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Engaging Auditors: Field Investigation of a Courtship

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Engaging Auditors: Field Investigation of a Courtship Krista Fiolleau, Kris Hoang, Karim Jamal, and Shyam Sunder Kozminski University Warszawa, June 20, 2012 – PowerPoint PPT presentation

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Title: Engaging Auditors: Field Investigation of a Courtship


1
Engaging Auditors Field Investigation of a
Courtship
  • Krista Fiolleau, Kris Hoang, Karim Jamal, and
    Shyam Sunder
  • Kozminski University
  • Warszawa, June 20, 2012

2
An Overview
  • A publicly traded Canadian company, and a
    Canadian government organization
  • Field investigation documents, interviews on
    RFPs. Findings
  • Complex courtship, conflicting incentives
  • Significant management control of auditor
    selection
  • Asymmetry of power and information flow in favor
    of management
  • Auditor references from senior officers of
    current and past clients
  • Repeated demonstration of responsiveness and
    commitment to client management
  • Extensive price competition
  • Implications for audit transparency, quality,
    auditor risk management, expertise
    differentiation, auditor rotation, and corporate
    governance

3
Information and Audit Reforms
  • Regulatory reforms (e.g., mandatory rotation of
    auditors) assume common knowledge
  • Hayek (1945) Most such information is dispersed,
    little incentive to reveal it to a central
    planner
  • Individuals, markets and regulators have to
    acquire, aggregate and interpret information
  • Information dispersal, and conflicts between
    private and collective interest, sand in the
    gearbox of well-intentioned reforms
  • Pre-engagement courtship to gather information
    about each other
  • A field examination may help understand the
    consequences
  • Also, policy insights (e.g., Will mandatory
    rotation increase frequency of courtship?)

4
Client-Auditor Courtship
  • Kinds of information sought and gathered during
    the courtship?
  • Justification for regulation of auditing audit
    quality being opaque, customers informational
    disadvantage
  • Clients view of audit quality?
  • Client (and board audit committee) knowledge of
    quality of audit at the time of engagement?
  • Auditors knowledge of prospective client (for
    selection, risk management)?

5
A Case for Case Study
  • What do managers, the board and auditors look
    for, and how?
  • Alternative disciplinary approaches choose
    different abstractions
  • Case study opposite of abstractionrich details
    of complex interactions of auditors and clients
    (possible inputs into traditional analyses of
    larger datasets)
  • Supplement observations with discussion and
    conjectures
  • Detailed direct observation and analysis of a
    single instance of phenomena has a rich tradition
    in social sciences (Graham 1971, Cuban missile
    crisis Downs 1967)
  • Importance of direct observation in an
    institutionalized discipline (accounting)
  • Methodological portfolio small and large sample
    studies

6
What We Did
  • Client confidential records RFPs, board and
    audit committee minutes, executive notes
  • Audit firms (bid documents submitted)
  • 18 interviews (client executives and partners)
  • Both RFP processes arose from mandated audit
    partner rotation in Canada
  • Case 1 mandatory engagement partner rotation led
    client to invite bids, ultimately led to
    un-mandated change of audit firm.
  • The BAC chair and the CFO availability of senior
    audit partners with industry experience due to
    rotation in their own firms major factor
  • Case 2 a government organization implemented
    decision to invite bids every three years
  • Both cases prestigious, profitable, growing, and
    successful organizations targeted by Big-4 audit
    firms

7
Method
  • Approval from the research ethics board
  • Consent form by firm, we promised
    confidentiality, a copy of the written research
    report, and the opportunity to suggest
    corrections of any errors or misunderstandings
    (no veto)
  • Obtained RFPs (Client 1, gt10 Billion assets,
    listed on TSX with NYSE sub, regulated,
    financially healthy) sent to the Big-4 audit
    firms (Auditors 1-4)
  • Bid documents from all Big-4 audit firms,
    authorized by local managing partners, Auditor 1
    incumbent, Auditor 2 winning bidder, Auditor
    3, and Auditor 4.
  • Interviewed CFO, BAC chair (60-90 minutes each,
    scripted in advance (Appendix B), recorded and
    hand notes, within 6-12 months of RFP
  • After clearance MDs of four audit firms
    identified the proposed lead engagement partner
    interviewed each proposed engagement audit
    partner (sometimes with the local managing
    partner) script in Appendix C taped and
    handwritten notes

8
Method
  • Clarify initial observations obtain additional
    records minutes of board and audit committee
    meetings on auditor selection outline of the
    clients prescribed RFP process written
    correspondence between the audit committee and
    management completed evaluation forms assessing
    the auditor bids and managements completed
    scorecard recording deliberations about each
    audit firm
  • Steps a-d repeated for an audit put up for bid in
    a government-funded organization (Client 2 a
    large, complex, prestigious organization with a
    budget of more than 2 Billion in 2008)
  • RFP to all Big-4 firms plus one national firm,
    received 3 Big-4 bids. Bid documents from all
    bidders and conducted interviews with the three
    proposed engagement partners (sometimes local MD
    participated) as well as three executives from
    Client 2. The interview process commenced within
    weeks of auditor selection
  • Supplemented primary and secondary cases recent
    RFPs for audit services of five other
    organizations, together with the written bids
    submitted by one Big-4 audit firm on all five
    potential engagements (Clients 3-7 one publicly,
    one private, three public sector)
  • Summarized in Table 1

9
Summary of Findings
  • Involvement of the audit committee in the auditor
    selection, although management ran the process
  • Management the main producer and gatherer of
    information and controls what, when, and how it
    is distributed to the audit committee and
    auditors
  • Auditors struggle to differentiate themselves
    through their technical expertise
  • Relationship building by auditors is critical to
    success in the courtship process
  • This effort raises concerns about independence
  • Significant differences in bids (audit fees)
  • Audit partner rotation can catalyze the RFP
    process rotation influenced client satisfaction
    with the incumbent auditor, freed up expert
    resources at other audit firms, and fueled
    auditor courtship practices.

