Going In Circles: A Few Remarks On Audit Reform

By • Jul 14th, 2011 • Category: Audit Quality, Food for Thought, Latest, Liability Caps, Pure Content

Don’t get me wrong.

I’m thrilled that there’s a lot of traffic in my lane. What I mean is, it’s good for everyone that we’re talking about these issues and that someone other than me and a few other broken records are playing these tunes.

Fairly new PCAOB Chairman Jim Doty and his fellow board members have been on the road constantly since the three newest members – Doty, Ferguson and Hanson – took their seats in February. And they’re not letting up on the auditors and their firms.

Every speech is laced with lessons, examples, and promises of more to come.

Some key areas of focus:

There’s been significant activity in many of these areas. In fact, Board member Lew Ferguson is currently in China with representatives of the SEC to discuss opening up that country to PCAOB inspectors.

But whenever talk of audit industry reform comes up, usually after the latest accounting scandal or major fraud, the same old suggestions come up again, too.

The global financial crisis set in motion, again, the soul searching that occurs every ten years or so in the audit industry. It’s been almost ten years since the Enron scandal bred the Sarbanes-Oxley legislation that was supposed to be the “be all end all” for auditor failures and to prevent frauds and failures of all kinds.

But, of course, this wasn’t the case.

Before that the U.S. had a savings and loan crisis and, before that, other crises of confidence in the profession sparked by individual malpractice cases or fraud and corruption where the auditors either missed the problem or, worse yet, were complicit in it.

The auditors’ role in the latest crisis is only recently being examined. I’ve been pushing hard for that since 2007 when we started to see the subprime crisis and the failures of mortgage originators and home builders. The subprime crisis turned into a credit crisis which turned into a full blown financial crisis and recession or depression depending on which country you live in and your personal circumstances.

I think the turning point in attitudes towards this crisis, and the auditors’ role in particular, was the Lehman bankruptcy examiner’s report in March 2010. This was the first time the issue of fraud was raised relative to major failures that precipitated the financial crisis and, specifically, with regard to the auditors. In the Lehman case it’s Ernst & Young.

Until then, most media accepted the bankers’ and government’s version that the end of 2008 was a black swan economic calamity of unpredictable and unprecedented proportions that no one could have prevented.

But even that didn’t really turn the tide completely for the auditors. Critics in the UK started asking the question, “Where were the auditors?” much sooner than anyone in the mainstream media in the U.S..

U.S. regulators began to take notice when Big Four audit industry leadership claimed, in testimony in the House of Lords in November of 2010, to have been ordered to stand down and not issue going concern warnings on the major banks that failed and were nationalized. In response, the PCAOB’s Investor Advisory Group (IAG) raised the issue of the auditors’ role in the crisis and requested deeper study. It remains to be seen if that study will be completed by the IAG or another group, but just the fact the issue was raised, and so pungently by so many, meant that the auditors’ “good crisis” was, perhaps, over.

The PCAOB, at least, has taken up the challenge of responding to investors’ concerns about the value of the audit report, the role of the audit industry in the crisis and the profession’s role in preventing another one. The audit report itself, in spite of the profound changes in the business environment, has changed very little in the last forty years. In the meantime, frauds, Ponzi schemes, business failures and various other financial calamities continue to occur all over the world with increasing frequency and little or no warning from the auditors. The PCAOB has issued a Concept Release on the subject and is expecting comments from all fronts.

A few other reforms are less dramatic but equally likely to elicit strong feelings on all sides.

Auditor rotation is a suggestion that comes up over and over with no resolution. The Financial Times’ Agenda (subscription only) explored the pros and cons of the issue. I was quoted and so were a few other notables such as Denny Beresford, who currently chairs the Audit Committees at Fannie Mae and Legg Mason.

I get the last word with this quote:

But even Francine McKenna, an outspoken critic of the industry, does not advocate mandatory term limits. “In a perfect world, if we had enough firms and if we had enough capacity and ability to go around, then it would be a wonderful idea,” she says. “But I think, practically speaking, it would make things worse. Trading one potentially corruptible firm for another potentially corruptible firm doesn’t really help.”

Instead, McKenna advocates radically changing the industry structure. “My personal feeling is we’re not going to get a good audit until we take it out of the companies’ hands and put it into the hands of an agency that controls the fees and controls who does the work,” she says. “You can’t have companies paying for audit firms directly.”

Another perennial favorite audit reform straw man is audit partner signatures on audit reports. I wrote a column about it at Forbes.com this week.

As usual, I think the proposals never go far enough – more likely a feature rather than a bug  – and that’s why they end up spinning, eventually, down the drain.

The PCAOB approved Auditing Standard No. 7, Engagement Quality Review on July 28, 2009. They also issued a Concept Release on requiring the engagement partner to sign the audit report.

The suggestion was not a new one. On October 14, 2009, the PCAOB’s Standing Advisory Group (SAG) discussed the concept release and the comments that were received.

Auditors have traditionally opposed individual partner signatures for audit reports arguing the engagement partner is already known to the client audit committees and partners already hold themselves accountable to their own own high standards of professionalism and accountability. Those professional standards are supplemented by mechanisms that are in place to allow third parties to hold them accountable.

Like lawsuits.

The comment period closed September 11, 2009 and boy oh boy were there a lot of comments. The audit firms arrived en masse to denounce the proposal. Jim Hamilton’s World of Securities Regulation had a great summary of their arguments.

Whenever there’s talk again of reforms, the audit industry uses fear of catastrophic liability and higher fees to inure alignment with their clients – rather than shareholders the auditors view the public company executives who hire them as their client – and to scare everyone else into leaving sleeping dogs lie.

