Exhibit 4 shows a purported decline and converging rate of findings in most industries around the 20% mark. That is what the real story is about: On average, 1 in 5 audits that were inspected were deficient. This is an alarming rate; although it’s pointing downward, it is still a high number. Said another way, would a pre-retirement person accept a 401(k) plan that can at any point drop in value of 20% because the one-fifth of the underlying audit reports were not reliable?
What’s also collaboratively concerning is a finding not in the article—which is the PCAOB’s own findings with respect to Part I.A. The PCAOB classifies an audit as Part I.A. when: “Deficiencies that were of such significance that we believe the firm, at the time it issued its audit report(s), had not obtained sufficient appropriate audit evidence to support its opinion(s) on the issuer’s financial statements and/or ICFR” (emphasis added; see https://pcaobus.org/oversight/inspections/firm-inspection-reports).
In reading the 2020 findings of the six largest U.S. accounting firms (PricewaterhouseCoopers LLP, KPMG LLC, Ernst & Young LLP, Deloitte & Touche LLP, BDO USA, LLP, and Grant Thornton LLP), the median finding is that at least 11% of all audits inspected have been found to “qualify” for the dubious classification of Part I.A for financial statements and 10% for Internal Controls over Financial Reporting. This means that approximately 1 in 10 audit reports are so deficient that the audit opinion is not supportable.
These findings should not cause auditors and stakeholders to rejoice. Rather, the findings both in the aforementioned article and elsewhere are disappointing and alarming—and they should be shared with decision makers on policy, standards, and users of audited financial statements.
The Authors Respond
We would like to thank Yigal Rechtman for his response to our article, “The New Working World of the COVID-19 Pandemic: A Tumultuous Time for Auditors, Industries, and the PCAOB” (March/April 2022). We appreciate your diligence in analyzing our exhibits carefully and hope that our response below provides you with assurance that, overall, the CPA firms are providing high-quality audits. When auditors make errors, the PCAOB is diligent in finding the deficiencies and alerting the auditors and the public. We hope that our response below clarifies misconceptions as to the implications of deficiencies and restores your confidence in the quality of public accounting.
First, thank you for noticing that by 2020, in most industries, an average 20% of the inspected audits had Part 1.A deficiencies. To emphasize, the percentages of deficiencies cited in our article are calculated only for the audits that were inspected—not for the entirety of audits completed. Auditors conducted additional audits that were not inspected. For example, Deloitte & Touche issued 1,142 audit opinions for 10-K filings in 2019, but only 53 audits were reviewed in 2020 by the PCAOB, which represents less than 5% of Deloitte & Touche’s audits of public companies. On average, 1 in 10 audit reports were inspected. The Big Four had about 53 audits inspected on average, which represents less than 17% of the audit reports issued for public companies during 2019, which would have been inspected in 2020. (see Exhibit 1).
Big Four Audits for 10-K Filings
Because it is not feasible to inspect every audit, the PCAOB attempts to focus on audits that are more likely to be deficient. For each of the Big Four, of the 52 or 53 audits the PCAOB reviewed in 2020, 37 were risk-based selections. Therefore, the 20% deficiency rate is likely based on audits that were more suspect to begin with. This percentage should be much lower if inspections could have been conducted for all of the audits (see Exhibit 2).
Big Four Audits Reviewed
Specific to your concern that a 401(k) plan may lose 20% in value because 20% of the inspected audits had deficiencies, the average 401(k) includes many companies that were likely not included in the inspected audits. The most common 401(k) plan is a mutual fund, and the “average plan offers between 8 and 12 alternatives” of mutual fund and other fund combinations (Financial Industry Regulatory Authority, 2022, https://bit.ly/39tYrrT). Each mutual fund within an overall plan can have as few as two dozen stocks to more than 1,000 (Charles Schwab, 2022, https://bit.ly/3HrHKdi). To put this into perspective, the PCAOB reviewed 510 audits in 2020 (PCAOB, Spotlight: Staff update and preview of 2020 inspection observations, 2021, https://bit.ly/3thnd5J), a fraction of the companies that a 401(k) may be invested in.
