Accounting & Auditing | Legislative / Regulatory

PCAOB contemplates more random inspections

The Public Company Accounting Oversight Board is contemplating a shift in its inspection methodology, a board member told a financial reporting conference in New York City.

The shift, said PCAOB member Jeanette Franzel, would be to increase the number of audits chosen at random, thereby increasing the scope of audits inspected. That's in addition to the PCAOB's longstanding emphasis on a "risk-based" approach to inspections.

Her remarks were provided at Baruch College's 15th annual Financial Reporting Conference. 

"Increasing the selection of audits or audit areas outside of the risk-based selection approach could help us assess firms' compliance with standards in the types of audits and areas that PCAOB inspections have not focused on in the past," said Franzel. "This may provide information about how firms' quality control systems are operating across a wider span of issuer audits." 

The PCAOB's risk-based inspection approach was developed to provide maximum efficiency and effectiveness, much like the approach used by auditors in conducting audits of clients. However, the usefulness of randomly chosen transactions or audits to inspect has increased over time. That's due in large part to the growth of data analytics technologies that can quickly examine large quantities of data, finding needles in the haystack, so to speak, that may lead to more pervasive technical or quality control issues.

Views among stakeholders in the PCAOB inspection process are mixed, noted Franzel. "Some have speculated that the less risky audits may have lower incidences of audit deficiencies due to less complexity inherent in those audits, while others speculate that audit deficiencies could actually be higher in that group due to less focus and attention being placed on those audits by the firms," she said. 

Another potential change in the PCAOB's inspection process (contingent on further evolution and improvement in audit firms' quality controls, said Franzel) would be for the PCAOB to rely more on the quality control system to decrease the level of substantive inspection procedures. This type of change in methodology, she noted, would follow the methodolgy that audit firms use when they determine they can rely on a company's internal control system and reduce a certain amount of substantive testing accordingly.

Specifically, Franzel said, "If a large firm strengthens its quality control system to the point that it has very few or no Part I audit deficiencies in the individual audits inspected by the PCAOB, then it may make sense to increase the inspection focus on testing the firm's quality control system while potentially decreasing the number of audits inspected. This follows the same theory used in an audit when considering the effectiveness of internal controls in determining the level of substantive testing that is needed."

4 enforcement priorities
Franzel also outlined the four current priorities of the PCAOB's Division of Enforcement and Investigations (DEI). Noting the DEI has a "robust pipeline of cases," she said, "DEI is currently focused on the following priority areas involving serious audit deficiencies:"

  1. Lack of independence and integrity of the audit.
  2. Lack of professional skepticism associated with serious audit deficiencies.
  3. Non-cooperation with the board's inspection process or enforcement proceedings.
  4. Violations of the board's standards and rules in cross border audits. 

Rulemaking on Auditor's Reporting Model 'in the coming weeks'
Discussing the PCAOB's standard-setting priorities, Franzel noted that an earlier proposal on the Auditor's Reporting Model, which proposed requiring auditors to provide a narrative discussion of critical audit matters as part of the auditor's report. The PCAOB has completed its review of comment letters on the original proposal and is preparing to come forward with a reproposal "in the coming weeks," said Franzel. She indicated that the other significant area of the original proposal − addressing an expansion of the auditor's procedures and reporting related to "other information outside the financial statements that is contained in documents that include the audited financial statements and the related auditor's report" − would be taken up in a separate proposal at a later date.  

 Other significant standard setting projects, and their status, include the following:

  1. Auditing Accounting Estimates, Including Fair Value Measurements: Anticipated proposal to revise current standards in the fourth quarter of 2016.
  2. The Auditor's Use of the Work of Specialists: Anticipated proposal to revise current standards in the fourth quarter of 2016.
  3. Quality Control Standards, Including Assignment and Documentation of Firm Supervisory Responsibilities: Staff is conducting research and outreach activities exploring whether to recommend changes to PCAOB quality control standards.
  4. Going Concern: Staff is continuing research and considering next steps.

Engagement partner disclosure
Additionally, Franzel noted that the PCAOB's final rule requiring disclosure of the name of the engagement partner was awaiting SEC approval, a step mandated by the Sarbanes-Oxley Act. "If approved by the SEC," said Franzel, the engagement partner disclsoure rule "will take effect next year." Disclosures about other accounting firms participating in the audit would also be required.

Accounting firms will need to file a new form, said Franzel, called Form AP, "Auditor Reporting of Certain Audit Participants," for each issuer audit. She explained key items reported will include:  

  • the name of the engagement partner;
  • the name, location, and extent of participation of each other accounting firm participating in the audit whose work constituted at least 5 percent of total audit hours; and
  • the number and aggregate extent of participation of all other accounting firms participating in the audit whose individual participation was less than 5 percent of total audit hours.

In related news, SEC Deputy Chief Accountant Wes Bricker, speaking at the same Baruch conference, praised the PCAOB's progress on its standard-setting actiities and its progress generally on increasing efficiency and effectiveness. 

Details on Franzel's remarks can be found in her speech, Progress and Evolution in Audit Oversight to Protect Investors and the Public Interest.