The PCAOB’s recently proposed auditing standards aim to “provide investors and other financial statement users with potentially valuable information that investors have expressed interest in receiving but have not had access to in the past” by changing the standard auditor’s report and increasing the auditor’s responsibilities. Sounds like a lofty goal, except that the information that they are proposing to require auditors to provide is either (i) self-evident; (ii) an infringement on the judgment of the issuer’s audit committee; or (iii) just plain not helpful. What the proposed auditing standards do accomplish, however, is to add more costs to being a public company just like their last proposal on mandatory auditor rotation.
Critical Audit Matters. Under the proposed auditing standards, an auditor will be required to include a discussion in its auditor’s report about the issuer’s “critical audit matters.” Difficult, subjective, or complex judgments, items that posed the most difficulty in obtaining sufficient evidence, and items that posed the most difficulty in forming the opinion on the financial statements are deemed to be “critical audit matters.” While this requirement may seem straightforward at first, the reality is that this “new” information should be self-evident by anyone who knows how to read a financial statement. Revenue recognition, estimates for allowances, pension assumptions, etc. are typically deemed to be “critical audit matters” by an auditor when planning audit procedures. These critical accounting policies are already discussed in issuers’ MD&A and in their financial statements. Further, any investor who actually is looking at the fundamentals of an issuer’s business and historical results should already be highly focused on estimates that, if wrong, could materially impact the financial statements. Auditors will end up being overly inclusive on what is deemed “critical” for fear of having an accounting restatement occur as a result of an incorrect estimate that was not listed as “critical.” In the end, auditors will end up spending more time auditing matters that would not have been deemed “critical” in the audit planning, but for the fact that the auditor will list the matter as “critical” to protect against potential legal liability. The result will be higher audit fees for audit work that does not provide investors any additional comfort.
Tenure of the Auditor. Despite having their mandatory auditor rotation proposal lambasted by the U.S. House of Representatives in a recent vote of 321-62, the PCAOB doesn’t seem to want to give up. The proposed auditing standards require a seemingly innocuous statement from the auditor in the auditor’s report regarding the year the auditor began serving as the issuer’s auditor. As PCAOB Board Member, Jeanette Franzel, noted, the inclusion of the auditor’s tenure in the auditor’s opinion may imply that there is some sort of empirical evidence that tenure plays a role in the quality of the audit. Whether or not there is evidence about auditor tenure is beside the point, however. It is the audit committee’s responsibility to determine whether an auditor is or is not independent. (Similar problems exist with Say-on-Pay, especially the Switzerland fiasco.) We cannot be opening up company decisions to direct democracy. Whether an auditor has served too long (or not long enough) should be firmly in the control of competent members of the audit committee who are much closer to the issue and know many more details than simply the auditor’s tenure with the issuer. Further, just like Say-on-Pay was supposed to be advisory, once ISS and Glass-Lewis get involved, all bets are off. Arming the proxy advisory firms with more information that they can use in their annual rejiggering of their own “good governance” policies is not in the best interest of shareholders.
Requiring Auditors to Report on “Other Information” such as the MD&A. Currently, auditors are required to “read and consider” other information found in an issuer’s Annual Report. In practice, auditors, for example, review the MD&A and verify that (i) the numbers tie to the financial statements and (ii) the explanation is consistent with the evidence gathered in the audit. The PCAOB is proposing that the auditor’s report now state that they have “evaluated whether the other information in the Annual Report on Form 10-K filed with the SEC…contains a material inconsistency with the financial statements, a material misstatement of fact, or both.” While the auditor’s report will also state that the auditor “did not audit the other information and does not express an opinion on the other information,” a disclaimer of an opinion is hard to take seriously when clearly the auditor is giving an opinion that all of the information contained in the Annual Report is consistent with the financial statements. This is an unnecessarily overly broad directive from the PCAOB. Requiring auditors to give this “nonopinion opinion” subjects auditors to additional liability, which will require the auditors to perform additional procedures (beyond what they are already performing) and charge issuers more to compensate the auditors for their additional risk.
While I believe that the PCAOB has good intentions in their attempts to improve public company audits, they seem to be blind to the reality that continually subjecting the auditors to additional legal liability just ends up costing issuers more fees and lowers the investors’ potential returns. The PCAOB is accepting comments on this proposal until December 11, 2013.