When auditing the financial statements of their clients, one of the principal goals of an auditor is to be fair and independent. However, meeting this goal has proven to be a difficult feat. Although auditing companies like the “Big Four” are partially to blame, fault may also lie with the agencies that monitor auditors.[1] The agencies that monitor auditing firms may be apprehensive about setting bright-line rules delineating when an auditing firms’ actions compromise fairness and independence.
Auditing firms can be monitored by several organizations including the American Institute of Certified Public Accountants (“AICPA”), the Financial Accounting Standard Board (“FASB”), and the Public Company Accounting Oversight Board (“PCAOB”).[2] These organizations are not independent of each other, but instead are considered to be an “integrated system.”[3] The Securities and Exchange Commission (“SEC”) works closely with these agencies to ensure independence in auditing reviews.
Despite the concerted efforts of all these organizations, several auditing firms have come under fire for failing to be fair and independent when auditing their clients. Scott Marcello, KPMG’s top auditor, was fired along with four other partners for “mishandling [] a tip that gave the firm improper advance word about which of its audits its regulator planned to scrutinize in its annual inspections.”[4] This is particularly problematic because “[t]he leaked information could have given KPMG a leg up in preparing for the PCAOB’s inspection.”[5] Though it is not clear how the partners became privy to the leaked information, KPMG released a statement in April admitting that the company failed to make a timely report of the incident.[6] Just last year, Ernst and Young agreed to pay approximately $152 million to investors who were harmed by an accounting fraud related to “failed audits of an oil services company that used deceptive income tax accounting to inflate earnings.”[7] Two partners agreed to settle their charges after the SEC determined that they had ignored “significant red flags during audits and reviews.”[8] Despite periodic inspections, agencies like FASB, PCAOB, AICPA, and the SEC are unable to eliminate huge auditing failures within the accounting profession.
In response to these accounting scandals, regulators have considered implementing strict rules to prevent collusion between the auditing firms and their clients. One such rule entails a mandatory audit firm rotation (“MAFR”).[9] Under this system, auditing firms would be forced to change their clients on a periodic basis.[10] It seems logical that such a proposal could ensure the quality of audits by reducing the number of years an auditing firm can serve a specific client. However, research suggests that the drawbacks of the MAFR may not outweigh its benefits.[11] A major issue with the MAFR concerns the significant switching costs: costs borne by the auditor and the client when an auditing-client relationship ends.[12] Another huge concern entails the loss of “specific knowledge” that only an auditor would know after working with the same client for an ongoing period of time.[13] A study compared the time-length of an auditor-client relationship to instances of fraud and abuse.[14] The results of the study showed that longer auditor-client relationships are not associated with auditing failures, thus confirming that the MAFR is ineffective in ensuring fairness and independence.[15]
AICPA has also attempted to improve auditing quality, but without establishing bright-line rules.[16] In 2014, the AICPA updated and reorganized its Code of Professional Conduct, which “mandates [auditors]to act with integrity and objectivity, maintain independence, and exercise due professional care and competence when performing audit and attest services for clients.”[17] The AICPA has proposed “updating the CPA exam to increase assessment of higher-order skills, such as professional skepticism and critical thinking.”[18] Though these proposals are proactive ways of improving audit quality, determining whether this Code is actually influencing and changing the way auditing occurs is difficult.
Another widely discussed option is to have a committee of external directors select a company’s external auditor.[19] J. Royce Fichtner argues that by having “the external auditor only answer to a committee of external, non-employee directors, [the auditor]would be more likely to perform its audit function in a robust and unbiased manner and less likely to capitulate to the demands of an overzealous management team.”[20] Academic research suggests that though this method does not have a negative impact on the auditing process, studies are inconclusive as to whether its benefits are significant enough to warrant the use of an external auditing committee.[21]
Despite the lack of bright-line rules for ensuring independent auditing, there is reason to believe that fewer financial reporting issues have arisen in recent years.[22] This may be an indication that the methods and rules already in place are working and that the use of strict rules might be too risky and cause more harm than good.
[1] The Big Four consists of PricewaterhouseCoopers LLP, Ernst & Young LLP, KPMG LL and Deloitte & Touche LLP. See Michael Rapoport, Big Four Accounting Firms Show Fewer Problem Audits, Wall street J. (Dec. 12, 2016), https://www.wsj.com/articles/big-four-accounting-firms-show-fewer-problem-audits-1481553252.
[2] Suzanne Whitehead, Accounting, Business, Government, AICPA, FASB & PCAOB: Roles, Impacts, Accounting Issues, Panmore Inst. (Jul 1, 2015), http://panmore.com/aicpa-fasb-pcaob-roles-impacts-accounting-issues.
[3] Id.
[4] Michael Rapoport & Dave Michaels, Fired KPMG Audit Head: How Did Scott Marcello Fall From Grace?, Wall street J. (Apr. 16, 2017), https://www.wsj.com/articles/fired-kpmg-audit-head-how-did-scott-marcello-fall-from-grace-1492371198.
[5] Id.
[6] Id.
[7] Press Release, Sec. Exch. Comm’n, Ernst & Young to Pay $11.8 Million for Audit Failures 2016-219 (Oct. 18, 2016), https://www.sec.gov/news/pressrelease/2016-219.html.
[8] Id.
[9] Sarah A. Core, Only Fools Rush in: Mandatory Auditory Firm Rotation and the PCAOB, 17 N.C. Banking Inst. 137, 139 (2013).
[10] Id.
[11] Mara Cameran, Giulia Negri & Angela Pettinicchio, The Audit Mandatory Rotation Rule: The State of the Art, J. of Fin. Perspectives, July 2015, at 26.
[12] Id. at 11.
[13] Id.
[14] Marshall A. Geiger & K. Raghunandan, Auditor Tenure and Audit Reporting Failures, American J. of Practice and Theory, March 2002.
[15] Id. at 75.
[16] Ken Tysiac, A 6-Point Plan to Improve Audit Quality, J. of Accountancy (July 1, 2015), https://www.journalofaccountancy.com/issues/2015/jul/improving-audit-quality.html.
[17] Id.
[18] Id.
[19] J. Royce Fichtner, International Audit Committee Independence Requirements: Are Policymakers Putting the Academic Research to Use?, 13 Atlantic L. J. 117, 118 (2011).
[20] Id. at 118.
[21] Id. at 131.
[22] Michael Rapoport, Big Four Accounting Firms Show Fewer Problem Audits, Wall street J. (Dec. 12, 2016), https://www.wsj.com/articles/big-four-accounting-firms-show-fewer-problem-audits-1481553252.
