New Rules Expected for Annual Audit Reports requiring auditors to tell investors more about what they find in companies’ books

Updated August 12, 2013, 9:03 p.m. ET

New Rules Expected for Annual Audit Reports

MICHAEL RAPOPORT

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The annual audit report is about to get an extreme makeover. After seven decades in which the auditor’s letter hasn’t changed much, U.S. regulators on Tuesday are expected to propose major new rules requiring auditors to tell investors more about what they find in companies’ books. The Public Company Accounting Oversight Board, the government’s audit-industry regulator, is pushing the accounting industry to disclose more about its views on a company, which some say will make the document attached to each public company’s annual report more useful, albeit a little longer. While the PCAOB hasn’t said specifically what it will propose, having auditors provide their opinions on broader matters appears likely to be the crux of it. Regulators and industry critics say investors need more information from auditors about matters such as whether a company’s accounting is aggressive, and what auditors think are the most important features of a company’s finances. Many investors rely on the audit report to help assure them a company’s numbers are accurate. But some critics have become concerned that the letters’ boilerplate, pass-fail format doesn’t tell investors much about what is actually happening at a company or where problems may lie. “It’s been 70 years since there has been a fundamental change to the information the public receives about the audit,” PCAOB Chairman James Doty said. A revamped audit report will be “a significant step” in the effort to “provide more useful reporting to the public,” he said.Many in the accounting industry agree some change is needed. “I think one of the things we can do is be more transparent about what we do,” said Steve Howe, Ernst & Young LLP’s managing partner for the Americas.

But a major fight could be brewing if the PCAOB pushes aggressively for accountants to analyze and discuss a company’s results on its own.

“You don’t want to insert the auditor into the role of management,” said Cindy Fornelli, executive director of the Center for Audit Quality, which represents the accounting industry.

The overhaul is part of an effort by regulators to address concerns that auditing is still deeply flawed, even more than 10 years after the Sarbanes-Oxley Act was supposed to address and fix its problems.

Earnings restatements at larger companies, most likely to be audited by the Big Four accounting firms, have risen sharply in each of the past three years, according to consulting firm AuditAnalytics.com. In PCAOB inspection reports issued last year, 36% of Big Four audits the inspectors scrutinized were deemed deficient, up from 14% two years before that.

Regulators have rebuked three of the Big Four firms for not fixing past problems fast enough. Each of the four—Ernst, PricewaterhouseCoopers LLP, Deloitte & Touche LLP and KPMG LLP—have had major clients that collapsed or required huge government bailouts in recent years without any warning from regulators that anything was amiss.

“The perception of the auditor’s independence, objectivity and professional skepticism has suffered in the wake of these findings of audit failures,” Mr. Doty said. “You have an industry that has been slow to come to realize that it must change.”

The quality of audits has been a lingering concern ever since the accounting scandals of the early 2000s, such as Enron Corp. and WorldCom Inc. Sarbanes-Oxley was enacted in response to those scandals, creating the PCAOB to regulate the accounting industry and barring firms from consulting for audit clients to avoid conflicts of interest.

“We have gone back to being as bad as we were when I was chief accountant,” said Lynn Turner, who was chief accountant at the Securities and Exchange Commission from 1998 to 2001, just before the 2002 passage of Sarbanes-Oxley.

The crux of the problem, critics say, is the auditing-industry’s business model. Companies hire and pay their own auditors, leading auditors to be insufficiently skeptical of their clients, the critics say. It is akin to what happened with bond-rating firms that gave triple-A ratings to toxic mortgage securities during the housing boom, they say.

The PCAOB has been debating potential changes to the auditor’s report for the past two years.

Any proposal from the PCAOB will likely be subject to a lengthy public comment period and potential revision before it is enacted, and it wouldn’t take effect until further down the road.

Among other ideas, PCAOB officials have discussed requiring a new “Auditor’s Discussion and Analysis” section of the annual report in which the auditor would offer its views about a company in more detail. They also have looked at “emphasis paragraphs” in the audit report to spotlight what the auditor sees as significant matters.

They also have floated the idea of having the auditor offer its opinion on matters beyond the financial statements, such as earnings news releases, and providing definitions of key terms in the audit report.

As a result, audit reports may well get much longer than the current standard four-to-six-paragraph letter, but they also may have more useful and specific information for investors.

The firms say they already have plowed money and resources into improving audits and beefing up their auditors’ training. Ernst & Young has boosted its auditing head count by 10% each of the past two years and analyzed work loads to make sure its auditors have enough time to do thorough work. PwC says it is investing $100 million a year.

John Veihmeyer, KPMG’s chairman and chief executive, said the firm’s staffers “understand the important role their work plays for investors, companies we work with and other stakeholders, and it’s a responsibility we and the entire profession take very seriously.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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