Auditor Reporting Model Modifications: Practical Insights from the ...

Current Issues in Auditing Volume 6, Issue 1 2012 Pages C7–C14

American Accounting Association DOI: 10.2308/ciia-50122

COMMENTARY

Auditor Reporting Model Modifications: Practical Insights from the Academic Community Hubert D. Glover and Matthew Reidenbach SUMMARY: Public Company Accounting Oversight Board (PCAOB) Concept Release No. 2011-003 (PCAOB 2011a) proposes changes that may require auditors to disclose qualitative information about management and the audit. While there is evidence that a change may be necessary, it is unclear how the proposed changes would impact auditors. Based on our practitioner and educational experiences, we discuss potential impacts of these proposed changes on the current audit environment. We provide insights and recommend that the PCAOB perform additional research concerning this proposed standard prior to implementation to gain a more thorough understanding of all relevant issues. Keywords: audit reporting; audit education; audit practice.

INTRODUCTION As part of its current standard-setting agenda, the Public Company Accounting Oversight Board (PCAOB) released Concept Release No. 2011-003 (PCAOB 2011a) to address potential changes to the auditor’s reporting model. In the concept release, the PCAOB attempts to address an underlying ‘‘expectations gap’’ between what investors want an audit (and the auditor’s report) to provide and what an audit actually provides. Nowhere is this issue more relevant than with respect to the content of the standard audit report. From a historical perspective, the audit report has undergone numerous modifications to reflect stakeholders’ desired changes. Over time, the audit report has been transformed from a long-form, detailed report to a predominantly standardized report.1 Investors argue that auditors should discuss ‘‘subtleties that underlie the opinion in his or her report on the company’s financial statements’’ (PCAOB 2011a, 9). Four different issues proposed Hubert D. Glover is a Clinical Associate Professor and Matthew Reidenbach is a Ph.D. Candidate, both at Drexel University.

The authors thank Hsihui Chang, Tony Curatola, Barbara Grein, George Tsakumis, and journal editors Dorsey Baskin and Richard Houston for their feedback on the authors’ views expressed in this paper.

Submitted: November 2011 Accepted: January 2012 Published Online: January 2012 1

We refer interested readers to pages 2–7 of the briefing paper for the PCAOB Standing Advisory Group’s April 7, 2010 meeting (PCAOB 2010) for an excellent in-depth discussion of the transformation of the audit report. Available at: http://pcaobus.org/Rules/Rulemaking/Docket034/Concept_Release.pdf.

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in the concept release would impact the audit report or the reporting process directly, including (1) providing a supplement to the auditor’s report, referred to as Auditor’s Discussion and Analysis (AD&A), (2) expanding the use of emphasis paragraphs, (3) reporting on information outside of the financial statements, and (4) clarifying phrases used in the current audit report. In practice, this concept release would require auditors to provide insights into either specific audit procedures performed during fieldwork or, as most investors hope, into auditors’ views concerning specific risks and accounting treatments implemented by management.

PRIOR ACADEMIC RESEARCH Over the past 30 years, accounting scholars have considered numerous issues related to how investors utilize audit reports (Church et al. [2008] provide a comprehensive review). A recent series of studies considers how sophisticated analysts and non-professional investors use audit reports. Turner et al. (2010), citing Mock et al. (2009), provide evidence that non-professional investors do not use audit reports at all, and that analysts pay attention to the existence, but not the form, of audit reports. Coram et al. (2011) extended these studies, noting that the ‘‘standard nature’’ of the unqualified audit report causes analysts to not consider audit report content in corporate valuation analyses. These findings imply that financial statement users need information beyond the standard audit report to assist with investment decisions. From an audit practitioner’s perspective, there are some important difficulties involved with requiring a ‘‘non-standard’’ audit report. In particular, if qualitative information related to the auditor’s view of management’s accounting decisions and key business risks is involved, as proposed by the PCAOB (2011a), significant challenges to the delivery of audit services are likely to occur. We discuss two specific items proposed in the concept release in greater detail: creating the audit equivalent of Management Discussion and Analysis (i.e., the AD&A), and providing assurance on information outside of the financial statements. As noted in the following sections concerning qualitative information, these two proposals present clear challenges and issues to the practice of auditing and related delivery of assurance services. At the same time, with respect to the other two aspects of the PCAOB’s proposal, we are uncertain about how the increased use of emphasis paragraphs and clarification of current phrases will impact audit practice. While it is possible that they may improve investors’ understanding of the audit, they may adversely impact audit practice by either confusing the investor with unclear terminology about the nature of audits (e.g., defining ‘‘reasonable assurance’’) or confusing investors via information overload resulting from emphasis paragraphs cluttering the audit report. In any case, these issues are beyond the scope of this commentary.

