During a presentation at the Foundation for Accounting Education’s SEC Conference on Jan. 23, Martin Bauman, chief auditor and director of professional standards for the Public Company Accounting Oversight Board (PCAOB), expressed concern about what he described as a lack of professional skepticism and poor internal control audits.
According to Bauman, PCAOB inspectors have found that between 35 percent and 40 percent of audits lack sufficient evidence to properly back up the opinions they express. This, he said, is especially concerning, given that investors rely on the accuracy of financial statements to make decisions.
“One out of three is a very high failure rate,” he said.
Problem areas that the board has detected include audits of fair value measurements, internal controls, revenue recognitions and management estimates. Bauman stressed that an audit failure does not necessarily mean that the financial statements are wrong, but simply that auditors had failed to gather sufficient evidence for their assertion of the soundness of the information therein.
Nonetheless, he views this as a serious matter that speaks to problems within the culture of the audit profession itself. Too often, Bauman said, there are situations where auditors see contrary information and react by looking for evidence that supports management’s assertion in the financial statements, rather than being skeptical and looking at other evidence that the information might not be fairly stated.
For Bauman, one of the factors behind this troubling lack of skepticism is the way that firms view themselves, which can send the wrong message to less experienced auditors. Many firms, he said, are too accommodating to audit clients, presenting themselves as the client’s partner, there to help “solve complex business problems.”
Such attitudes, he said, are a product of the current auditor payment model, where firms are paid by the very same entities that they are meant to objectively audit. Citing his own experience as a partner in an accounting firm, he said that certain clients are considered a “crown jewel” and partners don’t want to be the one to lose the account for whatever reason.
“Academics say students get it when they leave school—they know they have to dig into things and find the right numbers,” he said. “But they get to firms and too often hear, ‘we need outstanding client service in this engagement.’ It sounds like accommodating, being helpful.”
He also addressed poor internal control audits, which he said were often a factor in audits that failed to pass PCAOB inspection. Board inspection reports are filled with cases where the auditor failed to properly examine an entity’s internal controls, which makes internal controls themselves less effective, he said.
“What [we’ve found] is that you rarely see an audit report a material weakness in internal control unless there is a restatement of financial statements and [they ask], ‘what is the material weakness that led to that?’” he said. “Some think material weakness disclosure should be an early indicator of potential problems, but it’s a lagging one, occurring after the restatement has occurred. So, this is an area where auditors need improvement.”
Tackling hot topics
Bauman also took on several hot-button issues in the audit world, including the recent PCAOB proposal for changes to the standard audit report, which would expand the information and disclosures required in order to better aid investors looking for additional information. Among other things, the proposal would require the communication of critical audit matters, and would expand the scope of the audit to include other information outside the financial statement itself.
Bauman stressed that the board is not going to rush into making any final decision, and noted that, as much as it seems like the proposal would add additional information to the normally parsimonious audit report, investors had actually been clamoring for even more than what the board ultimately proposed. Moreover, the auditor, he said, is not going to have to start talking about the financial statements and analyzing them in any fashion. Instead, Bauman said, “we’ve asked the auditor to stick to what the auditor does. It’s about the audit: What areas were the most challenging as part of your audit?”
“So if there’s information in there about new drugs the company is going to produce and the auditor has done no work to understand the efficacy of those products, the auditor’s responsibility is not to suddenly start studying that,” he said. “There is no expansion of the auditor’s scope of doing additional work on the other information, simply reading and evaluating that based on what the auditor has learned while auditing the financial statements.”
For example, if an auditor finds that a company’s market share is declining, but the company says in its other information that its market share is increasing—which Bauman said would be market-moving information—the auditor would discuss this with management to get them to change this material misstatement of fact. If they don’t, the auditor would be required to say in the report that they became aware of this misstatement.
The NYSSCPA, in a comment letter published Dec. 10, came out strongly against the PCAOB’s proposal. It argued that, because auditing is a complex, professional discipline that takes years of education and experience, it was skeptical that financial statement users would get anything meaningful from critical details of the audit itself. Moreover, it said that there is little persuasive evidence that users would actually find the expanded report helpful or would rely on it in making or recommending investment decisions.
The Society also felt that the PCAOB proposal goes too far with regard to the auditor’s responsibility for other information outside the audit report. The auditor, the Society said, should read the other information in the context of understanding the entity, its environment, activities and financial condition, and could certainly consider whether there may be a material inconsistency or misstatement of fact. This, however is a far cry from the PCAOB’s call for the auditor to evaluate that information, which the Society felt implies a more in-depth level of analysis than should be required.
During the presentation, Bauman also responded to a concern that the proposal could erode the function of audit committees, which typically lead the discussion about audit findings. Bauman, though, noted that the purpose of the project is to make the audit report more useful, adding that investors “want to know more about the financial statements, more about the audit, the auditor’s view.”
“The profession has heard their product is not useful to investors, and it’s time to put out a product the investors will find useful,” he added.
Stressing the slow, deliberate path the PCAOB is taking with this proposal, though, Bauman said that there is no date for when the board is expected to release a final draft. The PCAOB, he said, will continue to hold hearings, roundtables and other outreach events in order to hear from all constituencies and to debate the proposal.
“We want to change it, but we want to get it right,” he said.