More audit transparency for investors makes a bitter proposal easier to swallow

When it comes to auditing financial information, under current professional rules, only the name of the auditing firm appears at the bottom of audit reports.

That is about to change.

The Public Company Accounting Oversight Board (PCAOB) has recently issued its latest attempt to require disclosure of the name of the person who oversaw an audit of a comany’s books, making it binding federal law. All US publicly traded companies are required to have an accounting firm audit their financial statements.

Is this a good thing? Maybe, maybe not. Disclosure of the name of the partner in charge of a public company audit is one the biggest changes to auditing standards I have seen in more than 30 years as a certified public accountant. It may not seem like a big deal to those outside my profession, but it should matter a lot to investors, because the PCAOB and others see it as a critical piece of the debate about the usefulness of the financial information investors rely upon when making investment decisions.

And it’s during times of stock market turmoil like we see today or when accounting scandals reach the front pages such as Enron’s that this long-simmering debate gets renewed attention. When a company’s stock price drops, investors get really interested in who is responsible for the financial information they claim to have relied upon when they bought the stock – and who they might sue to recover their losses.

But despite objections from auditors – myself included – it is time to accept the inevitable and enact the plan, because this latest proposal is a more balanced alternative compared with other approaches we’ve seen in recent years. And more importantly, it includes a separate rule that will go a long way toward helping investors assess the quality of a corporate audit – and whether they should put their money elsewhere.

The PCAOB plan

The PCAOB believes disclosing the signing partner’s personal identity is critical to protecting the interests of investors – that is, all of us who invest in stocks, bonds and mutual funds directly or through employee benefit plans at work.

The latest proposal seeks to include the name of the actual auditor who prepared the report in a separate form filed with the PCAOB, a new document called Form AP (for audit participants). The contents of this form will be posted to the PCAOB website and will be fully searchable.

This alternative approach put forth by the PCAOB is an improvement over previous proposals that would have required auditors’ names and signatures to be included directly in the report itself. Auditors objected to this because of valid concerns of increased risk of being sued by unhappy investors by signing their own names along with their firms’ names, while proponents argued that increased personal liability would improve audit quality.

I disagree with the proponents. Audit partners already fully understand that regulatory censure and litigation under existing rules can ruin their careers.

Problems with the approach

The PCAOB says its goals are transparency and increased accountability. However, audits are performed not by one person but by a multi-member engagement team supported by a quality review partner, internal specialists, consulting partners and the entirety of the auditing firm.

Naming the signing partner puts too much focus on one individual and distorts the reality of the audit process. Listing one person’s name when in excess of 50 people have had a hand in preparing the final report creates a target, not transparency.

Auditors are also already acutely aware of their responsibilities. We have more-than-adequate methods in place to maintain accountability, such as inspection processes, enforcement by the Securities and Exchange Commission, peer review, internal firm inspections and private litigation.

Concerns also remain about misinterpretation and misuse of the disclosed partner names. The reasons for restatements or revised opinions are often complicated, and to attribute accountability to one individual is too simplistic and often unfair. The inevitable lists of “bad partners” will not benefit anybody.

Research cited by the PCAOB in previous proposals is of limited value because studies involve primarily private companies located outside of the United States. For example, one study often cited by the PCAOB includes only statutory audits of private companies in Sweden – clearly not representative of public companies and the litigious environment that exists in the United States today.

The limited research in these studies does not appear to indicate any significant impact on audit quality when the partner is named.

Plan still boasts benefits

But this new rule does more than just list individual audit partners, and this is where the true benefit to investors lies.

Because the signing auditing firm often engages other firms to perform significant portions of cross-border audits, the new proposal will require that they disclose the names and locations of any other firm that provides at least 5% of the total audit hours for any given report. This includes affiliates and non-affiliates of the primary (signing) firm.

This is good because audit quality differs materially among various countries due, in part, to cultural factors and the prevailing regulatory environment in each. It is important for users of financial statements to understand which public accounting firms are actually performing the audit work and where they are located, because many recent accounting fraud cases in the US have involved poorly supervised foreign firms performing low-quality audits.

If investors are aware that the signing firm in the US is performing only minimal work while a foreign audit firm incurs most of the audit hours, many investors might change their investment decisions because of a reduced level of confidence in the audit report. Improved audit quality from this disclosure is a real possibility, and that’s the change we need.

In spite of some reservations about certain elements, this new proposal should be supported for continuing to seek a reasonable compromise on a contentious topic in the face of significant criticism. Investors and the public will be better off because of it.

Jeffrey L Johanns does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.