PCAOB Increases Auditors’ Work

Have you been told your audit fee is going to increase because the audit team has to do more work due to PCAOB inspection findings or audit alerts? This seems to be a common refrain I hear from a lot of preparers when I talk about the COSO 2013 ICIF. If you reacted by blaming the PCAOB for this increased cost, you may be on the wrong track.

I am sure your auditor explained that the PCAOB sent out an inspection finding to their firm or an audit alert to all auditors and that is causing the increased work, but this is where a little knowledge can go a long way. Instead of wondering how the PCAOB can issue rules that increase costs without going through a formal rule-making process that requires a comprehensive cost/benefit analysis, you need to realize that inspection findings and audit alerts do not make new rules at all. These two documents instead explain cases where the auditor was not following the rules and standards already in place for auditors of public companies.

So, if the auditor is telling you that findings or alerts are resulting in increased fees, what they are really telling you is that they have not been performing an adequate audit of your internal controls in the past. That leads to two possibilities. One, your audit team did not understand the auditing standards and therefore completed a substandard audit or two, your audit team knew the rules and decided to cut corners in order to low-ball the bid for your work, or increase the firms margins on the work performed.

What do you do then if you are being told by your auditor that they need more money for increased work over testing internal controls? I think its time to have a little fun. Ask your auditor if they were cutting corners, deliberating doing a bait and switch with a bid they knew they could not meet, or just simply incompetent. You still might end up agreeing to pay a little more, but at least you can make your engagement partner sweat!

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.

U.K Strikes on Auditor’s Report – Can U.S. Be Far Behind

The Financial Reporting Council (FRC) in the U.K. (think of the PCAOB/SEC in the U.S.) has proposed rules that will require auditors to provide commentary on the “risks of material misstatement” as well as how they applied the concept of materiality in the audit and how the audit scope responded to company risks.  These new requirements would be a huge departure from the current pass/fail auditor report model used by much of the world.

The PCAOB has also been looking at potential audit report modifications and had previously released a request for comments on potential changes to the report ranging from more information on how the audit was conducted to an auditor’s discussion and analysis.  The FRC proposal seems to be somewhere between these two extremes, but it would definitely seem to not be in alignment with the comments from most preparers in U.S. that said information about the company should come from the preparers not the auditors.

If the PCAOB decides to go down this path as well, I can see several significant issues from a preparer perspective.  First, in the U.S. management is required to provide an assessment of its system of internal controls to prevent material misstatements of the financial statements and the auditor then provides its opinion on that assessment.  If the auditor were then required to also comment on specific risks and what they did about them in the audit would this lead to either (1) questioning of managements assessment about the effectiveness of its internal controls or (2) management feeling compelled to specifically address their response to those risks as well in their report on internal controls.  And this doesn’t even address what might happen if management and the auditor have serious differences in opinion about what the risks really are in the first place.

I am also very concerned about the impact the required disclosure on how the concept of materiality was applied would have on the auditor’s evaluation of materiality.  Will auditors feel compelled to use lower than necessary materiality levels to prevent lawsuits that say if they had only used a slightly lower level of materiality problems that lead to the investor losses in the stock market would have been discovered?  If you don’t believe that would happen, then let me tell you about a recent development.

Previous to this audit cycle, most audit firms used a different dollar threshold of materiality for the income statement and the balance sheet.  I can hear the purest out there saying materiality is a qualitative measure, not a quantitative measure and they are correct, but when it comes down to it we have to measure whether potential misstatements are material so we have to quantify materiality in order to measure. The PCAOB decided that the auditing literature did not support separate materialities for the balance sheet and income statement so all of the auditing firms started using the lower of the two materiality measures for their evaluations.  This meant that many preparers had to change their controls to support a more precise measurement requirement – probably beyond the true cost-benefit trade off if materiality had been appropriately defined.

The point is that as firms lower materiality levels in defensive response to perceived threats, then the whole concept of materiality will be distorted as preparers find they must pay for more precise systems and controls then are necessary hurting the whole economy in the process.  So let’s hope cooler heads prevail in the U.S. and we don’t follow the U.K. lead in this case.