Here We Go Again: Regulators Looking Anew at Audit Firm Consulting

Regulators are taking a fresh look at whether the quality of public company audits is threatened when audit firms also focus on selling consulting services.

The Public Company Accounting Oversight Board has asked its Investor Advisory Group to consider whether the independence and objectivity of auditors is compromised when audit firms are rebuilding or ramping up the consulting services they provide to companies.

Lynn Turner, an IAG member and former chief accountant for the Securities and Exchange Commission, says the PCAOB is questioning the consulting issue as a result of what it sees during inspections. “They’re coming to the conclusion that auditors aren’t being objective,” he says. “They’re driven by the fact that management is paying not only for the audit but for these various consulting arrangements.”

With the Sarbanes-Oxley Act, Congress established restrictions on non-audit services that auditors could provide to their audit clients more than a decade ago. Auditors are not allowed to provide any non-audit services that would create a conflicting or mutual interest with the company, or that would put them in a position of auditing their own work. Nor can they provide any services that put them in a role of acting as management or employees for the company or that cause them to become an advocate for the company.

The Securities and Exchange Commission and the PCAOB specifically prohibit some services, such as bookkeeping, information system design and implementation, appraisals, valuations, actuarial services, internal audit, management or HR functions, and broker-dealer or investment advising. Where an audit firm might provide a permitted non-audit service, the company’s audit committee is required to review the arrangement and pre-approve it to assure it won’t compromise the independence of the audit, and companies must disclose it to investors.

“Audit committees should definitely be having conversations with auditors about their independence. It’s fair when the audit committee is having discussions with auditors about their PCAOB inspection reports to ask: Are there any concerns raised about independence?”
Cindy Fornelli, Executive Director, Center for Audit Quality

Back in the Consulting Game

In the early 2000s, most major audit firms spun off or otherwise disposed of many of their non-audit service businesses in response to the restrictions and the market environment. In recent years, though, the firms have begun rebuilding or renewing their efforts on the consulting services side of their businesses. Last year, for example, PwC acquired Booz & Co., a management consulting and strategy firm that it renamed Strategy. The IAG says in 2012, advisory revenue at the Big Four excluding tax grew at a rate of four times the gains in audit fees. These efforts have sounded alarm bells at the PCAOB and SEC.

PCAOB Chairman James Doty has noted that audit firm revenues from audit services have been stagnant for the past decade, rising only with the rate of inflation at best, while firm growth through consulting has mushroomed by some 15 percent annually over the last few years. Paul Beswick, when he was chief accountant at the SEC, said more than once that he worries audit firm expansion into other areas probably does little to promote audit quality. “It has the potential to distract a firm’s leadership and other personnel from providing appropriate attention to their audit practice,” he said in a speech last year. “Such expansions run the risk of damaging the accountant’s reputation.”

Turner notes that while regulators may be wringing their hands over the issue, they have brought very few actions against auditors for a lack of independence. “If it’s a problem, where are the enforcement actions?” he asks. The SEC brought a prominent action against EY in 2014 alleging legislative lobbying on behalf of an audit client, and it punished KPMG earlier in 2014 over bookkeeping services, but those weren’t part of a string of actions. An analysis commissioned by the Center for Audit Quality found eight SEC enforcement actions involving independence, five of them involving non-national firms, from 1998 through 2010.

AUDIT FEE AND NON-AUDIT FEE TRENDS

Below, Audit Analytics provides details on audit fees from the years 2002 to 2013.
In 2002, non-audit fees were 51 percent of the total fees paid by accelerated filers, but after three years of steady decline non-audit fees appear to have leveled off at about 21 percent of total fees.
During calendar year 2002, non-audit fees represented 51.05 percent of the total fees paid to independent auditors by the 2,323 accelerated filers that comprise the research population of this analysis.
For the next three years, non-audit fees declined as a percentage of total fees to a value of 21.34 percent in 2005. At this point, the percentage leveled off at about 21 percent for the following eight years. In 2013, the non-audit fees equaled about 20.81 percent of total fees.

Source: Audit Analytics.

Is There Really a Problem?

Cindy Fornelli, executive director of the Center for Audit Quality, questions whether there’s a problem for regulators to address. Recent data from Audit Analytics shows companies are paying no more for non-audit services to their principal audit firm than they have since the present rules took effect in the early 2000s. Back then, companies routinely paid as much for non-audit services as they did for the audit itself. The ratio has shifted to almost 80/20, with only 20 percent of the total bill going to non-audit services that are permitted under current rules, and has held steady through 2013.

“I don’t know that there’s an issue here,” says Fornelli. She contends that audit firms and capital markets can benefit rather than suffer by having audit firms build their expertise in consulting services like IT systems, tax, treasury, financial management, valuation, due diligence, actuarial assessments, and fraud detection and deterrence. “The list goes on and on,” she says. “If they develop systems and processes on the advisory side that can be transferred over and used on the audit side that can improve audit quality.” Having a broader practice also helps the firms attract talent, she says. “If you have just a monolithic type practice, you might find fewer people who are interested in joining.”

Gaylen Hansen, a partner with regional Colorado firm EKS&H and a former member of the PCAOB’s Standing Advisory Group, says he’s surprised to hear the fee data has held steady (as the Audit Analytics data indicates) as regulators have raised the caution flag. The larger firms, he says, seem to have distinctly separate businesses for audit and consulting, but the PCAOB’s level of concern would suggest they’re mingling among audit clients too much. “But that doesn’t seem to bear out with the Audit Analytics figures, does it?”

Fornelli says audit committees would be wise to take extra care to assure they are on their game in assessing non-audit services provided by their audit firms for any potential problems. “Audit committees should definitely be having conversations with auditors about their independence,” she says. “It’s fair when the audit committee is having discussions with auditors about their PCAOB inspection reports to ask: Are there any concerns raised about independence?”

Audit committees should have the tools and knowledge they need to assure they are assessing independence properly, she says, and audit firms have some responsibility to address it as well. “It’s a two-way street.”