ACCG 340 Auditing and assurance services
The PCAOB and the Social
Responsibility of the
Independent Auditor
By Douglas R. Carmichael, Chief Auditor
It is a distinct pleasure to speak to this group that uniquely blends a passionate interest in auditing standards, practice, and education. I have the honor of being the first Chief Auditor of the Public Company Accounting Oversight Board – the primary advisor to the Board on policy and technical issues related to the auditing of public companies, including auditing standards, and the head of the PCAOB’s professional standard-setting division. However, the views I express today are my own and do not necessarily reflect the views of the Board members or other staff members. I am sure that this audience has a general understanding of the PCAOB’s origin, composition, and areas of responsibility, including registering public accounting firms, inspecting the practices of those firms, setting professional standards of auditing, ethics, quality control and independence, and enforcing those standards and applicable securities laws. I do not plan on explaining those things in any detail in my prepared remarks, but I would be pleased to address any questions you have in those areas later. In trying to decide what to talk about today I reviewed the PCAOB’s charge as stated in the Sarbanes-Oxley Act of 2002.
Independent Auditor
By Douglas R. Carmichael, Chief Auditor
It is a distinct pleasure to speak to this group that uniquely blends a passionate interest in auditing standards, practice, and education. I have the honor of being the first Chief Auditor of the Public Company Accounting Oversight Board – the primary advisor to the Board on policy and technical issues related to the auditing of public companies, including auditing standards, and the head of the PCAOB’s professional standard-setting division. However, the views I express today are my own and do not necessarily reflect the views of the Board members or other staff members. I am sure that this audience has a general understanding of the PCAOB’s origin, composition, and areas of responsibility, including registering public accounting firms, inspecting the practices of those firms, setting professional standards of auditing, ethics, quality control and independence, and enforcing those standards and applicable securities laws. I do not plan on explaining those things in any detail in my prepared remarks, but I would be pleased to address any questions you have in those areas later. In trying to decide what to talk about today I reviewed the PCAOB’s charge as stated in the Sarbanes-Oxley Act of 2002.
The Act requires the PCAOB – … to
oversee the audit of public companies that are subject to the securities laws,
and related matters, in order to protect the interests of investors and further
the public interest in the preparation of informative accurate and independent
audit reports for companies the securities of which are sold to, and held by
and for, public investors. To carry out this mission, the Act instructs the
PCAOB to perform any activities the Board – … determines are necessary or
appropriate to promote high professional standards among, and improve the
quality of audit services offered by, registered public accounting firms and
associated persons, or otherwise to carry out this Act in order to protect
investors, or to further the public interest. In short, the mission of the
PCAOB is to restore the confidence of investors, and society generally, in the
independent auditors of public companies. There is no doubt that repeated
revelations of accounting scandals and audit failures have seriously damaged
public confidence. The focus on public confidence caused me to recall the work
of a widely respected teacher of auditing who observed that if the confidence
that society places in the effectiveness of the audit and the opinion of the
auditor is lost, then the social usefulness of the audit is destroyed. I am
speaking, of course, of Professor Theodore Limperg of the University of
Amsterdam and his basic theory of the auditor’s function that has come to be
known as the Theory of Inspired Confidence. In a series of essays published
over 70 years ago, Professor Limperg set forth a dynamic theory that connects
society’s need for reliable financial information to the ability of auditing
methods to meet that need. He explained how changes in the needs of society and
changes in auditing methods interact to bring about changes in the auditor’s
function. Limperg based his theory on the science of business economics and
viewed the development of the audit function from an economic perspective. From
this perspective the development of a separate function of auditing was a
natural product of differentiation in production. As with any other aspect of
the production process, when the process could be carried out more efficiently
by an autonomous branch than in combination with other processes a separate
function developed. He observed, however, that with respect to the practice of
public accounting the differentiation was caused by more than efficiency in the
production process.
The independent auditor acts as a
confidential agent of the community, or an agent of confidence for society. For
the function of confidential agent, independence of the auditor is essential.
