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How Good Is Your Audit Firm?

With each new fraud and "audit failure" divulged in the financial press, more pointed questions are being raised about audit quality. What is it? How do you define and measure it? And, how can audit committees obtain a better understanding of an audit firm's quality? While "audit quality" is a key concept supporting the reliability of financial reporting, this concept is neither well defined nor well understood. A public company's audit committee shares the responsibility for audit quality, through its responsibility to select, compensate, oversee, and evaluate the company's independent auditor. Certainly, audit committees routinely obtain some information on indicators of quality from audit firms during the process of appointing or retaining their external auditors. However, the extent to which this information is actually sought and used in the appointment process for new and continuing auditors is unknown. An October 2008 report issued by the U.S. Treasury Department's Advisory Committee on the Auditing Profession has triggered the current debate on Arthur Levitt and former SEC chief accountant, Don Nicolaisen, directs the Public Company Accounting Oversight Board (PCAOB). The report from the committee, co-chaired by former Securities and Exchange Commission chairman Arthur Levitt and former SEC chief accountant, Don Nicolaisen, directs the Public Company Accounting Oversight Board (PCAOB)—the U.S. regulator of public company audits—to examine the feasibility of requiring audit firms to periodically report on key indicators of audit quality. The PCAOB is now considering whether a set of audit-quality indicators should be regularly disclosed by the Big Four and other firms that are auditing public companies, and if so, the specific nature of those indicators. The implication for audit committees is that in the near future, there may be available annually a standard set of audit-quality indicators on public company audit firms. This information should more fully inform audit committees as they appoint or retain their independent auditors. As audit committees consider appointing new or retaining their incumbent independent auditors, they traditionally consider some information relevant to "audit quality" in making that decision. While the specific information used in this process likely varies by company and director preferences, standard information often considered includes the size and breadth of operations of the audit firm; the composition and experience of the engagement team; prior audit results for the audit firm and the company (if it's a continuing audit relationship); and the firm's planned audit approach. In a competitive audit-proposal situation, audit committee members often request additional comparative and firm-specific information. While these auditfirm characteristics are useful, they are not comprehensive in measuring audit quality. A Framework for Evaluating Audit QualityWhat is audit quality? According to the Government Accountability Office, a quality audit is one in which the audit is conducted in accordance with generally accepted auditing standards (GAAS) to provide reasonable assurance that the audited financial statements and related disclosures are (1) presented in accordance with generally accepted accounting principles (GAAP) and (2) are not materially misstated, whether due to errors or fraud. Implicit in this definition are attributes of "inputs" to the audit (such as knowledge and independence of the audit-engagement team), "process" features (such as the appropriate type and amount of audit tests), and the appropriate "outcomes," such as reliable financial reports and an accurate audit opinion. This suggests that audit quality is multi-dimensional, so approaches to addressing it will be as well. The European transparency reports focus primarily on inputs to audit quality and providing information on quality controls at the audit-firm level. Such information is useful to audit committees in understanding the extent to which an individual audit firm provides resources in training and knowledge support for its personnel, and in ensuring that individual engagement teams perform audits according to professional standards. Other areas of emphasis may include concentrations or financial dependence by client size, type, or industry at the firm or geographic (i.e., office or region) level. Information on these firm-level quality indicators augments the information on the characteristics of engagement partners and other team personnel that audit firms routinely give to current or prospective clients as part of the appointment process. Other audit-quality indicators, however, go beyond firm-level inputs and include "process" information about specific characteristics of the firm's professional staff and the conduct of an audit. Audit-quality process indicators could include statistics on the firm's partners, managers, and staff, and the average ratios of staff levels employed on engagements (including information on the level of supervision of junior staff). It could also include years of experience of professional staff by partner, manager and staff level; areas of expertise; relative time spent on client service, administration, training, and nonchargeable time; number of public clients per partner; audit firm personnel-retention rates by professional level; and specific types of industry-relevant training. Some U.S. audit committee members, particularly those with public accounting firm experience, report receiving such information as it relates to the engagement team assigned to their particular public company audit in the past. While the inclusion of such specific indicators in publicly available reports is still being debated, their availability could significantly increase the information set available to audit committees on which to base their appointment or retention decisions. For instance, investors as well as audit committees could use this information to compare the extent to which competing firms ensure that audit engagements are adequately supervised by partners. Information on audit "outputs" may also be included in the proposed periodic reports by auditing firms. For instance, output indicators could include the number of restatements or enforcement actions against the audit firm's clients in the recent past. Also, audit firms could report on the appropriateness of "going concern" opinions—for example, rates of bankruptcy among their clients that were not given an audit opinion warning of imminent failure. Because academic research shows better financial health among audit clients of larger firms, it is particularly important that such outcome indicators be presented in comparison to a firm's direct competitors. Other potential "output" indicators include prior reports resulting from PCAOB inspections, particularly Part II reporting (now kept confidential unless identified problems are not addressed by the firms) and reports on external quality-assurance review. Public Reporting by Audit FirmsSome