The idea of introducing a third-party payer into the auditor-client relationship has received some attention from regulators, academics, and accounting firms in recent years. Years ago, both the PCAOB and the European Commission (EC) noted the idea as a potential solution to the presumed independence problem created by the auditor being hired and compensated by the auditee (European Commission, “Audit Policy: Lessons from the Crisis,” 2010, http://bit.ly/2BbYKmW; PCAOB, “Concept Release on Auditor Independence and Audit Firm Rotation,” 2011).
In 2018, the proposal was revived by Grant Thornton in the United Kingdom, recommending “auditor selection for large listed companies and other public interest entities … be carried out by a public body such as a newly established commission or the National Audit Office” (Madison Marriage, “Grant Thornton Calls for Independent Public Body to Appoint Auditors,” Financial Times, Sept. 11, 2018, https://on.ft.com/2Sknjro).
Under such a system, the PCAOB, rather than the client, could hire, retain, and pay the auditor. While the idea may be politically radical, there is substantial empirical evidence that it is workable and that it could achieve the desired goal of reinvigorating public confidence in the audit process. The PCAOB has now had more than a decade of experience as the regulator of the American audit profession; it possesses a unique expertise of the audit function, approving, through registration and regular inspection, all firms who conduct audits of publicly traded companies.
This article discusses the viability and potential obstacles to the PCAOB acting as a third-party payer. It looks at 1) the auditor-client relationship in countries that have greater regulation than the United States, including the modified third-party payer system used in South Korea; 2) an encouraging experiment where a third-party payer was used in India; 3) how the U.S. government handles outsourced regulation in other industries; 4) a long-forgotten advocacy of third-party payers from the 1933 Congressional hearings on the Securities Act; and 5) a discussion of the proposal in more detail, assessing the pros and cons.
Auditor Hiring and Compensation in Other Countries
The 21st century has seen increased government regulation of the audit process, most notably the Sarbanes-Oxley Act of 2002 (SOX), which created the PCAOB. Recently the European Union took the step of requiring mandatory rotation of auditors every 10 years. In the United States, mandatory rotation was seriously considered by the PCAOB, but encountered overwhelming opposition and was ultimately abandoned in 2014. Nevertheless, changes to the 70-year-old standard audit report requiring specific mention of investigation for fraud, the introduction of “critical audit matters,” and the requirement that the name of the audit partner be disclosed in Form AP make clear that concerns remain. Even with these reforms, moving to a third-party payer system would still require a tremendous change in thinking about what is necessary to ensure the integrity of the audit process.
Even in countries with a much stronger tradition of government regulation than the United States, the auditor is hired and compensated by the client. In France and Germany, while auditors are seen as an arm of the state, compared to their counterparts in the United States their distance from the client is largely a matter only of degree. (C.R. Baker et al., “Regulation of the Statutory Auditor in the European Union: A Comparative Survey of the United Kingdom, France, and Germany,” European Accounting Review, February 2001, http://bit.ly/2RUO0nj). In China, where the modernization of the profession has occurred only since the move towards a market economy began in 1979, the government does not interfere with auditor-client compensation (E. Bertin and J. Jaussaud, “Regulation of Statutory Audit in China,” Asian Business and Management,August 2003, http://bit.ly/2FZ53ON).
A modified third-party payer system may appear radical and unworkable to some; however, such a system already exists in South Korea. Under the Mandatory Auditor Designation Rule, introduced in 1991, the Financial Supervisory Service (FSS) can assign an auditor to a company deemed “problematic” under the Mandatory Auditor (MA) rule. Criteria for designation as problematic can include financial distress, previous violations of GAAP, poor corporate governance, or other risk factors the FSS identifies (D. Lee, et al., “New Auditors’ Decisions for Released Firms from the Mandatory Auditor Designation Rule: Evidence from South Korea,” Australian Accounting Review, 2013, http://bit.ly/2HSq27N; S. Jeong, et al., “The Effect of Mandatory Auditor Assignment and Non-Audit Service on Audit Fees: Evidence from Korea,” International Journal of Accounting, February 2005, http://bit.ly/2sVNgzx).
Under this system, the auditor determines the audit fee it will charge, and the negotiation between auditor and client is eliminated. The auditor can remain assigned to the client until the FSS determines the company is no longer a risk. Auditors are chosen based on their size and the FSS’s determination of their quality (Lee et al. 2013). Not surprisingly, auditors assigned to problematic firms under the MA rule tend to charge higher fees than other engagements. Research has found that both auditor independence and the quality of financial reporting have improved under this system. While mandatory assignment is done for only a small percentage of firms, it does provide some evidence that government assignment of auditors can be effective.