POTENTIAL CHALLENGES OF PROVIDING AN AUDITOR’S DISCUSSION AND ANALYSIS TO INVESTORS Our view concerning the proposed AD&A is that the proposed changes would introduce significant issues that could adversely affect auditing practice. One author has recent experience as a lead audit senior for an accelerated filer, while the other has experience as an auditor for an accelerated filer, an office practice leader for an audit firm that handled accelerated filers, and as the chair of an accelerated filer’s audit committee. Based upon our diverse practical experiences in the current environment, we present unique implementation challenges for both auditors and audit committee members related to this proposal. Current Issues in Auditing Volume 6, Issue 1, 2012

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AD&A Background As noted previously, the PCAOB (2011a) proposes that auditors provide direct representations to stakeholders. Based upon our experience and the PCAOB roundtable discussion on September 15, 2011 (PCAOB 2011b), there are two potential areas of additional qualitative disclosure. These include the auditor’s opinion on management’s accounting quality for a list of critical accounting policies and estimates (e.g., revenue recognition) and areas that involve significant negotiation between the auditor and management regarding proper accounting treatment. While the form and nature of the required disclosure remains uncertain, we believe that requiring auditors to disclose their views concerning the quality of management’s accounting methods places them in the role of a preparer rather than their traditional assurance role. Further, requiring auditors to disclose a list of significant accounting method negotiations usurps the audit committee’s responsibility. As an agent of the company’s shareholders, the audit committee is charged with receiving this communication at the end of the financial statement audit, to ensure that they comprehend the auditor’s work and to assess the overall impact upon the company. Because audit committees are required to be independent and have a financial expert, our view is that if the PCAOB believes that management cannot be relied upon for adequate reporting of accounting method disagreements, the audit committee is well equipped as an independent party to provide any additional qualitative disclosure about accounting method negotiations. Nevertheless, despite our view about the impact of this proposed standard, the PCAOB should conduct research to ensure that investors could benefit from an AD&A that reports qualitative information about the audit and, if so, what the most beneficial format and frequency (e.g., annually, quarterly) of this report would be. Audit Committee Perspective For audit committees, there are several issues of concern related to reporting qualitative information about management. First, because of the important reforms instituted under the Sarbanes-Oxley Act of 2002 and, in turn, by the New York Stock Exchange, audit committees have an enhanced role in providing financial governance. Beasley et al. (2009) interviewed 42 audit committee members, noting that these individuals are involved in reviewing and discussing critical accounting policies with auditors (see Beasley et al. 2009). As a result, audit committees meet at least quarterly to discuss the results of the auditor’s work and independently assess its impact on the company as a whole. Requiring auditor disclosure of qualitative information, particularly if related to the auditors’ views concerning accounting matters, would further increase audit committee members’ workload beyond an already high level. Second, and perhaps more important, the composition of the audit committee may need to be reconsidered in light of the increased auditor disclosure requirements. As part of the SarbanesOxley implementation rules issued by the Securities and Exchange Commission (SEC 2003), all audit committee members must be independent, and at least one must be a financial expert. However, the definition of financial expertise includes those who have experience supervising a principal financial or accounting officer and those with ‘‘other relevant experience.’’ In practice, individuals such as former CEOs and lawyers often are considered to be financial experts even though they may not be equipped to provide guidance on accounting matters. Academic research has provided evidence of more conservative accounting by companies with strong corporate governance, as evidenced by instances in which audit committee financial experts have accounting backgrounds (Krishnan and Visvanathan 2008). Current Issues in Auditing Volume 6, Issue 1, 2012

