For Auditors’ Eyes Only

Why audit committees should ask for confidential information on the quality-control systems of their companies' audit firms.

A federal law that enables auditors to keep clients in the dark about the audit firms’ quality-control deficiencies for as much as a year leaves public companies open to the risk of financial restatement, audit-committee activists contend.

The statute, Section 104 of the Sarbanes-Oxley Act, says that if the Public Company Accounting Oversight Board (PCAOB) finds during its inspections of auditors issues that need improvement—particularly in the area of quality control—the audit firm has one year from the date of the report to fix them. If they do so within that time frame, the matter stays confidential.

William McDonough, chairman of the PCAOB, praised the statute last summer as an “effective tool” that would help the PCAOB keep auditors honest. “It is a wonderful discipline,” he said at the House Committee on Financial Services hearing. “It is like telling your kid you have to pass school this year.”

At the same time, he noted that he had heard public concern about keeping key parts of the inspection confidential. Under Sarbox, the board is barred for 12 months from making public parts of the report “that deal with criticisms of or potential defects in the quality control systems of the firm under inspection” if the firm mends its ways. PCAOB is, however, required to provide a copy of each report, “in appropriate detail,” to the SEC and certain state regulatory authorities.

To be sure, some of the findings of PCAOB auditor inspections are made public on the regulator’s Web site. But Part II, which addresses internal control deficiencies of the audit firm, isn’t revealed to audit clients.

Fred Lipman, president of the non-profit Association of Audit Committee Members, however, is one of a number of Sarbox critics who believe a client has a right to know if their external auditor is failing in certain areas. He reasons that the nonpublic portion of the PCAOB reports could detail controls deficiencies that could threaten the quality of the client’s audit and potentially lead to a restatement.

That’s why he’s urging corporate directors to ask their companies’ auditors for a copy of the full inspection report. “Many audit committees are naive and do not know that they should be requesting [the reports],” Lipman says.

At the same time, having the entire report could help companies “defuse problems” or even head off a Securities and Exchange Commission (SEC) investigation, Lipman says. At the very least, it could alert audit committee members to accounting practices that need to be altered, not to mention signaling that a change in auditors might be a good idea.

Auditors, however, are under no legal obligation to share the confidential part of the report. Lipman, who is also a partner at Blank Rome LLP, a law firm, says audit committees should negotiate with auditors for a stipulation in the firm’s engagement letter releasing the full report to clients— even if the firm insists that it’s correcting all of its problems.

Lipman wonders about the information audit committees might be missing out on by not seeing it for as much as a year. “If you are an audit committee member, you may want a lot more detail,” he says.

At least one Big Four firm is apparently trying to reveal a bit more of the confidential inspection material, however. In a move KPMG says is “in the spirit of transparency,” the firm is disclosing on its Web site a summary of the PCAOB’s nonpublic observations about its 2003 inspection of the firm and actions the firm is taking in response to them. The audit firm calls the full report “detailed and technical.”

In its summary, for instance, KPMG notes that the PCAOB observed that although the importance of audit quality is clearly stressed in gauging audit partners’ compensation, it’s not clearly stated that it’s “the most important factor.” In response, the firm is clarifying its 2004 pay practices to document that it is the most important factor, according to the summary.

Asked whether KPMG received requests for the full report from its clients and what the auditor’s response had been to those requests, Tom Fitzgerald, a spokesman for the firm, declined to comment.

Steve Silber, a PricewaterhouseCoopers representative, said the firm does not intend to “part from the process” set forth from Congress. “We think the confidential process to improve audit quality is working,” he added, noting the firm does not comment on communications with clients.(Representatives from Deloitte & Touche and Ernst & Young did not return calls requesting comment for this story.)

Lipman says that audit clients are likely to find that getting full inspection reports may be next to impossible without a change in the law. Auditors, he says, “don’t want their ‘dirty laundry’ disclosed to their clients.”

From the client’ point of view, however, knowing what’s in the full report is crucial since the nonpublic part could include details requiring the client to make a future accounting restatement, he contends.

Christi Harlan, a PCAOB spokesperson, dismisses Lipman’s claim that the seeds of a restatement could be hidden in the nonpublic details. “I don’t suspect that there would be anything that would be with the internal quality control that would have to do with a restatement,” she said.

Harlan explained that the inspections into internal quality controls concern internal firm actions and rules, not specific audits.

For the public part of the inspection, however, PCAOB officials do look at selected auditing engagements, she said, noting that client names are kept confidential. The board’s inspectors typically speak to at least the chair of audit committee “when we think it’s material to the company’s financial statements,” according to Harlan.

“Our inspectors have conversations with the chair or member of that audit committee in [their] general course of examining specific audit engagements to test whether the auditor is communicating as he or she should,” she said.

If the PCAOB finds that an audit firm is not complying with generally accepted accounting principles, Harlan says, alerting the audit committee to that “could cause a change right then and there, which is much better for the investing public.”

Last year, the PCAOB inspected the eight largest accounting firms (those that have more than 100 public company audit clients each), as well as 91 smaller accounting firms. This year, it will inspect the top eight again and continue to chip away at the long list of smaller firms.

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