Rather than 'who', the most important question is 'how' auditors are audited, argues Lukas Löhlei

Löhlein, Lukas

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8/16/2016Should auditors be reviewed by peers or should the state doit?blogs.lse.ac.uk /businessreview/2016/08/16/should-auditors-be-reviewed-by-peers-or-should-the-state-do-it/Financial reporting and auditing are vital elements for global capital markets. The confidence in the financialmarket’s efficiency is bolstered by the trust placed in auditing being able to operate as an external controllingfunction, something that has led to the audit profession being perceived as the “guardians of truth in markets”.However, concerns over the guardians’ trustworthiness are raised on a regular basis every time it emerges, in theface of serious accounting scandals, that the audit profession has remarkably failed to meet society’s expectation.On this view, the so-called peer reviews (firm-on-firm reviews) and government inspections are seen as pivotalinstruments for restoring the necessary trust in auditing. In short, peer reviews and government inspections aremodes of external quality control that aim at assessing whether audit firms have developed appropriate qualitycontrol policies and procedures, and whether these are implemented in compliance with professional accountingand auditing standards.Over the last decade, the audit profession has been directly responsible for safeguarding audit quality through firm-on-firm peer reviews. Yet, the pendulum has swung away from self-regulation towards state actors playing a moreactive role, a trend that was initiated at the beginning of this century, when the detection of massive accountingfrauds, that were not revealed by the firms’ audit firms, severely put the public’s belief in professional self-regulationto the test. As a direct consequence, the European Union, starting from 2006, has passed various regulatoryreforms, requiring European Member States to introduce “independent audit oversight systems”, includinginspections for audit firms with public interest clients.It is often argued that the change from self-regulation to government inspections represents a trade-off of expertisefor independence because government inspectors are perceived as being more independent but lacking sufficientaccounting skills. In my paper, I investigate whether the shift from self-regulation to government regulation can besupported through research findings. In other words, I have taken the freedom to find fault with the guardians’guardians by acting as their guardian myself.1/3The analysis compares the research findings on the former U.S. self-regulatory peer-review system and theliterature on the current government inspections under the Public Company Accounting Oversight Board (PCAOB),the latter being the independent regulator in the U.S. (i.e. the U.S. equivalent to the Financial Reporting Council inthe U.K.).The analysis shows that critics of the professional self-regulatory peer review system are not entirely unfounded asmultiple studies revealed that peer review results were significantly affected by the characteristics of the reviewingfirm. The findings demonstrate that reviewing firms were more likely to issue unfavourable review opinions if theywere a direct competitor of the reviewed audit firm, and that audit firms strategically changed their reviewer afterunfavourable review outcomes. Yet, synthesising the research on the regulatory regimes suggests that both peerreviews and government inspections improved overall audit quality. However, the analysis indicates that externalusers, such as financial investors or audit committees, do not seem to recognise peer review and PCAOB reports ashelpful tool in financial decision-making, which is in line with an identified rather skeptical perception of the auditprofession itself on reviews and inspections.From my analysis, it emerges that increased regulation (both through peer reviews and inspections) particularlyimpacts the segment of small auditors. As a direct consequence of the PCAOB inspections, almost half of the smallaudit firms left the audit market in the U.S. Similar effects can be observed in various European countries, therebycontradicting one of the main objectives of the European regulatory reforms, which was to break up the dominanceof large audit firms over the accounting industry.Overall, my paper reveals that whether government regulation has decreased the risk of major accounting scandalsis still to be shown. The impact of government inspection on large audit firms, commonly referred to as the “Big 4”, isnot straightforward. This is because of two main reasons.First, the debates on audit regulation tend to focus on the question of who is controlling the quality, rather than how itis controlled. As government inspections are not much different than the review procedures, the risk of “creative-compliance” exists, a term that refers to the practice of complying with rules by box ticking, rather than takingsubstantive organisational steps. I therefore argue that both policy makers and researchers have to move beyondthe classical dichotomy of self-regulatory reviews versus government inspections, and to concentrate more on thepotentials of process modifications of external quality controls.Second, regulatory failure needs to be separated from the organisational failures of regulated parties. In otherwords, a late train does not necessarily indicate poor railway regulation. In the end, it is the individual audit firm thatdetermines audit quality. It is important to assess the intra-organisational learning processes subsequent to an auditinspection.In my paper, I identify a gradual improvement in review and inspection results over time. But can we really link theseresults to an actual improvement of audit quality? An alternative explanation might be that the inspection philosophyshifted over time or that audit firms have become better prepared for the inspections by providing more attention toissues that are common targets for inspection or by “stylising” working papers to appease inspectors. Thus,although literature suggests that the results for an audit firm improve with the number of reviews and inspections,the organisational learning process is unknown, and whether and how internal audit procedures are adjusted withinaudit firms is still unclear. Thus, we still need to investigate whether and how government inspections processeschange, shape, and eventually improve the audit practices of audit firms, as this still remains unfathomable.♣♣♣Notes:This post is based on the author’ paper From peer review to PCAOB inspections: Regulating for audit qualityin the U.S., Journal of Accounting Literature, June 2016.2/3The post gives the views of its authors, not the position of LSE Business Review or the London School ofEconomics.Featured image credit: Wall Street, by Sue Waters, CC-BY-SA-2.0Before commenting, please read our Comment PolicyLukas Löhlein is a Research Fellow of Accounting at the London School of Economics andPolitical Science. He received in PhD in Accounting from the University of Luxembourg. Hisprimary research interests include audit regulation, independent audit oversight structures and theaudit profession. His research has appeared in international accounting journals such as theJournal of Accounting Literature  and the Accounting Research Journal, and has generated theinterests of practitioners, regulators and policy makers. Copyright © 2015 London School of Economics3/3

Should auditors be reviewed by peers or should the state do it?

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