Dear PCAOB: My Response To Your Request For CommentsBy Francine • Aug 15th, 2011 • Category: Audit Firm Management, Latest, PCAOB, Pure Content, Regulators, Laws, Standards, Regulations, You Can Quote Me On That
The PCAOB will hold an open meeting tomorrow to discuss a concept release soliciting public comments on ways that auditor independence, objectivity, and professional skepticism could be enhanced, including mandatory audit firm rotation. They are also soliciting comments on their Concept Release for changes to the auditor’s reporting model.
I can’t be there tomorrow in person so I thought I would answer a few of the questions for you and for them.
I’ve provided comments to some of the questions below in Bold. I’ve written on these topics many, many times. Instead of repeating those remarks, I’m directing you to some of the most relevant posts. If you’d like to add your comments please add the appropriate question number for the PCAOB Board.
Ernst & Young Lehman Litigation: It’s No Victory If You’re Going To Trial (Judge Kaplan was damning in his criticism of vague and subjective auditing standards and found it impossible to hold Ernst & Young liable for not complying with them.)
Going In Circles: A Few Remarks On Audit Reform (On auditor rotation and auditor signing of audit reports.)
McKenna At The Georgia Southern Fraud And Forensic Accounting Conference (With a link to my presentation, “The Skeptical Professional: Requirements and Case Studies”)
Not Over Until It’s Over: Price Waterhouse India Settles Satyam (The Satyam case is a classic one regarding auditor independence and auditor skepticism. Price Waterhouse India demonstrated not much of either. The PwC US and International firms lack the authority to force them to. The regulators are not doing anything about this and the courts are impotent, in many cases, to correct this fault.)
Questions in PCAOB Concept Release on the Auditor’s Report
Content of the Auditor’s Report
1. Many have suggested that the auditor’s report, and in some cases, the auditor’s role, should be expanded so that it is more relevant and useful to investors and other users of financial statements.
a. Should the Board undertake a standard-setting initiative to consider improvements to the auditor’s reporting model? Yes
Why or why not? Investors pay billions worldwide for an audit report that is universally panned. Investors have been vocal In the UK and in the US regarding the uselessness of the ‘pass/fail” approach to the auditor’s opinion. The current report provides little information about the judgments and decision processes taking place behind the scenes. Auditors failed during the financial crisis to warn investors of trouble, let alone provide the realistic guaranty of safety for even a limited period of time that shareholders expect. If this is an “expectations gap” we must close it, either by removing the requirement for an audit opinion from exchange rules – and admitting its futility like the US SEC did with ratings agencies – or improving it so it has a useful purpose for investors. They deserve to get their money’s worth from the effort.
b. In what ways, if any, could the standard auditor’s report or other auditor reporting be improved to provide more relevant and useful information to investors and other users of financial statements? Two places where the current report could be improved are:
1. Development of a clearing house of auditor names attached to public company audit engagements worldwide with their biographies and information about sanctions, suspensions and litigation against them. I’m not so concerned about seeing a name on a printed report as knowing who is responsible for that audit over time and their qualifications and professional history.
2. The addition of an auditor’s “Disclosure and Analysis” would be priceless. It should be addressed directly to shareholders, not the Audit Committee, and be written in the style of Warren Buffet’s letter to shareholders. It should state where the auditors and management disagreed and which one prevailed. It should focus on judgments, estimates, and the range of practices especially regarding interpretation of key accounting standards amongst that issuer’s peer group.
c. Should the Board consider expanding the auditor’s role to provide assurance on matters in addition to the financial statements? If so, in what other areas of financial reporting should auditors provide assurance? Auditors should provide explicit assurance on MD&A. They are already required by standards to communicate with the Audit Committee regarding the adequacy of required disclosures. Interim Auditing Standard AU 380 requires auditors to determine whether all audit-related matters are communicated to the committee:
The auditor’s responsibility under Generally Accepted Auditing Standards (GAAS)
- Significant accounting policies
- Management judgments and accounting estimates
- Audit adjustments
- The auditor’s judgments about the quality of the entity’s accounting principles
- The quality of the management discussion and analysis (MD&A)
- Disagreements with management
- Consultation with other accountants
- Major issues discussed with management before retention
- Difficulties encountered in performing the audit
An Auditor’s Discussion and Analysis should repeat the substance of these communications and highlight where the Audit Committee and/or management disagree with auditors.
2. The standard auditor’s report on the financial statements contains an opinion about whether the financial statements present fairly, in all material respects, the financial condition, results of operations, and cash flows in conformity with the applicable financial reporting framework. This type of approach to the opinion is sometimes referred to as a “pass/fail model.”
a. Should the auditor’s report retain the pass/fail model? No If so, why?
b. If not, why not, and what changes are needed? The auditor’s report requires more detailed grading with an explanation of the grades. Perhaps the grades can be assigned based on whether the failings are individually material or material in aggregate and whether they relate to adherence to standards, aggressive use of estimates and models, lack of disclosure, or poor internal controls. I am in favor of the separate opinion on internal controls and question a company that could have an adverse opinion on internal controls (material weaknesses) and yet receive a clean opinion on their financial statements.
c. If the pass/fail model were retained, are there changes to the report or supplemental reporting that would be beneficial? If so, describe such changes or supplemental reporting.
