Report Card for Auditors
Howard W Wolosky. The Practical Accountant. Boston: Dec 2007. Vol. 40, Iss. 12; pg. 24, 3 pgs
Abstract (Summary)
The Public Company Accounting Oversight Board (PCAOB) has issued a report on its inspections of registered firms that audit no more than 100 issuers. They are known as "triennial firms" because they are subject to PCAOB inspections at least once in every three calendar years. Within the 439 inspection reports, 124 didn't identify any audit performance deficiencies or concerns about potential defects in the firm's quality control system. Firms failed to perform adequate audit procedures to test the allocation of the purchase price and the reasonableness of the estimated fair values assigned to the assets acquired. Firms failed to circulate requests for confirmation or obtain other evidence to assess the existence of accounts receivables. Finally, the report found there was a recurrent contributing factor to many of the deficiencies: failure by some firms to ensure that their concurring partner reviews were effective.
The Public Company Accounting Oversight Board (PCAOB) has issued a report on its inspections of registered firms that audit no more than 100 issuers. They are known as "triennial firms" because they are subject to PCAOB inspections at least once in every three calendar years.
"PCAOB's 2004, 2005, and 2006 Inspections of Domestic Triennially Inspected Firms," at pcaobus.org/News_and_Events/ News/2007/10-22.aspx focuses on areas where auditing or quality control deficiencies were observed during the 497 inspections of U.S. triennial firms from 2004 through 2006. Of the firms inspected, four percent had from 51 to 100 public company audit clients, six percent had 26 to 50,27 percent had six to 25, and .62 percent had five or fewer.
Within the 439 inspection reports, 124 didn't identify any audit performance deficiencies or concerns about potential defects in the firm's quality control system. Sixty-seven identified concerns about potential defects in the firm's quality control system, but didn't identify any audit performance deficiencies. The remaining ones identified audit performance issues ranging from a single audit deficiency, to multiple serious deficiencies in one or more audits, as well as criticisms and/or concerns about potential defects in the firm's quality control system.
Revenue Recognition
Inspection teams identified deficiencies relating to the testing of recognition of revenue, including the firms' failure to (a) perform any or adequate substantive procedures to test the existence, completeness, and valuation of revenue; (b) review representative contracts or appropriately evaluate the specific terms and provisions included in significant contractual arrangements; or (c) test whether revenue was recorded in the appropriate period.
In several instances, firms relied on testing performed in other audit areas, such as accounts receivable and inventory, for testing the assertions related to revenue, but the testing performed didn't address sufficiently whether the issuer was recognizing revenue appropriately and in the correct period. In other cases, firms relied on management representations for important evidence regarding the appropriateness of revenue recognition without obtaining corroboration.
Related Party and Equity Transactions
Deficiencies were observed relating to firms' failures to identify and address the lack of disclosure of related party transactions, and the effectiveness of firms' testing of the nature, economic substance, and business purpose of transactions with related parties.
Some firms failed to test, or insufficiently tested, the accounting for equity transactions, including evaluating their disclosure in the notes to the financial statements. Common deficiencies related to the failure to evaluate whether issuer clients had appropriately determined the fair values assigned to equity-based transactions, and to test the reasonableness of the fair values assigned to equity-based transactions.
Business Combinations and Asset Impairment
Firms failed to perform adequate audit procedures to test the allocation of the purchase price and the reasonableness of the estimated fair values assigned to the assets acquired.
They also didn't challenge incorrect accounting when the issuer (a) treated parties to a merger as entities under common control when some of the acquired entities didn't meet the criteria to be treated as being under common control; (b) recorded an asset acquisition as a business combination; (c) recorded assets or liabilities in connection with a business combination even though the combination was contingent on future events and the outcome of the contingency couldn't be determined beyond a reasonable doubt; (d) determined the purchase price of an acquired entity by assigning an arbitrary discount to the value of the restricted shares issued; or (e) recorded die value of a consulting agreement as part of the purchase price of an acquisition, rather than as a compensation expense in the subsequent periods when the consulting services were in fact rendered.
Instances were observed where firms' procedures to test and conclude on the valuation of goodwill and other long-lived assets were inadequate. Firms also didn't challenge managements' assertions that asset values weren't impaired, despite evidence of impairment indicators, such as recurring losses and declining revenue prospects. And there were instances where the reasonableness of managements' significant assumptions and underlying data used to assess the recoverability of assets wasn't tested. Other times, issuers calculated impairment charges, but the firms failed to test the rationale for the charges and the analyses that was supporting the assets' values.
