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February 7, 2023

The PCAOB Has a Few Specific Criticisms for Auditors But Faith in Them Regardless

The Journal of Accountancy interviewed PCAOB board members Jay Hanson and Lewis Ferguson for a piece in its September issue and the conversation is surprisingly candid. For example, Ferguson totally gets that auditors are sick of the PCAOB's alleged moving target, but has faith these auditors will appease their regulatory overlords anyway:

"I’m not aware of any other profession where individuals are looked at as intensely as this profession is looked at by the PCAOB and other regulators. I think it has put the profession under great pressure in some ways."

Well duh. But let's look at the bigger question:

JofA: Firms may need to devote more senior personnel to auditing internal control over financial reporting (ICFR).

Hanson: If students fresh out of college—who are still learning the craft of auditing—are assigned the task of understanding this complex ICFR business process—identifying where the risks are, where the controls are, and doing the control work—those are probably the wrong people doing the work.

These new auditors can play a very important part in conducting the testing, but some of the firms have realized that they need to get the more senior people on the engagement, up to and including the partner, to understand the end-to-end aspects of a given transaction cycle and to answer the questions: How does this work? How does the business work? How does its business cycle work? How are the controls designed to address the risks, and do they really work?

Ferguson: This raises a significant question of economic implications for the way a firm is structured. To be able to do these tasks such as auditing internal control in a way that satisfies PCAOB auditing standards, you probably have to have more senior people on the job.

A firm may need to involve much more partner time, or maybe employ a cadre of people who don’t necessarily become partners, but are expert in this and are able to focus on highly complex functions of the audit. But this raises fundamental questions about how you run, particularly, a large accounting firm today. My sense is the firms are going through that rethinking about how they run their businesses.

This changes everything. All this time we've been talking about how crappy inspection reports make audit firms look and what a pain in the ass the PCAOB can be. What we haven't asked (at least in awhile) is why the hell are inexperienced staff doing this work?

Now, it's worth noting the JofA article, in case you skimmed by it, is titled "Audit regulators see positive signs" but I'm wondering if we're reading the same article?

JofA: Firms are being asked to look deeply at the root causes of common audit inspection findings.

Ferguson: There are firms that are now looking into statistical correlations with audit quality. They are looking into the relationship between higher rates of inspection findings and, for example, partner-staff ratios, partner workloads, or a whole variety of other factors that might provide a deeper understanding of what’s impacting the quality of audit performance.

We are looking at the root causes of these inspection findings to see if there are correlations and, importantly, causation. Firms have hired behavioral psychologists to talk to them about the behaviors of the firm and the incentive structures of the firm, for example. Understanding quality drivers also involves looking at the economic incentive structures of these firms. There’s a variety of ways of looking more deeply at the issues to try to understand what the problems are.

Hanson: They’ve realized over time that, to use a figurative term, “sending out a memo” is not going to fix the problem. If there are some very simple things to remediate, that’s fine. But the type of things that are the most difficult for preparers to do—determining estimates or fair value, for example—those are also very difficult for the auditors to audit. Firms need to think through the best ways to approach that problem.

The smaller firms, we recognize, usually don’t have the same level of resources, so one of the things we try to do to help them is to put on a series of forums for auditors of smaller companies. Every year we do six to nine of those, and we discuss important issues that we are dealing with in inspections, enforcement, and standard setting.

Sounds to me less like positive signs and more like these two taking a big dump on auditors. Behavioral psychologists? Jeez, this is more complicated than it needs to be.

What I believe this tells us — which we kinda knew already — is that inspection reports will get a lot worse before they get better. A LOT WORSE. What this also tells us, though, is that a terrible inspection report is not necessarily indicative of really shitty audit work but instead an inability to meet the PCAOB's demands.

The bad news for auditors is that those demands need to be met, like it or not.

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