by Cydney Posner
The PCAOB has announced the publication of a new paper designed to address audit committees. The paper, Audit Committee Dialogue, provides insights from inspections of public company auditors that should assist audit committee members in overseeing their auditors. Other similar papers are anticipated. This paper highlights two areas: key recurring areas of concern that the PCAOB has identified and new risks that the PCAOB is monitoring. Especially helpful are the series of suggested questions related to each topic that committee members may want to ask their auditors.
RECURRING CONCERNS
In its inspections, the PCAOB has found frequent significant deficiencies in the following areas:
- Auditing internal control over financial reporting (ICFR) (39%)
- Assessing and responding to risks of material misstatement (26%)
- Auditing accounting estimates (13%), including fair value measurements (11%)
- In cross-border audits, deficient “referred” work — work performed by other audit firms and used by the signing audit firm
ICFR
Among the problems found in connection with ICFR were failure of the auditor to perform sufficient procedures to test the effectiveness of controls or to sufficiently evaluate whether the identified deficiencies constituted material weaknesses. Of reported material weaknesses, 77% were in connection with the issuer’s disclosure of a related financial reporting error that the issuer addressed through a restatement or an adjustment. However, no material weakness was reported in the ICFR opinion preceding the announcement in 83% of the restatements announced in 2013 and 2014 (by companies required to report on ICFR).
Suggested questions that audit committee members should consider asking their auditors:
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“What are the points within the company’s critical systems processes where material misstatements could occur? How has the audit plan addressed the risks of material misstatement at those points? How will your auditor determine whether controls over those points operate at a level of precision that would prevent or detect and correct a potential material misstatement?
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What is your auditor’s approach to evaluating the company’s controls over financial reporting for significant unusual transactions or events, such as the acquisition of assets and assumption of liabilities in a business combination, divestitures, and major litigation claims?
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If the company enters into a significant unusual transaction during the year, how will your auditor adjust the audit plan, including the plan for testing ICFR related to the transaction? For example, how would the company’s acquisition of a significant enterprise during the third quarter affect the audit plan for the year? How might your auditor’s materiality assumptions change? Would the audit plan focus on different systems and controls than originally planned? How would your auditor test controls over the systems used to generate information for recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree? How would the internal control over financial reporting of the acquired company be considered? Asking about the effectiveness of controls before such transactions and events occur will signal to your auditor that preparedness is a priority, as will asking similar questions about new systems and processes.
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If the company or your auditor has identified a potential material weakness or significant deficiency in internal control, what has been done to probe the accuracy of its description? Could the identified control deficiency be broader than initially described? Could it be an indication of a deficiency in another component of internal control??”
Risks of Misstatement
With regard to addressing risks of misstatement, the PCAOB noted that audit plans need to be responsive to changes in the business and advises that auditors “should conduct a rigorous analysis of changes in the company’s business and its environment as part of its risk assessment process and then be able to describe to you how this year’s audit plan addresses those changes.” In addition, in integrated audits of large companies, audit plans sometimes relied on entity-level controls to cover some high-risk locations without adequate testing and evaluation of those controls and related data, resulting in insufficient audit procedures for those locations.
Suggested questions that audit committee members should consider asking their auditors:
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“Which audit areas are designated by your auditor as having significant risks of material misstatement and what audit procedures are planned to address those risks?
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In your auditor’s view, how have the areas of significant risk of material misstatement changed since the prior year? What new risks has your auditor identified? What is your auditor’s process to make sure that it identifies new or changing risks of material misstatement and tailors the audit plan appropriately? How is the engagement partner involved?
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How does your auditor’s audit plan address the varied risks in a multi-location environment? If your auditor assumes that controls are uniform across multiple locations, how does your auditor support that assumption?
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If the company has operations in countries that are experiencing political instability, how has your auditor identified and addressed the specific risks that might result from such a circumstance? Or, if some of the company’s products are approaching technological obsolescence due to competitive new products, you might ask how your auditor plans to address the risks of inventory obsolescence.”
Estimates
Because estimates and fair value determinations involve subjective judgments, they are more “susceptible to management bias and material misstatement” and, therefore, require more audit attention. Key areas where the PCAOB has seen deficiencies with respect to estimates are revenue, allowances for loan losses, inventory reserves, fair value measurements and tax-related estimates, as well as asset impairments, especially in periods of economic downturn. In some instances, auditors did not appropriately take into account available information that was contrary to the information management used to support its estimates, such as different cash flow forecasts used for the budgeting process and for determining fair value of intangible assets in testing impairment.
Suggested questions that audit committee members should consider asking their auditors:
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“What does your auditor do to obtain a thorough understanding of the assumptions and methods the company used to develop critical estimates, including fair value measurements?
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What is your auditor’s approach to auditing critical accounting estimates, such as allowances for loan losses, inventory reserves, and tax-related estimates?
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How has your auditor assessed whether management has identified all separable intangible assets that, while not included in the financial statements, must nevertheless be valued in connection with assessing goodwill for possible impairment (e.g., customer-related intangibles and in-process research and development)? Has your auditor considered contrary information that suggests the existence of such assets that management has not identified?
