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Doty seeks ‘cultural change’ in auditing profession

In a speech delivered at the FAE’s Nov. 3 Auditing Conference, James R. Doty, chair of the Public Company Accounting Oversight Board (PCAOB), called for cultural change in the audit community, to address what he said was a fundamental conflict: allowing an independent, objective auditor to be paid by the same entities it is supposed to be auditing.
“From the beginning of mandated audits of public securities issuers’ financial statements, the profession has faced an inherent conflict built into the structure of our system of corporate governance in that the company itself hires, fires and pays the auditor,” said Doty.

This conflict means there are strong incentives not to challenge management, and while there have been many improvements in both auditing standards and regulatory activities to create powerful disincentives to accommodate management, “the underlying conflict has not been resolved,” he said.

Doty noted the history of the accounting and auditing profession in New York (starting with Johannes Dyckman, a settler who served as a bookkeeper for New Netherland Gov. Peter Stuyvesant, and ending with the passage of the Securities Exchange Act of 1934), and pointed out ways the profession has grown and changed. Despite it all, however, Doty said that one fundamental problem has remained.

“I don’t pretend that it can ever be completely resolved … but we must do better,” he said.
While there are occasionally blunt-force cases—such as the 1940 McKesson & Robbins scandal, in which management expressly instructed auditors not to do anything that would reveal possible misappropriations—Doty said that today’s auditors face more subtle pressures from management. He explained that management might argue with the auditor that a standard doesn’t apply because it’s too broad, or too narrow, or that an error isn’t material.

“I fear the most reliable measure might be that the more memos that are generated to explain why an error is not material, the more likely it is,” he said.

Regardless of the details, an auditor may simply want to avoid trouble with management. The PCAOB’s roughly 3,000 audits of large and small firms found “hundreds of flaws” that went beyond reasonable judgment calls or deficiencies in documentation, and “cut to the heart of an audit’s fundamental objective of obtaining reasonable assurance that a financial statement is free of material misstatement,” Doty said.

Creating a cultural shift
Many of the PCAOB’s recent major proposals have bent toward shifting what Doty called the “culture of the audit” to align with “a culture consistent with the franchise that the securities regulatory regime accords the audit profession.”

The PCAOB proposal to change the format of the standard audit report, released to the public in a June 21 concept release, is one example of that effort. While the proposed measures were varied, and while the PCAOB’s release did not explicitly endorse any one measure in particular, all the possibilities explored in the document would ultimately require auditors to provide richer insights into an entity’s financial information, beyond the current pass/fail model, for the benefit of investors. One of the methods suggested by the PCAOB would add an auditor’s discussion and analysis to the report, providing the auditor’s perspective on significant matters and how they were addressed in the audit engagements.

In a Sept. 27 comment letter, the NYSSCPA disagreed with the ideas laid out in the concept release and defended the current pass/fail reporting model, saying that if the current audit report format is not easily understood by the marketplace, educational efforts should be made to bring the market up to speed.

Renee Mikalopas-Cassidy, chair of the International Accounting and Auditing Committee and one of the principal drafters of the Society’s comment letter, said in the November issue of The Trusted Professional that many of the changes proposed by the PCAOB, particularly the addition of the auditor’s discussion and analysis, “fundamentally shift the role of what the auditor’s report is supposed to do.”

But during his speech at the conference, Doty maintained such changes would not alter the fundamental role of the auditor, and that role would still be to “perform an audit and attest to management’s assertions as embodied in management’s financial statements.

“That said, [the proposal is] intended to spur debate over how to change auditing from a culture that emphasizes client service to a culture that emphasizes public service,” he continued.

Doty’s emphasis on public service underlies another proposal the PCAOB put forth in October that, if implemented, would require the audit engagement partner be named in the report, as well as the names of anyone else who took part in the audit. Doty said the change could improve audit transparency and, in turn, help investors make more informed decisions about how to use the audit report. He noted that key management executives and board members are already named in public reports, and that investors have been calling for the auditors to be included as well.

“As a general matter, auditors don’t relish the idea, but it has become an issue of public interest,” Doty said.

Creating a cultural shift away from client service also motivated the PCAOB to issue a concept release on Aug. 16 exploring options for improving auditor independence and objectivity, introducing the idea of mandatory audit firm rotation. The concept release said that by ending a firm’s ability to turn each new engagement into a long-term income stream, term limits for audit firms could shift the auditor’s relationship with its client in a way that could enhance its objectivity and independence.
In his speech, Doty said firm rotation is an option that at least merited discussion, and that the problem it would address—allowing an independent auditor to rely on the audited entity for payment—is a real one.

Doty recognized this could be a tough pill for auditors to swallow, acknowledging that auditors are generally opposed to the idea of mandatory firm rotation, and that such a change might not be welcome among the community. But he urged the audience to think about it.

“Whether you’ve found a potential problem in an engagement or not, do you ever think about how important retaining a client is to your own career or standing in your firm?” he asked.
Doty challenged skeptics to find alternative methods of increasing auditor objectivity and independence, saying the PCAOB has allowed for a long comment period in the matter that extends until Dec. 14, which will be followed by a public roundtable for further discussion in March 2012.

The NYSSCPA is currently preparing a response to the PCAOB’s concept release.

Doty said these proposals, individually, are not the silver bullet that will create the cultural change he thinks needs to happen within the audit profession. However, taken together, they create a “holistic approach aimed at enhancing the credibility, transparency and relevance of audits,” he said. While such a change might be uncomfortable, it’s needed to face the future challenges of the profession.
“It is my hope that, as auditors, you will look back on this time as the moment when you turned to seize the future,” Doty told the audience. “With a century of experience responding to the public interest, the New York State Society will be an important voice.”


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