Investor confidence is fragile but vital to healthy markets. So, when it comes to the issue of the quality of public company audits, we are troubled to see regulators make alarming assertions that are incomplete and potentially misleading.
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.
A couple of years ago, however, the PCOAB began using the term audit failure in a very different way. Specifically, the PCAOB started using audit failure when, in their judgment, the auditor failed to obtain sufficient appropriate evidence to support its opinion on the financial statements, irrespective of the fairness of the financial statements in question. Investors, many of whom we suspect are unaware of the PCAOB’s new and unconventional usage of the term audit failure, may worry unnecessarily that these “failures” portend heightened future restatements of public company’s financials.
Further, even investors who are aware of the PCAOB’s new definition are still left in the dark. This is because there are good reasons to question PCAOB criticism of an auditor’s evidential basis.
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.
Since public statements and reports from leading regulators can matter a great deal, we are reminded of the wisdom in the statement made in the opening sequence of the 1980s television show Hill Street Blues — Let’s be careful out there!
Mark E. Peecher is a professor of accountancy at the College of Business at the University of Illinois at Urbana-Champaign. Ira Solomon is the dean of the A. B. Freeman School of Business at Tulane University.