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Executive Summary
The disclosure of engagement partners and other participants in audits of public companies can add to the transparency and accountability of financial reporting significantly as it has been suggested by PCAOB and approved by SEC. With the implementation of this policy change, investors and other financial statement users can know the identity of the engagement partners and other participants in the audit. Therefore, investors can make well-informed investment decisions based on these disclosures. However, these disclosures have both direct and indirect costs that will be ultimately passed on to the company management and investors. Although the new disclosure information may persuade engagement partners to take voluntary steps to enhance the quality of their audit work, they would be also reluctant to undertake complex audit works because of the dreadful consequences of an adverse audit outcome. However, this policy change can assist financial statement users to obtain a great deal of information regarding engagement partners and other participants.
Introduction
A number of corporate scandals occurred in the United States over the last decade, such as Enron and WorldCom, were attributed to accounting fraud; and this dreadful scenario persuaded federal regulators to come up with a range of stringent policy measures. Sarbanes-Oxley Act was formed in response to these massive corporate failures. In order to enhance the quality of financial reporting, the Public Company Accounting Oversight Board (PCAOB) has recently issued a rule by which the disclosure of the identity of engagement partners and other accounting firms involved in the audit is mandatory. It has been duly approved by the Securities and Exchange Commission (SEC) and will be on effect from301st January 2017. This paper will critically analyze this new rule regarding the disclosure of the engagement partner and other participants in audits of public companies. The paper will also discuss possible outcomes, both intended and unintended, of the new rule.
Disclosure of the Engagement Partner and Other Participants
Public Company Accounting Oversight Board (PCAOB) recently issued a rule mandating the disclosure of engagement partner and other participants. The new rule intents to keep investors informed of the details of participants in public company audits. It requires audit firms to disclose the details of audit engagement partner and other audit firms involved in each audit. As per the article published by PCAOB “PCAOB Adopts Rules Requiring Disclosure of the Engagement Partner and Other Audit Firms Participating in an Audit, auditors are “required to file a new PCAOB Form AP, Auditor Reporting of Certain Audit Participants, for each audit” (PCAOB para.3). The PCAOB Form AP requires the disclosure of information such as the name of the engagement partner; details of other accounting firms “if their work constituted 5% or more of the total audit hours”; and “the extent of participation of all other accounting firms” (PCAOB para.3). Audit professionals claim that greater transparency regarding the partner and firms engaged in the audit would significantly add to investor trust in the company. According to the PCAOB article, the Form AP has to be filed mandatorily 35 days after the inclusion of auditor’s report in a document that is filed with the Securities and Exchange Commission; however, the standard deadline for the filing of Form AP will be 10 days in case of initial public offerings (PCAOB para.7). For all the public company audit reports submitted on or after 31st January 2017, audit firms should ensure the filing of Form AP.
Critical Evaluation of the New Rule
While analyzing the current PCAOB rules and standards, it seems that the Board does not require companies to disclose the identity of the engagement partner or other participants publicly. According to PCAOB Release No. 2015-008, currently, people close to the financial reporting process such as the company’s top management and audit committee who interact directly with the engagement partner know the identity of the engagement partner and other participants (45). In addition, the current rules and standards require auditors to give certain information regarding other accounting firms and participants involved in the audit to the audit committee.
