PCAOB Provides Preview of Current Year’s Inspection Process

Protiviti Project Consulting
PCAOB Provides Preview of Current Year’s Inspection Process

July 21, 2016

The Public Company Accounting Oversight Board (PCAOB) has released several reports over the past year to provide guidance to auditors, audit committees and management around the inspection process and its results. On July 14, the issuer-focused 2016 Staff Inspection Brief, “Information about 2016 Inspections,” was released by the PCAOB to lift the curtain on its plan, scope and objectives for inspections in 2016 of registered audit firms.1 This builds upon the April 2016 Staff Inspection Brief, “Preview of Observations from 2015 Inspections of Audits of Issuers,” which covered very similar focus areas.2 While PCAOB releases such as these are of principal interest to public accounting firms, their contents and results ultimately impact those firms’ clients – the issuers. Consequently, we believe it is important for public companies to be familiar with these reports and plan and prepare accordingly.3

Inspection Focus Areas

This year’s inspections will continue to place attention on the most frequent audit deficiencies in three broad areas: internal control over financial reporting, assessing and responding to risks of material misstatement, and auditing accounting estimates, including fair value measurements. These areas are discussed further below:

  • Internal control over financial reporting (ICFR): PCAOB inspections will evaluate the sufficiency of auditors’ procedures performed to identify, test and evaluate controls that address the auditors’ assessed risk of material misstatement, and auditors’ testing of management review controls.
  • Risk of material misstatement: Conformance to the engagement quality review standard will be assessed to connect the dots between failures to link significant risks of material misstatement to the engagement quality review process. Specific areas of inspections focus include: (1) the sufficiency of testing the design and operating effectiveness of controls to support the auditors’ planned level of control reliance, including testing the controls over the accuracy and completeness of system-generated data and reports; (2) whether the substantive procedures, including tests of details, were specifically responsive to fraud risks and other significant risks identified; (3) the evaluation of the presentation of the financial statements, including the accuracy and completeness of the disclosures for those focus areas included in the inspection; and (4) the evaluation of relevant audit evidence that appeared to contradict certain assertions in the financial statements.
  • Auditing accounting estimates, including fair value and estimates: Reviews will cover auditors’ procedures performed to understand how estimates were developed, testing of data used in the estimate, and evaluation of significant assumptions. Fair value measurements and other accounting estimates involve the potential for management bias and the PCAOB has raised concerns about a lack of professional skepticism by auditors when testing these estimates. Inspection reports have historically found issues with auditors not sufficiently evaluating or considering contradictory/inconsistent information that could impact the valuation of estimates.

The usual financial statement focus areas will remain. These are:

Economic trends will be assessed during the inspection of individual audits to determine the impact on financial statement accounts and disclosures. In particular, the following areas will be considered:

  • Effects of the strengthening U.S. dollar on multinational issuers;
  • Increasing merger and acquisition activity;
  • Search for higher-yielding investment returns in a low interest rate environment; and
  • Effects of the continued fluctuations in oil and natural gas prices.

New areas of emphasis have been added to the inspection workstream. These areas include:

  • Evaluation of segment identification and disclosures (including conformity with the applicable financial reporting framework);
  • Consideration of the entity’s ability to continue as a going concern; and
  • Evaluation of income tax accounting and disclosures.

Other areas within the inspection scope include:

  • The audit firm’s implementation of Auditing Standard No. 18 on related parties;
  • Information technology issues such as the use of firm software tools in the audit and consideration of cybersecurity risks;
  • Conduct of multinational audits (and, in particular, the oversight of referred work on multinational audits);
  • The audit firm’s system of quality control;
  • Audit committee communications; and
  • Independence monitoring systems (with emphasis on addressing the growth in consulting and other non-audit services).

Assessments of the firm’s quality control system will include evaluating the audit firm’s “tone at the top” as it relates to audit quality; policies, procedures and practices concerning audit performance; training; partner management; and the firm’s self-monitoring through internal inspections and corrective action efforts.

Inspection Selection Process

The 2016 inspections cover 2015 audits, with inspectors concentrating on audit areas that present auditing challenges and significant audit risk, including risks of material misstatement in the financial statements, as well as areas of recurring audit deficiencies both within and across firms. As such, these risk-based selections are not representative of the overall population of the firms’ audit portfolios. The PCAOB plans to conduct inspections of 210 firms, including 10 U.S. firms that audited more than 100 issuers in 2015.

Closing Thoughts

The PCAOB inspections process continues to evolve. Accordingly, issuers will likely see new demands this year from their auditors as a result of the shifting of PCAOB focus areas. New financial statement focus areas will generate further scrutiny on additional audit areas and will likely result in more work by management to support the attestation process. That said, it is important that preparers continue to focus on prior inspection areas, as our experience is that nothing ever seems to come off the PCAOB’s list. Seasoned issuers will have an easier time adjusting, but newly public companies will find the bar moved even higher on the preparation side, transitioning from an “AICPA audit preparation” mode to the more demanding “PCAOB audit preparation” mode.

One other point: The PCAOB and SEC continue to question why material weakness disclosures are not preceding financial restatements. It’s becoming a matter of significant concern to both regulators. Therefore, expect to see rigorous analysis to source the root cause of proposed adjustments from the financial statement audit, with management being asked to explain why these exceptions, while not always material, are not the reflection of a material weakness in ICFR.

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1See PCAOB Staff Inspection Brief – July 2016.
2See PCAOB Staff Inspection Brief – April 2016.
3The PCAOB has commented that its inspections have observed some improvements at some of the firms in certain focus areas; however, inspections continue to find high numbers of deficiencies at many firms. For more information, read “Where Audits Go Awry, Internal Control Audit is Faulty Too, Analysis Shows,” Tammy Whitehouse, Compliance Week, January 28, 2016: www.complianceweek.com/blogs/accounting-auditing-update/where-audits-go-awry-internal-control-audit-is-faulty-too-analysis#.V4_C3j_2YuR.
 

 

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