Insights on reforms

By Clive Lennox + Jeffrey Pittman
Illustration: Baiba Black

While scarce, there are some indications that the new regulatory landscape has strengthened auditing in Canada

Are reports from regulatory oversight institutions informative to public companies and audit committees? Have regulatory changes strengthened audit practice? Research that outlines and analyzes the impact of recent reforms to the oversight of audit firms in the US and Canada sheds light on these issues. These reforms follow a surge in high-profile financial reporting failures and reflect attempts by regulators to restore investor confidence in capital markets. For example, the Canadian Public Accountability Board (CPAB), which has been conducting inspections since 2003, strives “to contribute to public confidence in the integrity of financial reporting of public companies in Canada by promoting high quality, independent auditing.”

Rigorous auditing is grounded in auditors’ incentives to constrain managers from excessively exploiting their discretion over accounting policies and estimates.¹ Jere R. Francis reviews prior theory and evidence that public accounting firms supply high-quality audits to protect their reputations and to avoid becoming ensnared in potentially ruinous litigation.² However, Mark DeFond stresses that countries’ oversight institutions — such as the CPAB in Canada and the Public Company Accounting Oversight Board (PCAOB) in the US — that monitor the profession likely also play an integral role in shaping audit firms’ incentives that, in turn, affect the credibility of their clients’ financial statements.³ It is important to keep in mind that Canada still mainly adheres to professional self-regulation while the US recently shifted to government oversight of public company audits.

Although CPAB has apparently made progress in improving the auditing process for public company engagements, some commentators argue that its oversight suffers from failing to publicly divulge the results of its inspections by individual audit firm.⁴ Rather than identifying audit firms in its public reports, CPAB only comments on their collective performance. For example, in its initial report on the state of the audit profession in Canada that focused strictly on the four largest public accounting firms, CPAB concludes that although there were no systemic problems with the quality of their external audits, there were several ways that the Big Four could strengthen their assurance services. However, users cannot rely on this disclosure to gauge the audit quality of any of the firms within the Big Four.

Brian Hunt, CEO of CPAB, defends this approach: “Firms take our inspections seriously. As long as we’re seeing improvements, we don’t see the need” to report at the firm level.⁵ In the opposite direction, Steve Salterio, a renowned accounting scholar at Queen’s School of Business, calls for more extensive disclosures: “The report is too much of an aggregate level. It needs to be firm specific... . Tarring everybody with the same brush is not helpful.” Similarly, the Fraser Institute encourages CPAB to disseminate its findings by audit firm to ensure that market participants are in a better position to evaluate audit quality.⁶ In sharp contrast to the situation in Canada, PCAOB in the US provides more transparency on the outcome of its inspections by making portions of its report cards on individual audit firms publicly available. However, recent evidence implies that US capital market participants do not perceive that these disclosures on the performance of specific audit firms to be informative.

In one of its major provisions, the Sarbanes-Oxley Act of 2002 (SOX) created PCAOB to handle the periodic inspection of the firms that audit US public companies, reversing almost 25 years of professional self-regulation under peer review. In this institutional structure, the US Securities and Exchange Commission (SEC) continues to monitor public companies, while PCAOB monitors the audit firms. Clive Lennox and Jeffrey Pittman dissect from an information standpoint the implications of this transition in the regulations governing the oversight of audit firms.⁷ They document that changes in audit firms’ market share are insensitive to PCAOB inspection reports, implying that public companies ignore this information when choosing an auditor. In other words, Lennox and Pittman find no evidence that public companies tend to appoint (dismiss) audit firms receiving favourable (unfavourable) PCAOB inspections reports, which is somewhat surprising given that audit committees routinely insist on reviewing reports on audit firm quality before settling on an auditor.⁸

Lennox and Pittman’s results stand in stark contrast to prior research that the former peer review program, which the American Institute of Certified Public Accountants abandoned for public companies after PCAOB began its inspections in 2004, was informative according to audit firm client perceptions.⁹ Although the program has long been criticized for independence shortcomings, clients nonetheless interpret peer review reports as reliable signals of audit firm quality.¹⁰ Consequently, Lennox and Pittman sharpen their analysis to help empirically resolve which disclosures under the old peer review system are considered informative. Their evidence suggests that clients value peer review reports because they render an overall opinion on the audit firm’s quality and include an evaluation of its quality control systems. However, PCAOB’s public disclosures do not cover either of these issues, leading the authors to infer that this partly explains why these reports are irrelevant to public companies’ auditor appointment decisions.