The new disclosure information would benefit different stakeholder groups including investors, research analysts, and credit rating agencies. Undoubtedly, investors are the primary stakeholder group benefited from the introduction of the new disclosure policy. This disclosure information is very much helpful for investors to assess whether the engagement partners have been linked to any adverse audit outcome that led to deficiencies in their audit work. As Browning points out, recently a senior partner at KPMG, one of the Big Four auditors, disclosed confidential information about the firm’s two clients, Herbalife and Skechers, and this unethical practice forced the company to resign as the auditor of those companies (para.2). The new disclosure policy can help stakeholders to identify whether the audit work was performed by firms involved such allegations. In addition, using this information, investors can identify whether the engagement partners have been strictly following the policies and standards of SEC. The disclosures can greatly assist the users of the financial statement to understand what portion of the audit was performed by the report issuing firm and what portion was done by other accounting firms (Deloitte, para.1). In addition, it would assist financial statement users to recognize the exact part of the audit performed by firms from outside jurisdictions where PCAOB cannot perform inspections. Since disclosures are analyzed with other publicly available information, “investors and financial intermediaries would have a basis to evaluate additional data points, together with the information disclosed on Form AP, that may give them insight into individual audits” (PCAOB No. 2015-008, 47). The disclosures would add significantly to the mix of overall information used by investors. The new policy change can benefit investors and other financial statement users to gather more granular information regarding accounting firms. This will also help them make well-informed assessment of audit quality and credibility of financial reporting. Experts indicate that the disclosures can really assist investors and other financial statement users to gain valuable information regarding the number of issuer audits conducted by an accounting firm, particularly when there is a high degree of information asymmetry (PCAOB No. 2015-008, 47). The newly announced disclosure would also increase the accountability for audits because the policy change has the ability to create incentives for engagement partners and other accounting firms to take voluntary measures aimed at the enhancement of audit quality. Hence, the disclosures are capable of meeting the needs of financial statement users by increasing the credibility and quality of audit reports.
Although the disclosures may assist investors and other financial statement users in numerous ways, this policy change has some potential costs too. Many experts claim that the new disclosure rule would result in a number of legal and practical issues with regards to federal securities laws, and this unfavorable situation would add to the costs of audits. Arguably, audit firms would simply pass the increase in costs to companies through higher audit fees and the situation would impose additional financial burden on companies (Ernst & Young LLP 1). It is identified that disclosure of engagement partners and other accounting partners involves both direct and indirect costs. The direct costs represent the costs associated with compiling the disclosure information and calculating the percentage of audit work performed by different participants involved in the audit. To be precise, costs of audits that do not involve participants will be comparatively lower because only engagement partner’s name and Partner ID need to be disclosed in this circumstance. The disclosures would also cause audit firms to incur significant initial implementation costs in terms of establishing systems to gather and track the information required. In addition, the ongoing costs involved in filling out Form AP also represent direct costs. According to some other observations, significant administrative efforts are required to comply with these disclosures effectively and it will also play a crucial role in enhancing costs. Due to the proposed disclosure rules, the engagement team is likely to undertake unnecessary procedures to maintain the status of a reputed auditor. In most circumstances, these additional audit procedures would not increase the quality of audit but lead to unnecessary costs and ineffective utilization of resources. As discussed already, the increase in audit costs will be simply passed on to companies and their investors in the form of higher audit fees. Therefore, investors will ultimately bear the additional costs associated with the disclosure of engagement partners and other participants.
A comprehensive evaluation of this policy change is inevitable in order to identify the consequences, both intended and unintended. Increased transparency and accountability would be some major intended outcomes of the policy change. Since investors are well-informed of the engagement partners, they can get other publicly available information regarding the engagement partners to gain a clear understanding of the audit quality. In addition, these disclosures can really assist investors to make sound investment decisions and determine whether or not to ratify the appointment of an accounting firm. In the context of the current policy change, investors would evaluate the histories of engagement partners and other accounting firms in detail, and this would create incentives for engagement teams and other participants to voluntarily improve their operational efficiency. It is identified that this new disclosure information has a lot of potential unintended consequences too. As discussed already, in the light of the current disclosure policy, engagement teams would follow unnecessary audit procedures to enhance the quality of the audit work, but leading to ineffective utilization of valuable resources. In addition, the issue of overauditing would also lead to unreasonable delay in financial reporting. Another unintended consequence of these disclosures is that overauditing would force the company management to spend additional time to deal with more audit procedures. It is identified that currently investors and financial statement users rely on criteria such as the size and industry experience of accounting firms to determine the quality of their financial reporting. In the context of the new disclosure policy introduction, this practice would be harmful to smaller and unpopular accounting firms even though their audit work is in strict compliance with PCAOB standards. Another negative aspect of this policy is that even an adverse audit outcome occurred at the outset of an engagement partner’s career may ruin the professional reputation of the firm. When an engagement partner comes under the allegation of adverse audit outcomes, the situation would negatively affect other public companies whose audits were performed by the same engagement partner. It also appears that engagement partners and other accounting firms would be reluctant to undertake risky audits, fearing the dreadful consequences of an adverse audit outcome. Undoubtedly, this situation would raise significant operational challenges to some multinational corporations whose audit involves a range of complex/risky tasks. In the current disclosure environment, audit committees are likely to select high-rated auditors rather than choosing auditors whose skills are relevant for the specific audit work. Undoubtedly, this practice would end up in a low quality audit report.
