PCAOB inspections focus on how a firm conducted selected audits and on the effectiveness of the firm’s quality control procedures.
The Guide describes:
- The PCAOB’s inspection responsibilities;
- How it conducts inspections;
- Inspection reports; and
- Remediation of identified deficiencies.
Created by the Sarbanes-Oxley Act of 2002, the Public Company Accounting Oversight Board (“PCAOB”) is a private-sector, nonprofit corporation that periodically conducts inspections of public accounting firms that are registered to perform financial statement audits of companies that are publicly traded in the U.S., as well as non-public broker-dealers that are required to file with the Securities and Exchange Commission. The SEC has oversight authority over the PCAOB, including the approval of its rules, standards, and budget.
The PCAOB Inspections Guide will be insightful to those performing or participating in financial statement audits of entities required to file with the SEC. Legal and other advisors, audit committee members and those charged with governance may also find the Guide informative.
PCAOB Inspection Responsibilities
With approximately 2,500 registered audit firms, the PCAOB annually inspects firms that audit more than 100 public companies. Those audit firms with less than 100 public company clients are inspected once every three years. Registered firms that do not issue audit reports but that participate in public company audits by performing work used by another firm, may also be inspected. The PCAOB inspections focus on how a firm conducted selected audits and on the effectiveness of the firm’s quality control procedures.
In regards to the largest accounting firms, the PCAOB generally takes a risk-based approach in its selection of audit engagements to review. Its selection process considers both objective and subjective variables and involves a variety of tools to identify audits that may pose difficult or complex issues.
Risk factors considered in the selection process might include:
- The nature of the client company, including its industry and market capitalization;
- Audit issues likely to be encountered;
- Whether the company has significant operations in emerging markets;
- Factors specific to the inspected firm, e.g., type and range of its public company engagements, results of prior PCAOB inspections and findings from the firm’s internal inspection process; and
- Assignments and inspection history of audit engagement partners.
Firms with a small number of public company engagements may find the PCAOB reviewing every individual engagement. Otherwise, the PCAOB generally focuses on audits of client companies with the largest market capitalizations and/or audit risk. When a smaller firm has several partners leading public company audits, the PCAOB will attempt to inspect, over time, at least one engagement led by each partner.
PCAOB Inspection Conduct
The inspection of most audits will not encompass the entire engagement; rather, the PCAOB chooses to focus on those areas that present significant challenges or potential difficulties. Prior to beginning its inspection, the PCAOB informs the firm in advance of the audits (and the specific aspects of those audits) on which it plans to focus.
The inspection team meets with the audit engagement team and examines the firm’s workpapers. The inspectors’ goal is to understand how the audit was performed, especially regarding:
- Compliance with PCAOB auditing standards;
- Identification of areas in financial statements that did not conform to GAAP;
- Handling of potential adjustments; and
- Matters of independence.
Areas of potential concern regarding compliance with PCAOB standards will be discussed with the firm and, if not resolved, the inspection team will request that the firm respond to its concerns in writing. After considering the firm’s response, the inspection team will determine whether the matter should be included as a deficiency in the inspection report. For matters involving an auditor’s professional judgment, the inspector generally expects to see evidence documented in the work papers that explains the auditor’s rationale and conclusion.
PCAOB inspection includes a review of the firm’s communications with its client’s audit committee and possibly an interview the audit committee chair. Such discussions might cover the frequency and nature of meetings with the firm, expectations and assessment of the auditor, the firm’s communications regarding critical accounting and auditing judgments, audit adjustments, related party transactions and management estimates.
The PCAOB also inspects accounting firm quality controls in areas such as the following:
- Management structure and processes, including the tone at the top;
- Partner management;
- Engagement acceptance and retention;
- Use of audit work performed by foreign affiliates; and
- Process for monitoring audit performance.
Once their review is completed, the PCAOB issues a draft report with its findings. The draft report is presented to the audit firm, providing it an opportunity to deliver a written response, which becomes part of the final inspection report. The draft report, including any written responses from the firm, becomes final following approval from a majority vote of the PCOAB board.
Inspection reports are divided into two parts: Public (Part I) and Nonpublic (Part II). The Public Portion of the report contains matters that were deemed significant audit deficiencies, those where the PCAOB believes that the audit firm did not have sufficient evidence to support its opinion; for example, a failure to perform required audit procedures and failures to identify or properly address potential accounting misstatements. Deficiencies do not include the company client name to which they pertain; rather, they are referred to as relating to “Issuer A”, “Issuer B”, etc. If no significant audit deficiencies are identified, this fact will be stated in Part I.
The Nonpublic Portion of the report discusses the quality control review performed by the PCAOB. If the inspection does not result in any criticisms of quality control, the Public Portion of the report will state that fact.
Audit firms are expected to respond to deficiencies and quality control criticisms raised in PCAOB inspection reports. If it is determined that a necessary audit procedure had not been performed, the audit firm needs to consider the impact that the omitted procedure would have on the firm’s ability to support its audit opinion. Accordingly, when addressing deficiencies, a firm may find it necessary to perform additional testing, include appropriate documentation in its work papers and consider whether its audit opinion requires modification or withdrawal.
An audit firm has 12 months to remediate the PCOAB’s quality control criticisms, such as changing audit procedure guidance and training. Failure to do so may result in public disclosure of the Nonpublic Portion of the inspection report.
Recent PCAOB publication regarding Audits of Internal Controls over Financial Reporting
From time to time, the PCAOB issues summary reports of observations from recent inspections. Most recently, “Observations from 2010 Inspections of Domestic Annually Inspected Firms Regarding Deficiencies in Audits of Internal Control over Financial Reporting” was released based on PCAOB inspections performed in 2010 that examined portions of 300 individual audits. A press release and the report itself can be found here: http://pcaobus.org/News/Releases/Pages/12102012_4010.aspx
The Center for Audit Quality
Founded in 2007, the CAQ is an autonomous public policy organization dedicated to enhancing investor confidence and public trust in the global capital markets. The CAQ is affiliated with the American Institute of Certified Public Accountants and represents a membership of approximately 650 public company auditing firms. It was established in response to unprecedented changes to capital markets and the public company auditing profession, beginning with the Sarbanes-Oxley Act of 2002. The CAQ was created to help the profession unite as a group to forge greater consensus on how to best enhance investor confidence and ensure strength and stability in capital markets.