Going-Concern Considerations
Some firms failed to identify or evaluate the significance of conditions that indicated that an entity may not have been able to continue as a going concern, such as cumulative losses since inception, accumulated capital deficits, and negative working capital. Other firms identified conditions that could affect the issuer's ability to continue as a going concern, but failed to evaluate management's plans to mitigate the effects of such conditions, or obtain information about the likelihood that such plans could be implemented.
Loans, Accounts Receivable, Service Organizations
Firms failed to circulate requests for confirmation or obtain other evidence to assess the existence of accounts receivable. Other firms circulated requests, but didn't perform any, or didn't perform sufficient, alternative procedures to address non-responses or responses with exceptions. Instances were observed where audit procedures to test the allowances for doubtful accounts or loan losses were deficient. Inspectors found that firms failed to perform sufficient procedures to conclude whether the allowance for loan losses was reasonable. Also observed were deficiencies related to the auditor's evaluation of management's estimate of the allowance for doubtful accounts. There were instances where firms failed to (a) obtain an understanding of management's evaluation of the collectibility of accounts receivable; (b) evaluate differences between management's estimates and the firm's expectations; (c) assess the appropriateness of the percentages that management had applied to the aging categories; or (d) evaluate the completeness and accuracy of the information in the aging reports that management had used when calculating the allowance. Deficiencies were found as to firms' reliance on controls over the information provided by service organizations, as well as firms' use of information produced or processed by service organizations.
Use of Other Auditors and Specialists
Several deficiencies regarding the use of other auditors were discovered, including firms' reporting on the financial statements as the principal auditor when their participation wasn't sufficient to enable them to serve in that capacity, and insufficient planning, supervision, review, and addressing of significant audit areas by the firms when other auditors were used as assistants.
Firms failed to perform the necessary procedures, including the failure (a) to evaluate the relationship of the specialist to the issuer in circumstances where the specialist has other business relationships with the issuer or otherwise has a relationship that may have a bearing on the specialist's objectivity; (b) to obtain an understanding of the specialist's methods and assumptions; or (c) to make appropriate tests of the data the issuer provided to the specialist.
Independence Issues
The most common deficiency in the independence area involved performing prohibited non-audit services, specifically the preparation of an issuer's financial statements and related footnotes, instances in which firms provided bookkeeping services, and when the firms prepared source data underlying the financial statements. Several times, firms entered into agreements with clients putting prohibited limits on the auditor's potential liability.
Some firms failed to comply with requirements for independence policies and procedures, and many firms' system of quality control didn't appear to provide sufficient assurances that the firm would make or document all the required independence communications to an audit committee.
Concurring Partner Review
Finally, the report found there was a recurrent contributing factor to many of the deficiencies: failure by some firms to ensure that their concurring partner reviews were effective. For example, some concurring partners didn't have the appropriate level of expertise and experience, or the timing of the review limited or negated its effectiveness. There were also shortcomings in the documentation, which prevented a determination as to whether the scope of the review was appropriate.
Both Predictable and Surprising
Bill Godshall, partner in charge of audit quality control at Frazier & Deeter in Atlanta, points out that the most significant of the report's audit performance findings relate to revenue, related party transactions, equity transactions, and going-concern considerations.
"For firms that have findings in these areas, they will have to assess the level of work required to comply with PCAOB standards. Generally, this will mean a significant increase in hours and fees. In the revenue section, the Board notes that some firms have failed to 'review representative contracts or appropriately evaluate the specific terms and provisions included in significant contractual arrangements.' Complex revenue arrangements can require a significant amount of time devoted to reading and summarizing the key terms of determining the proper revenue recognition principles to be applied by issuers. Related party and equity transactions are also usually accompanied by complex agreements that require the more experienced auditors to read the contracts and decipher the terms to ensure that the issuer's accounting is appropriate.'
Most areas of focus identified in the PCAOB report aren't surprising to Wayne Kerr, vice president of AuditWatch. He, similar to Godshall, points out that revenue recognition, equity transactions, and the valuation of intangibles acquired in a business combination are among the most complicated issues auditors address.
