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PCAOB Warns Auditors of Impending Changes

December 3, 2010

The Public Company Accounting Oversight Board is planning to be on the lookout next year for lax auditing practices, especially as companies and accounting firms have cut back on staff members who should be minding the financial controls.

During a presentation Thursday in New York, Martin Baumann, the chief auditor and director of professional standards at the PCAOB, also described some of the changes ahead for auditors next year as the PCAOB presses Congress to make auditor disciplinary proceedings public and works on updating a number of its standards. Baumann spoke at an auditing conference sponsored by Baruch College’s Robert Zicklin Center for Public Integrity and the NASBA Center for the Public Trust.

The PCAOB has asked Congress to amend Sarbanes-Oxley to make the disciplinary hearings public. Baumann noted that the reason for this is that many firms are able to drag out the proceedings in secret while not disclosing to investors about their auditing problems. “That means auditors we think have done a bad job can continue to do audits,” said Baumann. In one case, it took two years to get the disciplinary proceedings made public, while the firm continued to do over 30 audits of public companies.

Another frustration for the PCAOB has been its inability to inspect many foreign auditing firms that audit U.S.-based multinational businesses. Baumann called it a “really large issue,” especially because many investors assume the firms doing the audits of foreign companies like Barclays and Siemens whose stock trades in the U.S. are being inspected by the PCAOB when in fact they are not.

Baumann believes that the risk of fraud in financial reporting is elevated in the current economic environment, especially for companies whose auditing firms show material weaknesses in their audit procedures. “We need to find out where the breakdown is occurring and why,” he said.

The PCAOB has seen trouble spots in areas such as impairment, goodwill, fair value, and the use of specialists, which it had predicted in a report in the midst of the financial crisis could turn out to be problematic.

The economy is forcing many firms to cut back on staff, including experienced auditors. That is also happening at companies and their internal audit departments. Companies are pressuring their audit firms to reduce their fees, which often translates into less time spent on audits.

“We hear at the PCAOB that there is significant pressure on auditors that they reduce fees,” said Baumann. “We don’t want them to cut back.”

The PCAOB has proposed a number of auditing standards relating to the auditor’s assessment and response to risk. They run the gamut, covering the entire audit process from the initial planning activities to forming the opinions that will be expressed in the auditor’s report.

Baumann noted that the standards have been exposed and re-exposed, and he expects the SEC to approve them. They will be effective for audits of fiscal years on or after Dec. 15, 2010.

The PCAOB also wants to see better disclosures written in plain English in a way that the average investor can understand. The involvement of the engagement partner on the audit needs to be greater when the risks are greater, Baumann cautioned.

Other proposed standards aim to improve communication with audit committees. The PCAOB believes they should include a discussion of the audit strategy and the auditor’s assessment of significant risk.

There is also a new requirement to discuss staff disagreements, including complaints or concerns regarding accounting and auditing matters. These should be discussed prior to the filing of the audit report, Baumann emphasized.

The PCAOB has been poring over the comments it has received on the various standards it has proposed, and Baumann encouraged firms to send in their feedback. Some firms have complained that some of the upcoming standards are too proscriptive, and some standards, such as the one for audit confirmation procedures, may be revised and re-proposed next year.

Some standards and proposed standards may also need to change as a result of the ongoing convergence effort between FASB and the IASB on accounting standards. The IASB standards are generally less proscriptive and more principles-based, as in the case of the revenue recognition standards. That could result in some audit challenges, Baumann noted. Greater use will be needed of professional judgment and estimates under IFRS, and the PCAOB may need to issue more auditing challenges, Baumann warned.

The PCAOB staff has issued audit practice alerts on auditor considerations regarding significant unusual transactions and using the work of other auditors and assistants from outside the firm.

The PCAOB has seen instances of U.S. companies merging with Chinese companies in which the majority of the operations are moved abroad. However, auditors who engage assistants from outside the firm are governed by the same standards regarding planning the audit and supervising the audit, and supervising assistants, that apply when audit work is performed by assistants who are partners of, or are employed, by the auditor’s own firm.

The PCAOB is considering changing the auditor’s reporting model. The model “hasn’t changed in 100 years,” Baumann noted. “You can’t say that of many products.” The PCAOB has been hearing from many investors, as well as European Union officials, that the model should be revised. It plans to conduct research on what information pertinent to the audit and the activities of the auditor would be helpful to users in making a decision about whether to invest in a company.

Baumann believes investors should be able to learn on the auditor’s report about close calls and management’s complex decisions related to accounting matters. The PCAOB plans to conduct a roundtable discussion next year. Bauman predicts there will be “big changes coming down the pike.”

Other issues being addressed next year include fair value measurements and other accounting estimates, including the required procedures when an auditor uses a pricing service in audits of fair value.

“It is the responsibility of the auditor when there are unobservable inputs to understand those unobservable inputs,” said Baumann. The PCAOB is looking into improving the procedures regarding the auditor’s assessment of and response to risk relating to fair value estimates, including the risk of management bias or fraud.

In getting ready for audits of this year’s financials, Baumann encouraged auditors to ensure they have adequate staffing. He warned of challenges around unusual transactions, which “oftentimes come late in the game” as companies try to put the best face on their year-end financial statements.

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