PICPA Student Writing Competition Winner
By Melissa Cameron
The following is the first-place winner of the 2017 Pennsylvania CPA Journal Editorial Board Student Writing Competition. It was written by Melissa Cameron of Temple University, who received $3,000 for her accomplishment. The second- and third-place papers were written by Maria Chernaya and Leah Pillsbury, who received $1,800 and $1,200 respectively. Chernaya and Pillsbury also attend Temple University. Thanks go to the Editorial Board for its dedication to the program, with special recognition going to judges Steven G. Blum, Cory Ng, Margaret O’Reilly Allen, Mary Jeanne Welsh, and Michael A. Zaydon.
The audit opinion is a highly standardized report requiring specific wording and structure. Charged with a mission of protecting investors, the Public Company Accounting Oversight Board (PCAOB) is currently examining what changes it should make to the audit report as well as how to identify and disseminate information about audit quality indicators in order to improve the information investors have at their disposal regarding audits of public companies in the United States. The PCAOB has approved new rules – and appropriate amendments to the relevant standards – that require disclosure of additional audit information on a new form, Form AP, Auditor Reporting of Certain Audit Participants, effective for any audits of financial statements for periods ending on or after Dec. 15, 2016. The new form will require disclosures such as the name of the engagement partner and information on other accounting firms participating materially in the audit.
The PCAOB first began evaluating the possibility of requiring additional audit disclosures, specifically the name of the engagement partner, in 2009, just as the United Kingdom began requiring the signature of the engagement partner on audit reports. Several years earlier, in May 2006, the European Union (EU) had begun requiring the signature of the statutory auditor as well. Like the EU directive and the U.K. requirements, the original PCAOB proposal would have required the signature of the audit partner directly on the opinion letter. However, the final mandate by the PCAOB requires disclosure of the engagement partner on a separate form, Form AP, instead. This new form was established because under current securities laws in the United States, an auditor would incur additional liabilities by signing the engagement letter. Nevertheless, whether the engagement partner is identified in the opinion itself or on a separate form, the question of mandatory engagement partner disclosure has engendered significant debate and scholarly research.
In deciding whether engagement partners should or should not be disclosed, whether in the audit report or in separate publicly accessible databases, first we have to understand what disclosure achieves. The purpose of these disclosures is, according to the PCAOB, to increase both transparency and accountability and to thereby increase audit quality. Yet, what determines audit quality? How do we know when audit quality has been achieved? How we define audit quality determines whether engagement partner disclosure is a useful means of achieving the objective.
In its explanation regarding the requirement of additional disclosures, the PCAOB points to the difficulty financial statement users have in evaluating the quality of an audit and its resulting report: “Generally, in the United States, investor decisions about how much credence to give to an auditor's report have been based on proxies of audit quality, such as the size and reputation of the firm that issues the auditor’s report” [emphasis added by author]. Whether traditional proxies – and which proxies – set out in the literature actually signify quality audits is debatable. For example, higher audit fees are often considered a proxy for audit quality. Do higher audit fees, whether because of more billed hours or because of a higher rate of pay, correlate with higher quality audits? To step back, do we even know whether companies seek out high quality audits? As Jere R. Francis queries in “What Do We Know about Audit Quality?,” why is there a “demand for differential audit quality given that any licensed auditor can legally satisfy the requirement to have an audit?”
In “A Framework for Understanding and Researching Audit Quality,” Francis suggests that audit quality is a continuum with specific engagements falling somewhere on the spectrum between high quality and low quality audits. He points to several possible definitions of audit “failure,” including failed litigation (when users of the financial statements sue auditors but fail to make the case that auditors were negligent), SEC sanctions, and the relationship between going-concern audit reports and business failure (either when the auditor reports a going-concern opinion and the business does not fail, or when the auditor does not report a going-concern opinion and the business subsequently fails). Francis reminds us that all three dichotomous measures of audit failure have very low rates in relation to the overall number of audit engagements filed with the SEC (well below 1 percent). This might suggest that overall audit quality is more or less at an acceptable level. Francis also theorizes, however, that while audit failure is very rare, low quality audits may occur more frequently. Thus, the question remains: what drives the market for higher audit quality (if there is one)?
In most service provider-client transactions, the client can identify a high-quality product and, thus, evaluate the benefit of paying a premium for a higher-quality result. For example, a client can decide whether it is cost-effective to pay a premium for an Internet service provider that is more reliable or faster than another. In the case of audit services, the resulting product, an audit report, follows a standard template that may or may not correlate with the quality of the service provided. Nor is the audit process necessarily clear to the client. In fact, the reliability of the audit relies to a certain extent on the client's ignorance of exact audit procedures. Thus, the value of the product, the audited financial statements, is difficult to discern, and the efficiency of the process cannot truly be known by the client. Because of the intrinsic opacity of the service provided (the audit), it is in the best interest of both auditors and regulating authorities (such as the SEC) to be as transparent as possible in whatever ways the process allows.
