PCAOB Drops 2019 Hints

Audit firms can expect new types of regulatory inspections in 2019, audit committees and internal audit executives can expect inspection reports with new types of information, and the corporate accounting world may finally see new proposals on auditing estimates and use of data analytics in financial auditing.

So said William Duhnke, chairman of the Public Company Accounting Oversight Board, in a wide-ranging speech he delivered Thursday to accountants and lawyers in Washington. We haven’t heard much from Duhnke since he took over at the PCAOB in January — this is only the third speech he’s given — so let’s review what he had to say.

First, inspections of audit firms. Duhnke said the PCAOB has spent months “revisiting the fundamental purpose of our inspections program,” on everything from which corporate audits get selected for inspection to how those findings are conveyed to the public. “Audit firms should expect to see some changes in our inspections approach beginning with the 2019 inspection cycle.”

What kind of changes? Duhnke said audit firms should expect an increased focus on the firms’ systems of quality control. “We have observed increased audit quality where firms have emphasized strong root cause analysis, thoughtful engagement management, careful assignment of personnel, and risk-focused client acceptance and retention processes,” he said.

The PCAOB also plans to deploy teams of inspectors across multiple firms to review the firms’ work on specific topics. That’s a change from current practice, where PCAOB inspection teams focus on individual firms.

Duhnke also promised more PCAOB outreach directly to corporate audit committees, although he didn’t exactly how that outreach might happen. Nevertheless, “I’ve spoken with dozens of audit committee members over the past several months,” Duhnke said. “Nearly all have emphasized the need for the PCAOB to engage more often and more directly with them.”

While I’m hard-pressed to imagine an audit committee telling a sitting PCAOB chair, “No thanks, we’re good,” Duhnke does raise a valid point. Audit committees do remain unclear on how much they can push back against audit firms questioning judgments about risk or financial reporting items, especially since the firms themselves are under pressure from just about everyone to be more skeptical of management statements. Even prior PCAOB leadership wanted the agency to court audit committees more directly, although the PCAOB never quite figured out how to do that well. If Duhnke can, more power to him.

Shifting Enforcement Priorities

As one might expect, Duhnke also talked about changing PCAOB enforcement strategy — “not only to detect audit deficiencies but also prevent them from occurring in the first place… To the extent we identify changes that will make our approach to enforcement more efficient and effective, we will make those changes.”

Well, you prevent audit deficiencies in the first place by more rigorous inspection of firms, so they feel the heat to clean up their processes and procedures. Therefore the cynic in me wonders if we might see a shift in PCAOB resources and attention away from enforcement (especially of firms themselves, rather than individual rogue auditors) and into inspections and standard-setting. That would be in step with the Trump Administration’s general philosophy of fewer punitive measures against businesses anyway.

Duhnke did say, “In coordination with the SEC, we will prioritize our enforcement efforts so that those efforts focus on addressing the issues that pose the greatest risk to the investing public and are most likely to drive improvement in the quality of audit services. In particular, when we see significant audit failures — including the reckless exercise of auditor judgment — we will pursue those cases.”

Then again…

Effective audits unquestionably require auditors to exercise substantial judgment. So long as those judgments are made in good faith and are guided by the sound application of our auditing standards, auditors should feel empowered to make them.

We do not and will not second guess judgments that, when made, were reasonable under our standards and applicable law. However, where auditors refuse to see the obvious, choose to turn a blind eye, or fail to carry out their responsibilities under the securities laws and our standards… we will not hesitate to hold them accountable.

Take that as you will. But it is interesting that Duhnke spent so much time talking about auditors’ use of judgment just as audit firms will start exercising much more judgment thanks to the new audit report format going into effect next year. That format will include auditors’ disclosure of “Critical Audit Matters,” where issues of complex and subjective judgment will almost always qualify as CAMs they report to the public.

New Auditing Standards

Duhnke also mentioned a few new auditing standards or projects the PCAOB is cooking up, neither of which can get here too soon.

First, expect a proposal to overhaul standards for auditing estimates. Right now the PCAOB addresses estimates in three different standards, all from 2003, and Duhnke has had enough of that.

“The continuing evolution of accounting standards and financial reporting obligations has increased the prevalence and significance of accounting estimates, including those based on fair value measurements… I anticipate that our staff will recommend amendments that will replace the existing standards with a single, updated standard,” he said.

Duhnke also said the PCAOB is researching how to approach the use of data analytics in auditing and financial controls. He didn’t flat out say that a new standard will be proposed in 2019, but the potential for data analytics is auditing is enormous. I’ve seen some companies better at analytics than their audit firms, and some firms better at it than their corporate clients. Negotiating those expertise gaps can be painful, and expensive.

So I’m hard-pressed to see how this PCAOB project doesn’t result in a proposed standard. It’s pretty much the Wild West out there right now. Duhnke seems to be of similar mind:

We thus have a discrete project on our research agenda to explore whether there is a need for guidance, changes to PCAOB standards, or other regulatory actions in light of new and emerging technology-based tools… As we anticipate relevant advancements and the need for changes to our guidance and standards, we will develop specific action plans to respond, with the goal of ensuring that the advancements support informative, independent, and accurate audit reports.

That sounds to me like a new standard will be forthcoming. I haven’t met anyone who expects otherwise, really.