The Hindu Business Line : Insights from PCAOB report

The Public Company Accounting Oversight Board (PCAOB) — implementer of the Sarbanes Oxley Act in the US — has had a chequered existence. After an initial period of fear, the PCAOB came to be looked upon in later years as a nuisance. The PCAOB relaxed some of the harsh provisions in the Act, by providing an escape mechanism for small and medium enterprises (SMEs), etc.

However, the PCAOB has been consistent in reviewing the work done by audit firms and its reports on such reviews could serve as a quality benchmark to firms all over the world. Its latest report does provide some food for thought on areas that are the bread and butter for auditors.

Using work of other auditors

Audit firms increasingly depend on other auditors to complete an assignment. Using the work of other auditors has become a Guidance Note for audit firms. A firm should consider, among other things, the materiality of the portion of the financial statements that it has audited in comparison with the portion audited by other auditors, the extent of the firm’s knowledge of the overall financial statements, and the importance of the components the firm audited in relation to the enterprise as a whole.

In some instances involving the use of other auditors’ services, the firm takes the position that the other auditors are acting as its own assistants. In such a circumstance, the firm assumes responsibility for the other auditors’ work.

Whether a firm uses its own employees or other auditors as its assistants, the firm’s own involvement in the planning, supervision, review, and addressing of significant audit areas must be sufficient to meet PCAOB standards.

The inspection teams reported several deficiencies regarding the use of other auditors. These deficiencies included (a) firms’ reporting on the financial statements as the principal auditor when their participation was not sufficient to enable them to serve in that capacity, and (b) insufficient planning, supervision, review, and addressing of significant audit areas by the firms when other auditors were used as assistants.

Using the work of experts

As business grows complex, auditing records become even more complex. An auditor is certainly not expected to be a gnani who knows all. To give an example, with the increased emphasis on fair value measurements, valuation of assets is a significant area of haziness for an auditor who would have to put his faith on a valuer to assess the worth of an asset appropriately.

In using the work of experts, the PCAOB noticed instances where firms have failed to perform the necessary procedures, including the failure to:

evaluate the relationship of the specialist to the issuer in circumstances where the specialist has other business relationships with the issuer or otherwise has a relationship that may have a bearing on the specialist’s objectivity;

obtain an understanding of the specialist’s methods and assumptions; or

make appropriate tests of the data the issuer provided to the specialist.

Independence

Independence of auditors has been focused on so much in recent times that an auditor would hate to be seen with a client over dinner on a weekend. The most common deficiency noted in the independence area involves preparation of an issuer’s financial statements and related footnotes.

In some cases, the deficiency consisted of the preparation of a portion of the issuer’s financial statements (such as the statement of cash flows) or of the statements or disclosures in a single, specialised area (such as the income-tax provision and the related deferred tax asset and liability balances).

Even these more limited preparation services impair the firm’s independence. Other identified deficiencies include instances in which firms provided bookkeeping services by, for example, maintaining the trial balance or the fixed asset sub-ledger, classifying expenditures in the general ledger, preparing the consolidating schedules, or preparing and posting journal entries to record transactions or the results of calculations.

In other instances, firms prepared source data underlying their issuer audit client’s financial statements by, for example, determining the fair values assigned to intangible assets acquired in a business combination or to stock options and warrants, or calculating depreciation expense and accumulated depreciation.

With such reviews, one would not be very surprised if audit firms suspect and report everything instead of suspecting little and reporting only material misstatements.

(The author is a Hyderabad-based chartered accountant.)

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