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US Securities and Exchange Commission

Saying Audit Quality Is Stronger than Ever, Audit Profession Questions Need for Reform

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

As the SEC’s Investor Advisory Committee (IAC) is studying potential reforms regarding public company independent auditors, a group representing the auditing profession is pushing back.

In the view of the Center for Audit Quality (CAQ), the current state of audit quality has never been stronger, and its representatives questioned the need for extensive reforms. The CAQ, an affiliate of the AICPA, represents accounting firms that audit public companies.

One of the more drastic albeit intriguing ideas presented during an IAC meeting on September 9, 2021, was changing how the auditor is paid.

Former SEC chief accountant Lynn Turner said 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.

Currently, a company pays its own “independent” auditors, creating systemic conflicts of interest. While the audit committee of a company sets the audit fees, at the end of the day, the fees come out of the company’s coffers. And 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.

The CAQ did not speak at the advisory panel meeting, and during a September 13 interview, CAQ CEO Julie Bell Lindsay disagreed that there is inherent bias or conflicts of interest, pointing out that the Sarbanes-Oxley Act of 2002 charged independent audit committees with oversight of auditors, including their hiring and fee negotiations. Company management is not involved, she stressed.

“I understand what Lynn is saying…, but in actuality you do have independent audit committee oversight of the auditor and the fees paid to the auditor,” Lindsay said.

Congress passed Sarbanes-Oxley to prevent a repeat of accounting scandals that toppled companies like Enron and WorldCom and cost shareholders an estimated $85 billion two decades ago.

Cost-Benefit Test

Moreover, CAQ’s Lindsay said that any extensive regulatory changes should pass the cost-benefit test. And some may view Turner’s ideas as radical.

After a shareholder vote, the audit committee negotiates audit fees and gives the fees to the audit regulatory board PCAOB, which is overseen by the SEC, he said. The board in turn writes the check to the auditor.

Sarbanes-Oxley, which established the PCAOB, authorizes the board to collect accounting support fees from public companies and broker-dealers to fund its operations and inspect public accounting firms. Thus, there is already a mechanism to collect fees in place.

When the PCAOB inspection finds that the auditor is not doing a good job, then the board will have the authority to force the company to change the auditor, according to the suggested reform.

“I think you really need to look at the costs and the benefits of changing a structure and a mandate that has been in place since I believe 1934 when Congress looked at the existing system, and I think Congress knew about these supposed or perceived conflicts of interest at that time but yet decided that there would be a mandate for an audit,” Lindsay said. “As part of looking at the cost benefits, you really want to understand the objective, what are we solving for with such a change? So, I think that would be part of the analysis as well. That’s not clear necessarily to me.”

Many point out that inspections by the PCAOB have led to improved quality over the years, and company financial restatements have gone down in the past 15 years.

Further, Vanessa Teitelbaum, senior director of professional practice with the CAQ, said that accounting firms have incentives to keep quality high.

“The audit committee can switch auditors at any time, and a new set of auditors could go in and open the books,” she said. “They have a market incentive and reputation incentive to perform a good audit in addition to the fact that the PCAOB inspection process is very robust and has been working for a long time.”

Moreover, Lindsay said that the auditing profession is always striving to improve.

Improvement Still Necessary

Turner disagreed.

“Funny. That is exactly what they—AICPA—said just before Enron and WorldCom struck,” he said on September 14 and wondered if audits meet the cost-benefit test these days.

“Did the firms who audited Tyco, Adelphia, Xerox, HealthSouth, Qwest, etc. Carrillion, etc. all think about their reputations before issuing them to the public?” said Turner, who served as SEC chief accountant from July 1998 to August 2001 under Chairman Arthur Levitt.

“They always hide under the skirt of the audit committee rather than standing on their own,” Turner said. “And just look at the recent SEC enforcement action against EY for lack of independence—or better yet—look at all of the enforcement actions against EY in the last decade or so for lack of independence.”

In the most recent case, the SEC in August charged EY, a partner, and two former partners for violation of auditor independence rules when trying to land an audit engagement contract with a Fortune 500 company. Without admitting or denying the charges, EY and the individuals agreed to pay more than $10 million collectively.

Moreover, 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, and PCAOB inspections keep finding relatively high rates of audit deficiencies.

The average deficiency rate has stayed above 20 percent for Big Four accounting firms which dominate the audit market, especially audit of large public companies. The average rate of deficiency of other firms is higher at about 30 percent, according to Colleen Honigsberg, an accounting professor at Stanford Law School, who also spoke at the SEC’s advisory panel meeting last week. And this makes some investor protection advocates worried.

Some said that inspection findings do not fully capture true audit quality because the PCAOB inspection is largely based on a risk assessment of areas that are likely to have problems. However, others counter that if firms know that the board will inspect audits based on risk assessment, then they should have been more careful and paid much greater attention when doing riskier audits.

Further, Honigsberg said conceptually there is a difference between financial reporting quality and audit quality even as there is a correlation between the two.

“There’s a lot that affects financial reporting quality beyond the external auditor,” she said. “So, for example, internal attestation would be one thing. While we do see a very nice decline in restatements, [there has been a] recent uptick due to SPACs.”

Moreover, Honigsberg said she hears a lot from those who are concerned about how short-sellers were able to spot accounting frauds at companies such as Wirecard and Luckin Coffee when auditors could not.

In addition, she said some are questioning the true rate of the decline in restatements. When there is a material misstatement, then a company would restate its financial results. But with an immaterial misstatement, then a revision is made.

A “study recently that looked at all those revisions and found a third of them actually met one or more criteria for materiality,” she said. “And so perhaps some of these material misstatements are just Incorrectly being repackaged as revisions rather than restatements. These are things that make people very nervous.”

Nevertheless, another former SEC chief accountant who also spoke at the meeting seemed to disagree with Turner, without explicitly saying so.

Wesley Bricker, who was the top accountant from November 2016 to June 2019 first when Mary Jo White and then Jay Clayton ran the SEC, discussed “Trust Solutions” at the heart of the audit practice at PricewaterhouseCoopers LLP, where he is vice chair. And he said PwC strives to earn the public trust with its Trust Solutions, which he co-leads at the firm.

“The audit is designed with benefits and costs in mind, including the benefit of a lower cost of capital for audited companies over time offset by the costs,” he said. “Assurance delivers outsized benefits—in public and private markets alike. One only has to look at the circumstances where there is a lack of trust in information provided by a company or a class of them to appreciate the significance of a source of independent assurance.”

What’s Next?

In the meantime, it is unclear what the commission’s investor advisory panel will ultimately do. When advisory panels make recommendations, the SEC take them into serious policy and regulatory considerations.

“Speaking for myself, I am interested in helping the SEC address three problems: lack of competition in auditing, audit committee oversight of audit quality, and the lack of transparency from Chinese companies,” IAC Assistant Secretary J.W. Verret, a law professor at George Mason University, who put together last week’s panel discussion, told Thomson Reuters on September 14.

 

This article originally appeared in the September 16, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.

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