Small Auditors Pose Misstatement Risks: PCAOB

Deficiencies found in audits by smaller firms have dropped in recent years. But the oversight board warns that they’re still too high.
Kathleen Hoffelder

While the number of significant audit deficiencies for small domestic auditors has shrunk since the Public Company Accounting Oversight Board issued its last report on this group in 2007, the auditing overseer still believes the number of deficiencies is unacceptable.

“Audit deficiencies are still high,” said PCAOB board member Jeanette M. Franzel during a press call today describing the results of a study the board completed on small audit firms in the United States that were inspected between 2007 and 2010. “We continue to be concerned about the level and types of significant deficiencies in the triennial firm inspections.”

The PCAOB report showed that 44% of the audit firms, each of which audits 100 or fewer public companies, had at least one “significant audit performance deficiency,” meaning the deficiency resulted in the audit firm lacking enough evidence to support its opinion. That number compares with 61% that had audit deficiencies in the PCAOB’s last report on this group in 2007, which covered inspections from 2004 to 2006.

While the number of deficiencies is trending lower, the PCAOB considers the amount to be a wake-up call for CFOs and other corporate executives to scrutinize their auditors carefully. As Franzel noted, these deficiencies are “significant.”

The report should be “useful for the firms themselves so they may take note of the more troubling findings from the triennial inspection. Audit committees may wish to discuss this report with their auditors to better understand whether any of the deficiencies may be something they should consider in connection with their own company audit.” If its audit firm’s audit has a faulty basis in fact and the resulting audit goes awry, a company could face regulatory action or a shareholder lawsuit.

Most of the audit deficiencies in the study were found in auditing revenue recognition and other areas pertinent to smaller clients, such as share-based payments (like stock options or rights) and equity financing instruments. Because smaller audit clients often face difficulties in raising capital or accessing credit markets, share-based payments and equity financing instruments are more common, noted PCAOB board member Jay D. Hanson during the call. Such financing, he noted, may contain terms and conditions that increase the risk of material misstatements.

The PCAOB audits smaller audit firms once every three years, though some are audited a bit more frequently if warranted. (Audit firms with more than 100 issuers have an annual inspection.) The size of the firms in today’s study ranged from those that audited just 1 firm to others that audited more than 80 firms. The report included 748 inspections of 578 audit firms.

Other deficiencies outlined in the report included auditing convertible debt, fair-value measurements, impairment of intangible assets, accounting estimates, the use of analytical procedures, and the ways a firm responds to the risk of misstatements due to fraud.

Why the long list of deficiencies? The report cited a lack of technical competence in an audit area, a paucity of professional skepticism, ineffective supervision, client acceptance and inability to consider technical knowledge called for in particular audits, and ineffective auditor engagement quality reviews.

“These are just the nuts and bolts of high-quality auditing that need to be attended to. We hope that firms really focus on these areas,” said Franzel, who is also hopeful the PCAOB will be able to perform more frequent reports than once every three years for this group of audit firms.

To be fair, those firms that did have deficiencies seemed to take appropriate steps within 12 months to address those deficiencies, she said. At the same time, some ended up even worse the second time around. Of the 455 firms that had their second inspection during 2007 through 2010, 36%, or 164 firms, had at least one significant audit-performance deficiency in their second inspections, which compares with 55%, or 249 firms, in their first inspections.

“Many of those firms take advantage of the opportunity to ask questions from our inspection staff to enhance or refine their own efforts,” said Franzel. About 90% of the cases during the 2007–2010 inspection time period did include dialog and remediation between the PCAOB and the firm.

Still, the report flagged 20 firms that didn’t provide any remediation response to the board over their deficiencies. Their reason for noncompliance? “They just don’t care,” said the PCAOB’s Hanson, expressing his own personal view. “Maybe they shouldn’t be doing the work of public companies.”

The PCAOB has a similar report coming out on larger audit firms, which it expects to release later in 2013.