“If the community wants to be truly served by the function of the confidential
agent, then it cannot be satisfied with an unqualified opinion of the enterprise’s
employee accountant. The community asks for an independent opinion of the
accounts of the stewardship of the managers, and that can apparently not
generally be expected of one who is in the service of the manager and who,
organizationally speaking, has to dance to that manager’s tune.” Limperg also
pointed out that independence does not relate to the character of the auditor,
i.e., the individual’s integrity and objectivity, but rather the logic of the
structural arrangement. “The community cannot and may not be content with a
relationship which is irrational, economically speaking, and which does not
provide the required guarantees for the confidential agent’s effective
functioning.” Limperg observed that the confidence inspired by the independent
auditor was the essence of the function, its very reason for existing. He
described the social responsibility of the independent auditor as follows: “The
auditor-confidential agent derives his general function in society from the
need for expert and independent examination and the need for an expert and
independent opinion based on that examination.
The function is rooted in the
confidence that society places in the effectiveness of the audit and in the
opinion of the [auditor]. This confidence is therefore a condition for the
existence of that function; if the confidence is betrayed, the function, too,
is destroyed since it becomes useless.” Limperg noted that if the function of
the independent auditor is to achieve its objective, then no more confidence may
be placed in its fulfillment than is justified by the work carried out, and by
the competence of the auditor. Limperg described the essence of the Theory of
Inspired Confidence as follows: “The normative core of the Theory of Inspired
Confidence is therefore this: the [auditor] is obliged to carry out his work in
such a way that he does not betray the expectations which he evokes in the
sensible layman and; conversely, the [auditor] may not arouse greater
expectations than can be justified by the work done.” This takes the
principles-based approach to its logical extreme. At this extreme, there are no
definite rules for what procedures an auditor must perform in a particular
case, but the general principle that guides the auditor is to perform enough
work to meet the expectations the auditor has aroused in society. Thus, the
most important factor is society’s needs, and the related factor that interacts
with it is the ability of auditing methods to meet society’s needs. However,
society’s needs are not fixed and change over time. Also, auditing methods can
change and improve over time. In other words, changes in the needs of society
and changes in auditing methods combine to result in changes in the auditor’s
function. However, the touchstone for the auditor is always to perform the work
and obtain the evidence necessary to provide the assurance that society needs
and reasonably expects.
The enduring principles of Limperg’s
theory are especially pertinent at this juncture of the development of the
auditing function. We have a particular need in our current environment to try
to understand and appreciate the social significance of auditing and the
implications for how an audit should be performed. Limperg posited an audit
function in the Netherlands that had to be more responsive to the public
perception of the assurance provided by an audit than, for example, the British
system in which, at least from the early 1900’s on, the audit of financial
statements was compulsory as a matter of law. The United States system
developed along lines closer to the British system, but without the legal
requirement for an audit until passage of the Federal securities laws in the
1930s. The Securities and Exchange Commission, beginning in the 1940s, required
that an audit be performed in accordance with generally accepted standards, but
permitted the accounting profession to set those standards. Thus, independent
auditors made their own interpretation of their role in society. Using
Limperg’s framework, auditors, by setting their own standards, were to a degree
insulated from the consequences of public dissatisfaction with their
interpretation of their own social responsibility. In the late 1970’s, the
Cohen Commission identified an expectation gap between what auditors believed to
be their role and what user groups believed. This gap was concrete evidence of
a lack of social acceptance of the role of the auditor as it had been defined
by auditors. The passage of the Sarbanes-Oxley Act of 2002 is an even stronger
indication that the social usefulness of the audit as interpreted by practicing
auditors was being called into serious question by society. The Act removed
from auditors the ability to exclusively interpret their role in society. That
task is now in the hands of the PCAOB, and the Board’s charge effectively
requires it to be responsive to the public perception of the assurance that
society needs and reasonably expects from an audit. The first auditing standard
that the Board adopted that, similar to all Board rules, will not become final
until approved by the SEC, requires that the auditor’s report refer to the
audit as being performed in accordance with the standards of the PCAOB.
A reference to performance in
accordance with generally accepted auditing standards (or GAAS) is no longer
appropriate. The reference to generally accepted standards implied that the
legitimacy of the standards depended on their general acceptance by auditors,
i.e., a consensus of the accounting profession. That is no longer the case. The
audit report reference to the audit being made in accordance with PCAOB
standards is much more than a change in the identification of the source of the
standards. The PCAOB adopted auditing and other professional standards that had
been developed by practicing auditors as they existed at April 16, 2003. When
the SEC approved that decision on April 25, 2003, these standards became
Federal law. Thus, the standards that determine the work an auditor must do to
give an opinion are now a matter of Federal law. However, the performance of
the audit has not become a matter of compliance with static legal requirements.
