Annual inspection reports for BDO Seidman and Grant Thornton, released last Thursday by the Public Company Accounting Oversight Board, criticized some of the audit testing procedures and practices at the two large accounting firms.
The review of BDO focused mainly on issues related to testing controls around revenue recognition, while Grant Thornton was chastised for not identifying or sufficiently addressing errors in clients’ application of generally accepted accounting principles with respect to pension plans, acquisitions, and auction-rate securities.
With regard to BDO, the inspection staff reviewed seven of the company’s audits performed from August 2008 through January 2009 as a representation of the firm’s work.
The report highlighted several deficiencies tied to what it said were failures by BDO to perform audit procedures, or perform them sufficiently. According to the reports, the shortcomings were usually based on a lack of documentation and persuasive evidence to back up audit opinions. For example, the board said, BDO did not test the operating effectiveness of technology systems that a client used to aggregate revenue totals for its financial statements. The systems were used by the client company for billing and transaction-processing purposes.
The inspection team also reported that BDO’s audit of a new client failed to “appropriately test” the company’s recognition of revenue practices. Specifically, the audit firm noted that sales increased in the last month of the year but it failed to get an adequate explanation frommanagement. Also, the report concluded that BDO reduced its “substantive” revenue testing of two other clients, although more thorough testing was needed.
And while BDO identified so-called “channel stuffing” as a risk of material misstatement due to fraud, at another client, its testing related to whether the client engaged in the act was not adequate, said the inspectors. (Channel stuffing is the practice of accelerating revenue recognition by coaxing distributors to hold excess inventory.)
Other alleged problem spots for BDO included a failure to design and perform sufficient audit procedures to test: journal entries and other adjustments for evidence of possible material misstatement due to fraud; valuation of accrued liabilities related to contra-revenue accounts; a liability for estimated sales returns in connection with an acquisition; and assumptions related to a client’s goodwill impairment of a significant business unit.
In response to the inspection report, BDO performed additional procedures or supplemented its work papers as necessary. It also noted in a letter that was attached to the report that none of the clients cited had to restate their financial results.
In the letter, BDO acknowledged the importance of the inspection exercise, commenting that “an inherent part of our audit practice involves continuous improvement.” However, the firm also said the report does not “lend itself to a portrayal of the overall high quality of our audit practice,” since it reviews only a tiny sampling of audits. What’s more, BDO pointed out that many of the issues reviewed “typically involved many decisions that may be subject to different reasonable interpretations.”
Deficiencies highlighted in the inspection report on Grant Thornton, meanwhile, included failures to “identify or appropriately address errors” in clients’ application of GAAP. In addition, inadequacies were said to have been found with respect to performing necessary audit procedures, or lacking adequate evidence to support audit opinions. The Grant Thornton inspections were performed at on eight audits conducted between July 2008 and December 2008.
In five audits, the PCAOB said inspectors found deficiencies in testing benefit plan measurements and disclosures. In four of those audits, Grant Thornton was said to have failed to test the existence and valuation of assets held in the issuer’s defined-benefit pension plan. In one audit, the board said, the accounting firm failed to test the valuation of real estate and hedge fund investments and a guaranteed investment contract held by the client’s defined-benefit pension plan.
One client amended three of its post-retirement benefit plans to eliminate certain benefits, and Grant Thornton “failed to evaluate whether the issuer’s accounting” was appropriate, said the report. In another audit, the accounting firm allegedly did not perform sufficient procedures to evaluate whether the assumptions related to the discount rate andlong-term rate of return on plan assets — provided by the client’s actuary — were reasonable.
In a separate audit, a client acquired a public company that was described as having six reporting units. The client recorded the fair values of the net assets of each reporting unit according to the valuations provided by a specialist. But according to the inspection report, Grant Thornton did not audit the acquisition transaction sufficiently.
In particular, the firm neglected to evaluate which of the fair-value estimates represented the “best estimate” with regard to two units that were hit with an economic penalty for having a lower total fair value than their net assets, the inspectors said. They also concluded that Grant Thornton did not do a sufficient auditing job when it failed to note whether it was appropriate for the specialist to use liquidation values for two other units.
The accounting firm also ran into trouble with inspectors over a client in the software industry. Despite a wide range in the renewal rates charged to the client’s customers for post-contract support, the client concluded — and Grant Thornton concurred — that it could use a single stated renewal rates to establish the fair value of all the support contracts.
The firm was also written up for deficiencies in two audits related to testing auction-rate securities. In both audits, Grant Thornton obtained valuations for the securities from a specialist it hired. But the account firm “failed to obtain an understanding of the methods and assumptions that the specialist had used to value the securities.” Also, in one audit, the specialist was unable to estimate a value for some of the securities, and relied on an estimate supplied by the client.
In a written response to the inspection, Grant Thornton noted that “the issues raised in the report reflect the fact that accounting and auditing standards are highly complex, and require significant professional judgment.” Although the firm said that it supports the PCAOB inspection process, and discussed with the board certain comments made in the reports, “we disagree with certain views of the PCAOB.”
Grant Thornton contended that judgments questioned by the inspectors “were appropriately supported and well reasoned.” The letter continued, “While we believe that the PCAOB should continue to challenge judgments and documentation during the inspection process, we do not believe that, in the end, reasonable judgments should be criticized and second guessed. Such a process will ultimately lead to inefficient audits due to the fear of unnecessary criticism.”