Guest post: Public transparency for audit engagement performance metrics

We've been waiting since at least 2008, since the U.S. Treasury Advisory Committee on the Auditing Profession (ACAP) report’s recommendations. How dare anyone call this "midnight rule-making"?

Today at the AICPA & CIMA Conference on Current SEC & PCAOB Developments we heard PCAOB Chair Erica Williams talk about the work her team has accomplished and the remaining work she hopes to still do. One important thing she has accomplished is catching up on updating auditing standards and initiating new ones, important ones that have been waiting a long time to become a reality. Two of them are still to be approved by the SEC. With the changing of the guard at the SEC that will soon occur, that is not a certainty.

Here’s what Chair Williams said:

While the PCAOB has made great progress on our agenda, there is still critical work ahead of us to ensure investors are protected.

With the Board’s recent adoptions of the Firm and Engagement Metrics standards and Firm Reporting rules, this Board is making strides to provide investors with the level of transparency they have been asking for since at least 2008, as outlined in the U.S. Treasury Department 's Advisory Committee on the Auditing Profession (ACAP) report’s recommendations.

Firm and Engagement Metrics would provide investors, audit committees, and other stakeholders with valuable information on firms and their engagements to help them make knowledgeable decisions regarding audit firms and investment-related choices.

We believe these two projects provide valuable information to all market participants to enable, among other things, price discovery, and a market-oriented approach to improving audit quality.

These projects represent an unbelievable opportunity for private ordering. Recent academic literature has supported the link between equity prices and the quality of audits based on PCAOB inspections.³

We believe this information will help investors in their capital allocation, but it also will benefit other aspects of capital formation. Of course, you have heard me say that in addition to the PCAOB and the firms, investors and audit committees also play a significant role in demanding quality audits. This information further empowers them.

For example, if approved by the SEC, the information disclosed will provide a basis for investors to make more informed decisions when ratifying auditor appointments, electing board members, and allocating capital, and it will provide a basis for audit committees to make more informed decisions in retaining and monitoring auditors.

It was the late Kofi Annan who said that “Knowledge is power...[and] education is the premise of progress.”⁴ The PCAOB is indeed making progress on behalf of investors with these adoptions. As with the Firm and Engagement Metrics project, several of the overarching themes and concepts in the Firm Reporting amendments were originally outlined in the 2008 ACAP report.

Here’s what I wrote about ACAP back in the day, 16 years ago.

ACAP -The Acronym Tells The Story

March 18, 2008

On March 13, 2008, the U.S. Treasury Advisory Committee on the Auditing Profession (ACAP), co-chaired by former SEC Chairman Arthur Levitt, Jr. and former SEC Chief Accountant Don Nicolaisen, met to discuss the preliminary recommendations of its subcommittees on human capital, [audit] firm structure and finances, and concentration and competition.

Edith Orenstein was quick enough to summarize the key recommendations on the FEI Blog for our convenience. She has an even more complete summary of the whole meeting on the main blog page, as well as the comments made which foreshadowed the Bear Stearns crisis over the weekend.

It’s a luxurious collection of information.

I’d like to reprint her summary with my comments in bold and a few more comments about what wasn’t recommended. In particular, take a look at things that didn’t make the list that have been recommended by some great minds on these issues like…

So, I thought I would republish, by permission, a post made recently by Robert Conway, a retired Big Four audit partner, former PCAOB regional office leader, and author of The Truth About Public Accounting – Managing the Risks the Auditors Bring to the Audit. Conway’s post makes the case for the Firm and Engagement Metrics standards and Firm Reporting rules.

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The SEC Should Approve the PCAOB’s Rules Requiring Public Transparency to Audit Engagement Performance Metrics. By Bob Conway

I’ve been in and around the auditing profession for 40+ years. I’ve been a Big Four audit partner for 17 years and led inspections at the PCAOB for nine years. In the last five years, I’ve been an expert witness in controversies involving auditing and accounting. I firmly believe that the large audit firm staffing model is a mismatch for the complexity auditors are expected to master. This mismatch is the root cause of many audit failures and PCAOB inspection deficiencies.

