Comments by the Auditing Standards Committee of the Auditing Section of the American Accounting Association on the PCAOB Rulemaking Docket Matter 029: PCAOB Release No. 2011-007, Improving Transparency Through Disclosure of Engagement Partner and Certain Other Participants in Audits: Participating Committee Members: Free

Dear Board Members:

The Auditing Standards Committee of the Auditing Section of the American Accounting Association is pleased to provide comments on the PCAOB Rulemaking Docket Matter No. 029: PCAOB Release No. 2011-007, Proposed Rule on Improving the Transparency of Disclosure of Engagement Partner and Certain Other Participants in Audits.

The views expressed in this letter are those of the members of the Auditing Standards Committee and do not reflect an official position of the American Accounting Association. In addition, the comments reflect the overall consensus view of the Committee, not necessarily the views of every individual member.

We hope that our attached comments and suggestions are helpful and will assist the Board. If the Board has any questions about our input, please feel free to contact our committee chair for any follow-up.

Respectfully submitted,

Auditing Standards Committee

Auditing Section—American Accounting Association

Contributors:

Chair—Keith L. Jones, George Mason University

Jagadison K. Aier, George Mason University

Duane M. Brandon, Auburn University

Tina D. Carpenter, The University of Georgia

Paul Caster, Fairfield University

Ling Lie Lisic, George Mason University

Mikhail B. Pevzner, George Mason University

The Committee commends the PCAOB (“the Board”) for addressing the issue of including partner signatures on the audit report. The following section presents a number of specific comments or suggestions, organized along the lines of the questions posed by the Board in the proposed rule.

Here are comments to selected questions in the proposed rule:

Based on existing research, there is reason to believe that disclosure of the engagement partner's name in the audit report would enhance investor protection. Some countries (e.g., Australia, Taiwan, Sweden, China) already require disclosure of engagement partner names. Using this data, academic researchers conclude that engagement partner characteristics matter to audit quality. For example, Chi et al. (2011) find that an audit partner's pre-client and client-specific experience is associated with higher earnings quality and creditors' perceptions of higher audit quality. Knechel et al. (2011) show that partner compensation policies affect audit quality in Swedish clients. Hence, investors may find this information useful. Ceteris paribus, investors would prefer more experienced partners whose personal incentives are aligned with those of shareholders.

We note that, given the size of the audit market in the United States, the disclosure of the engagement partner's name may not have as dramatic an effect as shown in studies in smaller markets. However, requiring disclosure would provide market participants with potentially useful information as well as data for researchers to assess its usefulness.

We believe that both disclosure of the partner's name and his/her signature would be useful. Disclosing the partner's name allows investors to track partner behavior more efficiently over time. Requiring a signature also should have a positive effect on audit quality since it should foster a partner's sense of personal accountability for the audit. Requiring audit partner signature on the audit report is analogous to the SOX 302 requirement that CEOs/CFOs sign 10-K reports. Prior research has established that CEO reputation is a strong disciplining mechanism when it comes to corporate malfeasance; specifically, CEO turnover is much more likely in the presence of accounting irregularities (Hennes et al. 2008) or restatements (Desai et al. 2006). Job prospects of executives following accounting restatements are much worse due to reputational effects. Similar arguments should apply to audit partners who do sub-par work.

We believe that both the audit partner's name and his/her signature are useful in increasing the audit partner's sense of accountability to the audit. While disclosure of the engagement partner's name is informative, it does not clearly bind the engagement partner to the audit work or attest to the quality of the audit. Requiring the engagement partner to sign the audit report enhances accountability and ensures that the engagement partner certifies that the audit was performed in accordance with PCAOB standards and to the best of his/her abilities.

Security risks arising out of increased transparency and individual liability can most likely be negated by some form of insurance for audit partners similar to directors and officers (D&O) liability insurance. One possible problem would be the number of direct calls and correspondence an engagement partner may get from shareholders, investors, analysts, or other interested parties. It raises concerns about what the engagement partner may or may not disclose about a company's performance, plans, and financial health outside of what is required in the audit report.

We are not experts in this area. However, it seems likely that partners would be subject to frivolous personal lawsuits as a result of their personal association with problematic audits. In addition, the proposed amendments may lead to privacy and security issues for engagement partners. Thus, we do recommend that the Board give consideration to these potential negative consequences.

Since Form 2 summarizes all information for a convenient review by investors, we think that it is useful to also require disclosure of engagement partner names in Form 2. Behavioral research in accounting suggests that easily accessible information is more effectively and efficiently used by consumers of accounting information.

We recommend disclosing audit partner names, whether it is in audit reports or Form 2, but preferably in both. In addition, if the Board does this, it will certainly facilitate research into individual engagement partner quality.

Shareholders prefer more timely information. Bryant-Kutcher et al. (2011) find that SOX's requirement of accelerated 10-K filing deadlines increases the value relevance of financial reporting. A similar argument can be applied here. Shareholders need to be notified of any material changes in the company. Audit partner turnover is important information. Studies have shown that the stock market reacts significantly to audit firm turnover. For example, Dunn et al. (1999) and Eichenseher et al. (1989) find that switching from Big N to non-Big N auditors raises a “red flag” to investors. Knechel et al. (2007) find that firms switching between Big 4 auditors experience significant positive abnormal returns when the successor auditor is an industry specialist and that they experience significant negative abnormal returns when the successor auditor is not a specialist. We expect that the market would react similarly to audit partner turnover if the audit partner's identity is publicly available. Consistent with our expectation, Fried and Schiff (1981) show that the market reacts negatively to CPA switches. Immediate reporting will be particularly useful if an engagement partner resigns or steps down from a particular audit because it would highlight whether the change in engagement partner was attributable to differences with company officials or disagreements within the audit firm.

We believe that such disclosure may provide benefits. We recommend additional research on the quality of “offshored” audit work. The extent of work as measured by hours (proposed later in the release) would be appropriate.

We believe that investors would like to know who participated in the audit besides the engagement partner. The individuals who perform the work largely determine the quality of the work. If investors know the names of the participants, they are better able to make informed judgments regarding the overall quality of the audit. It also is important to know the percentage of hours attributable to other participants so that investors can form judgments regarding the quality of the audit. The requirement is particularly relevant for multinational audits where the main auditor relies on other audit firms or their branch offices to conduct parts of the audit.

In addition, a requirement to disclose other audit participants would lead to additional research in this area that would inform investors and regulators about the quality of work provided by “other participants.”

We believe that the proposal is clear in stating the requirement.

We believe that the proposed requirements are sufficiently clear and that the example is very helpful in describing the requirement. We think that it is appropriate to disclose the name of the firm (person) based on the contractual relationship because it (he/she) is the entity that is legally liable for the work performed.

Disclosing other participants in the audit would help the audit firms establish and maintain a reputation for audit quality if the firms consistently use other similarly competent firms to help complete the work. Greater disclosure of other participants in the audit improves investor confidence in the audit firm and also creates a mechanism to promote high-quality firms.

We do not think that disclosing all participants in the audit is necessary. In addition, investors do not want information overload. The focus should be on key participants. We recommend disclosure of names of those whose participation is more than 10 percent. A 10 percent threshold reflects a balance of supply of sufficient information while avoiding information overload.

Again, while we would recommend a 10 percent threshold, the manner proposed is appropriate.

We believe that the requirement to disclose the name and country of headquarters' office location of the referred-to firm is sufficiently clear and appropriate.

We do not believe that the different disclosure metrics would cause any confusion.