How Good Is Your Audit Firm?

What your audit committee needs to know in order to choose and oversee an independent auditor. Doing it right can keep you out of court

By Ed Smith, Jean C. Bedard and Karla M. Johnstone

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 Quality

What 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.

Business Exchange

Track and share business topics across the Web.