What Were the Auditors Thinking?

The financial crisis and the corporate scandals that preceded it have wreaked serious havoc on the credibility of corporate financial statements and the opinions of the auditors who approve them, said participants in a roundtable held by the Public Company Accounting Oversight Board on Thursday.

Perhaps the most controversial of a bevy of PCAOB proposals to improve the quality of auditor reports is the addition of an auditor's discussion and analysis (AD&A) section similar to the management’s discussion & analysis (MD&A) found in companies’ annual financial statements. And the sharp differences of opinion on the merits of introducing an AD&A -- mainly between investors and auditors themselves -- were very much on display during the panel discussion.

The AD&A could provide investors and other financial-statement users with a view of the audit and corporate financials "through the auditor's eyes," according to a briefing paper for the roundtable. The PCAOB sees the AD&A as “a supplemental narrative report that would accompany the standard auditor’s report.”

To Lynn Turner, a former Securities and Exchange Commission chief accountant and long-time investor advocate, the AD&A would provide meaningful context to the mere pass/fail grades that auditors provide on their clients’ financials. The issue of adding a narrative of auditors’ reasons for their opinions has been raised because investors have noted, in retrospect, that companies with prominent roles in the financial crisis, like Lehman Brothers and AIG, have received “the same clean report” that companies without such problems have, he said.

At the same time, a look at the testimony of auditors in litigation involving Adelphia, Xerox, Waste Management, and other accounting scandals provides valuable information about what went wrong at those companies, according to Turner, now a managing partner at LitiNomics, a consulting firm that provides expert-witness testimony.

Such information could be released to investors in a more timely and efficient way by incorporating it in an AD&A. Currently, auditors provide such information to board audit committees, which turn it over to corporate lawyers for use in defending the company against lawsuits, he said. “We’ve got to pull the attorneys out” of the process of providing auditors’ views to the public, he said.

As a result investors mistrust auditors, not audit committees, he added. Turner was taking issue with a point made by Sam Ranzilla, an auditor and a national managing partner of KPMG’s audit quality and professional practice, about investors’ loss of trust regarding the financial information provided to them. "When you boil this down, what investors are saying is, ‘We don’t trust audit committees,’” he said. “They are looking for the same information provided to audit committees” by auditors.

Noting that he doesn’t favor the introduction of the AD&A, Ranzilla said he supports an “alternative that gets to a potential root of the issue [of investor mistrust]”: corporations’ use of estimates in important financial-reporting calculations. Such an alternative could be for auditors to attest to portions of corporate MD&As in such a way as to “provide investors with confidence around critical accounting estimates,” he said.

Auditors have long expressed anxiety about making subjective statements in public -- statements that could be held against them in court. Thus, they have favored making the sparest statements possible about their clients’ financial processes. Joan Waggoner, a partner in charge of quality assurance at Blackman Kallick, a Chicago-based accounting firm, said she worries that by adding the AD&A “we would be introducing an element of bias” into auditor assessments.

By contrast, assessment of financial reporting “needs someone truly objective,” she said. That’s a part auditors should be continuing to play, “rather than moving into the preparer role” and speaking interpretively about how financial statements were put together, according to Waggoner.

While Peter Nachtwey, CFO of Legg Mason, an asset management firm, said the AD&A would be “nice to have,” he noted it might also add an undesirable level of complexity to the process of interpreting financial statements. He wondered to what extent a given AD&A might differ from the corporation’s MD&A: if there would be no difference at all, why introduce the AD&A at all? “On the other hand, if they’re different, investors will spend a great amount of time reconciling their differences,” said Nachtwey.

That process, however, might lead to more accuracy, according to Stephen Kozeracki, co-leader of the corporate bond group at The Vanguard Group. “The differences could be worked through, [and the process would then raise questions about managements reporting and estimates,” he said. In the end, “you might get much better behavior,” he added.