Audit Deficiency or Audit Failure? Let’s Be Clear

I just read another article about audit quality that includes this quote from the PCAOB chief auditor (the quote was originally published in The Wall Street Journal): “When we look at an audit, the rate of failure has been in the range of around 35 to 40 percent.” What, exactly, does this mean? It depends on your point of view—and your purpose in using the term failure.

Let’s first look at what the chief auditor was actually referencing. In more precise language, he was referring to the rate of deficiencies found in PCAOB inspections where the inspection team concluded the audit firm had not obtained sufficient appropriate evidence to support its opinion that the financial statements were presented fairly, in all material respects. In other words, the auditor had failed to perform one or more procedures required by generally accepted auditing standards. Presumably, the chief auditor was not referring to the number of inspected audits issued with unqualified or “clean” audit opinions that nonetheless covered financial statements with material errors in the numbers. As the nearby informal table including inspection results only for the “Big 4” illustrates, these are two very different metrics.

The “audit failure” statistics that continue to be quoted in various media sources are accurate—if you define an audit failure as a lack of compliance with all required PCAOB audit procedures as determined by PCAOB inspectors. However, if you define an audit failure as issuing an unqualified opinion on a set of financial statements containing material errors, then the quote is inaccurate and out of context. (For a good discussion of this issue, refer to an article on CFO.com by professors from the University of Illinois and Tulane University.)

The PCAOB inspection results contained in the individual firm reports accurately convey the PCAOB’s intent: an analysis of each instance of non-compliance with PCAOB standards as determined by the inspection team that rise, in their opinion, to the level of “significant deficiencies.” However, in my view, those results should not be associated equivalently with the term “audit failure.” Although it might logically follow that some unqualified audit reports issued without complying with all necessary auditing standards might be inappropriately covering financial statements that contain material errors, it doesn’t logically follow that all or even many audit reports should be viewed in that manner.

I have been accused of thinking like an “old-time auditor,” but it is very possible through experience and sound judgment for an auditor to design and execute an effective audit that “gets the numbers right” without fully complying with each and every standard. Clearly, full compliance should be the goal to which all auditors strive, and the PCAOB inspection process helps to further that goal.

The higher-percentage “audit failure” numbers make for more dramatic headlines in the press and social media. Each author will pick and choose statistics to make a point. It would be helpful if those headlines and statistics were accompanied by a clear and precise explanation of what they actually represent. Otherwise, we are contributing further to a widening expectation gap for users of audited financial statements—and that’s not helpful to anyone involved in the capital markets.