The Public Company Accounting Oversight Board is finding more problems at the audit firms it is inspecting, not less.
“Inspection results are not improving,” said Helen Munter, director of the PCAOB’s Division of Registration and Inspection, speaking at a conference Tuesday sponsored by the New York State Society of CPAs’ Foundation for Accounting Education. “2010 was not a good year for many auditors.”
PCAOB chief auditor Martin Baumann, who spoke at the same conference, was more upbeat, but he too highlighted a litany of problems. “I think we’re certainly starting to see at the board that audits are improving,” he said. “That’s certainly a good thing, but inspection findings are still numerous in many areas. Too often we find instances where standards aren’t being followed and situations where auditors are accepting evidence from management and not looking for, or ignoring, other evidence that may not corroborate or may contradict management’s position. We still find too many situations where professional skepticism is not where we think it ought to be.”
Audit risk and financial reporting risk remain high, in part because of problems with measuring the fair value of financial instruments. One of the main issues involves third-party pricing services, from companies like Bloomberg and IDC, which financial institutions, pension plans, preparers and audit firms are increasingly relying upon to provide them with valuations for portfolios.
“While there’s nothing wrong with that, these pricing services, which many years ago were relatively small, are now kind of behemoth organizations,” Baumann said. “In one fashion or another, data aggregators and most companies today are looking to the pricing services to give them information about the values of their financial instruments.”
All too often, preparers are simply relying on that data without doing their own valuations, and the auditors typically go to another pricing service or even use the same one to check on them.
“We’ve made it clear in our communications that that’s not good enough,” said Baumann.
He compared the situation to the problems a few years ago with the credit-rating agencies, which gave triple-A ratings to many mortgage-backed securities that ultimately turned out to be worthless.
When auditors have challenged some of the values issued by the pricing services, about 30 percent of the time they have changed the price they initially gave.
The PCAOB has also seen problems with fair value at banks that received financial bailouts. “We did have a number of criticisms related to fair value type items in financial institutions that took on TARP money,” said Munter. “One of the areas that we had a lot of discussion with auditors about was we were seeing evidence that the valuation was being performed as if that TARP money hadn’t been needed at all and that there was excess capital at a bank that had recently received TARP money in the prior year. We really struggled with that. This was an institution where there was a need to get a bailout, and yet the valuation people and the auditor took the position that there was excess capital available and there was no need to do an impairment analysis.”
Another area of concern has been Chinese companies that have been doing reverse mergers with U.S. shell companies to gain entrée to the U.S. public markets. The PCAOB issued a practice alert on Monday about audit risks in emerging markets like China (see PCAOB Warns of Audit Risks in Emerging Markets).
So far the PCAOB has been unable to gain entry to inspect firms in China because of Chinese concerns about national sovereignty. “Our inability to gain access to PCAOB-registered firms in China is especially troubling in light of the growth of the number of Chinese companies seeking access to U.S. capital in the U.S. securities markets,” said Munter.
She noted that with one firm that did audits in China for a U.S. issuer, the managing partner and the engagement partner in charge of the audit traveled to China in the year preceding the audit, but during the year that the audit occurred, there was no travel. Nevertheless, almost all of the auditing work was performed in China by a non-registered firm, and substantially all of the audit documentation was kept in China. The PCAOB disagreed with the U.S. firm's assertion that it was appropriate to rely on the work done in China.
“I guess fraud can occur in any market,” said Baumann. “Certainly we’ve had our share in the United States over the years. But right now in emerging markets, there’s oftentimes a close relationship between the banker and the company itself, and difficulty getting third-party confirmations, and sales to companies that don’t even exist. There’s been quite a lot of press about the companies in the emerging markets, and if you’re associated in any fashion with auditing them or have subsidiaries operating there, I think the antenna is up with respect to the risk in that area.”
The passage of the Dodd-Frank financial reform bill last year removed one hurdle for the PCAOB, allowing it to share confidential informatiin with regulators in other countries. That made it easier for the PCAOB to reach agreements on mutual inspections in Europe, and the agency has signed agreements this year with the U.K., Switzerland and Norway. In one case this year, the PCAOB shared information on a large multinational company with a foreign regulator for the first time.
Another problem is with shady companies that move from audit firm to audit firm. The PCAOB keeps track of these "problem issuers," even though it does not make the information public. Still, it could affect the PCAOB's inspection report for the auditing firm.
"If a problem issuer moves to your firm, a bad inspection report might not be far behind," Munter warned.
Another area of auditing risk is the large amount of change underway in accounting standards with the Financial Accounting Standards Board and the International Accounting Standards Board. Baumann noted that FASB recently made changes in its standards for the assessment of goodwill impairment, going from a complex quantitative analysis to a more subjective qualitative analysis (see FASB Issues Goodwill Impairment Testing Standard). The PCAOB will be looking to see what kind of evidence supports that qualitative assessment.
The PCAOB’s Standing Advisory Group recently raised concerns about the pace and volume of accounting changes, and Baumann is happy that the pace has quieted down lately.
“I am glad to see that all of the goals to try to get every one of these converged standards done by June 30 has slowed down,” he said. “Effectively, for all of these standards on revenue recognition, leases, consolidation and financial instruments, the current dates have been pushed out.” He noted that there are several hundred pieces of literature on revenue recognition and it has always been one of the more difficult areas to audit. Under the new proposed standard, there would be “one size fits all” for rev rec.
“That will require identifying performance obligations under a contract, allocating the value to each of the performance obligations and recognizing the revenues when the obligations are fulfilled,” he said. “Each of those is filled with lots of judgments, estimates and assumptions. And auditing revenue will become a challenge.” It may even require a new standard from the PCAOB just to audit revenue recognition determinations.
More time spent auditing such calculations should mean bigger fees, except that many companies now balk at paying high audit fees. However, Baumann said investors in those companies don’t mind the fees so much.
“You’ve heard about companies having some difficulties and putting pressures on audit fees,” he said. “The interesting thing is that the investors in our advisory groups say they don’t really understand the pressure on those fees. They as the owners of those companies say they understand that fees would be increasing in this environment, so investors are thinking that if they had a louder voice in this situation, they say they would want the right time spent on audits to make sure that financial statements are fairly presented and tell the right story.”
Investors are demanding changes in the audit report to provide more disclosures. In many cases during the financial crisis, investors were surprised that within months of receiving an unqualified audit opinion, many financial institutions either went out of business or would have gone out of business if not for the bailout money they received from the federal government. Investors have questioned the value of the audit and why there wasn’t better disclosure of problems such as the many mortgage loans that lacked proper documentation.
“The bottom line is that investors are clamoring for changes in the audit report,” said Baumann. “It’s just not working.”
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