The Public Company Accounting Oversight Board should limit any initial proposal calling for the use or disclosure of audit quality indicators to just a handful of AQIs and encourage their use as part of a principles-based framework, members of an advisory group told the PCAOB recently. 
 
The remarks came during the second day of a two-day meeting of the PCAOB’s Standing Advisory Group, with SAG members having spent a considerable amount of time in small breakout groups on the first day of the meeting to discuss the PCAOB’s Concept Release on Audit Quality Indicators. SAG members, PCAOB board members and staff were able to reflect on comment letters received on the Concept Release, in addition to their own views. The PCAOB staff’s summary of comment letters on the AQI Concept Release appears in Appendix A to the SAG Briefing Paper.
 
The PCAOB had extended the comment deadline to Nov. 30 “to provide an opportunity for members of the public to offer their views, including on any new information that becomes available as a result of the SAG meeting.”
 
Many SAG members applauded the PCAOB and Greg Jonas, director of the PCAOB’s Office of Research and Analysis in particular, for moving the major (some may say game-changing) project into the common consciousness within a short number of years.
 
While there was a strong view among numerous SAG members that the PCAOB should proceed in moving this project to the next step, there was a wide range of views as to just what that next step should be.  
 
Narrow the number of AQIs
There appeared to be general agreement with a suggestion that the PCAOB narrow its focus from the 28 AQIs listed in the Concept Release to four key factors − specifically, AQIs 1, 5, 6 and 7 as numbered in the Concept Release, which relate to: 
  • staffing leverage,
  • persons with specialized skill and knowledge,
  • experience of audit personnel, and
  • industry expertise of audit personnel. 
“Narrowing the range of AQIs from 28 to say, four or five would really catalyze the project,” said SAG member Tom Selling, a professor and president of Grove Technologies, LLC. “It would enable us to start the process of documenting and validating the benefits of AQIs.”
 
“My personal vision,” he continued, “is AQI reporting could someday look like the way MD&A has evolved: there could be certain tabular disclosures, but also a mix of voluntary qualitative information that a lot of people feel is sorely needed.”
 
Voluntary vs. mandated
Since the concept of AQIs is new and relatively untested (and since there is a need for audit committees and auditors to have flexibility and confidentiality for the discussion of audit quality to be sufficiently robust, and for that conversation to be relevant to their facts and circumstances), a number of SAG members suggested that the PCAOB consider publishing a principles-based framework to drive “best practices” and create a more consistent threshold level of audit quality across all industries and companies. 
 
SAG members also suggested the standard-setting board use its formidable “bully pulpit” through podcasts such as their well-received Audit Committee Dialogues and related PCAOB Dialogues podcasts to reinforce voluntary use of AQIs. They also suggested that, at least in the early years, such voluntary use could be more effective and efficient in achieving the PCAOB’s goal of raising audit quality and discussions around audit quality, versus issuing a one-size-fits-all rule with its risk of unintended consequences. 
 
Walt Conn Jr., U.S. partner and global head of audit methodology and implementation at KPMG, took this approach one step further. He suggested the PCAOB “issue a thought leadership piece encouraging auditors and audit committees to have dialogue (and) provide examples of AQIs (and) how they are calculated. That thought leadership piece could be updated after a year or two,” during which time constituencies and the PCAOB could discuss their experiences applying AQIs. 
 
Mike Gallagher, managing partner of assurance quality at PwC, said he believes a “hard-wired approach” to AQIs by a regulator would be “premature,” adding, “There may be a point where the role of (AQIs) can be enhanced by the regulator. We don’t want to ruin it by being too heavy-handed at this stage of the journey.”
 
Asked by PCAOB Chief Auditor Marty Baumann if a requirement for AQIs should be added to the PCAOB’s existing Auditing Standard No. 16 on communications with audit committees, Gallagher said that “bolting on” a requirement for AQIs onto AS 16 would be viewed negatively.
 
