October 18, 2011

A First: PCAOB Releases a Part II Inspection Report for a Big 4 Auditor

Here’s news from Lynn Turner: Yesterday, the PCAOB issued its first ever Part II of an inspection report on a Big 4 audit firm to the public – it relates to Deloitte & Touche. Here’s the PCAOB’s related statement. Such reports do not become public unless the auditor fails to address and remediate the deficiencies noted in the report. One would think a firm would be incented to do so. The report notes a number of deficiencies and questions the judgments of Deloitte. This is important as auditors have been clamoring for greater latitude in their ability to make judgments – the PCAOB’s report seriously calls that into question.

The report notes deficiencies in Deloitte’s internal systems for monitoring independence on a global basis. In the spring of 2001, the then SEC Chief Accountant called each of the auditing firms down to the SEC to discuss weaknesses in controls that the SEC had identified. That meeting was subsequent to a 1998 letter sent to the CEOs of each of the Big 5 firms. Yet 8 years later, Deloitte still has not addressed and remedied the identified weaknesses. Tough to figure out an excuse for that.

It will interesting to see how the state boards of accountancy react to this – and what, if any, action they take. It also raises a question as to inspections of private audits being performed by the AICPA.

This report – relating to inspections conducted in 2007 about 2006 audits, with Part I released in May 2008 – raises a serious public policy issue of why is such a Part II report citing such serious deficiencies in audit work permitted to remain confidential until almost five years after those audits were performed. And even with the release of this report, investors are not told which companies received deficient audit reports and which partner led those audits. Presumably, Deloitte told the audit committee chairs which audits were determined to be deficient – and yet that information was not provided by audit committees to investors.

Here’s a list of all the Part II reports that the PCAOB has issued over the years – you can see how they are mostly unheard of firms other than Deloitte. Here’s today’s NY Times article about this development.

Webcast Transcript: “”How to Handle Contested Deals”

We have posted the transcript of our webcast: “How to Handle Contested Deals.”

EU to Break Up the Big 4 Auditors?

Some pretty wild stuff from this article from “The Economist” that is repeated below:

HOW to improve the work of audit firms, on which investors in public companies depend? Should clients be forced to change them every so often, so auditors and management will not get too cosy? Should two auditors be appointed to especially important companies, so they can check each others’ work? Should, perhaps, auditors even be forbidden from offering any other services, to force them to stick to the knitting so important to investor confidence?

“All of the above” is the answer from the European Commission, according to a leaked proposal from the directorate-general for the European Union’s single market. Michel Barnier, the commissioner in charge, is due to unveil a formal set of proposals for the audit industry in November. The leaked document suggests that he thinks the industry is overdue for reform from top to bottom.

The proposal for mandatory rotation of audit firms has been floating around for the better part of a year. There is little evidence to suggest that it will improve audits, and some weak evidence (based on national experiences in countries like Italy) that it will not help, or make things slightly worse. The big audit firms say that their work improves as they get to know their clients over the years. Their critics say that these years stretch into decades, with auditors forgetting that they serve investors, not company management.

But by far the most radical proposal would be to forbid audit firms from providing non-audit services, even to clients that they are not auditing. In America, providing most non-audit services to audit clients is already forbidden under the Sarbanes-Oxley financial reform passed in the wake of the meltdown of Enron, an energy-trading company. In some European jurisdictions, selling both audit and, say, consulting to a client is still permissible. Mr Barnier’s leaked proposal would not just go down the route of Sarbanes-Oxley and forbid this, but force the creation of pure audit firms.

This would be a huge change to the business model of the “big four” audit firms: PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG. These are technically networks of firms, rather than single global entities. All have seen robust growth in their consulting business in recent years, which now accounts for around a third of total revenues for most of them, whereas the mature audit business has grown more modestly. Forcing the break-out of pure audit firms would separate an exciting and growing business from a plodding but vital one, in Europe at least.

Would that force the big four to split elsewhere? Joe Echevarria, the new head of Deloitte in America, merely says that policy pendulums will swing, sometimes overshooting their ideal mark. Well might his parent network, Deloitte Touche Tohmatsu, not want to lose its consulting work. In the year ending in May 2011, the consulting business grew by 14.9%, against 4.7% for the audit business, a result in line with recent years. If such a trend continued for another decade, Deloitte (like its rivals) would go from being an audit business with a consulting arm to a consulting business with an audit arm.

Mr Barnier’s proposals are still in draft, and may change before formal unveiling. After that, the EU’s Council of Ministers (representing national interests) as well as the European Parliament will take a crack at modifying it. It is unlikely that the leaked draft will become final law in its entirety. But it does represent a marker: the mood in Europe (reflected elsewhere) that auditors have a crucial function that is being weakened by distractions like consulting, and even by over-long audit engagements.

– Broc Romanek