In a nutshell, the PCAOB inspection reports fail to provide the very information that clients value according to research on self-regulation under peer review. This evidence squares with the take of J. Michael Cook, past chairman of Deloitte, in CFO magazine, 2007: “I think the [PCAOB inspection] process is well intentioned, and it is helpful and constructive, but right now it is not producing the kind of results that it should for people who are using the results and trying to understand what this means.’’ Similarly, Joah Hodowanitz and Steven Solieri criticize the lack of transparency in PCAOB reports, ‘‘With today’s emphasis on full disclosure by public companies, a confidentiality escape clause does little to inspire investor confidence in the PCAOB as the auditing profession’s newly appointed watchdog.”¹¹ The partial public disclosure in PCAOB reports is required according to Section 104 of SOX, which stipulates that defects in quality control systems are not divulged unless the audit firm neglects to correct these within 12 months of the release of the inspection report. Predictably, the absence of reporting on audit firms’ quality control system has prompted calls for more transparency; e.g., John Coates argues that ‘‘client firms will not know about and will not be able to react to those criticisms. Increased disclosure by PCAOB would be appropriate.’’¹²
Although PCAOB was supposed to improve transparency, Lennox and Pittman conclude that less is known about audit firm quality under the new regulatory regime. In fact, their analysis suggests that the informational value of peer review reports stem from findings that PCAOB inspectors withhold from the public. This research may have policy implications for Canadian regulators since the argument that CPAB falls short on transparency fails to consider that the more comprehensive disclosure under the PCAOB inspection process provides minimal incremental information to the capital markets; i.e., US public companies appear to almost fully discount these disclosures when selecting an audit firm.

Indeed, despite the difficulty in justifying policy prescriptions at this early stage — both CPAB and PCAOB have short track records — it would appear that the best way for CPAB to improve transparency would be to follow the reporting format under the US’s old peer review program that PCAOB supplanted (please see chart on p. 37). This would involve publicly disclosing the audit firm’s quality control problems along with an evaluative summary of its overall level of audit quality in the form of, for example, an unmodified, a modified or an adverse opinion. In comparison, the public portion of the PCAOB inspection reports diverge from peer review by narrowly focusing on engagement weaknesses without outlining any quality control deficiencies or issuing an evaluative summary. Still, PCAOB’s reporting format was specified in SOX such that inspectors must ensure their disclosures on audit firm performance comply with this legislation.

Importantly, evidence that PCAOB reports lack information value does not necessarily mean their inspections fail to strengthen audit quality. In fact, although there is no empirical evidence to date on this issue, DeFond stresses that PCAOB might rely on imposing stricter standards and harsher penalties to motivate firms to improve their audits in anticipation of a visit from one of its inspectors. Besides initiating its own disciplinary proceedings, PCAOB can notify the SEC of auditor misconduct or the US Justice Department of potential criminal violations. Prior evidence implies that holding auditors civilly or criminally responsible for deficient performance has a sobering impact on their incentives to conduct better audits; e.g., Omrane Guedhami and Pittman.¹³ Reinforcing that its inspections are intended to play a remedial role, PCAOB holds that its primary purpose is “to promote ongoing improvements in audit quality of registered firms.”¹⁴
Another potential upside of the PCAOB inspection process is that audit firms are prevented from selecting their own reviewers, which may improve objectivity. In fact, consistent with the heavy criticism levelled at the former peer review system, Lennox and Pittman find that audit firms tended to exploit this discretion by choosing lenient reviewers, which was permissible under the old system; i.e., audit firms were more likely to switch to another reviewer if the incumbent filed an unfavourable report.

