Several recent changes in the regulatory environment continue to increase demands on independent public company auditors. Since the passage of Sarbanes Oxley and creation of the PCAOB in 2002, the rules governing outside auditor work for public companies have evolved, sometimes gradually and sometimes rapidly. The past year has seen several developments that are beginning to coalesce around a common theme: regulators appear to be increasing their scrutiny of auditors and expecting more from their audit work.

Three key regulatory factors determine a great deal regarding the nature, timing, and extent of the work performed by your outside auditor: inspections, enforcement, and rulemaking.  Regulators, and the PCAOB in particular, have used each of these three tools to increase the demands on outside auditors in the past year.

Inspections 

The largest audit firms undergo annual inspections by the PCAOB, including detailed review of the audit work performed for specific clients. Recent inspection results are a key barometer of the regulatory scrutiny over independent public company auditors. At the end of 2022, the PCAOB released its inspection reports covering 2021 and reported an increase in the number of audits it viewed as having serious compliance issues compared to the previous year. While the PCAOB identified what it believed to be serious deficiencies in 29% of the audits under inspection in 2020, that number rose to 33% for 2021. The PCAOB’s preview of 2022 inspection results states that audit deficiencies have risen yet again to 40% of audits under inspection, with the biggest increase seen in the largest global audit firms.  PCAOB Chair Erica Williams referred to these findings as “absolutely unacceptable” and indicated that the PCAOB plans to take steps to address this trend with audit firms in 2023 and beyond.

Enforcement

When the PCAOB believes audit firms or their professionals have violated audit rules, it may institute a formal enforcement investigation that can lead to disciplinary proceedings. These investigations bear many of the hallmarks of traditional civil lawsuits: document discovery, sworn testimony, hearings, and appeals. 2022 saw a rise in certain metrics of enforcement activity by the PCAOB. Cornerstone Research reported that the PCAOB imposed the largest total monetary penalties on audit firms and professionals in 2022, with aggregate penalties approaching $10.5 million. Cornerstone also reported that the PCAOB disclosed twenty-nine finalized enforcement actions in 2022, the most since 2017. While many of these recent proceedings involve smaller firms and non-US audits, enforcement activity targeting US-based audits by large firms also shows signs of a potential uptick.  Recently, on September 26, the PCAOB disclosed a $2 million civil monetary penalty to be paid by BDO USA in connection with disciplinary proceedings related to revenue recognition issues at a US-based client. 

Rulemaking 

Against this backdrop of increased inspection findings and enforcement activity, the PCAOB’s recent rulemaking activity is calling for greater auditor involvement and stricter accountability for individual auditors. In June, the PCAOB proposed sweeping changes to PCAOB Rule 2405 governing the auditor’s role in detecting and assessing a client’s non-compliance with laws and regulations. While the merits of the rule change have been hotly debated, one thing is clear: the change would lead to more work for auditors and audit fees will necessarily increase. As many commentors have observed, the proposed change would greatly expand the role of outside auditors because it would require auditors to gain an understanding of all laws and regulations that “could reasonably have a material effect” on a company’s financial statements. The current standard requires that the auditor focus only on laws and regulations likely to have a “direct and material” effect on the financial statements. What has received somewhat less attention is that the proposed changes to Rule 2405 would require the auditor to understand and assess instances of noncompliance “regardless of whether the effect of such noncompliance is perceived to be material to the financial statements.” In other words, under the proposed changes, the auditor may be charged with evaluating immaterial instances of non-compliance. Over 130 individuals and organizations have submitted comments to the proposed changes, many of which voice serious concerns. For example, the American Bar Association stated that the proposed changes “significantly expand the scope of auditor responsibilities beyond those contemplated by Congress” and “the anticipated risks to the legal and accounting professions cannot be understated.”  

More recently, on September 19, the PCAOB announced proposed changes to Rule 3502 governing when individual audit professionals may be held accountable for their firm’s audit standard violations. Under the current version of the rule, an individual auditor may be held accountable when their actions “directly and substantially contribute” to a violation by the firm if the individual auditor acts knowingly or recklessly. The proposed changes would lower the liability bar and impose responsibility on individuals when they act only negligently, rather than knowingly or recklessly. Here, too, the proposed rule has not yet been adopted, but a focus on individuals and not just their firms has been a noticeable trend in enforcement bodies such as the PCAOB and SEC recently.

Audit firms themselves are also strengthening their own policies and procedures in ways that may lead to more rigorous audits. Last month, the Wall Street Journal reported plans by PricewaterhouseCoopers to make several internal changes to boost audit quality, including additional procedures aimed at identifying fraud, new approaches to assessing a client’s ability to continue as a going concern, and formal compensation claw-back provisions for senior firm executives that would be triggered by negative events at the firm.

In short, your outside auditor is likely under increased pressure from regulators with high expectations and internal firm policies meant to ensure these expectations are met. This increased pressure may result in expansion of audit scope and increased audit fees in the near term.

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