Eroding auditor independence a concern for PCAOB member

By:
Chris Gaetano
Published Date:
Jan 26, 2017

Steven B. Harris of the PCAOBMajor accounting firms have been moving away from traditional tax and audit services and into consulting and advisory services to boost earnings. In recent years, consulting has become a significant source of revenue for some firms.

For Steven B. Harris, a member of the Public Company Accounting Oversight Board (PCAOB), a well-documented shift from audit services toward consulting services for revenue raises concerns about auditor independence.

Speaking this past fall at the Foundation for Accounting Education’s SEC Conference, Harris said that the auditor’s gate-keeper role has been cemented since United States vs. Arthur Young & Co.—the 1984 case in which the Supreme Court unanimously held that “the independent auditor assumes a public responsibility transcending any employment relationship with the client”—as the result of various financial crises in the intervening years, investors have called into question auditors’ independence and quality of work.

Investors have questioned “whether the auditors were more concerned with maintaining their client relationships than serving the public,” Harris said.

Auditors have faced increasing public scrutiny over the integrity of their work following accounting fraud scandals in the past two decades, including those involving publicly traded companies such as Waste Management and Enron, and continuing through to the Ponzi scheme masterminded by Bernie Madoff. These cases shone a spotlight on several issues: whether the auditors were truly independent, whether their fiduciary responsibility was primarily to the public, and whether being paid by a client whose work needs to be audited was free of conflict of interest.

Harris said he is “troubled” by the fact that while auditor independence rules have been in place for more than a decade, inspection staff continue to identify violations of those rules, including impermissible nonaudit services, noncompliance with partner rotation requirements, impermissible financial relationships between the auditor and the client, and indemnification provisions in engagement letters.

Some of the top accounting firms are now frequently referred to as consulting firms because their initiative in taking on consulting and advisory work has contributed significantly to overall revenue. Based on data from fiscal year 2016, as reported by Statista, advisory/consulting services accounted for 38 percent of KPMG’s revenue, compared to 36 percent for Deloitte, 32 percent for PricewaterhouseCoopers and 26 percent for Ernst & Young.

Harris said that revenue from consulting and advisory services is growing at a faster pace than audit revenue, and for a number of the largest firms, consulting and advisory revenue will soon surpass audit revenue.

“Given this trend, many wonder whether the firms will be able to resist the powerful temptation to cross-sell or market their advisory and consulting services to audit clients,” said Harris.

That concern is why the PCAOB has made it a particular point to focus on auditor independence as part of its strategic plan, released in November 2015, titled “Improving the Quality of the Audit for the Protection and Benefit of Investors,” Harris said. He observed that independence matters are a high priority for inspectors today. While the strategic plan has a heavy enforcement component, he pointed out that it also involves continuing assessment of whether and how independence-monitoring systems provide reasonable assurance of independence from audit clients, including how these systems address growing revenue from consulting and other nonaudit services across the profession.

Harris noted, too, that simply being independent wasn’t enough. Firms needed to also appear independent, as well. He urged firms to review their client relationships and to ask whether they think a reasonable investor—aware of all the relevant facts and circumstances—would conclude that the auditor is capable of exercising objective and impartial judgment on all issues encompassed within the audit.

Harris strongly encouraged firms to take action on wider audit quality issues, as well.

“I urge you to review your client relationships carefully by asking whether a reasonable investor, with knowledge of all relevant facts and circumstances, would conclude that you are capable of exercising objective and impartial judgment on all issues encompassed within the audit,” he said.

While there has been progress since the Sarbanes-Oxley Act’s implementation almost 15 years ago, he said that there remains much room for improvement in protecting investors from accounting fraud. He added that inspectors are still finding high rates of deficiencies in areas such as auditing internal controls, assessing and responding to risks of material misstatement, and accounting estimates like fair value measurements. For instance, a 2015 PCAOB report on compliance with risk assessment standards found that 26 percent of audits failed to comply with at least one of the standards in 2012. at number of noncompliance then rose to 27 percent in 2013.

