A recent report from audit regulators finds smaller audit firms are reducing the number of deficiencies spotted by inspectors, even as larger firms have moved in the opposite direction during the past few years.
But don't expect large firms to start looking over the shoulders of their smaller peers. Audit experts say the inspection results don't necessarily mean that smaller firms are making bigger improvements in audit quality, or are doing higher-quality audits than larger firms. In fact, the results may say nothing about audit quality at all, they say.
The Public Company Accounting Oversight Board recently published a report summarizing its inspection findings regarding about 500 U.S.-based firms that each audit fewer than 100 public entities annually. As such, they are required under the Sarbanes-Oxley Act to be inspected by the PCAOB every three years. The firms collectively audit about 4,600 companies with a combined market capitalization of $115 billion. The larger firms—including the Big 4, and the second-tier of four major firms—are inspected annually if they audit more than 100 public companies.
While the smaller firms are lumped into a single category, they vary considerably in size, number, and nature of public companies they audit, said PCAOB member Jay Hanson during a recent media briefing to discuss the report. The report summarized the board's findings from inspections that took place from 2007 through 2010 and found that the smaller firms as a whole reduced their rate of reported “significant audit performance deficiencies” compared to the rates of the prior three-year period, from 2004 to 2006.
The PCAOB found that 44 percent of the firms had at least one significant audit performance deficiency from 2007 to 2010, down from 61 percent of firms that had at least one deficiency in the earlier period. In addition, 28 percent of all audits inspected showed at least one deficiency, compared with 36 percent of all audits inspected in the three prior years.
According to PCAOB member Jeanette Franzel, this marks a modest improvement but not necessarily cause for celebration. Franzel said during the same briefing that the trend is headed in the right direction, but the level of deficiencies is still significant. “Certainly the current level is too high,” she said, although she declined to say what the board would consider to be an acceptable level of deficiency. The common problem areas cited by the PCAOB for smaller firms include many of the same issues that occur most frequently in larger firm reports—revenue recognition, fair value, business combinations, impairments, accounting estimates, and related-party transactions, among others.
The PCAOB is still working on a report it expects to issue later this year that will summarize its most recent inspection findings for the larger firms. The board already issued a report summarizing its concerns about how the large firms are auditing internal control over financial reporting, but the next report will look broadly at the other financial statement audit concerns.
Even before the report is published, however, it's easy to expect it won't be kind to audit firms, given the tone of the individual inspection reports that have been issued on each of the major firms for the past two inspection cycles. The board began flagging a significantly increased number of audit failures across all major firms in 2010 inspection reports, and the 2011 reports have offered no signs of improvement.
“Deficiencies are coming down. It's sending the right message that regulation and oversight coming out of Sarbanes-Oxley would appear to be working. I view that as positive.”
—Scott Peterson,
Managing Director,
Warbird Consulting Partners
Some say the fact that smaller firms are showing improvement indicates that regulation of audit firms is effective. “Deficiencies are coming down,” says Scott Peterson, managing director at Warbird Consulting Partners. “It's sending the right message that regulation and oversight coming out of Sarbanes-Oxley would appear to be working. I view that as positive.”
Gaylen Hansen, a partner with Colorado regional firm EKS&H, which is inspected every three years, says smaller firms have benefitted from the forums the PCAOB has conducted the past several years targeted at small firms. “I think they've listened closely to what's coming out of the PCAOB, and they're serious about getting it right,” he says.
Bigger Firms, Bigger Problems
Yet Hansen agrees that the inspection results don't necessarily correlate to audit quality. “It's unfortunate that these inspection reports tend to be looked at as scorecards,” he says. “They are observations as of a particular point in time. I would expect the larger firms to have more deficiencies because their clients are larger and their audits are more complex. It's hard to compare why there are more deficiencies with larger firms than smaller ones.”
COMMON DEFICIENCIES
Below are PCAOB observations of audit areas with common deficiencies.
Although audit deficiencies can occur in many different areas of an audit, inspections staff have identified certain areas in which deficiencies occurred more frequently. This report includes general descriptions of deficiencies in certain such common problem areas, along with specific examples from inspection reports. Audit areas with frequent findings in the 2007-2010 period related to:
auditing revenue recognition (deficiencies also discussed in prior reports);
auditing share-based payments and equity financing instruments (deficiencies also discussed in prior reports);
auditing convertible debt instruments (new category in this report);
auditing fair value measurements (deficiencies also discussed in prior reports, but re-categorized);
auditing business combinations and impairment of intangible and long-lived assets (deficiencies also discussed in prior reports);
auditing accounting estimates (deficiencies also discussed in prior reports, but re-categorized);
auditing related party transactions (deficiencies also discussed in prior reports);
use of analytical procedures as substantive tests (deficiencies also discussed in prior reports, but re-categorized); and
audit procedures to respond to the risk of material misstatement due to fraud (new category in this report, but previously the subject of a separate report).
Source: PCAOB.
Bob Hirth, managing director for consulting firm Protiviti, says smaller firms do fewer audits, which perhaps enables them to provide more individual focus on the problem areas uncovered by the PCAOB. It's also possible the firms are auditing smaller companies with issues that are not as complex, making it easier to grasp the issues and get them right, he says. “The large firms are clearly dealing with huge, complex organizations and complex transactions that in many cases are very difficult to address,” he says.
John McGonigal, managing director at audit firm Smart & Devine, cautions against paying too much attention to the data emerging from PCAOB reports. “We want to see the numbers come down, but the area of focus is the important thing,” he says. “The PCAOB and the firms are getting smarter, and the focus does change and evolve over time.” The individual and the summary reports give audit firms good guidance on where to focus their improvement efforts, and that's more important than the numbers, he says.
Audit and accounting professors also agree there's little comparison among larger and smaller firms when it comes to audit quality, and the PCAOB reporting process doesn't reflect it. “It's like apples to oranges,” says Accounting Professor Dana Hermanson of Kennesaw State University. “And perhaps more like apples to toasters.” Following its risk-based approach to inspecting firms, the PCAOB digs deep into large firms and their complex audit work. “For smaller firms with only a handful of issuer clients, there may not be that many high-risk audit settings to inspect,” he says.
Scott Showalter, a professor at North Carolina State University and a former partner at KPMG, says the profession has yet to define audit quality, but it's clear in his mind the number of PCAOB findings in an inspection report doesn't equate to audit quality. “The inspection process is significantly more thorough than it was 10 years ago,” he says. “Because they're doing a better job doesn't mean the profession is doing a worse job.”
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