Risk Management

The Cost of Confidence

Two proposals aim to increase auditor independence, but may cause problems for CFOs.
David KatzFebruary 1, 2012

If CFOs had any doubt about whom the Public Company Accounting Oversight Board serves, the audit watchdog spells it out in big capital letters at the top of its Website: PCAOB OVERSEES THE AUDITORS OF COMPANIES TO PROTECT INVESTORS.

In other words, the board doesn’t see itself as primarily serving finance chiefs or the companies that employ them — and certainly not the audit firms it regulates. That distinction became crystal clear last year with the board’s issuance of two concept releases, one on providing more-robust accounting reports and the other on boosting auditor vigilance. In both cases, the board said it was responding to investor concerns.

With public comment on the releases in, the PCAOB is now mulling whether to turn them into full-blown regulatory proposals. Such proposals, if enacted, would produce dramatic changes in the client-auditor relationship — and finance chiefs see themselves as being on the wrong end of those changes. The suggested moves would “create a lot of tension” between finance executives and auditors, says Clyde Hosein, CFO of Marvell Technology Group, “and a lot of work for management that [would be] nonproductive.”

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Expensive Narratives
The first concept release, issued last June, introduced the idea of requiring auditors to supply a “narrative” about their clients in addition to their usual pass/fail opinions on company financial reports. Dubbed the Auditor’s Discussion and Analysis (AD&A), the prose paragraphs would resemble the Management’s Discussion and Analysis contained in corporate quarterly and annual reports.

While the cost of a mandatory AD&A report may not be readily apparent, it could be sizable. Dee Mirando-Gould, a director in the financial management practice at consulting firm MorganFranklin, recalls the issue being “very actively discussed” during her tenure as an associate chief auditor with the PCAOB from August 2008 through January 2011. Investors on the board’s Standing Advisory Group (which also includes auditors and public-company executives, among others) wondered why AD&As would cost companies more money, says Mirando-Gould. If the narrative merely amounted to what the auditor was already communicating to the client’s audit committee, why couldn’t the auditor simply use that for the AD&A?

The reason is that the report supplied by the auditor to the audit committee is often a bare-bones summary that the auditor elaborates on during audit committee meetings. “If an auditor is going to prepare an [AD&A], it’s going to take a lot longer to prepare it, and a lot more review time,” says Mirando-Gould, who notes that as many as three audit partners might have to opine on it. The result: more billable hours.

Auditors themselves have also raised ethical questions about the AD&A. Some say it would create an awkward situation in that they would be required to discuss the nature of management’s financials. “Should the auditor be in a position to create original material [concerning] financial statements,” asks Mirando-Gould, “or is that really the responsibility of management?”

Costly Transitions
The PCAOB’s second concept release, issued in August, offered a plan to boost auditor independence by mandating audit-firm rotation. The plan would limit the number of consecutive fiscal years that a registered public accounting firm could serve as the auditor of a public company. Among the questions the board posed in the release was whether it should consider a rotation requirement only for audit tenures of more than 10 years or only for the auditors of the largest companies.

Many finance chiefs think that being compelled to change audit firms every 5 or 10 years would be especially disruptive. Roger Moody, CFO of Nanosphere, notes that the medical diagnostic toolmaker enjoyed a particularly smooth transition when its auditor, Deloitte, had to switch lead audit partners. Aided by a “relationship partner” who wasn’t involved with the company on a day-to-day basis, the firm and the client worked to find a lead partner who was a “good fit,” according to Moody.

Mandatory audit-firm rotation, however, would make it “much harder to provide that seamless transition we had when we had the partner transition,” he says. “I’m quite sure it wouldn’t be as seamless, and could create problems for shareholders by causing hiccups or confusion [in the company’s financial reporting].”

There’s little doubt that such disruptions would have costs attached to them — especially in the early stages of the transition. “If you have a whole new engagement team with no history [with the company], they’re going to have to look at past work papers. It’s going to take longer to do the audit in the first year, even the first two years,” says Mirando-Gould.

Another cost would come in the form of the hours that CFOs and finance staffers would have to spend on the auditor transition, instead of on more-worthwhile endeavors. “They’re all busy doing normal work, and they don’t necessarily build in time to deal with the auditors” in such situations, says Mirando-Gould.

What’s Broken?
In view of such arguments against the two concept releases, some CFOs are puzzled about why the PCAOB has served them up now. “What’s broken that they’re trying to fix?” asks Marvell’s Hosein.

For its part, the board has alluded to a growing number of auditor mistakes. The PCAOB’s inspectors have “identified more issues than in prior years,” James Doty, the overseer’s chairman, said in 2011. “The board is troubled by the volume of significant deficiencies, especially in areas identified in prior inspections.” The assumption is that such errors stem from auditors’ increasingly cozy relationships with their clients. Hence the need for audit-firm rotation.

But a more compelling reason may be the loss of investor confidence following the collapse of many prominent financial-services firms in 2008, starting with Lehman Brothers. “Investor representatives have . . . made clear to the PCAOB that they do not understand how, during the height of the financial crisis, virtually all companies that received government assistance, or went bankrupt, were given clean audit opinions,” Steven Harris, a member of the oversight board, said in a speech last fall.

As long as that question lingers, the regulatory pressure on auditors — and their clients — is sure to grow.

David M. Katz is New York bureau chief and senior editor for accounting at CFO.