A Blog by Jonathan Low


Aug 26, 2013

Audits Get Audited: You Can Fool All of the People Some of the Time

You can also fool some of the people all of the time. But when it comes to the process by which companies' books are audited and their activities accounted for, there is clearly considerable room for improvement.

The Public Company Accounting Oversight Board was established a decade ago (how time flies when you're losing money). The proximate cause was the spate of scandals that emerged in the wake of the dotcom collapse, Enron being the most notorious. What was especially galling to regulators and investors was that Enron's final annual report was a model of brisk reportage. It's CFO was even voted CFO of the Year by CFO Magazine, just before he was convicted of fraud and carted off to jail.

Sarbanes-Oxley, the supposedly tough new regulations of that era did not, alas, prevent the creative reporting and selective disclosure that led to the financial crisis in 2008. Nor has it notably reduced the level of 'issues' with regard to the gap between audited financial statements and subsequent problems, sometimes of an organizationally terminal nature, that ' no one could have foreseen.'

So, in a bold departure from tradition, the PCAOB has proposed that auditors be required to state whether the assertions and reportage in a company's annual report are accurate. While laymen might be naive enough to think that the whole point of the audit is to insure accuracy, this proposal has inspired a storm of indignation from the businesses who the rather more indefinite approach has benefited. They have cloaked their concerns in the customary rhetoric about 'competitiveness,' which usually means that they want to preserve whatever wriggle room they have in case they need it to put one over on, well, anyone. The accounting industry has taken a 'cautiously supportive' public stance that will presumably give their lobbyists the cover necessary to amend or kill it quietly.

This proposal matters, as the following article explains, because the factors for which audits account no longer convey as much of the value of the enterprise as they did in the industrial era. In addition, the rules have become sufficiently flexible that they no longer provide investors, business partners, customers and suppliers in a global economy with information on which to adequately base a strategic decision. Accuracy: what a concept. JL

Michael Rapoport reports in the Wall Street Journal:

Auditors would have to tell investors more about the tough decisions they had to make in evaluating a company's finances under a new proposal from the government's audit-industry regulator
The proposal, issued by the Public Company Accounting Oversight Board, also would require auditors to evaluate whether the assertions a company makes in its annual report are accurate—a move which would take the auditors beyond their traditional rule of verifying a company's numbers.
Both changes are part of a plan by the PCAOB to overhaul and expand the audit report— the letter in every annual report in which an auditor avers that the company's financial statements are "fairly presented." The moves are aimed at making the audit report more useful for investors, as opposed to the current boilerplate letter that critics say tells investors little of substance about a company's true condition.
The PCAOB's proposal also would add some disclosures to the audit report, notably information about how long the auditor has worked for the company. Many companies have used the same audit firms for decades, and some critics think that can lead to coziness that can jeopardize an auditor's professional skepticism and ability to conduct a tough audit.
"I think we've got a better mousetrap," said PCAOB Chairman James Doty. He called the proposal "a watershed moment for auditing."
Change won't come soon, though.
If the PCAOB's proposal is enacted in its current form, the first audit reports with the new information wouldn't be required until early 2017. The board is accepting public comments through Dec. 11 and may hold a public roundtable early next year to discuss the proposal.

Investor advocates and accounting-industry leaders were both guardedly positive about the proposal. The Council of Institutional Investors, which represents pension funds and other large investors, called it "a positive step forward to considering improvements to the usefulness of the standard form auditor's report."
PricewaterhouseCoopers LLP, one of the Big Four accounting firms, "strongly supports any enhancements to the auditor's report that will address the needs of today's users," said Vin Colman, PwC's U.S. assurance leader.
Cindy Fornelli, executive director of the industry's Center for Audit Quality, said her group is "committed to embracing calls for responsible change to the auditor's report."
The proposed new report would retain the current pass-fail judgment by the auditor on a company's numbers.
In addition, however, auditors would have to discuss any "critical audit matters," or "CAMs," as PCAOB members and staff are already calling them—parts of the audit in which the auditor had to make its toughest or most complex decisions, or which gave it the most difficulty in forming its audit opinion.
For instance, the PCAOB said, an auditor might have a "critical audit matter" when it tries to determine whether a company has assigned a reasonable valuation to a large portfolio of thinly traded, hard-to-value securities.
"It's telling investors what kept the auditors awake at night," said PCAOB member Jay Hanson.
Auditors also would have to evaluate other information in a company's annual report beyond the financial statements—the company's assertions in its Management's Discussion and Analysis section, for example—to see if they have any errors or misstatements and to make sure they don't conflict with the numbers the company is reporting.
Not everyone was on board with the PCAOB's proposal. PCAOB member Steven Harris said he voted to issue the proposal to start a discussion, but that he still thought it was "not strong enough to meet the concerns of investors."
Some investor advocates had pushed for the PCAOB to propose an "Auditor's Discussion and Analysis" section of a company's annual report in which the auditor would provide its own view of the company's financials. The PCAOB rejected that idea, siding with the industry, which contended that its role was to weigh in on what a company says and not provide its own analysis.
On the other end, the U.S. Chamber of Commerce sees the PCAOB's proposal in a harsher light. "This is a fundamental change that can harm both businesses and investors alike, and may drive up liability for management and auditors," said Tom Quaadman, vice president of the Chamber's Center for Capital Markets Competitiveness.


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