While the quality of a public company’s financial statement audit has gotten better over the past decade, the pace of improvement seems to have plateaued somewhat, and PCAOB inspections keep finding relatively high rates of audit deficiencies. To really improve audit quality, former SEC chief accountant Lynn Turner wants to change how the auditor is paid.
Currently, there is an inherent bias towards pleasing public company audit clients. Company pays their own “independent” auditors, creating systemic conflicts of interest. Turner wants to cut that tie and make auditors truly beholden to investors who want to have confidence in the financial statements of the companies that they own shares.
“We’ve got to totally change the mode of operation and thinking,” Turner, senior adviser with Hemming Morse, LLP, said.
In his view, the provisions in the securities laws that require companies to have an audit should be removed. Instead, it should be replaced with a market-based requirement that investors shall vote every five years on whether they want an independent audit or not.
“So, instead of this government mandate ‘you’ve got to have an audit,’ it’s ‘you better keep your investors happy if you want to keep auditing,’” Turner said.
Then the PCAOB steps in.
The audit committee of companies will negotiate audit fees without management being involved. Then the audit committee will give the audit fees to the PCAOB, which in turn will write the check to the auditor, according to Turner’s reform ideas.
Section 109 of the Sarbanes-Oxley Act of 2002, which established the PCAOB, authorizes the board to collect accounting support fees from public companies and broker-dealers to fund its operations and supervise public accounting firms. For example, the total accounting support fee for 2021 is estimated to be $264 million, with $236 million assessed on public companies and $28 million on broker-dealers.
“Since they collect money from all the public companies, they got a vehicle for collecting more,” Turner said.
“And this came from [former SEC chairman] Richard Breeden: PCAOB will have the right, if they go in and do an inspection and finds it’s a really lousy audit, the PCAOB will have the right to require the company to change its auditors,” said Turner, adding that he got input from a lot of people before writing a white paper that details his ideas.
This paper was circulated internally among SEC officials and members of the commission’s Investor Advisory Committee (IAC) ahead of the advisory panel’s public meeting on September 9, 2021, where he is invited to speak.
One of the IAC discussion topics will be “Competition and Regulatory Reform at the PCAOB.” The SEC oversees the audit regulatory board.
Another Pay Model
About a decade ago, Jack Ciesielski, founder of investment research firm R.G. Associates who is currently a member of the FASB’s Emerging Issues Task Force, floated another idea to change the issuer-pay model during a public meeting hosted by the PCAOB about auditor independence.
He wants insurance companies involved.
“The remarks I made … were echoing Joshua Ronen’s idea, from NYU, about having insurers sort of guarantee the financials to be fit for use for investors. Insurers would hire and pay the auditors. Interest of insurers and users would be aligned; insurers would be on hook to pay for investor losses due to fraud, so they’d certainly champion investors,” Ciesielski said. “Auditors would have to please insurers, rather than the auditee, so they could audit as they saw fit. And they’d have to earn their pay.”
During the board’s public meeting in March 2012, Ciesielski further explained how this pay structure would produce better audit.
“By transacting with the insurance company, the issuing firm would have a direct interest in the quality of the reporting process,” he said at the meeting. “The more confidence the insurer can place in the financial reporting process of the insured, the lower the premiums that would be needed to be charged the issuer. There would be a tension between the issuer and the insurer that plays out in the price of the premiums which, incidentally, should be publicly disclosed, along with the amount of coverage.”
Credit Rating Agencies Have Same Problem
Turner meanwhile said that issuer-pay problems also happen with the credit rating agencies. Companies that are being rated pay the fees to the raters.
Major credit rating agencies were criticized in the aftermath of the 2008 financial crisis for understating the risks in mortgage-backed securities, collateralized debt obligations, and other complex instruments.
Similarly, many auditors failed to warn the markets about the severe problems banks were having prior to the 2008 financial crisis. Several large financial institutions collapsed, two of the nation’s Big Three carmakers had to be rescued by the federal government, and the pain was felt throughout the economy.
“And we have the same type relationship between management and the people they are hiring to give the grades in both scenarios, and neither of those scenarios work. It simply does not work,” Turner said. “Until we fix that problem, we will spend another 100 years running up expenses trying to find some fixes that would work that you know will never work.”
This article originally appeared in the September 1, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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