Sarah N. Lynch is a young business reporter for Reuters. She has previously published such good work that I’ve started looking for her by-line. Her story on Friday, June 29, 2012 alerts us to an important auditing issue.
Lynch’s story is “SEC official backs shareholders on auditor independence.” In this story, she reports on a speech by SEC Commissioner Louis A Aguilar (Democrat) to the NAPPA 2012 Legal Education Conference in Philadelphia, PA, on June 27, 2012.
Aguilar’s speech is noteworthy for two reasons. First, it was one of two speeches last week by SEC Commissioners in which it was emphasized that audit quality is deteriorating and investor confidence in securities markets is waning. Second, Commissioner Aguilar disagrees with SEC staffers who have blocked shareholder proposals to rotate auditors at their company or to promote other forms of improving auditor quality.
Really? Companies have received at least two dozen shareholder proposals to vote on auditor rotation and increased auditor disclosure, and the SEC’s Division of Corporation Finance let companies block them from shareholder vote? Aguilar’s comments on this are highlighted below.
It is apparent that pressure is being directed at the PCAOB from the lofty heights of the Commissioners of the SEC.
Aguilar’s speech is important. To promote your reading of relevant portions, I’m publishing them in this blog post.
A Challenge for Investor Protection — Promoting Audit Quality
Another significant corporate governance challenge is the unacceptably large number of audit deficiencies identified by the Public Company Accounting Oversight Board (“PCAOB”), in routine inspections of outside auditors. This is a disturbing trend, which raises serious concerns about the proper functioning of the securities market.
As this group knows well, the PCAOB was established by Congress in the wake of Enron, WorldCom and other accounting scandals of the “dot-com bubble” era. The PCAOB is charged with overseeing the audits of public companies to protect the interests of investors and to further the public interest in the preparation of informative, accurate, and independent audit reports. We are heading into the Board’s ninth annual inspection cycle, and the largest accounting firms — that is, those that issue audit reports for 100 or more public companies — are audited annually, so there is a wealth of information about audit quality that can be analyzed.
Unfortunately, the available data raise serious issues about the quality of the audits. For the 2010 inspection cycle, the Board issued inspection reports for eight accounting firms in the “annual inspections” category.29 In the aggregate, these firms are responsible for auditing the financial statements of the great bulk, by market capitalization, of public issuers.30 In each case, the Board identified multiple audits with deficiencies in the performance of audit work reviewed; and in each case, the Board’s inspection team identified multiple weaknesses that rose to the level of audit failures. In these cases, the Board’s inspection team determined that the deficiencies were of such significance as to appear that the auditors had “failed to obtain sufficient appropriate audit evidence” to support their audit opinion on the financial statements.31 This is a criticism that goes to the very heart of what an independent audit is all about.
Moreover, the evidence suggests that this year’s results were not an aberration. Many common deficiencies cited in those recent inspection reports were also identified as frequent weaknesses in the PCAOB’s 2010 report on audit risk areas affected by the economic crisis, which focused on the 2007, 2008 and 2009 audit cycles.32
This is simply not acceptable. Investors need reliable and useful information to make good investment decisions. They must have confidence that an issuer’s financial statements fairly reflect its true financial condition and results of operations, and properly disclose its contingencies and other risks.33 It is of particular concern that, in the wake of the financial crisis, audit quality appears to be deteriorating.34
A Public Discussion on Promoting Better Audit Quality
In reaction to its findings, last year the PCAOB issued a concept release that explored some potential ways to promote better audit quality.35 The Board noted that its inspections “frequently find audit deficiencies that may be attributable to a failure to exercise the … professional skepticism and objectivity” required of auditors.36 The release requested advice and comment on potential approaches the Board could take to help auditors maintain that required mindset more consistently.
