The PCAOB Could Use a Lesson in Context

“Investors and audit committees cannot easily observe the services performed by auditors.”

So begins the Public Company Accounting Oversight Board’s latest Proposal to mandate additional disclosures by auditors of public companies (PCAOB Release No. 2024-002: Firm and Engagement Metrics).

The public deliverable for an audit of financial statements (and possibly internal controls over financial reporting) that may require thousands of hours of work and millions of dollars of fees is a two- or three-page report. The work supporting that report is a “black box” to stakeholders using it.

Past efforts to open that audit black box include expanding the auditor’s report to include a discussion of “critical audit matters” and PCAOB Form AP which names the engagement partner and includes details of other firms participating in the audit.

The Proposal

The latest push for disclosure is a revival of a project started by the PCAOB in 2015 that created measures labeled as audit quality indicators or “AQIs”. In the new Proposal, AQIs are relabeled as “firm and engagement metrics” but are essentially the same things.

The Proposal would mandate specific metric disclosures in 11 areas relating to inputs, processes and measurements of an audit (see the following charts). The PCAOB indicates that the purpose of the Proposal is to provide a dataset of useful information for investors, audit committees and other stakeholders about an audit firm and its individual audit engagements, which has been calculated on a uniform basis, for the purpose of evaluation and comparison against other firms and other engagements.

The mandates would apply to any firms that audit at least one “large accelerated filer” or an “accelerated filer”, as defined by the SEC.

Firm level data comparable to several of the 11 areas mandated by the Proposal are already being disclosed in some large firms’ audit quality and transparency reports, including (i) staffing leverage ratios (ii) use of specialists (iii) retention/turnover rates (iv) restatements and (v) internal inspection data. However, types of metrics disclosed vary widely among the few large firms who voluntarily report them, and consistency of computation can’t be ascertained.

Maybe the Biggest Issue – Engagement Level Metrics

A fundamental objection to the Proposal from audit firms is likely to be the public disclosure of engagement level metrics. This is where context comes into play.

If an engagement partner on retail Issuer A has 10 years of experience in the industry and the engagement partner on retail Issuer B has 4 years of experience in the industry, does that mean the quality of Issuer B’s audit is less than Issuer A’s?

Or, if the ratio of partner and managers’ hours to total hours on the audit of Issuer C is 40%, but the same ratio for Issuer D is 30%, does that mean audit quality for the Issuer C audit is higher than Issue D?

Finally, consider this scenario: 60% of audit hours for Issuer E are incurred prior to the balance sheet date, while 40% of audit hours for Issuer F are incurred prior to the balance sheet date? Which audit’s quality is higher – Issuer E or F? How could an investor know? Also, why would an investor care?

Context does matter, and the Proposal gives little consideration to this acknowledged concern. The Board’s solution? An auditor has an “option to provide a narrative description accompanying each metric, which they could use to supply any missing context”.

Another related push back against engagement level metrics disclosures is likely to be that the responsibility to evaluate and select an auditor belongs by law to the company’s audit committee which has full access to all the decision critical information they require from any firms they are considering for audit services – and the ability to question and discuss with the firms directly, thus providing context to the metrics.

Issues with Firm Level Metrics

There are possible strong objections to certain proposed firm level metrics as well – especially the metric labeled “Quality Performance Ratings and Compensation”. The calculation process itself is somewhat confusing, but the basic concept is a calculation and comparison of summarized partner compensation increases based on quality performance ratings. For example, if the highest rated quality performers (“1” rated) received a $100,000 increase in compensation in 2023 over 2022, what percentage raise did the “2” performers receive relative to the “1” performers – 80% of the $100,000, or 60%? Talk about a lack of context. As if partner evaluation and compensation decisions are as simplistic as the Board seems to believe.

Who Will Actually Use the Metrics?

As discussed above, certain of the proposed metrics will be useful to audit committees, but without the need for public disclosure. The PCAOB predictably touts the specified metrics as information “useful” to investors, but details on how it would be useful to investors are limited, citing shareholder ratification of auditors as a primary example. Ratification is, of course, non-binding and never fails anyway. Is it realistic that investors will actually use or care about this granular level of detail?

How Much Is All of This Going to Cost?

It’s clear that much of mandated metrics data is not accumulated by firms today, especially outside of the large firms. Data capture systems will have to be built, people employed to operate those systems and produce reports, internal controls designed, and compliance monitored. Substantial costs. The Proposal provides little meaningful analysis of potential costs, stating “Because there are limited data to quantitatively estimate the economic impacts of the proposal, much of the Board’s economic analysis is qualitative”.

How Will Smaller Firms Be Impacted?

The Board has an interesting take on the potential impact of the Proposal on smaller firms. They reason that if firms begin competing on the mandated metrics, some may fail and exit the audit market. But the Proposal provides a silver lining, stating that “exit may be limited primarily to smaller firms, which could be disproportionately impacted by the costs of the proposal”. Since the firm level requirements apply to any audit firm with at least one large accelerated or accelerated filer, it may be the Board’s intent to drive smaller firms out of that market entirely. If so, they should be straightforward about it.

Required public disclosure of some additional audit quality related information is likely a foregone conclusion. Large accounting firms have tried to get out in front of the regulator through voluntary disclosure of some firm level metrics. The debate will be about (i) the nature of, and how many, measures are ultimately required (ii) to whom are they disclosed and (iii) does the Proposal actually protect investors in any significant way? And, of course, is any of it justified compared to the associated large, incremental costs.

The piling on continues – one proposed standard or rule after another.