Audit regulators see positive signs

Jay Hanson and Lewis Ferguson bring different perspectives to their duties as board members of the PCAOB. Hanson, a CPA, has personal experience auditing public companies. Ferguson, a lawyer who specialized in securities and corporate governance matters, brings legal expertise and a global perspective enhanced by his work as chairman of the International Forum of Independent Audit Regulators (IFIAR).

During a recent conversation with the JofA at the PCAOB offices in Washington, Hanson and Ferguson shared their perspectives on a variety of issues facing the auditing profession. They spoke for themselves and not the PCAOB. Here are some of their main points:

Audit quality is getting better, but continued vigilance is needed.

Hanson: It’s a very different environment in the auditing profession today than it was pre-SOX [Sarbanes-Oxley Act of 2002, P.L. 107-204]. And even though inspection findings are still at a high level and we hope they go down, the nature of the findings has evolved over time. We see the efforts that many firms are putting in place to comply with our standards. And there is a shift in thinking we see, in many of the firms and down to the engagement teams, acknowledging that the audit is really for the investors. It isn’t for the controller or the CFO sitting across the table. We’re seeing that shift, but it’s going to take some time because it’s very much embedded in the culture in public accounting that your client is the one that sits across the table from you.

Ferguson: I’m not aware of any other profession where individuals are looked at as intensely as this profession is looked at by the PCAOB and other regulators. I think it has put the profession under great pressure in some ways.

But I also think the profession has responded to it very well. It took them a while, but I think they’ve accepted the fact that they are being regulated now by the PCAOB, and while we still have a high level of findings, there is an effort on the part of the profession as a whole to try to up their game. I’m actually pretty optimistic about the fact that we will see improvements.

Firms are being asked to look deeply at the root causes of common audit inspection findings.

Ferguson: There are firms that are now looking into statistical correlations with audit quality. They are looking into the relationship between higher rates of inspection findings and, for example, partner-staff ratios, partner workloads, or a whole variety of other factors that might provide a deeper understanding of what’s impacting the quality of audit performance.

We are looking at the root causes of these inspection findings to see if there are correlations and, importantly, causation. Firms have hired behavioral psychologists to talk to them about the behaviors of the firm and the incentive structures of the firm, for example. Understanding quality drivers also involves looking at the economic incentive structures of these firms. There’s a variety of ways of looking more deeply at the issues to try to understand what the problems are.

Hanson: They’ve realized over time that, to use a figurative term, “sending out a memo” is not going to fix the problem. If there are some very simple things to remediate, that’s fine. But the type of things that are the most difficult for preparers to do—determining estimates or fair value, for example—those are also very difficult for the auditors to audit. Firms need to think through the best ways to approach that problem.

The smaller firms, we recognize, usually don’t have the same level of resources, so one of the things we try to do to help them is to put on a series of forums for auditors of smaller companies. Every year we do six to nine of those, and we discuss important issues that we are dealing with in inspections, enforcement, and standard setting.

Firms may need to devote more senior personnel to auditing internal control over financial reporting (ICFR).

Hanson: If students fresh out of college—who are still learning the craft of auditing—are assigned the task of understanding this complex ICFR business process—identifying where the risks are, where the controls are, and doing the control work—those are probably the wrong people doing the work.

These new auditors can play a very important part in conducting the testing, but some of the firms have realized that they need to get the more senior people on the engagement, up to and including the partner, to understand the end-to-end aspects of a given transaction cycle and to answer the questions: How does this work? How does the business work? How does its business cycle work? How are the controls designed to address the risks, and do they really work?

Ferguson: This raises a significant question of economic implications for the way a firm is structured. To be able to do these tasks such as auditing internal control in a way that satisfies PCAOB auditing standards, you probably have to have more senior people on the job.

A firm may need to involve much more partner time, or maybe employ a cadre of people who don’t necessarily become partners, but are expert in this and are able to focus on highly complex functions of the audit. But this raises fundamental questions about how you run, particularly, a large accounting firm today. My sense is the firms are going through that rethinking about how they run their businesses.

Auditing fair value measurements is difficult because of the estimations involved and is an area with frequent inspection findings.

