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Auditing Update: Academic Study and the PCAOBs

Report on Engagement Quality Review
A.

Introduction

Currently, both the Public Company Accounting Oversight

Board (PCAOB) and the Securities and Exchange Commission
(SEC) are concerned about the quality and the accuracy of audits
occurring in the United States.1 The auditing process itself is
extremely important to the economy, because investors are more
likely to invest if they have confidence in financial statements.2
Recently, notable developments have shed new light on auditing
quality.3 First, the results of an academic study conducted in India
suggested methods to improve the accuracy of auditor reports.4
1

See Tammy Whitehouse, PCAOB Plans Rules on Auditing Estimates,

Quality in 2014, COMPLIANCE WEEK (Dec. 10, 2013), http://
complianceweek.com/pcaob-plans-rules-on-auditing-estimates-quality-in2014/article/324984 (reviewing the PCAOBs progress in making
improvements to auditing standards, and the SEC staffs willingness to
help).
2
Joshua Ronen, Corporate Audits and How to Fix Them, J. ECON. PERSP.,
Spring 2010, at 189, 189.
3
See Esther Duflo et al., Truth-Telling by Third-Party Auditors and the
Response of Polluting Firms: Experimental Evidence from India, 128 Q.J.
ECON. 1499 (2013). See generally PUBLIC COMPANY ACCOUNTING
OVERSIGHT BOARD, RELEASE NO. 2013-011, OBSERVATIONS RELATED TO
THE IMPLEMENTATION OF THE AUDITING STANDARD ON ENGAGEMENT
QUALITY REVIEW (Dec. 6, 2013), http://pcaobus.org/Inspections/
Documents/120613_EQR.pdf [hereinafter OBSERVATIONS].
4
Duflo et al., supra note 3, at 150002. Michael Greenstone is a Professor
of Environmental Economics at the Massachusetts Institute of Technology.
Michael
Greenstone:
Short
Biography,
MIT
ECONOMICS,
http://economics.mit.edu/faculty/mgreenst/short (last visited Apr. 16, 2014).
Esther Duflo is a Professor of Poverty Alleviation and Development
Economics at Massachusetts Institute of Technology. Esther Duflo: Short
Bio, MIT ECONOMICS, http://economics.mit.edu/faculty/eduflo/short (last
visited Apr. 16, 2014). Rohini Pande is a Professor of Public Policy, the
Area Chair for Political and Economic Development, a Co- Director of
Evidence for Policy Design, and a Director of Governance Innovations for
Sustainable Development Group at the Harvard Kennedy School. Rohini
Pande, HARVARD KENNEDY SCHOOL: JOHN F. KENNEDY SCHOOL OF
GOVERNMENT, http://hks.harvard.edu/about/faculty-staff-directory/rohinipande (last visited Apr. 16, 2014). Nicholas Ryan is a post-doctoral research

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Although the general applicability of the study is questionable, its

findings are likely relevant to United States companies financial
reports.5 Second, the PCAOB issued a report on engagement quality,
in which the PCAOB discovered that engagement quality reviewers
were not catching all the deficiencies of engagement teams,6 even
though they were tasked to review audit engagements and were
qualified to do so.7 The report found that even with the
implementation of engagement quality reviewers, in one year of
inspections, a large number of audit and engagement quality review
deficiencies persisted.8 This article highlights the importance of audit
quality and reviews the various methods by which companies can
improve audit quality. Part B presents the background of the audit
system and its quality issues. Part C discusses current efforts to
improve the audit system. Part D analyzes these efforts and predicts
how future audit quality concerns may be addressed.
B.

