The “Chilling Effect”: No One Important Wants The Auditor’s Opinion

Update November 14, 2014.

Michael Gallagher, an Assurance partner in New York and PwC US Assurance National Office Leader, actually used the expression “chilling the dialogue” today!

You can listen to the webcast via this link on the PCAOB site.


It’s a funny thing that auditors are both in the middle of everything and, yet, clearly and comfortably on the outside.

I’d like the auditors to be Sam Kinison, truth beacon:

But they’re more often like Rodney Dangerfield, getting no respect. (NSFW)

The PCAOB will ask its Standing Advisory Group today and tomorrow to discuss two important new auditing standards, proposed for comment last August 13:

  • The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion (the “proposed auditor reporting standard”), which would supersede portions of AU sec. 508, Reports on Audited Financial Statements, and
  • The Auditor’s Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Auditor’s Report (the “proposed other information standard”), which would supersede AU sec. 550, Other Information in Documents Containing Audited Financial Statements.

I wrote about the first proposed standard on changes to the auditors report when it first came out. My concerns have not changed. I was quoted by the Financial Times on the day the proposal was announced.

“The audit firms are very much against even this mild expansion of what they may be required to say,” said Francine McKenna, a former auditor and a critic of many of the profession’s failings. “They would rather say less not more, because they’re very strongly aligned with management who are concerned about them usurping their role.”

I’m talking about the “chilling effect”. Yes, those words are actually used by two SEC commissioners to describe auditor-related amendments made by the SEC to the Securities Exchange Act of 1934 (“Exchange Act”) related to broker-dealer annual reporting, audit, and notification requirements. Broker-dealer audits must now be conducted in accordance with standards of the Public Company Accounting Oversight Board (“PCAOB”) in light of explicit oversight authority provided to the PCAOB by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) to oversee these audits.

(If you can believe it, until these rule changes were approved, the specific audits of broker-dealer subsidiaries even in large public financial services organizations such as JPMorgan, Goldman Sachs, and Barclays, were conducted according to AICPA standards not PCAOB standards.  It’s no wonder, but maybe it should be, that even firms who audit large public issuers were caught by the PCAOB interim inspection process providing prohibited services, in willful defiance of longstanding rules on auditor independence for SEC filers. )

The SEC’s amendments also require, according to the SEC, “a broker-dealer that clears transactions or carries customer accounts to agree to allow representatives of the Commission or the broker-dealer’s designated examining authority (“DEA”) to review the documentation associated with certain reports of the broker-dealer’s independent public accountant and to allow the accountant to discuss the findings relating to the reports of the accountant with those representatives when requested in connection with a regulatory examination of the broker-dealer.”

SEC Commissioners Troy A. Paredes and Daniel M. Gallagher felt so strongly about this particular set of requirements they issued a joint statement on July 31, 2013:

Earlier today, the Commission adopted a final rule amending certain broker-dealer annual reporting, audit, and notification requirements (Release No. 34-70073). We respectfully dissented from the adoption of the rule amendments because of our concerns regarding the requirement that broker-dealers provide access to accountant and audit documentation. We are concerned that the final rule does not explicitly limit the scope of the Commission’s audit documentation requests and the uses to which the Commission could put any information it receives from an auditor. Accordingly, the final rule could chill important discussions between a broker-dealer and its auditor. Because of the gatekeeping role that auditors perform in the securities markets, we cannot support a rule that could deprive auditors of potentially important information regarding the broker-dealers they audit. In addition, the rule could compromise any privileges that cover communications between a broker-dealer and its auditor or between a broker-dealer and its attorney, depending on the documents that are produced. In our view, the Commission’s decision to adopt a final rule that places such privileges at risk sets a problematic precedent.

the final rule could chill important discussions between a broker-dealer and its auditor…”

“a rule that could deprive auditors of potentially important information regarding the broker-dealers they audit.”

“the rule could compromise any privileges that cover communications between a broker-dealer and its auditor…”

We’re talking here about the requirement that broker-dealers, not the auditors, give up information about their audit to the industry self-regulating organization charged with inspecting the broker-dealers on things like customer segregation, internal controls, risk management and capital adequacy. The Commissioners are threatening that broker-dealers will not be forthcoming with their auditors if they think those communications will be accessible by the SEC or DSROs such as CME Group, NFA, FINRA and the CFTC. (Kind of tells you who the broker-dealers are more fearful of.) The Commissioners also seem to think that auditors and their clients have some kind of “privileged” relationship like attorneys and their clients and forget that the auditors’ duty is to the shareholders/investors, customers and the capital markets globally.

The audit firms themselves don’t want to have to say or write more to shareholders and the public. They’ like to keep it between the auditor and management and the auditor and the Audit Committee. Here’s PwC commenting in May 2010 on PCAOB Rulemaking Docket Matter No. 030, Proposed Auditing Standard Related to Communications with Audit Committees and Related Amendments to Certain PCAOB Auditing Standards:

We believe that the kind of robust, substantive communications with the audit committee that the Board intends are facilitated by restricting the use of the auditor’s written communication because doing so reduces the risk that such communications will be inappropriately used and relied upon by parties who may not have the appropriate context to understand them.

