The Public Company Accounting Oversight Board (“PCAOB”) recently published a communication to audit committees, its new Audit Committee Dialogue, the first of a series designed to provide audit committees with helpful insights from the PCAOB’s inspections of public company auditors. 

The PCAOB provides oversight of the work of accounting firms that audit publicly traded companies and periodically inspects accounting firms for compliance with the PCAOB’s rules and auditing standards.  Each year, the PCAOB conducts hundreds of inspections focusing on how the accounting firm conducted selected audits and the effectiveness of the accounting firm’s quality control policies and procedures. Inspections are designed to identify if there are deficiencies in how accounting firms perform audits and if there are weaknesses in quality controls over public company auditing.

In this first publication of Audit Committee Dialogue, the PCAOB identified several key recurring areas of concern, as well as new risks that it is monitoring, and provided helpful sample questions for audit committees to discuss with their accounting firms.  In addition to audit committees using these questions to assist with their oversight responsibilities, parties performing auditor and financial due diligence of public companies, including underwriters, lenders and their counsel, may wish to pose similar questions during their due diligence investigations. The sample questions may also be helpful to company management and its audit firm in developing the audit plan for the upcoming year.  The PCAOB has previously provided audit committees with sample questions to ask their accounting firms about PCAOB inspections, which remain relevant.

Recurring Areas of Concern

PCAOB inspections have identified frequent significant deficiencies in the following areas:

• Auditing over internal control over financial reporting (“ICFR”)

• Assessing and responding to risks of material misstatement 

• Auditing accounting estimates, including fair value measurements

• In cross-border audits, deficient “referred” work – work performed by other audit firms and sued by the signing audit firm

ICFR

Inspections have often found that the auditor did not perform sufficient procedures to test the effectiveness of ICFR or to sufficiently evaluate if the identified ICFR deficiencies constituted material weaknesses.  In particular, the PCAOB notes that audits of ICFR do not achieve their objectives if material weaknesses remain undetected until a material misstatement occurs and highlights the existence of the weakness, but points to evidence that delayed identification of material weaknesses frequently occurs. For example, of reported material weaknesses in 2012 and 2013 audit reports, 77% were in connection with, or after, the issuer’s disclosure of a related financial reporting error that required a restatement or adjustment.  Sample questions to ask the auditors include:

• What are the points within the company’s critical systems processes where material misstatements could occur?  How has the audit plan addressed the risks of material misstatement at those points? How will you determine whether controls over those points operate at a level of precision that would prevent or detect and correct a potential material misstatement?

• If the company or the auditor has identified a potential material weakness or significant deficiency in internal control, what has been done to probe the accuracy of its description? Could the identified control deficiency be broader than initially described? Could it be an indication of a deficiency in another component of internal control?

Material Misstatement

The PCAOB notes that auditors do not always properly identify the audit risk or respond effectively to risks.  The report highlights that when a company’s business and environment change, the audit plan should address those changes. Further, integrated audit plans for large companies sometimes provide for insufficient procedures at certain locations or business segments that are significant contributors to the results of operations and that involve higher risk of material misstatement.  In particular, the PCAOB’s findings indicate that audit firms may rely on entity-level controls but fail to sufficiently test those controls.  Sample questions to ask the auditors include:

• Which audit areas are designated as having significant risks of material misstatement and what audit procedures are planned to address those risks?

• In your view, how have the areas of significant risk of material misstatement changed since the prior year? What new risks have you identified? What is your process to make sure that it identifies new or changing risks of material misstatement and tailors the audit plan appropriately? How is the engagement partner involved?

• How does the audit plan address the varied risks in a multi-location environment?  If you assume that controls are uniform across multiple locations, how do you support that assumption?

Estimates

Estimates warrant significant audit attention because they involve subjective factors and judgments, which make them susceptible to management bias and material misstatement.  The PCAOB has identified a large number of significant deficiencies in the auditing of accounting estimates over many years in areas such as revenue, allowances for loan losses, inventory reserves, fair value measurements, tax-related estimates and, particularly when economic conditions deteriorate, asset impairments.  Sample questions to ask the auditors include:

• How do you obtain a thorough understanding of the assumptions and methods the company used to develop critical estimates, including fair value measurements?

