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From Securities Regulation Daily, October 20, 2014

PCAOB panel sees decreasing relevance of external audit

By Jim Hamilton, J.D., LL.M.

The PCAOB’s Investor Advisory Group examined a number of contentious, important global issues, including the role of audit committees in the external audit, auditor rotation, and consultancy creep in the audit firm model, all against the looming specter that maintaining the current system is no longer a viable option.

SEC Chair Mary Jo White attended the morning session and noted that auditors are critical gatekeepers in the financial reporting process and it follows that audit standards are very important. The relationship between the external auditor and company audit committees is of particular interest to the SEC. Audit committees are also key gatekeepers, said the Chair.

PCAOB Members Steve Harris and Lewis Ferguson spoke about the global nature of the issues facing audit regulators, including audit quality, the role of the audit committee, and auditor independence. Member Ferguson speaks with added authority in this area as Chair of the International Forum of Independent Audit Regulators (IFIAR). He noted that companies in the E.U. have begun mandatory audit firm rotation, even ahead of the effective date of legislation. He said that one concern of mandatory rotation is a loss of sector experience.

IAG member, and former SEC Chief Accountant, Lynn Turner said that the loss of expertise objection to audit firm rotation is overblown. He noted that most of the work on an audit is done by lower level staff, who are generally subject to a large turnover, and so the knowledge is lost anyway. There is not that much inherent knowledge loss with mandatory firm rotation.

PCAOB Member Jeanette Franzel said a framework needs to be created on how regulators and the financial services firm are progressing on these issues, such as the role and relevancy of the audit and professional skepticism. The PCAOB has been emphasizing professional skepticism. She said that audit quality indicators is an extremely important project. It is a complex topic, she pointed out. Other vital areas are audit firm governance and auditor interaction with the audit committee.

Consultancy creep. IAG member, and former SEC Director of Market Regulation, Brandon Becker said that there has been consulting creep in the outside auditor area. After Enron, audit firms pulled back from providing consulting services, he continued, but there has been a gradual crawl back towards consulting. It is a creep, not a dominance, he assured.

There has been a gradual increase in consulting fees among the Big Four, in the provision of both tax and non-tax services. The IAG has concerns around consultancy creep, with one concern being talent management, which involves the draw-down of talent from the financial statement audit to consultancy. One question is whether there are good governance controls at the audit firm that would allow the firm to focus on auditing and not tip its focus into the consultancy world. There is also a broader public interest concern that core audit services are not being met because of the increase in consultancy. A robust governance process is needed to address these issues.

IAG member Mercer Bullard said that auditor transparency is key. Audit firms are major players in the financial markets and should have financial transparency. They serve a public function and have an exclusive federal license.

Lynn Turner approved of the idea of an audit-only firm advanced by former Fed Chair Paul Volcker and said this would obviate the need for audit firm rotation.

IAG member Damon Silvers noted a perception that public company audits are of diminishing relevance. Boilerplate in audit reports must be addressed. He said that one way to get away from boilerplate is to require a discussion of the most significant concern that arose during the audit.

IAG member Norman Harrison suggested that consulting creep could be monitored through PCAOB inspections. PCAOB Chair Jim Doty said that Board inspectors do look at compensation swings, and will look at this more. The Board also addresses supervision issues in areas where the auditor is not an expert.

Audit committees. The role of the audit committee also has global implications. The IAG noted that the audit committee has a fiduciary role and a statutory role and a key role in financial reporting, yet a report on their work does not appear in the financial statements, but months later in the proxy statements. Audit committees are expected to challenge the work of the external auditors, but they don’t have the expertise of the auditors. They are also subject to multiple regulators, with the SEC overseeing independence, the exchanges overlooking governance, and the PCAOB covering auditor-audit committee interactions.

The IAG believes that the audit committee must become more transparent as part of the disclosure framework. The audit committee report is currently in the proxy statement, some three months after the audit. It should be part of the annual reporting process with the financial statements.

The question of whether the external auditor should be required to assess the effectiveness of the audit committee is extremely complex and contentious. It comes down to a question of internal controls. IAG member Tony Sondhi said that the effectiveness of the audit committee is a component of internal controls: The lack of an effective audit committee is a material weakness. IAG member Norman Harrison added that if an audit firm is tasked with opining on the effectiveness of the audit committee that hired it, it will be difficult to get an objective assessment.

Agreeing, Damon Silvers found it problematic to ask the auditor to assess the audit committee that hired it. The current model is a process whose fundamental content is obscured from investors. The ability to hold parties accountable comes from entities that are intertwined with each other. The PCAOB should ask if we need external transparency and accountability, he said, adding that while these issues have been discussed for years, what is different now is that transparency has been embraced by the global auditing regulatory community and the U.S. risks being left behind. The PCAOB should ask if maintaining the current system is viable or face the diminishing importance of the audits. Maintaining the current system is not an option.

MainStory: TopStory AccountingAuditing

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