A new report from the Public Company Accounting Oversight Board found that firms that audit 100 or fewer public companies and are inspected every three years showed a reduced rate of reported “significant audit performance deficiencies” in their 2007 through 2010 inspections, compared to when they were inspected from 2004 through 2006, but in 2011, the rate of deficiencies showed little sign of declining.
In addition, the report found that 20 firms with significant deficiencies never responded to the PCAOB with a remediation plan.
The PCAOB report indicated that 44 percent of the audit firms inspected during the 2007-2010 period had at least one “significant audit performance deficiency,” compared to 61 percent in the 2004 to 2006 period. Twenty-eight percent of the individual audits inspected during 2007-2010 had at least one “significant audit performance deficiency,” compared to a higher 36 percent of the audits inspected in the 2004-2006 period.
“Significant audit performance deficiencies” are deficiencies that result in the audit firm lacking sufficient evidence to support its audit opinion.
The results also showed that firms had fewer significant audit performance deficiencies after they had been inspected for a second time. Of firms that had a second inspection during the 2007-2010 period, 36 percent had at least one such deficiency in their second inspection, compared to 55 percent in their initial inspection.
But despite the decrease in the rate of significant audit performance deficiencies noted in second inspections, the persistence of such deficiencies in audits performed by a large number of domestic triennial firms is still a major concern for the PCAOB.
“We do have some good news here,” said PCAOB member Jeanette Franzel in a conference call Monday with reporters. “However, the significant audit performance deficiencies are scoped too high overall. Even though we’re reporting some good progress today, the story is more complicated. The persistence of such significant deficiencies in audits performed by a large number of the domestic triennial firms remains a concern of the board. In fact, despite the overall decrease in significant deficiencies during the 2007 through 2010 period, we noted that in the 2011 inspection year, the percentage remained at 45 percent, which was pretty much unchanged from what we’re reporting in this report.”
PCAOB member Jay Hanson noted that the inspection results varied widely across firms of different sizes.
“The firms range in size from sole practitioners to firms with several partners to firms with operations in multiple cities with thousands of staff members,” he 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-size and larger firms amongst this population, 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 really have no evidence to draw a direct correlation between the size of the firm and its ability to perform an audit that complies with PCAOB standards. To quote a phrase that has been used often, the firms that ‘stick to their knitting’ tend to do a better job on what they know how to do.”
The audit areas with frequent inspection findings in the 2007-2010 period related to auditing revenue recognition; auditing share-based payments and equity financing instruments; auditing convertible debt instruments; auditing fair value measurements; auditing business combinations and impairment of intangible and long-lived assets; auditing accounting estimates; auditing related-party transactions; use of analytical procedures as substantive tests; and audit procedures to respond to the risk of material misstatement due to fraud.
“The findings include certain pervasive areas such as auditing revenue recognition, which is an important area to virtually all investors and which we generally review in every inspection,” said Hanson. “Many issuer clients of the firms covered in this report used financing and compensation arrangements that involved limited or no cash. We have seen many examples of deficiencies in the audits of share-based payments, for example, stock options and equity-financing instruments as well as convertible debt instruments. The audits of business combinations and then the subsequent impairment of the intangibles and long-lived assets that are frequently acquired in a business combination also result in frequent findings. For any of these and other audit areas, fair value measurement and accounting estimates are critical to the accounting and often were not given enough attention by the auditors. Related-party transactions are another significant area where we observed that PCAOB standards were not met.”
Hanson noted that the PCAOB has a standard in process for increasing the auditor’s responsibility for related-party transactions.
Audit Firms That Don’t Seem to Care
The report also noted that 20 firms did not provide any remediation response to the PCAOB. Under the PCAOB’s rules, the board made all of its quality control criticisms of those reports public while encouraging the firms to initiate a dialogue with the PCAOB inspection staff about how the firms intended to address the criticisms.
When asked about the firms that have not responded to the PCAOB’s inspection findings, Hanson noted that there were some sanctions available. “One of the two biggest levers that we have at the PCAOB is releasing the quality control criticisms portion of the report,” he said. “The Sarbanes-Oxley Act provided an incentive for firms to remediate them so that they wouldn’t be publicly released. The other lever is our enforcement process where we actually pursue adversarial actions against the firm on specific audits, many times on specific individuals. Sometimes sanctions against the firms that we successfully pursue and effectively prosecute through our enforcement division are extreme, such as banning them from issuing opinions on public companies anymore, and sometimes a substantial fine. We have an active pipeline of enforcement cases that we’re pursuing against all sizes of firms.”
Hanson acknowledged, however, that the process can take a long time. The PCAOB has asked Congress to amend the Sarbanes-Oxley Act to make its disciplinary proceedings public while the process is ongoing.
Franzel noted that the PCAOB also tries to work with the firms to remediate the problems it finds. “When firms do in fact have quality control problems, our inspection staff really does try to work with them,” she said. “These firms that end up having their quality control criticisms made public due to a lack of response really send a negative signal to us and to the world, and then we do have the tools to use in such cases if we need to.”
Hanson pointed out that the vast majority of firms work cooperatively with the PCAOB, and the board encourages them in letters and phone calls to communicate early. “If they’ve missed something, we can give them some feedback to say, ‘Yes, this seems you’re on the right track,’ versus ‘No, you haven’t done enough.’ That’s positive, and most firms do react and get to the goal they have of successfully remediating. For those firms that, in my own personal view, appear they just don’t care, a combination of factors can go into that, but I empathize with the inspection staff that has to deal with a firm that is just not cooperative and doesn’t care. We can only hope that over time they get the message that maybe they shouldn’t be doing work on public companies.”
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