Understanding the observations noted in Part I.B, I.C and II of the PCAOB inspection reports can help improve audit quality.

A few weeks ago, I shared which PCAOB auditing standards resulted in the most inspection deficiencies for the annually inspected firms. The GAAP Dynamics team spends hours each year looking at the reports of the annually inspected firms and compiling data to use in our PCAOB eBook. While the inspection observations found in Part I.A seem to get the most attention, don’t neglect the “other” parts of the inspection reports! I’ll highlight what each part covers and the results of our analysis.

Our analysis is based on the annually inspected firms, which means these firms provide audit opinions for more than 100 issuers. For the 2022 inspection cycle, there were 14 annually inspected firms. 

Parts of the PCAOB Inspection Reports

PCAOB inspection reports are divided into two main parts: Part I – Inspection Observations and Part II – Observations Related to Quality Control. Part I is further divided into three subparts: Part 1.A, Part 1.B and Part 1.C.

Part I – Inspection Observations

• Part I.A deficiencies are likely what you think of when you hear the words “PCAOB deficiency”, as these are the deficiencies that have risen to the level of significance that the PCAOB did not feel the firm had obtained sufficient audit evidence to support its opinions on the issuer’s financial statements and/or internal controls over financial reporting (ICFR) at the time the report was issued. If you want a thorough analysis of these deficiencies for the most recent inspection cycle, check out our newly released PCAOB eBook.
• Part 1.B contains deficiencies that do not relate directly to the sufficiency or appropriateness of evidence the firm obtained to support its opinion(s) but nevertheless relate to instances of non-compliance with PCAOB standards or rules.
• Part I.C discusses instances of noncompliance with the PCAOB’s independence rules.

Part II –Observations Related to Quality Control

These observations relate to criticisms of, or potential defects in, the firm’s system of quality control. Part II deficiencies are not publicly disclosed when the report is first issued, but will be made public if any such deficiency is not remediated to the Board’s satisfaction within 12 months after issuance of the report.

Part I.B – Instances of non-compliance with PCAOB standards or rules

As a reminder, these are deficiencies that do not directly relate to the appropriateness or sufficiency of audit evidence obtained by the auditor to support its opinion on the financial statements. What is important to note is that the PCAOB does not review every aspect of every audit, meaning the areas below were not reviewed for every audit inspected. Below are some of the commonly noted Part I.B deficiencies.

• Critical audit matters (CAMs) (AS 3101): Common issues related to CAMs were associated with documentation of the auditor’s evaluation of items communicated to the audit committee and audit reports lacking a sufficient description of how the CAM was addressed in the audit and the principal considerations that let to determination that the item was a CAM.
• Auditor tenure (AS 3101): While this isn’t a complex calculation, auditors continue to get it wrong! The PCAOB has published documents to help teams appropriately comply.
• Audit committee communications (AS 1301): There’s a slew of required audit committee communications. The main issues included failure to communicate regarding other auditors, critical accounting policies and practices, and the management representation letter.
• Audit documentation (AS 1215): Compliance with the required time period to have all audit documentation completed and archived was the most common issue.
• Fraud considerations (AS 2401): Many of these issues are recurring issues, including testing the completeness of the journal entry population, thoroughly brainstorming fraud risk characteristics and selecting those most relevant to the company and performing additional procedures beyond inquiry for each journal entry identified with a fraud risk criteria.
• Required forms (Form AP, Form 3, etc.): Timely and accurate completion of required forms has been the source of comments and fines.

Part I.C – Non-compliance with independence rules

New in 2022, this section of the report indicates instances of potential non-compliance with the SEC and/or PCAOB rules relating to maintaining independence. An instance of potential non-compliance does not mean that the firm was not objective and impartial during the audit. This section is split into PCAOB-identified and firm-identified instances of potential non-compliance. Common instances of potential non-compliance noted by the PCAOB and firms related to:

• Performance of non-audit services (e.g., performing management functions or bookkeeping)
• Lack of audit committee pre-approval for services provided
• Financial relationships such as investments in issuer audit clients (and/or issuer’s affiliates) by a member of the engagement team
• Employment relationships (e.g., a former employee of the firm was employed at an issuer audit client in a financial reporting oversight role)

It is important to note that there are many variables that impact the firm-identified instances of potential noncompliance, including the size of the firm, the significance of the instance of potential non-compliance, the number of non-US associated firms in the global network, the complexity of the issuer it audits (including the issuer’s affiliates) and the firm’s independence monitoring program. Because of these variables, the PCAOB cautions against comparing firm-identified instances of potential non-compliance to other firms.

Part II – Observations related to quality control

Part II of the inspection reports contain observations related to quality control. These could be criticisms or defects in the firm’s system of quality control. Part II deficiencies are not initially disclosed publicly, however, if the firm does not address the items noted within 12 months of the inspection report’s issuance date, then the PCAOB will publish the issues publicly. Examples of quality control observations are listed below, but remember, these are from prior year inspections.

• Inappropriate tone at the top, specifically noting a repeated high level of deficiencies year-over-year
• Acceptance of clients and engagements and partner workload
• Supervision of the audit
• Engagement quality review

Quality control overhaul

A significant overhaul of quality control systems is coming for all audit firms (public and private). While the IAASB is leading the charge internationally, the AICPA has adopted quality management standards and the PCAOB has its own version. With the passage of these new quality control standards, audit firms will be required to implement a system of quality management to ensure compliance with quality objectives, thereby enabling quality audits. Annually, firms will need to assess the effectiveness of their systems of quality management by testing controls and monitoring various firm metrics. Need to get up to speed on these changes? Register for our FREE, CPE-eligible (1.0 CPE) webinar on June 11, 2024 at 11:00 AM here.

Want to learn more?

We’ve only scratched the surface when it comes to discussing all the data we found in the PCAOB inspection reports! Check out our newly released PCAOB eBook to dive into the details of our analysis.

Whether you want to refresh on foundational audit concepts or dive deep into a technical accounting topic, GAAP Dynamics can help! We have a full catalog of eLearning courses. Additionally, we have extensive libraries covering both U.S. GAAP and IFRS, as well as industry-specific training. If you have any questions, don’t hesitate to reach out! 

About GAAP Dynamics  

We’re a DIFFERENT type of accounting training firm. We don’t think of training as a “tick the box” exercise, but rather an opportunity to empower your people to help them make the right decisions at the right time. Whether it’s U.S. GAAP training, IFRS training, or audit training, we’ve helped thousands of professionals since 2001. Our clients include some of the largest accounting firms and companies in the world. As lifelong learners, we believe training is important. As CPAs, we believe great training is vital to doing your job well and maintaining the public trust. We want to help you understand complex accounting matters and we believe you deserve the best training in the world, regardless of whether you work for a large, multinational company or a small, regional accounting firm. We passionately create high-quality training that we would want to take. This means it is accurate, relevant, engaging, visually appealing, and fun. That’s our brand promise. Want to learn more about how GAAP Dynamics can help you? Let’s talk!

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.