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If the proposed guidance on qualitative information is enacted, the importance of accounting expertise on audit committees is likely to increase, because these experts likely would be required to serve as arbiters of accounting method judgments between management and auditors. Without an accounting expert, audit committees will have to make subjective accounting decisions without having prior professional experience in accounting for disputed issues. In particular, validating the appropriate accounting methods for subjective issues (e.g., revenue recognition policies) would become more difficult and time consuming for the audit committee because they would have to review the relevant guidance cited by both management and the auditor to determine whether management’s accounting policy choice is appropriate. An almost certain result would be a time delay in the overall reporting process. While adding an accounting expert to the audit committee may not be a realistic possibility for all companies, this additional AD&A reporting requirement raises the stakes for the audit committee because accounting disagreements between client management and the auditor would become public and subject to scrutiny. Under adverse circumstances, if an overly aggressive accounting decision was related to a major financial loss for the client company, it is possible that the circumstances surrounding the accounting disagreement would become evidence in a director negligence lawsuit. Consequently, premiums for directors and officers liability insurance could increase due to this increased external reporting by the auditor. Auditor Perspective First, requiring auditors to provide qualitative information about client audits would increase the time required to complete the reporting stage of the audit. Despite the increased use of interim audit testing, many audit teams must work virtually around-the-clock at year-end in order to complete their work by management’s regulatory filing deadline. By adding the proposed reporting requirements, and given the relatively minimal change in audit fees since the financial crisis of 2008, it is possible that some combination of cost efficiency and audit effectiveness will have to be sacrificed to meet the new requirements. While it is possible that audit firms may be able to raise their audit fees because of this additional work, we believe that an increase is unlikely given that audit fees have remained flat in recent years despite a more difficult audit climate. Second, requiring qualitative audit disclosures could, in essence, increase audit risk because of the imposition of additional compliance activity necessary to generate the audit report. From a management and logistical perspective, adding more audit staff to an engagement will not resolve this increased audit risk. Despite any increase in audit staff, there are only a limited number of individuals involved with recording accounting information (the client) and a limited number of individuals involved in the ultimate review process for the audit work (the audit manager, audit partner, and the review partner). During the year-end audit at one of the author’s former audit firm, a labor-intensive review process was utilized for all public company audits, under which all substantive testing working papers for accounts identified as significant risks during audit planning were reviewed by an audit team manager, audit partner, and an outside review team. While incredibly valuable from a risk-mitigation perspective, these reviews constrained the amount of time that senior leadership could spend on other areas during the audit’s reporting phase. It simply is not practical to assume that audit firms of any size can realign staffing resources to accommodate what is already a challenge—meeting the demands of deadlines, especially during busy season. Finally, it is likely that the disclosure requirement will have a more adverse impact on audits of small-to-midsize companies that do not qualify as large accelerated filers per the SEC. While large Current Issues in Auditing Volume 6, Issue 1, 2012

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accelerated filing companies have vast resources in both their financial and legal departments that may allow them to cope with additional reporting requirements, smaller companies have relatively fewer resources to help auditors obtain the accounting information necessary to develop the required disclosures proposed by the PCAOB. Because of these reduced resources, we expect additional disagreements. This expectation is based upon our experience that there is an increased likelihood of accounting errors and a smaller pool of capable audit committee members available to these companies. For some of these companies, auditors may be more likely to disagree with management’s evaluation of their accounting policies and, in turn, disclose this in their AD&A. While there is likely a benefit from AD&A disclosure for investors if the current auditor retains the client (because accounting discrepancies should be resolved in future periods), it is possible that this benefit may not be realized due to an auditor change. We believe that there are two distinct scenarios in which auditor changes may occur. First, auditors may resign from these clients to devote their labor resources to higher-quality clients. In the period following the Sarbanes-Oxley Act, auditor switches from Big 4 firms to third-tier audit firms were associated with a positive market reaction due to a desire for higher-quality service (Chang et al. 2010). It is possible that a similar shift to smaller auditors for smaller companies could occur due to accounting disagreements under the AD&A reporting requirements if the original auditor believes that the audit risk for these smaller companies is too high to justify continuing the relationship. Second, the company may fire the auditor in order to hire a new auditor that will make fewer comments in their AD&A. In either case, the new auditor may not share the predecessor auditor’s view on the disclosed accounting disagreement, and accounting quality could suffer if the company’s accounting position is not acceptable under U.S. GAAP. Implications of an AD&A for Investors While both auditors and audit committees are likely to face challenges implementing this proposed guidance, investors are the ultimate recipients of the additional information. However, even for this group of stakeholders, we believe that there could be adverse consequences from this additional disclosure. Requiring auditors to report on management’s accounting quality could confuse investors because they may interpret the auditor’s AD&A disclosure as a type of qualification to the audit opinion. If investors misinterpret this disclosure in this way instead of interpreting it as merely highlighting areas of significant accounting judgment, several potentially adverse consequences may occur. There may be a reduction in the credibility of the appropriateness of client accounting policies, reduced investment in the client company, and an increase in auditors’ litigation risk if investors’ view of the quality of management’s accounting treatment for an issue falls out of favor in the future. As a result, auditors may become less confrontational with management on some of these critical accounting policies for fear of losing the client engagement or discrediting management’s credibility for proper accounting judgment if a disagreement is disclosed to stakeholders.

