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Why New PCAOB Rule Should Improve Audit Quality

Dec 28th 2016
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A new regulation by the Public Company Accounting Oversight Board (PCAOB) launches in January 2017 that will require the principal engagement partner in corporate audits to be identified. But read between the lines of a new audit study published by the American Accounting Association. The message is: It’s about time.

Under the new PCAOB rule, which goes into effect on Jan. 31, auditors will be required to file a new PCAOB Form AP, Auditor Reporting of Certain Audit Participants, for each issuer audit, disclosing the following information:

  • The name of the engagement partner.
  • The names, locations, and extent of participation of other accounting firms that took part in the audit, if their work constituted 5 percent or more of the total audit hours.
  • The number and aggregate extent of participation of all other accounting firms that took part in the audit whose individual participation was less than 5 percent of the total audit hours.

The study, The Effect of Networked Clients’ Economic Importance on Audit Quality, which is featured in the latest issue of Auditing: A Journal of Practice and Theory, explores the effect of engagement partners on audit quality. The authors contend that the new regulation will clearly help investors recognize situations ripe for auditor conflict of interest.

Those conflicts are most likely to happen when a member of a client’s audit committee serves in the same function in at least one other company that happens to be a client of the engagement partner – what the study calls “interlock networks.”

Audit partner dependence on fees from these networks affects the quality of audits, the study states.

The study’s authors are professors Sarowar Hossain and Gary Monroe of the University of New South Wales, Mark Wilson of Australian National University, and Christine Jubb of Swinburne University of Technology in Melbourne, Australia.

It should be noted that the disclosure of audit engagement partners has been required in Australia since the 1970s.

US companies currently disclose the audit firms that handle their financial statements but not the partner in charge. Yet “research has found aggressive or conservative reporting styles to be associated with the engagement partner over and above any influence of the accounting firm involved,” the study states.

So, let’s get back to interlock networks. If an engagement partner earns more than 10 percent of annual fees from a troubled company’s network, the likelihood of the firm getting a going-concern opinion is less than half of what it would be without that network.

“Our results strongly support requiring identification of the engagement partner,” Monroe said in a prepared statement. “Coupled with disclosure of audit committee members and audit fees, it uniquely enables investors and regulators to identify interlocking networks likely to impair audit quality – as, for example, in willingness to issue a going-concern opinion.”

The study’s authors believe their results should be a heads up for academics, regulators, company directors, and the auditing profession.

“Both the academic literature and regulatory pronouncements indicate that audit committees play a critical role in ensuring auditor independence and audit quality,” the authors state. “Therefore, it is important to consider the potential impact of the auditor’s economic dependence created by interlocking on audit quality.”

Related article:

PCAOB Adopts New Rules on Naming Audit Engagement Partner


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