proponents of audit-quality reporting believe that audit firms should provide detailed reports on their financial condition, including how funds are invested and relative profitability. Such reporting would have two basic purposes: First, it would help regulators ensure that audit firms are sustainable. In recent decades, the number of large firms capable of auditing complex global entities has declined, and liability concerns have increased. Because losing another large firm due to financial distress could severely impact the financial markets, some regulators have expressed the need to provide oversight on the financial condition of the largest firms. A second purpose of periodic financial reporting by auditing firms is to reassure financial report preparers and users that the firm's costs and sustainability are reasonable. Such information could also be useful to audit committees in assessing competitive proposals. While audit-firm financial reports are public and audited in other jurisdictions such as the United Kingdom and Germany, because of the firms' legal structure and local-company law requirements, auditing firms in the United States have resisted public reporting of detailed financial information on the basis that they are private entities. Audits are primarily human endeavors and audit firms are very dependent upon the quality of their professionals, including competence and decision-making skills. How and to what extent audit firms invest in their personnel could also be informative in judging a firm's commitment to audit quality. Such disclosure would demonstrate the importance placed by the firm on building and investing in human capital, technology, or infrastructure. Firms that make such investments demonstrate their commitment to the auditing profession and to corporate responsibility, rather than purely to performance and growth. While public financial reporting by audit firms was considered by the Treasury's Advisory Committee, its final report advocates audit-firm financial reporting only to the PCAOB, which would monitor the firms for sustainability concerns. Audit Quality AbroadThe PCAOB discussion does not exist in a vacuum, as the U.S. auditing profession had previously developed frameworks to support peer review of audit quality, while the PCAOB, since its inception, has been conducting periodic inspections of "registered" accounting firms. Also, because audit quality is a worldwide concern, other countries have been considering this issue. It is interesting to note that in the United Kingdom, which may be further along in considering the indicators of audit quality than the United States, the Institute of Chartered Accountants for England and Wales has reduced the definition of audit quality to a more principles-based approach that "at its heart is about delivering an appropriate professional opinion supported by the necessary evidence and objective judgments." A particularly useful framework for thinking about specific indicators of audit quality is provided by the UK's Financial Reporting Council ( The FRC Audit Quality Framework (summarized in chart at left) includes the following key elements that have significant effects on the level of audit quality, reflecting inputs, processes, and outcomes: (1) the characteristics of and the culture within an audit firm, (2) the skills and personal qualities of audit partners and staff, (3) the effectiveness of the audit process, (4) the reliability and usefulness of audit reports, and (5) factors outside the control of auditors that may affect audit quality. There is also precedent in the European Union, which requires member states to ensure that auditors and audit firms that carry out statutory audits of public-interest entities publish on their websites, within three months of the end of each financial year, an annual Transparency Report. Such reporting includes a description of the audit firm's system of quality controls. As an example, the Transparency Reports of the largest U.K. public accounting firms identify quality-control mechanisms including: (1) the system for tracking partner and employee investments for independence purposes, (2) procedures for approval of prospective and continuing clients, and (3) standards for supervision, review, and consultation during engagements. A "Transparency Report"The Treasury's Advisory Committee on the Auditing Profession report and recommendations provide a lead for audit committees in considering additional information that could be sought from their company's external auditor or from firms placing competitive proposals. The chart (right), summarizes a variety of possible audit-quality indicators that have been discussed in the academic and practice literature. However, there are other important implications of these disclosures. First, a U.S. "transparency report" for public company auditors would expand the set of information normally considered by audit committees, and, importantly, standardize that information and ensure its reliability through an assurance process. Thus, audit committees would have information readily available on all firms that audit public companies, prior to seeking proposals for audit services. This information could be used to provide a preliminary screen that might admit or rule out certain audit firms, without incurring the cost to the firm of preparing the proposal or to the company for evaluating it. To the extent that specific information items are required, consistency and comparability would be increased. Second, standardizing reporting requirements would enable parties outside of audit committees such as regulators, shareholders, and potential investors to better judge how well each audit firm is managing its financial and human resources and addressing longterm sustainability concerns. The third and likely most important outcome of such reporting is that it would also facilitate the competitive process, driving all firms to a higher level of audit quality and thereby advancing the important objectives behind the public policy of requiring audits. For these reasons, annual transparency reporting at the audit-firm level seems an idea whose time has come. While the PCAOB's position on this issue has not yet been released, audit committee members may in the interim explicitly request and consider these measurable audit-quality indicators. It may be that once the quality indicators become known and measurable within the context of the appointment process, audit quality (including inputs, process, and output measures) will significantly gain in importance as a differentiating factor in the independent auditorappointment process.
Ed Smith, retired partner at KPMG and former executive director of KPMG's Audit Committee Institute, is a faculty adjunct at Boston College Carroll School of Management.
Jean C. Bedard is the Timothy B. Harbert Professor at Bentley University, and Professorial Visiting Fellow at the University of New South Wales.
Karla M. Johnstone is a professor at the University of Wisconsin School of Business.

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