What Investors Need to Know About Audits

On Monday, November 4, 2019, the CFA Society of New York hosted What Investors Need to Know About Audits, a forum that focused on the state of today’s audit process, how it has and continues to change over time, and what signals investors should look for in evaluating financial statements.

Among the five speakers was our very own CEO, Michael Nohrden, who presented on “Are Audits Improving?” In an attempt to answer this question, we looked at four areas of financial reporting:

  • Internal Controls
  • Financial Restatements
  • Audit Opinions
  • PCAOB Inspections

Internal Controls

Since 2004, auditors have been required to attest to the effectiveness of internal controls for large public companies. The attestation, as required by Sarbanes-Oxley Act Section 404 (SOX 404), is separate from the audit of the financial statement and ensures companies have processes in place to limit errors and to deter fraud.

In the years following the implementation of SOX 404, there was a dramatic drop in the percentage of companies that received an adverse internal control attestation from their external auditor. That trend did reverse a little, but has steadied around 6% over the past few years; far below the high of 16% in 2004.

Conversely, small companies have been required to have an assessment of internal controls conducted by management on an annual basis since 2007. Since then, the percentage of adverse management assessments steadily climbed but has leveled around 40%.

Financial Restatements

While the reason for the improving trend in auditor attestations can be debated, the trend in financial restatements suggests that attestations of internal controls improves the quality of financial reporting.

Following the implementation of Sarbanes-Oxley, there was a large increase in the total number of restatements, though that number quickly fell as the number of companies with adverse internal controls declined. And despite the slight uptick in adverse internal controls, the number of restatements has continued to fall, with just over 500 in 2018.

In addition to the declining number of restatements, the overall financial impact of restatements has been shrinking. Prior to the improvement of internal controls, large restatements were devastating, with adjustments of well over $1 billion as a regular occurrence.

Since 2007, these massive restatements have become much less common. However, there has been a concerning uptick in the materiality of financial restatements in recent years.

Audit Opinions

Going Concerns

Another way to assess the quality of an audit is to look at the accuracy of the information being disclosed in the audit opinion. Specifically, the going concern modification.

“If the auditor, when performing an audit, determines that there is “substantial doubt” that an entity can exist through the “forward-looking period,” after considering any plan by management to address this issue, a going concern emphasis or explanatory paragraph (or qualification) will be required in the auditor’s report.”

The Concerns with Going Concern – CPA Journal

Since 2008, the frequency of going concern modifications has continued to fall from a high of 21% to just 13% in 2018. However, while the number of going concern modifications is important, the accuracy of them is even more significant.

Over 20% of large companies that receive an initial going concern modification file for bankruptcy within the 12 months following the opinion. This is compared to 0.15% of large companies that file for bankruptcy without receiving a going concern modification, suggesting that going concern modifications are fairly accurate.

Engagement Partners

PCAOB Rule 3211, effective for audit opinions issued on or after January 31, 2017, requires audit firms to submit names of the engagement partners to the PCAOB.

Due to limited historical data, the effect audit partner disclosure has on the quality of audit opinions is still being determined. Early papers exploring this matter have found mixed results. Burke, Hoitash, and Hoitash found that “disclosure of partner name in Form AP enhances the audit information environment.” Cunningham, Li, Stein, and Wright found that “any immediate impact of Rule 3211 on audit quality or fees is limited to specific dimensions of audit quality, specific control groups, and/or specific company characteristics.”

Based on audit opinions from 2018, the vast majority – over 80% – of engagement partners have just one or two public clients.

KAMs and CAMs

In an effort to improve the information provided in the audit opinion, key audit matters (KAMs) were implemented internationally and critical audit matters (CAMs) were implemented in the US.

Since the implementation of KAMs in 2017, certain topics such as asset impairments, revenue recognition and the valuation of investments have been disclosed relatively frequently.

In the US, although CAMs have only been required for a few months, we have already seen similar topics rise to the top, specifically, impairments and revenue recognition.

Although we expect to see some differences between KAMs and CAMs due to their slightly different definitions and variances between IFRS and US GAAP, general trends are likely to stay the same.

One question to ask about these new auditor disclosures is “what do they tell us that we didn’t already know from management disclosure?” And the answer to this has two parts.

First, CAMs are from the perspective of an external third-party. The information in these can be used to validate or question management’s disclosures. In addition, it addresses the specific steps the auditor takes to audit these matters. Secondly, and maybe more importantly, CAMs are areas of the audit that the auditor found to be the most “challenging, subjective, or complex.” Meaning, these topics are surrounded by the most uncertainty.

To illustrate this, we compared the auditor’s CAMs to management’s critical accounting policies and estimates (CAPEs). In summary, there are far fewer CAMs per disclosure than CAPEs. There are also differences in the content; some topics that are popular CAPEs are not common CAMs.

PCAOB Inspections

Since 2005, the PCAOB has conducted inspections of public company audits to ensure the quality of the audits. Overall, the number of inspections has been declining over the years. However, the percentage of audits that were considered to be deficient has been relatively steady since 2012, remaining between 35 and 40%. On average, the PCAOB has found about two issues per deficient inspection. Keep in mind, inspections are not always random; often, the PCAOB selects audits on a risk-based approach.

While it may be difficult to draw a correlation directly from PCAOB actions to improvements in audit quality, academic studies have found benefits of PCAOB actions. In particular, DeFond and Lennox found that inspections improve quality around audits of internal controls and lead to a higher rate of internal control deficiencies being disclosed. Additionally, Chi, et. al., found that the engagement of a PCAOB-registered audit firm improves the overall quality of audits in China.

These analyses use various databases provided by Audit Analytics.

To access the full recording of What Investors Need to Know About Audits, click here. For any questions pertaining to “Are Audits Improving?”, please contact us.