Five years of increasingly rigorous inspections have led audit firms to shift away from defending their work, toward improving their efforts at scrutinizing corporate financial statements and internal control.
Audit and compliance executives on the receiving end of that pressure say they can clearly see the heightened scrutiny. The question is whether it is making audits better, or just bigger and more expensive.
The Public Company Accounting Oversight Board has delivered steadily rising rates of audit deficiency findings to leading audit firms in the last five years, sending auditors on an odyssey to determine what they need to do to satisfy regulators. In the earliest days of PCAOB inspections—even before the PCAOB provided data that let anyone outside the inspection process understand how many audits in a given inspection cycle presented problems—audit firms routinely defended themselves against PCAOB criticisms.
In PwC’s 2006 inspection report, for example, where the board flagged six audits with problems, the firm’s response attached to the report gave a detailed rebuttal to the findings in all six audits. “We have concluded that, in each instance, our original procedures were sufficient to support our audit conclusions and the opinion rendered at the time,” PwC wrote. “As with any audit process, judgments are necessarily involved in the PCAOB’s inspections.”
EY took a similarly defensive stance in its response to its 2005 inspection, where the PCAOB found fault with 10 audits. “Although we do not always agree with the general characterization of the work we performed or the related existing audit documentation, in some instances we did agree to perform certain additional procedures or improve aspects of our audit documentation in response to the inspection,” the firm wrote. “In all instances, no new facts came to our attention that caused us to believe that our previously issued auditor’s reports should be withdrawn as a result of these actions.”
“Auditors now are really pushing for more sample testing and additional documentation. And in some places where they relied on internal audit reports, they are having to go out and redo the work. The audit process has become longer and more difficult.”
Lorraine Malonza, Director of Accounting Advocacy & Financial Research, Financial Executives International
Fast-forward to 2013, and responses to inspection reports are far more accepting of findings. In KPMG’s response to it latest report, where inspectors called out 23 of 50 audits inspected, John Veihmeyer, chairman and CEO at KPMG, and James Liddy, vice chair in charge of audit, offered no hint of defense. “We share the PCAOB’s objectives of continually improving audit quality,” they wrote. “We believe that the PCAOB’s inspection process serves to assist us in identifying areas where we can continue to improve,” and “We remain committed to full cooperation.”
Instead of defending their work, firms are focusing more today on what they need to do within their audit practices to deliver what the PCAOB is demanding: audits that better comply with auditing standards. Deloitte & Touche, whose inspection results from the PCAOB have improved, is one of the few firms that openly discusses how it responds to regulatory pressure.
The firm focuses heavily on root cause analysis, says Alex Schillaci, national managing partner of inspections for Deloitte. “We try to determine why we had the comment and what, if anything, we need to do,” he says. “Is it engagement-specific, partner-specific, or a firm-wide issue?” When a finding is remediated, then comes a gap analysis. “For that engagement, what did we do compared to what the standards require? That serves a couple of purposes. It resolves the issue, and it’s also a learning tool.”
Deloitte has put an emphasis on improving project management, Schillaci says, to better manage and improve the overall engagement team performance. The firm is also investing in technology, such as data analytics and data visualization. “We’re going to see a lot in audit innovation as we move forward,” he says. It not only improves the precision and quality of the audit, but it also improves the job experience for auditors who are released from more routine tasks that technology can perform.
Audit firms are providing staff with more training, says Nancy Reimer, a partner with law firm LeClairRyan, who works closely with a number of audit firms. “They’ve really stepped up the education in terms of what they have to do,” she says. “I do think they are making a concerted effort to improve their processes.”
Phil Wedemeyer, an audit committee member for Atwood Oceanics and a former auditor and staff member at the PCAOB, says he sees increased quality control structures at the firms, leading to more consultations on trickier issues and more formal consultations. He also sees more work in root cause analysis.
“They are grinding through their own process to figure out if they can see causal factors,” he says. “Is it lack of training? Lack of competency in certain areas? Lack of supervision? Are partners or managers overloaded? Is it the incentive systems?” He sees firms beefing up their internal inspections as well, to stay ahead of PCAOB inspections.
‘Longer and More Difficult’
Those on the receiving end of the audit process say they see the increased activity. “Companies are feeling the pressure from auditors,” says Lorraine Malonza, director of accounting advocacy and financial research at Financial Executives International. “Auditors now are really pushing for more sample testing and additional documentation. And in some places where they relied on internal audit reports, they are having to go out and redo the work. The audit process has become longer and more difficult.”
Indeed, tension over auditors’ reliance on company work came to a head in the 2014 year-end audit cycle, prompting the Center for Audit Quality and the Institute of Internal Auditors to call for a truce and implore audit committees to get more involved in mediating. A member of the PCAOB even commented in a speech that auditors’ apparent reactions to PCAOB demands through inspections seemed out of sync with the level of concern raised by the PCAOB in a 2012 alert to auditors.
CHALLENGES FOR EXTERNAL/INTERNAL AUDIT
Below, the Center for Audit Quality and the Institute of Internal Auditors outline some of the challenges in the external and internal audit working relationship based on the results of their recent roundtable.
