Last month the Public Company Accounting Oversight Board (PCAOB) issued its staff inspection brief detailing the scope, focus, and objectives of its ongoing 2016 inspections of auditors of public companies and other issuers. This brief is helpful for those who may be seeking better understanding of the PCAOB’s inspection process as well as identifying potential trends to take note of.
PCAOB’s Role
As a background, Mark Olson, former Chairman of the PCAOB, explained in 2007 that the Sarbanes-Oxley Act of 2002 (SOX) established the PCAOB as the independent auditor oversight body in the United States. “The PCAOB’s mission,” he stated, “is to oversee the auditors of public companies, protect the interests of investors, and further the public interest in the preparation of informative, accurate, and independent audit reports.” The PCAOB seeks to accomplish its goals through its standards setting, inspections, enforcement, and outreach programs.
Today, the PCAOB oversees over 2,100 registered firms that audit issuers. Among these registered firms are the following 10 audit firms, which the PCAOB inspects annually:
- Global network firm inspection program – There are six firms in this program. They include BDO International Limited, Deloitte Touche Tohmatsu Limited, Ernst & Young Global Limited, Grant Thornton International Limited, KPMG International Cooperative, and PricewaterhouseCoopers International Limited.
- Non-affiliate firm inspection program – The PCAOB’s inspection program encompasses inspections of registered firms that are not covered by its global network firm program. Many of the firms in this program are members of other international networks, alliances or affiliations. Four of these non-affiliate firms, Crowe Horwath LLP, MaloneBailey, LLP, Marcum LLP, and RSM US LLP, are inspected annually by the PCAOB because they have historically, including in 2015, issued audit reports for more than 100 issuers.
Inspections
The PCAOB inspects these 10 firms and approximately 550 other registered public accounting firms to assess compliance with SOX, the rules of the PCAOB, the rules of the SEC, and professional standards, in connection with the firm’s performance of audits, issuance of audit reports, and related matters involving issuers.
When conducting inspections, the PCAOB inspects specific portions of a firm’s audits or aspects of a firm’s audits on a sample basis. In addition, the PCAOB posts statistics of financial statement areas of focus in its inspections of audit firms. To illustrate, in its most recent 2015 inspection cycle the PCAOB’s top five financial statement reporting areas of focus included the following:
|
Financial statement reporting area |
Global network firms (as % of total audits inspected in 2015) |
Non-affiliate firms (as % of total audits inspected in 2015) |
| Revenue and receivables |
79% |
58% |
| Non-financial assets |
58% |
30% |
| Inventory |
36% |
28% |
| Income taxes |
20% |
17% |
| Financial instruments |
17% |
15% |
The PCAOB’s emphasis on revenue and receivables as the top financial statement reporting area is consistent with the level of risk typically inherent in revenue recognition.
First, Auditing Standard (AS) 12, Identifying and Assessing Risks of Material Misstatement, states that the auditor should presume that improper revenue recognition is a fraud risk (at ¶ 68). The word “should” is deliberately used in this auditing standard to signify a presumptively mandatory responsibility. In essence, a risk of fraud in revenue recognition is presumed to exist and the auditor must comply with requirements of this type specified in the PCAOB’s standards unless the auditor demonstrates that alternative actions he or she followed in the circumstances were sufficient to achieve the objectives of the standard.
Second, a key consideration with respect to audit risks in revenue recognition is the fact that revenue recognition has historically been key area for financial statement restatements.
To add to the table above, the PCAOB’s other commonly inspected financial reporting areas in the recent past have included: allowance for loan losses, other liabilities (e.g., accounts payable and accrued liabilities), debt, other investments (e.g., equity method, joint ventures, variable interest entities, etc.) and others (e.g., discontinued operations, various income statement items, other assets, etc.).
2016 inspection cycle
With regard to its recently issued staff inspection brief, Helen Munter, PCAOB Director of Registration and Inspections, stated that the information in the brief “may help audit firms, investors, and others better understand the risk-based factors that the PCAOB considers when inspecting audits.”
Following are six key areas of focus by the PCAOB in its current inspection cycle:
- Audit areas where deficiencies have been identified in previous inspection cycles, including internal control over financial reporting, assessing and responding to risks of material misstatement, and accounting estimates, including fair value measurements. Recurring audit deficiencies continue to be identified in the most frequently selected financial reporting areas, such as revenue, non-financial assets, inventory, financial instruments and other areas.
- Audit areas affected by economic trends, including the effect of the strengthening U.S. dollar, the increasing merger and acquisition activity, the search for higher-yielding investment returns in a low interest rate environment, and the effect of the fluctuations in oil and natural gas prices.
- Audits of certain areas that may involve significant judgment from management and/or auditors, including the auditor’s evaluation of segment identification and disclosures, the auditor’s consideration of an entity’s ability to continue as a going concern, and evaluation of income tax accounting and disclosures.
- The implementation of AS 2410, Related Parties (also known as AS 18). This auditing standard was effective for audits of fiscal years beginning on or after December 15, 2014.
- Audit procedures involving IT, particularly auditors’ use of software tools, and procedures to assess and address risks of material misstatement posed by cyber security.
- An audit firm’s system of quality control, including its policies and procedures for (i) identifying the “root causes” of audit deficiencies and positive quality events, (ii) complying with required audit committee communications, including those communications related to independence, (iii) monitoring and maintaining independence, (iv) performing engagement quality reviews with due professional care, and (v) applying professional skepticism throughout the audit.
Historical inspection trends
According to its statistics, the PCAOB’s sweet spot for inspections of global network firm audits is companies with a market capitalization between $1 billion and $5 billion. In contrast, more so than any other market capitalization, the PCAOB has historically inspected audits conducted by non-affiliate firms of companies with market capitalization up to $100 million.
As it relates to industry sector, the PCAOB’s inspections of global network firm audits have covered a variety of industries more evenly than its inspections of non-affiliate firm audits. To illustrate, since 2013, approximately 80% of its inspections of global network firm audits have included four industry sectors: (1) industrials and materials; (2) financial services, benefit plans, and miscellaneous; (3) IT and telecom; and (4) consumer discretionary and staples. The remaining approximately 20% of its inspections of global network firm audits have included two other industry sectors (energy and utilities; healthcare). This should come as no surprise as the S&P 500 sector weightings, which represent the distribution among industries of the 500 largest publicly-traded U.S. firms, most of which are audited by the Big 4, are consistent with the PCAOB’s emphasis on these four industry sectors.
On the other hand, since 2013, approximately one-third of the PCAOB’s inspections of non-affiliate firm audits have been in the financial services, benefit plans, and miscellaneous industry sector. The remaining approximately two-thirds of inspections of non-affiliate firm audits have been evenly distributed among five other industry sectors.
Emphasis on quality
In summary, even though the PCAOB’s inspection program has evolved over time, we have experienced a declining historical trend of financial statement reissuance restatements. This decline can be attributed to improvement in the quality of financial reporting and, at least in part, to the PCAOB’s focus on audit quality and compliance with auditing standards.
