Recent Comments On European and U.S. Audit Reform

The topic of audit industry reform is hot again. OK, that’s relative to where you stand on what’s hot. But in the world of legal and regulatory compliance and auditors the only thing hotter would be a significant development in the New York Attorney General’s case against Ernst & Young.

Here in the U.S. the PCAOB has been busy. I’ll give them – mostly Chairman James Doty and the Investor Advisory Group led by Board Member Steve Harris – credit for that. The Investor Advisory Group – rather, the boldest amongst them – recently sent a letter to the PCAOB to provide comments on the PCAOB’s June 21, 2011 Concept Release entitled Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards.

It is worth noting that a number of other parties agree that the current form of the auditor’s report fails to meet the legitimate needs of investors.  First, the U.S. Treasury Advisory Committee on the Auditing Profession (ACAP) called for the PCAOB to undertake a standard-setting initiative to consider improvements to the standard audit report.  The ACAP members support “… improving the content of the auditor’s report beyond the current pass/fail model to include a more relevant discussion about the audit of the financial statements.”

Second, surveys conducted by the CFA Institute in 2008 and 2010 indicate that research analysts want auditors to communicate more information in their reports.

Finally, even leaders of the accounting profession have acknowledged that the audit report needs to become more relevant.  In testimony before ACAP, Dennis Nally, Chairman of PwC International stated, “It’s not difficult to imagine a world where the … trend to fair value measurement — lead one to consider whether it is necessary to change the content of the auditor’s report to be more relevant to the capital markets and its various stakeholders.”

Finally, leaders of the accounting profession have previously stated that changes to the audit report should reflect investor preferences.  In their 2006 White Paper, the CEOs of the six largest accounting firms stated, “The new (reporting) model should be driven by the wants of investors and other users of company information …” (their emphasis).

Before we turn to a discussion of the IAG investor survey, we believe it is important to underscore the fundamental but often overlooked fact that the issuer’s investors, not its audit committee or management team or the company itself, are the auditor’s client. It is therefore not only appropriate, but essential, that investors’ views and preferences take center stage as the PCAOB considers possible changes to the format and content of the audit report.

In the meantime, I’ve written two articles about the proposals on auditor regulation before the European Commission.

In Forbes, I told you not to count on Europe to reform the audit model or auditors, in general.

The audit industry is reportedly under siege in Europe and on the verge of being broken up, restrained, and rotated until all the good profit is spun out.

This is neither a foregone conclusion nor highly likely.

The European Commission’s internal markets commissioner Michel Barnier is talking tough, but the rhetoric should be no surprise to those who have been following the European response to the financial crisis closely…

Please read the rest at, “Don’t Count On Europe To Reform Auditors And Accounting”.

In American Banker, I focused on the impact of auditor reforms on financial services. Why is the European Commission taking such strong action now? Why is the U.S. lagging so far behind?

The clamor for accountability from the auditors for financial crisis failures and losses has been much louder, much stronger, and going on much longer in the U.K. and Europe, than in the United States. Barnier’s most dramatic proposals are viewed by most commenters as a reaction to the bank failures. “Auditors play an essential role in financial markets: financial actors need to be able to trust their statements,” Barnier told the Financial Times. “There are weaknesses in the way the audit sector works today. The crisis highlighted them.”

There’s is a concern on both sides of the Atlantic over long-standing auditor relationships.

The average auditor tenure for the largest 100 U.S. companies by market cap is 28 years. The U.S. accounting regulator, the PCAOB, highlighted the auditor tenure trap in its recent Concept Release on Auditor Independence and Auditor Rotation. According to The Independent, quoting a recent House of Lords report, only one of the FTSE 100 index’s members uses a non-Big Four firm and the average relationship lasts 48 years. Some of the U.S. bailout recipients — General Motors, AIG, Goldman Sachs, Citigroup — and crisis failure Lehman had as long or longer relationships with their auditors…

Please read the rest at American Banker, “Bank Debacles Drive Europe to Raise the Bar on Audits”.

2 replies
  1. Aubrey M. Farb, CPA
    Aubrey M. Farb, CPA says:

    There is no question that failure to rotate auditors is a major cause for poor performance; however, there is a problem much larger than that. Lack of independence. It is impossible for auditors to really be independent when their remuneration is paid by their clients. There is an old adage : “Don’ bite the hand that feeds you.” So long as the client feeds the auditor, there is the likelihood that when push comes to shove, the auditor will put the client’s interest before that of his true clients, the investors.

    I suggest that each publicly owned company that is audited pay into an independent fund a percentage of its market capital plus its long term indebtedness. This fund would select the auditors and pay them for their professional services

  2. Anon
    Anon says:

    These analyses start from assumed root causes that are likely wrong. Audit quality comes down to the judgement exercised. There are certain, albeit rare, skills required for an excellent auditor, but many excellent performers leave the profession, partners included. Why is this so? One potential answer is risk/reward. An audit partner often earns less than a CFO and audit staff earn less than their counterparts in commerce. The imbalance can, at certain levels, be in the multiples. Yet the personal risks attached to error are greater. So how does finding ways to increase profitability pressure improve the outcome? Answer, it won’t. And neither will effective nationalization, as the per the suggestion above. Outsourced government audits, which act as a proxy for the model suggested, are no better or worse in quality.

    In reality, this problem needs a far more intelligent analysis than simplistic bandaid responses like attacking profitability, independence and the business model. Trust me, talent will stay in the audit profession, and be effective at it, when the risk/reward equation balances out.

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