3. Some preparers and audit committee members have indicated that additional information about the company’s financial statements should be provided by them, not the auditor. Who is most appropriate (e.g., management, the audit committee, or the auditor) to provide additional information regarding the company’s financial statements to financial statement users? I am skeptical that most Audit Committees are sufficiently detached and independent of management that communications from them would be any more useful to shareholders. That is a problem in and of itself. If auditors were required to provide their own discussion or analysis, they may be reminded of their own need for independence from management. However, the problem we have, and which is not solved by revisions to the audit report itself, is the problem of auditor independence as long as the auditors are paid by and contract for their services with an Audit Committee controlled by and in service to management.
At the PCAOB’s public meeting in March I heard some object to the auditor providing information to shareholders directly because that might harm the “relationship” between auditors and management. Yes. And that is exactly why auditors should be forced to face shareholders directly. Even the SEC’s Chief Accountant and the PCAOB Chairman have admitted auditors are too cozy with management, a non-independent Audit Committee encourages and enables that, and many auditors have forgotten who their true clients are – shareholders. Auditors should respond directly to shareholders, not to the management-controlled proxy – a potentially non – independent Audit Committee.
4. Some changes to the standard auditor’s report could result in the need for amendments to the report on internal control over financial reporting, as required by Auditing Standard No. 5. If amendments were made to the auditor’s report on internal control over financial reporting, what should they be, and why are they necessary?
We should go back to a separate auditors report on internal controls over financial reporting. If an issuer receives an adverse opinion on internal controls it should be rare or impossible for that issuer to receive any “passing” grade on the financial statements.
Potential Alternatives for Changes to the Auditor’s Report
A. Auditor’s Discussion and Analysis
5. Should the Board consider an AD&A as an alternative for providing additional information in the auditor’s report? Yes
a. If you support an AD&A as an alternative, provide an explanation as to why. See above 1.b.
b. Do you think an AD&A should comment on the audit, the company’s financial statements or both? Both. Provide an explanation as to why. Should the AD&A comment about any other information? The quality of management’s D&A and any disagreements in that regard over sufficiency or quality of disclosures.
c. Which types of information in an AD&A would be most relevant and useful in making investment decisions? I think information about how the issuer compares in key metrics, disclosures, aggressive interpretation of standards, and use of models and estimates to their peers would be very useful. In some industries, one auditor has an audit relationship with several major companies, addresses similar issues, evaluates similar approaches and either sees consistent or inconsistent results. This type of discussion and comparison would be very useful to identify outliers and anomalies as well as instances of collusion amongst companies with significant business alliances or who act as counterparties to each other.
d. If you do not support an AD&A as an alternative, explain why.
e. Are there alternatives other than an AD&A where the auditor could comment on the audit, the company’s financial statements, or both? What are they?
6. What types of information should an AD&A include about the audit? What is the appropriate content and level of detail regarding these matters presented in an AD&A (i.e., audit risk, audit procedures and results, and auditor independence)?
7. What types of information should an AD&A include about the auditor’s views on the company’s financial statements based on the audit? What is the appropriate content and level of detail regarding these matters presented in an AD&A (i.e., management’s judgments and estimates, accounting policies and practices, and difficult or contentious issues, including “close calls”)?
8. Should a standard format be required for an AD&A? Why or why not?
9. Some investors suggested that, in addition to audit risk, an AD&A should include a discussion of other risks, such as business risks, strategic risks, or operational risks. Discussion of risks other than audit risk would require an expansion of the auditor’s current responsibilities. What are the potential benefits and shortcomings of including such risks in an AD&A? The auditor is required to be aware of and knowledgeable about these areas per the standards. The auditor must take them into consideration in planning the scope of the audit. I see no additional work to disclose them and to give investors information about how this issuer compares to peer group.
10. How can boilerplate language be avoided in an AD&A while providing consistency among such reports? Regulators should forbid it and enforce accordingly. All shareholders will, hopefully, start demanding meaningful information.
11. What are the potential benefits and shortcomings of implementing an AD&A?
12. What are your views regarding the potential for an AD&A to present inconsistent or competing information between the auditor and management? I’m not troubled by this. In fact, I look forward to it. What effect will this have on management’s financial statement presentation? Management will be required to defend it. They should be prepared to do so or to back down.
B. Required and Expanded Use of Emphasis Paragraphs
13. Would the types of matters described in the illustrative emphasis paragraphs be relevant and useful in making investment decisions? If so, how would they be used?
14. Should the Board consider a requirement to include areas of emphasis in each audit report, together with related key audit procedures?
a. If you support required and expanded emphasis paragraphs as an alternative, provide an explanation as to why.
b. If you do not support required and expanded emphasis paragraphs as an alternative, provide an explanation as to why.