A modified third-party payer system may appear radical and unworkable to some; however, such a system already exists in South Korea.
In another example, researchers in India conducted an experiment that introduced a third-party payer, with encouraging results. E. Dunflo et al. participated in a two-year field experiment with the environmental regulatory body in Gujarat state. The practice in this industry had been the same as for financial statement audits: an outside firm was hired to inspect and report on the level of pollution by regulated plants. The authors found that all parties agree that this system failed to provide meaningful enforcement, because the inspectors had no incentive to issue negative reports on the plants that hired and paid them. Working with local authorities, the authors conducted an ingenious experiment:
Treatment plants were randomly assigned an auditor they were required to use. Second, auditors were paid from a central pool, rather than by the plant, and their fee was set in advance at a flat rate, high enough to cover pollution measurement and leave the auditor a modest profit margin. (E. Duflo, et al., “Truth-telling by Third-Party Auditors and the Response of Polluting Firms: Experimental Evidence from India,” Quarterly Journal of Economics, 2013, http://bit.ly/2HFhWz5).
A random sample of audits was then backchecked by engineers from local colleges. The authors found evidence that the quality of inspections improved:
The treatment greatly increased the accuracy of auditor reporting, viewed in terms of compliance, levels, or differences with backchecks. This finding is robust to the inclusion of auditor fixed effects, which provide estimates based on a comparison of the behavior of the same auditor working under both the treatment and control or status quo market structures simultaneously. Third, treatment plants reduced their pollution emissions.
Government Outsourcing of Regulatory Enforcement in the United States
While some may argue that the South Korean model would not work in a larger, more complex system, a review of how the U.S. government outsources many of its regulatory functions can provide a context with which to reexamine the proper role of government in financial statement audit regulation.
While government outsourcing of regulatory enforcement is ubiquitous in the United States, no arrangement like a third-party payer system exists. As in financial statement audits, when an outside party enforces government regulations through audits or inspections, it is paid by the regulated party, not the government. One such field is the approval of hospitals to receive Medicare and Medicaid patients; this system merits particular attention because of its similarity to the financial statement audit process.
The United States has never witnessed a real debate over the role government should play in the audits of publicly traded companies’ financial statements.
Hospitals in the United States can receive approval to take in Medicare and Medicaid patients through certification by the Centers for Medicare and Medicaid Services (CMS). As an alternative, the CMS allows certification by a private body, the Joint Commission on Accreditation of Healthcare Organizations (JCAHO). The viability of most hospitals depends on being able to admit Medicare and Medicaid patients, and hospitals overwhelmingly choose JCAHO accreditation over government inspection (L. Pawlson, and M. O’Kane, “Professionalism, Regulation, and the Market: Impact on Accountability for Quality of Care,” Health Affairs, May/June 2002, http://bit.ly/2Ti6Q4w).
Criticism of this system bears a striking resemblance to complaints about the financial statement audit process. The JCAHO is faulted for “being too ‘collegial’ with hospitals.” While it possesses an “advantage with respect to having knowledge of the hospital system,” its relationship with the hospitals it accredits still “creates a conflict of interest,” and “almost every medical facility that JCAHO inspects is awarded accreditation” (M. Moffett and A. Bohara, “Hospital Quality Oversight by the Joint Commission on the Accreditation of Healthcare Organizations,” Eastern Economic Journal, Fall 2005, http://bit.ly/2sWkgYs). Increased government regulation is often seen as the most viable solution (C. Schoenbaum et al., “Obtaining Greater Value from Healthcare: The Roles of the U.S. Government,” Health Affairs, November/December 2003, http://bit.ly/2GbAHaT). A more recent review was published three years ago (J. Short and M. Toffel, “The Integrity of Private Third-Party Compliance Monitoring,” Administrative and Regulatory Law/News, Fall 2016, https://hbs.me/2BadXFc).
The Third-Party Payer Proposal in the 1933 Securities Act Hearings
The United States has never witnessed a real debate over the role government should play in the audits of publicly traded companies’ financial statements. The financial statement audit was hastily delegated to the accounting profession with little debate more than 80 years ago, when the Securities Acts were written.
As recently as August 2011, the PCAOB stated: “Among the other proposals the [AICPA’s 1978] Cohen Commission considered in this area was ‘to have independent auditors approved, assigned, or compensated by a government agency or to have audits conducted by a corps of government auditors … arrangements such as these were specifically rejected when the federal securities acts were adopted’” (“Concept Release on Auditor Independence and Audit Firm Rotation,” Aug. 16, 2011, http://bit.ly/2FYPfeD). This is an inaccurate summary of what took place in 1933.