Kerr adds, "On the other hand, issues such as not sending accounts receivable confirmations or not adequately addressing related party transactions are concerning because they suggest weaknesses in the underlying audit strategies. Auditors need to ensure that their methodologies allow for the flexibility to address unique risks while still covering the basics."
As to the PCAOB's quality control findings on independence, concurring partner review, and using other auditors, Godshall believes that to address these areas firms may have to make significant investments in experienced personnel to enhance the quality control function, and revise their procedures to ensure compliance. "Addressing quality control findings can be more difficult and expensive than audit findings, as these findings can get to the core of how a firm is run. Changes in these areas require time and may even require a change in the firm's culture," he observes.
Kerr believes issues such as independence highlighted in the report and professional skepticism underlying several of the issues in the report require auditors to revisit their client relationships. In particular, he believes smaller firms that have historically provided a "full service" solution to their clients must now redefine that relationship in light of the specialization and independence needed to perform an audit. Kerr is optimistic that the PCAOB's report "should help firms improve their audit processes, and dentify specific training needs," but he adds that the report might result in some firms deciding to discontinue auditing public companies.
On the Plus Side
On the plus side, the report pointed out, "Many of these firms have taken steps to address findings related to quality control deficiencies during the 12-month remediation period following the issuance of their inspection reports."
The steps identified are:
* Improving their methodologies, including audit programs and practice aids;
* Arranging for annual technical training for personnel performing audits;
* Better availability of appropriate technical resources;
* Encouraging or requiring personnel appropriate use of external resources; and
* Enhancing internal monitoring of audit performance.
It's a Roadmap
Cindy Fomelli, the executive director for the Center for Audit Quality believes, "The inspection process results in a range of observations that help firms identify areas where improvements can be made for benefit of the nation's investors. However, the PCAOB makes clear that its report is meant to provide useful information-not draw broad conclusionsabout the quality of audits performed by any of these firms."
Godshall concludes, "The Board's report provides a good roadmap for what firms can expect in the coming years' inspections. Proactive firms can help themselves by taking a hard look at their own audits as well as their quality control policies and procedures to determine if remediation is required. If these firms are able to address these concerns before the Board initiates an inspection, then the inspection process should go much smoother, and the firms will have less impact in the post-inspection follow-up process."
The Public Company Accounting Oversight Board (PCAOB) has issued a report on its inspections of registered firms that audit no more than 100 issuers. They are known as "triennial firms" because they are subject to PCAOB inspections at least once in every three calendar years. Within the 439 inspection reports, 124 didn't identify any audit performance deficiencies or concerns about potential defects in the firm's quality control system. Firms failed to perform adequate audit procedures to test the allocation of the purchase price and the reasonableness of the estimated fair values assigned to the assets acquired. Firms failed to circulate requests for confirmation or obtain other evidence to assess the existence of accounts receivables. Finally, the report found there was a recurrent contributing factor to many of the deficiencies: failure by some firms to ensure that their concurring partner reviews were effective.
The Public Company Accounting Oversight Board (PCAOB) has issued a report on its inspections of registered firms that audit no more than 100 issuers. They are known as "triennial firms" because they are subject to PCAOB inspections at least once in every three calendar years.
"PCAOB's 2004, 2005, and 2006 Inspections of Domestic Triennially Inspected Firms," at pcaobus.org/News_and_Events/ News/2007/10-22.aspx focuses on areas where auditing or quality control deficiencies were observed during the 497 inspections of U.S. triennial firms from 2004 through 2006. Of the firms inspected, four percent had from 51 to 100 public company audit clients, six percent had 26 to 50,27 percent had six to 25, and .62 percent had five or fewer.
Within the 439 inspection reports, 124 didn't identify any audit performance deficiencies or concerns about potential defects in the firm's quality control system. Sixty-seven identified concerns about potential defects in the firm's quality control system, but didn't identify any audit performance deficiencies. The remaining ones identified audit performance issues ranging from a single audit deficiency, to multiple serious deficiencies in one or more audits, as well as criticisms and/or concerns about potential defects in the firm's quality control system.
Revenue Recognition
Inspection teams identified deficiencies relating to the testing of recognition of revenue, including the firms' failure to (a) perform any or adequate substantive procedures to test the existence, completeness, and valuation of revenue; (b) review representative contracts or appropriately evaluate the specific terms and provisions included in significant contractual arrangements; or (c) test whether revenue was recorded in the appropriate period.
