Will Auditors Be Held Accountable? The PCAOB Has A Plan

I view successful litigation against negligent auditors and strong enforcement of sanctions for auditor malpractice as positive developments. This is a view many of my readers would disagree with. However, I’ve learned over the last four years not to get too excited by any one positive development on the auditor regulation or litigation front.

If you think auditors should be immune from liability or accountability for their malpractice and aiding and abetting fraud, you’ve bought the “too few to fail” argument. You’ve abandoned the expectation of a public duty for audit professionals. Maybe you don’t think audit is a profession anymore. The global audit firms have a successful business model – albeit an oligopolistic one. You’ve accepted the fact that audit firms will look after their partners and their profits before the public and believe they have every right to do so.

You would be wrong on all counts.

This week I will be in Washington DC to attend the March 24 meeting of the new Standing Advisory Committee (SAG) of the new PCAOB. Three new PCAOB Board members were appointed late last year after the Supreme Court removed the cloud of uncertainty over its continued existence with their decision in Beckstead v. PCAOB.

The SAG 2011 group includes some new members and some in their second term. Many of them I have met and spoken to in the past. Some of them I even knew professionally prior to their appointment. The PCAOB also initiated an Investor Advisory Group (IAG) in 2010. There are some SAG members in this group and some additional members as it is intended to represent the investor community – the intended users of auditor reports and the auditors’ true client.

Last Wednesday, March 16, 2011, the PCAOB IAG held their first meeting of 2011. Several working papers were presented and some strong statements were made. New PCAOB Chairman Jim Doty also reiterated statements that portend changes for auditors and increased scrutiny of their actions, especially surrounding the financial crisis.

I was less than optimistic about the new PCAOB Board members’ interest in investors when the appointments were announced in December. In fact, I was fairly critical of the SEC’s choice of Doty, Ferguson, and Hanson:

SEC Stacks The Deck Against Investors At PCAOB

The Securities and Exchange Commission (SEC) announced their picks to fill three empty chairs at the PCAOB, the accounting industry regulator.  Those picks do not include a single investor candidate and perpetuate a white-male, insider, auditor-friendly tone that makes me quite pessimistic. I’m less than sanguine about the possibilities for improvements and reforms needed at the PCAOB or for serious disciplinary and enforcement actions against firms and individuals for auditor failure.

And I have withheld applause for Doty’s tough-guy statements to journalists from a few weeks back.

It’s what you do, not what you say.

US audit reform debate not as raucous as in UK?

Accountancy Age Editor Gavin Hinks boldly stated in a headline on 14 February, “US on the path to audit reform”.  He quoted new PCAOB chairman James Doty warning auditors that the PCAOB and others are asking questions “in important venues where thoughtful people discuss things” and that on the agenda was the issue of  “what auditors do, what they say they are doing and what people understand about what they do”. Doty added that the profession is in a “critically important transition period”, and a “period of self examination”.

I’m skeptical of this touchy-feely, drawn-out, repeatedly ineffective introspection.

But I was surprised twice by a report presented by the IAG at last week’s meeting. First surprise: Doty was right. Good people are looking at the issue of auditor effectiveness, especially during the crisis. Second surprise: The report quoted me.

They got my cards!  They got my letters!

The Watchdog that Didn’t Bark … Again

Presentation of the Working Group on Lessons Learned from the Financial Crisis

The recent financial crisis presented auditors and, by extension, the Sarbanes-Oxley Act audit reforms, with their first big test since these reforms were put into place. By any objective measure, they failed that test.

• Dozens of the world’s leading financial institutions failed, were sold in fire sales, or were prevented from failing only through a massive government intervention – all without a hint of advance warning on their financial statements that anything might be amiss.
• Investors suffered devastating losses. Millions of Americans lost their homes or their jobs, and $11 trillion in household wealth has vanished, according to the Financial Crisis Inquiry Commission.
• As a result, serious questions have been raised both about the quality of these financial institutions’ financial reporting practices and about the quality of audits that permitted those reporting practices to go unchecked.

