How Good Is Your Audit Firm?

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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 Abroad

The 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 (www.frc.org.uk). 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.

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