

So, what do I propose?  Well, as an advocate of the KISS rule (keep it simple stupid), I have a simple solution based on history.  And contrary to Michael Rapoport who asserted that its “pretty hard to ever make audit reports scintillating reading,” here is a report that does just that in only TWO paragraphs.  

We have examined the balance sheet of X Company as of [at] December 31, 20XX, and the related statements of income, retained earnings and statement of cash flows for the year then ended. Our examination was made in accordance with generally accepted auditing standards and, accordingly, included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances.
In our opinion, the financial statements referred to above present fairly the financial position of X Company as of [at] December 31, 20XX, and the results of its operations and cash flows for the year then ended, in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year.

Yes, scintillating in its simplicity, conciseness, and directness!  We came, we audited, we reported!  That’s what investors want to know: the numbers in the financial statements are presented fairly.

Where did I get this you ask?  Except for three modifications to update references to changes in financial position with cash flows and the date, this is the standard auditor’s report presented in Statement on Auditing Standards No. 2 in October 1974, issued by the Auditing Standards Executive Committee of the American Institute of CPAs. Yes, a blast from the past, that only an accounting geezer would remember.   As a student, this Grumpy Old Accountant was required to memorize these two paragraphs for his auditing classes.  But for this to work, auditors have to do quality audits!

The issue is NOT the audit report…it’s the audit!  My advice to the PCAOB is to put your head down and keep your eye on the ball.  Don’t be distracted by the politics of the BFA. The audit quality problem will NOT be solved by letting the BFA off the hook with an expanded report that further dilutes their accountability. The audit quality problem will NOT be solved by transferring the risk of misleading financial statements from the BFA to investors via an expanded audit report.  

And a recent survey by the Financial Executives International raises further questions about whether the BFA are being over compensated for avoiding their responsibility.  Is auditor accountability really too much to ask for given the outrageous amounts the BFA are earning for their public company audits? For example, according to Audit Analytics, the BFA “earned” $12.3 billion in audit fees for audits of 6,308 public firms with 2012 fiscal year ends.  And if this doesn’t make your blood boil, just consider how much the BFA brought in for their 2007 audits of firms involved in that year’s market collapse:

 

If the size of the fees and the related abrogation of responsibility don’t bother you enough, consider the following.  For a variety of reasons, the BFA perform substandard audits while engorging themselves with audit, non-audit, and a variety of other consulting fees.  Numerous audit failures and PCAOB inspections are a testimony to their larceny.  And while the BFA continue to grow, investors pay the price.  And many of the laws passed in the wake of the 2007 financial crisis have actually contributed to the further enrichment of the BFA (e.g., Sarbanes-Oxley internal control requirements).  Does this seem appropriate?  And the BFA also continue to lobby legislators to remove or weaken audit quality legislation (i.e., auditor rotation, partner signatures, etc.) proposed after the financial crisis.  A testimony to the strength of the BFA’s lobby is their ability to convince regulators that they are “too few, to fail,” thus insulating themselves from any meaningful regulatory intervention.  And their government mandated charter to audit public companies truly does appear to have given the BFA the “goose that laid the golden egg.”

But let’s not give up on the hope for audit quality and auditor accountability. There IS something that can be done to reign in the BFA’s arrogance, and refocus them on their public duty.  And the solution has been tested numerous times and actually works!  Remember the banking crises of the 1980’s, 1990’s, and 2000’s?  Three decades of “too big to fail” financial institutions spawned an intervention process in which banking regulators assumed control of failing institutions.  Once in charge, the failed “banks” were either liquidated, or rehabilitated sufficiently to be sold.  I propose we do something similar with the BFA… after all, they now are regulated entities right?  Here’s how it would work.

Once the PCAOB determines that an audit firm has not adequately addressed deficiencies reported in inspection reports, the following would occur:

  1. The PCAOB would issue a “cease and desist” order to the accounting firm preventing them from engaging in any new audit business, or beginning any new audits for existing clients.  It would not affect any of their tax or consulting practices.
  2. Next, the PCAOB would assume control of the audit unit of the cited firm using its own inspection staff. PCAOB inspectors would assume control of all audit leadership and administration functions for any remaining audits at the firm, and begin a complete investigation of the firm’s audit business model.  The PCAOB would now run the audit firm.  Of course, the PCAOB would be free to contract with outside professionals to supplement their staffing.
  3. The PCAOB might find that that the audit firm’s problems are isolated to a particular office or regional practice.  In such cases, the PCAOB would require that this unit be liquidated, as previous firm attempts to rehabilitate the practice had not been productive.  Once completed, and satisfied that audit firm problems were corrected, the PCAOB would return control of the audit firm to its partners, and the “cease and desist” order would be terminated.
  4. If the audit firm’s problems were found to be systemic, the PCAOB would begin a gradual liquidation of the entire firm by selling off separate audit practices to interested parties.  During this time period, the PCAOB (and its representatives) would continue to manage on-going audits to their completion.  On an exception basis to minimize effects on the audit markets as a whole, the cited firm might be allowed to continue performing audits for existing clients, but these would be under the ultimate supervision (and scrutiny) of the PCAOB and its representatives. Ideally, this gradual “downsizing” and “cleansing” of the firm would ultimately yield a more appropriately “sized” firm capable of resuming normal operations.  If so, and satisfied that audit firm problems were corrected, the PCAOB would return control of the audit firm to its remaining partners, and the “cease and desist” order would be terminated.

Resolving the audit quality problem requires intense focus, intestinal fortitude, and real imagination.  Unfortunately, the “new” audit report is just a figment of the imagination, and yet another distraction in the continuing battle for audit quality.


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