Chuck Senatore, executive vice president and head of regulatory coordination and strategy for Fidelity Investments, said of AQIs, “There’s no disagreement on the value of the discussion, but many times with a highly quantitative approach with certain rifle-shot indicators, there’s a danger of getting information but missing the view.” Appearing to fall into the “phased-in approach” camp, he continued, “We talked about the importance of context; perhaps as experience unfolds we’ll learn through the examination experience of the PCAOB (and) maybe see correlations between certain indicators and outcomes. … There may be something of value, but a little time needs to unfold before we get there.” 
 
SAG member Bob Hirth, chairman of the Committee of Sponsoring Organizations of the Treadway Commission (COSO), a private-sector organization that publishes guidance on internal control, corporate governance and anti-fraud studies, suggested the PCAOB apply its suggested AQIs during its audit firm inspection process. The PCAOB would then be in a position to study actual data to see if there are correlations or “causations” between certain AQIs and audit quality. 
 
PCAOB Chief Auditor Marty Baumann called such suggestions “excellent,” with respect to suggestions that the PCAOB apply the AQIs as part of inspectors’ root cause analysis. 
 
Another reason some SAG members called for voluntary application of AQIs was so voluntary efforts currently under way, including the transparency reports issued by the large audit firms and voluntary initiatives led by the private-sector Center for Audit Quality, could have more time for feedback and development.
 
Investor views mixed
There was debate about how useful AQI measures would be to investors, with investors themselves having different views.
 
“From an investor perspective, I’m a really big fan of disclosure, but I just don’t see this information as decision-useful at all,” said Jerome Perler, partner and director of research for Schilit Forensics. “I’m not a fan of quantitative metrics, especially ones designed to capture an inherently nuanced system, especially that cross geographies.” He noted that forcing such disclosures into quantified terms can force a move to the “lowest common denominator” and “runs the risk of the engagement being structured around these metrics.” 
 
“My recommendation,” Perler said, “(is that) I wouldn’t move forward on the investor side. From the audit committee side: If it’s helpful, great. If not, kill it.” 
 
In contrast, Peter Clapman, senior advisor with CamberView Partners, who has held senior leadership positions in corporate governance, argued, “I think investors need this.” Clapman said AQI disclosure “gives real meaning to the role of investors in ratifying auditor selection. I would encourage the PCAOB to get started with it right away.” 
 
“I would permit flexibility in exactly what factors are involved in those discussions” between the auditor and audit committee, said Clapman. “Ultimately, I think investor disclosure has got to get into this process.” He emphasized that the disclosure available to investors should focus on “what is happening in terms of the audit firm and audit committee reviewing AQIs  that make sense for that particular company in that particular industry. … Since this is the PCAOB,” he continued, “I would prefer the PCAOB do it in the auditor’s report. If the SEC wants to take over and put it in the proxy statement, I don’t have an objection to that, but too often (there is a) question of which agency should take over a disclosure.” 
 
A middle ground was expressed by Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. Elson stressed three points:


 
  1. “The notion of AQIs is a pretty good one for a lot of reasons. You have too many categories (in the Concept Release). I concur with earlier comments to have fewer than the 20-some odd AQIs you’ve got now.
”
  2. “That said, the question is: What is the value of this thing? Any time you force someone to be introspective has value, (but) vis-à-vis making disclosure mandatory − I would be against that. When you create mandatory disclosure, the whole exercise becomes legal boilerplate. I would keep it voluntary. I think you’ll ultimately get better audits out of it versus mandatory.
”
  3. “Does it mean anything to audit committees and investors? Any transparency is good. … Ratings are only helpful if you have a real choice in who you can pick. … At this point in large-cap companies, there really isn’t all that much choice. It’s down to a few firms, and (even fewer to avoid) conflicts. … Ratings only really matter if you have choice.” 
 
Elson added that the AQI project is “a great project, very thoughtfully done,” and that he was “eager to see it to its conclusion.” 
 