POTENTIAL ISSUES WITH AN AD&A FOR THE PCAOB INSPECTION PROCESS Since the formation of the PCAOB, an additional layer of auditor review has existed. Adding additional qualitative information disclosures would ostensibly be subject to PCAOB inspection. If the concept release is passed and auditors’ disclosures contained qualitative AD&A information, Current Issues in Auditing Volume 6, Issue 1, 2012

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PCAOB review comments could be of a subjective nature and may not noticeably improve future audit work. This possibility could lead to difficulties for auditors when complying with PCAOB inspections and, additionally, could lead to misunderstanding by other stakeholders if the full inspection reports become public as part of the current U.S. Senate proposal (Ackerman 2011). Because the PCAOB focuses on key risk areas in their inspections, these key risk areas are likely to overlap with the areas of qualitative auditor disclosure proposed by the PCAOB. It is possible that the PCAOB could become a de facto third party in determining client companies’ accounting policies, because they could conclude that the auditor did not adequately evaluate management’s accounting methods for these key risk areas. Based on this disagreement, the PCAOB may question the completeness of the auditor’s work in other audit areas and conclude that the audit was substandard. Because it is difficult for auditors to fully communicate the scope and nature of the audit given the short timeframe of a PCAOB review, we believe that there is an increased likelihood for disagreements between the audit firm and the PCAOB in future inspections. While we agree that it is beneficial for the PCAOB to protect investors from auditors that perform substandard work, it is difficult to support an inspection process that could involve the PCAOB second-guessing an auditor’s qualitative AD&A disclosures because it could destroy that audit firm’s reputation, even if the qualitative disclosure was made in good faith.

POTENTIAL ISSUES WITH AUDITOR ASSURANCE OVER MANAGEMENT’S DISCUSSION AND ANALYSIS As proposed in the PCAOB’s concept release, requiring that auditors provide assurance over Management’s Discussion and Analysis (MD&A) could result in a wide range of additional audit reports. While the current debate includes auditor assurance over other management disclosures (e.g., quarterly earnings releases), our discussion considers the proposal for assurance on MD&A, as it was the primary focus of the PCAOB roundtable debate (PCAOB 2011b). Under SEC regulations, management is required to provide a variety of information for investor decision making, including a discussion of qualitative risks that the company faces, critical accounting estimates, legal proceedings, and other key operational information. When the SEC established the requirement for the MD&A in 1968, its purpose was to have management provide further support for their representations to stakeholders, most notably investors. If the requirements are limited to historical information regarding critical accounting estimates already reviewed by auditors as part of the financial statements, it is possible that the overall impact on the length of the audit process may be minimal. However, if auditors also must provide assurance over other sections of the MD&A, we believe that there are significant implications. In the current litigious environment that auditors face in the United States, even a cursory review of the 10-K filing can take multiple weeks to complete because of the significant number of disclosures provided by management under SEC regulations. As required by the PCAOB (2001) and discussed in Cohen et al. (2008), auditors must verify that the information in the MD&A is materially consistent with the financial statements and the footnote disclosures. Because large accelerated SEC filing companies only have 60 calendar days from their fiscal year-end to submit Form 10-K (75 days for accelerated and 90 days for non-accelerated filers), any additional requirements in the reporting process would necessitate that auditors complete their fieldwork even faster than currently required. Auditors have neither experience developing these types of forward-looking disclosures, nor the legal safe harbor that management receives when providing the MD&A. Therefore, it is likely that audit firms would need to either retain external legal counsel to review the auditor’s disclosure Current Issues in Auditing Volume 6, Issue 1, 2012

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or increase the involvement of national office personnel to ensure that their assurance over MD&A is warranted. In either case, the audit costs are likely to increase further, potentially without the benefit of being able to increase audit fees.

PRACTICAL IMPLICATIONS FOR AUDIT EDUCATION While auditors are trained to review evidential matter, in general they currently are not trained in their undergraduate and graduate education to perform assurance procedures related to management’s qualitative forward-looking information provided. However, given that much of the information in the MD&A section is forward looking, providing auditor assurance that disclosures other than accounting policies and amounts are materially consistent with SEC regulations as proposed in the concept release would be a significant change for auditors. Because this may become a vital role for the auditor, it is imperative that educators assist future auditors by incorporating concepts from finance, economics, management, and other business disciplines in their advanced auditing course. However, as colleges and universities face increased enrollment with less capital to invest per student, especially in public institutions, the reality of adapting the education model to train accounting students to acquire new skills does not appear to be achievable. Further, subject matter outside of the normal business curriculum may be necessary for auditors to provide assurance related to the MD&A. For example, auditors would need to understand communication techniques and contract law concepts that provide methods and best practices for business disclosures. It is not clear how the content analysis capability necessary to write qualitative audit disclosures can be provided in traditional auditing courses, as most universities do not possess the requisite skills in the accounting, and even business, faculty. We suggest that if the MD&A assurance proposal is enacted, audit educators should collaborate with audit professionals and non-business faculty to design coursework that provides future auditors with requisite skills that currently are not included in the accounting curriculum.

