The Public Company Accounting Oversight Board (PCAOB) recently issued a information release directed at public company audit committee members. The release aims to provide committee members with information about the nature of PCAOB audit firm inspections and the meaning of reported inspection results, so that audit committees might be in a better position to engage in meaningful dialogue with audit firms about their own inspection results.
The release is made up of three main parts, the first describing the public portion of PCAOB audit firm inspection reports, the second describing the non-public portion and the third offering suggestions about specific topics that audit committee members might address with audit firms about their own PCAOB inspections.
Understanding Audit Firm Inspection Reports
As part of the audit firm inspection process, the PCAOB generates reports about each firm that it inspects. It also generates general reports about trending audit issues and non-firm specific reports about issues that arise in certain categories of inspections.
Firm-specific inspection reports consist of information that the PCAOB is required to publicly disclose and information that it is prohibited from publicly disclosing, but which audit firms themselves may voluntarily disclose (firms which make voluntary disclosures usually do so in the context of audit committee discussions).
The public portion of a firm-specific inspection report discloses whether review of an audit firm’s audit work has identified performance deficiencies that are significant enough to lead PCAOB staff to conclude that the firm failed to obtain sufficient reasonable assurance that a company’s financial statements were free of material misstatement or that a company’s internal control over financial reporting was effectively maintained in all material respects, and, accordingly, that the firm did not have a sufficient basis for issuing an audit opinion.
The release is careful to note, however, that a finding of performance deficiencies in an audit firm’s audit work does not necessarily lead to the conclusion that a company’s financial statements are misstated. In some instances there may not be enough information to reach such a conclusion, in other instances a material misstatement may be discovered, but only after the audit firm goes back and performs additional work in response to PCAOB criticisms. In either case, the release notes that the PCAOB inspection staff does not engage with a company’s management on issues related to financial reporting matters. All the more reason for audit committees to engage with audit firms about such matters.
The public portion of a firm-specific inspection report may also include a firm’s written response to the report, if the firm elects to make that response, or parts thereof, public. In particular, the release addresses three types of responses that firms sometimes put forth which the PCAOB views with skepticism, noting that they may create uncertainty or confusion about the significance or nature of deficiencies identified in a firm’s audit report. Those responses include: (i) characterizing PCAOB criticisms as documentation deficiencies rather than performance deficiencies; (ii) characterizing PCAOB criticisms as differences in professional judgment; or (iii) asserting that criticisms have been addressed in accordance with PCAOB standards.
Lastly, the non-public portion of a firm-specific inspection report addresses criticisms that the PCAOB has regarding a firm’s quality control systems. These criticisms are generally based on performance deficiencies identified in the firm’s audit procedures and other aspects of the firm’s audit practice management. If a firm does not address these criticisms to the PCAOB’s satisfaction within 12 months of the inspection report, they will also be made public.
Talking to Audit Firms About Inspection Reports
Among the primary responsibilities of an audit committee are oversight of a company’s accounting and financial reporting processes and oversight of its financial statement audits. It is in relation to these responsibilities that the PCAOB feels audit committees will derive the most value from discussions with audit firms about inspection results.
But how should audit committees approach such a discussion and what topics should it cover?
Throughout the release the PCAOB emphasizes that audit firms are free to discuss any issues that arise during an inspection process with a company’s audit committee. The release also notes that audit committees should be aware that the PCAOB regularly communicates company-specific inspection information to the Securities and Exchange Commission, including information about auditing deficiencies, possible material misstatements, potential audit firm independence violations and other issues, all of which are first discussed with the company’s audit firm during the inspection process.
As such, the first thing the PCAOB recommends is that an audit committee consider asking its audit firm to advise the committee if its company’s audit is selected for review in a PCAOB inspection and, if selected, to be kept abreast of the areas of the audit being reviewed and concerns being raised by inspection staff about the audit or the company’s financial reporting in general.
Other questions the PCAOB suggests audit committees address include:
- whether anything has come to the audit firm’s attention suggesting the possibility that an audit opinion on the company’s financial statements is not sufficiently supported, or otherwise reflecting negatively on the firm’s performance on the audit, and what if anything the firm has done or plans to do about it;
- whether a question has been raised about the fairness of the financial statements or the adequacy of the disclosures;
- whether a question has been raised about the auditor’s independence relative to the company;
- whether any of the matters described in the public portion of an inspection report on the firm, whether or not they involve the company’s audit, involve issues and audit approaches similar to those that arise or could arise in the audit of the company’s financial statements;
- to the extent any such similarity exists, whether and how the firm has become comfortable that the same or similar deficiencies either did not occur in the audit of the company’s financial statements or have been remedied;
- how issues described by the Board in general reports summarizing inspection results across groups of firms relate to the firm’s practices, and potentially the audit of the company’s financial statements, and how the firm is addressing those issues; and
- what changes the firm has been making to its policies and procedures to address quality control issues indicated by deficiencies in the audit of the company’s financial statements or to reduce the chance that types of deficiencies identified in other audits will arise in audits of the company’s financial statements.
Understanding the PCAOB Inspection Process
The release also includes an appendix that offers an overview of the audit firm inspection process itself. Even if you already have a general idea about how the PCAOB’s inspection process works, the appendix is worth the read if not just for the insight that it offers into how company audits are selected for review and how company-specific information gleaned from a review might be used.
For example, inspections typically focus on companies and financial reporting areas that are at a greater risk of misstatements or auditing deficiencies. Risk factors that the PCAOB considers when selecting an audit for review include, among others, the nature of a company or its industry and a company’s market capitalization. The appendix also identifies some of the circumstances under which the PCAOB will transmit detailed reports about a company, in addition to the inspection report itself, to the Commission or other regulatory or law enforcement authorities.
The full release is reproduced below.
The PCAOB Re-proposes an Auditing Standard Related to Communications with Audit Committees
In a somewhat related vein, on Friday the PCAOB announced an open meeting for Wednesday, August 15th, to reconsider adopting an auditing standard related to communications with audit committees. The initial standard was first proposed on March 29, 2010 and later revised and re-proposed on December 20, 2011.