PCAOB – Seeing The Big 4 Through Rose Colored Glasses

/18 Comments/in , , , ,

Unfortunately, I was unable to attend the AICPA National Conference on PCAOB and SEC Developments  in person.  As much as I would have loved to be there live, to ask questions and, perhaps, walk all over the wafflers with my Manolos, it’s not always possible.  In this case it may have been just as well.  

“Is he talking about the same firms?”

In the spirit of Saturday Night Live and the famous parody of Sarah Palin’s interview with Katie Couric, where Tina Fey (as Governor Palin) got laughs by repeating no more than exactly what Governor Palin actually said….
From Mark Olson’s speech:
“Times have certainly changed — as we are now in the midst of a well-documented global financial crisis. For these difficult times, the supervisory approach is more important than ever to help us achieve our important mandate of improving audit quality….”

From the  Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections…:

“…certain trends have emerged: 


• Inspectors continue to find deficiencies in important audit areas, both established and emerging. These areas include critical and high-risk parts of audits, such as revenue, fair value, management’s estimates, and the determination of materiality and audit scope. These deficiencies occurred in audits of issuers of all sizes, including in some of the larger audits they reviewed. 


In some cases, the deficiencies appeared to have been caused, at least in part, by the failure to apply an appropriate level of professional skepticism when conducting audit procedures and evaluating audit results. In addition, even in areas where inspectors have observed general improvement, deficiencies continue to arise. The inspectors will continue to focus on the significant areas where they have encountered deficiencies…” 


From Mark Olson’s speech:
“I will share some observations from the inspections of large audit firms and address some aspects of the firms’ remediation efforts (under Sarbanes Oxley, remediation is the voluntary action taken by a firm to fix defects identified during the inspection). 

The inspection and remediation information to date demonstrate that, while the PCAOB continues to in\dentify audit deficiencies in the course of its inspections, firms are making a number of efforts to remediate these deficiencies. This is true for larger and smaller firms and is an indication that the PCAOB inspection program is making a positive impact.”

And…

“The PCAOB’s inspection program goes beyond simply assessing compliance with standards that govern the performance of specific audits. It has evolved into a model that scrutinizes key factors, such as client selection, compensation practices, leverage, and the overall management approach, including a measure of a firm’s tone-at-the-top…” 

From the Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections…:

“Pursuant to the Act, inspection reports include a portion that is available to the public. The public portion contains descriptions of deficiencies noted (ordinarily on an audit-by-audit basis) that reach a certain level of significance. 


The threshold for inclusion in the public portion of an inspection report is that the deficiency is of such significance that it appeared to the inspection team that the firm, at the time it issued its audit report, had not obtained sufficient had not obtained sufficient competent evidential matter to support its opinion on the issuer’s financial statements. ( In some cases, when an inspection team identifies serious deficiencies,the matter is referred to the Board’s Division of Enforcement and Investigations for its consideration and action, as appropriate. )

Pursuant to the Act, if an inspection gives rise to concerns about a firm’s quality control system, the issues are described in a nonpublic portion of the report. While not every deficiency in auditing that the inspection team observes may be indicative of a quality control defect, certain deficiencies, or repeated instances of a similar deficiency, may support the conclusion that such a defect may exist. Accordingly, the nonpublic portion of these reports may include descriptions of certain auditing areas or procedures where the firm’s quality controls may need improvement. 


These descriptions can be based both on deficiencies that met the level of significance to be included in the public portion and other potentially consequential deficiencies. The nonpublic portion of the reports also may include criticisms of the firm’s quality controls related to the specific areas of the quality control systems that were reviewed.

 
The Act provides that any discussion of defects in, or criticisms of, a firm’s quality control system that are in the nonpublic portion of an inspection report will remain nonpublic, unless the firm fails to address them to the Board’s satisfaction within 12 months of the date of the issuance of that report. The process for addressing the defects or criticisms is referred to as remediation. To date, all of the domestic annually inspected firms have submitted to the PCAOB evidence of their remediation of defects noted in their 2004 and 2005 inspection reports.”

From Mark Olson’s speech:

“You can be assured that PCAOB inspectors will continue to focus on the significant areas where they have encountered deficiencies, as well as new areas that emerge as economic conditions and accounting and auditing guidance continue to evolve.

