Who Is the Auditor’s Client? Addressing the ‘Elephant in the Room’

Ask any auditor who they consider their client, and a good bet is they almost always say it’s the company. No matter what reforms the Public Company Accounting Oversight Board (PCAOB) and the International Auditing and Assurance Standards Board (IAASB) undertake to enhance the independence, objectivity, and professional skepticism by the independent auditor, the “elephant in the room” will remain that management negotiates and pays the audit fee. But in fact, it is the investors who pay the fee and who trust the auditor to protect their investment interests. The investor is the client.

An illustration of how an outsider might interpret where auditors show their allegiance, look at EY Global Limited’s 2013 annual earnings announcement, and count how often investors are mentioned. Zero. Even more telling is the EY Global Review 2013. “Client” is used more than 150 times, and “investor” is used a mere four times. Through this simple comparison, it seems clear who is top of mind for them.

If the business model were changed, many, if not all, matters associated with independence would suddenly disappear. Accomplishing this wouldn’t be easy, but that is no reason not to tackle it.

At a recent meeting of the PCAOB Investor Advisory Group (IAG), an investor working group was tasked with offering suggestions on reforming the audit firm business model and incentives. The following suggestions are taken directly from their presentation on potential reforms for how audit fees might be negotiated and paid (the first of which is likely to shock you):

Step 1 Eliminate the requirement in the federal securities laws mandating an independent audit be performed.

Step 2 Replace the government mandate with a requirement that companies hold a shareholder vote on whether to require an audit every three to five years. This would leave this important decision up to investors, a market-driven approach.

Step 3 Investors would vote annually on the appointment of auditors. Prior to the vote at the annual shareholders meeting, investors would be provided disclosure of audit quality indicators for their specific audit.

Step 4 Annually, the audit committee would negotiate the audit fee with the independent auditors. It would be the obligation and responsibility of the audit committee to negotiate the fee, not management.

Step 5 The PCAOB would collect a fee from each company, as they do now, that would cover the expected audit costs. From the pool of audit fees collected, the PCAOB would pay the audit firm for the audit services.

Step 6 The PCAOB could require a change in an auditor when, as a result of an inspection, it found the auditor had not followed generally accepted auditing standards in the performance of the audit.

To be sure, much thought would need to go into how to practically change the business model. In the meantime, perhaps as an initial step, investors should be given a “say on auditor pay” similar to executive compensation. In essence, each year investors should be given details of the proposed audit fee and an opportunity to approve or reject the recommendation. In this way, the general perspective of “who the client is” might change.

This IAG working group attempted to tackle a tough issue and continues to keep attention on the “elephant in the room.” Changing this paradigm, where auditors are beholden to management when in fact investors are the client, is essential to fully resolving independence and objectivity challenges.

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Photo credit: iStockphoto.com/vicnt