Philip Scott Andrews/The New York TimesJames R. Doty, chairman of the Public Company Accounting Oversight Board.The federal regulator that polices accounting firms is proposing a major overhaul of how company audits are reported to the public, a move that could provide investors with deeper insight into the health of corporations.
For more than 70 years, auditors have had to provide only relatively superficial opinions about what they see when delving into companies’ books. But that would change under new rules that the Public Company Accounting Oversight Board proposed on Tuesday.
The board wants accounting firms to include a potentially large amount of new information in the audit report that is attached to a company’s annual report.
For instance, an auditor would have to explain where it found it difficult to form judgments about a company’s books. That difficulty might stem from the complexity of the company’s financial statements, or from a lack of evidence to support management’s estimates of an accounting item.
The proposal is one of the most ambitious initiatives to come from the oversight board, which was set up 10 years ago after devastating accounting scandals at large companies revealed serious shortcomings at auditing firms.
“The proposed standards to enhance the auditor’s reporting model mark a watershed moment for auditing in the United States,” James R. Doty, the chairman of the oversight board, said in a statement. He added that the new rule “would make the audit report more relevant to investors.”
The overhaul would not do away with the current and longstanding practice of requiring the auditors to give a simple pass or fail opinion in the reports. It would add to it by requiring accounting firms to discuss what it calls “critical audit matters.”
Critics of the current approach say that accounting firms get to see a lot of important information when conducting audits, but do not necessarily have to share significant insights they may arrive at when looking at the numbers.
Under the proposal, the auditors would have to communicate details of the difficult parts of the audit. And at large corporations, there could be many situations where an auditor may find its task nettlesome.
For example, many companies use a substantial amount of guesswork when setting the value of items on their balance sheet or income statement. An auditor currently has to vet such values. But with the new rules, it would have to discuss why that task was taxing and potentially show how it became comfortable with the values.
“If something caused a huge amount of agita, it’s probably incumbent upon the auditor to disclose that,” said Peter H. Nachtwey, chief financial officer at Legg Mason, an asset management company.
Requiring the extra information may draw opposition from some auditors because it could add expenses. Companies may also balk, fearing that investors may interpret the proposed disclosures by an auditor negatively. After the comment period that now follows, the rules may be diluted and they may not go into effect for many months.
Still, the board has floated the ideas in the proposal for a long time and some auditors say they favor them.
“PwC strongly supports any enhancements to the auditor’s report that will address the needs of today’s users,” said Vincent P. Colman, the partner who oversees the audit and accounting practices at PricewaterhouseCoopers, a large accounting firm. “And we look forward to working expeditiously with the P.C.A.O.B. and all stakeholders to achieve this objective.”
Investors will most likely support the move to add information to the auditors’ report.
“It serves the interests of investors and sell-side analysts,” Mr. Nachtwey said, referring to Wall Street analysts who cover public companies. As a chief financial officer, he expects the new proposals would lead to more inquiries about his company’s financials. “Yes, it will make my job a little harder, but I don’t mind answering more questions,” he said.
Other accounting specialists, however, do not think the changes would go far enough.
Steven B. Harris, a member of the oversight board, said the proposals might “improve communication of areas of high audit risk.” But he added, “The language in today’s proposals, however, does not appear to me to create a rule that will be sure to do that.”
Joseph V. Carcello, an accounting professor at the University of Tennessee, gives an example of a situation where the proposed rules may be lacking. A bank may place a value on securities that barely trade. Under the new rules, the auditor may describe the difficulties in involved in valuing those securities. But the proposed standards may not require the auditor to clearly state where the bank’s estimate fell in relation to others.
“Was the estimate down the fairway, or was it in the rough?” Mr. Carcello asked.
In another significant shift, the board is proposing that auditors broaden their oversight over company reports. While an auditor’s chief focus would remain on financial statements like the balance sheet, it would also have to cover other information in the annual report. Specifically, the proposal would require the auditor to evaluate the other information for material misstatements or inconsistencies.
Past accounting frauds may have motivated this proposal. In some narrow way, audited financial statements like the income statement might not include material problems, which means the company might pass an audit under the current rules. But there may be shortcomings or inconsistencies elsewhere in the annual report, which the auditor would probably have to mention under the new approach.
After the accounting problems more than 10 years ago at Tyco International, a conglomerate, some auditors argued that the subsequent revisions to the company’s audited financial statements were minor. But other Tyco disclosures, which didn’t require an audit opinion, were considered materially misleading.
The accounting oversight board is also proposing that accounting firms make public statements about their independence from the companies they audit and give details of how long they’ve been auditing the companies. Some investors feel that auditors can become too close to the companies they audit. By requiring accounting firms to state their independence and the length of the audit relationship, the board may hope to definitively remind the firms of the need for autonomy and rigor.
“Any time you say something publicly, it puts a higher bar on the firm,” Mr. Nachtwey said.