Investor confidence is fragile but vital to healthy markets. So, when it comes to the issue of the quality of public company audits, we are troubled to see regulators make alarming assertions that are incomplete and potentially misleading.

In a recent article, the Public Company Accounting Oversight Board’s chief auditor is quoted by the Wall Street Journal as saying, “When we look at an audit, the rate of failure has been in a range of around 35 to 40%.”

Opinion_Bug7How can such a statement not strike at the heart of investor confidence? We believe any inferences about overall audit quality from this alleged failure rate are highly suspect. Because the PCAOB selectively screens audits for inspection, this supposed rate of failure might reflect only that the PCAOB is good at screening. Investors lack a defect rate based on a representative sample by which to generalize.

In addition, and perhaps more important, investors would be better served if the PCOAB stopped conflating audit deficiencies with audit failuresDeficiencies occur when an auditor does not comply with PCAOB standards, including documentation standards. On the other hand, an audit failure is much more serious. The traditional definition of an audit failure is the joint occurrence of an unqualified (clean) audit opinion and materially misleading financial statements.

A couple of years ago, however, the PCOAB began using the term audit failure in a very different way. Specifically, the PCAOB started using audit failure when, in their judgment, the auditor failed to obtain sufficient appropriate evidence to support its opinion on the financial statements, irrespective of the fairness of the financial statements in question. Investors, many of whom we suspect are unaware of the PCAOB’s new and unconventional usage of the term audit failure, may worry unnecessarily that these “failures” portend heightened future restatements of public company’s financials.

Further, even investors who are aware of the PCAOB’s new definition are still left in the dark. This is because there are good reasons to question PCAOB criticism of an auditor’s evidential basis.

One reason is that PCAOB inspections usually occur after fieldwork, so hindsight bias can surface, especially when inspectors try to assess audit work on management’s estimates, which often are predicated on future economic events. That is, inspectors form retrospective judgments about auditors’ judgments regarding the reasonableness of management’s judgments. The management judgments in question concern things like the reasonableness of complex financial-statement estimates or the sufficiency of internal controls. It is hard to manufacture precision at the end of this judgment chain when it starts with so much ambiguity and uncertainty.

Still another reason for caution is that, even when working on the same problem at the same time, professionals in accounting and elsewhere regularly reach different conclusions after careful, good faith judgment processes. If we give tax-return case materials to 10 highly experienced tax professionals, we can obtain 10 different conclusions of tax due. Similarly, before we undergo major surgery recommended by a trusted family physician, we still customarily seek another physician’s point of view because we know second opinions have value.

Since public statements and reports from leading regulators can matter a great deal, we are reminded of the wisdom in the statement made in the opening sequence of the 1980s television show Hill Street Blues — Let’s be careful out there!

Mark E. Peecher is a professor of accountancy at the College of Business at the University of Illinois at Urbana-Champaign. Ira Solomon is the dean of the A. B. Freeman School of Business at Tulane University.

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13 responses to “PCAOB’s ‘Audit Failure’ Rate Is Highly Suspect”

  1. This is absolutely right. The PCAOB has virtually unlimited time to review files vs. the time restraints of actual auditors. Moreover, as government bureaucrats they have a vested interest in finding failures when it is a difference in opinion about how much documentation is necessary.

  2. It’s a good thing Congress put lawyers in charge of the Auditing profession because they’re so much smarter and more ethical than accountants. Let’s hope lawyers can start regulating physicians soon so there won’t be any more sickness.

  3. I am a partner in a CPA firm that only deals with small businesses.
    We have undergone peer review in my firm for over a decade. We have been dinged on many minor issues. A couple medium size issues. But, none of the work done by the peer review ever looked at the actual numbers.

    They look at our documentation to make sure we complied with the standards, and reviewed the financials to make sure we included every note we could possibly have included, but not once did they ever look at if the numbers themselves were correct.

    So, It would not surprise me that PCAOB only looks at compliance with the standards as a failure. They probably never look at if the financial statements are actually correct. They only look at if the workpapers, checklists and other paperwork are all filed out.

    Our profession has entered a time where we are safer, for the most part, ignoring the actual numbers, and spending the entire audit budget on paperwork. Since that is the only thing regulators look at.

    • I couldn’t agree with you any more. I’m currently a A grade staff in an audit firm. It took me more time focusing on the paper work than focusing on the field work. The field work always lasts for 1 week for ordinary entity, but the following-up would take me 2 week or more, which also charges the same job code of the client creating no value and makes me suffer.

  4. I am in agreement with this article. The PCAOB was established, in part, to inspect audit firms in order to hopefully prevent major frauds like those which were occurring at the time Sarbanes-Oxley was written, Enron, etc. However, the PCAOB has morphed into a bureaucratic nightmare for auditors, whereby the PCAOB has become very fastidious, challenging auditors on insignificant items, then seldom listening to auditor rationale, and in the end, writing up the auditor for an audit failure. There is a significant amount of judgment required in performing an audit, and the PCAOB inspectors replace the auditors’ judgment with their own, which is not necessarily any better, but which results in an audit failure.

    • Don’s comment is right in the money. In my view, documentation requirements must be revisited. Even though it may sound counter intuitive, I think that, just like the IFRS v. US GAAP controversies and/or issues, auditing principles and practices, including PCAOB Standards, should be based more on principals and less on rules. Less may be more…I too have been dinged in my peer review with comments that seem really…well immaterial and trivial.

  5. The combination of rapidly expanding expectations and “rules” in the profession have presented a challenge to auditors. Partners too are often distant from the real supervision needed with their field teams due to sales pressure. Many are weary of the constant change in rules and tools. But, at the end of the day, greed for more money and better margins is still a detractor from quality. Self regulation is often ineffective so others, like the PCAOB, step forward with their perspectives. If we could solve the real human issues, lack of authenticity, transparency, integrity, etc., then the rest would fall in place, but much of the world refuses to even try to repair those broken pieces. Just watch 30 seconds of the evening news….

  6. As a staff auditor, who has began working two years earlier, I most likely don’t have the historic refrence to comapre the current working conditions against the work performed prior to PCAOB. However, it often seems rather redundant and unnecessary to perform hours worth of documentation that the team performs. It not only makes the work boring and frustrating for the team, it takes away the precious resource (time) that auditors don’t have.

  7. Amen. There have been many criticisms of the PCAOB’s loosely used “audit failure” when they are really deficiencies. Even some SAG members have criticized this loose characterization. One might also look at the quality and experience of the reviewers who are making these calls. another area is materiality of the comments, no one knows whether the “deficiencies” are material. Does the PCAOB require the firm in question to revisit a client, perform more work, or edit documentation. Are they talking about major corporations, mid caps or small caps, just how serious are the deficiencies.
    the current PCAOB report makes no effort as is done in the UK to classify its findings or even render an opinion on the audit practice of the firms in question.
    Having been a member of the SECPS Peer review committee, firms performing reviews at least rendered an opinion of sorts. Granted this process has been discredited, but at least there was some attempt to render a conclusion. The current approach and reporting is merely an aggregation of “called strikes” which is meaningless without context.

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