While it is critical to keep in mind that continued focus on avoiding deficiencies in these important audit areas is called for, we should not ignore the encouraging signs that have appeared. For example, in certain areas, we are seeing fewer deficiencies than we did in the earlier years of our inspection program. This trend is apparent in a few well-established audit areas, such as the confirmation of accounts receivable…”


From the Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections…:

“In most audits, revenue is an important area of focus. Material misstatements due to fraudulent financial reporting often result from misreporting of revenue.  Inspection reports on domestic annually inspected firms have described audit deficiencies related to firms’ failures to audit revenue sufficiently, and these failures have related both to basic principles of revenue recognition, such as the timing of booking revenue in connection with the sale of goods, and to revenue issues that are encountered when issuers have complex revenue-generating transactions or processes. 


To assess the existence of amounts due from customers, firms commonly request that customers confirm in writing amounts due to the issuer as of a certain date.  When amounts due from customers are derived from revenue-generating transactions, these tests also provide evidence about certain aspects of the related revenues. 

Inspectors identified instances where firms failed to (a) perform appropriate procedures when confirmation replies indicated discrepancies between the amounts that the customer indicated were due and the amounts the issuer indicated were due, or (b) perform appropriate alternative procedures when customers failed to respond to requests for confirmation.  

In some instances, firms failed to perform other appropriate substantive procedures to test the recorded amounts due from customers when the firms had chosen not to request confirmations because they had deemed the use of confirmations to be ineffective…”

From Mark Olson’s speech:

“Additional evidence of progress came from inspection procedures that we employed in recent years. In these procedures, inspectors selected certain audits that they had previously inspected where they had found significant deficiencies, and then reviewed the more recent audits – of the same issuers by the same auditing firms – in order to see whether the auditors continued to commit the same errors. 


In the majority of these specific audits, PCAOB inspectors observed improvements in the auditing procedures where inspectors had previously identified deficiencies. It is significant to note that this occurred both when the auditing firm had agreed with our prior observations, and when the firm had expressed disagreement with the existence of a deficiency…”

From the Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections…:

“Certain deficiencies raised questions about the sufficiency, rigor, and effectiveness of the supervision and review activities of engagement managers and partners, including the thoroughness with which they reviewed audit documentation. 


In some cases, it appeared that the engagement partners had not devoted sufficient attention to their responsibilities, or their commitment to engagements did not appear to correlate with the risk that the engagements presented. Certain of the deficiencies described above were in areas that required management’s most difficult or complex judgments, and thus were in areas where the partners and managers should be devoting significant attention…

Further, in some instances, the inspection teams observed that the concurring review partner for an audit for which there were deficiencies committed a relatively small amount of time, compared to the firm’s overall commitment to the audit. These observations suggest that there may have been weaknesses in the applicable firm’s policies and procedures, or the application of them, in this important area. 

Certain of the deficiencies also raised concerns about the sufficiency of firms’ application of professional skepticism and objectivity in some audits, including some of the larger audits inspected. In some instances, firms did not sufficiently test or challenge management’s forecasts, views, or representations that constituted critical support for amounts recorded in the financial statements. In many of these instances, they limited their audit procedures to obtaining management’s oral representations…”   

From Mark Olson’s speech:

“I will briefly highlight two of the five remediation areas discussed in the report. First — partner evaluation and certain other aspects of firm structure, organization, and management. In this area, we have made the following three observations:

One, firms have taken steps to more closely align audit partner compensation with audit quality, and to place a consistent emphasis on professional excellence.   


Two, firms have also tried to diminish the chances that the economic priorities of the audit business can inappropriately influence decision-making on technical accounting and auditing matters.  

Three, some firms have created national- or regional-level positions and/or committees to promote and monitor audit quality issues such as (a) training, (b) audit tools and techniques, (c) client acceptance and retention, and (d) auditing fair value….

We have also seen significant changes to some firms’ internal inspection programs. These programs are, of course, an important element in the firms’ monitoring systems. Some firms have moved from a part-time reviewer model to one where many of the internal inspectors are assigned to that task on a full-time, year-round basis. Other firms increased the time commitment of their part-time internal inspectors in an effort to drive consistency in their own inspections.

All of these changes are positive, but work remains to be done.” 

From the Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections…:

“In some instances, inspection teams found various matters that provided cause for concern about firms’ partner evaluation and compensation processes. These included situations where audit quality did not appear to be a significant factor in the partner evaluation process or its role in the process was unclear. 


In some cases, partners received high ratings on technical competence even though there were significant deficiencies in their audits that were reviewed in the firm’s internal inspection program or in the PCAOB’s inspection program. In addition, inspectors observed situations where concurring review partners or internal inspectors were not held accountable for failing to identify significant deficiencies in audits they reviewed and where partners’ quality ratings were affected significantly by the results of client satisfaction surveys or the profitability of their audits or their ability to increase revenues.

