Measurement of Audit Quality is the Key

This blog is a continuation of one I posted earlier today and follows up on a blog posted a couple of weeks ago.

The question of whether audits provide useful information and protect investors has been discussed for many years. It is an important issue because if audits do not at least meet minimum standards then the auditing profession is failing to carry out its mandate, which is to protect the public interest. With the formation of the Public Company Accounting Oversight Board (PCAOB) under the Sarbanes-Oxley Act (SOX) of 2002, a system of inspections of accounting firms with public companies as clients was developed to improve the quality of audits. The question is whether the inspection reports issued by the PCAOB i adequately assesses audit quality. The results are mixed, although the trend during the past three years has been a decline in the number of audit deficiencies cited in PCAOB inspection reports. The exhibit below illustrates the point.

PCAOB Audit Deficiency Rates

The audit inspection results in Exhibit 1 show a declining rate of deficiencies between 2018 and 2020. The reduction in the rate for Deloitte continues a trend of relatively low audit deficiency rates. EY’s rate has declined as well while KPMG’s is relatively stable. The decline for PwC seems to be an anomaly. It is difficult to accept that their deficiency rate could all but disappear. The 92 percent decline is by far the largest reduction in deficiency rates. If we compare the 2020 rate to 2019, the rate of decline is even greater. We should wait to see the 2021 results before deciding whether the 2020 results for PwC are an outlier.

Protecting Investor Interests

Independent and consistently high quality audits are an essential tool in helping ensure trustworthy financial reporting, giving investors from Wall Street to Main Street added confidence when pursuing market opportunities. Despite the audit’s foundational importance to the capital markets, it can be challenging to discern and assess the quality of audits.

The PCAOB points out that investors and other users of the audit report cannot evaluate the quality of the completed audit in the same way consumers of other products and services often can. An Uber or Lyft ride share customer can readily assess the quality of the service by whether he gets to his destination safely and timely. In contrast, an investor may not have any indication as to whether an audit was performed well or poorly unless there is a restatement of the audited financial statements. And restatements by themselves are not a complete indicator of audit quality, given an auditor can poorly execute an audit on high quality financial statements where restatement is not warranted.

While audit quality is often not readily apparent to audit report users, there are oversight mechanisms in place to help better promote audit quality such as SOX and the PCAOB. Oversight and regulation of the accounting profession have expanded over time, often in response to high profile financial crises or corporate failures involving low quality or sometimes fraudulent financial reporting not uncovered by the auditor.

The SOX  provides measures that can contribute to a high quality audit. Section 302 requires the CEO and CFO to certify their financial statements are not materially misleading. Section 404 requires management to establish, maintain, assess, and report on internal controls over financial reporting (ICFR), and the Act makes it unlawful for any company officer or director to improperly influence the conduct of an audit for the purpose of rendering financial statements that are materially misleading.

Other measures of audit quality include: audit quality controls in audit firms, likelihood of switching audit firms, the rate of financial statement restatements, and company ICFR. The latter is most important because they indicate whether the company (i.e., client) has in place the quality internal controls to ensure that financial statements are not materially misstated.

Financial Statement Restatements

Financial statement restatements are indicators of audit quality. Audit Analytics defines corporate restatements as “errors due to unintentional misapplication of U.S. GAAP” and corporate financial frauds as “intentional manipulation of financial data or misappropriation of assets.” Audit Analytics reports that material misstatements discovered through the audit or otherwise determined after the financial statements have been issued may require the reissuance or revision of prior years’ financial statements. According to Audit Analytics, there were 81% fewer restatements in 2020 than the high in 2006 and 26% fewer than in 2019. In 2020, just 4.9% of companies restated previous financial statements, compared to 6.8% in 2019 and 17.0% at the peak in 2006.

The Project on Government Oversight (POGO) studied the work of the PCAOB over a 16-year period and released a critical report on the Board’s accomplishments. According to the report, the “Big Four performed audits that were so defective that the audit firms should not have vouched for a company’s financial statements, internal controls, or both.” POGO alleges there were 808 audit failures, but the PCAOB bought only 18 enforcement cases against those firms or employees of the firms. Those cases involved just 21 audits. POGO concludes that, assuming “the 808 audits cited as fatally flawed in the inspection reports were as bad as the reports said,” it appears that the PCAOB “could have fined the audit firms more than $1.6 billion.” However, the fines were just $6.5 million, less than one half of one percent of the potential fines.

Where Do We Go From Here?

There is a need to better protect the public interest by strengthening the audit quality controls of audit firms and making sure the client has adequately assessed ICFR, which, in turn, should lead to a complete and accurate review of management's report and an independent conclusion by the auditor whether those controls are operating as intended. Audit firms seem to have "cleaned up their act," which may be a response to a high level of audit deficiencies. What is needed now is for the firms to build on their recent progress and act as if the public good hangs in the balance.

Blog posted by Dr. Steven Mintz, The Ethics Sage, on March 1, 2022. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.