The Public Company Accounting Oversight Board (PCAOB) has recently introduced significant changes aimed at improving the quality of audits performed by audit firms (Maurer, 2024). The new rules, approved on May 13, 2024, mark a crucial step in updating decades-old standards, ensuring that audits are conducted with greater accuracy and transparency. This move is part of a broader effort to enhance the effectiveness of audits and align them with contemporary expectations.
New Quality Control Requirements
The PCAOB's new rule mandates that audit firms assess and address risks associated with their quality control systems, which encompass ethics, personnel management, and audit-engagement performance. Audit firms are now required to report annually to the PCAOB on the efficacy of their policies and procedures. Two firm leaders must personally certify these reports, reinforcing accountability at the highest levels of firm leadership. Chair Erica Williams emphasized that "simply designing elaborate processes on paper won’t be enough," highlighting the necessity for actionable and effective quality control measures.
Independent Oversight
Additionally, firms auditing over 100 companies annually must appoint an independent member to their governance board. This independent member will play a crucial role in monitoring the quality control systems and ensuring the annual evaluations are performed properly. This requirement aims to bring an external perspective to the internal quality controls of audit firms, promoting objectivity and rigorous oversight.
Controversies and Concerns
Despite the clear intentions behind these rules, they have not been without controversy. Board member Christina Ho, who previously supported the proposal, opposed the final rule, arguing that it may impose excessive burdens on audit firms without providing commensurate benefits. Ho's concern centers around the potential reduction in firm competition and the increased responsibilities that could deter future accountants from entering the profession. Additionally, these new rules could ultimately increase the costs of audits, particularly affecting smaller reporting companies with limited resources.
Accelerating Audit Documentation
In tandem with the new quality-control rules, the PCAOB also approved a rule to expedite the documentation process of audits. Auditors will now have up to 14 days to assemble their final audit documentation, a significant reduction from the previous 45-day period. This change aims to enable the PCAOB to begin inspections sooner, ensuring timely reviews and oversight.
Effective Dates and Implementation
These new rules are set to go into effect on December 15, 2025, pending approval from the Securities and Exchange Commission (SEC). They reflect a concerted effort to modernize auditing standards and enhance the reliability of financial reporting.
Research on Auditor-Client Compatibility
The importance of these changes is underscored by recent research that highlights the critical role of auditor-client compatibility in audit quality. A new metric developed to measure this compatibility has shown that better auditor-client fit is associated with lower instances of restatements and abnormal accruals, and it positively influences market reactions to earnings reports. This research underscores the value of rigorous PCAOB inspections and the necessity of aligning audit practices with companies' critical accounting policies (Erinc & Zach, 2024).
Real-World Examples
Experienced CFOs are likely familiar with audit firms exposed for inadequacies in their internal control systems. In the examples below, our seasoned CFO identified potential issues and recommended that Audit Committees take the inconvenient steps to terminate their auditors mid-audit due to significant concerns.
In one case, a national audit firm failed to detect massive accounting and reporting fraud perpetrated by the CEO and CFO of a public company. This fraud went undiscovered (or unreported) for several years until the company faced a sudden liquidity crisis. Once an Interim CFO was brought in to address the situation, he recommended terminating the audit firm. The Interim CFO then restated several years of the company's financial statements. Subsequent investigations revealed that the audit firm's workpapers were substandard and contained suspect or fictitious documentation from the client that had been overlooked. The SEC later charged the engagement partner, and subsequently the audit firm for widespread quality control deficiencies.
In another instance, an audit firm had taken on so many audits that it could not, or chose not to, maintain adequate controls. This situation was likely exacerbated by the SPAC boom in recent years. In the opinion of our CFO, another contributing factor was the firm's outsourcing model, which involved sending audit work to inadequately trained staff in other countries, resulting in excessive billing, ineffective communication with the client team, and challenges completing the audit. The fractional CFO terminated and replaced the auditor mid-audit. Within months, the SEC charged the audit firm with deliberate and systematic failures and a "100% failure rate," affecting more than 1,500 filings over a two-year period. The firm was fined and permanently banned from practicing before the Commission, leaving hundreds of public filers without an auditor and with worthless audits for preceding periods.
The PCAOB's new rules represent a significant advancement in the field of auditing. By enforcing stringent quality controls and accelerating the documentation process, these measures aim to bolster the integrity and effectiveness of audits, ultimately fostering greater confidence in financial reporting. As the auditing landscape evolves, continuous efforts to refine and enhance standards will be essential in maintaining the trust and reliability of the financial markets.
The Authors
Ernie Scheidemann is a Partner at the Florida CFO Group and a seasoned professional, with a proven track record of implementing best practices, enhancing internal controls, and strategic financial leadership across diverse industries. Ernie has significant experience in the financial and risk management areas, having served as Chief Financial Officer for multiple public, private, and PE backed companies. You can also visit Ernie’s LinkedIn profile for more information.
Don Noble, a Partner at the Florida CFO Group and a technology expert, boasts an extensive background in financial leadership and advisory roles. Leveraging his wealth of experience, he collaborates with businesses to optimize their financial and technological strategies, fostering growth and resilience in the dynamic marketplace. You can also visit Don’s LinkedIn Profile for more information.
If you have any questions or would like to have a discussion in your organization’s goal posts, please give the Florida CFO Group a call at (877) 652-2367. We are here to help you navigate your financial challenges and achieve success.
References
Erinc, M., & Zach, T. (2024). Auditor-Client Compatibility and Audit Quality (SSRN Scholarly Paper 4703916). https://doi.org/10.2139/ssrn.4703916
Maurer, M. (2024, May 13). PCAOB Adopts Tighter Rules on Auditors’ Quality Controls. Wall Street Journal. https://www.wsj.com/articles/pcaob-adopts-tighter-rules-on-auditors-quality-controls-f00d3202