On November 10, the Public Company Accounting Oversight Board (PCAOB) published a Staff Inspection Brief that highlights frequent audit deficiencies identified by their Division of Registration and Inspections during the 2016 inspection cycle. The release is designed to help registered public accounting firms comply with PCAOB Auditing Standards. However, we believe it also provides preparers and issuers an opportunity to plan and prepare for accounting, reporting and disclosure areas likely to receive extra scrutiny by their auditors in their upcoming audits.
The PCAOB examined more than 780 issuer audits in 2016 and reviewed the system of quality control at more than 190 firms. The inspection process also included a significant number of multinational audits that used the work of auditors in domestic and non-U.S. locations. In this Flash Report, we highlight some of the most notable areas that the PCAOB underscored in its brief. The full Staff Inspection Brief can be found here.
The “Audit Deficiency” Leaders
The PCAOB’s brief emphasizes three key areas identified as having the most frequent audit deficiencies: assessing and responding to risks of material misstatement; auditing internal control over financial reporting (ICFR); and auditing accounting estimates, including fair value measurements. Following is a summary of those areas and what the efforts by external auditors to prepare for potential deficiencies might mean for management.
Risks of Material Misstatement
- Evaluate and mitigate reporting risks for each significant account – Auditors are being urged to design and perform audit procedures that assess the risk of material misstatement for each significant account and disclosure. Issuers likely will be asked by their auditors for more detailed supporting documentation in these high-profile areas.
- Fraud potential in revenue transactions – Based on the PCAOB’s guidance, auditors are being asked to presume that fraud risk surrounding an issuer’s improper revenue recognition is inherent. Auditors will also evaluate the types of revenue, revenue transactions or assertions that are likely to foster fraud. Management would be well-served to demonstrate effective controls to inhibit potential inherent fraud risk around revenue recognition and reporting.
- Presentation and disclosure – The board has reminded auditors to evaluate whether financial statements are presented fairly, in all material respects, and conform to the applicable financial reporting framework. They also will evaluate whether an issuer’s statements contain the information essential for a fair presentation of the financial statements. Ultimately, however, this responsibility lies primarily with management, and companies can expect more scrutiny and perhaps stronger than expected management representations in this regard in upcoming audits.
Internal Control Over Financial Reporting
- Sufficiency of management review controls – Issuers and preparers should anticipate extra testing emphasis on the design and operating effectiveness of management controls, especially those that should include a significant review element. The PCAOB is stressing that auditors evaluate management’s cash flow projections that may be used to substantiate and support estimations underlying revenue transactions, business combination valuations, impairments on long-lived assets and goodwill, as well as accruals and reserves.
- Testing controls over the accuracy and completeness of financial information – The PCAOB is advising auditors to ensure they are sufficiently testing controls for completeness and accuracy of system-generated data or reports used in the operation of those controls.
Issuers should keep in mind that accounting estimates will likely warrant audit focus on potential management bias, which is often derived from the complexity of methodologies and models, subjective factors and significant judgments involved in the process, as well as the propensity for management to undertake aggressive positions in applying accounting policies for determining estimates. Auditors will pay particular attention to how an issuer’s estimates were developed, and they will sufficiently test the methodologies and significant inputs, and evaluate the assumptions used by management relating to revenue estimation, allowance for loan and lease losses (ALLL), inventory reserves, and financial instruments, just to name a few.
Other Areas of Note
In addition to deficiency-leading audit areas in the 2016 inspection cycle described above, the PCAOB highlighted other items that could pose a concern, and thus represent areas for issuers to assess and address as needed. These include:
- Economic risk – How might the economic environment during the relevant fiscal period affect reporting risk? Trends to consider include M&A activity, the search for high-yielding returns, and foreign currency and commodity (i.e., oil and natural gas) price volatility.
- Business combinations – How an issuer developed estimates regarding acquired assets, liabilities assumed, contingencies, purchase price considerations and other assumptions will likely come under the auditor’s skeptical microscope.
- Investment portfolios – Auditors are being urged to understand and evaluate the criteria that management has used when testing review controls over fair value measurements and disclosure of investments. This criteria will focus on the appropriateness of methodologies and inputs to models, especially on hard-to-value illiquid equity and debt instruments.
Audit Quality Concerns
Finally, the PCAOB has recommended reviews of the performance and compliance of audit committees and external audit firms. Questions to consider include:
- Are audit committee communications providing details about audit strategy, audit timing and significant risks identified by the audit firm?
- Are auditors complying with PCAOB and/or Securities and Exchange Commission rules and regulations relating to auditor independence?
- Are the individuals conducting an engagement quality review (EQR) qualified to do so? For example, has a person performing the EQR served as the engagement partner during either of the two audits preceding the audit subject to the EQR?
The PCAOB’s periodic release of its Staff Inspection Briefs continues to provide auditors and issuers alike with valuable insight into financial reporting areas that are subject to enhanced examination by staff inspection teams. In addition to preparing for the new areas of emphasis, it is important for preparers and issuers to concentrate on areas identified for extra scrutiny in past PCAOB briefs. Among others, those include a preview of the PCAOB’s inspection process in 2017, a blueprint that emphasized new accounting standards, information technology and financial reporting areas. Protiviti issued a Flash Report earlier this year that summarizes these areas.