15. What specific information should required and expanded emphasis paragraphs include regarding the audit or the company’s financial statements? What other matters should be required to be included in emphasis paragraphs?
16. What is the appropriate content and level of detail regarding the matters presented in required emphasis paragraphs?
17. How can boilerplate language be avoided in required emphasis paragraphs while providing consistency among such audit reports? 18. What are the potential benefits and shortcomings of implementing required and expanded emphasis paragraphs?
C. Auditor Assurance on Other Information Outside the Financial Statements
19. Should the Board consider auditor assurance on other information outside the financial statements as an alternative for enhancing the auditor’s reporting model?
a. If you support auditor assurance on other information outside the financial statements as an alternative, provide an explanation as to why.
b. On what information should the auditor provide assurance (e.g., MD&A, earnings releases, non-GAAP information, or other matters)? MD&A, 10Qs. Auditors should distance themselves from non-GAAP disclosures. Earnings releases should not be inconsistent with 10Qs.
c. What level of assurance would be most appropriate for the auditor to provide on information outside the financial statements?
d. If the auditor were to provide assurance on a portion or portions of the MD&A, what portion or portions would be most appropriate and why?
e. Would auditor reporting on a portion or portions of the MD&A affect the nature of MD&A disclosures? If so, how?
f. Are the requirements in the Board’s attestation standard, AT sec. 701, sufficient to provide the appropriate level of auditor assurance on other information outside the financial statements? If not, what other requirements should be considered?
g. If you do not support auditor assurance on other information outside the financial statements, provide an explanation as to why.
20. What are the potential benefits and shortcomings of implementing auditor assurance on other information outside the financial statements?
D. Clarification of the Standard Auditor’s Report
21. The concept release presents suggestions on how to clarify the auditor’s report in the following areas:
- Reasonable assurance
- Auditor’s responsibility for fraud
- Auditor’s responsibility for financial statement disclosures
- Management’s responsibility for the preparation of the financial statements
- Auditor’s responsibility for information outside the financial statements
- Auditor independence
a. Do you believe some or all of these clarifications are appropriate? If so, explain which of these clarifications is appropriate? How should the auditor’s report be clarified?
b. Would these potential clarifications serve to enhance the auditor’s report and help readers understand the auditor’s report and the auditor’s responsibilities? Provide an explanation as to why or why not.
c. What other clarifications or improvements to the auditor’s reporting model can be made to better communicate the nature of an audit and the auditor’s responsibilities?
d. What are the implications to the scope of the audit, or the auditor’s responsibilities, resulting from the foregoing clarifications?
22. What are the potential benefits and shortcomings of providing clarifications of the language in the standard auditor’s report?
Questions Related to all Alternatives
23. This concept release presents several alternatives intended to improve auditor communication to the users of financial statements through the auditor’s reporting model. Which alternative is most appropriate and why?
24. Would a combination of the alternatives, or certain elements of the alternatives, be more effective in improving auditor communication than any one of the alternatives alone? What are those combinations of alternatives or elements?
25. What alternatives not mentioned in this concept release should the Board consider?
26. Each of the alternatives presented might require the development of an auditor reporting framework and criteria. What recommendations should the Board consider in developing such auditor reporting framework and related criteria for each of the alternatives?
27. Would financial statement users perceive any of these alternatives as providing a qualified or piecemeal opinion? If so, what steps could the Board take to mitigate the risk of this perception?
28. Do any of the alternatives better convey to the users of the financial statements the auditor’s role in the performance of an audit? Why or why not? Are there other recommendations that could better convey this role?
29. What effect would the various alternatives have on audit quality? What is the basis for your view?
30. Should changes to the auditor’s reporting model considered by the Board apply equally to all audit reports filed with the SEC, including those filed in connection with the financial statements of public companies, investment companies, investment advisers, brokers and dealers, and others? What would be the effects of applying the alternatives discussed in the concept release to the audit reports for such entities? If audit reports related to certain entities should be excluded from one or more of the alternatives, please explain the basis for such an exclusion.
IV. Considerations Related to Changing the Auditor’s Report
A. Effects on Audit Effort
B. Effects on the Auditor’s Relationships
C. Effects on Audit Committee Governance
D. Liability Considerations
31. This concept release describes certain considerations related to changing the auditor’s report, such as effects on audit effort, effects on the auditor’s relationships, effects on audit committee governance, liability considerations, and confidentiality.
a. Are any of these considerations more important than others? If so, which ones and why?
b. If changes to the auditor’s reporting model increased cost, do you believe the benefits of such changes justify the potential cost? Why or why not?
c. Are there any other considerations related to changing the auditor’s report that this concept release has not addressed? If so, what are these considerations?
d. What requirements and other measures could the PCAOB or others put into place to address the potential effects of these considerations?
32. The concept release discusses the potential effects that providing additional information in the auditor’s report could have on relationships among the auditor, management, and the audit committee. If the auditor were to include in the auditor’s report information regarding the company’s financial statements, what potential effects could that have on the interaction among the auditor, management, and the audit committee?