Smaller audit firms recently received a heads-up from audit regulators on where they should focus their attention in the next audit cycle—which also gives chief financial officers hints on where they should be focusing attention themselves.
The Public Company Accounting Oversight Board issued a report summarizing its findings from three years of inspections at nearly 500 audit firms that individually audit no more than 100 public companies each. The report tells auditors at smaller audit firms to pay more attention to their audit procedures around 11 core accounting areas. Not surprisingly, the hot spots are typically associated with complicated rules and financial misstatements that lead to a restatement.
Specifically, the PCAOB said it found the greatest problems in revenue recognition, related-party transactions, equity transactions, business combinations and impairment of assets, going-concern considerations, loans and accounts receivable, service organizations, use of other auditors, use of the work of specialists, auditor independence, and concurring partner reviews.
Those sore points are similar to the issues inspectors generally have found with larger audit firms, says George Diacont, director of registration and inspections at the PCAOB. The Board thought it helpful to summarize the findings in a broad report for smaller firms, so inspectors might share their overall findings more directly.
“The report gives the opportunity for the Board to speak plainly about the market as a whole,” Diacont says. “The Board can’t speak out as directly or in plain words in individual reports. This gives accounting firms a chance to peak over the shoulder of the inspection team not just for an individual firm but for other firms as well.”
Diacont says the 11 accounting issues highlighted in the report aren’t definitively connected to recent trends in restatements, but the casual observer certainly would see a link. “These 11 areas were selected because we’ve determined there were significant audit issues tied to these, and any one of these issues could result in restatement, some more likely than others,” he says.
McLaughlin
John McLaughlin, senior managing director at Smart Business Advisory and Consulting, says the report will be useful for audit firms and their clients to ensure they’re focused on areas of the most concern to regulators. While the report focuses on audit deficiencies, it can be instructive to CFOs as well because it also spotlights where companies are having trouble applying U.S. Generally Accepted Accounting Principles, he says.
“Certainly auditors are not executing sufficient auditing procedures around these more complicated accounting areas,” McLaughlin says. “But then the natural question would be: Did the companies get their GAAP right? My suspicion is they didn’t. If they did, the auditors would have been able to audit it more succinctly.”
To McLaughlin’s thinking, the report provides a wake-up call to smaller companies still dragging their feet in complying with Section 404 of the Sarbanes-Oxley Act. Starting with the 2008 reporting cycle, Section 404 will require smaller public companies to assess and report on their internal control over financial reporting (although small filers won’t be required to get an audit opinion on the same report until the following year).
McLaughlin says many of the accounting issues addressed in the report can be remediated with better internal controls, but many small companies are still putting off internal control documentation and improvements, hoping regulators will give them yet another delay in the Section 404 compliance deadline. The report telegraphs the message that such wishful thinking is a bad idea.
“The auditors are being warned through this report that they’d better start executing better auditing procedures,” he says. “Auditors are going to become more vigilant.”
Beyond GAAP and Internal Controls
Now that the PCAOB has adopted Auditing Standard No. 5 to replace Auditing Standard No. 2—essentially closing the books on new audit rules governing the internal control audit—the Board is at an apparent crossroads, looking for direction on where to turn next.
To that end, the PCAOB assembled its Standing Advisory Group recently to develop suggestions on how the Board should prioritize its work these days, as the Securities and Exchange Commission ponders whether to allow foreign and domestic issuers to file financial statements according to International Financial Reporting Standards.
The Board asked its advisers to weigh the implications for auditing if (or more likely, when) IFRS sits shoulder-to-shoulder in capital markets alongside U.S. Generally Accepted Accounting Principles. It seems hard to know where to begin.
Richson
“There are material differences between IFRS and U.S. GAAP, and in some cases IFRS doesn’t have standards at all,” says Cynthia Richson, an investor advocate and president of Richson Consulting Group. “It would make auditing particularly difficult in those circumstances. It’s only going to add to investor confusion.”
Joe Carcello, director of research at the Corporate Governance Center of the University of Tennessee, says he wonders how auditors will proceed on issues where IFRS offers no specific guidance. “I assume they’ll go back to U.S. GAAP because that’s all that’s there,” he says. “But the company could argue, ‘We don’t have to follow that. The SEC’s given us the option of using IFRS.’”
Kueppers
In fact, the audit issues around allowing IFRS as a financial reporting system in the United States are much bigger, contends Robert Kueppers, deputy CEO at Deloitte & Touche. “We have one generation of people, maybe more, who were trained an their skills are based on the rules and guidance we have today,” he says. “If we’re really going to transition and take it all away, where principles-based standards rule the creation of financials statements, that’s a big, big change in terms of how we work with our client as auditor.”
Given the increased amount of judgment such a system would require, Kueppers worries about increased tension between auditors and their clients. “As awkward as it is today to have clients say, ‘Tell me where it says I can’t do that,’ we’re going into a much less definitive space when we say, ‘I just disagree with you; my judgment versus yours,’” Kueppers says. “If you disagree to the point where you’re not willing to sign the opinion, you’ve got a bit of a standoff. There’s general support for more principles, but there are many who are ill-prepared to live in that world.”
On the corporate side, Arnold Hanish, chief accounting officer at Eli Lilly & Co., says he believes the shift to IFRS and a principles-based approach is achievable because it will call on auditors to assure a consistent application of a principle within a given company. “From an auditing standpoint, whatever the definition of the principle, assure it is consistently applied year in and year out to the same kinds of transactions and activities, and make sure it’s documented and disclosed,” he says. “Then you shouldn’t have any concerns.”
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