Background

The Sarbanes-Oxley Act of 2002 (Act) established the

PCAOB to manage the auditors of publically traded companies.9 The

fellow in the Sustainability Science Program and a Prize Fellow in

Economics, History, and Politics at Harvard University. Nicholas Ryan,
HARVARD KENNEDY SCHOOL: MOSSAVAR-RAHMANI CENTER FOR
BUSINESS AND GOVERNMENT, http://hks.harvard.edu/centers/mrcbg/
programs/sustsci/people/research-fellows/current-fellows/nicholas-ryan
(last visited Apr. 16, 2014).
5
See Duflo et al., supra note 3, at 1541; Peter Dizikes, An Experiment Puts
Auditing Under Scrutiny, MIT NEWS (Oct. 9, 2013), http://web.mit.edu/
newsoffice/2013/experiment-puts-auditing-under-scrutiny-1009.html.
6
OBSERVATIONS, supra note 3, at 34. The engagement team draws
conclusions from the substantial judgments they make during an audit
engagement. See PCAOB STANDARDS and RELATED RULES, Auditing
Standard No. 7: Engagement Quality Review, 2, 9 (Am. Inst. of Certified
Pub. Accountants 2011) [hereinafter Auditing Standard No. 7]; PCAOB
STANDARDS and RELATED RULES, Auditing Standard No. 3: Audit
Documentation, 3 (Am. Inst. of Certified Pub. Accountants 2011).
7
See Auditing Standard No. 7, supra note 6, 15.
8
OBSERVATIONS, supra note 3, at 6.
9
Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 101, 116 Stat. 745,
750; Public Company Accounting Oversight Board (PCAOB), SEC,
http://sec.gov/answers/pcaob.htm (last modified Jan. 16, 2013).

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Act granted the SEC supervisory power over the PCAOB.10

Consequently, the SEC must approve all PCAOB rules.11
Large companies hire external firms to audit their financial
12
records. Although the third-party audit system can be successful in
certain circumstances, it has undeniable flaws.13 Because the
company requesting the audit also pays the auditing firm, auditors
may feel pressured to give the company favorable results, in order to
preserve their jobs.14 Auditors may be incapable of overlooking
biases that incentivize them to report what is in their clients best
interests, notwithstanding their own obligation to report their
findings objectively.15
C.

Attempts to Improve the Audit System

Officials at both the PCAOB and the SEC have identified

concerns regarding the quality of audits taking place in the United
States.16 Currently, there are two notable developments concerning
audit quality.17 The first is an academic study conducted in India.18
The second is a PCAOB report on engagement quality review.19

10

15 U.S.C. 7217(a) (2012); SEC, supra note 9.

15 U.S.C. 7217(b)(2) (2012); SEC, supra note 9.
12
Dizikes, supra note 5.
13
See id. (But when an auditing firms revenues come directly from its
clients, the auditors have an incentive not to deliver bad news to them.).
14
See id.
15
See Max H. Bazerman et al., Opinion: The Impossibility of Auditor
Independence, SLOAN MANAGEMENT REVIEW, Summer 1997, at 9394
([T]hey may be unable to overcome cognitive or psychological biases that
make them arrive at marginal decisions in the clients favor.).
16
See Whitehouse, supra note 1; see also Ronen, supra note 2, at 195 (The
quality of [auditor] performance is a contentious issue . . . .).
17
See Duflo et al., supra note 3; OBSERVATIONS, supra note 3.
18
Duflo et al., supra note 3.
19
See OBSERVATIONS, supra note 3.
11

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Truth-Telling by Third-Party Auditors and

the Response of Polluting Firms:
Experimental Evidence from Indiaan
Academic Study by Duflo, Greenstone,
Pande, and Ryan20

The academic study by Esther Duflo, Michael Greenstone,

Rohini Pande, and Nicholas Ryan (together, the Researchers),
sought to pinpoint ways to promote the accuracy of auditor
reporting.21 The Researchers based their study on the
environmental audit system,22 and designed and evaluated a
modified audit system23 for industrial [plant] pollution levels.24
The studys treatment (Treatment) included four major steps.25
First, a research team randomly assigned auditors to selected
Treatment plants.26 Second, the study collected funds to pay the
auditors from a central pool of money with a flat rate fee that
was decided upon beforehand.27 Third, an independent party was
assigned to check random samples of the work the auditors
completed.28 Finally, the auditors were paid in accordance with the
accuracy of their reports, based on random samples of their work
checked by the independent party during the second year of the
Treatment only.29
The Researchers recorded the results of the Treatment and
developed several conclusions.30 First, they concluded that general
auditing system for plants likely to pollute at large levels was
misleading, since auditors recorded readings of plant pollution just
below the regulatory standard.31 Second, the Researchers found that
auditors under the Treatment were more honest and their reports
20

Duflo et al., supra note 3.