In several instances, firms relied on testing performed in other audit areas, such as accounts receivable and inventory, for testing the assertions related to revenue, but the testing performed didn't address sufficiently whether the issuer was recognizing revenue appropriately and in the correct period. In other cases, firms relied on management representations for important evidence regarding the appropriateness of revenue recognition without obtaining corroboration.
Related Party and Equity Transactions
Deficiencies were observed relating to firms' failures to identify and address the lack of disclosure of related party transactions, and the effectiveness of firms' testing of the nature, economic substance, and business purpose of transactions with related parties.
Some firms failed to test, or insufficiently tested, the accounting for equity transactions, including evaluating their disclosure in the notes to the financial statements. Common deficiencies related to the failure to evaluate whether issuer clients had appropriately determined the fair values assigned to equity-based transactions, and to test the reasonableness of the fair values assigned to equity-based transactions.
Business Combinations and Asset Impairment
Firms failed to perform adequate audit procedures to test the allocation of the purchase price and the reasonableness of the estimated fair values assigned to the assets acquired.
They also didn't challenge incorrect accounting when the issuer (a) treated parties to a merger as entities under common control when some of the acquired entities didn't meet the criteria to be treated as being under common control; (b) recorded an asset acquisition as a business combination; (c) recorded assets or liabilities in connection with a business combination even though the combination was contingent on future events and the outcome of the contingency couldn't be determined beyond a reasonable doubt; (d) determined the purchase price of an acquired entity by assigning an arbitrary discount to the value of the restricted shares issued; or (e) recorded die value of a consulting agreement as part of the purchase price of an acquisition, rather than as a compensation expense in the subsequent periods when the consulting services were in fact rendered.
Instances were observed where firms' procedures to test and conclude on the valuation of goodwill and other long-lived assets were inadequate. Firms also didn't challenge managements' assertions that asset values weren't impaired, despite evidence of impairment indicators, such as recurring losses and declining revenue prospects. And there were instances where the reasonableness of managements' significant assumptions and underlying data used to assess the recoverability of assets wasn't tested. Other times, issuers calculated impairment charges, but the firms failed to test the rationale for the charges and the analyses that was supporting the assets' values.
Going-Concern Considerations
Some firms failed to identify or evaluate the significance of conditions that indicated that an entity may not have been able to continue as a going concern, such as cumulative losses since inception, accumulated capital deficits, and negative working capital. Other firms identified conditions that could affect the issuer's ability to continue as a going concern, but failed to evaluate management's plans to mitigate the effects of such conditions, or obtain information about the likelihood that such plans could be implemented.
Loans, Accounts Receivable, Service Organizations
Firms failed to circulate requests for confirmation or obtain other evidence to assess the existence of accounts receivable. Other firms circulated requests, but didn't perform any, or didn't perform sufficient, alternative procedures to address non-responses or responses with exceptions. Instances were observed where audit procedures to test the allowances for doubtful accounts or loan losses were deficient. Inspectors found that firms failed to perform sufficient procedures to conclude whether the allowance for loan losses was reasonable. Also observed were deficiencies related to the auditor's evaluation of management's estimate of the allowance for doubtful accounts. There were instances where firms failed to (a) obtain an understanding of management's evaluation of the collectibility of accounts receivable; (b) evaluate differences between management's estimates and the firm's expectations; (c) assess the appropriateness of the percentages that management had applied to the aging categories; or (d) evaluate the completeness and accuracy of the information in the aging reports that management had used when calculating the allowance. Deficiencies were found as to firms' reliance on controls over the information provided by service organizations, as well as firms' use of information produced or processed by service organizations.
Use of Other Auditors and Specialists
Several deficiencies regarding the use of other auditors were discovered, including firms' reporting on the financial statements as the principal auditor when their participation wasn't sufficient to enable them to serve in that capacity, and insufficient planning, supervision, review, and addressing of significant audit areas by the firms when other auditors were used as assistants.
Firms failed to perform the necessary procedures, including the failure (a) to evaluate the relationship of the specialist to the issuer in circumstances where the specialist has other business relationships with the issuer or otherwise has a relationship that may have a bearing on the specialist's objectivity; (b) to obtain an understanding of the specialist's methods and assumptions; or (c) to make appropriate tests of the data the issuer provided to the specialist.
