Exposing Engagement Partners?

On October 11, 2011, the PCAOB released for comment a proposal to require auditors to disclose the name of the audit engagement partner in a company's annual report, as well as other firms or persons not employed by the audit firm who participated in the independent audit of the company. The PCAOB considers this proposal an augmentation of transparency in the audit of public companies.

While I can certainly understand the argument that identification of an individual partner would increase that person's obligation to adhere to all professional standards and the highest ethical guidelines in overseeing an audit, I feel it might further confuse investors. If a company goes under, investors will simply have another person to personally crucify for any fatal risk that may have led to the downfall. While I am not a lawyer, I can foresee a host of legal issues when investors start assuming that an individual partner is solely responsible for their bad investment. The entire structure of the LLC used by public accounting firms is overshadowed by the engagement partner's name in the audit report.

In considering the second item in the PCAOB's proposal, I think it would be helpful to know when something has been outsourced. Consider the recent mess many homeowners facing foreclosure are now dealing with, as they find out that their bank outsourced the processing of their loan to companies who made up signatures and bank presidents to sign false loan documents. Investors certainly deserve to know to what extent a reputable auditor may be relying on the work of a less reputable auditor. Simply naming firms used by the auditor would not necessarily be helpful, unless the extent of their involvement were disclosed. Perhaps setting a threshold for disclosure would be reasonable, e.g. if a third party is involved in the audit of a high risk area or conducts more than 20% of the audit, their involvement should be disclosed.

What do you think, will the added scrutiny of disclosing engagement partners and third parties involved in the audit improve transparent financial reporting and auditing?

PCAOB Releases Potential Changes to Auditor's Report

Last week, the PCAOB issued a concept release presenting four potential changes to the auditor's report on public company financial statements. The changes, open for public comment, include the following:

• Auditor's Discussion and Analysis (AD&A) - Presented as a narrative intended to "facilitate an understanding of the auditor's opinion of the financial statements taken as a whole," according to the PCAOB. This section might include a discussion of audit risks identified, significant management judgments, and critical accounting policies.
• Expanded and requisite use of emphasis paragraphs - While emphasis paragraphs are currently optional, they might be required in a standard auditor's report to point the reader's attention to where significant financial statement items can be found in the financials and related footnotes.
• Auditor assurance on information outside the financial statements - Auditor's may be required to issue an opinion on information such as the management discussion and analysis (MD&A), press releases, or other published financial information.
• Clarification of standard language in the auditor's report - The auditor's report might also clarify the auditor's role and concepts mentioned in a standard auditor's report, such as reasonable assurance, and auditor's responsibilities vs. management's responsibilities.

While each of the above recommendations seem to address the need for investors to have a stronger grasp of the level of assurance provided by an independent audit, I fear any or all of the aforementioned changes could further bury investors in a heap of esoteric language. Studies have shown that few information within the audited financial statements and footnotes is consistently read and understood by analysts and investors, so adding even more audited information and discussion may only add to the current level of confusion.

Given that investors feel they have been duped by public companies, auditors, and hedge funds when so much market capitalization evaporated in the recent recession, I understand the legal concerns of the auditing profession and their regulators. If we audit more and disclose more, how could investors ever be duped again? They would have no excuse for making bad investments, right? The information was all there in front of them. Unfortunately, a clean audit opinion is not equivalent to an analyst's recommendation to buy or hold a security. Perhaps auditors do have it a little too easy only having to issue a pass/fail audit report right now, but I fear that the addition of some of the information suggested by the PCAOB, particularly the AD&A, would confuse investors into thinking that an auditor was making an investment recommendation. We need to be careful not to overwhelm investors. It is not the volume of information, but the relevance of it that investors are in need of.

New Study Sheds Light on Investor Use of Audited Financial Information

There were many times when, as an auditor of public companies, I questioned if all of my hard work was in vain . Was I being idealistic telling myself that my independent auditing would amount to greater transparency and understanding of by clients' performance by countless investors? A recent study conducted by the Journal of Accountancy found that professional and retail investors have a tendency to rely on financial information included in the MD&A portion of a company's annual report, which is reviewed but not audited by the company's independent auditors. The investors in the study, particularly retail investors, were less likely to reference the audited financial statements or footnotes when making investment decisions.

These results support something we auditors have often suspected: that the copious, detailed, and often technical financial information included in the financial statements and more specifically in the footnotes seems to be resulting in information overload. Retail investors, who generally have less financial knowledge than professional investors, can often get overwhelmed by all of this data that we CPAs have worked so hard to tick and tie down to audited information. Professional investors reference the footnotes occasionally, still preferring other sources of information on which to base their investing decisions. The SEC should consider revising their disclosure requirements to either include greater objectivity and disclosure of information in the MD&A portion of annual reports, or even require an expansion of the independent auditors' report to include such information that is the preferred source of financial information used by investors. The SEC should also review requisite footnote disclosures, perhaps eliminating redundant or less important data, and expanding more frequently referenced data such as the allowance for doubtful accounts footnote.

As auditors, we should not be discouraged, thinking that our independent audit work over our clients' financial statements and footnotes is in vain. Most of this information is the support behind the financial data included in the MD&A portion of an annual report. It would be difficult for a company to fabricate MD&A information given this close relationship. Also, with the introduction of searchable financial filings through the use of XBRL, hopefully audited data will be dissected to a greater extent by financial analysts and investment professionals to make more objective and informed investment decisions on behalf of their clients.

To read an overview of the Journal of Accountancy's study, visit http://www.journalofaccountancy.com/Web/20102682.htm#