Blake Oliver

In a recent episode of The Accounting Podcast, we explored alarming trends in audit quality shaking the foundations of our profession. The numbers are stark: the Public Company Accounting Oversight Board (PCAOB) found that Ernst & Young (EY), one of the Big Four firms, has a staggering 37% deficiency rate in its audits. Even PricewaterhouseCoopers (PwC), the “best” performer among the Big Four, has an 18% deficiency rate. These deficiencies are so significant that, according to the PCAOB, the auditors should not have issued their opinions.

As audit deficiency rates remain stubbornly high and scandals shake investor confidence, the accounting profession must confront systemic issues undermining audit quality—including misaligned incentives, inadequate staffing, and outdated practices—to restore trust in financial markets and secure their future relevance.

The Alarming State of Audit Quality

When we discuss a crisis in audit quality, we’re not exaggerating. The deficiency rates reported by the PCAOB paint a troubling picture of the state of auditing in the United States:

• EY has a 37% deficiency rate—the highest among its peers.
• PwC, despite performing “best” among the Big Four, still has an 18% deficiency rate.
• BDO, a top 10 firm, has an alarming 86% deficiency rate.

But what do these numbers mean? A Part 1.A deficiency indicates that the auditor “had not obtained sufficient appropriate audit evidence to support its opinion(s) on the issuer’s financial statements and/or ICFR.” In other words, it means the auditor should not have issued their opinion, and potentially, investors should not rely on it.

This is not just a minor oversight—it’s a fundamental audit process failure. When nearly four out of ten audits at a Big Four firm like EY are deficient, or when 86% of BDO’s audits fail to meet standards, we’re looking at systemic issues that threaten the foundation of our financial markets.

The most common deficiencies relate to basic audit tasks:

• Performing substantive testing.
• Testing controls over data accuracy.
• Evaluating the effectiveness of internal controls.

In essence, auditors are failing to perform the core responsibilities that investors rely on them to perform. These high deficiency rates directly erode investor confidence. When investors can’t trust the audited financial statements, the entire financial reporting and investment system becomes compromised.

Why are these deficiency rates so high? We need to examine the business models and incentives driving audit firms to answer that.

Misaligned Incentives and Flawed Business Models

At the heart of the audit quality crisis lies a troubling truth: audit firms’ business models are fundamentally misaligned with the goal of producing high-quality audits. Instead, they incentivize practices that prioritize profit over thoroughness and accuracy.

One primary strategy audit firms employ to maximize revenue is understaffing. Having the fewest people work on the audits leads to overworked staff and rushed audits, increasing the likelihood of errors and oversights.

EY provides a stark example of this strategy in action. The firm boasts the highest revenue per employee among the Big Four at $383,900. While impressive from a business perspective, it raises serious questions about the firm’s ability to allocate sufficient resources to each audit.

Another concerning practice is the lack of transparency around materiality thresholds. Auditors use these thresholds to determine what issues are significant enough to report. However, these standards are not publicly disclosed and can be manipulated. It’s possible to cover up something undesirable by deeming it “immaterial.” This lack of transparency allows auditors to ignore or downplay significant issues, further undermining the reliability of their opinions.

However, the biggest problem is that auditors lack the financial incentive to detect fraud or significant issues. They have every incentive to do the audit quickly, even if it means overlooking critical problems.

These misaligned incentives and flawed business models directly contribute to the high deficiency rates. They create an environment where cutting corners is rewarded, and thoroughness is penalized, contradicting the fundamental purpose of an audit.

The Supermicro Scandal: A Case Study in Audit Failure

The recent Supermicro scandal provides a vivid example of how systemic auditing issues can lead to significant market disruptions and erode investor confidence.

Supermicro Computing, a major player in the tech industry, recently announced an accounting delay that caused its stock to plummet 19% in a single day. This followed a report by Hindenburg Research, which alleged dubious accounting practices at the company.

Based on a three-month investigation, the Hindenburg report uncovered glaring accounting red flags, including:

• Undisclosed related-party transactions involving nearly $1 billion were paid over three years to suppliers partly owned by the CEO’s brothers.
• Rehiring executives involved in previous accounting scandals less than three months after paying a $17.5 million SEC settlement for widespread accounting violations.

But where was Deloitte, Supermicro’s auditor, in all of this? Despite charging $4.5 million annually for their services, Deloitte failed to identify or report these significant issues. Their audit letters for 2022 and 2023 were nearly identical, focusing only on inventory valuation as a critical audit matter.

Adding to the concern, an AI system developed by Hudson Rock had identified potential accounting risks at Supermicro two years before these issues came to light. As my co-host, David Leary, points out, “If AI can surface these audit problems before companies can, people aren’t going to want to pay $4.5 million for an audit.”

The emergence of AI challenges the traditional audit model and demands a reevaluation of how we approach financial oversight.

A Call for Reform

The audit profession stands at a crossroads. The alarming PCAOB deficiency rates, misaligned incentives driving audit firm business models, and high-profile failures like the Supermicro scandal all point to a systemic crisis in audit quality.

This isn’t just an issue for accountants and auditors—it’s a threat to the integrity of our entire financial system. Investors rely on audited financial statements to make informed decisions, and when those audits fail, the consequences can be catastrophic.

The emergence of AI as a potentially more effective tool for detecting accounting irregularities further challenges the traditional audit model. Significant changes are needed—from realigning incentives to embracing new technologies—to restore trust in the audit process and secure the future relevance of the profession.

But change won’t happen without a concerted effort from all of us in the accounting world. We must confront these challenges head-on, push for meaningful reforms, and reimagine what high-quality auditing looks like in the 21st century.

To hear our full analysis, including potential solutions and ways you can make a difference, listen to this episode of The Accounting Podcast.