10
RFP and the Bid Process
  • RFP1 describes engagement, selection committee
    members, communication process, deadlines, page
    limits. Responses on firm expertise, transition,
    rapport, cultural fit
  • RFP2 similar, more detailed template, rigid
    structure in auditor proposals
  • RFP3-7 similar specifications.
  • Confidentiality agreement, information
    acquisition process private and public documents
    in a data room executives available
  • Auditors written proposals summarized,
    compared evaluated by management (CFO)
    proposals and summary to all selection committee
  • Auditors oral presentations, selection committees
    deliberates recommendation to the audit
    committee, approves, sends to the Board. The
    selected auditor notified losing firms debriefed
  • Table 2 details the timeline and records of the
    RFP process for Client 1

11
Table 1Documents and Information Gathered
12
Guidelines for Analysis
  • One author summarized the interviews transcripts,
    RFPs, and bid documents, categorizing it into
    broad themes.
  • Two independent coders, both Canadian CAs,
    independently read all materials and coded them
    into the same summary table. Coding differences
    were discussed and resolved by the two
    independent coders.
  • The five sections organize observations
    (selection, information acquisition, expertise,
    relationships, and fees)
  • Expectations of the information produced and
    requested from (1) a sample request for
    proposal letter for CPA services from the AICPA
    (2004), and (2) a Canadian Big 4 audit firm guide
    to RFP preparation (Audit Firm 2007).
  • Interviewed a U.S. Big-4 firm audit partner

13
1. Control of Process
  • The regulations (OSC, TSX, NYSE) BACs key
    function select and recommend the independent
    external auditor to the board
  • AICPA With the passage of the Sarbanes-Oxley
    Act (SOX), audit committees now own the
    relationship between the independent auditor and
    the organization
  • We expected the BAC to run the selection
  • Management Takes the Wheel
  • But management controlled the process, all
    communication and the flow of information to both
    the audit committee and the bidding firms
  • The RFP was sent out to auditors by the CFO with
    the approval of the audit committee
  • Examination of Clients 2-7 and interviews with
    audit partners suggests this practice of having
    CFOs establishing contact and controlling the
    interaction is currently the norm in Canada
  • The process we observed is inconsistent with the
    best practice we had expected (audit committee
    contacts prospective audit firms, cover letter
    jointly signed by the CFO and audit committee
    chair, suggested by the AICPA guide)

14
Control of Process
  • Client 1 Auditor selection committee of six
    managers (CEO, CFO, etc.) listed by name and
    position with BAC chair and anonymous members
  • Client 1s VP Finance was single point of contact
    for auditor inquiries and site visits, no contact
    information provided for the audit committee
    chair or members respondents prohibited from any
    direct contact with officers or directors of
    Client 1 under threat of disqualification
  • The chair, (no other members) of audit committee
    met auditors individually for half hour each
  • No meeting between the prospective auditors and
    the audit committee without executives present
  • The CFO in follow up interviews such a meeting
    would have taken place if the audit committee was
    dissatisfied by the selection process or
    managements choice
  • The AICPA guide suggests management (e.g., CEO,
    CFO), and the BAC chair meet prospective auditors
  • The audit firm RFP guide suggests all audit
    committee members to meet prospective auditors
  • The U.S. audit partner impractical to require
    all audit committee members to be available for
    meetings with auditor, geographical challenges.
    Client 1 practice of Client 1 is closer to AICPA
    guide.

15
Auditor Selection
  • Auditors given access to a data room with public
    and private client information
  • Executives available for interview by appointment
  • The auditors written proposals (30 pages max)
    evaluated and summarized by the CFO and VP
    Finance. Copies of proposals and CFOs evaluation
    to the selection committee
  • Auditors make oral presentations to selection
    committee
  • The selection committee discusses each
    presentation for half hour each member ranks the
    four firms on a set of attributes listed in RFP
    (e.g., knowledge of business, people,
    relationship, organization fit, commitment, audit
    methodology, other services, and fees)
  • Selection committee members provide additional
    qualitative comments on each auditor to the CFO,
    ask for managements recommendation
  • The CFO and VP Finance, compiled the evaluation
    forms, as well as a scorecard for each audit firm
  • The six management members of the selection
    committee hold a meeting, select the top two
    candidates, and then examine the CFOs summary of
    the pros and cons of the two finalist firms to
    arrive at a recommendation
  • The audit committee accepted the recommendation,
    and forwarded it to the board and the
    shareholders.
  • The timeline in Table 4 six-day interval for
    auditors presentations and the board approval
    of the change of auditor BAC and board meetings
    held on the same day

16
Auditor Selection
  • Client 1 audit committee followed the letter of
    the Ontario Securities Commission rule of
    recommending the auditor to the board, but hardly
    owned the process
  • All auditors interviewed said that their level of
    engagement with the audit committee of Client 1
    was normal CFOs usually drive the process
  • A review of RFP documents from Clients 2-7 also
    shows the process being coordinated by
    management, primarily the CFO
  • The AICPA guide and Audit Firm RFP guide also
    recommend that management control and coordinate
    the flow of information, and the scheduling of
    interviews and meetings
  • The RFP and interviews of Client 2 indicate that
    the audit committees involvement was limited to
    attending the all hands meeting, where all
    bidding firms asked questions of management
    before developing their proposals. The audit
    committee authorized the information that could
    be shared in the RFP process but did not weigh in
    on the selection of a new auditor.
  • For Clients 3-7, one of which is publicly traded,
    only BAC chair (no other member) involved

17
Audit committee oversight of the courtship
  • BACs participation limited to comfort with the
    process, not as decision makers
  • A BAC member did not think that the committee
    would not have the power to reverse managements
    choice of auditor
  • One of the audit partners in our study lamented
    that the audit committee had asked management for
    a recommendation felt more appropriate to ask
    management for its assessment, with the final
    decision by the audit committee
  • Our field study suggests that management controls
    the courtship process, with the audit committee
    in the passenger seat. Management sets the
    destination, they read the auditors signs and
    signals, and the audit committee signs off at the
    end of the journey safely executed. The Audit
    Committee Chair summarized the process as
    follows
  • Our AC saw its primary role as one to ensure
    that a robust selection process was followed by
    the company, where the BAC had substantive
    oversight, and, had the final decision. We didn't
    see this role as requiring, or necessarily being
    compatible with, the BAC actually conducting all
    work.