Independence Issues
The most common deficiency in the independence area involved performing prohibited non-audit services, specifically the preparation of an issuer's financial statements and related footnotes, instances in which firms provided bookkeeping services, and when the firms prepared source data underlying the financial statements. Several times, firms entered into agreements with clients putting prohibited limits on the auditor's potential liability.
Some firms failed to comply with requirements for independence policies and procedures, and many firms' system of quality control didn't appear to provide sufficient assurances that the firm would make or document all the required independence communications to an audit committee.
Concurring Partner Review
Finally, the report found there was a recurrent contributing factor to many of the deficiencies: failure by some firms to ensure that their concurring partner reviews were effective. For example, some concurring partners didn't have the appropriate level of expertise and experience, or the timing of the review limited or negated its effectiveness. There were also shortcomings in the documentation, which prevented a determination as to whether the scope of the review was appropriate.
Both Predictable and Surprising
Bill Godshall, partner in charge of audit quality control at Frazier & Deeter in Atlanta, points out that the most significant of the report's audit performance findings relate to revenue, related party transactions, equity transactions, and going-concern considerations.
"For firms that have findings in these areas, they will have to assess the level of work required to comply with PCAOB standards. Generally, this will mean a significant increase in hours and fees. In the revenue section, the Board notes that some firms have failed to 'review representative contracts or appropriately evaluate the specific terms and provisions included in significant contractual arrangements.' Complex revenue arrangements can require a significant amount of time devoted to reading and summarizing the key terms of determining the proper revenue recognition principles to be applied by issuers. Related party and equity transactions are also usually accompanied by complex agreements that require the more experienced auditors to read the contracts and decipher the terms to ensure that the issuer's accounting is appropriate.'
Most areas of focus identified in the PCAOB report aren't surprising to Wayne Kerr, vice president of AuditWatch. He, similar to Godshall, points out that revenue recognition, equity transactions, and the valuation of intangibles acquired in a business combination are among the most complicated issues auditors address.
Kerr adds, "On the other hand, issues such as not sending accounts receivable confirmations or not adequately addressing related party transactions are concerning because they suggest weaknesses in the underlying audit strategies. Auditors need to ensure that their methodologies allow for the flexibility to address unique risks while still covering the basics."
As to the PCAOB's quality control findings on independence, concurring partner review, and using other auditors, Godshall believes that to address these areas firms may have to make significant investments in experienced personnel to enhance the quality control function, and revise their procedures to ensure compliance. "Addressing quality control findings can be more difficult and expensive than audit findings, as these findings can get to the core of how a firm is run. Changes in these areas require time and may even require a change in the firm's culture," he observes.
Kerr believes issues such as independence highlighted in the report and professional skepticism underlying several of the issues in the report require auditors to revisit their client relationships. In particular, he believes smaller firms that have historically provided a "full service" solution to their clients must now redefine that relationship in light of the specialization and independence needed to perform an audit. Kerr is optimistic that the PCAOB's report "should help firms improve their audit processes, and dentify specific training needs," but he adds that the report might result in some firms deciding to discontinue auditing public companies.
On the Plus Side
On the plus side, the report pointed out, "Many of these firms have taken steps to address findings related to quality control deficiencies during the 12-month remediation period following the issuance of their inspection reports."
The steps identified are:
* Improving their methodologies, including audit programs and practice aids;
* Arranging for annual technical training for personnel performing audits;
* Better availability of appropriate technical resources;
* Encouraging or requiring personnel appropriate use of external resources; and
* Enhancing internal monitoring of audit performance.
It's a Roadmap
Cindy Fomelli, the executive director for the Center for Audit Quality believes, "The inspection process results in a range of observations that help firms identify areas where improvements can be made for benefit of the nation's investors. However, the PCAOB makes clear that its report is meant to provide useful information-not draw broad conclusionsabout the quality of audits performed by any of these firms."
Godshall concludes, "The Board's report provides a good roadmap for what firms can expect in the coming years' inspections. Proactive firms can help themselves by taking a hard look at their own audits as well as their quality control policies and procedures to determine if remediation is required. If these firms are able to address these concerns before the Board initiates an inspection, then the inspection process should go much smoother, and the firms will have less impact in the post-inspection follow-up process."
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