CONCLUSION While auditors gain insight into the types of qualitative information that the PCAOB proposes for public disclosure, auditors may conclude that it is not beneficial to require them to provide these disclosures. Requiring these AD&A disclosures could significantly modify the role of the auditor in the eyes of investors, management, and the courts. Also, providing assurance over the disclosures generated by management in the MD&A involves a skill set not currently provided to auditors in their undergraduate studies. Even though auditors are not developing their own disclosures in the case of the MD&A, assurance over the MD&A would distract auditors from their primary role of providing reasonable assurance for the fair presentation of the financial statements and footnotes. If the PCAOB implements these changes, there would be significant implementation challenges for auditors. In particular, it is unclear how specific types of disclosure would affect investor perceptions of the audit report. Therefore, additional research should be performed before a large-scale change is implemented by the PCAOB. Academics play a unique role in helping develop and improve auditor reporting. Given their independence from the audit process, academics should increase their engagement with the standard-setting community by linking research to the pressing issues facing the auditing profession. Without this dialog, the auditing profession runs the risk of becoming dominated by a single constituency and passing policies that negatively impact the profession as a whole. Given the importance of this PCAOB concept release, the authors hope that scholars will perform Current Issues in Auditing Volume 6, Issue 1, 2012

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research on this highly important issue and provide this much-needed information to both users of financial information and the auditing profession.

REFERENCES Ackerman, A. 2011. U.S. senators seek transparency for auditor discipline. Wall Street Journal (November 18). Beasley, M. S., J. V. Carcello, D. R. Hermanson, and T. L. Neal. 2009. The audit committee oversight process. Contemporary Accounting Research 26 (1): 65–122. Chang, H., C. S. A. Cheng, and K. J. Reichelt. 2010. Market reaction to auditor switching from Big 4 to third-tier small accounting firms. Auditing: A Journal of Practice & Theory 29 (2): 83–114. Church, B. K., S. M. Davis, and S. A. McCracken. 2008. The auditor’s reporting model: A literature overview and research synthesis. Accounting Horizons 22 (1): 69–90. Cohen, J. R., L. M. Gaynor, L. L. Holder-Webb, and N. Montague. 2008. Management’s discussion and analysis: Implications for audit practice and research. Current Issues in Auditing 2 (2): A26–A35. Coram, P. J., T. J. Mock, J. L. Turner, and G. L. Gray. 2011. The communicative value of the auditor’s report. Australian Accounting Review 21 (3): 235–252. Krishnan, G. V., and G. Visvanathan. 2008. Does the SOX definition of an accounting expert matter? The association between audit committee directors’ accounting expertise and accounting conservatism. Contemporary Accounting Research 25 (3): 827–858. Mock, T. J., J. L. Turner, G. L. Gray, and P. J. Coram. 2009. The Unqualified Auditor’s Report: A Study of User Perceptions, Effects on User Decisions and Decision Processes, and Directions for Further Research. A Revision of the Summary Report Presented to the Auditing Standards Board and the International Auditing and Assurance Standards Board, New York, NY, April 29. Public Company Accounting Oversight Board (PCAOB). 2001. AT Section 701—Management’s discussion and analysis. Available at: http://pcaobus.org/Standards/Attestation/Pages/AT701.aspx Public Company Accounting Oversight Board (PCAOB). 2010. ACAP committee’s recommendation relating to the auditor’s reporting model. Available at: http://pcaobus.org/News/Events/Documents/04072010_SAGMeeting/ Auditor%27s_Reporting_Model.pdf Public Company Accounting Oversight Board (PCAOB). 2011a. Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements. Concept Release No. 2011-003, Docket 034. Washington, D.C.: PCAOB. Available at: http://pcaobus.org/Rules/Rulemaking/Docket034/Concept_Release. pdf Public Company Accounting Oversight Board (PCAOB). 2011b. PCAOB roundtable on auditor’s reporting model. Available at: http://pcaobus.org/News/Events/Pages/09152011_Roundtable.aspx Securities and Exchange Commission (SEC). 2003. Disclosure Required by Sections 406 and 407 of the SarbanesOxley Act of 2002. Release No. 33-8177. Washington, D.C.: SEC. Turner, J. L., T. J. Mock, P. J. Coram, and G. L. Gray. 2010. Improving transparency and relevance of auditor communications with financial statement users. Current Issues in Auditing 4 (1): A1–A8.

Current Issues in Auditing Volume 6, Issue 1, 2012