Please ensure Javascript is enabled for purposes of website accessibility

Is the PCAOB’s “Audit Failure” Rate Really a Little Dramatic?

Here's the deal. Last week, Mark Peecher and Ira Solomon published an opinion piece on titled PCAOB’s ‘Audit Failure’ Rate Is Highly Suspect. Just so we know these guys might have some idea what they are talking about, Mark teaches accounting at the University of Illinois Urbana-Champaign and Ira is dean of the A. B. Freeman School of Business at Tulane University.

Let's get straight to the point:

In a recent article, the Public Company Accounting Oversight Board’s chief auditor is quoted by the Wall Street Journal as saying, “When we look at an audit, the rate of failure has been in a range of around 35 to 40%.”

How can such a statement not strike at the heart of investor confidence? We believe any inferences about overall audit quality from this alleged failure rate are highly suspect. Because the PCAOB selectively screens audits for inspection, this supposed rate of failure might reflect only that the PCAOB is good at screening. Investors lack a defect rate based on a representative sample by which to generalize.

In addition, and perhaps more important, investors would be better served if the PCOAB stopped conflating audit deficiencies with audit failures. Deficiencies occur when an auditor does not comply with PCAOB standards, including documentation standards. On the other hand, an audit failure is much more serious. The traditional definition of an audit failure is the joint occurrence of an unqualified (clean) audit opinion and materially misleading financial statements.

Fair enough. But let's be real about it, anyone who knows anything knows the term "audit failure" is more a favorite of sensationalist accounting writers than something that would make an educated investor think twice about trusting that the financial statements are, in fact, free of material misstatement.

Perhaps the PCAOB could consider tweaking the language just a little. Because, you know, failure in this context is really dramatic. Any reasonable person who knows nothing about PCAOB inspections, audits, and/or reasonable assurance might assume "failure" means, well, THIS AUDIT IS A FAILURE. Really what it means is "the clowns who did this audit were a little sloppy with their work."

As Board member Jeanette Franzel said to an AAA conference in early 2013:

PCAOB uses its own definition of audit failure in inspection reports. It is a deficiency of such significance that the firm, at the time it issued its audit report, failed to obtain sufficient appropriate evidence to support its audit opinion on the financial statements and/or on the effectiveness of internal control. Under the definition, deficiencies include instances where a firm did not identify or address appropriately financial statement misstatements or improper disclosures, as well as failures by the firm to follow auditing standards.

The CFO article continues:

One reason is that PCAOB inspections usually occur after fieldwork, so hindsight bias can surface, especially when inspectors try to assess audit work on management’s estimates, which often are predicated on future economic events. That is, inspectors form retrospective judgments about auditors’ judgments regarding the reasonableness of management’s judgments. The management judgments in question concern things like the reasonableness of complex financial-statement estimates or the sufficiency of internal controls. It is hard to manufacture precision at the end of this judgment chain when it starts with so much ambiguity and uncertainty.

Still another reason for caution is that, even when working on the same problem at the same time, professionals in accounting and elsewhere regularly reach different conclusions after careful, good faith judgment processes. If we give tax-return case materials to 10 highly experienced tax professionals, we can obtain 10 different conclusions of tax due. Similarly, before we undergo major surgery recommended by a trusted family physician, we still customarily seek another physician’s point of view because we know second opinions have value.

Not to mention the PCAOB takes a risk-based approach to selecting audit engagements to review [PDF from CAQ, good reading], meaning they are looking for screw ups.

What say ye, oh GC faithful?