18
Information Acquisition
  • The RFP document outlines the information the
    client wants and uses about the auditor
  • These specifications closely reflected the
    available guidelines experience and expertise
    relevant to client industry transition and
    continuity plans audit and quality control
    approach dispute resolution process fees and
    references.
  • Absent (although recommended by guidelines)
    relationships and infractions with regulators
    identification of large clients lost, with
    reasons and peer review reports.
  • Extensive documents available to prospective
    auditors annual and quarterly reports, business
    and strategic plans, Board and committee minutes,
    and investment listings
  • We had expected that the auditors would be highly
    interested in risk related documentation made
    available to them by the clients.
  • The auditor interviews pointed to a different
    approach to information acquisition.

19
Management Gives a Little, Gets a Lot
  • Client acquires information about the auditor
  • Auditor hesitates to request client for
    information and submits proposal in the face of
    much uncertainty
  • The client defines the terms of audit quality,
    and collects information about auditors from
    multiple sources to develop a clear picture of
    auditor
  • Managers of Client 1 quite assertive in obtaining
    the answers they were interested in
  • Wanted to know the auditors reasoning and
    process for arriving at critical accounting
    estimates and judgments.
  • Wanted to be sure that there were no accounting
    policy differences between the company and the
    auditor, no restatements of their past reports
  • Client 1s BAC chair We were very concerned
    about making sure that they believed they knew
    enough of the companys results, and the
    companys transactions, to ensure that they did
    not view the risk of restatement as being even a
    low probability. We wanted to clear that outright
    from the start.
  • The U.S. audit partner prior to engagement,
    wants to understand significant transactions and
    the accounting for such transactions to reduce
    the likelihood of a potential restatement felt
    he could identify potential accounting issues by
    reviewing the public filings by the client and
    discussion to avoid surprises

20
Meticulous Client, Hungry Auditor
  • Client 1 any lawsuits against the auditor
    (distraction, reputation risk)
  • Management contacted all client references, and
    explored informally with industry colleagues
  • Management did not ask for results of Canadian
    Public Accountability Board (CPAB) reports, which
    are issued privately to registered audit firms
  • Auditors bidding on Client 1 paid no attention to
    internal control weaknesses of the client
    reported in the most recent management letter
    from the incumbent auditors
  • Interviews many clients do not provide such
    information. Auditors did not investigate the
    details of accounting adjustments and reporting
    issues raised by the incumbent auditor, nor
    whether these items were booked or carried
    forward to future periods.
  • Although management letters issued by the
    incumbent Auditor 1 for the last two years were
    available to them in the data room, two of the
    three other auditors stated that they had not
    read the management letters.
  • Auditors showed limited interest in an assessment
    of the internal auditing system of Client 1, and
    assumed internal audit must be adequate since the
    company was subject to review by the industry
    regulator
  • Auditors in both Canada and the U.S. felt that
    they could not ask Client 1 for certain items,
    such as the schedule of unadjusted errors,
    although they had the right to do so. Instead
    they asked indirect questions to try and gauge
    the number of items that came up for negotiation

21
Private and Public Clients
  • Auditors did not ask to see correspondence with
    the federal regulator on accounting related
    issues, any internal reports that had been
    prepared for the board and audit committee, or
    breakdowns of how the incumbent auditor allocated
    staff time
  • One audit partner explained it as follows
    Company X would be such a big frog in a small
    pond for any of the audit firms that I can
    understand why they probably all had the attitude
    of we dont care how ugly it is, we want the
    brand and we want the business.
  • Client 2 (public organization) made significantly
    more detailed information available to the
    auditors (budget breakdown of hours for each
    account and location, control weaknesses and
    managements implementation status on
    improvements, and issues raising audit concerns)
  • One common question-and-answer session was
    organized at Client 2s office all bidding
    auditors were asked to submit written questions
    ahead of time, and a single set of responses was
    provided. The auditors were reluctant to ask
    questions in this common forum out of fear of
    giving away strategic information to competitors.
    Instead, they relied more on examination of
    documents provided by management, and less on the
    personal contact we observed to be dominant in
    the case of Client 1.

22
Bargaining Power Imbalance
  • Auditors seemed to lack of bargaining power
    vis-à-vis management
  • Probing a client too deeply on sensitive issues
    during courtship may generate enough antagonism
    to lose the hoped-for engagement
  • Some aspects of auditors apparent lack of
    interest in critical information might be
    attributable to their prior due diligence,
    overall assessment of the client as being low
    risk, and the desirability of this client. But,
    they could not have known the unadjusted errors
    through their own independent investigations
  • Auditor efforts were centered on personal
    meetings and conversations to understand the
    clients, to build a relationship, and to sell
    themselves
  • Less attention on papers, and more on cues from
    interpersonal encounters with the management
  • Auditors focused on assessing senior managements
    candor, forthrightness, competence and integrity
  • The results from interview with the U.S. audit
    partner was very similar to those conducted with
    Canadian partners.
  • The proposals indicated a good understanding of
    how to serve the client prospectively relying on
    their personal judgment from interacting with key
    management personnel

23
Client to Auditor Feedback on RFP Process
  • Interviews with the auditors extensive knowledge
    about their competitors well-informed about
    their competitors proposals and the clients
    assessment of each competitor
  • Some auditors even offered their opinions on the
    viability of competitor proposals
  • A similar detailed and informative feedback
    process at Client 2
  • In both Canada and the U.S., the bidding audit
    partners sought and received feedback from the
    client (whys for both winners and losers)
  • Unsure about the reasons for providing such
    debriefing by the client, and its consequences
    not common in most areas of the economy
  • Linked to (1) the clients desire to gain
    advantage by promoting intense competition among
    auditors (2) clients retaining losing firms for
    other professional services and gleaned
    additional feedback from interaction with the
    client outside of the formal RFP debriefing
  • This level of debriefing also suggests that it is
    difficult for an audit firm to develop
    proprietary strategies or response formats. Bids
    from audit firms appear very similar (making it
    harder for audit firms to differentiate
    themselves) partly because of structure imposed
    by the client, but also as a result of common
    knowledge amongst firms from receiving client
    feedback about what features were effective and
    ineffective in the bid process.

24
Expertise
  • Clients demanded auditor expertise in their RFPs
  • In all seven cases, auditors responded by
    assembling an audit team of relationship
    partners, engagement partners, managers, and
    senior/junior audit staff
  • All senior personnel, had industry specific
    experience spelled out in detail
  • Client 1 introduced industry specialists from
    head office, tax partners, and the lead IT
    partner dedicated 5-12 pages to staff profiles,
    lengthy descriptions of their industry-specific
    experience, firms industry-specific market share
    regionally and globally industry-specific
    clients as references all bids listed thought
    leadership resources in the firm (forums,
    websites, roundtables, e-mail alerts and industry
    specific publications)
  • Client 2 similar approach to demonstrating
    auditor expertise, although emphasis on local
    office resources and IT qualifications, in line
    with the clients needs
  • These strategies consistent with common practices
    suggested by the U.S. audit partner importance
    of demonstrating expertise through industry
    leadership and knowledge resources.
  • RFPs demanded, and audit bids conveyed expertise

25
All Auditors Look Good
  • All auditors appear to be suitable prospects for
    the client
  • Differentiation by commitment of senior personnel
    to Client 1 (national CEO attend the oral
    presentation and designated as the relationship
    partner location of expertise and involvement of
    experts in the industry)
  • Auditor 3 proposed to move a partner with
    industry experience, and Auditor 2 proposed to
    move a senior manager with industry experience
    for Client 1.
  • The U.S. audit partner also suggested moving a
    partner to the head office city as a way of
    showing commitment.
  • Client 1 valued membership of audit firm
    personnel on advisory committees in the relevant
    industry associations or regulatory advisory
    bodies, and all auditors responded by including
    team members with such credentials in their
    proposals, and included industry peers of Client
    1 as references.
  • All Big-4 bidders had the technical expertise to
    perform a satisfactory audit of this client and
    closely bunched in management and audit committee
    scores for industry expertise Client 1s CFO
  • We all unanimously felt that every firm could do
    the job very well with the team they had
    presented.
  • The same sentiment was expressed by the selection
    committee of Client 2.
  • During interviews, an audit partner frustrated
    that the standardized accounting environment made
    differentiation difficult, reducing it to price
    competition

26
Management Seeks Softer Dimensions of Expertise
  • Client 1 RFP explicitly asked auditors to provide
    a Summary of relevant training and/or networking
    opportunities (with locations) offered to your
    clients.
  • The RFP guides (AICPA Audit Firm) list
    involvement with other clients in the industry,
    and other participants in the value chain (e.g.,
    customers, suppliers) as desirable considerations
  • Networks keep auditors at the forefront of
    technical knowledge, but also provide a platform
    for management views and issues to be given due
    consideration by regulators
  • Auditors potential as a connecting link to
    opportunities with industry competitors and
    regulators dominate concerns about conflict of
    interest and leakage of proprietary information
  • Auditor seen as clients leads to new customers
    as well as competitors with whom Client 1 wanted
    to collaborate
  • Audit engagement viewed as more than an audita
    relationship that brings opportunities for
    business advantage and future connections.
  • Management wishes not stated in RFP
    responsiveness to management Client 1 wanted to
    be treated like a first tier client Client 2
    wanted its own complexity to be appreciated, and
    overcome geographical challenges
  • Expressed through subtle cues in meetings and
    interviews (responsiveness, cultural fit,
    chemistry, sharing wavelength)

27
Building Relationships
  • There are processes and there are structures,
    but people do business with people.---a Big-4
    Managing Partner
  • The interviews the issuance of the RFPs by
    Clients 1 and 2 was not the beginning of the
    courtship
  • Client 1 all invited auditors knew of the coming
    RFP
  • All non-incumbent audit firms had active business
    development processes through which they had
    already targeted Client 1, and visited senior
    managers (CFO/CEO) of Client 1 in their offices,
    or invited them to dinner and presentations
    (express their interest, exchange information,
    and develop personal rapport)
  • Client 1 and Client 2 auditors established prior
    relationships from providing other services or
    through involvement in business and social
    communities.
  • Early courting targeted at Client 1s senior
    managers (i.e., the CEO, CFO), and not the audit
    committee, as the key decision makers in this
    process
  • The U.S. audit partner also indicated that the
    key people who would be involved in courting
    would be the CFO and Controller, and sometimes
    the CEO, even though the appointment formally
    made by the audit committee
  • Prior research weakly linked relationships
    (i.e., past client experience) with auditor
    satisfaction (Behn et al. 1997).
  • Our cases importance of relationships for
    clients and auditors effort in building them
    possible impact on auditor independence.

28
Rapport and Cultural Fit
  • The neutralization of expertise shifts importance
    to rapport and cultural fit
  • Interviews Client 1 had been dissatisfied with
    the bedside manner of the newly rotated
    engagement partner
  • Clients 1 and 2 clearly expressed in their RFP
    documents and interviews that demonstrating
    rapport was paramount to auditors winning the
    engagement.
  • Imitating the style, dress, appearance, and
    manners of those one wishes to please is a
    deliberate strategy in courting clients
  • Written proposals mirror the clients client
    references whose positions closely matched those
    of selection committee majority of the
    references provided were executives of other
    clients over 75 of the references that auditors
    provided to Client 1 were from CFOs, and only one
    audit committee chair.
  • Interviews with audit partners confirm that the
    audit firms identify the key decision makers, and
    then choose referees to match the roles of the
    key decision makers
  • The U.S. audit partner indicated that the key
    variable in choosing references was to identify
    the key decision maker and then choose a peer
    (the CFO, in this case) as the key reference.
  • Auditors considered references from clients as
    being very credible and having a significant
    influence on the hiring decision.
  • Auditors adopting client mottos and slogans in
    proposals and presentations (fit, culture,
    thinking, attitudes, chemistry, resonance of
    values)

29
Past Guides the Present
  • Auditors reputation with the clients wins new
    ones
  • Reputation and past experience with their client
    was a major deciding factor with Clients 1 and 2.
  • For Client 1, the CFO and the audit committee
    chair interpreted auditor reputation as the
    engagement partners personal reputation with
    other CFOs
  • Client 1 Do other CFOs classified the auditor as
    either rigid (undesirable) or flexible
    (desirable). Rigid was sometimes described as
    issuing edicts (undesirable) versus discussing
    rationale (desirable) for an accounting treatment
  • The audit committee chair said The most
    important issue for us is their reputation that
    we can discern by references on how they operate
    with other companies in our industry.
  • No evidence of reputation with investors or any
    third party users of financial statements being a
    consideration.
  • Auditors reliance on references from current
    clients to get future clients is potentially
    troubling for auditor independence this reliance
    may bias auditors to gain favor with clients to
    serve as references.

30
Independence of Auditor
  • What does it mean to be an independent auditor?
  • Absence of a prior relationship?
  • Yet, in both Canada and U.S., having a prior
    relationship with the prospective client is an
    important qualification to be on the audit team
    (Client 1 and 2).
  • Interviews reveal that including people with
    pre-existing relationships with the client in the
    audit team is a critical factor in engagement
  • This relationship preference not limited to the
    engagement partner but percolates down all the
    way to junior auditors
  • Audit firms sees auditing as a relationship
    business, and interested in assigning people to
    their teams who already knew management and had a
    cordial relationship with the prospective client
  • U.S. partner revealed that auditors seriously
    consider the RFP process as a relationship-buildin
    g opportunity to establish a connection with
    client even if the there is no immediate
    engagement
  • Another channel for the prospective auditors
    past to influences success in the present
    courtship

31
Demonstrating The Locus of Decision Making Power
  • Clients consider the decision making powers of
    the local team vis-à-vis the head office
  • Client 1 preferred to have senior audit
    expertise available locally to handle and resolve
    all complex accounting issues by the engagement
    partner.
  • Clients impatient with rules imposed by distant
    bureaucracies and would rather deal with a person
    they know understand the thought process of the
    partner who makes final decisions
  • After the collapse of Enron and Arthur Andersen,
    LLP, this insistence on local partner autonomy is
    a sensitive issue for Big-4 audit firms partners
    in Canada and the U.S. thought it was reasonable
    for the client to express a preference for
    engagement partner autonomy.
  • One reasons given for the collapse of Arthur
    Andersen was the transfer of authority for making
    the final call on disputed technical issues from
    its vaunted headquarters unit of experts in
    Chicago to the local engagement partners (Toffler
    2003)
  • Apparently, the headquarters unit serve several
    important functions, including (1) having a high
    level of expertise available to all audit
    engagements (2) enforcing a uniform application
    of judgment across the firm and (3) protecting
    the engagement partners from undue pressure from
    client executives by allowing them a shelter
    behind the opinion of the headquarters experts
    when differences with client executives arise

32
Local vs. HQ Decisions
  • Interviews Clients want local partner autonomy
    including all complex accounting decisions
  • Auditors 1 and 4 emphasized the seniority of
    their proposed audit partner and provided a
    description of their process to identify,
    discuss, and communicate such issues without
    promising local control
  • Auditors 2 and 3 promised that final and binding
    decision on complex accounting matters will be
    made by the engagement partner. One firm promised
    that they do not hide behind the head office.
  • One of the latter two firms a communication and
    not substantive issue, because of firms normal
    consultation and quality control processes (the
    engagement partner would be a single point of
    contact for all accounting discussions with the
    client, not an important concession)
  • The second firm indicated that the audit partner
    did, in fact, have autonomy and could decide if
    and when (s)he needed to consult head office
  • The client cannot know whether the local partner
    or the head office makes the decision they can
    only identify the person who negotiates with them
    on a contentious item and communicates the firms
    position
  • Prior research involvement of technical partners
    in the negotiation is beneficial to the audit
    firm (Gibbins et al. 2001).
  • Auditors appear to be split on the benefits of
    involving head office technical experts in
    communication and negotiation
  • Local partners share of engagement revenue
    exceeds their share of the cost of reputation
    damage, audit firm faces a difficult agency
    problem that clients seek to exploit

33
Audit Fees
  • Client 1s RFP invites bids for two years,
    constraining auditor ability of auditors to
    low-ball the fees
  • Incumbent fee for the current year as a benchmark
    (reflects knowledge of the client, assessment of
    risks and the extent of audit work necessary for
    the engagement)
  • Client 1 bids for total engagement fee varied
    from materially below to materially above the
    current fee
  • The successful bid materially below the current
    fee, although the management had stressed
    repeatedly that fees were not a major motivation
    for issuing the RFP.
  • Incumbent was expected by others to bid (publicly
    disclosed) current fee, and this common knowledge
    was accurate.
  • Client 1 the RFP preference for greater
    involvement of senior auditors, the low (winning)
    bidder proposed higher staff hours and lower
    partner/manager hours relative to incumbents
    current time budget
  • Interviews Client 1 audit chair and CFO
    concerned that a low bid meant the auditor might
    not have understood the amount of work involved.
    The CFO said For Audit Firm 2, we were not sure
    on how they would do because the audit fee was
    too lowI think they may have underestimated the
    work they needed to do on a couple of our
    subsidiaries.

34
Hours and Rates
  • Auditor 3 bid marginally lower, and Auditor 4 bid
    marginally higher than the current fee for
    substantially more partner/manager hours and more
    than double the staff hours
  • The AC chairman of Client 1s did not consider
    the Auditor 4 hours credible
  • RFP solicited hourly rates, but did not factor in
    the clients decision
  • Auditor 4 may have misinterpreted the importance
    of this number, and undermined his own
    credibility
  • Client 2 auditors believed fees would be a major
    determinant management indicated it wasnt a key
    factor the incumbent bid 100 of current fee,
    and the rest bid just below that
  • All audit firms developed a table breaking down
    fees by rank and financial statement cycle,
    (e.g., sales, receivables), and auditors claimed
    that estimating the total required hours was
    important in determining their fee
  • RFP indicated that future billings for audit fees
    had to identify each person by rank, hours
    worked, and the hourly rate quoted in the
    proposal (bid).
  • Conjecture Breakdown of total quoted fee into
    hourly rates, hours, and task components may be a
    client strategy to reduce auditors degrees of
    freedom, serving as additional bargaining and
    monitoring instrument, facilitating
    cross-checking the auditor billings against the
    accepted bids
  • Client 2 requested a blended hourly rate, which
    facilitated comparison of bids

35
Multiple Bids from a Single Auditor
  • Auditor 4 submitted bids for three different
    levels of audit service middle bid for
    marginally higher than the current fee, the other
    two bids were priced at materially above and
    marginally below the current fee
  • The premium priced service more experienced
    partner and staff on the engagement, and many
    other non-audit related items such as more
    frequent meetings , more free time to consult
    on issues, more customer satisfaction
    discussions, and more industry and strategy
    related discussions.
  • The discounted fee option required extensive work
    commitment from Client 1s internal audit
    department, less frequent meetings and fewer
    advisory discussions.
  • This endogenous appearance of multiple bids for
    service of variable quality/quantity in a
    regulated domain raises several intriguing
    questions.
  • What should be the regulatory stand on such
    variety of service levels? Auditor bundling its
    consulting services into the audit fee? Parallels
    in other learned professions?
  • Unclear how widespread this strategy is in
    practice, as we did not observe fee levels in any
    other cases studied
  • Unexpected appearance of this practice provokes
    some rethinking about pricing of audit services

36
Gradation of Partners
  • What does the gradation of partners imply for the
    value of the audit firm and its brand?
  • Informal identification of audit managers and
    staff by seniority and industry experience (e.g.,
    industry expert senior manager) is common, this
    type of differentiation in pricing among partners
    by experience is uncommon
  • In professional service markets where services
    are sold to retail customers, it is common to see
    differential pricing based on the service
    providers experience (Lasik eye surgery, the
    price increases with the number of operations
    done by an eye surgeon)
  • Can audit firms do better by such partner-level
    differentiation, as opposed to relying on the
    firms brand name and a single billing rate for
    all audit partners
  • In this case, the multiple billing options
    created confusion, and the attempt to very
    explicitly price the experience of team members
    backfired and undermined the credibility of the
    audit firm.
  • When commenting on the multiple prices proposed,
    Client 1s AC chair said I think at the end
    result that was probably a mistake on their
    partI dont care for that type of stuff I
    didnt think the idea of having an audit firm
    where the service you get depends on how much you
    pay is really the impression that they would want
    to give.
  • In the courtship process, setting fees is a way
    for auditors to demonstrate their value and
    signal their commitment to the clients. Some of
    the competing audit firms were aware of the three
    price strategy used by Auditor 4 and disapproved
    of it.

37
Discussion
  • Client 1 developed an elaborate RFP, and engaged
    its internal stakeholders in meeting and rating
    exercises to determine its preferred auditor
  • In the courtship, Client 1 wanted, expected, and
    received numerous gestures and promises from the
    audit firms, who were all seeking to show their
    commitment to providing good client service and
    responsiveness to managements needs
  • Management knew its definition of audit qualitya
    partner with a reputation for working well with
    management, and visible signs that they would be
    a preferred client, and how to get the relevant
    information needed to make its assessments and
    rank the prospective audit firms
  • Audit quality was not opaque for management.
  • Audit committee was involved in the selection
    process they relied on management to collect,
    evaluate and summarize information. At the end of
    the auditor-client courtship, the audit committee
    asked for, received, and endorsed the
    recommendation of management.
  • The auditors had also done their homework, and
    based their pre-courting behavior on the
    desirability of becoming the auditor of Client 1.
  • Courtship emphasized demonstrations of auditor
    commitment to the client, audit reliance on CFOs
    of current clients to vouch for them, and the
    inability of auditors to access crucial
    information for assessing risk (e.g., schedule of
    unadjusted errors).
  • Significant power imbalance between the client
    and prospective auditors auditors had
    surprisingly limited understanding of the
    underlying quality of internal controls, the
    disagreements (if any) between the client and
    incumbent auditor, and the unadjusted errors they
    might inherit

38
Discussion
  • Suggest that new auditors are not only more
    vulnerable to fraud (Treadway 1978), but also to
    errors in early years (Johnson et al. 2002).
  • Auditors lack of proper risk assessment during
    engagement Placing high reliance on management
    reputation and oral representations is a risky
    strategy for audit firms.
  • Client perception that all four audit firms had
    the capacity to do a good job on engagement
    neutralized the auditor efforts in assembling
    teams of experts for engagement
  • Auditors differentiate themselves through (1)
    pre- and post-RFP courting of the client
    (bringing the national CEOs) being responsive to
    client desires for local expertise, offering to
    move an industry specialists mirroring the
    client in presentations of self and selection of
    referees promising engagement partner autonomy
    and lowering their fees
  • Inability of audit firms to create a clear
    expertise-based differentiation and reliance on
    referrals from CFOs of current clients may
    undermine the profitability and independence of
    audit firms.
  • Auditor rotation has often proposed as a way of
    preserving the independence of auditors from
    their clients. Rotation of auditors (partners or
    firms) will bring a fresh set of eyes (Tan 1995),
    fewer blinders, and uproot entrenched
    relationships that may override their objectivity
    and independence. There are also well-known
    arguments against rotation as time and repetition
    can help the auditor develop perspective and
    expertise (Arel et al. 2005)

39
Discussion
  • A counterargument from this field investigation
    process of engagement, combined with competition
    in the market for audit services, weaken auditor
    independence, promotes perennial courtship by
    audit firms, and repeat this weakening of
    independence more often. Rotation affords clients
    the opportunity to shop for opinion and avoid
    auditors who they dont like without having to
    fire them (regulatory red flags) Rotation
    pressures on auditors to demonstrate commitment
    and responsiveness to the management of
    prospective as well as current clients (to win
    new engagements)
  • Reforms and regulations often based on the
    mistaken assumption that the relevant information
    for making decisions is readily available,
    perhaps even as common knowledge
  • Regulatory debates about auditor independence
    ignore the selection processes, the level of
    information asymmetry between contracting agents
    and the difficulty in gathering the relevant
    information for making good decisions are
    underestimated
  • Lack of alignment of private incentives of
    contracting agents and their public duties adds
    an additional layer of friction in this process
    (Jamal and Sunder 2009). Dispersed information
    and conflicting incentives can undermine most
    well-intentioned regulatory reforms
  • Auditor rotation requirement will drive small-
    and medium-sized audit firms out of the market,
    and increase the concentration of the audit
    market
  • Questions Does increasing the frequency of
    courtship through mandatory audit rotation serves
    to increase the welfare of shareholders? The only
    benefit to shareholders from the process
    documented here was a lower audit fee, which is
    offset by transition costs incurred by Client 1

40
What Did We Get?
  • New details of engagement, absent in public
    record, useful to review assumptions new
    variables for models
  • New questions, and conjectures about engagement
  • Documenting the process (for auditors, managers,
    boards, and regulators)
  • Understanding how information is produced,
    exchanged and used in auditing
  • Rich materials for nuanced class discussion of
    accounting and governance

41
Thank You.
  • Shyam.sunder_at_yale.edu
  • www.som.yale.edu/faculty/sunder

42
RFP Introduction
  • Introduction
  • X Company At close to XX billion in balance
    sheet assets and more than Y years of strong
    growth including XX percent over the last 12
    months, the necessity to continually review
    business strategies and risks is paramount in
    ensuring sustained success.
  • Of late, there have been multiple and significant
    changes in accounting standards, regulations and
    the XYZ industry that have all combined to add a
    great deal of complexity to our business with no
    slowdown in sight. To name a few, the recent
    adoption of XYZ accounting standards, the
    upcoming implementation of the XYZ Industry
    regulations and the transition to IFRS over the
    next 5 years represent major changes to our
    business organization.
  • Against this backdrop, X company has determined
    it is timely to review the availability of
    financial services audit expertise and resources
    in Canada and is undertaking a Request for
    Proposal (RFP) for independent audit services.
    This document outlines the general principles of
    the RFP. We highlight that our preference would
    include the most senior expertise to be based in
    Region of Canada, but it is not essential.
  • All information will be provided to you in strict
    confidence. Please complete the RFP Acceptance
    and Confidentiality Agreement (Appendix A) and
    return it to Mr G as outlined in the
    Communications Section. The supplemental
    information package will not be distributed prior
    to the receipt of the RFP Acceptance and
    Confidentiality Agreement. Please note this RFP
    is being extended to Deloitte, Ernst Young,
    KPMG and PricewaterhouseCoopers.

43
RFP Scope of Services
  • Your audit should be conducted in accordance with
    Canadian Generally Accepted Auditing Standards
    and will commence with the period ending year end
    date. The audit will be for the consolidated
    financial statements of X company.
  • The mandate will include a review of the interim
    financial statements for each of the interim
    periods. For greater clarity, the first interim
    review would be for the three months ending Date.
  • The mandate also includes
  • The statutory audit of Subsidiary 1, 2, and 3
  • Communication of weaknesses found in internal
    controls during the course of the financial
    statement audit
  • Analysis of accounting questions and issues in
    the context of the audit
  • Review of Managements Discussion and Analysis,
    Annual Information Form, and Annual Report to the
    extent required by professional standards
  • Review of quarterly report to shareholders
    (including financial statements and notes)
  • Specified audit procedures for Subsidiary 4 as
    required by the New York Stock Exchange
  • Specified audit procedures and audit report on
    specified financial information for X Company as
    required by Industry Association
  • Review of audit working papers of Subsidiary 5s
    external auditors (Audit firm)
  • Audit of financial statements of Special entity
    (non-consolidated special purpose entity).
  • Note The RFP does not include the audit of
    Subsidiary 5.

44
RFP Process Description
  • The RFP process will be conducted in the
    following phases
  • Information gathering
  • Submission of a written offer of services
  • Presentations and
  • Selection.
  • The Audit Committee has established a Selection
    Committee to oversee the RFP process. The
    Selection Committee is comprised of
  • A, Chair of the Audit Committee,
  • Members of the Audit Committee,
  • B, Chief Executive Officer,
  • C, Chief Financial Officer,
  • D, Head Internal Auditor,
  • E, Senior Vice President,
  • F, General Counsel, and
  • G, VP Finance
  • The Selection Committee will make recommendations
    to the Audit Committee and the Audit Committee
    will select the external auditor for
    recommendation to the Board and shareholders.

45
RFP Communications
  • The RFP process will be open and equitable for
    all firms. We will endeavor to ensure all firms
    have access to the same information. No
    information in one proposal will be disclosed to
    another firm in the RFP process.
  • Management will be available to answer questions
    throughout the process. To aid in the
    information-gathering phase, a schedule of
    availability with management will be established.
  • To help ensure an efficient and equitable
    proposal process, Company X is requesting that
    each proposing firm comply with the following
    general guidelines
  • All inquiries relating to this proposal process,
    including arrangements for site visits and
    interviews, are to be directed to G, VP Finance.
    He will be your single point of contact.
    Contacting any other member, officer or director
    of X Company could lead to disqualification.
    Gs contact information follows
  • Contact information
  • To facilitate the review of the Companys
    information, a data room will be established at X
    Companys corporate office located at address. A
    list of information that will be available in the
    data room is attached as Appendix C.
  • In addition, the following individuals will be
    available to meet with and provide each firm with
    their perspective of the critical business issues
    facing Company X. The individual interviews will
    be restricted to 30 minutes, unless an
    alternative time frame has been agreed upon in
    advance, and no more than three people from your
    firm should attend each interview. The VP
    Finance will coordinate the interviews.
  • B, Chief Executive Officer,
  • A, Chair of the Audit Committee,
  • C, Chief Financial Officer,
  • G, VP Finance,
  • F, General Counsel,
  • H, Treasurer,
  • D, Head Internal Auditor,
  • I, Senior Vice President, Operations,
  • J, Chief Technology Officer.

46
RFP Proposal Form and Content
  • Eight (8) copies of the submissions are to be
    received by the undersigned no later than date.
    Your submissions should be no longer than 30
    pages, plus curriculum vitae for proposed team
    members. The submission should contain the
    following
  • 1. Detailed description of audit approach
  • Approach
  • Methodology for assessment of risks and
    establishing audit approach
  • Risks identified
  • Scope and approach of work (including adoption of
    new significant accounting policies)
  • Objectives
  • Split of work among various locations and
    corporate functions
  • Communication with audit committee, including all
    communications required by X Companys Audit
    Committee Terms of Reference
  • Engagement Letter
  • Breakdown of audit hours for X Company audit
    broken down by major financial section for field
    staff (i.e. cash, , other assets) with partner
    and manager time noted in total.
  • Use of Internal Audit
  • Quality control
  • Independence policy

47
RFP Proposal Form and Content
  • Expertise
  • Experience and location of the audit team members
  • Partners
  • Senior Managers / Managers
  • Industry expertise by location
  • Brief summary of Industry 2 audit and assurance
    experience
  • Availability and location of resources for
    complex accounting questions
  • Functioning and size of professional practice
    groups
  • Availability of local resources
  • Confirmation that the firm is duly registered
    with the Canadian Public Accountability Board
    (CPAB)
  • 3. Transition plan (if applicable)
  • Description of transition plan to ensure minimum
    disruption to X Company management
  • Description of team experience in transition of
    audits, references if applicable
  • 4. Independence
  • Confirmation of your independence from X.
    Company.
  • If confirmation not available, then an
    explanation of the process to ensure
    independence.
  • 5. Fees (including any separate fee for CPAB)
  • An itemized fee quotation for the year ended Year
    1.
  • An itemized fee estimate for the year ended Year
    2

48
RFP Proposal Form and Content
  • References
  • The Firm shall provide a list of clients (minimum
    three (3) maximum five (5)) that are significant
    Companies in Industry X who are currently major
    accounts of the Firm for services similar or
    identical to the Services outlined in this RFP.
    The firm will describe how the services provided
    to these references are similar to the services
    proposed to X Company.
  • The Firm must include the clients company name,
    address, contact name, telephone number and
    e-mail address, and the length of the
    association. The Firms references will be
    contacted.
  • 7. Tax
  • We would like you to address your view on the
    nature and extent of work that you could provide
    for tax compliance or tax planning activities.
  • 8. Other services offered by your firm
  • We would like your proposal to include an
    overview of the other services offered by your
    firm, remaining independent. Overview could
    include
  • Listing of relevant publications available
  • Summary of relevant training and/or networking
    opportunities (with locations) offered to your
    clients
  • 9. Presentation
  • The objective of the presentation is to allow you
    to present your offer for services, respond to
    the questions from the Selection Committee and
    allow us to meet your engagement team.
    Presentations to the Selection Committee are
    expected to be scheduled for Date with the Board
    decision to follow on Date.
  • We request that your oral presentation not exceed
    60 minutes. After your presentation, thirty
    minutes will be allotted for questions and
    discussion.

49
RFP Expectations
  • Throughout the auditor/client relationship we
    expect
  • An open and professional rapport with direct
    access to decision makers for all
    accounting/auditing matters
  • An efficient and effective risk-based audit
    process
  • Significant and relevant industry experience of
    the members of the audit team
  • As partners or managers assigned to the
    engagement change over time, the firm will agree
    to provide resumes of new personnel to ensure
    that each have the requisite technical knowledge
    and industry expertise to conduct a thorough and
    efficient audit
  • All billings will be cleared in advance of
    submission. All billings should provide a
    detailed description of the work performed and a
    summary of the hours and rates billed by person.
  • The annual audit plan will be reviewed with X
    Company and its Audit Committee in sufficient
    detail to allow X Company to understand your
    audit approach (including the assessment of
    significant risks) and efficiently prepare for
    the audit process.
  • Timeline
  • RFP request letters sent to firms.Day 02.
  • Return of RFP Acceptance and Confidentiality
    AgreementDay 7
  • Distribution of Supplemental Information
    packageDay 7
  • Data room availabilityDays 7-35
  • InterviewsDays 35-36
  • Receipt of submissionsDay 51
  • Presentation to Selection CommitteeDay 81
  • Board approves selectionDay 87
  • Communication of decisionDay 88
  • Debrief for firmsDays 98-102.

50
RFP Acceptance and Confidentiality Agreement
  • RFP Acceptance and Confidentiality Agreement
  • To C, Chief Financial Officer
  • Fax X Company
  • We accept the request to present a proposal to
    provide external audit services to the X Company
    . We agree to keep in confidence all information
    received by us in connection with the proposal
    process, including the Supplemental Information,
    not to disclose it to third parties, not to use
    it for any other purpose than for the proposal,
    and to destroy all paper and electronic
    information in the event that our firm is not
    selected to be the independent auditor as a
    result of this proposal process.
  • Firm Name
  • Partner
  • Contact Information
  • e-mail

51
RFP Supplemental Information (To be provided on
receipt of signed RFP Acceptance and
Confidentiality Agreement)
  • Organization structure
  • 200X Annual Report, Annual Information Return and
    Management Information Circular.
  • Q3 200X Report to Shareholders
  • Data room details and arrangements
  • List of statutory audits and most recent
    financial statements
  • Appendix C
  • Information to Be Available in the Data Room
  • Organizational Charts
  • Corporate structure
  • Executives
  • Finance
  • Internal Audit
  • Corporate Office
  • 200X Strategic Plan 200X Business Plan
  • Consolidation worksheet (and entries) as at Date,
    200X
  • Operating Manual
  • Board and Committee Minute Books
  • Accounting Policy Manual
  • Certification Project flowcharts for key controls

52
Table 2 Timeline of RFP process for Client 1
53
Interview Script for Clients
  • I. Background
  • Q1. How long did your previous audit firm audit
    you before you put out the request for Proposal
    (RFP) ? _______Years.
  • Q2. Why did you decide to put the audit up for
    bid? Please list the reasons in the order of
    importance (highest first)
  • 1. _______________________________________________
    ____________
  • 2. ____________________________
    _________________________
    ________
  • 3. ____________________________
    _________________________
    ________
  • Q3. When you issued the RFP, what chance did you
    think the incumbent firm had of retaining the
    audit engagement? ______
  • Q4. How did you decide which audit firms to
    i
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