PCAOB Report Finds One-Quarter of Corporate Financial Audits are Deficient

The Public Company Accounting Oversight Board (PCAOB) released a report in October that assessed auditing firms’ compliance with Auditing Standards No. 8 to 15. At first glance the results are not great, especially for investors who rely on company financials.

The study found that over the span of three years examined (2012 – 2014), there were significant deficiencies in auditing standards. The report cited that “recurring audit deficiencies related to these standards suggest that audit quality challenges remain and that more should be done to improve the quality of audits.”

In a nutshell, the report found that firms did not “evaluate the accuracy and completeness of financial statement disclosures,” nor did they “take into account relevant audit evidence that appeared to contradict certain assertions in the financial statements,” among other mistakes.

In 2012, 26 percent of the 632 audits inspected (where the standards were applicable) had an audit deficiency in one or more of those standards. In 2013, the rate increased to 27 percent of the 848 audits reviewed.

For 2014, preliminary data show that deficiencies were high among the 780 audits that applied the standards – most frequently in Audit Standards 13, 14 and 15 – important standards for checks and balances. (Note that these were the same standards that had deficiencies in the 2012 and 2013 analysis as well.)

You can view the standards and their objectives in the following chart pulled from the report:

The report gives several examples of what happened when auditors weren’t following Auditing Standards 13 to 15. The report also discusses the potential root of non-compliance.

Some of those reasons included:

• The auditing firm didn’t have sufficient understanding of the issuer, its processes and internal controls over financial reporting.
• The auditing firm’s tools weren’t appropriately designed.
• The auditing firm didn’t create and carry out the proper procedures to address risks of material misstatements.
• Senior members of the auditing team were not engaged enough in the adherence of standards.
• General lack of due diligence.
• Lack of training or care with testing journal entries.

With audit committees and their individual members under the magnifying glass of agencies like the Securities and Exchange Commission (in fact, the SEC refers to these individuals as the "gatekeepers" of compliance), directors and officers may need to do some diligence when it comes to verifying auditing firm results.

The report outlines three questions audit committees can ask of their auditors:

Have the PCAOB's inspections or firm's internal inspections identified any significant deficiencies in the firm's compliance with the Risk Assessment Standards, and if so, what actions has the firm taken to address these?

Which audit areas have been identified by the auditor as having significant risks of material misstatement and, at a high level, how does the audit plan address those risks?

In the auditor's view, how have the areas of significant risk of material misstatement changed since the prior year and why? What new risks has the auditor identified?

Is This Report a Big Deal?

It’s hard to tell. The PCAOB is on a mission to improve audit quality, and surely that’s a worthy goal. On the other hand, it’s notable that no major accounting firm seems to be able to get through a PCAOB audit with a gold star.

In a statement to Accounting Today, a KPMG spokesperson (one of the “big four” auditing firms), said the firm has taken “robust steps” in recent years to “further our commitment to audit quality” and that “these efforts, as well as additional initiatives undertaken since the 2014 inspections were completed over a year ago, have led to significant improvements which will be reflected in future inspection reports.”

Is it the case that all the major accounting firms are not, in fact, very good at their job? That seems unlikely, particularly in light of the scrutiny that they know they are facing.

One perspective is that the PCAOB inspections are too complex, and some feel the organization is not doing enough to help with developing workable standards as opposed to just critiquing audit firm performance.

And as this Bloomberg article points out:

Deficiencies are not failures—deficiencies occur when an auditor doesn’t comply with certain PCAOB standards. However, the occurrence of deficiencies doesn’t necessarily mean that the whole audit is failed, or the financial statements are misstated.

The bottom line is that the audit firms know they are being scrutinized. No one wants to be responsible for the next WorldCom or Enron.  Management, audit committees and audit firms are all united in the goal of producing high-quality audits.

The full PCAOB report and its results can be found here.

The views expressed in this blog are solely those of the author. This blog should not be taken as insurance or legal advice for your particular situation. Questions? Comments? Concerns? Email: phuskins@woodruffsawyer.com.