You could have taken these directly from this site and my Forbes column.

And then they did:

The Expectations Gap

In the wake of the crisis, investors and independent commentators have been highly critical of the auditors for these failures and of regulators for failing to hold them accountable.

“The public accounting firms and their hundreds of thousands of auditors should be an investor’s first line of independent defense. But these firms turned a blind eye to the excesses, mismanagement, and fraud of executives managing their client firms. The public accounting firms issued clean financial opinions for all of the firms that eventually, most less than a year later, failed, were taken over, or nationalized. And the regulators slept.”

Francine McKenna, blogger

Chairman Doty reiterated these strong statements by the IAG but then – and this is the catch – said that any changes or insight into auditors’ actions during the crisis will take a long time to materialize.

The PCAOB inspected the audits of many of the issuers that later failed or received federal bail-out funds. In several cases — including audits involving substantial financial institutions — PCAOB inspection teams identified what they determined to be audit failures of such significance that, in the inspectors’ view, the firm had failed to support its opinion.

Some of these audits are now also the subject of pending PCAOB investigations and may lead to disciplinary actions against firms or individuals. Under the Sarbanes-Oxley Act, our disciplinary actions must remain non-public, unless the respondent consents, until both our proceeding and any SEC appeal are finished. This will take a long time.

So in spite of mainstream media focus on these issues – gratifying and encouraging – we see the possibility of the same old, same old result when it comes to transparency and reform.

Auditors In The Doghouse, Barrons, March 19, 2011

Sherlock Holmses at the Public Company Accounting Oversight Board are puzzling over the auditing watchdogs that never barked in 2008, as the country’s largest financial institutions were about to be deluged by a tidal wave of red ink.

The financial statements of Lehman Brothers, AIG, Fannie Mae, Freddie Mac, Washington Mutual, Bear Stearns and Countrywide all were graced with unqualified opinions by their auditor a few months before each of them entered bankruptcy or had to be rescued.

The oversight board sees two possible explanations for the Hound-of-the Baskervilles behavior by auditing firms, including the Big Four (Ernst & Young, PricewaterhouseCoopers, KPMG and Deloitte). Either auditors covered up for the firms, or U.S. auditing standards are so lax that they let auditors suppress any urge to bark. The PCAOB is investigating the role of the auditors in the financial crisis, playing catch-up with regulators in Europe.

There have been so many studies, whitepapers, and initiatives during just the four years I’ve been covering the audit industry. Those reports and recommendations have been produced in both the US and the UK.  All have come to nought. The audit industry pretends to engage in dialogue, to cooperate fully, (their professionals are often strongly represented on any panels) and appear to acquiesce to “reforms” that, in the end, serve their business objectives more than they require independence in thought and action or strengthen their resolve in favor of investors.

The Sarbanes-Oxley Act of 2002 is a good example. Legislated limits on auditor liability will be the next. The best strategy for the industry is to allow well-meaning professionals to pontificate about ideal reforms so they can feel they’ve had their say. Unfortunately, much of what is passed off as possible “reforms” has either already been debunked as unworkable and impractical or is already required of the profession. Requirements such as use of experts, supervision of foreign member firms, and fraud risk assessment are already in the auditing standards but not being enforced. It’s a business issue. They reduce the firms’ profit margins. Client management chafes at higher fees and more skeptical and intrusive independent auditors.

That’s my complaint about much of what is included in the rest of the IAG’s reports from last week: Auditor’s Report and The Role of the Auditor and The Global Networks and Audit Firm Governance. Both of these presentations seemed repetitive of years of prior recommendations and were, apparently, prepared in a rush.

I’m looking forward to this week’s SAG meeting and to any opportunities to meet and talk with Board members and SAG members. We’ll see if this time is truly different than all the other times.

Main page photo source here.