Harris said that some factors in this high rate of failures include poor supervision, failure to exercise appropriate professional skepticism, ignoring contradictory evidence, poor audit planning, lack of training or knowledge of audit personnel, and tight deadlines. He pointed out that these are all items that firms can control, and he called on firms to change their practices in order to adequately address these issues.

A “mere ‘good faith’ effort at remediation is not enough,” warned Harris. “Firm leaders have proven that they can make timely and impressive changes when they so desire. This is what is expected by the PCAOB and contemplated in the Sarbanes-Oxley Act.”

He also pointed to a worrying trend of practitioners improperly altering audit documentation. Harris said that the majority of disciplinary orders for failing to cooperate with inspections or board investigations include improper audit documentation, resulting in 15 firms losing their registration, and the sanctioning of 33 individuals. The PCAOB also released a staff audit alert in April to clarify for practitioners what the board expects when it comes to documentation, and to remind them that improper audit documentation comes with severe penalties.

Harris took the time to promote the PCAOB’s proposed expansion to the standard auditor’s reporting model, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion. Under the proposal, the audit report would retain the traditional pass/fail model but would also include critical audit matters and a standardized statement about the role and responsibility of the auditor—including its duty to be independent—and the length of employment of an auditor at a company.

A critical audit matter is defined by the PCAOB as “any matter that was communicated or required to be communicated to the audit committee and that: relates to accounts or disclosures that are material to the financial statements, and involved especially challenging, subjective, or complex auditor judgment.”

The latest recommendation, which was released in May, is less expansive than the 2013 proposal. The recent guidance indicates that critical audit matters are limited to what’s communicated to the audit committee—adding a materiality component to the definition of a critical audit matter, as well as narrowing the definition to only those matters that involved especially challenging, subjective or complex auditor judgment, and revising the related documentation requirement. It does, however, expand the communication requirement to direct the auditor in describing how the critical audit matter was addressed in the audit.

The NYSSCPA was not a fan of the 2013 proposal and didn’t find the second one much of an improvement. In a comment letter written in response to the most recent proposal, the Society said the inclusion of critical audit matters would serve only to confuse investors and dilute the message of a pass/fail test. It also raised concerns that it would increase litigation risk for CPA firms.

Harris acknowledged the concerns raised about the proposal but pointed out that there is increasing support, even within the profession, for measures such as these. He also pointed out that the U.K., the EU and the International Auditing and Assurance Standards Board have all adopted an expanded audit report.

“And the reaction abroad has been generally positive, because investors believe the expanded report deepens their knowledge of important aspects of the audit and improves audit quality,” he said.

He added that he believes the United States should embrace an expanded auditor’s report, too, noting that it’s appropriate that since auditors have access to more data than ever, investors expect more information about the audit.

Harris touched on how technology is changing the process of audits, particularly analytical tools that enable auditors to examine 100 percent of a client’s transactions and track and analyze trends, as well as anomalies and risks. Technology, Harris said, is also helping to identify problematic areas or transactions, and to benchmark a company’s financial information against others based on industry, geography, size or other factors. He warned, however, against becoming too enamored with technology, saying that it’s no replacement for inquiry and professional judgment.

“If applied properly and with due care, these technological tools could allow auditors to make better decisions and assessments throughout the audit process by enabling them to, among other things, identify fraud and operational risks, thereby improving audit quality. With deeper insights through access to more data and more incisive analytics, auditors may be better positioned to challenge management’s assertions when necessary,” said Harris.

Overall, he noted that the profession has seen many changes and will see even more in the years to come.

“Since the 1970s, the profession—especially for the large firms—has faced significant changes, including changes to its business model, governance structure, audit approach, and tone and focus at the top. Auditing of public companies is no longer self-regulated. More changes are coming as a result of the revolutionary use of technology in the performance of the audit,” Harris said. “No matter what changes are ahead, I encourage you to strive to improve audit quality, be vigilant in protecting your independence f rom management, and not lose sight that your client is the investing public.”

Harris’s remarks at the SEC Conference can be read in their entirety on the PCAOB’s website.

cgaetano@nysscpa.org 

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