According to me, stakeholders of audit reports, particularly investors will appreciate the PCAOB’s move to disclose the identity of the engagement partner and other participants in audits of public companies. Investors have been consistently asking the PCAOB to introduce this rule for the last several years, and therefore, this change would best meet the interests of corporate investors. Many users of audit reports have already indicated that this newly introduced rule would make the auditor’s report more informative, helping investors take sound investment decisions (Heller, para.5). Obviously, this rule assists investors to know who conducted the audit, and this information is really beneficial for investors to assess the overall quality and reliability of the audit report. Investors think that disclosure of engagement partners and other participants is inevitable because ‘auditing is a professional built on reputation’. Another reason why investors appreciate the policy change is that mandatory disclosures would persuade audit firms to be more efficient and vigilant at their work. Hence, the new disclosure information would considerably increase the accountability of auditors through Justice Burandeis’ ‘disinfectant’ effect (PCAOB No. 2015-008, 47). As investors point out, these disclosures would be very relevant to their decision making. For instance, the disclosure of the engagement partner and other participants may assist investors to make sound decisions while voting to approve the firm’s choice of auditor.
Conclusion
In total, the disclosure of engagement partners and other accounting firms proposed by the PCAOB and approved by SEC would significantly contribute to the transparency and accountability of audit works. Currently, administrative bodies that directly interact with the engagement team such as the top management and the audit committee only know the identity of the engagement partner and other participants. The most advantageous feature of this disclosure policy is that it can assist investors and other financial statement users to obtain deep insights into the quality of the audit work performed. In addition, these disclosures would help financial statement users understand how the audit work was distributed among different engagement partners and other participants. However, the new disclosure policy would cause accounting firms to incur significant initial costs with respect to the establishment of systems for gathering and tracking required information. Such additional costs of audit would be simply passed on to the company management and investors in the form of higher audit fees. The disclosure would adversely affect the scope of smaller and unpopular firms and partners even though their operations are in strict adherence to PCAOB standards. In addition, engagement team would be reluctant to undertake complex audit work as an adverse audit outcome may dreadfully affect their professional reputation. However, investors may find these disclosures increasingly useful because it helps them make well-informed investment decisions.
Works Cited
Browning, Lynnley. “After KPMG, Audit Firms Reconsider Procedures”. The New York Times, April 10, 2013. Web. http://dealbook.nytimes.com/2013/04/10/after-kpmg-audit-firms-reconsider-procedures/?_r=1 [Accessed 20 July 2016.
Deloitte. “SEC approves PCAOB rules requiring disclosure of engagement partner and other audit participants”. May 10, 2016. Web. http://www.iasplus.com/en-us/news/2016/05/sec-approves-pcaob-rule [accessed 20 July 2016].
Ernst & Young LLP. “PCAOB Rulemaking Docket Matter No. 029 Supplemental Request or Comment: Rules to Require Disclosure of Certain Audit Participants on a New PCAOB Form”. EY. 31 August 2015. Web. file:///C:/Users/Owner/Downloads/commentletter_ee1000_pcaobformap_31august2015.pdf [accessed 20 July 2016].
Heller, Matthew. “PCAOB Adopts New Form for Naming Audit Partner”. CFO. December 15, 2015. Web. http://ww2.cfo.com/auditing/2015/12/pcaob-adopts-new-form-naming-audit-partner/ [accessed 20 July 2016].
PCAOB. “PCAOB Adopts Rules Requiring Disclosure of the Engagement Partner and Other Audit Firms Participating in an Audit”. Washington, Dec. 15, 2015. Web. https://pcaobus.org/Rulemaking/Docket029/Release_2015_004.pdf [Accessed 20 July 2016].
PCAOB Release No. 2015-008. Web. https://pcaobus.org/Rulemaking/Docket029/Release-2015-008.pdf December 15, 2015 [accessed 20 July 2016].