Second, it is also important to remember that Part 1.A deficiencies for an audit firm do not necessarily lead to a significant decrease in an audit client’s market value. The severity of the implications of the deficiencies may range from mild corrections of future audits (i.e., remediation) to more severe restatements of published financial statements. Even the more extreme consequence of restatements is not expected to wipe out an entity’s value. The expected drop in market prices is 2% on average for restatements due to errors and 14% on average of restatements due to fraud (Hennes, K.M., Leone, A.J., and Miller, B.P., “The importance of distinguishing errors from irregularities in restatement research: The case of restatements and CEO/CFO turnover,” The Accounting Review, vol. 83, no. 6, pp. 1487-1519, 2008). During the past decade, less than 1% of restatements were due to fraud (see Exhibit 3).
Moreover, few uncovered deficiencies actually require a restatement. The 2020 reports mentioned that there were no audits with incorrect opinions on the financial statements or internal controls. The inspection reports define this as follows: “This classification includes instances where a deficiency was identified in connection with our inspection and, as a result, an issuer’s financial statements were determined to be materially misstated, and the issuer restated its financial statements. It also includes instances where a deficiency was identified in connection with our inspection and, as a result, an issuer’s ICFR [internal control over financial reporting] was determined to be ineffective, or there were additional material weaknesses that the firm did not identify, and the firm withdrew its opinion, or revised its report, on ICFR. This classification does not include instances where, unrelated to our review, an issuer restated its financial statements and/or an issuer’s ICFR was determined to be ineffective. We include any deficiencies identified in connection with our reviews of these audits in the audits with multiple deficiencies or audits with a single deficiency classification below.”
In case errors need more time to be uncovered, we also looked at the previous year’s numbers. The largest number of incorrect opinions was for PricewaterhouseCoopers’s 2019 inspections. In that inspection report, of the 18 audits that had Part 1.A deficiencies, only 4 opinions were flagged as incorrect. It is also worth noting that a restatement may actually be in the company’s favor. In the last decade, 17% of restatements improved the financial statements, for example, by correcting overstated expenses.
Third, we would like to point out that the graph in our article’s Exhibit 4 describes a downward trend and not a convergence, and it is likely that the downward trend will continue in the post-pandemic years. Exhibit 4 in our article shows an overall decline in the percentage of number of deficiencies. The graph ends with the last inspections to be published by Jan. 15, 2022. The graph shows an impressive improvement over time. Note that only three industries—healthcare and consumer discretionary, which we discussed in our article, and financial services—had an increase in the average deficiencies published. All other industry averages fell from 2019 and 2020. Overall, the graph indicates a decline in the average number of deficiencies over time.
It is worth mentioning that the graph is not expected to converge to zero deficiencies. In auditing, there is a tradeoff between minimizing errors and cost constraints (Chu, L., Fogel-Yaari, H., and Zhang, P., “The estimated propensity to issue going concern audit reports and audit quality,” Journal of Accounting, Auditing, & Finance, 2022, doi:10.1177/0148558X221079011). For example, the efforts to improve audit quality via the Sarbanes-Oxley Act (SOX) increased auditing costs to the point of driving smaller public companies to go private (Engel, E., Hayes, R.M., and Wang, X., “The Sarbanes-Oxley Act and firms’ going-private decisions,” Journal of Accounting and Economics, vol. 44, no. 1/2, pp. 116-145, 2007). Therefore, we do not expect audits to be perfect; rather, we expect inspectors to discover some deficiencies.
We believe CPAs should take heart in the few deficiencies that are found and even fewer restatements that are needed after a PCAOB review. On average, 80% of inspected audits have been found to have no deficiencies. Both the auditors and the PCAOB are doing their jobs by producing quality audits and finding audit deficiencies, respectively. Moreover, academic research has demonstrated that PCAOB oversight lent financial statements more credibility (Gipper, B., Leuz, C., and Maffett, M., “Public oversight and reporting credibility: Evidence from the PCAOB audit inspection regime,” The Review of Financial Studies, vol. 33, no. 10, pp. 4532–4579, 2020). We commend the PCAOB’s inspectors for their hard work.