PCAOB to Take Next Step on Plan to Increase Audit Transparency

Audit regulators are planning to move forward on a proposal to bring more transparency to audits by requiring audit firms to identify the engagement partners and other key players in the audit.

The Public Company Accounting Standards Board says it will take action on the proposal by the end of the year, although it has not indicated if it will finalize the current proposal or issue a new one. What is clear, however, is that the plan is controversial, and audit firms and others are lining up in opposition of the measure, which they say has several unintended negative consequences.

The PCAOB proposed an auditing standard nearly two years ago that would require registered audit firms to disclose the name of the engagement partner in each audit report, plus the names of any independent accounting firms or other individuals who took part in the audit. Audit firms would also be required to disclose in their Form 2 filing with the PCAOB the name of the engagement partner for each audit reported on the form. It was a step back from the board's original idea, floated in a concept release, of requiring the engagement partner to take pen in hand and sign each audit report.

Investors have called on the PCAOB to require engagement partners to sign the audit report, just as CEOs and CFOs certify financial statements, as a way to get auditors to take more ownership over the audit opinions they express. When the PCAOB first talked of requiring an engagement partner's signature, now common practice in the United Kingdom, auditors and their legal counsel balked, saying the signature would heap added liability onto auditors. Citing both case law and the litigation environment in the United States, auditors would be subject to increased liability and increased litigation, they said.

Cindy Fornelli, executive director of the Center for Audit Quality, supported largely by the major audit firms, told the PCAOB then that engagement partners are already held accountable to multiple parties, including their firm, audit committees, regulators, and investors. “These multiple layers of accountability provide a significant incentive for engagement partners to conduct high quality audits in accordance with professional standards,” she wrote. 

The PCAOB responded with a proposal that required not the engagement partner's signature, but only for him or her to be identified. Most audit firms continued to protest that even naming engagement partners would not improve audit quality or increase the auditor's sense of accountability for the audit opinion, but would still expose them to added liability because they would be deemed “experts” under SEC rules, therefore assumed to have certified the contents of the report. Their naming in the report would also complicate subsequent registration statements, firms said.

In its comment letter to the PCAOB, KPMG explains that Section 11 of the Securities Act of 1933 allows for claims against every accountant who has consented to be named as having prepared or certified any part of a registration statement or any report or valuation used in a registration statement. “Liability under this section is not dependent on whether the accountant signed the report, but rather on whether the accountant consented to being named in it,” the firm says. The Act also requires issuers to file the consent of any accountant who is named as having prepared or certified any part of a registration statement. “Should it be determined that issuers are required to file the consent of an engagement partner whose name is disclosed in the audit report, significant increased liability for engagement partners may result,” KPMG says.

EY even continues to protest naming the engagement partner at all. The firm wrote to the PCAOB: "Consider how such information might be utilized, whether by the trial bar in litigation or by others who would associate the name with other publicly available information." 

“It's not going to stop certain rogue individuals from doing what they want to do.”

—Salvatore Collemi,

Director,

WeiserMazars

In a letter to the PCAOB, Bob Moritz, PwC's U.S. chairman, and Tim Ryan, U.S. assurance leader, said the firm would support the proposal if the board could engage the SEC to address the liability issue. Ryan and Moritz said they don't see how the proposal would improve audit quality or give investors useful information, but they support the objective to increase transparency.

In fact, they suggest the board take the naming of key auditors a little further. "In addition to naming the engagement partner responsible for the audit, a member or members of firm leadership should also be named in the audit report," Moritz and Ryan wrote. "Examples could include the firm's audit/assurance leader and/or CEO/senior partner. Including the name and/or names of firm leadership will convey to the users of the financial statements that the accounting firm as a whole takes responsibility for the audit and alleviate any misimpressions that the audit report is the product of the engagement partner rather than the firm."

