PCAOB Member Worried About Eroding Auditor Independence

Chris Gaetano
Published Date:
Oct 27, 2016


Steven B. Harris, a member of the Public Company Accounting Oversight Board (PCAOB) who spoke at the FAE's SEC Conference on Oct. 27, expressed concern that auditor independence is threatened by firms' increasing reliance on consulting services over auditing for its revenue. He said that while the auditor's gatekeeper role has been cemented since U.S. v. Arthur Young (where a unanimous decision by the U.S. Supreme Court held that "the independent auditor assumes a public responsibility transcending any employment relationship with the client"), various financial crises since then have called into question the independence and quality of its work, with investors questioning "whether the auditors were more concerned with maintaining their client relationships than serving the public." 

He said he is "troubled" by the fact that, though auditor independence rules have been in place for more than a decade, inspection staff continues to identify violations of those rules, including provision of impermissible non-audit services, non-compliance with partner rotation requirements, impermissible financial relationships between the auditor and the client, and indemnification provisions in engagement letters. He said that there is growing concern within the PCAOB that the rise of consulting and advisory services in audit firms could be threatening audit independence and compromising the gatekeeper role that the auditor plays. He said that revenue from consulting and advisory services is growing at a faster pace than audit revenue, and at 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. 

This is why, he said, the PCAOB has made it a particular point to focus on auditor independence as part of its strategic plan, with independence matters being a high priority for inspectors today. While this initiative has a heavy enforcement component, he said 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 non-audit services across the profession. 

He 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 ask whether they think a reasonable investor, who knew all the relevant facts and circumstances, would include the auditor is capable of exercising objective and impartial judgment on all issues encompassed within the audit. 

He also urged that firms take action on wider audit quality issues as well. While there has been improvement since the Sarbanes-Oxley Act was implemented, he said that there remains much room for improvement, as 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. He 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. Harris pointed out that these are all things that firms can control, and called on changes in firm practice to adequately address these issues. 

"Mere 'good faith' effort at remediation is not enough. 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," said Harris. 

He also pointed to a worrying trend of people 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 to practitioners of what the board expects when it comes to documentation, and to remind them that improper audit documentation comes with severe penalties. 

He also took the time to plug the PCAOB's proposed expansion to the standard auditor's reporting model. Under the proposal, the audit report would retain the traditional pass/fail model, but would also include critical audit matters (defined 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; or involved especially challenging, subjective, or complex auditor judgment); a standardized statement about the role and responsibility of the auditor, including its duty to be independent; and how long the auditor has been an auditor for the company.

The latest proposal, which came out in May, is less expansive than the previous 2013 proposal in 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, narrowing the definition to only those matters that involved especially challenging, subjective, or complex auditor judgment, and revising the related documentation requirement. It did, however, also expand the communication requirement to require the auditor to describe how the critical audit matter was addressed in the audit

The NYSSCPA was not a fan of the first proposal, and didn't find the second one that much of an improvement either. In a comment letter written in response to the most recent proposal, the Society said the inclusion of critical audit matters would only serve to confuse investors and dilute the message of a pass/fail message. 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 E.U., and the International Auditing and Assurance Standards Board have all adopted an expanded audit report already.

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 said he believes the United States should embrace an expanded auditor's report too, saying it's appropriate that, given that auditors have access to more data than ever, investors expect more information about the audit. 

He also touched on how technology is changing audits, particularly analytical tools that enable auditors to examine 100 percent of a client's transactions, track and analyze trends, as well as anomalies and risks, to identify problematic areas or transactions, and benchmark a company's financial information against others based on industry, geography, size or other factors. He warned against, however, becoming too enamored with technology, saying 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," he said. 

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. ... No matter what changes are ahead, I encourage you to strive to improve audit quality, be vigilant in protecting your independence from management, and not lose sight that your client is the investing public," he said. 

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