Decreasing External Auditor Willingness to Use Internal Auditor Work
A significant portion of participants believed that there has been a substantial change in the PCAOB’s posture on the use of internal audit’s work. One external auditor said, “So far as reliance is concerned, this Fall it seems like the nature and extent of the testing of internal audit has been questioned more than ever …”
… Various participants noted that the level of risk associated with an area is a key consideration. Some external auditors have become more reluctant to use internal auditor work for high-risk areas. Indeed, one external auditor stated flatly: “I will be very candid. If it’s a high-risk area, we will not use the internal auditor’s work.”
External auditors also perceive that the PCAOB was taking a more exacting stand on external audit evidence. In addition, some external auditors thought the PCAOB placed too much weight on whether the work had been done by the external auditor itself, and too little on the experience and qualifications of the auditor, whether internal or external. One external audit partner commented that it sometimes seemed that the PCAOB inspectors were more comfortable accepting the work of an external auditor with two years’ experience than an internal auditor with 12 due to a perceived lack of independence and objectivity on the part of the internal auditor.
A More Difficult Relationship Between External and Internal Audit
Some expressed the opinion that PCAOB requirements were increasing tension between external and internal audit. Remarked one internal auditor: “I was on the external audit team 10 years ago, and I saw the relationship between internal audit and external. It was very, very good. And when I came back into internal audit 10 years later, that relationship was not the same ... I would say that it’s been strained.”
Both external and internal auditors expressed their belief that the PCAOB had become more stringent in its documentation requirements. External auditors said they were including much more of the information given to them by internal auditors in their working papers. An external auditor commented, “This year, we’re having to be very detailed at documenting at the attribute level. Documentation has become an important point of discussion for external and internal audit teams as they seek to make the financial statement audit more efficient and less costly.” Several external auditors noted that they have shared templates that internal audit can utilize.
There has been pushback by company management upset about what they perceive as changes in the audit environment and the requirements surrounding the external auditor’s ability to use the work of internal audit. Participants said that management was concerned about “audit fatigue,” i.e., company staff constantly having one set of auditors or another in its offices, often asking for the same documents.
An internal auditor said: “Management is having a hard time [with the reliance issue]. They’re thinking ‘internal audit was here, now external audit is... well, I gave them all that. I know they have copies of it. Why do they have to ask for it again? Why am I having to answer these questions again?’ Management is really pushing back on this.”
Sources: CAQ & IIA.
Dee Mirando-Gould, senior technical director at consulting firm MorganFranklin and a former associate chief auditor at the PCAOB, says she works with companies that are growing weary of increased audit activity. “I do think they are taking a lot more time in doing their audits,” she says. “That gets some of my clients frustrated. Auditors have always had the mindset if we find errors, we have to dig in more, and they’re doing that even more now.”
On the upside, Mirando-Gould says, audit firms generally are elevating more issues to the national office, especially where significant judgments are involved, even on transactions where the issues are familiar. She also sees more questions from engagement partners and engagement quality review partners. “A lot of that is in response to PCAOB inspections,” she says.
There’s a downside as well, in Mirando-Gould’s view. She’s also seeing more “almost administrative stuff,” like checklists. An increased number of managers, senior managers, and even partners in the field are asking for more documentation, more memos, and more white papers, she says.
“I worry about that and how much it is really improving the process,” she says. “How much of that is affecting substantive testing auditors are doing, and how much is that just to make sure they don’t get a comment on an inspection report?”
Schillaci at Deloitte acknowledges the concern. “That’s one of the reasons we spend so much time on root cause analysis,” he says. “We want to make sure our response is going to be grounded in professional standards. It comes down to assuring we are complying with the auditing standards in performing a high-quality audit.”
And the Money Question
While audit firms have not been willing to discuss audit costs, the latest data from research firm Audit Analytics shows that audit fees took a turn upward in 2013 for the first time after several years of downward pressure. As a percentage of revenue, audit fees paid by more than 2,300 accelerated filers rose 1.4 percent in 2013.
The increased audit activity and increasing costs leave people on the receiving end of audits wondering what they’re really getting out of the entire process. If inspection findings correlate in some way with a reduction in restatements or some other indicator of improvement to financial reporting, then maybe those on the receiving end will see benefit, Malonza says. “Right now, it’s a lot of work and a lot of cost,” she says. “But we don’t truly know if inspections are leading to better-quality audit work.”
Investors aren’t sure what to make of the situation. “I am aware that some firms and companies complain that inspectors are identifying immaterial issues, increasing audit costs,” says Jeff Mahoney, an accountant and general counsel for the Council of Institutional Investors. He says he hears it from both sides: Audit firms say inspection results do not reflect improvements they’ve made, but instead result from more targeted inspection processes; while he hears from some at the PCAOB members who say audit quality has deteriorated, leading to increasing findings in recent reports.
“I don’t know whether audit quality is actually declining or not, but I am personally not sympathetic to the argument that the inspections are too tough or unfairly critical,” he says.