you can’t build it in at the end.
by alan anderson, cpa
transforming audit for the future
“it takes less time to do things right than to explain why you did them wrong.” – henry wadsworth longfellow
many audit firms think about quality as a task carried out at the end of the audit by the quality control reviewer. the problem with that thinking is that sometimes the qc reviewer misses major problems. for example, i was working with the new qc reviewer at one firm who spent most of the review time looking at the superficial details of formatting and punctuation, but almost disastrously missing a $3 million error that i spotted right away because the relationships between the numbers didn’t make sense.
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quality in audit shouldn’t be just an extra step at the end of the audit, but it should be an approach woven into the fabric of the firm. quality is an attitude of “first time right” that permeates every task and every step in the audit. if you leave quality for the end, you’ll be challenged at delivering quality in your audits.
we’ll start our discussion of the quality attribute by defining what quality is, and how outsiders measure it. then we’ll look at how quality is practiced in firms today.
what is the definition of quality in audit?
academics try to connect audit quality with external signs. for example, they look for organizations that have replaced an auditor after a prior period restatement or after late issuance of the audit report. they are limited to these external signs as indicators of quality because audit is a process, and that process is largely invisible to outsiders. i have a simple definition of a quality audit:
does what you do meet the objective of the audit, which is to render an appropriate opinion on the financial statements, taken as a whole?
did you protect the interests of the stakeholders? did you serve the needs of your client? now there are an awful lot of underpinnings that you need to ensure that the opinion is appropriate. but at the end of the day, it’s the opinion that we’re responsible for. we have to make sure that the quality is such that we’re rendering an appropriate opinion. an appropriate opinion means we did enough work to provide reasonable assurance, not absolute assurance, that the financials are stated fairly.
now when i’ve talked to firms around the country, they have a different notion of quality. if you ask the audit partner, he or she might say that quality in audit means you got through peer review. the staff might say that quality means making it through review.
quality is about getting it right the first time, so we don’t have to depend on someone catching our mistakes. it’s not a game of gotcha, where the reviewer catches you at the end. the key to quality in audit is building it into the fabric of your culture and moving from quality control to quality assurance. this is an attitude and a mindset. this means taking pride in your work and being willing to stand behind it at all times.
reasonable assurance, not 120% quality
remember, an audit is reasonable assurance, not absolute assurance. you won’t get paid any more if you provide 120 percent quality. review engagements are limited assurance. despite the fears of many partners, firms don’t lose clients over comments in peer review. but how much partner compensation are you willing to forego to have a “perfect” peer review?
doing more work than is required to provide reasonable assurance can actually have a negative impact. overauditing by adding more detail than is necessary can lead to reviewers and preparers getting lost in all that detail and missing the big picture. they can miss the $3 million mistake or fail to see fundamental problems with the client’s business. this can easily happen when a staff member blindly follows saly without first understanding what a particular audit procedure is intended to achieve. too much detail can be a sign that the person or team don’t have a clear understanding of how to perform an audit.
first time right does not ensure that you are absolutely right. but you exercise good discipline and use professional judgment and professional skepticism and do the best you can.
how do outsiders measure quality?
getting it right the first time appears to be an elusive goal for even the biggest audit firms. since 2013, the international forum of independent audit regulators (ifiar) has been performing an annual inspection of individual firms affiliated with the six biggest audit firms (bdo, deloitte, ernst & young, grant thornton, kpmg and pricewaterhousecoopers). they collect two categories of data in these inspections: firmwide systems of quality control and performance on individual audits.
in their latest report for the 2020 inspections, they found that 34 percent of the publicly traded companies had at least one finding. one in three sounds terrible, but this is an improvement from 47 percent in 2014 when they first started collecting this data.
overall, the annual inspections show improvements in audit quality, but there’s clearly room to raise the quality standard further. now the report explains this isn’t as dire as it may sound. as their report explains, “a finding is a significant deficiency in satisfying the requirements of auditing standards. it is important to note that a finding from an inspection of an audit engagement does not necessarily indicate that the audited financial statements are misstated or that the audit firm necessarily has a deficient system of quality control related to the finding” [emphasis in original]. but, even if those deficiencies are not terrible, their existence is worrisome. as we’ve seen with audit failures that bring down whole companies – like enron and arthur andersen – overlooking an accumulation of small problems can be disastrous.
there’s not a lot of corresponding research on the state of quality in audit among smaller firms but gauging from commoditization of audit and the trend toward dropping fees, i’d say that at the very least, quality in audit isn’t apparent to the outside world.
how do regulators view quality?
one way that the regulators attempt to improve audit quality is through mandatory audit firm rotation. but if you look at the coso studies on fraud, you’ll find that in public companies, the preponderance of fraud occurs in the first two years after they change auditor. and that’s because if people at a company are going to commit fraud, the time to do that is in the first few years with a new auditor because the new people don’t understand the nuances of the company’s accounting and business.
the other thing that gets overlooked when a new firm takes over, it really becomes staff rotation. often, when a new firm takes over a large and complex audit that another firm has been performing for years, the new firm hires people from the old firm who worked on the audit. that can be a relatively quick way to get the new firm up to speed on how the client’s business operates and how the accounting systems work. but it does not necessarily lead to an improvement in audit quality. the same people may be doing the same tasks, using the same methodology, so it’s not quite the fresh set of eyes that the regulators had in mind.
