3 Recurring Audit Deficiencies – How companies should react to auditor regulation

Recurring Audit deficiencies

The Public Company Accounting Oversight Board (“PCAOB”) issued an October 2015 Staff Inspection Brief (2015/2), regarding its 2015 public inspection related activities. Not surprisingly, the PCAOB are again focused on three general areas across inspections of applicable accounting firms.

The three general areas of inspection related activities highlighted in the October brief are:

  • Internal control over financial reporting
  • Assessing and responding to risks of material misstatement
  • Accounting estimates that include fair value measurements

All of these audit areas are a historic hotbed of significant inspection deficiencies and issues can occur on audit engagements that include referred in work.

Internal control over financial reporting

Internal control over financial reporting is a broad area, but when applicable, the PCAOB’s focus will be on the auditor's assessment and testing of the design and/or operating effectiveness of controls. A significant miss here could affect both management's assessment and the auditor's opinion on an entity's internal control over financial reporting.

Assessing and responding to risks of material misstatement

With respect to assessing and responding to risks of material misstatement, the PCAOB noted that some auditors did not always sufficiently identify the risks or, when they did identify the risks, the auditors did not always perform effective tests responsive to the risks identified.

Accounting estimates that include fair value measurements

For accounting estimates and fair values, the PCAOB pointed out that testing of key data and significant assumptions used by management to develop estimates or fair values is a key focus. One key here is the reference that assumptions are used by management, which should remind companies of the responsibilities of management for developing and supporting accounting estimates and fair value measurements with well-reasoned and auditable assumptions.

Additional information found in the brief

The PCAOB brief has additional information about their focus on financial areas (including a new or additional emphasis on income tax accounting and the statement of cash flows), economic and industry sector risks and various information about the inspections process.

This PCAOB brief is a highly recommended read for all public company financial accounting managers.

Our Recommendations

How should you, as a company under audit, respond to this PCAOB brief? First, it is always advisable that you understand the public accounting regulatory environment. For those who operate in a regulatory environment know and understand, it is often challenging to successfully navigate the regulatory environment. In this particular case, the PCAOB and the SEC have significant direct and indirect “teeth” that require full attention of auditors and companies subject to audit. Even if you are a private company, the AICPA standards are not too dissimilar from PCAOB standards. The views and interpretations of the PCAOB often are adopted or leak into the execution of AICPA auditing standards. Therefore, it behooves the private company to understand how auditors execute their audit. This is particularly true around estimates and fair value measurements where auditors will perform significant and challenging audit procedures around these higher risk areas in all cases.

Resources for staying tidy

It should be expected that as you prepare for your audit, your financial staff is aware of these areas of audit focus and their responsibility to sufficiently address them (refer to blog post " 8 Radical Ways to Engage a Financial Statement Audit " for more practical tips on how to plan for an audit). Internal controls over financial reporting should be sufficiently assessed, documented and monitored. All significant changes in business and financial processes, personnel and information systems should be considered and documented. One off transactions, such as acquisitions, divestitures and nonrecurring adjustments (impairments, changes in estimates) should also be thoroughly documented with internal control considerations highlighted. The financial closing process should be appropriately planned, executed and reviewed. Without a robust closing process, issues can be unintentionally hidden, only to rear its ugly head sometime after the audit is complete (see our blog post " Is your financial closing process hiding accounting issues " to further explore this idea). For accounting estimates, management must have a sufficient and robust process for choosing assumptions and have a verifiable process where key data is used to develop such estimates (please refer to our blog post " 6 Practical Tips for Avoiding an Auditing Nightmare - Accounting Estimates and Fair Value Measurements " for more information on preparation for auditing accounting estimates and fair value measurements).

Two recommended questions to ask your audit team

If I was a CFO or controller of a public company and I was responsible for planning and executing audit preparation, I would, likely after full discussions with my audit committee, contact my auditor and ask two simple questions:

  • “How will this Staff Inspection Brief affect my audit?
  • ”What can we do, above and beyond our normal audit support preparation, to ensure we have the appropriate documentation and support for my audit?”

I would expect a reasoned response from my auditors and not a boilerplate answer that, in effect, they have everything under control and you should not see any changes. If I was the auditor, I would welcome the questions as an opportunity to dialogue about the audit and regulatory developments, my expectations of my client and our goals of mutual satisfaction of the audit process. Private company controllers or CFOs should be asking similar questions regarding changing audit areas of focus, particularly around accounting estimates and fair value measurements, and how the company can prepare more thoroughly. In the end, full audit preparation supports a well-executed, no surprises, cost-contained audit process.

J. Seelye Harrison is a retired Big 4 assurance partner and currently is a consulting director for Carrtegra LLC. In his 36 years of public company experience he has consulted with companies on numerous purchase business combination allocations, financial instrument fair values and intangible assets, goodwill and other long lived asset valuations. In addition he performed numerous audit quality reviews of public and private audit clients.