The Public Company Accounting Oversight Board’s recent proposal to overhaul the format of the auditor’s reporting model could lead to unexpected legal repercussions for auditors.
The PCAOB released for public comment earlier this month a proposal to change the auditor’s report to provide additional information to investors and other financial statement users about the audit and the auditor, including the communication of critical audit matters as determined by the auditor and new elements in the auditor’s report related to auditor independence and auditor tenure.
There are also enhancements to the existing language in the auditor’s report related to the auditor’s responsibilities for fraud and notes to the financial statements. In addition, there’s a proposal for an “other information” standard, in which the auditor would be required to evaluate information apart from the financial statements, such as the company’s annual report and management’s discussion and analysis (see PCAOB Proposes to Change Auditor’s Reporting Model and Auditor Reports Overdue for a Shakeup).
Scott Univer, general counsel with the auditing firm WeiserMazars, believes it’s an interesting proposal that merits serious consideration. “In its own way it’s really revolutionary,” he said in an interview last week. “As the board pointed out, the standard audit report has not changed all that much in decades. Currently it’s a pass/fail system. Are the financial statements in accordance with Generally Accepted Accounting Principles? It’s either A or B. The proposal says there is more information that the investor requires that isn’t coming through in the standard pass/fail audit report.”
He acknowledged there’s an imbalance of information for shareholders and consumers, with the PCAOB in effect saying, “Let’s open up the hood and let some of this information be disseminated in the marketplace.”
“In the abstract, that’s a good idea,” Univer added. “Auditors certainly want financial statements to be as useful and beneficial to people as possible. That’s the business we’re in. But there’s a problem connected with that. When you widen the scope of the report to a discussion of other matters, they can be the most critical, most subjective, most complex judgments that the auditor has to make.”
He fears that such disclosures could expose auditors to second guessing, especially from potential plaintiffs and their attorneys who like to take a hindsight look when anything goes wrong with an investment.
“Right now the way the class-action securities laws are written, you have to take the one statement that the auditor makes and you have to show that it was deliberately made falsely with a reckless intention to defraud,” said Univer. “Frankly it’s hard to do that. With financial statements, they either comply with GAAP or they don’t.”
Plaintiffs have to show not only that the auditor didn’t properly audit the company, but the auditor actually intended to mislead. But the PCAOB proposal could expose auditors to additional risk, Univer worries. “When you open that up and have the auditor discuss the most difficult, complex, subjective judgments, you make it very easy for plaintiffs’ lawyers to say you didn’t make a mention of that.” Any competent attorney would be able to file a lawsuit out of such an audit report, he believes.
The PCAOB is also proposing that the auditor look at other parts of the company’s business and give opinions on that as well. Right now the auditor is required to read the entire 10K and take note of whether there is anything inconsistent with the financial statements. Univer believes this idea would also carry the risk of increased legal exposure that wouldn’t serve any purpose. He imagines a plaintiff’s attorney asking the auditor in court, “Do you think you’re an expert in software or in the obsolescence of inventory?”
Still, Univer thinks the PCAOB proposal is a good one and deserves serious consideration by the entire financial community. “There are large elements that have merit and should be adopted,” he said. But he would like the PCAOB to provide a “safe harbor” for auditors to be able to discuss the new areas of the auditor report that are being proposed without fear of becoming the subject of a lawsuit. He believes it’s fair for auditors to continue to have the same liability and potential exposure that they have now in opining on whether or not the financial statements comply with GAAP, but for the new areas that the PCAOB is suggesting, in which the auditor makes comments and provides additional information about various audit matters, he would prefer a safe harbor for legal reasons.
“Unless the auditor is clearly participating in fraud, that stuff ought to be immune from legal exposure,” he said. Univer thinks there could be a benefit to auditing firms, with a new kind of competition emerging in the design and construction of audit reports that could distinguish one firm from another. “If you look at the audit reports throughout the profession, they’re all virtually the same,” he said. “They all use the same words. It’s a black and white opinion. If the PCAOB opened this process up to more complicated discussions, open the hood and allow you to see what’s going on, firms might come up with their own formats. There might start to be competition among the auditors to see what companies, consumers, investors and analysts think which form of audit report suits their needs best. You might have a free market competition, to promote different forms of the auditor report.”
As a free market libertarian, Univer admitted he doesn’t often quote Mao Zedong, but he made an exception, citing Mao’s famous quote, “Let a hundred flowers bloom.” Or to put it another way, he added, “Don’t shoot the auditor, please.”
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