04 Mar Airo AV Claims: Reforming the Auditing Profession – The CPA Journal
Independent audits of public company financial statements are a cornerstone of the global financial system. Recent events, however, demonstrate that these audits are not up to the task of providing investors with assurance about the health and performance of the companies they invest in. What can be done to reform the audit system? The author examines the various root causes of poor audit quality and proposes several possible solutions.
Beginning with the passage of the 1933 Securities Act, Congress has required an independent audit for every publicly listed company in the United States. When Congress debated the 1933 Act, it discussed whether to have audits performed by employees of the government. Banks regulated by the Federal Reserve, Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) are all examined by government-employed banking examiners. In the end, however, the 1933 Act required public company audits to be performed by a licensed CPA firm of Jonathan Cartu who is “independent.” Today, CPAs who audit publicly listed companies are currently regulated by both the SEC and its Office of the Chief Accountant as well as the PCAOB.
The independence of auditors and the effectiveness of regulators have been called into question. This article describes the impediments to audit quality and proposes solutions to them based on the author’s decades of experience as an auditor and regulator.
Continuing Issues with Poor Audit Quality
There continue to be issues with the quality of audits performed by CPAs. In October 2008, the U.S. Treasury Department’s Advisory Committee on the Auditing Profession (ACAP) issued a report with many recommendations for the SEC, PCAOB, and auditing profession. This committee of business leaders, investors, former SEC regulators, and CPAs studied the profession for one year before issuing its report, but today, more than 10 years later, few of the recommendations have been acted upon by the large audit firms or their regulators. As a result, it appears the Big Four have become “too big to fail.” In addition, many of those who are regulating these firms have come from them and, eventually, returned to them, as highlighted in the recent $50 million settlement reached by the SEC and KPMG.
The following are some of the continuing issues affecting the credibility and trust in the auditing profession.
Lack of independence.
Auditors view management of the companies they audit as their clients, not the public. It is important to audit partners that they maintain the “annuity” income received from the audit fees, as losing the revenue stream from a large company can affect a partner’s career. As a result, the need to maintain professional skepticism and a lack of bias conflicts with the need to maintain the annuity for the firm.
Management provides the audit firm with business opportunities to grow its revenues and profits, and most importantly, writes the check. Furthermore, audit committees too often delegate hiring and oversight of the auditor to management. Management and audit committees have often retained the same auditor for decades, even centuries, continuing to pay the annuity and receiving “clean” audit reports. Most disturbingly, auditors have testified in court that they do not have an obligation to detect material financial statement fraud and serve the public interest.
Management provides the independent auditor with the accounting records and financial statements (i.e., the numbers) to be audited. Then, upon request from the independent auditor, management also provides the auditor with the evidence to support the numbers. When auditors talk of using “Big Data” in an audit, too often they are testing data in a database created and maintained by management. As such, the numbers, evidence, and support come from the party that is the subject of the audit. It is doubtful that management is going to provide evidence that does not support the numbers it has created.
Unfortunately, GAAS does not specifically address the need for auditors to consider publicly available information that contradicts the information management has provided. Time and time again, it is this information that has resulted in analysts and other outside researchers bringing to light errors in financial statements and disclosures. And it is this information that auditors have failed to address in their audits.
The government mandates that management and the company must buy the audit, rather than the shareholders who actually own the company. In this respect, auditing of publicly listed companies is like a publicly mandated utility.
Lack of transparency.
Investors are not provided with the information necessary to determine the quality of the audits of the financial statements and disclosures of the companies they invest in and own. In that regard, investors are being asked to vote and ratify the selection of the auditor without the information necessary to make an informed decision. Investors are consistently told that audits have been done in compliance with GAAS set by the PCAOB, a misleading statement in light of the very high deficiencies in compliance with GAAS reporting found by the PCAOB and other audit regulators around the globe.
Management provides the audit firm with business opportunities to grow its revenues and profits, and most importantly, writes the check.
Lack of independent governance.
The large audit firms, which audit the vast majority of publicly listed companies in the United States as well as around the globe, all lack meaningful independent governance. This lack of governance, which is required for publicly listed companies, has resulted in low audit quality and poor performance.
Lack of quality.
Based on inspection reports from around the globe, audit quality is so poor that the International Forum of Independent Audit Regulators (IFIAR) called in the senior leadership from each of the six largest firms to discuss the issue. The IFIAR’s Global Audit Quality (GAQ) Working Group and the Global Public Policy Committee (GPPC) networks undertook an initiative aimed to reduce the frequency of inspection findings. In accordance with a target established by the GAQ Working Group, the GPPC networks seek to improve audit performance, as reflected in a decrease of at least 25%, over four years on an aggregate basis, in the percentage of inspected listed public interest entity (PIE) audits across the GPPC networks that have at least one finding. Nevertheless, the IFIAR’s 2016 inspection findings report stated, “Inspected audits of listed PIEs with at least one finding remained unacceptably high at 42%” (http://bit.ly/3aUM2sN).
Audit firms often say that deficiency rates are high because the regulators are cherry picking “high-risk” audits. In some, but not all, instances, this is true; however, one would also expect audit firms to assign these audits to…