Auditors Told to Get Skeptical

Regulators are pushing audit firms to take a more serious look at financial statements in 2009, to catch the deluge of financial reporting problems expected to appear after this year’s dizzying market plunge.

The Public Company Accounting Oversight Board has telegraphed that message in the form of a 33-page alert to auditors, telling them to plan their audits with an eye toward the new risks that spring from management acting under economic pressure. Fair-value measurement and management estimates could be particularly contentious, the PCAOB warns, but auditors should also police a laundry list of other concerns: impairments, revenue recognition, restructurings, consolidations, contingencies and guarantees, derivatives, debt obligations, receivables, deferred tax assets, goodwill, intangibles, inventory, and pensions, to name a few.

Susan Markel, chief accountant for the enforcement division at the Securities and Exchange Commission, says the PCAOB alert is worth reading for anyone involved in financial reporting. “As I read the practice alert, [I thought] yeah, I get that,” she said at a recent conference of the American Institute of Certified Public Accountants. “I think it’s a pretty good document to pick up and get acquainted with.”

Speaking at the same AICPA conference, PCAOB Chairman Mark Olson said he has heard considerable talk from auditors and companies that a huge issue will be the analysis of whether a company can continue as a going concern; fair-value measurement and determinations around impairment also fall into that same category. As a result, Olson said, PCAOB staff will examine those issues closely when they inspect audit firms’ work—so companies can expect their auditors to dwell on those points, too.

The PCAOB alert lists several key indicators auditors should examine when they assess whether a company can continue as a going concern: strained liquidity, reduced availability of credit, violations of debt covenants, limited access to commercial paper, a decline in collateral, difficulty restructuring loans, and delayed payments from customers. Any of those criteria could worsen dramatically in the sort of environment that has gripped Wall Street since September.

Ray

“It’s reasonable to assume that more companies than in the past will [exhibit] one or more indicators of substantial doubt,” Tom Ray, chief auditor at the PCAOB, told the AICPA audience. “If one or more are present, we would encourage you to engage in a dialogue with the company’s management as soon as possible.”

The PCAOB also advises auditors to scrutinize how various accounts are affected by the use of fair-value accounting rules, how valuation models and techniques have been applied, the assumptions that go into the fair-value measurements, the availability and reliability of evidence to support such assumptions, and the adequacy of disclosures to explain them. At the AICPA conference, Ray reminded auditors that his staff published a similar alert to auditors a year ago looking solely at how auditors should scrutinize fair-value measurements, and it still applies, he said.

Measurement of fair value under Financial Statement No. 157, Fair Value Measurement, has been a particularly heated topic in recent weeks as financial institutions have lobbied hard for more flexibility to mark instruments that have become difficult or impossible to unload at any price based on the cash flows they produce rather than current market prices.

Impairments, or the write-down of devalued assets, will be tricky as well, Olson said, because companies are required to cut earnings for impairments deemed “other than temporary” when the securities are classified as available for sale or held to maturity.

Olson

Auditors must consider a variety of factors when examining other-than-temporary impairments, Olson said, such as management’s intent and ability to hold a security to recovery, the anticipated recovery period, and the need to quantify an impairment. “As a consequence, this is an area likely to continue to require significant attention and audit judgment,” he said.

And All the Other Details …

The PCAOB alert reminds auditors to be more watchful for fraud, and to ferret out temptations management might face as it weathers the economic storm. That could include threats to a company’s financial stability, pressure on management to meet expectations, or indications that management or directors’ personal situations are threatened. Auditors also are advised to look for opportunities to commit fraud—deficient internal controls, an inattentive board, or an unstable organizational structure, for example—and to plan the audit accordingly.

As for specific accounting issues that may lead to reporting problems, regulators are telling auditors to watch for entities that have provided support to off-balance-sheet structures and therefore should bring them onto the balance sheet. Commitments to provide such support can be found in various contractual arrangements, like leases, supply contracts, service contracts, or derivative contracts, the PCAOB advises.

PCAOB CHAIRMAN REMARKS

Below are excerpts from PCAOB Chairman Mark Olson's speech to the AICPA, noting a few points auditors should watch with extra vigilance.

Fair Value

The debate over fair value continues. We have heard a great deal about the challenges surrounding fair value measurements in the current environment, and we also have heard from a number of investors and others of the important benefits of fair value accounting. The PCAOB is not the accounting standard setter. Instead, through our oversight role, we assess whether auditors apply PCAOB standards appropriately in their auditing of fair value measurements. We have been engaged in a dialogue with auditors throughout the course of last year regarding the audit challenges in this area. Our response, among other things, was to issue an alert last year–as concerns were emerging—to assist auditors with audit issues in this area.

