“Hmm. I wonder which work paper areas the inspectors are going to review?” Well, probably the same areas where they’ve found problems in the past! This post provides auditors with a top 5 “hit list” of financial statement areas that inspectors or peer reviewers will focus on based on our review of PCAOB inspection reports.

In previous blog posts, we’ve covered the auditing standards contributing to the most audit deficiencies which are:

• Testing internal controls over financial reporting
• Assessing and responding to the risk of material misstatement
• Auditing accounting estimates, including fair value measurements

These focus areas related to auditing standards haven’t changed from prior years. However, as we noted in this post, PCAOB inspection reports have recently been providing more information. This additional information includes financial statement accounts or auditing areas related to identified audit deficiencies.

We’ve reviewed this information within the 2015 PCAOB inspections reports of the ten annually inspected firms and compiled our top 5 “hit list” to help auditors improve audit quality.

Number 5: Impairment of Goodwill and Intangible Assets

When testing internal controls in this area, auditors relied heavily on management inquiry and inspecting documentation indicating the control had been performed. However, their testing did not include evaluating the procedures performed, including the basis for the control owners’ expectations and whether matters identified for follow up were appropriately resolved.

Assessing and measuring goodwill and intangible assets for impairments requires fair value measurements so it makes sense that several deficiencies in this area related to auditing fair value measurements. Specifically, the firms failed to perform sufficient procedures to test the issuers’ analyses of possible impairment, heavily relying on internally-produced memoranda and schedules, as well as inquiry of management, without any corroboration.

Number 4: Loans and the Allowance for Loan Losses

The audit deficiencies in this area were evenly split among:

• Internal control over financial reporting
• Risk assessment
• Auditing estimates
• Audit sampling

Inquiry of management alone is not sufficient audit evidence! Many of the deficiencies related to auditors inquiring of management without obtaining corroborating evidence of the explanations they received. In addition, the allowance for loan losses (ALL) is a significant estimate made by management using probably-of-default and loss-emergence-period assumptions, among others. It is imperative that auditors test these assumptions, including testing the accuracy and completeness of the underlying data. Finally, when testing controls over the ALL, auditors inquired of control owners and inspected documentation used in the operation of the controls, but failed to evaluate the expectations applied in the reviews, the criteria used to identify matters for follow-up, and the resolution of such matters.

Number 3: Business Combinations

Most of the audit deficiencies attributable to business combinations, including contingent consideration, related to internal control over financial reporting and auditing estimates and fair value measurements.

Auditors failed to perform sufficient procedures to test controls over the valuation of assets acquired and liabilities assumed. Specifically, auditors failed to evaluate whether these management review controls were designed and operated at a level of precision that would prevent or detect material misstatements. In addition, auditors failed to ascertain the nature of the review procedures that the control owners performed, including criteria used by the control owners to identify matters for follow up and whether those matters were appropriate resolved.

When allocating the purchase price in a business combination, companies must determine the fair value of assets acquired and liabilities assumed. As we noted in this post, valuation of intangible assets often involves sophisticated models using unobservable inputs. According to the PCAOB, much of the testing of the fair value assigned to intangible assets was insufficient as auditors failed to sufficiently evaluate the reasonableness of the significant assumptions underlying internally developed cash-flow forecasts used by issuers to determine the fair value of the assets.

Number 2: Inventories

Over half of the audit deficiencies related to either internal control over financial reporting or assessing and responding to the risk of material misstatement. With respect to the deficiencies related to internal control, many related to what we’ve previously covered. That is, failure to:

• Test controls over the accuracy and completeness of the data and reports used in the performance of the control;
• Evaluate whether controls operated at a level of precision that would prevent or detect material misstatements; and
• Evaluate whether items identified by the control owners for follow up were appropriately addressed.

Relating to risk assessment, many the deficiencies related to not doing enough test work over certain inventory balances. Specifically, auditors would plan on performing limited substantive procedures, such as analytical procedures, over certain balances as they planned to rely on controls. However, when their tests of controls indicated deficiencies, the audit plan was not subsequently revised.

Number 1: Revenue

Nearly one-third of all audit deficiencies noted in the 2015 PCAOB inspection reports related to auditing revenue, including accounting receivable, deferred revenue and the allowance for doubtful accounts. From failure to evaluate whether the issuers’ accounting was in conformity with GAAP to failure to identify and test controls, the auditing standards attributable to the deficiencies in this area ran the gamut. However, two stood out, contributing to nearly two-thirds of the deficiencies – internal control over financial reporting (AS 5) and assessing and responding to the risk of material misstatement (AS 8 through AS 15).

It should be noted that these audit deficiencies were noted in firms auditing clients under the OLD revenue standard (ASC 605 / SAB 104). As I’m sure you’ve probably heard, there’s a new revenue recognition standard out there (ASC 606) and, according to Helen Munter, Director of the PCAOB’s Division of Registration and Inspections, the PCAOB is going to want to understand whether the auditor has:

• Had discussions with their clients about changes in processes and controls;
• Has remained independent during the client’s implementation; and
• Is appropriately reporting any concerns about readiness or technical ability to the audit committee on a timely basis.

Need to get up-to-speed on ASC 606? We’ve compiled a list of helpful resources here.

So, there you have it. The top 5 financial statement areas that inspectors or peer reviewers are sure to focus on during their next inspection.

Disclaimer
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.