Public Company Accounting Oversight Board member Jay Hanson said he would like to see the PCAOB change the format of its inspection reports, including reducing the use of terms such as “audit failures.”

“I am troubled by the board's use of the term ‘audit failure’ in our reports,” Hanson said in a speech Tuesday at the CBI 10th Annual Pharma/Biotech Accounting & Reporting Congress in Philadelphia. “Our firm-specific inspection reports publicly identify inspection findings that are of ‘such significance that it appeared that the firm, at the time it issued its audit report, had failed to obtain sufficient appropriate audit evidence to support its audit opinion’ on either the financial statements or the effectiveness of internal control over financial reporting. In the context of a financial statement audit, for example, this would mean that the identified audit deficiency indicates that the firm did not do enough audit work and did not gather sufficient audit evidence to render its unqualified opinion that the financial statements are fairly stated. It does not necessarily mean, however, that those financial statements are misstated. Rather, it just means that the auditor did not do enough to know whether or not they were.”

Such inspection findings are referred to as “audit failures” in both the PCAOB’s firm-specific inspection reports and its general summary reports. Even if the inspected firm did not do enough work in the inspected areas, Hanson said that calling every such deficiency an “audit failure” appears to have caused confusion among investors, audit committees and others, some of whom have interpreted the findings as meaning that the financial statements are misstated or that there is a problem in the company's accounting or internal controls.

“In fact, however, only very few of our inspection findings ultimately can be linked to a problem in the company’s financial statements, and restatements arising out of our inspection process are rare, although they do occur,” he said. “Meanwhile, in other contexts, the term ‘audit failure’ is understood to mean that the company’s financial statements were misstated, and that the auditor did not identify the relevant problems during the audit.”

He noted that the U.S. Government Accountability Office, in the context of a congressionally mandated study of whether public companies should be required to rotate their audit firms periodically, defined the term “audit failure” as “audits for which audited financial statements filed with the SEC contained material misstatements whether due to errors or fraud.”

“I don’t believe it is necessary or appropriate for us to deviate from this more commonly understood definition of ‘audit failure’ by using that term to refer to our inspection findings, which are deficiencies in the firm’s work but not necessarily representative of problems in the audit client’s financial statements or internal controls,” said Hanson. “Therefore, I would like to see the board eliminate the use of the term in our inspection reports (unless we know, with respect to a particular audit, that the auditor's failure, in fact, relates to misstated financial statements).”

Hanson said he was also troubled by the practice of providing a “rate” of audit failures in the PCAOB’s public reports and said it could be misleading. “Indeed, we include language in our inspection reports explaining that audits are selected for review based on risk and that our reports are not ‘balanced scorecards’ with respect to any particular firm, much less across firms,” he said. “The risks associated with each audit, and each firm’s audit practice, are unique. Presenting ‘rates’ of audit failures, then, which inevitably will be utilized to compare one firm to another, may be misleading at best and harmful at worst.”

Hanson also believes that the PCAOB’s inspection reports would be more meaningful if they provided more context about the severity of each finding.

“Currently, each inspection finding in the public portion of a PCAOB inspection report must meet the threshold I just described—that the audit firm did not gather sufficient evidence to render an opinion—but the reports provide no information about which of the deficiencies are relatively minor or involved only a portion of a disclosure, and which indicate a much more significant problem with the audit,” he said. “I would like to see the board consider whether it would be possible to classify inspection findings by severity level, in order to provide that additional context.”

Hanson also believes that certain information that he has access to as a board member would be helpful in providing more context to readers of PCAOB inspection reports. “When I review draft inspection reports, I request and consider information related to the size and industry of the company whose audit was reviewed, as well as the risks based on which our staff decided to review the particular audit or audit area,” he said. “While routinely providing this information in inspection reports likely would present implementation challenges to our inspection staff, I believe the board should add this to its list of potential improvements to consider.”

On the positive side, Hanson noted that the PCAOB staff has been working on issuing inspection reports more quickly without compromising accuracy, consistency or fairness, and they have made substantial progress.

“Many of our reports are issued within a matter of months, and for those that take longer than a year after we complete our work in the firm’s offices, there is usually a good reason, such as the need to consult internally or with the SEC about complex accounting or independence questions or delays in obtaining or evaluating relevant information from the inspected firm,” he said.

In addition to revamping its inspection reports, the PCAOB has also been trying to improve the general reports that the PCAOB periodically issues about auditing trends across the industry, summarizing its inspection findings over a period of time and across firms. One improvement has been the addition of an “executive summary,” written in plain English, that the board hopes will be helpful to investors, audit committees and readers who may not be accountants.

In the new reports, Hanson said the PCAOB has tried to go beyond merely summarizing inspection results by providing more context and meaning behind the results, including pointing out the relevance of the information presented to audit committees and their work.

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