Auditors are Bike Mechanics, not Inside Traders

Despite the insider-trading allegations against the former accounting firm partner that appeared this week, auditors are more like bike mechanics than white-collar criminals.

Keep this comparison in mind as the public debate about accounting firms delves deeper into whether lead audit partners should be publicly identified and drifts away from issues that truly matter to the public companies compelled to pay accounting firms for their auditing services. Any debate about external auditing would be more productive if it focused on:

• Auditors’ reliance on compliance work (documentation and testing) conducted by “others” (i.e., corporate finance, internal audit and other internal folks involved in Sarbanes-Oxley compliance),
• External audit fees; and (perhaps most important),
• The Public Company Accounting Oversight Board’s (PCAOB) ongoing inspections of public accounting firms.

In the hours before former KPMG partner Scott London, who lead audits Herbalife LTD and Skechers USA, owned up to The Wall Street Journal that he regretted his behavior, arguments as to whether companies and auditors should be required to publicly name the auditing partner in charge of a public company’s audit exploded on business sites.

That may well be worth discussing, even changing. However, there is bigger – and much more overlooked – news that has more immediate cost implications on public companies that hire accounting firms to conduct annual audits of their financial statements.

In December, PCAOB, the SOX-spawned regulatory body that oversees public accounting firms, issued an important report summarizing its inspection observations related to deficiencies in registered public accounting firms' 2010 audits (roughly 300 of them) of the internal control over financial reporting (ICFR) at public companies. The report is a just a bit longer than its title: “Observations from 2010 Inspections of Domestic Annually Inspected Firms Regarding Deficiencies in Audits of Internal Control over Financial Reporting.” If you have anything to do with Sarbanes-Oxley compliance, the audit process, internal audit or the audit committee of the board, save the breaking news for later and read this report.

“Firms should take note of the matters identified in the report in planning and performing their audits,” PCAOB chairman James R. Doty said at the time. And they have.

The primary problem the PCAOB report finds is a lack of sufficient evidence to support audit opinions on the effective of internal control. This lack of evidence stems from several root causes, according to PCAOB, including:

• Improper application of the top-down approach to the audit of internal control as required by Auditing Standard 5;
• Decreases in audit firm staffing through attrition or other reductions, and related workload pressures;
• Insufficient firm training and guidance, including examples of how to apply PCAOB standards and the firm’s methodology; and
• Ineffective communication with the firm’s information system specialists on the engagement team.

PCAOB’s findings explain why your audit fees likely are increasing even as your auditor relies more on the compliance work (involving internal controls related to lower-risk processes that affect financial reporting) that you and your colleagues conduct. That’s counter-intuitive and frustrating: Many companies are doing significantly more work to support the internal controls reviews their outside auditors conduct, yet audit fees are rising.

As are my mountain-bike-maintenance fees, despite the fact that I’ve significantly increased the amount of time, expertise and sweat I invest in cleaning my dual-suspension, disc-braked Stumpjumper/mid-life-crisis-purchase after every ride. When I point this out to my bike mechanic – who always frowns at my bike and shakes his head before launching into all the various and increasingly expensive tune-ups and care my ride quires – he holds his hands up and launches into a lecture.

“I hear you, brother,” he says. “But don’t blame the messenger. The companies that make all your components like to hide the fact that their stuff requires more love as their components get more and more technical.”

My mechanic is only doing what the manufacturer and its suppliers tell him to do. And what they’re telling him to do is changing, which drives up my tune-up fees and also continually changes how I should and shouldn’t clean and tune my bike after each ride.

The same holds true for your external auditors and the ways in which you and your colleagues tune up your internal controls each quarter. Before you blame your internal-controls mechanics, brothers and sisters, make sure you are keeping tabs on how the rules and guidance they follow are changing.