The Public Company Accounting Oversight Board (PCAOB)’s new quality control (QC) standard, QC 1000, represents a radical change from how major audit firms have historically operated, according to Joseph Floyd, a partner and co-founder of Floyd Advisory, writing for Bloomberg Tax. Floyd Advisory is a consulting firm offering financial and accounting expertise. The new standard requires independent overseers to assess quality controls at some registered auditing firms. What has often gone unnoticed, Floyd observed, is how radical that departure is.

He noted that the audit industry was self-regulated for decades before the PCAOB was established in 2002 pursuant to the Sarbanes-Oxley Act. Firms were on rotation to evaluate the quality controls of peers. 

However, history proved that peer reviews failed to uphold transparency and had inherent conflicts of interest that nullified their aim of testing and reporting failures in audit quality, he wrote.

After the PCAOB was created, registered audit firms were subject to board inspections and enforcement actions, although they remained free to operate independently. But that freedom is going to change with the new QC 1000.

The Securities and Exchange Commission (SEC) approved the new quality control standard on Sept. 9. It will require registered audit firms to report to the PCAOB annually about the effectiveness of their overall quality control system, including certification by audit firm leadership. 

Audit firms that issue yearly audit reports for over 100 issuers will also need to establish an external QC function with independent individuals who will offer oversight and evaluate the audit firm’s QC system.

According to the new rules, the oversight panel should be composed of one or more individuals who are neither partners, shareholders, members, other principals nor the firm’s employees. They also should not have a commercial, familial or other relationship with the firm that will interfere with exercising independent judgment regarding matters related to the quality-control system. The group will evaluate “the significant judgments made and the related conclusions reached by the firm when evaluating and reporting on the effectiveness of its QC system," according to a PCAOB news release. 

Floyd stated that the audit profession has come a long way from self-regulation to regulators regularly inspecting the quality of its audits to, most recently, external parties involved in corporate governance and evaluating its audit processes' quality control. He characterized this evolution as “a seismic shift for firm leadership to accept.”

He further observed that the new requirements are similar to integrating the mandate to document, test and certify the effectiveness of a public registrant’s internal controls under Section 404 of the Sarbanes-Oxley Act—the statute that created the PCAOB—with establishing an audit committee meant for oversight of an audit firm’s quality control system.

He added that Section 404 has significantly upgraded the quality of financial reporting for public registrants and lessened restatements. QC 1000 has the potential to improve audit quality and limit audit deficiencies. Floyd said that the need for improvements in audit quality is apparent when reviewing the increasing deficiency rates reported for the industry based on PCAOB inspections.

Although the concept of an independent oversight function for audit firm quality isn’t exactly new, for the quality control requirements to maximize their potential, the external function’s role must be highly respected within the audit firms. For this reason, recruiting individuals who will be independent is crucial for it to be effective.

Selection is not just an issue for the PCAOB, Floyd noted. Audit committees should be very interested in determining how their audit firm will select individuals for the external function. Floyd said that he hopes these individuals will represent the interests of the financial statement user community and comprehend why quality financial reporting is essential.

He listed the types of individuals who will be ideal for the role: respected business and government leaders, former SEC and PCAOB regulators, attorneys who are experts in audit issues, and investment professionals who depend heavily on the audit industry.