For some firms, the PCAOB inspectors noted that technical personnel who were responsible for audit quality were reporting to and evaluated by those whose responsibilities included maintaining and growing the audit practice. This may compromise the objectivity of the technical personnel and may increase the possibility that decisions on technical accounting and auditing matters may be inappropriately influenced by compensation considerations and the firm’s desire to grow the size and profitability of its audit practice. 


In other instances, the technical personnel also had significant client responsibilities that may have led to conflicting priorities and to not having enough time to fulfill their responsibilities for audit quality.”  

From Mark Olson’s speech:

“As you know, an auditor must consider whether an issuer’s use of the going concern assumption is appropriate, or whether there is substantial doubt as to an issuer’s ability to continue as a going concern that needs to be reflected in the financial statements and in the auditor’s report. Because of the challenges in this area, we will continue to monitor going concern assessments closely.

We know that the year-end audits for 2008 will present these and a number of other audit challenges that I expect will not be limited to the audits of large financial institutions. With the spread of the crisis, auditors need to be alert to risks in other sectors and plan their audits accordingly. 


The current economic climate will likely require auditors to take a hard look at other areas, such as the collectability of receivables, potential inventory obsolescence, and the impairment of other assets, such as deferred taxes and goodwill. Moreover, as history has shown, fraud risk can also be elevated in times like these, when there may be pressure on earnings. The PCAOB will continue to monitor economic developments closely and engage in discussions with auditors as new issues arise.

From the Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections…

“Auditors are responsible for evaluating the reasonableness of accounting estimates made by issuers in the context of the financial statements taken as a whole, and their objective when performing this evaluation is to obtain reasonable assurance that (a) all accounting estimates that could be material to the financial statements have been developed, (b) those accounting estimates are reasonable in the circumstances, and (c) the accounting estimates are presented in conformity with GAAP and are properly disclosed. 

To audit an estimate, a firm should first gain an understanding of how management had developed the accounting estimate and then perform one or a combination of the following: 


(a) review and test the process management used to develop the estimate, 

(b) develop an independent expectation of the estimate to corroborate the reasonableness of management’s estimate, or 

(c) review events or transactions occurring after the period covered by the financial statements and before the date of the auditor’s report. 

Inspectors observed that the firms often chose to evaluate accounting estimates by reviewing and testing management’s process for developing the estimate. In these instances, deficiencies involved failures to 


(a) obtain an understanding of the methodology management had used to develop the accounting estimate, 

(b) test the reasonableness of management’s key assumptions, including performing tests beyond inquiries of management, or 

(c) test the data underlying management’s calculation of the accounting estimate.

In other cases, firms chose to develop an independent expectation of the estimate. Inspection teams observed that, when this approach was chosen, firms sometimes failed to support the assumptions or test the underlying data they used in developing the independent expectation.”   

From Mark Olson’s speech:

“The PCAOB will provide input into the SEC study, where appropriate, and looks forward to hearing its conclusions. The application of FAS 157 will be a critical issue for audits of 2008 financial statements, and the PCAOB’s inspections in the coming year will review auditors’ compliance with existing audit guidance — as auditors evaluate their clients’ accounting in light of the FASB standard and any applicable guidance.”

From the Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections…

“Inspection teams observed instances of inadequate testing by firms of fair value estimates in connection with firms’ evaluation of the possible impairment of goodwill and other long-lived assets. The inspectors observed instances where firms had not tested the reasonableness of management’s significant assumptions and the underlying data that the issuers had used in valuation models. 


As a result, the auditors did not have sufficient evidence to conclude on the issuers’ estimates of fair value. 

For example, the inspectors identified instances where significant assumptions, such as the future revenue growth rate, operating margins, discount rates, and terminal values, were either not tested at all, or were tested only through discussions with management. In some of these situations, management’s assumptions were that revenues would increase significantly in the near future despite evidence to the contrary, such as recent declining revenue trends or known increases in competition in the issuer’s industry. 

Inspection teams also observed instances where firms had not challenged management’s conclusions that assets did not need to be tested for impairment, despite evidence of impairment indicators.