Professional skepticism is a key element of the professional conduct required of all auditors. It requires “an attitude that includes a questioning mind and a critical assessment of audit evidence.”37 Exercising such objectivity means that an auditor must be, in fact as well as in theory, truly independent of management. As the PCAOB’s chairman has put it: “Skepticism is what makes the auditor’s work relevant to investors…. [It] is the foundation for investor confidence in financial reporting.”38
Following that concept release, the Board received hundreds of comment letters; convened a two-day public meeting with dozens of panelists; and sought the views of its Standing Advisory Group and its Investor Advisory Group. This public discussion has generated a truly extraordinary amount of valuable information about auditors, audit committees, management, and investors and the way they prepare, review, audit, and/or use financial statements, including a broad range of issues that need to be considered in terms of improving auditor independence and objectivity and, ultimately, audit quality.39
The Board is currently considering a wide range of potential options for improving audit quality, including possible measures regarding periodic auditor rotation, enhanced disclosure in the audit opinion, an “Auditor’s Discussion and Analysis” in the issuer’s Annual Report, improvements to auditing standards, and the continued importance of effective root cause analysis when audit failures do occur, as well as ideas for strengthening the role of the audit committee and improving audit committee performance.40
Whatever the outcome of the PCAOB’s project, the discussion should certainly be useful to anyone committed to improving audit quality.
As shareowners and investors, public pension funds can make an important contribution to the current dialogue on improving audit quality. I encourage you to provide comments to the PCAOB and the SEC, and I urge you to ask the companies you invest in, and their audit committees, to promote independence, objectivity, and professional skepticism on the part of their auditors. I know that many of you are already doing so.
Shareholder Oversight — A Right of Ownership
In addition to the PCAOB, some shareholders have also expressed concerns about audit quality by submitting shareholder proposals relating to the audit engagement process. For example, a proposal submitted to companies such as Walt Disney, Deere, Alcoa, GE, and AT&T requested that the company establish an auditor rotation policy that would have imposed a seven-year term limit on the engagement.41
Another proposal, submitted by a shareowner to companies such as CA, Dell, and McKesson, called for the issuer’s audit committee to provide an annual “audit firm independence report,” disclosing the length of tenure of the company’s current audit firm, the aggregate fees paid to the firm, and other information regarding auditor independence and objectivity.42
The companies that received these proposals generally sought to exclude them from their proxy statements on the ground that the proposal related to a matter of ordinary business that should be left to management and the board.43 The SEC’s Division of Corporation Finance received at least 24 requests to exclude the above proposals on such grounds, and in each case the staff sided with the issuer by issuing a “no-action letter.” However, such letters by the staff do not require Commission input, and do not represent a determination by the Commission or any of the Commissioners.
The staff action was predicated on current SEC rules that permit a company to exclude a shareholder proposal if the proposal deals with a matter relating to the company’s ordinary business operations.44 However, there is an important exception to that rule: In those cases in which a proposal’s underlying subject matter transcends the day-to-day business matters of the company and raises significant policy issues, the proposal is generally not excludable on such grounds.45 This is particularly the case when an issue has emerged as a topic of “widespread public debate,” as this issue has been.46 Given the extensive public discussion occasioned by the PCAOB’s concept release, and the long history of debate on this issue,47 a strong case can be made that shareholder proposals relating to auditor independence and objectivity and audit quality raise significant policy issues and should not be excluded on ordinary business grounds.
More broadly, I am not convinced that the engagement of the independent auditor should necessarily be considered a matter relating to “ordinary business operations” within the meaning of the Federal proxy rules. For example, shareholders of public companies have routinely been given the right to ratify the company’s selection of an independent auditor since the 1930s.48 According to reports, in 2010, 92% of the companies in the S&P 500 held a shareholder vote on auditor ratification.49
We know that the quality of audit services is of paramount importance to investors. It is also a matter of great public importance. In the words of Chief Justice Warren E. Burger of the United States Supreme Court, the role of the independent auditor is “a public responsibility transcending any employment relationship with the client.”50 As the Chief Justice said:
The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public. This “public watchdog” function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.51
Clearly, this public function “transcends” a company’s ordinary business operations as well.
As the Court of Appeals for the Third Circuit has held, “Surely, the audit of a corporation’s books may not be considered to be peculiarly within the discretion of the directors. A corporation is run for the benefit of its stockholders and not for that of its managers.”52 Accordingly, as that court stated, the selection of the corporation’s auditors is “beyond any question … a proper subject for action by the stockholders.”53
In other words, issues relating to auditor independence and audit quality are matters of corporate governance, not merely ordinary business operations. It is only prudent that shareholders, as the owners of their companies, should have a voice on these issues.
In light of the wide prevalence of audit failures so clearly documented by the PCAOB, I respect that shareholders are trying to protect their interests. As a Commissioner of an agency that proclaims itself the “Investor’s Advocate,” I am on their side.
Debit and credit – – David Albrecht