how do clients define quality?
clients don’t generally care about quality the same way that we do. clients assume quality in audits, just as everyone assumes quality in everything they buy. they don’t want to have their audit redone if it turns out to be deficient in some way. they figure that the quality rules are for the auditors. the client just wants an audit report for their bank or another user that says that the financials are fairly stated in all material respects. because they’re not getting relevance or value, all they care about is getting that opinion at the lowest possible price.
building in quality from the beginning, not correcting it at the end
in simon sinek’s book, “start with why,” there’s a story at the beginning about a group of american car executives who toured a japanese auto assembly line. they watched as the car doors were hung on the hinges at the end of the line, much as it was done in their own plants.
but there was a step missing at the end. in every one of the u.s. plants, as a final step, a worker with a rubber mallet would gently tap around the edges of the door to fit it into place. baffled, they asked the tour guide how they made sure that the door fit perfectly in the frame. their tour guide told them, “we make sure it fits when we design it.”
it’s the same thing in audit: if you want quality in audit, you need to build it in at the beginning, not try to mash it in at the end.
the qc system is broken
the current quality control process in firms makes it easy for staff to get complacent and think, “i don’t have to get it right, because the qc reviewer will catch it.” but in our experience, comments written by qc reviewers are often more about what forms are filled out versus whether the audit complied with professional standards. my team and i at accountability plus refer to these qc reviewers as the forms police.
we heard about one qc reviewer who seemed to have a quota for review comments. this person assumed that everyone was always trying to cut corners. even if there were no problems, the reviewer would still write up a painful list of review comments. sometimes the staff would purposefully leave errors in the file so the reviewer would find them quickly and would stop looking for additional trivial points.
even the partners had to get involved and act as a buffer between staff and this qc reviewer because this person was just making everyone crazy with the picky and trivial questions. that firm is risking running off their best accountants. life is just too short to deal with that nonsense, and good accountants know that firms need them more than they need a job at a particular firm.
firms that have a full-time qc reviewer think they’re doing the right thing to ensure quality, but i think it’s often exactly the wrong thing. that can create a presumption among audit staff and even partners that the qc person will catch it, so they should just go fast and then when they make a mistake, the qc person will catch it so it can be fixed. that puts a lot of pressure on qc. you can’t build quality in at the end. qc review is best when it acts as a check and balance to make sure that the major issues haven’t been missed.
one firm i worked with never had a qc person and did not have an independent partner review of financials before they go out the door. they operated from the premise that they had to get things right. they’ve never had a problem with peer review. but that firm – like many other small firms – will have to change their method of quality control. under the latest exposure draft to update the quality standards from the aicpa, no one single person can issue an audit report without an independent review. this means that the solo practitioner audit firms will have to hire another auditor for quality control if they are going to continue performing audits.
qc review shouldn’t be about checking for commas or alignment of numbers or perfectly formatting the financials like the qc reviewer i mentioned at the beginning of this chapter who missed the $3 million error. the qc reviewer should have a feeling for relationships between elements on the financials and for making sure you’re complying with gaap.
if the partner or qc reviewer is spending time making comments about numbers and formatting, then maybe the staff need more coaching so that mistakes like those don’t get through to that level.
one reason we got to this point where qc spends time looking at formatting and punctuation is because we brought on technology that makes it easy to push work up the food chain. firms used to hire students to type up financials and to do the word processing. then we all got word and excel, so they got rid of those low-cost workers. now firms are paying $100,000 a year to a manager to create financials and format and proof the financials when they could hire a student at $16 an hour.
peer review shouldn’t be the obstacle it is
everyone wants to do a quality audit. and many audit partners believe that if they get even one comment on a peer review, the managing partner will hold that against them as a weapon. but i don’t think the market cares. the problems with peer review are more of perception than fact.
sometimes the peer reviewers go a little too far. i worked with one firm that was having trouble with its peer review. there was just one point where the peer reviewer thought that something was not documented to the required level of sufficiency. so i asked him to identify what the auditors missed in the standards. he couldn’t point to anything. i pointed out that if he couldn’t find anything in the standards that was missed, then he was just pushing his personal preference, and that i would recommend to the firm that they should disagree with that comment. after about a week, he came back and told the firm he was dropping the comment.
maintaining the balance among quality, profitability and client service
i’ve explained before how quality is one side of an equilateral triangle that spells out success for audit firms. the other two sides are profitability and client service. without a balance among these three elements, an audit firm will face challenges. if you put too much emphasis on quality, you’ll interrupt client service and profitability. too much focus on profitability, you might impact quality, and client service might suffer because you’re trying to squeeze every dollar out of them you can. if you emphasize client service and keeping the client happy, you might compromise on decisions that impact quality, and even put the firm at risk. you might also lose profitability by being far too willing to give discounts where none are warranted.
all three of these need to work together in balance. you won’t put the firm at risk by neglecting quality. you’ll serve the clients well, and done correctly, you’ll even have profitability. being profitable means you can afford competitive pay for the best employees who will gain knowledge, and these people will stay not only because of the pay, but because their work elevates them from form-filler-outers to auditors.
this balance – like most other elements that create success in audit firms – is driven by people, processes and systems.