Early next year, the Securities and Exchange Commission will release a study that considers the impact fair value accounting standards have on the quality of financial information provided to investors, as well as the Financial Accounting Standards Board’s process for developing accounting standards, and whether existing fair value measurement guidance should be modified or replaced with an alternative approach I expect that you have heard, or will hear, about the study from SEC representatives today. The PCAOB will provide input into the SEC study, where appropriate, and looks forward to hearing its conclusions. The application of FAS 157 will be a critical issue for audits of 2008 financial statements, and the PCAOB’s inspections in the coming year will review auditors’ compliance with existing audit guidance—as auditors evaluate their clients’ accounting in light of the FASB standard and any applicable guidance.

Other Than Temporary Impairment

Over the last few months, in discussions with issuers and auditors, several have raised the challenges involved in the evaluation of other than temporary impairment. As accountants are aware, accounting rules require a charge to earnings for impairment that is “other than temporary” in held-to-maturity and available-for-sale securities. There is further guidance from the SEC and FASB providing direction regarding “other than temporary” impairment and when a write-down should be accounted for and a realized loss should be recorded. For auditors, there are a variety of considerations with respect to other than temporary impairments, such as management’s intent and ability to hold a security to recovery, the anticipated recovery period, and the need to quantify an impairment. As a consequence, this is an area likely to continue to require significant attention and audit judgment.

Going Concern

Going concern considerations is another topic of many interesting discussions recently with auditors and issuers. As you know, an auditor must consider whether an issuer’s use of the going concern assumption is appropriate, or whether there is substantial doubt as to an issuer’s ability to continue as a going concern that needs to be reflected in the financial statements and in the auditor’s report. Because of the challenges in this area, we will continue to monitor going concern assessments closely.

We know that the year-end audits for 2008 will present these and a number of other audit challenges that I expect will not be limited to the audits of large financial institutions. With the spread of the crisis, auditors need to be alert to risks in other sectors and plan their audits accordingly. The current economic climate will likely require auditors to take a hard look at other areas, such as the collectability of receivables, potential inventory obsolescence, and the impairment of other assets, such as deferred taxes and goodwill. Moreover, as history has shown, fraud risk can also be elevated in times like these, when there may be pressure on earnings. The PCAOB will continue to monitor economic developments closely and engage in discussions with auditors as new issues arise.

Source

Mark Olson’s Speech at the AICPA Conference (Dec. 8, 2008).

The Board also is warning auditors to study meeting minutes, contracts, bank confirmation forms, and other documentation for evidence of promises the company has made that could give rise to lawsuits. Companies could face all kinds of claims related to guarantees to buy back receivables or other property that’s been sold, guarantees of others’ debts, or purchase commitments at prices that are now in excess of market values, to name a few.

Companies may need to take a fresh look at deferred tax assets, or assets on the balance sheet that the company plans to use to offset income tax expense, since they may not be worth as much as originally booked, the Board warns. The PCAOB reminds auditors that FAS 109, Accounting for Income Taxes, takes a hard line on reducing the value of deferred tax assets when confronted with negative evidence.

The Board also warns auditors to be mindful of whether inventory should be written down by changes in market prices or obsolescence, whether receivables may not be as collectable, whether changes in business practice have affected revenue recognition, and whether goodwill and other long-lived intangible assets may require a markdown.

Marc Panucci, associate chief accountant with the SEC, said at the AICPA conference that auditors also need to look for problems with internal controls when they encounter reporting problems. “Management has to determine whether it has the proper controls in operation to address the changes in financial reporting risks,” he said.

He gave the example of impairments of long-lived assets. Those assets might be classified as higher risk if some triggering event requires management to evaluate whether an impairment charge is necessary, he said. That’s fine, but the company and auditors should assess whether they have the proper controls in place to ensure that process happens.

The design of internal control might also be affected by restructuring or employee terminations, Panucci said, so companies and auditors need to be alert to whether controls have been addressed through such changes.

Carmichael

Doug Carmichael, former chief auditor at the PCAOB and now an accounting professor at Baruch College, says major audit firms typically provide similar types of alerts based on their specific audit work. “They can be more focused because they can identify things that have been problems for the specific firm as raised in internal and external inspections of audits,” he said. “The PCAOB cannot be that specific, but nevertheless the general advice should be helpful.”