Who’s Your Auditor

The PCAOB re-proposed including the name of the lead partner in the auditor report last week.  The Board seemed split on the proposal when you read their comments.  There are those that believe disclosing the partners name will make things more transparent to users of the audit report.  They even envision data gathered over time on which individual partners are involved in restatements, lawsuits over financial reports and other issues (and of course which aren’t).  The other point of view is that disclosing the partners name won’t do anything for audit quality and it actually might cause problems because auditors will do unnecessary work “just to be sure” and others won’t even consider becoming partners in the first place because of the increased scrutiny and liability such a requirement will create.

On the Industry front, this proposal could create some very interesting dynamics when combined with the existing requirement to change partners every few years.  While management and the audit committee are always very interested in who the new partner will be, under the proposed rule that interest will take on more of a public relations bent rather than just caring about whether the person is a good auditor and will work well with the company.  In theory companies don’t negotiate with their firm who the specific partner will be, but could you imagine a scenario where an excellent audit partner who was involved in a lawsuit that was settled in the last couple of years was suggested as the next partner for the audit.  I could easily see an audit committee telling the firm that if that partner will be the lead partner on the audit, then the company may decide to tender the audit work and go with a different firm.  Keep in mind, this decision has nothing to do with the actual audit skills of the partner involved.  Instead it has everything to do with PR perceptions of the investors.

While this scenario might actually get rid of a few bad auditors, I think the more likely result is that many good auditors end up being blackballed and more and more young CPAs question why they would ever want to subject their livelihood to such a possibility in the first place.

The really backwards part of this scenario is that less experienced auditors who handle “easier” clients are more likely to have a clean record while more experienced auditors that are willing to take on the tough assignments will likely end up with a black mark or two.  This may end up with companies seeking less experienced auditors with a history of not dealing with difficult situations – this is exactly the opposite of what would be considered the necessary ingredients for a better quality audit.  Maybe I’m wrong and the scenario I laid out won’t happen, but it sure seems plausible to me.  I just wonder if the cost of the potential for lower quality audits is truly outweighed by the benefit from possibly getting rid of a few bad auditors.

The New Auditor’s Report

Remember that feeling of satisfaction when your auditor questioned your accounting for a large transaction and, after lots of discussion, fact finding and research, the auditor finally agreed you were presenting it correctly resulting in a pretty, clean audit opinion.  Well, those days are over if the PCAOB gets it way.  Even if you were right, the PCAOB proposal on revisions to the audit report will require the auditor to identify the “critical audit matter,” describe why it was critical and refer to the appropriate disclosures in the financial statements.  This is beyond the old emphasis of matter paragraphs and is only one of several new requirements proposed by the PCAOB.

Normally, preparers don’t care much about PCAOB rule changes impacting the auditors, but this time they should take notice because it is going to significantly change that audit report attached to your financial statements.  In fact, you might also need to plan on additional page(s) for your report because the audit report is likely to be much longer in the future.

In addition to a new statement on auditor independence and a required disclosure on when the auditor began serving as the company auditor, the new report will also require the auditor to “evaluate” “other information” previously not subject to the audit.  “Other information” includes selected financial data and Management’s Discussion and Analysis (MD&A).  While “evaluate” is something less than “audit,” it is also clearly more than the current requirement to review such information for inconsistencies with the audited financial statements.

In addition, this “evaluation” will be included in the auditor’s report.  That would seem to open up the auditor to potential liability if there was something “wrong” in the MD&A so I think we will see significantly more work in that area, if only as a purely defensive measure, if the PCAOB proposal becomes a final rule.  You can also bet that the auditors will ask for higher fees as a result of the additional work.  We all remember how much the fees went up with the adoption of Sox 404 reporting.  While this should not be on that scale, I think it will be more than insignificant (to borrow from our standard setter’s terminology in the leasing standard).

There of many out there that believe it’s about time the MD&A is subject to some audit procedures given its importance to investors, and there are others that feel just as strongly that the MD&A needs to stay out of the audit so it can be truly focused on forward looking information which is notoriously difficult to audit.  Whatever your feelings, now is the time to let them be known by the PCAOB. The comment deadline in December 11 which will be here before you know it, so check out the most sweeping revision to the auditor’s report in years and let your voice be heard.