The common principle for the practice of auditing that Limperg postulated is
now embedded in the mechanism for developing professional standards. The PCAOB’s
process must be directed by what is necessary to protect investors and further
the public interest. The dynamic theory that connects society’s need for
reliable financial information to the ability of auditing methods to meet this
need is the essence of the process that the PCAOB must follow. The views of
investors and the public will be important input to the process. The PCAOB with
the assistance of practicing auditors will need to determine the auditing
methods necessary to meet society’s needs. One means the PCAOB will use to
accomplish this is the Standing Advisory Group that will soon be appointed. The
procedures and evidence necessary to support an audit opinion will have to be
grounded on the confidence that society places in the effectiveness of the
audit, as interpreted by the PCAOB in accordance with the Act. The way that the
PCAOB’s process can be expected to work to develop standards based on the
interaction of society’s needs and the ability of auditing methods to meet
those needs is demonstrated by another standard recently proposed by the PCAOB
– audits of internal control over financial reporting. This standard is related
to Section 404 of the Sarbanes-Oxley Act. The SEC adopted rules implementing
Section 404(a) that require management to assess and report annually on
internal control over financial reporting. The PCAOB has proposed a standard to
implement Section 404(b) on the auditor’s attestation of management’s
assessment. This proposed standard involves something much more than additional
information being covered by the auditor’s report. It is Limperg’s concept of
an expansion of the audit function in action.
The financial reporting of a public
company under the Federal securities laws is a continuous disclosure process.
As this continuous disclosure process evolved, the audit function remained
largely an annual expression of opinion on the reliability of financial
information—annual financial statements—that several months earlier had already
impacted securities prices. Auditors did not expand their role to make timely
review of quarterly financial statements required until relatively recently.
Under the PCAOB’s proposed standard, the audit of a public company is now an
audit of the company’s financial reporting process. The annual and quarterly
financial statements are the primary outputs of the process, but internal
control over financial reporting provides discipline and safeguards over the
process that produces those financial reports as well as other timely releases
of financial information. The ultimate objective of this new audit of a public
company is to meet society’s need for reliable outputs of the financial
reporting process. Reliable and credible financial information promotes
informed investment and lending decisions. Investors need and want assurance
that the public company’s releases of financial information during the period
between audited annual financial statements are reliable. The PCAOB’s standard
includes many imperatives on the scope of work necessary to give an opinion on
internal control over financial reporting. These imperatives are driven by an
evaluation of what public expectations require. The auditor has to perform
enough work to provide assurance not just that management’s assessment process
is adequate, but that the controls over the financial reporting process are
effective.
The approach to development of this position
is the one formulated by Limperg – what work is necessary to provide warranted
assurance that the outputs of the financial reporting process are reliable? As
Limperg might have put it: The audit procedures required by the PCAOB’s
standard are determined by the rational technical demands that arise from the
confidence that society will attribute to this new audit function. Limperg’s
formulation also has important implications for educators who want to assure
that they are teaching the knowledge and skills that will be needed by auditors
to perform an audit function that meets society’s needs. For example, as the
accounting information in financial statements includes more assets and
liabilities stated at fair value, auditors will need the knowledge and skills
of a valuation expert. Auditors now meet these needs by using the work of
valuation specialists, but that is not sufficient to meet society’s need for
reliable fair value financial information. The accounting curriculum must
expand to include valuation expertise as part of an auditor’s basic knowledge.
I do not want to give the impression by making this recommendation that I favor
unrestricted expansion of use of fair value information. In keeping with
Limperg’s theory, the auditor should not arouse greater expectations than can
be justified by the work performed. When fair value information is based on a
model that incorporates management intent rather than being based on
objectively verifiable market prices, there is a serious risk of arousing
unjustified expectations. This possibility should be of concern to all those
involved in the financial reporting process. In particular, accounting standard-setters
should carefully consider the verifiability of required information and
independent auditors should not accept information that does not meet
reasonably expected levels of reliability. Limperg’s formulation also includes
society’s expectations being informed by the auditing methods that are
understood to be used by auditors. For example, users generally understand that
auditors use a sampling approach and that an auditor does not examine every
transaction.
A reasonable user does not expect that
accounting information is precise, but only that it is materially correct.
Auditors, and educators of auditors, need to be mindful of the auditing methods
that have engendered the confidence of society and not abandon these methods
unless they are being replaced by even more effective approaches as part of
expanding the function to meet the increased needs of society. For example, the
sampling approach that has long been used in auditing depends for its
justification on several assumptions. One is that the auditor will understand
the company’s business and industry well enough to notice significant or
unusual items when they are included in the items tested, scanned, or reviewed.