Hanson: This is very challenging. Some have said, “Are the expectations you have unrealistic?” I would respond to that by saying that some auditors are doing just fine. When we look at their work, we see that they complied with the standards, and we don’t have any issues. So, some are managing to do it right.

A fundamental question I ask myself, and ask our staff a lot, is, “What does ‘doing it right’ look like? And how can others learn from that process of doing it right?” Within the major firms, we do see differences from engagement to engagement, where even in similar situations, some audit teams comply with the standards and we don’t have criticisms, and for other teams, we do.

The major firms’ guidance, for the most part, usually lines up with what our standards require. And their methodologies, their training, all their tools are not areas in which we tend to have specific criticisms. The problems usually lie in the execution. Do the teams actually follow the methodologies? And that’s where we see inconsistencies from engagement team to engagement team within firms.

Finding a way for auditors’ reports to communicate more to investors—without encroaching on management’s territory—is a priority.

Ferguson: Some recent audit reports in the United Kingdom are worth looking at in this regard (see sidebar, “Auditor’s Reports: A New Approach in the UK”). The auditor’s reports for Rolls-Royce and New World Resources, for example, include discussion of the key aspects of the audit and actually comments on the nature of management’s estimates—were they conservative, were they not conservative, in the auditor’s opinion.

Now I don’t know whether that should be a model for anybody else or not, but these are at least two examples in the world today where the auditor is giving some context to aspects of the audit that required careful consideration of management’s judgments.

Hanson: The minimum requirements of the U.K. model—describing holistically what the risks of material misstatement were, how the firm defined materiality, and how the audit plan addressed those risks of material misstatement—it has been reported that, operationally, it wasn’t that difficult to do. And there didn’t seem to be much resistance from the boards and the preparers, and the investors found it insightful.

After hearing that description, it seems that their approach is different from the approach described in our proposal. Our approach is really focused on identifying the most difficult things to audit, whereas their approach is more holistic. I’ve wondered—and we had some discussions about this at our April public meeting to discuss the auditor’s report (see tinyurl.com/lefglvs)—if there is a way to blend together some of the concepts in the U.K. model with our approach in a way that might get better preparer support behind it.

Ferguson: Clearly, while we hope to improve disclosure or give people more disclosure or give people more information—there is also a fine line that we don’t want to cross by requiring the auditor to report on original information about the financial statements outside the areas of critical audit matters. We agree that management should be the primary spokesperson on the financial statements.

At the same time, we face the issue of how to arrive at disclosures that both improve audit transparency and don’t deteriorate into boilerplate language, where we end up with disclosures that get repeated year after year after year, and cease to be a meaningful communication. We’re trying to avoid that.

It’s difficult to tell if increased regulation, including SOX, has led to difficulties recruiting auditors.

Hanson: The noise and stress of hiring good auditors has always been there. What I don’t have a really good gauge on is whether it is higher than it’s been in the past, or is it the same, or getting lower? Directionally, is it getting worse, and if so, what should we do about it? And I don’t have any good answers to those questions, but we’re certainly asking them.

I do a lot of traveling around the country to universities and talking to accounting students, and I try very hard to encourage them and thank them for choosing their careers and thank the faculty for educating those future auditors. While auditing has become increasingly complex in recent years, and obviously is subject to more scrutiny, it is also a very exciting time to be an auditor, allowing accountants to become experts in important skills and concepts that can be applied in a wide variety of careers.

Ferguson: One of the reasons I worry less about this than some of my colleagues is that in an era of relatively high unemployment and slow economic growth in most countries, I believe there will always be high demand for trained auditing and accounting professionals.

People who graduate with a degree in accounting are usually not unemployed. Regulation of this profession ensures that the audit requirement for public companies by a registered independent auditor will continue. I think the fact that there will always be high demand for skilled auditors will continue to draw people into the profession.

The expansion of firms’ nonaudit practices is on the PCAOB’s radar.

Ferguson: If you look at the projected growth rates of nonaudit services compared to audit services, nonaudit services are growing much more rapidly than audit services, and that trend is projected to continue. What does that mean? Does it mean that, at some point, audit services become dispensable, especially to the multi-business line firms? If there are wide divergences in profitability between lines of business, or the audit business is growing slower or perceived as higher risk, what do those factors mean for the pursuit of audit quality?