When discussion of these reforms started to gain momentum in the U.K. earlier last year, the first thing out of the industry’s mealy mouths was liability caps. I suppose worrying about no moral compass is moot if there’s moral hazard.

The Standing Advisory Group (SAG) discussion of the concept release in October 2009 highlighted that previous panels and studies had raised the suggestion before, the objections were always the same, and nothing ever came of it. The SEC put together a group in 2008 to streamline financial reporting that touched on audit industry issues. The Treasury’s Advisory Committee on the Auditing Profession (ACAP), a panel formed after the Enron scandal, also delivered recommendations in early 2008.

Gaylen Hansen: During the Treasury Committee proceedings and the testimony, the investors felt very, very strongly about this…We’ve been over these arguments. I didn’t hear any new arguments in the comment letters that we’ve heard during the testimony that came before ACAP or in the discussion that we had last year, or maybe it was the last SAG meeting, on this particular issue. But we’ve been doing what we have for the last hundred years…

The Concept Release on Requiring the Engagement Partner to Sign the Audit Report is still on the PCAOB standards setting docket. No further public action has been taken on it since 2009.

Please go to the Forbes.com article, “Auditors and Audit Reports: Is The Firms’ ‘John Hancock’ Enough?” for my suggestion.

Hint: It’s something like what they do with sex-offenders.

Main page photo courtesy of The Guardian UK.

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11 Responses »

  1. Francine, it looks like your persistence in covering the auditing industry is having a real affect. It may be subtle, but it’s more than the flap of a butterfly’s wing.

    Now that Chairman Doty’s actions are causing the audit firms to fret, it would be logical for them to take some new, bold steps to both reform their audit function and, at the same time, keep their business models. But, of course, that would be very unbusiness-like. They will likely come out fighting with the standard threats of job losses, economic collapse, etc. Unfortunately, they are not easily replaced. Over the ages, the accounting industry has developed a structure that is neither well understood, nor held under a microscope.

    Hmmm… maybe we should design some performance ratios. How about number of lobbying dollars to lawsuits filed against the firm?

  2. As a first year auditor, I can already see how it is difficult to remember who your “client” really is especially when auditing a company that is making things difficult. When it finally comes down to it, issuing a “going concern” opinion certainly seems like it will take a client in an unstable situation and turn it into an even worse situation – but if it’s a going concern, it’s the auditor’s role to let financial statement users know that. I can imagine it would be hard for an audit firm to see things that way when you’ve built a “relationship” with the client, and you want their business to succeed.

  3. @Oversight for the Better

    Remember when we met and it seemed I was flapping my wings like a butterfly a million miles away? Yes, it is very gratifying to see my quotes and my ideas in speeches from the PCAOB and others.

    Last week someone sent me a lawsuit that quoted me on AIG, Goldman Sachs and PwC – Wanda Mimms, derivatively on behalf of the AIG Incentive Savings Plan v. PricewaterhouseCoopers LLP, the AIG Retirement Board, et al . It was thrilling.

    :)

  4. Francine, I have only recently found your articles. I have never written a single comment to a reporter or any other person for that matter. But, I have found your thoughts and your words refreshing and inspiring, which is unusual—I began to think it would be a lot more productive to seek help through anti-depressants rather than continuing the fight. My firm has been dealing with these issues in the retail industry for over 20 years now. And, I must admit, I was getting to the point where I was starting to think that no one saw what was happening to public corporations in America. My firm began a “mission” to fight the financial shenanigans that exist in the retail industry on three fronts: 1. By offering litigation support against the offenders. 2. By trying to bring about a higher level of awareness through corporate governance in the retail industry—which really depressed me! 3. And, finally, through the capital markets, in an effort to enlist the support of institutional shareholders to the fight. Without elaborating further, I just want to thank you for shedding light on a very important topic—and for saving me the expense of pharmaceuticals!

  5. [...] million – of the total fees paid to EY by News Corp. That’s a serious indictment of EY’s independence as [...]

  6. @ Tom Yake

    Well, if I can save even one dejected soul from drugs, my work is done.

    But seriously, I’m glad you like what I’ve been writing. Sometimes it takes a lot out of me. And sometimes, just when I think I’m making headway, some ne’er do well drive-by journalist who never looks at the audit firms but once in a blue moon when there’s a big story steals my thunder and deflects attention from the core issues. But, I digress… I do feel there’s been huge progress in awareness over the last four years. I’ve played a small part, if only in encouraging others to speak up. I’ve been very satisfied with that.

  7. You should be very proud of yourself. I know it must feel like an uphill battle at times. This is one very good example of where the power of the press can make a huge difference. On a different note, however, do you see any windows of opportunity to have a larger impact? It would seem to me that there might be a small segment of institutional investors that could apply pressure where it’s needed the most. Other than that, and abesent the option of making mandatory prefrontal lobotomy a criteria for becoming a managing partner in those firms, I am at a loss!

  8. [...] Going In Circles: A Few Remarks On Audit Reform (On auditor rotation and auditor signing of audit reports.) [...]

  9. . I totally agree that most of the proposed solutions are strawmen. They do not remove the incentive. I am glad to see someone reputable advocate :

    McKenna advocates radically changing the industry structure. “My personal feeling is we’re not going to get a good audit until we take it out of the companies’ hands and put it into the hands of an agency that controls the fees and controls who does the work,” she says. “You can’t have companies paying for audit firms directly.”

  10. [...] to the ones cited recently by PCAOB Chairman Jim Doty. Doty has been emphasizing the need for more auditor skepticism. PCAOB inspectors see an appalling lack of it and the deficiencies cited in their reports are [...]

  11. [...] recipients — General Motors, AIG, Goldman Sachs, Citigroup — and crisis failure Lehman had as long or longer relationships with their [...]

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