And when the idea of an Auditors’ Discussion and Analysis was suggested, for the sake of discussion, in the original proposal for the auditors’ report changes, the objections citing some kind of “chilling effect” were universal. PCAOB Board member Lew Ferguson describes these objections in his statement on the proposed standard on August 13:

Many issuers, preparers, and auditors expressed concern that an AD&A would usurp management’s primary role in financial reporting, could raise difficult quality assurance issues in audit firms,[1] would destroy the uniformity and therefore the comparability of audit reports (a strength of the current model), and could lead to inconsistent disclosures between management and the auditor (“dueling disclosures”), either forcing management to adopt the auditor’s views or, if inconsistent disclosures persisted, leading to confusion in the marketplace. These critics contended that the role of the auditor should be confined to attesting to the fair presentation of the financial disclosures, not expressing opinions on other matters such as the business prospects or risks of the company since such matters are beyond the expertise of the auditor. Comments on such matters should be left to management or, if by outsiders, to securities analysts and investment professionals.

[1] A number of commenters, particularly audit firm representatives, expressed concern that an AD&A would lead to “free writing” by individual audit engagement partners that could vary widely from engagement to engagement, as auditors expressed essentially impressionistic views of the audited entity. The commenters said this could make review both difficult and time consuming from a quality control and consistency viewpoint, could delay opinions, and could seriously diminish comparability among audit reports.

“…not expressing opinions on other matters such as the business prospects or risks of the company since such matters are beyond the expertise of the auditor.” This sounds like Judge Richard Posner’s opinion of who an auditor is and what an auditor does, found in an opinion in 2007 that dismissed Ernst & Young from liability regarding a firm that went bankrupt with no auditor’s “going concern” warning. ( I used this quote in a speech to audit undergraduates and MAcc students at Michigan State University recently and they were quite disheartened by it.)

Judge Richard Posner during oral arguments in Fehribach v. Ernst & Young LLP, 2007 WL 2033734 (7th Cir. 7/17/07) (pdf),

Posner: The auditor’s responsibility … so far as the company is concerned … is to make sure the [numbers] are accurate….  You don’t need an auditor to tell you your market is collapsing….  The auditors are not supposed to have business insight.  They’re counters.  They’re not supposed to make predictions about how your markets are doing.  They’re supposed to reconcile your books and indicate you’re not a going concern because your debt is too high and so on….

Do you think the auditor is supposed to know about market power?…  An auditor is not an economic consultant who goes out and figures out what the market trends in an industry are!…Your trends? That’s what the company knows. [Plantiff’s Attorney: You’re right. Here’s what the auditor’s responsibility under SAS 59…]

Posner: That is too vague for me…”

Unfortunately, in this case, the plaintiff’s attorney failed to convincingly explain the function of an audit report and the proper audience for it, in particular for a small private company heavily dependent on a bank credit line. This was unfortunately necessary for Judge Posner.

Judge Posner, and the folks complaining to Lew Ferguson, fail to recognize the auditors’ role and responsibilities under Auditing Standard 9:

Planning Activities

7.     The nature and extent of planning activities that are necessary depend on the size and complexity of the company, the auditor’s previous experience with the company, and changes in circumstances that occur during the audit. When developing the audit strategy and audit plan, as discussed in paragraphs 8-10, the auditor should evaluate whether the following matters are important to the company’s financial statements and internal control over financial reporting and, if so, how they will affect the auditor’s procedures:

  • Knowledge of the company’s internal control over financial reporting obtained during other engagements performed by the auditor;
  • Matters affecting the industry in which the company operates, such as financial reporting practices, economic conditions, laws and regulations, and technological changes;
  • Matters relating to the company’s business, including its organization, operating characteristics, and capital structure;
  • The extent of recent changes, if any, in the company, its operations, or its internal control over financial reporting;
  • The auditor’s preliminary judgments about materiality,5/ risk, and, in integrated audits, other factors relating to the determination of material weaknesses;
  • Control deficiencies previously communicated to the audit committee6/ or management;
  • Legal or regulatory matters of which the company is aware;
  • The type and extent of available evidence related to the effectiveness of the company’s internal control over financial reporting;
  • Preliminary judgments about the effectiveness of internal control over financial reporting;
  • Public information about the company relevant to the evaluation of the likelihood of material financial statement misstatements and the effectiveness of the company’s internal control over financial reporting;
  • Knowledge about risks related to the company evaluated as part of the auditor’s client acceptance and retention evaluation; and

Finally, I heard it with my own ears from a respected major law firm attorney. A few weeks back I recorded a webcast for Broc Romanek and on the PCAOB’s proposed changes to the auditors report.  My fellow panelist is Joseph Hall of law firm Davis Polk & Wardell LLP. You can listen to the whole thing here but his remarks say it all:

“There does seem to be an expectation on the part of the PCAOB that auditors are going to engage in a robust discussion of the areas they found most difficult that were part of that subjective judgment applied [by management]. As someone who regularly participates in due diligence calls with auditors I can tell you auditors are not the most voluble people.”

“When it comes to speaking about the substance of an audit to an audience outside of the Audit Committee they don’t like to venture too far with their opinions about the audit. The typical response is a question to any question. “We stand by our audit. We gave an unqualified opinion.”

“We are asking auditors for the first time to pass on non-financial information. It’s often the case that if there’s a question of materiality in the information outside the financial statements, the auditor completely defers to the company management and counsel without complaint and they won;t be able to do that with the new proposal. This is where I see the real risk to a company’s timetable to getting the ‘K” filed.  A real monkey wrench. Accountants are going to have to start making legal calls.”

Hall seemed to be particularly concerned when a filing deadline looms and a newly empowered auditor, or “accountant” in his parlance, have only the “nuclear” option of withholding the opinion or resigning if they can’t come to an agreement on a disagreement with management. (A veteran audit partner told me recently that in his 35+ years of auditing he has never seen an “adverse” opinion. The firm is fired first.)

But hasn’t that always been the case? If the auditors don’t have the last word, Kinison would say, “What’s the frickin’ point of the exercise?”