Just about every employer in corporate America is singing the blues about talent shortages caused by the Great Reset and the Great Resignation. However, these effects are not being felt uniformly across all businesses. Those employers with a history of mismanaging their human capital, like the largest audit firms, are being hit the hardest.
The public accounting business model has relied excessively on its ability to counter the effects of massive turnover with its ability to hire and train massive numbers of new people every year directly out of college. However, that pipeline of new talent is currently in an alarming state of decline. Enrollments in accounting majors and the quantity of newly minted CPAs are both down.
To stem the exodus of audit professionals, audit firms are paying higher salaries to attract and retain the same level of relatively inexperienced professionals. Of course, this means audit fees are going up. If you work through the consolidating and eliminating entries, the end result is that corporate America is paying higher audit fees due to the large audit firms’ mismanagement of their human capital. On what planet does this make sense?
Looking for solutions
At a recent SEC reporting conference, I was pleased to see a 70–minute session devoted to “Current Profession Talent Practice Issues.” The four-person panel included two representatives from the largest audit firms, an academic, and a representative from the preparer community. The panel was informative, but it also was disappointing in that it never addressed the elephant in the room—the absence of work-life balance in public accounting that 1) drives college students away from majoring in accounting, and 2) causes young audit professionals to prematurely exit public accounting.
I shared my observation with the panel moderator that the unfavorable experiences of the audit staff at the largest audit firms are rapidly transmitted back to college campuses via social media. I added that the root cause issue is the audit firms’ mismanagement of their human capital. When the moderator shared my observation with the audience, she conveniently omitted my view that audit firm mismanagement of human capital was the problem. Denial of reality? Absolutely yes.
The panel identified one potential savior: the “upscaling” of the audit experience by mixing in attestation work in the glitzy space of environmental, social, and governance (ESG) attestation. On the drawing board, this sounds like a good idea. However, there are serious logic flaws. This means that to field a sufficient number of professionals to serve ESG attestation clients, the audit firms are planning to borrow from a population of surplus auditors that doesn’t exist. Second, upscaling will dilute the specialization in auditing, accounting, and internal controls needed to conduct high-quality audits.
There is already a tremendous mismatch between the inexperience of audit professionals and the complexity auditors need to master to perform audits of high quality. With heavy workloads at all levels, there is a heightened risk that the work of inexperienced staff will be inadequately supervised and reviewed. This is a train wreck that has happened many times in the past and will continue to happen many times into the future—unless something changes.
Shining a light on reality
The largest audit firms are eager to get their share of attestation work in the booming field of ESG reporting. The audit firms are promoting their ability to unlock shareholder value that comes with the measurement, public reporting, and continuous improvement of ESG measures. There is a bit of irony here. A close look at what makes up the “G” in ESG shows that “human capital management” is a significant component, including statistics about employee retention. The large firm audit leaders should practice what they preach to their prospective ESG clients.
Converging interests in human capital management transparency
The ESG proponents are not the only ones looking to shine light on human capital management. SEC Chair Gary Gensler has been a champion for expanded disclosures by public companies about their human capital management by amending Item 101 of Regulation S-K, noting that “Investors want to better understand one of the most critical assets of a company: its people. … This could include a number of metrics, such as workforce turnover …”
It follows that these concepts should also be applied to the largest audit firms that audit the lion’s share of the US market capitalization. As it stands currently, investors have no insight as to whether an individual audit was conducted as planned with an experienced team with high year-over-year engagement continuity and an appropriate level of supervision as promised—or was the audit the product of chaotic personnel changes that diminished experience levels and potentially undermined audit quality?
Yes, audit committees are tasked with making the auditor retention decision. Unfortunately, a key element of the auditor retention decision continues to be input from company management who tend to be resistant to auditor changes (favoring the devil they know versus the devil they don’t know). This is why we continue to have many long-tenured auditors of public companies (often extending out a decade or more). If investors had more visibility into the realities of how the audit firms conduct their audits, I doubt that the shareholder ratification of auditor appointments would continue to be perfunctory. For this reason, it is important for the investors to have more visibility to auditor performance on individual audits.
The opportunity in front of the PCAOB
In December 2019, the PCAOB published a concept release titled “Potential Approach to Revisions to PCAOB Quality Control Standards.” That release proposes requirements for audit firms to identify metrics to monitor the conduct of audits in real time for situations warranting corrective action. If done correctly, this means audit firm monitoring at the engagement level for potential threats to audit quality, such as:
- Excessive turnover;
- Low year-over-year staff continuity;
- Low experience levels;
- Insufficient specialist time;
- Excessive workloads; and
- Inadequate supervision and review (evidenced by high staff hours relative to partner and manager supervision).
Many audit firms are already doing something like this, but this information at the engagement level generally stays within the audit firm.
If the audit quality indicators show that an audit was conducted outside of “safe zones of operation,” the investors should know what happened and what the audit firm did to assure that audit quality was not compromised. This audit quality indicator information should be required reporting externally in some fashion. A few possibilities that come to mind are:
- The critical audit matters section of the audit opinion;
- The audit committee report in the proxy statement; or
- A centralized database that is publicly accessible.
Without this information, it would be naive for investors to believe that all audits are conducted with uniform levels of experience, continuity, and supervision and review.
We are approaching the 20th anniversary of the Sarbanes-Oxley legislation. In the nearly 19 years of the PCAOB’s existence, the PCAOB has shown no inclination to focus on the inherent flaws in the large audit firm staffing model, instead leaving it to the audit firms to figure out how to improve audit quality. That hands-off approach has gotten us to a crossroads where audit quality today is under severe threat. We need to be sure that the auditing profession never finds itself in such a precarious position in the future. It is time for the PCAOB to be proactive. The downside is simply too great.
I’ll close with an observation made by former SEC Chief Accountant Don Nicolaisen during the proceedings of the Advisory Committee on the Auditing Profession: “The firms compete primarily on the basis of cost. That’s been the history of the profession and it has been disastrous for investors and for the firms.” The PCAOB has a unique opportunity to change that by using transparency to expose the flaws in the large audit firm business model and drive much needed improvement in how the audit firms manage their human capital.
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