Inspection teams also observed instances where firms’ procedures to test the fair values of financial instruments, including derivative instruments, loans, and securities, were inadequate. In these instances, deficiencies included 

(a) the failure to gain an understanding of the methods and assumptions used to develop the fair value measurements of financial instruments that were illiquid or difficult to price, 

(b) the reliance on issuer-supplied pricing information without obtaining corroboration of that information, and 

(c) the reliance on confirmation responses from third parties or counterparties that included disclaimers as to their accuracy and appropriateness for use in the preparation of financial statements.
Thanks for subscribing to the re: The Auditors feed. Please tell a colleague about the blog. Drop me a line at fmckenna@mckennapartners.com if you have a comment or complaint.
18 replies
  1. Anonymous
    Anonymous says:

    This post is very hard to read, extremely long, and lacks a conclusion. It demonstrates exceptional copy and paste abilities, as well as sold use of colors.

    I rate it a 2.5 on a scale of 1 to 10.

  2. Anonymous
    Anonymous says:

    Hi Fran,

    Nice snark, there.

    Do you know what percentage of SEC and PCAOB staff are former employees of the Big 8 – 4 firms? I don’t know but I bet it’s a significant percentage, with perhaps some impact on the free passes the firms seem to get.

    Do you know how many ex-SEC and ex-PCAOB employees are hired into the Big 4 firms? I don’t know but I bet it’s significant, with perhaps some impact on the free passes that the firms seems to get.

    The power of the revolving door should not be overlooked.

  3. Independent Accountant
    Independent Accountant says:

    Francine:
    I have long advocating disbanding the PCAOB. I believe it is a sham. Further, I have no confidence in the competence or integrity of the PCAOB technical staff.

    Anonymous:
    The majority of PCAOB technical staff are “former” Big Four partners. They are as “former” as Hank Paulson is a “former” Goldman Sachs CEO. The revolving door, revolves once more. Few SEC employees, except at a very senior level are former Big Four CPAs. CPAs go from the SEC to the Big Four. Hence, to keep their “options open”, SEC staffers go easy on the Big Four and hard on smaller CPA firms.

  4. Anonymous
    Anonymous says:

    Another bitter and ironic post. Seems Fran has cast her clothes off and shown us what she is – a bitter and twisted failed Big 4 consultant – rather than watching the audotirs why not just admit it she just wants to slag off the auditors. The reasons for said slagging seem to become more and more tenuous with each passing week.

    Sorry Fran your posts are getting longer and more bitter against your former Big 4 buddies – maybe less quantity but higher quality could be your new year resolution?

  5. Francine McKenna
    Francine McKenna says:

    I’ve posted these more personal attacks even though I normally might not. I was encouraged by some in the past to let the trolls speak for themselves.

    But I’m incredulous (and giggling at the thought) that a post with so few of my own words, that basically repeats verbatim the obvious doublespeak baked into two PCAOB documents, is generating such venom.

    Interestingly, I received praise for this post by telephone today from the President of one of the nation’s largest CPA societies and a link to this post by Yves Smith, the author of the highly reputable and noted blog, Naked Capitalism.

    I’m rubber you’re glue. Your words bounce off me and stick to you. :)))

  6. Where's the beef?
    Where's the beef? says:

    Anon@3:15

    What’s with people today? I don’t see anything wrong with this post other than it being slightly difficult to read (Francine has had a few of those in the past). Maybe that’s the problem. But i think the content is highly relevant. Isn’t it ironic of you to post a bitter comment accusing Francine of being bitter? I note that in this and your comment in the other post that you haven’t actually said what the problem with the post is. Do you know the meaning of the term ‘constructive criticism’? Looks like you ‘re one of those Big 4 loyalists who don’t want to admit that your industry is basically a sham that pays you comfortably and enables you and yours to live well.

  7. Where's the beef?
    Where's the beef? says:

    Actually, on a more relevant note, i read this post and noted how time immemorial, the same issues keep cropping up in audit deficiencies. It leads me to bring up an oft-ignored aspect of why the audit profession is such a sham – the human factor. People just aren’t good auditors, and when you try and make them such, you get hated and branded in the office. Nobody likes being the big bad cop or the nerd in the office. I was a victim of this and some people hate me to this day despite the fact that we ‘ve all changed employers. Heck, it can even come up in your annual review and dent your career. HR and your superiors may claim that you lack the ‘people skills’ and ‘soft skills’ to make it to the very top. As a result, many people (me included) end up going ‘easy’ on members of the audit team, resulting in deficient audits. The other thing is, like i ‘ve mentioned before in other posts, audit is a tough profession, requiring a sharp, keen, imaginative, abstract thinking mind that most people simply don’t possess.

  8. Independent Accountant
    Independent Accountant says:

    Where’s the Beef:
    I have a number of posts at my blog with the title, “31 More Years”, on this or related themes. This is such old news, it’s no longer news.

