The Public Company Accounting Oversight Board on Monday released a report listing 11 problem areas found during its inspections of smaller audit firms.
The PCAOB called on the firms to improve their audit quality by focusing on these issues, which include their reviews of business combinations and evaluations of whether a company is a going concern.
The PCAOB gathered the information from its nearly 500 inspections of firms that audit fewer than 101 public companies. The five-year-old regulator is entering the second round of its small-auditor reviews, which are conducted once every three years.
While the report is targeted toward smaller firms, many of the issues noted are found as well at the larger ones, which the PCAOB reviews annually, George Diacont, director of the PCAOB’s Division of Registration and Inspections, told CFO.com.
Of the 439 inspection reports of small firms conducted so far, 124 didn’t list an audit deficiency or a concern about possible defects in the firm’s quality-control system. In contrast, each of the Big Four reports so far have listed at least seven audit deficiencies.
According to Diacont, the areas listed in the new report are in no particular order, but the first one — revenue recognition —certainly has been a common sticking point for firms of all sizes. Indeed, it may be an “especially important” area for the audits of small businesses, “where investors may perceive revenue as a key indicator of the company’s prospects, particularly in situations where the company has yet to earn significant income,” the report says.
The PCAOB reminds firms that even audits of small companies could involve complex evaluations or testing procedures when it comes to revenue recognition. However, the board’s inspections have revealed the firms’ failure to perform proper procedures for testing the existence, completeness, and valuation of revenue; fully evaluating the terms of pertinent contractual agreements; and testing whether revenue was recorded at the right time.
The other issues listed by the board as the most common or significant:
• Related-party transactions: The PCAOB auditors have faulted the firms for insufficiently testing the validity of expenditures made by controlling shareholders on behalf of a company; whether receivables due from entities that officers own are likely to be collected; and the accuracy of payables due to related parties.
• Equity transactions: The inspection teams have found “numerous deficiencies” related to firms’ failure to test whether the fair-value estimates of equity-based transactions were reasonable.
• Business combinations and impairment of assets: Smaller auditing firms often fail to identify that a company had not followed all of the accounting and disclosure requirements necessary for reverse acquisitions. The PCAOB inspectors have also noted times when an auditor did not challenge a company’s incorrect accounting (such as when a company recorded an asset acquisition as a business combination).
• Going-concern considerations: Some firms have not conducted the procedures necessary to evaluate whether a company can continue as a going concern.
• Loans and accounts receivable (including allowance accounts): In this area, firms appear to be too trusting of management by not doing enough testing of the company’s estimates and assumptions. For instance, some firms have not grasped an understanding of the methodology managers had used to develop an allowance for loan losses.
• Service organization: Deficiencies found in the area of companies’ use of outside organizations for routine transactions, such as payroll, include not testing the company’s controls over its vendor’s activities and not testing the controls of the service organization itself.
• Use of other auditors: The inspectors have found some auditors apparently confused as to whether the firm should consider itself a principal or secondary auditor. This issue comes up for firms with few offices that need other firms to help them out.
• Use of the work of specialists: This area will receive much more attention as companies increase their use of the fair-value method of accounting, which involves more reliance on valuation specialists. Auditors need to evaluate the relationships between companies and their specialists; understand specialists’ methods and assumptions; and test the data that the issuer initially sent to specialists. However, inspectors have found that firms are not doing all of those procedures.
• Independence: The PCAOB has witnessed instances of firms negating their independence status from a company they audit by also: preparing that company’s accounting records; preparing the source data supporting the company’s financial statements; and providing book-keeping services, among other services that are not allowed under Securities and Exchange Commission independence rules.
• Concurring partner review: The inspectors have found that some firms have had ineffective reviews because the concurring partner lacked expertise and experience, and they were conducted at an improper time.