I don’t think we have any conclusions about this. It’s simply something we need to be very aware of. We need to be talking to the firms to understand the market forces and competitive pressures, to try to foresee the pitfalls or advantages of these seemingly inevitable developments, all to make sure that we don’t suddenly face problems that we hadn’t at least thought about. We also need to think about the potential impact upon investors.

Hanson: I’ve had deep discussions with firm leaders about this and questions around what are they doing to promote the independent and objective mindset of their auditors when an increasing part of their business is to provide services to support management. So that’s a challenging thing for all the firm leaders, and we plan to keep a close eye on it, to make sure that auditors keep their eye on protecting investors.

Ken Tysiac is a JofA editorial director. To comment on this article or to suggest an idea for another article, contact him at ktysiac@aicpa.org or 919-402-2112.

Auditors’ Reports: A New Approach in the UK

Auditors reporting on companies that apply the U.K. Corporate Governance Code are required to explain more about their work under rules published by the U.K. Financial Reporting Council in June 2013. The rules require auditors to provide an overview of the scope of the audit, to show how the audit addressed risk and materiality considerations, to describe certain risks in more detail, and to explain how they applied the concept of materiality.

Two auditor’s reports by KPMG prepared under these rules have been described by experts as particularly forthright in their descriptions of management’s judgments and estimates. Excerpts on the findings from those reports are below.

Auditor’s Report on the 2013 Annual Report of Rolls-Royce Holdings PLC

Findings on the measurement of revenue and profit in the civil aerospace business: “Our testing identified weaknesses in the design and operation of controls. In response to this we assessed the effectiveness of the Group’s plans for addressing these weaknesses and we increased the scope and depth of our detailed testing and analysis from that originally planned. We found no significant errors in calculation. Overall, our assessment is that the assumptions and resulting estimates (including appropriate contingencies) resulted in mildly cautious profit recognition.”

Findings on the valuation of Daimler AG’s put option: “We found that the resulting estimate was acceptable but mildly optimistic resulting in a somewhat lower liability being recorded than might otherwise have been the case.”

Findings on liabilities arising from sales financing arrangements: “We found that the assumptions and estimates were balanced and that note 18 appropriately discloses the potential liability in excess of the amount provided for in the financial statements for delivered aircraft and highlights the significant but unquantifiable contingent liability in respect of aircraft which will be delivered in the future.”

The full report is available at tinyurl.com/nvscxcz.

Auditor’s Report on the 2013 Annual Report of New World Resources PLC

Findings on impairment loss on property, plant, and equipment: “We found that the mining engineers were objective and had the appropriate experience and expertise to estimate the Group’s proven and probable coal reserves. We found that the mineable reserves in the value in use model were not significantly different to the reserves estimated by the mining engineers and that the production profile was not significantly different from the approved mine plans. We found that the forecast prices for the Group’s production were balanced when compared to a variety of publicly available forecasts and to our own analysis. We found that cost estimates were balanced when compared to projections of likely future costs used by the mining engineers and to our own analysis of cost trends. We found that the discount rate used was just below the mid-point of the acceptable range we derived. We found significant errors in calculations which were corrected in the final financial statements. Recognising the inherent imprecision in many of the key assumptions and estimates, we found that the Group’s disclosure provides sufficient information on the impacts of different assumptions and of the sensitivity of the impairment charge to variations in assumptions.”

Findings on mine closure and restoration provisions: “We found that the third party expert was objective and had the appropriate experience and expertise to estimate the Group’s closure and restoration provisions. We found the assumptions and resulting estimates to be acceptable but mildly optimistic resulting in a somewhat lower liability being recorded than might otherwise have been the case and that the Group’s disclosures appropriately [describe] the significant degree of inherent imprecision in the estimates. We found no errors in calculations.”

The full report is available at tinyurl.com/opknl7a.

AICPA RESOURCES

JofA articles

• “When the Rules and the Law No Longer Agree,” Nov. 2013, page 38
• “Clarifying the Standard for Group Audits,” March 2013, page 32

Publication

PCAOB Standards and Related Rules, 2013, (#APCAOB14P, paperback; #WPC-BX, online subscription)

Conference

Current SEC and PCAOB Developments, Dec. 8–10, Washington

For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.