Joyce Joseph, principal at Capital Accounting Advisory and Research, advocated for a principles-based and phased-in approach, with “the PCAOB providing a slate of AQIs with definitions, and allowing use of AQIs among audit committees to be flexible.” Then, ”over time, audit committees could determine which AQIs are most relevant to their company’s given particular needs, facts and circumstances, allowing it to evolve, and also allowing time for that process to gather actual data and how they provide the best indicators of quality.” 
 
“Based on that data over some appropriate period of time,” Joseph suggested, the PCAOB could “consider identifying a core set of AQIs that potentially could be useful for investors, with investor input.” 
 
Time to act, but how?
Interesting views on whether AQIs should be mandated or voluntary were posited by a number of former regulators and standard-setters, as well as others who currently serve on the SAG.  
 
“Having been a standard setter,” said SAG member and former IASB Chairman Sir David Tweedie, “I noticed constituents fall into two categories: Conservatives say, ‘Don’t do it.’ Liberals say, ‘Do it, but not yet.’” Further defining the “not yet” camp, Tweedie, explained, were calls to do more research, conduct field tests, consult with constituents, and re-expose proposals. 
 
Tweedie was also not impressed with the voluntary efforts made by the large firms to discuss audit quality in what are commonly referred to as their “transparency” reports. “I’m not terribly interested in firms’ transparency documents. They talk about centers of excellence. Well, nobody has centers of mediocrity. What I’d like to know is, can I trust them? Is there someone like Mike Gallaher (PwC’s managing partner of quality assurance) running this audit? I want to know what the audit team is like, the makeup. Is it senior people? Are they specialized?  Have they called specialists in? What’s their industry experience? How long have they been on this sort of engagement?”
 
Referencing whether there was any correlation between AQIs and critical audit matters (or CAMs, the subject of a rule proposal issued by the PCAOB on the “auditor’s reporting model”), Tweedie said it could be helpful to consider, in looking at CAMs such as valuation, what the AQI measures have to do with that. 
 
“What this organization is meant to do,” said Tweedie, referring to the PCAOB’s mission, “(is) giving me confidence the numbers I look at are right. Those four AQIs would give me a lot about the team. Some of these 28 have gone into the stratosphere, but as far as actual accountants — experience, the type of people .. I am all for putting it in. I would get on with it now, unless you want to be another liberal saying yes but not yet.”
 
However, former SEC Chairman Richard Breeden shared a different view. After noting, “I add my voice to others commending those at the PCAOB. You have done a real service to the country,” he continued, “As a former regulator, and I suspect former prosecutors would say the same thing, the hardest challenge is having the courage not to act. It is far easier, when a snowball is rolling downhill, to go on than to say, ‘This cake is not ready. It’s half baked.” 
 
Describing unintended consequences that initially occurred after banking regulators prescribed risk-based capital rules following a banking crisis, Breeden said, “I think this illustrates the problem of a concept: It is impossible to argue audit quality isn’t important, but can you really regulate it, and can you mandate anything that will end up not being counterproductive?
 
“I believe audit quality is an elusive and complex thing,” Breeden continued. “(It is) not only of quantitative things … but also things like character of the engagement partner, audit manager, others on the team, the culture. Those things don’t get measured by quantitative indicators. … I believe you should not mandate any AQIs. You should require each registrant to publish not less than every five years — a statement of what they believe to be relevant AQIs for their firm. The PCAOB should publish a summary and let the market decide.” 
 
“My view,” said Brandon Rees, deputy director of the Office of Investment at the AFL-CIO, “is the problem with voluntary disclosure is that only those issuers that have high-quality audit committees and high-quality audits will benefit from that. It’s the companies that have problems that would benefit the most from mandatory firm-level and engagement-level disclosure.
 
“I would like to see the PCAOB move forward for specialized disclosures in the auditor’s report,” Rees continued. “The SEC could supplement it by requiring a discussion of AQIs, but at end of day … if AQIs are not measured, they won’t be mandated. In my view, sunlight is the best disinfectant. Mandatory disclosures will help those most in need of it.”
 
