Outside Overseers of US Audit Firms Represent Radical Change

An overlooked aspect of a watchdog’s decision to have independent overseers assess quality controls at registered auditing firms is what a radical change it represents in how major audit firms have historically operated.

For decades prior to the Public Company Accounting Oversight Board’s establishment in 2002, the audit industry was self-regulated, with firms rotating to evaluate the quality controls of peers. History proved that the old peer review system lacked transparency and had inherent conflicts of interest that negated its intended purpose of testing and reporting audit quality failures.

Since the creation of the PCAOB, registered audit firms have been subject to board inspections and enforcement actions but were still free to operate autonomously. With the PCAOB’s new standard, known as QC 1000, that freedom is going to change.

QC 1000, approved by the Securities and Exchange Commission earlier this month, will require registered audit firms to report the effectiveness of their overall quality control system each year to the PCAOB, including a certification by audit firm leadership. Audit firms that issue annual audit reports for more than 100 issuers also must establish an external quality control function comprising independent individuals who will provide oversight and evaluate the audit firm’s quality control system.

The new rules say the oversight panel must be “composed of one or more persons who are not partners, shareholders, members, other principals, or employees of the firm and do not otherwise have a commercial, familial, or other relationship with the firm that would interfere with the exercise of independent judgment with regard to matters related to the QC system.” This group will evaluate “the significant judgments made and the related conclusions reached by the firm when evaluating and reporting on the effectiveness of its QC system.”

The audit industry has now evolved from self-regulation and control, to having regular inspections of the quality of their audits by a regulatory body, to having external parties involved in their corporate governance and evaluating the quality control of their audit processes: a seismic shift for firm leadership to accept.

The new requirements are akin to combining the mandate to document, test, and certify the effectiveness of a public registrant’s internal controls under Section 404 of the Sarbanes-Oxley Act—the law that created the PCAOB—with creating an audit committee equivalent for oversight of an audit firm’s quality control system.

Section 404 greatly improved the quality of financial reporting for public registrants and lessening restatements, and QC 1000 has the potential to improve audit quality and lessen audit deficiencies. The need for improvements in audit quality is obvious when reviewing the growing deficiency rates reported for the industry based on PCAOB inspections.

The concept of an independent oversight function for audit firm quality isn’t new. Individuals may recall the Volcker plan in early 2002 to save Arthur Andersen in its final days. The plan involved former Federal Reserve Chair Paul Volcker leading an oversight function for Andersen’s audit quality. The Volcker plan never happened but now, decades later, the concept will become reality for the entire audit industry.

For the new quality control requirements to reach their full potential, the external function’s role must be highly respected within the audit firms; for it to be most effective, recruiting individuals who will be independent is critical.

Hopefully, audit firms won’t recruit industry insiders such as retired partners from peer firms, or academics whose institutions receive major donations from the audit industry, such as endowed professorships by the major firms.

Doing so would appear more like the old peer review system than one worthy of respect with a former Federal Reserve chair leading the independent function of audit firm oversight.

This isn’t just a PCAOB issue. Audit committees should have a strong interest in knowing how their audit firm will select individuals for the external function. Hopefully, they will be people who can represent the interests of the financial statement user community and who understand the importance of quality financial reporting.

Respected business and government leaders, former regulators from the SEC and the PCAOB, attorneys with expertise of audit issues, and investment professionals who rely heavily on the audit industry may be among the best individuals to serve.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Joseph Floyd is partner and co-founder of Floyd Advisory, a consulting firm in Boston and New York City that provides financial and accounting expertise.

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