Oversight and inspection of auditing

With the rising importance of global capital markets in today’s economy, mechanisms designed to secure their proper functioning become increasingly important. The use of external sources of financing, especially via the stock market, is based on the concept that firms can credibly communicate their true economic performance by means of audited financial statements. If investors lose confidence in the reliability of audited financial information, market participation and the availability of capital will decrease, harming financial stability. Public oversight of the auditing profession represents a mechanism intended to ensure high audit quality and was installed in response to loss of investor confidence resulting from highprofile financial reporting scandals in which auditors were also blamed (e.g., Enron and Worldcom in the US, Ahold in the Netherlands, Lernout and Hauspie in Belgium, Parmalat in Italy). The idea of regulatory, in contrast to private, oversight relies on the existence of a public regulatory authority that is independent of the auditing profession. Independence can be defined with respect to various elements including financing, stafing, and enforcement power. Ideally, the oversight body is independent with respect to all of these elements. The tasks taken up by public oversight bodies can be numerous including registration of auditors, establishment of standards governing the audit process, quality assurance and disciplinary actions. As part of quality control and quality assurance, in most cases, a system of regularly conducted inspections of audit firms has been established. The inspections are perceived to be one of the key responsibilities of public oversight bodies. Depending on the size of the audit firm, the frequency and extent of inspections may vary. The Public Company Accounting Oversight Board (PCAOB) in the US, for example, performs annual inspections of audit firms having more than 100 clients with publicly traded debt or equity, while the remaining smaller audit firms are inspected every three years. In continental Europe, inspections are generally performed every three years for audit firms with public interest entities (PIE), and every six years for non-PIE audit firms. According to the PCAOB, the ‘inspections are risk-based and often focused on key areas in particular audits that pose risk to investors’ (Franzel 2012: 3). The US is one of the few countries that publicly disclose their inspection reports, but other countries seem to be starting to follow. For example, in continental Europe, the Netherlands recently announced that as of 2014 the Dutch Oversight Body (AFM) will be allowed to publish its findings on individual audit firms. An analysis of inspection reports over time reveals that the PCAOB continues to detect serious audit deficiencies in public company audits. A deficiency is flagged when the PCAOB believes that the audit opinion is not supported by sufficient, appropriate audit evidence. While often related, a distinction is made between audit performance deficiencies (which are always made public) and audit firm’s quality control system deficiencies (which are only made public if not satisfactorily addressed within 12 months). While one would expect that learning effects cause the percentage of audits with deficiencies to decrease over time, it turns out to be rather the opposite. For example, the average failure rate of the Big 4 in 2009 was 13.5% and jumped to 32.2% in 2010 and 33% in 2011 (based on the two reports that are currently available for 2011).2 This would suggest that the auditor’s learning curve may be lagging behind the inspector’s learning curve. Our analysis of the Big 4 inspection reports from 2007-11 further indicates that over time Big 4 audit firms continue to have the same deficiencies. This finding could also be attributed to the PCAOB increasing the bar of what is acceptable. For example, in every single year, the PCAOB noted deficiencies in PwC’s audit procedures related to revenue recognition. Similarly, the PCAOB repeatedly noted shortcomings in the analytical procedures in audit engagements of Ernst & Young. While many of the shortcomings identified are associated with more complex matters like fair value of financial instruments, goodwill and impairment, a substantial number of shortcomings also appear to relate to quite basic auditing issues and related procedures. This observation is confirmed by public oversight bodies in other countries (Maijoor 2012). In the remainder of this chapter, we outline the development of public oversight in the US and internationally, discuss current issues on the agenda of regulators, provide an overview of research findings on public oversight and suggest areas for future research.