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What to Do About the Audit Function?

Karen M. Kroll | June 7, 2011
"Audit reports ought to better reflect investor needs," says Chairman of the US Public Company Accounting Oversight Board.

FRAMINGHAM, MA, JUNE 6, 2011—Over the past few months, several members of the Public Company Accounting Oversight Board, including new chair James Doty, have expressed concerns about the usefulness of the current audit process. “Looking ahead,” Doty noted in an April speech to the Council of Institutional Investors, “our audits and audit reports ought to better reflect investor needs.”

At the same time, he added that “many forces prevent auditors from seeing investors as their direct or even ultimate masters.” For one thing, the company being audited pays for the audit. While audit committees hire the audit teams, “in too many companies, the audit committee still is a rubber stamp for the CFO and CEO,” says Joseph Carcello, an accounting professor at the University of Tennessee, Knoxville, and a member of the PCAOB’s Investor Advisory Group.

Even more troubling: Some audit committees see their mission as negotiating the lowest fee. “That’s not consistent, if done excessively, with high quality audits,” Carcello says. (Carcello and the others quoted in this article are speaking on their own behalf, and not for their respective boards or employers.)

‘Watchdogs for Investors’
To be sure, not all assessments are as bleak. “The independent directors are the watchdogs for investors, and independent of management,” says Gary Kabureck, vice president and chief accounting officer with Xerox Corp., and a member of both the PCAOB’s Standing Advisory and Investor Advisory Groups. If large numbers of investors lack confidence in the directors, that’s a call to question just what their role is, he adds.

And if the companies being audited didn’t hire the auditors, some ask, who would?

One alternative is to have the auditors become offshoots of the PCAOB, and paid by the government. “I don’t think that’s necessary or practical,” Kabureck says. Another is to require each investor – since they benefit from the audit – to pay a fee that is pooled and used to cover auditor fees. However, that still leaves open the question of who would choose the audit team for each firm.

Another concern is the depth -– or lack of it -– of the audit opinion. “The PCAOB is engaged in a broad dialogue with investors, auditors, audit committees, preparers and others to consider how the auditor’s report can be changed to provide more useful, relevant and timely information,” Doty said in a May address at Baruch College.

Benefits of Consistency
After all, an audit engagement may entail months of work and millions of dollars in fees. But it still boils down to several paragraphs in the annual report, Kabureck points out. “Should the auditor’s model of reporting change to provide considerably more information?” he asks.

Here again, however, changes likely would generate unintended consequences. “While thoughtful changes to the auditors’ report could be useful, we need to be thoughtful here [too], as it is a double-edged sword,” says Peter Nachtwey, chief financial officer with Baltimore-based global asset management firm Legg Mason Inc., and another member of the PCAOB’s Investor Advisory Group. First, investors and other users of financial statements gain some benefit from the consistent format. Even if he doesn’t spend a lot of time looking at the audit report, if it says what he expects, Nachtwey can be confident he knows what he needs to know. Moreover, offering auditors greater latitude to develop their reports may simply lead to more variety, making comparisons between them more difficult, he adds.

Expanding the opinion letter also prompts the question: Just what additional information should be included? Some call for including more information on the auditor’s work; this sometimes is referred to as the French audit model. For instance, auditors examining a firm’s inventory might state that they physically observed the goods and obtained an independent valuation of the products.

Rotate Your Firms?
Another model would have the auditor provide more information on the company’s financials. Some question whether this is the appropriate role for the auditors. “If the information is important, companies should be mandated to do [disclose] it,” Kabureck says. To require the auditor to make the disclosures puts them in the untenable position of possibly wanting to disclose more information than the management or the board feels is warranted, he adds.

One other area of concern is auditor independence, given that some audit teams remain with their clients for decades. One proposed solution: mandatory rotation of audit firms after a set period of time, such as five years.

“The idea of rotating auditors and/or audit partners more frequently may enhance the idea of getting more independent audits," Nachtwey says, but he adds that "I’m not sure that it will result in more knowledgable or effective audits.” (Nachtwey also says he knows his views run counter to much of the current thinking on the audit profession.)

As it stands now, anyone with a material role in an audit has to rotate off the team after five years. This is challenging, given that it can take an auditor years to gain an understanding of the integrity and strength of a global company’s systems and processes can take years.

So far, all the talk about changing the auditor’s role has been just that: talk. That’s not to say things won’t change. “I don’t think Doty took the job to be a caretaker,” Carcello says, noting that he left a distinguished career at the law firm of Baker Botts LLP. “He took it to make a difference.”

That said, any changes will need to be carefully undertaken. A range of constituencies, including the business, investor and audit communities, along with the SEC, would need to weigh in. Even so, Doty’s speeches have left no doubt that he isn’t afraid to use his bully pulpit, Carcello notes. “They’re designed to express concern and even displeasure in a way that puts the profession on notice that if the behaviors continue, we’ll look at more aggressive remedies.”

 

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