Id. at 1501, 1507.
22
Id. at 1505.
23
Id. at 1507.
24
Id. at 1503.
25
Id. at 1501.
26
Id. at 1501. The Treatment group consists of almost half of the 473 plants
that were eligible for the audit because of the amount of pollution they
produced. Id. at 1508.
27
Id. at 1501.
28
Id. at 1501, 1509.
29
Id. at 1501, 1510.
30
Id. at 150102.
31
Id. at 1502.
21

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were thus more accurate.32 This was demonstrated by a decrease in

the number of plants that auditors incorrectly recorded as compliant
with pollution standards.33 Third, the Researchers concluded that
emissions lessened once plant owners realized that the regulatory
authority would receive more reliable audit reports.34 Thus, overall,
the Researchers were able to design a Treatment that successfully
improved the overall accuracy of the audit system for pollution
plants in India.35
Even though the study focused on auditing compliance with
environmental regulations,36 the studys conclusions may also apply
to financial reporting in the United States.37 The Researchers
identified a common issue among all third-party audit markets
namely, that auditors are presented with a conflict of interest and
lack proper motivation to report honestly.38 Thus, it is likely that
performing a similar treatment in the United States on audits of
companies financial reports could elicit some measure of positive
change.39 However, such change may not be as radically successful
as the one in the Researchers academic study, as there may be other
variables at play in the United States financial system.40
2.

The PCAOBs Report on Auditing

Standard No. 7: Engagement Quality
Review

The PCAOBs Auditing Standard No. 7 addresses

engagement quality reviews.41 Engagement quality reviews are
32

Id.
Id.
34
Id.
35
Id. at 150102.
36
Id. at 150001.
37
Compare id. at 1541 (Our findings are likely of broader
relevance . . . .), with Dizikes, supra note 5 (Still, it is an open question
how broadly the current studys findings can be generalized.).
38
Duflo et al., supra note 3, at 1541 (We believe that the core problem
that auditors face a conflict of interest, or at least poor incentives to tell the
truthexists in all third-party audit markets.).
39
See id.; Dizikes, supra note 5.
40
See Duflo et al., supra note 3, at 1502, 1541 ([T]he exact nature of any
audit reform will reflect a particular markets status quo functioning and
institutional details.).
41
Auditing Standard No. 7, supra note 6, 1.
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meant to help improve the accuracy and quality of audits by

identifying incomplete and incorrect audit opinions.42 An
engagement quality reviewers assessment of an engagement teams
work also helps protect investors.43
Every audit engagement must be accompanied by an
engagement quality review.44 Auditing Standard No. 7 requires an
engagement quality reviewer to evaluate the significant judgments
. . . and related conclusions of the engagement team, in the course
of forming the overall conclusion on the engagement and . . .
preparing the engagement report.45 Engagement quality reviewers
must meet certain qualifications.46 To be eligible to become an
engagement quality reviewer, one must: (1) be an associated person
of a registered public accounting firm, unless the reviewers firm
conducted the engagement report, in which case he or she must be a
partner or comparable position, or separate from the firm,47 (2) be
objective,48 (3) be independent from the firm,49 (4) have integrity,50
and (5) be competent in accounting, auditing, and financial
reporting.51 Engagement quality reviewers assess an engagement
teams major decisions to see if they properly lead to the teams
conclusions.52
The PCAOB issued a report on Auditing Standard No. 7,
evaluating the implementation of engagement quality reviews.53 The
PCAOB concluded that most firms had trained their employees on
Auditing Standard No. 7 and began incorporating the requirements
of the standard into their procedures and practices.54 However, a
42

See OBSERVATIONS, supra note 3, at 1; Press Release, Public Company

Accounting Oversight Board, PCAOB Issues Report on Implementation of
Auditing Standard on Engagement Quality Review (Dec. 6, 2013),
http://pcaobus.org/News/Releases/Pages/12062013_EQR.aspx.
43
Press Release, Public Company Accounting Oversight Board, supra note
42.
44
Auditing Standard No. 7, supra note 6, 1.
45
Id. 9.
46
Id. 38.
47
Id. 3.
48
Id. 4, 7.
49
Id. 4, 6.
50
Id.
51
Id. 45.
52
Id. 9.
53
OBSERVATIONS, supra note 3, at i.
54
Id. at 3.

