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Are Audit Reports to Blame for the Failure of Ethics and Financial Misstatements?

Where’s the Beef? Audit Reports to get a Makeover

The auditor’s report is supposed to inform the readers of financial statements whether the statements “present fairly” financial position and results of operations and changes in cash flows from one year to the next. The report is the main way that auditors communicate with the public the results of their examination and the conclusions they have reached on the accuracy and reliability of those statements. However, the question is whether the general public understands what the audit report is saying.

Many investors rely on the audit report to help assure them a company's numbers are accurate. But some critics have become concerned that the letters' boilerplate, pass-fail format doesn't tell investors much about what is actually happening at a company or where problems may lie.

After seven decades in which the auditor's letter hasn't changed much, U.S. regulators are dealing with major new rules requiring auditors to tell investors more about what they find in companies' books. The Public Company Accounting Oversight Board, the government's audit-industry regulator, is pushing the accounting industry to disclose more about its views on a company, which some say will make the document attached to each public company's annual report more useful, albeit a little longer.

While the PCAOB hasn't said specifically what it will propose, having auditors provide their opinions on broader matters appears likely to be the crux of it. Regulators and industry critics say investors need more information from auditors about matters such as whether a company's accounting is aggressive, and what auditors think are the most important features of a company's finances. I would caution going down this road as it is open to interpretation and can place the auditor in an adversary position with respect to the client.

Many in the accounting industry agree some change is needed. "I think one of the things we can do is be more transparent about what we do," said Steve Howe, Ernst & Young LLP's managing partner for the Americas. But a major fight could be brewing if the PCAOB pushes aggressively for accountants to analyze and discuss a company's results on its own.

"You don't want to insert the auditor into the role of management," said Cindy Fornelli, executive director of the Center for Audit Quality, which represents the accounting industry. I agree with Cindy. The role of management in its selection of accounting policies and financial decision-making already is part of the auditor’s risk assessment. A new audit report is not needed to address these issues that are inherent in conducting an audit in accordance with generally accepted auditing standards.

The motivation for the review of the audit report seems to be concerns about earnings restatements at larger companies, most likely to be audited by the Big Four accounting firms, which have risen sharply in each of the past three years, according to consulting firm In PCAOB inspection reports issued last year, 36% of Big Four audits the inspectors scrutinized were deemed deficient, up from 14% two years before that.

Regulators have rebuked three of the Big Four firms for not fixing past problems fast enough. Each of the four—Ernst, PricewaterhouseCoopers LLP, Deloitte & Touche LLP and KPMG LLP—have had major clients that collapsed or required huge government bailouts in recent years without any warning from regulators that anything was amiss.

"The perception of the auditor's independence, objectivity and professional skepticism has suffered in the wake of these findings of audit failures," said James Doty, chair of the PCAOB. "You have an industry that has been slow to come to realize that it must change."

The crux of the problem, critics say, is the auditing-industry's business model. Companies hire and pay their own auditors, leading auditors to be insufficiently skeptical of their clients. It is akin to what happened with bond-rating firms that gave triple-A ratings to toxic mortgage securities during the housing boom, they say.

True enough, but this conflict has existed forever and is not likely to change any time soon. The issue is not the existence of a conflict but it is one of ethics. Auditors are supposed to act a higher level than to allow conflicts to taint their ‘independent’ decisions. Auditors face conflicts not only because the client hires, pays the fees, and can fire the auditors. Other conflicts include becoming involved in a business relationship with a client or performing certain non-audit services that bring into question the objectivity of auditors when performing audit services for the same client.

Ethical conflicts will always exist in auditing. It’s part of the DNA of the accounting industry. That’s why for so many years we referred to the group as the accounting profession. Professionals are supposed to operate on the high road and not let conflicts taint objective judgment. The real cause of the problem is not the audit report or its language. The real cause of the problem is unbridled commercialism that has infected the accounting industry since the mid-1980s when the Federal Trade Commission led the charge for rule changes that had restricted competitive behavior by CPAs, such as the acceptance of commissions, contingent fees, and advertising and solicitation.

The fact is CPAs now compete with non-CPAs for the same client (i.e., tax services, consulting, and personal financial planning). Non-CPAs are not constrained by the same ethical standards that apply to CPAs. The courts have tried to level the playing field by prohibiting blanket restrictions on such services. The profession has responded by prohibiting them for the same audit client but allowing them for non-audit clients and when audit services are not provided.  

The commercialization of the profession and expansion into services previously engaged in largely by non-CPAs has opened up the industry to hire specialists in performing non-audit services so that CPA firms can compete. The problem is many of these specialists do not come from a culture of high ethical standards as exists in auditing. The mix of cultures can diminish the ethical practices of CPA firms in both audit and non-audit services. Changing the audit report won’t make a difference in resolving that situation.

Blog posted by Steven Mintz, aka Ethics Sage, on August 20, 2013