Audit Relationships More Challenging Than Audits

A new PCAOB document on how to improve relations between audit committees, audit firms, and CFOs should help, but more work is needed.
Kathy HoffelderAugust 2, 2012

The Public Company Accounting Oversight Board (PCAOB) issued a document yesterday aimed at improving transparency between audit committees and external audit firms, and reeducating industry participants on what its inspection reports are all about. While the document could help improve financial reporting, a lot more work needs to be done on the interactions between audit committees and external auditors as well as those between CFOs and audit committees, say experts.

Why all the fuss about PCAOB audit inspections? In the past, PCAOB inspections of company audits have raised more questions than they answered. While some of that confusion can be blamed on companies’ audit committees for not asking the right questions of their auditor in the first place, committee members and executives also do not fully understand PCAOB audit-inspection procedures.

CFOs and company boards have routinely scoffed at the lack of information when their company’s audit is selected for PCAOB inspection. The confusion comes into play because some aspects of the audit report are public, but if a deficiency in an audit firm’s quality control is discovered, for example, the PCAOB is prohibited from releasing the data publicly. Similarly, the PCAOB cannot compel an audit firm to disclose nonpublic inspection information to an audit committee. Last May the PCAOB told CFO it was working on a proposal to improve its communications with audit committees.

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The oversight body’s new document hopes to coach audit committees on what to ask their auditors about PCAOB findings. Audit firms themselves have been criticized for disregarding the importance of audit-inspection reports. On the other hand, audit committees rarely challenge the results of the external audit when it is first performed, since too often they don’t have the expertise.

The PCAOB is trying to repair this disconnect by outlining better methods of communication. “Getting the information about these reports to audit-committee members will give them another [valuable] tool to do their important job,” said PCAOB chairman James Doty on a conference call Wednesday. “The audit committee plays a mission-critical role in a company’s financial reporting.”

Paula H. J. Cholmondeley, audit-committee chair for Nationwide Mutual Funds and a member of the audit committees of Minerals Technology and Albany International, has a few ideas on how to improve audit-committee relations inside a company.

At an American Institute of CPAs (AICPA) forum in New York this week, Cholmondeley noted that CFOs need to bring their audit committees into the loop sooner to fully improve transparency. The challenge, she finds, is that most CFOs wait far too long to address a problem with the committee. “They have an issue. They are not quite sure it’s a problem so they don’t want to tell you about it yet,” she said. “That is one of the biggest areas of risk: when the audit committee doesn’t find out about something until it’s too late. The organization is too far into the issue.”

And it’s not just the CFOs that are the problem, said Cholmondeley. Other members of an audit committee besides the chair should step up and communicate more with company executives, she noted. “There’s a tendency to focus on the audit-committee chair. I think the audit-committee members should also have a relationship with the CFO and CEO,” she said. “You really do have a whole committee and it really is important to use that whole committee.”

The relationship between a CFO and an audit committee has to be based on trust, Cholmondeley maintained. One way to keep that trust is to set up regularly scheduled phone calls between the CFO and the audit committee.

Nell Minow, co-founder of independent research and ratings firm GMI Ratings, would take that concept one step further. Not only does she recommend closer ties between the CFO and audit committee, but she favors CFOs reporting directly to the audit committee, not the CEO. “It would still be the same job, but the CFO would not have to worry about the consequences of raising problems with the CEO,” she says.

This kind of reporting structure, she adds, could help with transparency issues. “We’ve seen a lot of problems in the past from having CFOs who can be overruled by the CEO,” says Minow. “He or she should be encouraged to present bad news in a very forthright and candid way. Who has the incentive to prevent that? It’s not the board; it’s the CEO.”

Others, though, say that arrangement could alter the focus of a finance chief’s job from one centered on operations to one more concerned with governance. But Minow disagrees, noting that having a CFO report to the audit committee is the only way to ensure that a CFO could not be replaced by a CEO and would be held to standards set up by the audit committee instead.

Aside from reporting structures, some experts think CFOs’ pay should be changed to motivate them to communicate better with audit committees and audit firms.

At the AICPA’s audit forum, Steve Austin, audit-committee chairman of Avanir Pharmaceuticals and managing partner of regional accounting and tax consultancy Swenson Advisors, said CFOs should be rewarded for good governance practices as opposed to just the bottom line. The old model of rewarding short-term financial gains over long-term values needs to be altered, he said. Companies now need to say, “I’m going to reward you financially for these kinds of values,” said Austin.