Observations On Today's PCAOB Report On Auditing During The Economic Crisis

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Today the PCAOB issued Report On Observations Of PCAOB Inspectors Related To Audit Risk Areas Affected By The Economic Crisis. The 26 page report discusses in depth what they have found during inspections over the last three years, a period during which the financial markets nearly collapsed and valuations were all over the place.

As to be expected, the PCAOB hits on audits of the financial industry pretty hard, but they covered other industries and problems they note.  Deficiencies observed in audits of both financial services and non-financial services industry issuers are as follows:

  • Fair Value Measurements for Financial Instruments - no surprise here.  This is one of the most difficult areas to audit, as the concepts are hard to grasp.  Primary dificiencies included the failure to (1) evaluate, or evaluate sufficiency whether fair value measurements were determined using appropriate valuation methods or adequately test controls over issuers' valuation processes; (2) evaluate, or evaluate sufficiently, the reasonableness of management's significant assumptions, including performing tests beyond inquiries of management; and (3) evaluate available evidence that was inconsistent with issuers' fair value estimates.
  • Fair Value Measurements for Non-Financial Assets - again, no surprise here.  Weaknesses were observed especially as it related to fair values in business combinations and testing for goodwill impairment.   Specific conditions are similar to those in the previous paragraph.  PCAOB also noted that auditors "sometimes failed to challenge issuers' conclusions that goodwill did not need to be tested for impairment more frequently than annually despite the existence of impairment indicators..."
  • Revenue recognition - PCAOB noted that fraudulent financial reporting often involves inappropriate revenue recognition.  Special weaknesses were cited in testing fair value of certain elements in multiple element arrangements.
  • Valuation of Inventories - the reduction in consumer and business spending in some instances resulted in increased inventory in relation to sales, decreases in inventory turnover, etc.  Specific weakensses cited were auditor failures to sufficiently eveluate the reasonableness of reserves for excess and obsolete inventory, failure to adequately test whether all impaired inventory has been identified, and failure to consider whehter markdowns were recorded when necessary when the issuer is using the retail method.
  • Income Taxes - deficincies were primarily cited in testing valuation of deferred tax assets and tax contingency reserves.

I have to admit to being a little surprised by the focus on valuation of inventories, but none of the other areas is all that surprising.  As I was reading this report (I admit to skipping the pages on the financial industry as we don't do financial industry audits) the following thoughts kept coming to mind:

  • The areas cited, especially fair value measurements and revenue recognition, have been major hot buttons for a while.  Personally, I just attended a day and a half seminar on revenue recognition alone, and I'd like to go to a fair value session before the upcoming audit season.  These are very complex areas, especially fair value. 
  • The PCAOB inspectors have the benefit of 20/20 hindsight to say this is where you should look and what you should have done.  In the crunch of an audit, you are trying to get a lot done in a compressed time period, and it is easy to criticize after the fact.

One thing I can guarantee you - my audit planning for calendar year audits starts tomorrow.

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