The Public Company Accounting Oversight Board has proposed a rule that could help uncover corporate fraudsters’ common practice of masking the true amounts of accounts, such as receivables or cash balances.
The proposal updates a 15-year-old rule that governs audit confirmations — how auditors verify their clients’ receivables with third parties, such as lenders and customers. The practice is “one of the building blocks of auditing,” said PCAOB chairman Daniel Goelzer at a board meeting earlier this week. The board issued the proposal on Tuesday for a 60-day comment period.
If approved, the rule will require auditors to authenticate receivables not only stemming “from the sale of goods or services in the normal course of business,” as is currently mandated, but also from credit sales, loans, and other transactions. In addition, auditors will be expected to check cash balances with financial institutions, which is already a common practice at large audit firms but hasn’t been required.
The PCAOB also wants auditors to verify other types of “accounts or balances that pose a significant risk that the financial statements might be materially misstated,” according to the proposal.
Since its inception in 2003 as the accounting firms’ regulator, the PCAOB has kicked around these changes as part of its longtime goal of updating the standards it adopted from its predecessor standard-setter. And for the most part, auditors are likely already taking the steps outlined in the proposal, according to Gary Kabureck, chief accounting officer for Xerox who did confirmations when he was an auditor at PricewaterhouseCoopers over two decades ago. “To the extent this is codifying best or common practices, there will not be much change,” he says. “But not everybody is doing best or common practices, so some places could be affected.”
To be sure, the routine matter of confirming receivables has tripped up auditors in the past. A year ago, the PCAOB issued a rare enforcement action against Moore & Associates, pulling the accounting firm’s registration and leaving nearly 200 publicly traded companies without an auditor. Among the PCAOB’s complaints was the accusation that the firm’s uneducated staffers did not do any work to confirm either the existence or the valuation of a client’s receivables, and that staffers considered confirmation responses from management as acceptable. (For the most part, management is supposed to stay out of the confirmation process; ideally, auditors receive confirmations directly from lenders or vendors.)
Moreover, the board’s inspectors have questioned audit opinions, including those at the Big Four, after finding that auditors did not do enough work (under the PCAOB’s expectations) to be certain that the receivables claimed by their corporate clients were accurate. At the same time, the confirmation process failed to detect problems in such high-profile fraud cases as Parmalat, Ahold, HealthSouth, and Kmart.
Auditors have also run into snafus involving legitimate transactions, with some service providers refusing to verify specific numbers and others confirming figures but disclaiming any responsibility for the data. In rare cases, such as if there’s a pending lawsuit between a company and a customer, management may discourage auditors from making confirmations. In those cases, under the proposed rule, the PCAOB wants auditors to determine whether such a request is acceptable, let the audit committee know of management’s demands, and look at other ways to corroborate figures that won’t be confirmed through a third party.
Further trying to create more independence from management, the board’s proposal restricts internal auditors’ involvement in the process and emphasizes that the external auditors should have control over it. External auditors will not be able to use a company’s staffers for sending confirmation requests or receiving responses under the new rule. “We think losing control of the confirmation process by letting somebody else send and receive [the confirmations] is a weakness in the existing process,” said PCAOB chief auditor Martin Baumann at Tuesday’s meeting.
While the new proposal expands auditors’ mandated responsibilities, PCAOB staffers said they don’t think it will result in significantly higher audit costs. Still, one industry stands to benefit from the proposed changes. As the acceptance of electronic confirmations has expanded over the years (and will likely continue to do so since the proposal recognizes advances in technology beyond snail mail), so has the demand for intermediaries that can take over the requests.
One such intermediary, Capital Confirmation, handles confirmation requests for auditors with about 200 financial institutions. The company doesn’t vouch for the veracity of the information but serves as a middleman for the transportation of the data by computer network, according to CEO and president Chris Schellhorn. “We streamline the process to 24 to 48 hours from what was previously a three-to-four-week process,” he says. The proposal could help the company as it works to expand beyond cash confirmations to receivables, which will entail building relationships with companies. Schellhorn says he’s targeting the Fortune 1000.