PCAOB Inspections Reveal Problems; Board Way Behind

One-third of the limited number of inspection reports so far published by the Public Company Accounting Oversight Board have identified deficiencies in select audit engagements. In two cases, reports note that the inspection process ultimately led to an issuer’s restatement of financials.

Fewer than a dozen inspection reports completed in 2004 have been posted online so far by the PCAOB (see box at right). Results are being posted online as reports are finalized and ready to be published, a PCAOB spokesperson said.

Though industry reports have focused on the large percentage of firms with deficiencies, industry watchers are even more surprised to hear that the PCAOB is significantly behind its required inspection schedule.

According to final rules adopted by the Board in October 2003—as mandated by Section 104 of Sarbanes-Oxley—the PCAOB must conduct a continuing program of inspections to assess how public accounting firms are complying with the Act and subsequent rule-making and professional standards.

Under the rule, the Board must conduct annual inspections for firms that do the largest volume of audit work—like the Big Four—and "at least triennial inspections" for other firms that do some volume of audit work.

Currently, over 1,400 firms are registered with the PCAOB, and roughly 900 are subject to inspection. However, the Board completed only 99 inspections in 2004. That number includes the eight largest firms that will be inspected every year, and 91 smaller firms subject to inspection every three years.

But the PCAOB inspection pace includes only 10 percent of the eligible firms, and—more importantly—only about one-third the number the Board would need to complete in a year to inspect all firms over a three-year period.

PCAOB spokeswoman Christi Harlan, said the number was low because it was the first full year of inspections, during which there’s been a learning curve for the regulators. Ironically, that's the same reason many public companies cite for hardships related to the internal control provisions of Sarbanes-Oxley.

Failures To Test, Analyze, Document

The PCAOB inspection reports generally contain little detail, as most specific information is kept confidential per PCAOB rules. Public reports address deficiencies in select audit engagements, but not the identity of the audit clients. Public reports also omit any discussion of quality control deficiencies, giving firms a year to correct any shortcomings before they would be made public.

In cases where the PCAOB identified audit problems, the deficiencies were of such significance that “it appeared to the inspection team that the firm did not obtain sufficient competent evidential matter to support its opinion on the issuer’s financial statements.” In such cases, the reports list the specific deficiencies, usually revolving around failures to test, analyze or properly document various inputs to financial statements.

Cunningham

Colleen Cunningham, president and CEO of the Financial Executives International, says she found the reports surprising. “It is my understanding that what is posted is a summary of the findings, and quite frankly, I was surprised that the results of these inspections were so negative,” she said.

In addition, Cunningham says the inspection findings are having a distinct impact on the audit process. “I think the depth that the inspectors reviewed and the negative reports caused a natural behavioral reaction by the auditors,” she said. “Shortly after receiving these reports, our members noticed a significant increase in the scope and breadth with respect to the auditors’ attestation work associated with [Sarbanes-Oxley] Section 404. Hopefully, the inspectors are keeping the goal of restoring investors confidence in mind as they review the auditors’ work.”

Lewis

Colin Lewis, a partner ARC Morgan and an expert on the regulatory environment in Europe, was most intrigued by the revelation of restatements. “I guess it’s illuminating that even when an auditor gives a clean attestation, as was the case in the first place, that could not be relied upon,” he said.

While the public reports do not discuss problems with quality control systems, they make a distinction between when a firm has no such problems to discuss and when the discussion is not provided in the report to give the firm its 12 months to make corrections. If an inspected firm disagrees with the PCAOB’s findings, it has a window of opportunity to appeal to the Securities and Exchange Commission, which oversees the PCAOB, before the Board’s full findings would be published. Any ruling by the SEC is final.

The PCAOB also gives each firm the option to provide a written response that becomes part of the posted inspection report. Fewer than half of those posted online contain responses from the firm.

Lillian Ceynowa, director of the Center for Public Company Audit Firms, an arm of the American Institute of Certified Public Accountants, says accounting firms are pleased to see the reports beginning to appear online. “We were hearing from firms, especially smaller ones, saying we got an inspection but we don’t know what the report will look like,” she said. “Now the firms can see what they can expect to find in the reports.”

You can find links to the most recent inspections in the box above, right, and we'll continue to monitor and track the inspection reports for subscribers.