CPAB has also relied on sanctions to strengthen audit practice in Canada. For example, seven audit firms were recently forbidden from accepting new public company clients until CPAB recommendations were addressed, while another’s registration was revoked for failing to comply with CPAB standards. Moreover, some partners in firms ranging from smaller regional practices to the Big Four share the perception that CPAB has helped improve audit quality across the country.¹⁵ On the other hand, some small firms have elected to no longer audit public companies to avoid the higher regulatory burden under the CPAB, including its fees and registration requirements.¹⁶

In short, although evidence corroborating this remains scarce, there are some indications that the new regulatory landscape has strengthened auditing in Canada despite that CPAB reports do not provide audit firm-level disclosure on performance. However, recent research on US regulatory institutions suggests that capital market participants ignore PCAOB-style inspection reports in any event.

References
1   Watts, R. and J. Zimmerman. 1986. Positive Accounting Theory. Prentice-Hall.
2   Francis, J. R. 2004. “What do we know about audit quality?” The British Accounting Review 36: 345-368.
3 DeFond, M. 2009. “How should the auditors be audited? Com-paring the PCAOB inspections with the AICPA peer reviews.” Journal of Accounting and Economics, forthcoming.
4   Middlemiss, J. 2008. “From there to here.” CAmagazine 141: 22-28. However, some commentators dispute that the CPAB is effective in improving quality of public company audits; e.g., Jamal and Tan (2008, “Will IFRS help?” Financial Post, October 28, 2008).
5   Moulton, D. “Lack of CPAB specifics on firms bothers Salterio.” The Bottom Line 25: 1-2
6   Pritchard, A. C. and P. Puri. 2006. “The regulation of public au-diting in Canada and the United States: Self-regulation or gov-ernment regulation?” Fraser Institute. February: 1-43.
7 Lennox, C. and J. A. Pittman. 2009. “Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms.” Journal of Accounting and Economics, forthcoming.
8 Woodlock, P. and G. Claypool. 2001. “Your audit committee: How to cope with the end of the ‘rubber stamp’ era.” The Journal of Corporate Accounting and Finance 12: 27-39.
9 Hilary, G. and C. Lennox. 2005. “The credibility of self-regulation: Evidence from the accounting profession’s peer review program.” Journal of Accounting and Economics 40: 211-229.
10 The Public Oversight Board (2002, “The road to reform: A white paper from the Public Oversight Board on legislation to create a new private sector regulatory structure for the accounting profession.”: 22-23) summarizes that ‘‘peer review has come under considerable criticism from members of Congress, the media and others. ‘You scratch my back, I’ll scratch yours’ is the prevailing cynical view of peer review raised by many.’’ DeFond and Francis (2005, “Audit research after Sarbanes-Oxley?” Auditing: A Journal of Practice and Theory 24: 5-30) recount that Deloitte & Touche issuing a ‘‘clean’’ peer review report on Arthur Andersen in December 2001 — shortly before Andersen admitted shred-ding documents from the Enron engagement — was partly responsible for the US replacing professional self-regulation with external monitoring by the PCAOB.
11 Hodowanitz, J. and S. A. Solieri. 2005. “Guarding the guardians.” Strategic Finance, August: 47-53.
12 Coates, J. C. 2007. “The goals and promise of the Sarbanes-Oxley Act.” Journal of Economic Perspectives 21: 91-116.
13   Guedhami, O. and J. A. Pittman. 2006. “Ownership concentration in privatized firms: The role of disclosure standards, auditor choice, and auditing infrastructure.” Journal of Accounting Research 44: 889-929.
14    Public Company Accounting Oversight Board. 2008. Annual Report. PCAOB, Washington, DC.
15    Lorinc, J. 2002. “After Enron.” CAmagazine 135: 21-26.
16    Barcelo, Y. 2007. “Standards overload blues.” CAmagazine 140: 24-30. Gibbins, M. and K. Jamal. 2006. “The more things change…” CAmagazine 139: 41-45.

Clive Lennox, PhD, is a professor at Nanyang Technological University, and Jeffrey Pittman, PhD, CA, CMA, is a professor at Memorial University of Newfoundland

Technical editor: Christine Wiedman, PhD, FCA, School of accounting and finance, University of Waterloo