Another is that accounting information is produced by a controlled system that
includes overriding disciplines, such as debits being equal to credits and
other controls that we take for granted in an integrated accounting system.
Auditing standards have long reflected this assumption. The codification
section on evidence contains the auditing equation that evidential matter
supporting the financial statements consists of two components—the underlying
accounting data and all corroborating information available to the auditor. It
cautions that “without adequate attention to the propriety and accuracy of the
underlying accounting data, an opinion on the financial statements would not be
warranted.” (AU 326.16) It also notes that the “internal consistency” of the
accounting records itself provides evidence about the fairness of presentation
of the financial statements. (AU 326.19) This internal consistency cannot be
known to the auditor unless the auditor, among other matters, actually
determines that the financial statements agree to or reconcile with the general
ledger. Yet in practice today, there are auditors that only audit a trial
balance that has not been reconciled to the general ledger. Some auditors would
be quick to explain that the trial balance is generated by a computerized
general ledger system and that, therefore, actually looking at the general
ledger accounts is unnecessary. The reality is that the trial balance is only a
piece of paper. It is not the general ledger. The approach to auditing that has
evolved over decades and that society has come to place confidence in is based
on evidence from the internal consistency of accounting records that is not
being obtained by some auditors today. Some would counter that the reviews of
the computerized system made by the firm’s computer audit specialists ensures
that the trial balance can be relied on as being accurately generated by the
computerized general ledger system. The reality is that there is often
insufficient discussion between the computer auditors and general auditors for
the general auditors to know what assurance is provided by the work being done
by the computer specialists. The general auditors do not have enough knowledge
to know when computer audit techniques must be used to retrieve data directly
from the company’s computerized accounting records. As auditing educators, you
can make sure your students are acutely aware of the need to obtain a thorough
understanding of both the manual and computerized aspects of the accounting
system. Another previously neglected area in both auditing education and
practice is expertise in the ways that management and employee frauds are
perpetrated and concealed. The PCAOB in its inspections of auditing practice in
2004 will be very interested in how well SAS 99 on the auditor’s responsibility
for fraud detection is implemented. The link here to Limperg’s theory is clear.
The detection of material fraud is a reasonable expectation of users of audited
financial statements. Society needs and expects assurance that financial
information has not been materially misstated because of fraud. Unless an
independent audit can provide this assurance, it has little if any usefulness
to society. New required auditing procedures will be of little use unless the
auditors implementing them understand the possibilities of fraudulent
misstatement of financial statements and how perpetrators attempt to conceal
fraud. You can make sure your students have that knowledge. Limperg’s theory
also sheds light on the issue of whether there should be two sets of auditing
standards. It is difficult to imagine circumstances that would justify a
divergence between levels of assurance because different standards were
applicable to audits of public versus private companies. The only possibility
that Limperg’s theory would countenance would be if the perception of users of
private company financial statements was that auditors of such financial
statements inspired a distinctly different level of confidence in the
effectiveness of the audit. This could occur if auditors of private companies,
by design or direction, intended to create this difference in public
perception, but it is difficult to see how that would be in the public
interest. In closing, I would like to acknowledge that my remarks about
Limperg’s theory are based on a booklet published by the Limperg Institute’s
Scientific Board that had his essays translated into English.
This publication issued in 1985 is a
convenient source that I recommend to you. My first contact with Limperg’s
ideas, however, goes back to the early 1970’s when, as the first auditing
researcher at the AICPA, I wrestled with giving wider exposure to Limperg’s
enduring theory of auditing. At that time, members of the firm he founded,
Moret & Limperg, assisted me in translating his essays. I assure you that
the translation made available in the mid-1980’s is more elegant than the
translation I worked with. One key difference relates to the Dutch phrase that
Limperg used to describe his theory—“leer van het gewekte vertrouwen” of which
“Theory of Inspired Confidence” is referred to in the essay as “a rather clumsy
sounding English translation of the Dutch.” In my earlier translation, the
phrase we used was the Theory of Created Confidence. I think it is a more apt
phrase because it captures the notion that the confidence the public has in the
auditor’s opinion is one that has to be created. It is one that must be earned
by those who practice and teach auditing and also by those who aspire to set
standards for auditors. A great many things in my own career and in the world
of auditing prevented me from writing or speaking about Limperg’s theory until
now, but I sincerely appreciate the opportunity to share those thoughts with
you today.
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