Investors Want Names

Fueled by a handful of events since the PCAOB issued its proposal in October 2011, investors are even more fervent in their call for the engagement partner's name. In a May 2013 letter to the PCAOB, the Council of Institutional Investors said allegations of insider trading against Big 4 engagement partner Scott London provided a case in point. “In our view, as soon as news about Mr. London's conduct had been reported publicly, every shareowner in America should have had the ability to immediately access information to determine if Mr. London was the engagement partner at the company they own,” wrote CII general counsel Jeff Mahoney.

CII also pointed out that a recent academic study by a former member of the PCAOB's own Standing Advisory Group shows that the signature requirement adopted in the United Kingdom has been followed by an improvement in some key indicators of audit quality. Those include a reduction in abnormal accruals, an easing on the part of preparers to try to meet earnings targets, and an increase in the issuance of qualified audit reports. The study also points out a significant increase in audit cost after the signature requirement took effect.

PARTNER ACCOUNTABILITY

Below is an excerpt from the academic paper, “Costs and Benefits of Requiring an Engagement Partner Signature: Recent Experience in the United Kingdom,” which describes possible outcomes of increased engagement partner accountability.

An increase in partner accountability may change partner behavior in ways that would affect audit quality. First, greater accountability may lead the partner, and the audit team that s(he) directs, to perform more work (i.e., extent of procedures performed). Prior research finds that greater accountability leads auditors to put forth greater effort (e.g., Asare, Trompeter, and

Wright 2000; DeZoort et al. 2006). Also, Carcello and Santore (2011) develop an analytical model of the effects associated with a partner signature requirement and find that the auditor will gather more audit evidence.

Second, greater partner accountability may change the nature of audit procedures performed. The audit engagement team may gather not just more evidence, but more persuasive (better) evidence. For example, Asare et al. (2000) find that greater accountability led auditors to increase the breadth of the work they performed, and it was the change in the nature of audit procedures, not the extent of audit procedures, that led to better auditor performance.

Third, greater partner accountability may lead the partner and the engagement team to exercise greater diligence in performing their work (ICAEW 2005). For example, Messier and Quilliam (1992) find that greater accountability led to an increase in cognitive processing by auditors. Tan and Kao (1999) find that accountability only improved performance when both knowledge and problem-solving ability were high, and both traits characterize partners.

Finally, greater accountability may lead to more conservative auditor reporting. For example, Hoffman and Patton (1997) find that accountability led to more conservative fraud risk judgments. DeZoort et al. (2006) find that given greater accountability auditors were less likely to pass on proposed audit adjustments. Deciding whether or not to pass on a proposed audit adjustment is the type of key decision made by the engagement partner, and it has a direct effect on the amounts reported in the financial statements. The analytical model developed by Carcello and Santore (2011) also predicts that partners will report more conservatively in the presence of a signature requirement.

Source: Academic Paper.

The study doesn't establish a cause-and-effect link to the signature requirement, but author Joe Carcello, a professor at the University of Tennessee, says he speculates that people act differently when they know they are going to be publicly identifiable. “That's consistent with the reason the board issued the proposed standard,” he says.

Nancy Reimer, a shareholder at law firm LeClairRyan and a member of the firm's professional liability defense team, says she doesn't believe the actions of a rogue partner should drive any decision to name engagement partners. “This goes back to the Arthur Andersen days when you have one rogue partner putting a black eye on the profession,” she says. Identifying the partner in the Form 2 filing instead of in the body of the audit report might represent a fair compromise, she says. Investors will be able to access the information, but without exposing auditors to any further liability.

Salvatore Collemi, director at audit firm WeiserMazars, says he doesn't believe identifying the engagement partner will affect audit quality. “This is not the silver bullet to cure the problem,” he says. “It's not going to stop certain rogue individuals from doing what they want to do.” He says the majority of accountants abide by a code of professional conduct and the solution lies in more education about the appropriate conduct of audit engagements and the independence and ethics of accountants.

The PCAOB has said through its standard-setting agenda that it expects to act on its transparency proposal by December 2013 with either a final standard or a tweaked proposal. As that target date draws closer, the board is not saying which approach it will take.

Carcello says he would be surprised if the board were to issue a revised proposal. “Unless they change the proposed standard in a substantive way, it's hard for me to understand why we would need another proposal,” he says.