PCAOB Gives Audit Firms a Mixed Review
By Frank Byrt and Anne Rosivach
The Public Company Accounting Oversight Board (PCAOB) issued a cautiously optimistic report on US auditors' performance, saying the Board found a reduced rate of "significant audit performance deficiencies" compared to its last review in 2007; however, the Board did note that problems persist.
The Report on 2007-2010 Inspections of Domestic Firms That Audit 100 or Fewer Public Companies, published February 25, covered a review of 1,801 individual audits of the financial statements of public companies done by 578 audit firms that issued 100 or fewer audit reports each year for the period 2007 through 2010. PCAOB's last report of this type was issued in October 2007, which covered the years 2004 through 2006.
Approximately 500 smaller firms that audit public companies are regularly inspected by the PCAOB at least once every three years. These are called triennial firms. Large firms are inspected annually.
"While the data indicates a trend toward progress," board member Jeanette Franzen said in statement distributed to participants in a press call, "the whole story is more complicated. Despite the decrease in the rate of significant deficiencies in second inspections, the persistence of such significant deficiencies in audits performed by a large number of the domestic triennial firms remains a concern of the Board."
Significant audit performance deficiencies are defined by PCAOB as deficiencies that result in the audit firm lacking sufficient evidence to support its audit opinion.
Problematic Audit Areas
The PCAOB found the auditing areas with the most frequent and significant performance problems to be:
- Revenue recognition
- Share-based payments and equity financing instruments
- Convertible debt instruments
- Fair value measurements
- Business combinations and impairment of intangible and long-lived assets
- Accounting estimates
- Related-party transactions
- Use of analytical procedures as substantive tests
- Procedures to respond to the risk of material misstatement due to fraud
According to the report, 44 percent of the audit firms inspected had at least one "significant audit performance deficiency" compared to 61 percent in the 2004 through 2006 period.
Improvement has been spotty, as the report said that for the 2010 inspection year alone, the percentage of firms having deficiencies reached 51 percent; however, for the 2011 inspection year, the percentage declined to 45 percent.
Of the individual audits inspected between 2007 and 2010, 28 percent had at least one significant audit performance deficiency compared to 36 percent of the audits inspected between 2004 and 2006.
On a positive note, PCAOB said that of the 455 firms that had a second inspection in the 2007 through 2010 period, 36 percent had at least one significant audit performance deficiency in their second inspection, down significantly from a rate of 55 percent in their first inspection.
Despite the evidence of progress, Franzen said, "it was difficult to establish trends from the data, because of the number of significant variables in the group – the mix of firms inspected, the focus of the inspections, as well as improvements made within individual firms."
No evidence of correlation between firm size and ability to perform an audit
Board member Jay Hansen said, "Among the very smallest firms, we have inspections with no findings as well as inspections that reveal significant audit failures. Likewise, inspectors have encountered medium-sized and larger firms, even those with sophisticated clients that have billions of dollars reported on their balance sheets, with few or no findings, while multiple failures have been observed at other firms of similar sizes. Thus, we have no evidence of any correlation between the size of a firm and its ability to perform an audit that complies with PCAOB standards."
Areas where deficiencies were most frequent
The report includes deep analysis of nine audit areas where there were frequent inspection findings during the 2007 to 2010 period – a valuable resource for them, Franzen said.
"The findings include certain pervasive areas, such as auditing revenue recognition, which is an important area to virtually all investors, and that we generally review in every inspection," Hanson said. "Many issuer clients of the firms covered in this report used financing and compensation arrangements that involve limited or no cash.
"The audits of business combinations and impairment of intangible and long-lived assets also resulted in frequent findings. For many of these and other audit areas, fair value measurements and accounting estimates are critical to the accounting and often were not given enough attention by auditors. Related party transactions are another significant area where we observed that PCAOB standards were not met," Hanson said.
Hanson interpreted these findings in the context of the client base of smaller firms: "It's also worth noting that some of these audit areas are of particular prevalence among triennial firms because they work with small and midsized audit clients. For example, the issuance of share-based payments and equity financing instruments to employees, vendors, and others is a common means of funding operations by newer or smaller companies. . . . And while these are more prevalent tools among smaller businesses, the accounting for these arrangements is complex, which contributes to difficulties in auditing the transactions."
Root causes and remediation
While underlying causes for any audit failure are complex and the result of a combination of factors, Franzen said they would include:
- Lack of technical competence in a particular audit area;
- Lack of professional skepticism;
- Ineffective supervision, perhaps due to heavy partner and professional staff workloads;
- Ineffective client acceptance and continuance practices that don't adequately consider technical knowledge called for in particular audits; and
- Ineffective engagement quality reviews.
Both Franzen and Hanson stressed the importance of developing training for staff, particularly in the areas of revenue recognition and fair value measurement.
"The Board has issued this report to highlight areas where audit firms can focus their attention to enhance the quality of their audits," said James R. Doty, PCAOB chairman, in the organization's press release. "We also encourage firms to identify and address the root causes of any audit performance deficiencies identified during the inspections process."
PCAOB said its inspection staff discussed its findings with the firms it reviewed and made recommendations that would address their deficiencies. Firms have twelve months to remedy audit deficiencies following notification by the PCAOB.
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