The 1933 Securities Act was passed as part of the rush of legislation passed in the first “Hundred Days” of President Franklin D. Roosevelt’s administration in order to address the unprecedented financial crisis as the Great Depression deepened. The Securities Act itself received relatively little attention compared to the major reforms in banking and farm legislation, and the accounting and audit issues received a small fraction of that. There was no formal study of the extent to which government should be involved in audits of publicly traded companies, nor was there much interest in what audits were or the role they played in capital market regulation. The suggestion that other systems were “specifically rejected” in 1933 creates the false impression that the issue of government oversight of auditing was settled in 1933 (M.E. Doron, “The Colonel Carter Myth and the Securities Act: Using Accounting History to Establish Institutional Legitimacy,” Accounting History, Jan. 7, 2015, http://bit.ly/2Gbosv9).
Indeed, the idea of the government as third-party payer did draw the interest of one congressman respected on financial matters. At one point in the 1933 hearings, Senator James Couzens (D-Mich.) offered the White House’s chief spokesman at the hearings, Huston Thompson of the Commerce Department, “a practical proposition. Let the Federal Trade Commission, if they want to, pick the certified public accountants, at the expense of the person registering.” Thompson, apparently having not considered such a system, replied circumspectly that “if you are going to make those requirements perhaps you can protect the situation, but it will become somewhat involved” (J.S. Ellenberger and E.P. Mahar, eds. Legislative History of the Securities Act of 1933, vol. 2, Law Librarians’ Society of Washington, D.C., 1973).
In the intervening years, Congress has periodically suggested revisiting the system created so hastily in 1933:
A review of the SEC’s record on accounting and reporting matters shows clearly that it has seriously failed to protect the public interest and fulfill its congressional mandate … Independent auditors share the SEC’s responsibility to the public. Their role in assuring compliance with the provisions of the Federal securities laws is essentially a public service role that Congress might very well have assigned to the SEC or some other governmental authority. (U.S. Congress, Senate Committee on Government Operations, The Accounting Establishment, 1976)
The PCAOB as Third-Party Payer
Overcoming skepticism about increasing the government’s role in the audit process may be the biggest hurdle any third-party payer proposal faces. Perhaps now is the time to have the debate that should have taken place in 1933. From Arthur Levitt Jr.’s “Numbers Game” speech in 1998 to the creation of the PCAOB and the push for mandatory auditor rotation, the issue will not go away. For this reason, the proper role of government in this system should be reexamined.
The PCAOB as third-party payer could mitigate many of the concerns about ensuring auditor independence. The goal of more frequent rotation of auditors could be accomplished, not by a rigid formula (e.g., mandatory rotation every five years), but at the discretion of the PCAOB. This could also address auditors’ concerns that mandatory rotation would waste the expertise that the auditor has developed over time. With hiring at the PCAOB’s discretion, an effective auditor could keep an engagement indefinitely, as is done with auditors assigned to problematic entities under the South Korean system.
Second, a great deal of attention has been given in recent years to the dominance of the Big Four in the audit market. The PCAOB would have the power to assign more audits to the second-tier national firms, thus increasing competition, a professed goal of both regulators and the U.S. Chamber of Commerce. While it is true that only the Big Four have the resources to audit the largest publicly traded companies, Jeff P. Boone et al. suggest that up to 90% of Big Four audit clients could be handled by second-tier firms (“Do the Big 4 and the Second-Tier Firms Provide Audits of Similar Quality?” Journal of Accounting and Public Policy, July/August 2010, http://bit.ly/2GcsAuE).
This would be a substantial new responsibility for the PCAOB, but information that already exists could mitigate the burden. The audit fees that companies pay are already publicly disclosed; this amount would be paid to the PCAOB, which would then be tasked with hiring a suitable auditor. Adjustments to this amount could be made by the PCAOB if necessary to maintain firms’ profit margins.
Several empirical studies have demonstrated that audit fee models can be effective in predicting audit fees. Audit fees are divided into normal and abnormal components; “normal” audit fees are based on several variables involving the size of the company, the complexity of its operations, and audit risk. Audit risk is generally measured based on past restatements of 10-K filings, past qualified audit opinions, the life cycle of the company (i.e., growing companies are considered riskier), and financial statement ratios (companies with a higher percentage of current assets are considered less risky) (J.D. Eshleman and P. Guo, “Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management,” Auditing: A Journal of Practice and Theory, 2014, http://bit.ly/2HGGOGK).
