Grant Thornton Rebuked; Minority Interest Rules; More

The Public Company Accounting Oversight Board has given auditing firm Grant Thornton a stern rap on the knuckles, saying the firm failed in five audits to perform adequate testing on financial statement assertions to support its audit conclusions.

In its first report on a major audit firm from the 2007 inspection cycle, PCAOB inspectors picked apart five Grant Thornton audits performed in 2007 on 2006 financial statements and cited a number of instances where auditors failed to perform adequate audit procedures or failed to document the procedures that were performed.

Grant Thornton says it performed a total of 404 audits subject to PCAOB scrutiny in 2007, but declined further comment on the inspection findings.

For example, the PCAOB said that in one audit the firm didn’t adequately test the revenue and cost of revenue cycles in a number of respects and failed to test certain factors that went into a stock option valuation. In another audit, inspectors said auditors should have tested valuation assertions related to inventory, should have tested data provided to actuaries for use in reporting on benefit plans, and should have scrutinized management’s assumptions in calculating a general reserve in the allowance for doubtful accounts.

In a straightforward comment letter, Grant Thornton pointed out that many of the inspectors’ remarks involve complicated areas of accounting and auditing. “As such, there is a critical need to apply professional judgment when performing audit procedures and reaching conclusions, particularly on the extent of testing and appropriate documentation or the application of accounting principles,” Grant Thornton wrote. “In many cases the professional judgments of reasonable and highly competent people will differ.”

Grant Thornton is one of fewer than a dozen audit firms that issue more than 100 audit reports annually and, therefore, must be inspected every year by the PCAOB. Board Chairman Mark Olson has promised the inspection process will become more risk based and will reflect an acceptance of professional judgments to answer criticisms that the inspection process drives excessive auditing and fears of second guessing.

Several of the Board’s remarks remind auditors that they’re expected to be skeptical about assumptions and underlying data used in financial statement assertions. For example, the Board dinged Grant Thornton in one audit for failing to test historical information and assumptions behind financial projections provided to a valuation specialist. In another, the Board noted that auditors did not test a company’s systems-generated data used to evaluate allowances for loan losses.

Grant Thornton said in its comment letter that it doesn’t necessarily agree with the characterizations of its work. “In certain cases, we agreed to perform additional procedures or improve aspects of our audit documentation in response to the inspection comments,” the firm wrote. “In other cases, we concluded that no additional actions were necessary.”

The firm added that none of its rework results in any change in the original audit conclusions, nor did it affect the final audit report on financial statements.

The PCAOB has published a handful of 2007 inspection reports before Grant Thornton’s on smaller firms that only need to be inspected every three years, and a number of those reports indicated the Board’s inspectors found no audit deficiencies. That was a rare occurrence in earlier inspection cycles.

New Non-controlling Interest Rules Increase Equity

The new approach to accounting for minority, or non-controlling, interests in subsidiary companies will boost stockholders’ equity and net income—and some of those increases will be big enough to skew reported results, according to a recent analysis.

Financial Accounting Standard No. 141R, Business Combinations, and FAS 160, Noncontrolling Interests in Consolidated Financial Statements, were adopted in December and established new requirements for how companies should account for mergers and acquisitions. Also included were changes in how they should account for partial or non-controlling interest in subsidiaries.

Mulford

Old rules established a “mezzanine area” on the balance sheet and income statement for reporting equity and income arising from partially owned subsidiaries, says Charles Mulford, director of the Georgia Tech Financial Analysis Lab. The new standards, however, require companies to include equity and income arising even from the non-controlling or minority interest in the parent company’s total equity and income, with disclosures providing an explanation.

The result, according to Georgia Tech’s analysis, will be increases in net income and shareholder’s equity that may be big enough to produce meaningful new bottom-line numbers. The lab studied existing financial data for 876 public companies to determine how net income and equity figures might change under new accounting rules. Researchers summarized their findings in a report titled “The Effects on Measures of Profitability and Leverage of Recently Enacted Changes in Accounting for Minority Interests.”

The analysis concluded that shareholders’ equity would increase by 2 percent, although 10 percent of companies in the sample would show increases of more than 25 percent. On the income statement, companies would show an increase in continuing operations of 3 percent, but as many as 12 percent of companies would show an increase of 25 percent.

While disclosures should be adequate to explain the differences to investors, Mulford says it will be important for investors to note the differences, because investors and analysts rely so much on equity and net income figures as performance metrics.

“You can’t treat minority interest like you always have,” he says. “They play a role in how you measure leverage and how you measure risk. Companies will look better with this just because of how accounting standards have changed the treatment of minority interests.”

Mulford says that a big change in equity, if not understood in context of the new accounting, would significantly skew the appearance of creditworthiness. “It would be enough to make a creditor think a company’s credit quality has improved when in fact it hasn’t,” he says. “If the reader is careful, all the information is there, but they just have to be aware of how it has changed.”

AICPA’s Advice on Risk Assessments, International Audits

The American Institute of Certified Public Accountants has published some new guidance on applying its new risk-assessment standards on how auditors should evaluate the work of auditors reporting under other national auditing standards.

Landes

“We issue these Q&As from time to time as non-authoritative staff answers,” says Charles Landes, vice president for professional standards and services at the AICPA. The questions spring largely from the professional association’s accounting hotline, he says. “When we see a plethora of questions, that means more people are a little confused, so we put something in writing to help those members.”

The first batch of Q&As—or technical practice aids numbered 8200.05-09—focus on application of Statement on Auditing Standards No. 140-111, Risk Assessment Standards, which the AICPA adopted in 2006. A number of the questions focus on evaluating internal controls as part of the planning and auditing process.

The second piece of guidance, TPA 9120.08, Reliance on Others, focuses on how an auditor should view an audit prepared by a non-U.S. auditor on an entity outside the United States when it falls within the context of a larger U.S. audit. “Because so many firms now are auditing internationally, we’re receiving more and more questions,” Landes says.