David Kane, Americas vice chair of the Assurance Professional Practice at Ernst & Young, suggested that the PCAOB continue to encourage discussion of AQIs between auditors and audit committees and “monitor those discussions, what context is needed to understand AQIs, and then to use that (information) to get smarter around next steps − I don’t think mandated, but down the road. A lot of credit goes to the board − Greg (Jonas) and team.” The challenge now, he added, is “how do you keep the momentum going, but not stifle innovation?” 
 
A distinct and view was shared by Richard Murray, CEO of Liability Dynamics Consulting and former global head of Legal and Regulatory Affairs at Deloitte & Touche, who said, “The PCAOB should declare victory, should remind the world that thought leadership is a valuable tool of regulation (and) not limited to standard-setting. Monitor (the use of AQIs) for three years and see where nature takes this issue.” 
 
“I favor it not being mandated,” said Joan Amble, president of JCA Consulting and former EVP and principal accounting officer for American Express. Amble serves on a number of audit committees, including two on which she is audit committee chair. Instead, she said “a principles-based model which talks about objectives would be helpful, (with) examples. Audit committees would determine which (AQIs) are most relevant, decision-useful.”
 
Noting the importance of trend analysis, Amble also emphasized the importance of qualitative discussions. “I would not support disclosure of that; it’s way too soon. We should walk before we run. I think if you empower audit committees you will get a better result.” She added that in piloting AQIs at a company, “when we did it, we had 12 indicators – that was too many. … Once you make it a burden, you’ve lost the benefit.”
 
FASB Board Member Larry Smith, in his role as an observer of the PCAOB SAG, said he believes there are essentially “two buckets of AQs: The firm-wide AQIs are part and parcel of the inspection process and should guide you. I would stop talking about that with the SAG and have that part of the inspection process.”
 
“In terms of engagement-wide AQIs,” Smith cautioned, “I am extremely fearful that to mandate would have unintended consequences that aren’t necessarily the best consequences. From the engagement level, context is the most important thing needed to understand responses to quality indicators. If we were to require disclosure of those, it could lead firms to make not the best decisions — e.g., select the lesser of the two qualified candidates. … I am fearful of that. I think it should be a voluntary endeavor by the PCAOB.”
 
“Sarbanes-Oxley Section 101(c) 5 (establishes) the duties of the (PCAOB): to foster improvement in audit quality,” noted Smith. Therefore, he continued, the AQI initiative “falls into your bucket. What you’re doing in developing these things − working with the SAG, the CAQ or others, in terms of voluntary use of AQIs at the engagement level − can improve the quality of audits, but I would not mandate (AQs) nor publish (disclose them).”
 
Sri Ramamoorti, director of the Corporate Governance Center at Kennesaw State University, said of AQIs, “In supporting a bias for action, I would suggest the PCAOB move ahead.” Quoting Victor Hugo, he added, “Audit quality is ‘an idea whose time has come.’”
 
“Many audit committees in the past perhaps were guilty of picking auditors based on cost rather than audit quality,” said Ramamoorti, who suggested a principles-based approach be adopted by the PCAOB, in particular to provide guidance for investors and audit committee members that are not necessarily “experts.”
 
“The PCAOB is uniquely in the leadership position to become the tide that lifts all boats and improve audit quality worldwide,” Ramamoorti said. “This effect will echo around the capital markets worldwide. That’s the influence the PCAOB can have with this kind of project.”
 
Board, staff will consider feedback in determining next steps
The current status of the AQI project was subsequently summed up by PCAOB Board Member Jay Hanson in remarks at FEI’s Current Financial Reporting Issues Conference.
 
“We received 47 comment letters in response to the release, and just last week our Standing Advisory Group held a discussion to provide further input on this important topic,” Hanson said. “The feedback was mixed, with some commenters supporting the project but advocating that we should let practice develop on a voluntary basis. Other commenters supported the project and urged us to act quickly to mandate public disclosure of certain audit quality indicators. Our staff will digest all of this feedback, and I hope that we will be able to determine the most practical and useful next steps and a further narrowing of the most promising potential indicators.”
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