The PCAOB already has a system in place that can serve as a template for establishing a third-party payer system. An “accounting support fee” is collected from every publicly traded company; the PCAOB funds itself almost exclusively (97.5%) through these fees (“SEC Approves 2014 PCAOB Budget and Accounting Support Fee,” SEC Press Release, Feb. 14, 2014, http://bit.ly/2DJ3B0m.) The fee is based on the company’s size, as “the size of the entity may serve as an indication of the complexity of the audit.” The PCAOB also has an appeals system in place for those who disagree with the fee assessed (PCAOB Bylaws and Rules).
The PCAOB already has a system in place that can serve as a template for establishing a third-party payer system.
While calculating an audit fee would be a more complex process, it would, like the accounting support fee, be based on the complexity of the audit. The appeals process would allow for negotiation between the company, the auditor, and the PCAOB to achieve an appropriate audit fee.
Adding the hiring and paying of auditors to the PCAOB’s mandate could, however, lead an unintended consequence. The PCAOB would need to maintain its independence, objectively inspect firms that it put in place, and avoid being “captured” by the firms it regulates. Substantial research has, however, made the case for the PCAOB’s effectiveness. Auditors describe the PCAOB as a “powerful regulator” that operates in an “antagonistic environment in which auditors perceive the PCAOB has high coercive power” (L. Johnson, M. Keune, and J. Winchel, “U.S. Auditors’ Perceptions of the PCAOB Inspection Process: A Behavioral Examination,” Contemporary Accounting Research, forthcoming; D. Carmichael, “Reflections on the Establishment of the PCAOB and Its Audit Standard-Setting Role,” Accounting Horizons, December 2014, http://bit.ly/2HEWQAJ).
Some might object that this system would interfere with the free-market negotiation of audit fees. While this is true, there is reason to question whether the free market serves the goal of high-quality audits. A great deal of research has suggested that clients often use their bargaining power to depress audit fees, leading to decreased effort by the auditor (Eshleman and Guo 2014). This view was echoed by the former chief accountant of the SEC, Lynn Turner:
Certainly throughout the 1980’s and 1990’s, corporations, sometimes with the assistance of their audit committees, ‘twisted’ the arms of independent auditors to reduce their audit fees. Our experience includes corporations who competitively bid their independent audit work solely to reduce their fees well below levels that could generate a reasonable return for the auditors. In turn, the audit firms reduced the level of work they needed to perform in their role as gatekeepers for investors. Inevitably inferior audits resulted. (“Comment letter to the Securities and Exchange Commission,” Apr. 12, 2005, http://bit.ly/2UwDjnV)
The PCAOB apparently subscribes to this view, as firms with low audit fees (relative to their competitors) are targeted by the PCAOB for review (B. Bockwoldt, “Looking for Lower Audit Fees? Be Careful…” Vibato LLC, Nov. 4, 2010, http://bit.ly/2Wv3c9h).
One obvious risk is that the auditor, no longer beholden to the client, would lose the incentive to perform effectively. But the client, its board of directors, audit committee, or individual shareholders would be free to voice concerns to the PCAOB, which of course would be able to replace the auditor whenever it suspected substandard work. The PCAOB’s inspection process could provide the PCAOB with a basis by which to remove an auditor from an engagement and thereby serve as a backcheck to ensure quality.
An Idea Whose Time Has Come
This article sought to identify the benefits and obstacles of using the PCAOB to hire and compensate auditors as a means of ensuring the auditor’s independence from the companies they audit. A modified version of this system in South Korea and an experimental system in India have been successful; the PCAOB already has a simplified process in place to collect accounting support fees; and audit fee models developed by researchers have demonstrated strong explanatory power in predicting audit fees. As one cannot test a system that does not yet exist, this informal evidence must serve as the basis for debate.
While a range of operational issues would need remediation, the greatest obstacle to that debate may be political rather than empirical. Undertaking major reforms requires acceptance of the idea that the status quo is suboptimal. The importance of the independent audit in maintaining the integrity of the capital markets was not well understood during the drafting of the Securities Acts of 1933 and 1934, and the United States has been grasping for solutions ever since. Increased government involvement may strike many as too far outside the mainstream, and it would require rethinking the proper role of government in regulating the capital markets. But that should not preempt discussion of a solution with the potential to reinvigorate public trust in financial reporting.
While a range of operational issues would need remediation, the greatest obstacle to that debate may be political rather than empirical.