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survey of audits revealed audit deficiencies where an engagement

quality reviewer either did evaluate or was supposed to have
evaluated.55 Chairman of the PCAOB, James R. Doty, describes
audit deficiencies as situations where the auditor left insufficiently
audited an aspect of the financial statements that could include an
undetected material misstatement.56 Thus, the PCAOB discovered
that engagement quality reviewers did not perform their jobs
correctly, and that, specifically, they failed to appropriately evaluate
the engagement teams important judgments used to generate their
final conclusions.57
In their report on engagement quality review, the PCAOB
discussed possible causes of engagement quality reviewer noncompliance and potential solutions for these issues, so that firms
could better implement the standard.58 Likely causes include the
failure of the engagement team to record information pertinent to
comprehending the conclusions in the engagement completion
document,59 and the possible lack of time spent by the engagement
quality reviewer.60 Possible solutions include confirming the
engagement quality reviewer is suitable for the position,61 giving
engagement quality reviewers in firms an appropriate amount of time
to conduct their reviews,62 and ensuring that engagement teams
record an appropriate amount of information so that an engagement
quality reviewer can comprehend the conclusions of the engagement
team.63 The PCAOB states in its report that [a]ll registered firms
should review this report and consider whether the types of
deficiencies that the Boards Inspections staff has observed related to

55

Id.
James R. Doty, Chairman, The Role of the Audit in the Global Economy,
Speech at the ICAS Aileen Beattie Memorial Lecture (Dec. 10, 2013),
http://pcaobus.org/News/Speech/Pages/04182013_ICAS.aspx.
57
OBSERVATIONS, supra note 3, at 34.
58
Id. at 57.
59
Id. at 5. The engagement completion document must be used by an
auditor to identify all significant findings or issues. PCAOB STANDARDS
AND RELATED RULES, Auditing Standard No. 3: Audit Documentation, 13
(Am. Inst. of Certified Pub. Accountants 2011).
60
OBSERVATIONS, supra note 3, at 6.
61
Id. at 7.
62
Id.
63
Id.
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[Auditing Standard] No. 7 could manifest themselves in their

practices.64
D.

Analysis and Implications

There are clear problems in the auditing industry, and certain

government organizations, namely the PCAOB and the SEC, are
taking steps to resolve these issues.65 In todays climate, change
seems likely to occur, as these organizations are actively researching
and enacting reform proposals.66
The PCAOBs Auditing Standard No. 7 seeks to address the
same main problem that the Researchers academic study highlights:
the inaccuracy of auditor reports.67 Both the PCAOB report and the
Researchers academic study suggest ways to improve auditor
accuracy.68 Auditing Standard No. 7 focuses on correcting audits by
enlisting engagement quality reviewers to evaluate them.69 Similarly,
the Researchers academic study assigned an independent party to
check random samples of the work the auditors completed, and used
a number of other factors to further increase auditor oversight and
incentives to report accurately.70
While the Researchers academic study successfully
improved regulatory compliance of audited plants, as well as auditor
truthfulness and accuracy,71 it does not appear that Auditing Standard
No. 7 has been particularly effective, likely because engagement
64

Id. at ii.
See, e.g., Whitehouse, supra note 1 (Audit regulators will propose new
rules in 2014 for how auditors should audit accounting estimates, including
fair value measurements, and how firms should manage their own internal
audit quality control.); OBSERVATIONS, supra note 3; Auditing Standard
No. 7, supra note 6.
66
See Whitehouse, supra note 1 (Audit regulators will propose new rules
in 2014 for how auditors should audit accounting estimates . . . .).
67
Compare Duflo et al., supra note 3 at 150102 (Our experiment altered
the market structure in several complementary ways to incentivize accurate
reporting.), with OBSERVATIONS, supra note 3, at 3 (Inspections staff
concluded that the audit deficiency occurred in areas that were or should
have been reviewed in the engagement quality review process . . . .).
68
OBSERVATIONS, supra note 3, at 7; Duflo et al., supra note 3 at 150102.
69
Auditing Standard No. 7, supra note 6, 12; see OBSERVATIONS, supra
note 3, at 1.
70
Duflo et al., supra note 3, at 150102.
71
Id.
65