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Will your engagement team use its firm’s in-house valuation specialists? If so, how are the specialists integrated into the engagement team? How are specialists supervised, and how are significant issues they identify resolved? If the firm does not have in-house valuation specialists, does the firm engage external specialists to assist the auditor with their audit of complex estimates?”
Non-U.S. Referrals
In 2013, the PCAOB found problems in over 40% of the engagements for work referred to non-U.S. auditors in connection with audits of multi-national companies, including testing of revenue, inventory and controls. These deficiencies often occurred when the revenue, inventory or controls in question were significant to the issuer’s consolidated financial statements or ICFR, and the results reported by the other auditor formed part of the basis for the signing firm’s opinion.
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“Suggested questions that audit committee members should consider asking their auditors: “How does the engagement partner assess the quality of the audit work performed in other jurisdictions? Were the firms that participate in the audit recently inspected by the PCAOB? If yes, what does the engagement partner know about the results?
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How does your auditor review the work? Does your auditor visit other countries to review the audit work done there? What steps does your auditor take to make sure that the work is performed by persons who understand PCAOB standards and U.S. GAAP and financial reporting requirements?
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As part of planning the audit, does your auditor consider performing additional steps if the referred work is in an area that has recently been the subject of a significant number of PCAOB inspection findings on your auditor?”
EMERGING RISK AREAS
The paper also looked at emerging risk areas, including increases in M&A, falling oil prices, undistributed foreign earnings and the potential impact of the growth of audit firms.
M&A
The PCAOB found that even senior audit team members sometimes lacked sufficient experience in auditing business combinations because of the “relatively low level of merger and acquisition activity until recently,” leading the auditor to fail to detect material misstatements. Problems detected in connection with auditing business combinations included reliance on controls without testing them, failures to test company-produced data used to prepare cash flow projections to support fair value measurements and failures to detect that management had not identified all the intangible assets that needed to be valued, such as customer-related intangible asset.
Suggested questions that audit committee members should consider asking their auditors:
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“Does your auditor have the expertise necessary to address the audit issues that may arise from the reporting requirements related to business combinations as well as other effects of a business combination that may bear on financial reporting, such as the effects on segment reporting? If not, how will your auditor obtain or develop that expertise?”
Falling Oil Prices
The PCAOB cautions that companies outside the oil and gas industry can still be affected by falling oil prices (e.g., airlines). The PCAOB will be looking particularly at impairment and valuation issues and the collectability of loans and receivables.
Suggested questions that audit committee members should consider asking their auditors:
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“Have declining oil prices been identified as a risk factor and changed your auditor’s approach to testing related accounting estimates? Will your auditor require different evidence to support any assumptions and estimation methods used by the company that may depend on a certain level of oil prices?
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How might the estimated effects of falling oil prices be factored into estimates of the company’s future undiscounted net cash inflows used in the assessments of possible impairments of long-lived assets? How might those effects affect the possible need for recording or adjusting a deferred tax valuation account?
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Does the decline in oil prices create a need to disclose certain significant risks and uncertainties in the financial statements? Do oil price movements subsequent to year-end represent a subsequent event that requires disclosure in the company’s financial statements?”
Undistributed Foreign Earnings
With U.S. public companies asserting that over $2 trillion will be indefinitely reinvested outside the U.S. and therefore not subject to U.S. taxes, the PCAOB has observed that auditors have sometimes failed to evaluate the impact on that assertion of significant cash transfers from a foreign subsidiary to the U.S. parent, and has seen other problems in auditing controls over income tax accounting. The PCAOB also cautioned that, if the company faces liability based on a tax strategy that the auditor developed, conflicts could arise, which could affect the auditor’s independence (and ability to continue as the auditor). The PCAOB advises that audit committees “keep a list of past tax strategy engagements and monitor the list for potential effects on the audit.?”
Suggested questions that audit committee members should consider asking their auditors:
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“What is the nature and extent of audit evidence gathered by your auditor related to management’s assertions about indefinite reinvestment? Is there contrary evidence? If so, how did your auditor consider the contrary evidence?
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Has your auditor considered whether the company’s MD&A disclosure, including disclosure regarding liquidity and capital resources, is consistent with, or contradicts, management’s indefinite reinvestment assertion?”
Growth of Audit Firms
Although “audit firms currently do significantly less non-audit work for issuer audit clients than they did prior to the turn of the century,” that may be changing, as the percentage of revenue provided by advisory services has recently increased with audit firms acquiring or expanding consulting practices. The PCAOB is “concerned about the effects such business developments may have on the firm’s attention to audit quality. Depending upon how a firm manages that growth, there is a risk that the culture within a firm could tend to drift from a focus on audit quality to a focus that subordinates audit quality to other business opportunities and challenges.”
Suggested questions that audit committee members should consider asking their auditors:
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“Has your engagement team been affected by any changes in the firm’s business model? Has the engagement team lost key auditors or specialists to other lines of business? How are you ensuring that the quality of the audit team will remain high over time?”
