Audit Quality Indicators: An Integral Part of Transparency
CFA Institute recently responded to the Public Company Accounting Oversight Board’s (PCAOB) Concept Release, Potential Approach to Revisions to PCAOB Quality Control (QC) Standards.
Regarding communication, the Concept Release says,
We anticipate that a future PCAOB QC standard would include requirements that expressly address required communications by the firm or engagement teams to audit committees, the SEC, the PCAOB, or otherwise as required by law, regulation, and PCAOB standards and rules (for example, communications under Section 10A of the Exchange Act, AS 1301, Form AP, or Form 2, or in conjunction with company listing requirements).
CFA Institute believes this proposal is insufficient. The details of the quality control system of each audit firm should be fully communicated to the users of financial statements, including investors, given that the proposed standard is meant to accommodate US public company audits — that is, companies that are public because of their listing. Firms should be required to provide disclosures of audit quality and quality control, including audit quality indicators (AQIs), and explain how the firm responds to identified deficiencies. We believe the PCAOB should complete its project on audit quality indicators.
We agree with the Council of Institutional Investors (CII) that firms should be required to establish quantifiable performance measures for the achievement of quality objectives. Audit quality is not an elusive concept. Quality metrics are part of every manufacturing process. An audit is not so subjective that it cannot include metrics to judge quality. Indeed, audit quality is measurable through AQIs and the transmission of such information to investors (buyers).
CII states, and we agree, that a portfolio of properly chosen AQI’s of engagement-level and firm-level data would be useful to investors. As indicated in the Concept Release, “investors are the primary beneficiaries of the financial reporting process and the group at which audit quality is ultimately aimed,” yet investors have limited data available to them regarding audit quality. As we noted, the issue of how to improve quality and communication (transparency) to investors requires attention. With more information, investors will be able to better judge the quality of the audit; the price paid for the audit; the effectiveness of the audit committee in overseeing the auditors from selection, risk assessment, the performance of audit procedures, and reporting of results; and the effectiveness of regulators. Only with increased transparency can buyers of audit services (i.e., investors) and sellers of audit services (i.e., auditors) communicate and reduce the agency issues associated with the audit selection process.
The CII letter outlines that an audit quality report of a larger audit firm should include, at a minimum, a qualitative discussion of the following:
• How they define the US firm and its relationship with foreign affiliates
• How the firm performs individual audits
• How they run the business
• How they think about the role and relevance of the auditing profession
• How they train audit personnel
• How they compensate and incentivize audit professionals
• How they invest in new and enhanced audit technologies
• How they have designed the firm’s governance and structure
The discussion also should include information that would inform an audit committee’s or investor’s consideration of the audit firm’s commitment to factors that affect audit quality.
It would be helpful if audit committees were required to provide an independent certification to shareholders that they are satisfied with the report that they have received about audit quality measures put in place by their audit team. This certification would provide an additional and perhaps significant push to ensure that audit quality is front and center in terms of partner incentives. It also would mean that audit committees have significant incentives to focus on quality above price.
To further support transparency, we believe the PCAOB needs to be more transparent and timely with its inspection reports.
Image Credit @ Getty Images/Martin Barraud