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quality reviews are not being properly performed.72 However,

Auditing Standard No. 7s implementation lacks several factors that
are found in the Researchers academic study, including incentive
pay, pay from a central pool, and completely random assignment of
auditors.73 Thus, the PCAOB may be able to increase the
effectiveness of the standard, and thus improve audit accuracy, by
incorporating some of the Researchers Treatment into future
regulations.74
Another possible solution to this problem would be to have
the PCAOB Inspections staff increase direct training of firms who
are incorrectly implementing Auditing Standard No. 7.75 After
inspections of domestic audit firms that audit the financial
statements of issuers, the PCAOB staff already discusses the
findings with the firm to make sure that all of the facts are
considered and to help the staff and firm understand the deficiency
identified.76 Thus, more training may help increase the accuracy of
auditor reports.77
In addition to monitoring engagement quality review, the
PCAOB is also developing an audit quality indicator project, and
they plan to produce a Concept Release on the subject.78 The
PCAOB staff is actively uncovering indicators that may help
improve audit quality, while also analyzing these indictors to

72

See OBSERVATIONS, supra note 3, at 6 ([A] properly performed

engagement quality review should increase the likelihood that a registered
public accounting firm will catch any significant engagement
deficiencies . . . .).
73
Duflo et al., supra note 3, at 1501.
74
See id. at 150102.
75
See PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD, RELEASE NO.
2013-001, REPORT ON 20072010 INSPECTIONS OF DOMESTIC FIRMS THAT
AUDIT 100 OR FEWER PUBLIC COMPANIES at ii (Feb. 25, 2013),
http://pcaobus.org/Inspections/Documents/02252013_Release_2013_001.
pdf (The Board encourages firms to initiate a dialogue with the Boards
Inspections staff early on about how the firm intends to address quality
control criticisms . . . .).
76
See id. at iii.
77
See id.
78
Greg Jonas, Office of Research and Analysis Director, Update on Audit
Quality Indicators, Speech at the AICPA National Conference on SEC and
PCAOB Developments (Dec. 10, 2013), http://pcaobus.org/News/Speech/
Pages/12102013_Jonas_AICPA.aspx.

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improve their effectiveness.79 Their Concept Release will likely be

extremely useful to firms who aim to increase audit quality.80 The
PCAOB may add other standards to improve engagement quality
review in an attempt to bolster the accuracy of the auditing system
for public companies in the United States.81
E.

Conclusion

The Researchers academic study suggests that in some

contexts, firms can improve the accuracy of auditor reports by
assigning auditors randomly, checking auditors results, paying
auditors from a central pool while setting a flat rate fee beforehand,
and correlating the amount of pay auditors receive with how
accurately auditors performed.82 However, the applicability of the
studys findings in other contexts is questionable, and thus it is
unclear that implementing all of these approaches in financial report
auditing would yield the same positive results.83 The PCAOBs
engagement quality report found in their 2012 inspections that, even
with the presence of engagement quality reviewers in firms, a high
number of audit and engagement quality review deficiencies
remained.84 The PCAOBs plan for a new rule in 2014 may improve
the quality of audits,85 however, the staff may want to incorporate
new factors to improve the effectiveness of Auditing Standard
No. 7.86
Jacqueline Nutile87
79

See id.
See id. (describing root causes and [audit quality indicators] to be two
sides of the same coin [since] in both cases we need to identify, measure
and improve at the root cause level of audit quality).
81
Cf. Whitehouse, supra note 1 (PCAOB spokesman Colleen Brennan said
the boards agenda calls for adoption of a standard on related parties and a
proposal on using the work of specialists and other auditors in the first
quarter of 2014.).
82
Duflo et al., supra note 3, at 150102.
83
See Duflo et al., supra note 3, at 1541; Dizikes, supra note 5.
84
OBSERVATIONS, supra note 3, at 6.
85
See Whitehouse, supra note 1.
86
Cf. id. (Audit regulators will propose new rules in 2014 for how auditors
should audit accounting estimates, including fair value measurements, and
how firms should manage their own internal audit quality control.).
87
Student, Boston University School of Law (J.D. 2015).
80