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Going Old School: GAAP Audit Deficiencies in PCAOB Inspection Reports

Posted on May 16, 2023 by | Tags: PCAOB inspection reports,

The purpose of this blog is to take a deeper dive in the accounting-related audit deficiencies noted within PCAOB inspection reports. And, because I had just re-watched one of my favorite movies, the theme is Old School!

Types of audit deficiencies noted in the PCAOB inspection reports

We are about to release the 5th edition of our eBook Learn from PCAOB Inspections – Your Prescription for Better Audits. The findings set out in our eBook are based on our review of the PCAOB inspection reports for the annually inspected firms over the last ten inspection cycles, focusing on Part I.A deficiencies. We publish this eBook to help auditors:

  • Learn from PCAOB inspection findings,
  • Prevent recurring audit deficiencies,
  • Improve audit training, and
  • Strengthen the quality of their audits.

I’ll let you dive into the data later this week when it is published, but I wanted to give you sneak peek at some of the high-level findings. Our analysis of the 2021 inspection reports for annually inspected firms shows:

  • The combined audit deficiency rate is 26%, an increase of 6 percentage points from 2020.
  • The difference between the combined audit deficiency rate of the Big 4 firms (16%) as compared to other annually inspected firms (39%) has grown substantially over the past few years.
  • The lowest audit deficiency rate among the annually inspected firms was 4%. The highest was a whopping 76%!
  • Unfortunately, the types of audit deficiencies, including the related auditing standards and audit areas, remain unchanged.

So, what auditing standards are causing the audit deficiencies noted within the PCAOB inspection reports? Where are the auditors messing up? Well, for the most part, it’s the same old stuff:

  • Internal control over financial reporting (AS 2201)
  • Risk assessment (AS 2301)
  • Auditing estimates (AS 2501)

Most frequently identified audit deficiency was…

However, there was something new that was a bit unexpected! The most frequently identified Part I.A deficiency related to audits of financial statements was:

Did not sufficiently evaluate the appropriateness of the issuer’s accounting method or disclosure for one or more transactions or accounts

In layman’s terms, it means the engagement team did not properly evaluate the application of generally accepted accounting principles (U.S. GAAP).

This made me very happy, shouting, “The GAAP is back, baby!” Not because I delight in others’ misfortunes, but rather because it validates the entire purpose of our company. GAAP Dynamics was founded on the premise that we believe that you cannot audit what you don’t understand. This means that to be an effective auditor, you must understand the underlying financial reporting framework that the company is using to prepare their financial statements, either U.S. GAAP or IFRS.

So, what are the GAAP areas auditors are messing up?

old school

If you are looking to improve audit quality and reduce inspection findings, focus your efforts on the test work surrounding revenue and related accounts. Why? It is by far the number one area for both ICFR and financial statement deficiencies, accounting for one-third of all deficiencies in both categories!

Percentages of total ICFR deficiencies by audit area based on the number of comment forms (% of deficiencies in 2021 inspections):

  1. Revenue and related accounts (33%)
  2. Expected credit losses (15%)
  3. Inventory (13%)
  4. Business combinations (1%)
  5. Investment securities (5%)
  6. Long-lived assets (5%)
  7. Information technology (5%)
  8. Goodwill and intangible assets (5%)
  9. Other (18%)

Percentages of total financial statement deficiencies by audit area, excluding ICFR, based on the number of comment forms (% of deficiencies in 2021 inspections):

  1. Revenue and related accounts (35%)
  2. Inventory (9%)
  3. Expected credit losses (9%)
  4. Equity and equity-related accounts (8%)
  5. Business combinations (8%)
  6. Long-lived assets (6%)
  7. Goodwill and intangible assets (4%)
  8. Cash and cash equivalents (3%)
  9. Investment securities (2%)
  10. Accruals and other liabilities (2%)
  11. Leases (1%)
  12. Other (13%)

Here are some of the actual findings noted by the PCAOB in their inspection reports related to revenue and related accounts:

Identifying the contract with the customer (Step 1)

The firm did not perform sufficient substantive procedures to evaluate whether one type of revenue was appropriately recognized because the firm did not review certain customer contracts, which was necessary in order to identify performance obligations and evaluate whether this revenue was appropriately recognized. (AS 2301.08)

Identifying performance obligations (Step 2)

The issuer recorded certain revenue at the time services were provided to its customers. The firm did not perform any substantive procedures to test whether the performance obligations for these services had been satisfied when revenue was recognized. (AS 2301.08)

Determining the transaction price (Step 3)

The firm did not identify and test any controls that addressed whether the estimated transaction prices for certain types of contracts included in this disclosure were determined in conformity with FASB ASC Topic 606, Revenue from Contracts with Customers. (AS 2201.39) The firm did not identify, and evaluate the significance to the financial statements of, misstatements in this disclosure under FASB ASC Topic 606. (AS 2810.30 and .31)

Allocating the transaction price to performance obligations (Step 4)

The firm did not perform substantive procedures to evaluate the issuer’s determination and disclosure of whether it used observable prices to determine the standalone selling prices for these performance obligations in conformity with FASB ASC Topic 606, Revenue from Contracts with Customers. (AS 2810.30 and .31)

Evaluating whether the performance obligations were satisfied (Step 5)

For certain of the transactions selected for testing, which included multiple services provided to the customer, the firm did not evaluate whether multiple performance obligations existed in the associated contract that would affect whether this revenue was appropriately recognized. (AS 2301.08)

If you need help understanding the 5-step model within ASC 606 Revenue from Contracts with Customers, be sure to download our free step-by-step guide or check out our ASC 606: Revenue from Contracts with Customers online course collection.

I’d be remiss if I didn’t mention the other area contributing to the deficiencies in the application of GAAP.

old school

If you follow our blogs, webinars, or podcast, you know that we’ve discussed the restatement issues associated with special purpose acquisition companies (SPACs), specifically the restatements associated with the classification of warrants and redeemable shares. Here are a few of the actual PCAOB findings in this area:

During the audit, the firm did not identify, and appropriately address, that the issuer’s accounting for warrants as equity was not in conformity with FASB ASC Topic 815, Derivatives and Hedging. (AS 2810.30)

During the audit, the firm did not identify, and appropriately address, that the issuer’s accounting for certain redeemable shares as permanent equity was not in conformity with FASB ASC Topic 480, Distinguishing Liabilities from Equity. (AS 2810.30)

In a nutshell, the warrants issued by the SPACs were originally classified as equity but should have been classified as liabilities. Also, certain redeemable shares should have been classified as temporary equity as opposed to permanent equity. If you need help in this area, be sure to check out our online course, Issuance of Debt and Equity Securities: Classification and Accounting for Equity-Linked Investments.

Closing thoughts

If you’d like further insights into recent PCAOB inspection reports, I’d encourage you to download our PCAOB eBook. It’s over 50 pages of awesomeness and it’s completely free!

About GAAP Dynamics
We’re a DIFFERENT type of accounting training firm. We view training as an opportunity to empower professionals to make informed decisions at the right time. Whether it’s U.S. GAAP, IFRS, or audit training, we’ve trained thousands of professionals since 2001, including at some of the world’s largest firms. Our promise: Accurate, relevant, engaging, and fun training. Want to know how GAAP Dynamics can help you? Let’s talk!

Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.

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