• How have you assessed whether management has identified all separable intangible assets that, while not included in the financial statements, must nevertheless be valued in connection with assessing goodwill for possible impairment (e.g., customer-related intangibles and in-process research and development)? Have you considered contrary information that suggests the existence of such assets that management has not identified?

Referred Work in Cross-Border Audits

PCAOB inspectors have found significant problems in more than 40% of the “referred” work engagements of non-U.S. firms in connection with audits of multinational companies.  The deficiencies arose in critical areas such as revenue, inventory and controls and often arose where those areas were significant to the issuer’s financial statements or ICFR. Sample questions to ask the auditors are as follows:

• How does the engagement partner assess the quality of the audit work performed in other jurisdictions? Were the firms that participate in the audit recently inspected by the PCAOB? If yes, what does the engagement partner know about the results?

• How do you review the work? Do you visit other countries to review the audit work done there? What steps do you take to make sure that the work is performed by persons who understand PCAOB standards and U.S. GAAP and financial reporting requirements?

• As part of planning the audit, do you consider performing additional steps if the referred work is in an area that has recently been the subject of a significant number of PCAOB inspection findings?

Potential Emerging Risks

The PCAOB also identified potential emerging risks that are being incorporated into its inspection planning for 2015: increase in merger and acquisition activity, falling oil prices, undistributed foreign earnings, and maintaining audit quality when growing other business lines.

Mergers and Acquisitions

The PCAOB has identified that audit team members may lack substantial experience in M&A and auditing business combinations, leading to an increased risk of deficiencies when M&A activity is on the rise. For example, one problem has been a failure to detect that management had not identified all of the intangible assets that needed to be valued, such as customer-related intangible assets. A sample question for auditors follows:

• Do you have the expertise necessary to address the audit issues that may arise from the reporting requirements related to business combinations as well as other effects of a business combination that may bear on financial reporting, such as the effects on segment reporting? If not, how will the engagement team obtain or develop that expertise?

Falling Oil Prices

The PCAOB plans to examine how auditors approach the risks of material misstatement resulting from changes in oil prices, noting that falling oil prices impact companies in a number of industries and may affect valuation and impairment judgments and the collectability of loans and receivables.  Sample questions to ask the auditors include:

• Have declining oil prices been identified as a risk factor and changed your approach to testing related accounting estimates? Will you require different evidence to support any assumptions and estimation methods used by the company that may depend on a certain level of oil prices?

• How might the estimated effects of falling oil prices be factored into estimates of the company’s future undiscounted net cash inflows used in the assessments of possible impairments of long-lived assets? How might those effects affect the possible need for recording or adjusting a deferred tax valuation account?

Undistributed Foreign Earnings

The PCAOB has identified problems with firms’ ability to audit management’s assertions, as well as in auditing income tax accounting and related disclosures regarding undistributed foreign earnings that U.S. companies have asserted will be indefinitely reinvested outside the United States and therefore are not subject to U.S. taxes.  The PCAOB also highlighted that, if a company faces legal liability or sanctions based on a strategy developed by its audit firm, the audit firm’s independence and ability to continue as the auditor could be compromised.  Accordingly, the PCAOB suggests that audit committees may find it useful to maintain and monitor a list of past tax strategy engagements for potential effects on the audit.  Sample questions to ask the auditors include:

• What is the nature and extent of audit evidence gathered related to management’s assertions about indefinite reinvestment? Is there contrary evidence? If so, how did you consider the contrary evidence?

• Have you considered whether the company’s MD&A disclosure, including disclosure regarding liquidity and capital resources, is consistent with, or contradicts, management’s indefinite reinvestment assertion?

Audit Firm Growth and Expansion

The PCAOB notes that the largest audit firms are experiencing an increase in the percentage of revenue from advisory services and a decrease in the percentage of revenue from audit services in the recent past as firms have acquired consulting firms or otherwise grown their consulting practices.  It has identified a concern about the effects these developments may have on audit quality.   A sample question for auditors follows:

• Has your engagement team been affected by any changes in the firm’s business model? Has the engagement team lost key auditors or specialists to other lines of business? How are you ensuring that the quality of the audit team will remain high over time?