  10. Where's the beef?
    Where's the beef? says:

    Independent- your article relates to the credit rating agencies, who seem to have similar issues to the Big 4. So, why do you think these issues keep recurring? Maybe my theory of human failings rings true. But i guess that’s why we should have checks and balances and incentives to address these human failings.
    Bob Daniels – looks like PwC scored well there – see Francine, they ‘re not so bad.

  11. Anonymous
    Anonymous says:

    I thought this was great, juxtaposing the speech vs. the PCAOB comments, and I guess I don’t see the bitterness in that – it’s pretty darned funny. I think the point of the post speaks (screams) for itself. Talk about shooting the messenger.

    I’d be curious to read a real discussion on the post, such as, are partner compensation and competence interrelated? Are there other, more political factors that go into rewarding the big shots, and are those perhaps symptomatic of the issues Francine’s been pointing out? And do “client satisfaction surveys” recognize partners with the, ahem, fortitude to point out things clients may not want to hear?

  12. Anonymous
    Anonymous says:

    The problem is this post dropped so many random quotes on top of each other its tough to have any sort of discussion. Had Francine singled out one point we could discuss that then the next week another. Instead there are a bunch of vaguely made points. Congrats Frncine, you proved proved the head of the PCAOB is human. I was begining to thing he may actually be a commputer…. phew!

  13. Anonymous
    Anonymous says:

    This is far too long of a post with the way the blog is formatted. These long columned post do not allow for easy reading or any reading for that matter. Save this Francine until you get a new format.

  14. Francine McKenna
    Francine McKenna says:

    @1:24:00

    The quotes are not random. They are pairs, each discussing the same issue, one side from a speech that tries to put a good spin on the legacy of the Mark Olson PCAOB and the other with the inspection facts.

    Well, at least they’re the public facts that have been approved to be in the reports. You can bet that the public/private balance of the reports is negotiated with the audit firms. That’s why they take so long to issue and to finalize. In fact, it’s a winning bet to assume that audit firms have a say in which issues are in the public report and which are in the private report. I know so.

    Do you know as of Friday there have been 45 inspections that include public disclosure of private quality deficiencies and none are Big 4? This is out of 799 reports issued as of today, about 5.6 %.

    Not all posts are meant to be debated, although I really enjoy when they are. Some are just meant to inform and maybe motivate you to investigate and read more on your own. To develop a healthy skepticism…

    And I apologize for the presentation limitations of Blogger. It’s a major reason why I’m moving to WordPress and a new more professional blogging tool. I hope to make similar posts more readable in the future, with graphics and boxes and lines and headings and all the bells and whistles that wil get points across more easily. Thanks for your patience.

  15. Anonymous
    Anonymous says:

    in order to staff the PCAOB, it would seem reasonable that it would need former big 4 staff. It's responsible to review the audits of public companies, which means a deep understanding of not only GAAP but also auditing standards. Although the SEC would be capable on the GAAP front, it does not have the deep understanding of auditing standards. I can't think of anyone else who does. Remember the system we had before the PCAOB — a self regulated industry – that worked well (laugh). The PCAOB reports from 2003 on seem pretty damning to me – it seems like they find many exceptions (>10% of audits reviewed) – that doesnt seem like a free pass.

  16. Anonymous
    Anonymous says:

    I personally place minimal value in PCAOB inspectors as I consider them to be failed auditors.

    They should be required to do rotations with the audit firms in the field and be held accountable for the client service relationships and budgets while performing the audit and then lets see how their workpapers hold up to inspection!

  17. Time for Change
    Time for Change says:

    This once again highlights the need for a changed system. The auditing of public companies and the safeguarding of the public interest should not be left to a private system that likes to believe it’s laregly self regulated. The government themselves should audit the public companies and the governement should have an internal function that audits their audits. Companies can register their complaints and have their audit audited. If the company is right and the audit was not done properly, they should get some money back. If the company is wrong, then there should be some penalty, kind of like reviewing a play in football.

    Many will say that the goverment can’t do anything right, well recently the private sector hasn’t been looking too hot either. They should also consolidate all the accounting rules and have one agancy in charge of formulating standards and setting rules. The House of GAAP needs to be rebuilt (it maybe in foreclosure in the current market).

Trackbacks & Pingbacks

  1. re: The Auditors » Blog Archive » PCAOB Waiting For Godot: Reporting On Auditor Performance During The Financial Crisis says:
    October 8, 2010 at 8:01 am

    […] From the PCAOB Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections…: […]

Comments are closed.