Assuming that there is a market for high quality audits, how does the market regulate? A quick survey of the research indicates that most research into proxies of audit quality focused primarily on data at the firm or office level. Yet, there can be significant variation among different offices of a firm and even partners within an office. Studies in other jurisdictions suggest that data regarding engagement partners can provide valuable information regarding signals of quality audits, such as in China, where Ferdinand Gul, Donghui Wu, and Zhifeng Yang found that individual auditors have significant effects on audit quality, or in Taiwan, where Daniel Aobdia, Chan-Jane Lin, and Reining Petacchi found correlations between a measurement of partner quality and the reliability of earnings measurement. Perhaps the focus on firm attributes as possible proxies of audit quality is due to the very limited information regarding individual auditors on an engagement, at least in the United States. Disclosure of engagement partners would result in greater transparency, allow researchers to conduct better data-based archival studies, and ultimately put more information in the hands of investors, leading to more efficient capital investment decisions.
According to the PCAOB, another benefit of disclosing the identity of the engagement partner is accountability. With their names literally on the line, engagement partners risk their reputation and potentially their job prospects; thus, public disclosure “should provide an incremental incentive for auditors to maintain a good reputation, or at least avoid a bad one.” (PCAOB Release No. 2015-008, 53)
According to Jennifer S. Lerner and Philip E. Tetlock, accountability can be defined as the “implicit or explicit expectation that one may be called on to justify one’s beliefs, feelings, and actions to others.” Accountability “usually implies that people who do not provide a satisfactory justification for their actions will suffer negative consequences,” and, conversely, that good judgment will be rewarded. Many studies show that accountability pressures do influence auditor behavior. In the United Kingdom, for example, Joseph V. Carcello and Chan Li found that in the year after the United Kingdom began mandating engagement partner signature, the number of qualified audit reports increased and abnormal accruals declined.
This would suggest that not only does accountability influence auditor behavior, but that individual accountability results in higher quality audits. Lerner and Tetlock caution, however, against oversimplifying: “The accountability relationships that govern our lives are not only complex—because we must answer to a variety of others under a variety of ground rules—but often fluid and dynamic—as each party to the accountability relationship learns to anticipate the reactions of the other, we observe subtle patterns of mutual adaptation.” This framework is applicable to the auditor accountability situation. While the PCAOB believes accountability in the form of identifiability will provide “incentives to deliver high quality audits,” the PCAOB also recognizes that auditors already have other incentives to provide high quality audits, including internal firm reviews and external regulatory consequences, not to mention the risk of litigation. Auditors are accountable in varying degrees to multiple stakeholders: investors of public companies, audit committees, management of client companies, as well as the PCAOB and SEC, the auditing profession, and the firm they represent.
In “Accountability and Auditors’ Materiality Judgments: The Effects of Differential Pressure Strength,” a 2006 study examining the effect of different types of accountability pressure on auditors’ judgment of materiality levels, Todd DeZoort, Paul Harrison, and Mark Taylor found that auditors did respond to accountability pressures, and that the more combined pressure they endured the more conservative and less variable were their resulting judgments. Auditors under more accountability pressure established lower threshold recommendations for materiality than auditors who were anonymous with no threat of feedback or review. This would indicate higher quality judgments and better decision making when auditors were under accountability pressure. The study also found, however, that auditors under higher levels of pressure “spent more time on the tasks, produced longer judgment explanations, and emphasized more qualitative materiality factors than auditors under lower levels.” DeZoort, Harrison, and Taylor conclude that “higher accountability levels induced more complex and careful analysis of available information.”
To the extent that audit quality overall is already at a sufficiently high standard, additional accountability may be inefficient. There is a point at which auditors can be over conservative, fees can be too high, and the audit process is no longer an efficient means of minimizing information risk and/or asymmetry.
Engagement partner disclosure should be (as it is now) mandatory. More data available for scholars to analyze and more information for users of financial statements to evaluate is important. Ultimately, this can lead to greater efficiency in the market for audit services. The benefits of disclosing the identity of the engagement partner, including incremental improvements in audit quality and the potential for more and better knowledge regarding factors that affect audit quality, far outweigh the potential costs of disclosure, which may or may not be realized. Although submitting the Form AP may not affect accountability to the same degree as an auditor physically signing a form on which his or her name will appear to the public, signing and disclosure have the same results with regard to transparency, which is the PCAOB objective that has the greater potential for benefit. While, ideally, the statutes that make auditor signature impractical and highly risky in the United States could be amended, changing the law seems unlikely in today’s political climate. Luckily, disclosure on Form AP will reap almost all of the benefits.