In 2007, I submitted a recommendation to the Advisory Committee on the Auditing Profession (ACAP) to raise awareness to the workload problem and to propose a solution – give audit committees and prospective employees visibility into the operational metrics that define how each public company audit is conducted. This would enable informed decision-making (by audit committees and prospective employees) that will fuel competition on elements other than price. The metrics I suggested in 2017 included workloads, audit staff to partner leverage ratios, experience levels, turnover, and training hours (all very similar to those in the rules adopted by the PCAOB in November 2024).

During the ACAP deliberations of my recommendation in 2008, former SEC Chief Accountant and ACAP Co-Chairman Don Nicolaisen noted that, “The firms compete primarily on the basis of cost. That’s been the history of the profession and it has been disastrous for investors and the firms.”

Former SEC Chief Accountant Lynn Turner (also an ACAP member) publicly credited my recommendation with inspiring ACAP’s 2008 recommendation for the PCAOB to consider the potential benefits of transparent disclosure of audit engagement performance metrics. Lynn Turner reiterated those comments in a 2023 panel discussion he and I participated in for the benefit of the PCAOB’s board and its Investor Advisory Group (see video above).

The Large Audit Firm Staffing Model

The large audit firm staffing model is characterized by high leverage (each audit partner supervises many inexperienced staff) and workloads that are heavy at all levels. This means heavy workloads at the partner level that undermine effective supervision. Heavy workloads at the staff levels drive turnover that keeps experience levels low and undermines year-over-year continuity on individual audits. This is not the staffing model we would design if we were starting from scratch.

How Did We Get Here?

So how did we get to such an unhealthy equilibrium point? At its core, commodity pricing for audits is the culprit. The audit firms have failed to differentiate themselves on anything other than perhaps industry experience – the result being commodity pricing for audits. In most instances, audit committees have limited information upon which to make an auditor selection beyond price and promises from the audit firm that they will conduct a good audit.

To achieve the desired levels of profitability in a commodity pricing environment, the audit firms have had to squeeze their professionals (including partners) for productivity. The seasonality of the audit business further compounds the workload problem. The result is the high turnover, reduced experience levels, and reduced time for supervisory review described above. The result is lower audit quality and the auditing profession’s existing pipeline crisis (the profession’s inability to attract and retain sufficient talent in public accounting). The workload issues have also been identified as the rationale for why some professionals resorted to cheating on internal tests on essential technical material (asserting that there simply weren’t enough hours in the day to study course materials).

The workload problem is not just my personal view. It has been validated by numerous academic studies cited in the book I published in 2020 titled, “The Truth About Public Accounting.”

Help is on the Way (subject to SEC approval)

The PCAOB published a Concept Release on Audit Quality Indicators in 2015. More recently, that undertaking became known as Firm and Engagement Performance Metrics. On November 21, 2024, the PCAOB board adopted rules requiring auditors to report firm and engagement performance metrics to the PCAOB which the PCAOB will make publicly available on its website. The new rules require SEC approval within 45 days.

I have a caveat. Favorable engagement metrics are foundational to audit quality. However, they will not guarantee audit quality because there are other elements with a bearing on overall audit quality (such “fortitude to do the right thing” and auditor independence). That said, unfavorable metrics can be a red flag that audit quality has been or will be compromised. At the end of the day, audit committees (and investors) will be far better off with the metrics than without.

Below is a sampling of the accolades from PCAOB board members supporting the new rules requiring the public disclosure of audit firm and engagement level performance metrics:

PCAOB Chair Erica Williams stated that Firm and Engagement Level Metrics “… will provide a basis for audit committees to make more informed decisions on retaining and monitoring auditors ….”

PCAOB Board Member Kara Stein called these new rules “… a ground-breaking advance.”

PCAOB Board Member George Botic said “The collective transparency of these efforts [including CAMs and Form AP] represent the democratization of the audit process. With this change, every investor, director, academic, firm employee, or partner will have access to the same body of information.”

I owe many thanks to Lynn Turner for his tenacious efforts over 16 years to focus the PCAOB on this important opportunity to improve audit quality.

Robert Conway, CPA

Email: RetiredAuditPartnerACAP@Live.com

Website: www.TheTruthAboutPublicAccounting.com

Video from the PCAOB Investor Advisory Group Meeting, October 10, 2023, courtesy of Bob Conway.

© Francine McKenna, The Digging Company LLC, 2024