New PCAOB Chairman Pushes for Audit Overhaul

James R. Doty took over the chairmanship of the government regulatory board that inspects and disciplines auditing firms earlier this year. During a speech Thursday at a Baruch College financial reporting conference, Doty also discussed problems he has seen with audits of multinational companies, particularly in China, and in the way that audit firms communicate with audit committees on public company boards.

“Our system of capital formation relies upon the confidence of millions of investors and millions of savers to invest in the companies they trust,” he said. “The auditor’s opinion is critical to that trust, and there are formidable forces at work against that trust.”

Among them is the payment model. The auditor is still hired and fired by the company, Doty noted. The Sarbanes-Oxley Act reformed that to some extent by shifting away the hiring and firing of the auditor from management to the audit committee, but that change hasn’t gone far enough.

“As with management, audit committees see their jobs as negotiating the lowest possible audit fee, not championing audit objectivity and independence from management,” said Doty. “I think that’s a problem. In this environment, not surprisingly, the scope of the audit has not grown or expanded, even if society’s expectations have. The audit is arguably as important to our society and this culture as electricity or water. To retain that lofty status, auditors and the PCAOB need to do our best to make sure the audit is useful.”

He noted that auditors often face conflicts of interest in evaluating companies’ going concern assumptions. They have to listen to people who both prepare the market valuations for a company and actively trade in the same company’s equities. Conflicts can emerge in audit committees, which are drawn from boards of directors who profit when the company’s stock performs well and who don’t want to know about early warnings that may prove to be self-fulfilling prophecies.

He said these forces can discourage auditor objectivity. “There is no silver bullet to address these challenges,” said Doty. “There are as many problems, I believe, with structural alternatives, such as insurance-based systems. Eliminating the audit requirement entirely and replacing it with insurance would be impractical, and I believe outright reckless.”

Doty said the PCAOB should provide a counterweight against those tendencies. However, Doty rejected proposals by the European Commission and the United Kingdom to require companies to rotate auditors more frequently and reduce market concentration in global audit firms. “The European Commission has sought views on whether the consolidation of the past decades should be reversed by breaking up the Big Four,” he said. “The Financial Reporting Council in the United Kingdom has championed the concept of living wills to plan for the contingency that a large audit firm would fail and thus concentrate the audit market further.”

He said proposals such as these would do little to provide the public with more relevant information and early warnings from auditors. “I do not believe that the global audit firm networks themselves pose a systemic risk to our economy,” said Doty. “Initiatives to shrink the global audit firms would likely weaken their ability to audit large, multinational companies that may be systemically important.”

He said governments should instead focus on regulation. “To protect investors, governments should regulate such firms, not cripple them,” said Doty. “There’s no reason to think that if there were more major firms, they would be more likely to stand up to their clients.”

Doty wants to change the auditor’s report to provide more useful, relevant and timely information, and he plans to start a dialogue with auditors and investors on how that should happen. “How do we close the expectation gap between the investing public and the audit report in a meaningful way?” he asked. The PCAOB expects to issue a concept release early this summer summarizing and analyzing the suggestions it has received from various sources. “The concept release should result in the most substantial changes to the reporting model in half a century,” said Doty.

One of the problems that concerns Doty is the PCAOB’s inability to disclose any of its disciplinary proceedings against auditing firms to the public until all the appeals have been exhausted, as per the Sarbanes-Oxley Act. The PCAOB has asked Congress to change the law.

“In the years since Sarbanes-Oxley was passed, the PCAOB has built an active enforcement program, but unfortunately for investors, audit committees and the audit profession itself, that process takes place largely behind the scenes,” said Doty.

“That confidentiality, we believe, erodes public confidence in the oversight by the board,” he added. “Moreover, the public is denied any benefit from the deterrent effect that the filing of public complaints has on other auditors. Other auditors and their counsel are denied the benefit of timely access to the board’s precedents.”

In addition, the PCAOB plans to convene a task force on audits of fair value measurements, and produce standards governing auditors’ communications with audit committees.

“I’m troubled about reports that some auditors have downplayed the significance of our findings to their clients,” he said. “Audit committees, we think, should be informed about what the failures related to their company are, and they should be skeptical about any effort by the auditors to downplay the importance of it.”

He said the PCAOB is looking for ways to improve audit committee awareness of the risks of accepting an overly rosy characterization of what its inspectors’ findings represent in a particular audit of a company. “I am also concerned about possible disparities between their routine representations of the firms and the public responses they make to us about remediation,” he added. “We intend to look closely at what people are saying in their responses to us as to remediation, and the representations they make as to whether they have in fact remedied, and whether they in fact agree or disagree with the audit failures that we have found, because those are public representations.”

The PCAOB has also been pushing for the ability to conduct inspections of the affiliates used by firms in foreign countries to audit multinational public companies abroad. Those have produced particular problems since the affiliate firms often do not perform up to the level of U.S.-trained auditors, yet U.S. audit partners end up signing off on their work anyway. There have been many problems lately with Chinese companies doing reverse mergers with U.S.-based shell companies to gain access to the public markets in the U.S.

“Surprisingly, many savvy business people and senior policy makers are unaware of the fact that an audit report signed by a large U.S. firm may be based in large part on the work of affiliated firms that are completely separate legal entities in other countries,” said Doty. “For many of these large multinational companies, a significant part of the audit may be conducted abroad, even half the total audit hours in some cases. Nothing wrong with that, on the basis of theory, but when a network firm signs the opinion, the audit is supposed to be seamless and of consistently high quality. Unfortunately, in practice, that is often not the case.”

Based on the international inspections it has conducted abroad, the board has found that multinational audits have proven to be challenging for the big firms. “Our inspectors often see more than the principal audit or signing firm does,” said Doty. “In many cases, principal auditors rely on high-level reports from subsidiary auditors. They often don’t review the work papers of the other auditors. Our inspectors do, and they often find problems in that work.”

Doty noted that the PCAOB inspectors frequently find obvious errors that should have been detected by the principal auditor if they had been communicating better. “Inspectors have found unresolved audit issues between affiliates, disagreements that have not been reconciled,” he said. “One inspection team found a situation where the affiliate audit team pervasively failed to perform audit procedures, unbeknownst to the principal auditor. Once the problem came to light, the primary auditing firm arranged for the team to be removed, but it should not have fallen to the PCAOB to find that problem.”

In several cases, the affiliate had failed to appropriately audit revenue, even though the affiliate reported to the principal auditor that it had done so. Doty said the PCAOB intends to enhance its scrutiny of how principal auditors react to deficiencies in the work they refer to other auditors.

This month, the PCAOB is beginning joint inspections with the U.K. and Swiss audit authorities.

Doty said the PCAOB is also talking with other European countries and is in discussions with Chinese authorities on conducting audits. He hopes to make progress in the next several months.

“This is especially important given the growth in the number and size of Chinese companies seeking access to capital in the U.S. securities markets,” he said. “I believe Chinese authorities are beginning to understand, and do understand, that they have a real interest in solving what has been an impasse in this area.”

%d bloggers like this: