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 Sunder: Engaging Auditors

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?) Sunder: Engaging Auditors

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? • Auditor’s knowledge of prospective client (for selection, risk management)? Sunder: Engaging Auditors

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 abstraction—rich 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 Sunder: Engaging Auditors

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 Sunder: Engaging Auditors

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, >$10 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 Sunder: Engaging Auditors

8. Method • Clarify initial observations; obtain additional records: minutes of board and audit committee meetings on auditor selection; outline of the client’s prescribed RFP process; written correspondence between the audit committee and management; completed evaluation forms assessing the auditor bids; and management’s 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 Sunder: Engaging Auditors

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. Sunder: Engaging Auditors

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 Sunder: Engaging Auditors

11. Table 1:Documents and Information Gathered Sunder: Engaging Auditors

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 Sunder: Engaging Auditors

13. 1. Control of Process • The regulations (OSC, TSX, NYSE) BAC’s 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) Sunder: Engaging Auditors

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 1’s 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 management’s 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. Sunder: Engaging Auditors

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 CFO’s 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 management’s 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 CFO’s 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 Sunder: Engaging Auditors

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 committee’s 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 Sunder: Engaging Auditors

17. Audit committee oversight of the courtship • BAC’s 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 management’s 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.” Sunder: Engaging Auditors

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. Sunder: Engaging Auditors

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 1’s BAC chair: “We were very concerned about making sure that they believed they knew enough of the company’s results, and the company’s 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 Sunder: Engaging Auditors

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 Sunder: Engaging Auditors

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 don’t 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 management’s implementation status on improvements, and issues raising audit concerns) • One common question-and-answer session was organized at Client 2’s 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. Sunder: Engaging Auditors

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 management’s 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 Sunder: Engaging Auditors

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 client’s 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 (why’s 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 client’s 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. Sunder: Engaging Auditors

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, firm’s 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 client’s 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 Sunder: Engaging Auditors

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 1’s 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 Sunder: Engaging Auditors

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; • Auditor’s 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 client’s leads to new customers as well as competitors with whom Client 1 wanted to collaborate • Audit engagement viewed as more than an audit—a 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) Sunder: Engaging Auditors

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 personalrapport) • 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 1’s 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. Sunder: Engaging Auditors

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) Sunder: Engaging Auditors

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. Sunder: Engaging Auditors

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-building opportunity to establish a connection with client even if the there is no immediate engagement • Another channel for the prospective auditor’s past to influences success in the present courtship Sunder: Engaging Auditors

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 Sunder: Engaging Auditors

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 firm’s 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 firm’s 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 Sunder: Engaging Auditors

33. Audit Fees • Client 1’s 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 incumbent’s 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 low…I think they may have underestimated the work they needed to do on a couple of our subsidiaries.” Sunder: Engaging Auditors

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 1’s 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 wasn’t 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 Sunder: Engaging Auditors

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 1’s 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 Sunder: Engaging Auditors

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 provider’s 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 firm’s 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 1’s AC chair said: “I think at the end result that was probably a mistake on their part…I don’t care for that type of stuff… I didn’t 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. Sunder: Engaging Auditors

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 management’s needs • Management knew its definition of audit quality—a 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 Sunder: Engaging Auditors

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) Sunder: Engaging Auditors

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 don’t 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 Sunder: Engaging Auditors

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 Sunder: Engaging Auditors

41. Thank You. Shyam.sunder@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. Sunder: Engaging Auditors

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 Management’s 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 5’s 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. Sunder: Engaging Auditors

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. Sunder: Engaging Auditors

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. G’s contact information follows: • Contact information • To facilitate the review of the Company’s information, a data room will be established at X Company’s 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. Sunder: Engaging Auditors

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 Company’s 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 Sunder: Engaging Auditors

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 • An itemized fee estimate for each entity and requirement listed. Sunder: Engaging Auditors

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 client’s company name, address, contact name, telephone number and e-mail address, and the length of the association. The Firm’s 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. Sunder: Engaging Auditors

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. Sunder: Engaging Auditors

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: Sunder: Engaging Auditors