The PCAOB explains that one should read the reports with the understanding that they are written to identify and elaborate a number of deficiencies or potential deficiencies rather than to provide an overall evaluation of how the auditors are doing. Further, the reader should distinguish these deficiencies or potential deficiencies from violations of law. None of the deficiencies necessarily implies any legal troubles for the auditors. With these caveats in mind, let’s explore what these four reports show.
Part I.A of each report outlines the specific procedures that the PCAOB followed. I shall leave that material for interested readers to peruse on their own (they can find the reports at www.pcaobus.org). Part I.B lists specific observations made by the PCAOB.
The PCAOB noted problems with respect to Emerging Issues Task Force (EITF) 95-22 for some issuers of each of the Big Four. Recall that EITF 95-22 requires that certain types of revolving lines of credit be reported as current debt instead of long-term debt. Given the many exceptions, one wonders whether the board randomly selected this issue or whether it had some inkling of the problems in this area. I hope the latter, since the former would imply more problems over many accounting topics.
The other misapplications of Generally Accepted Accounting Principles (GAAP) do not show any particular pattern. They cover improperly mixing rebates with accounts receivable, commingling additional paid-in capital with par value, not segregating current and noncurrent deferred income taxes, improperly netting translation reclassification adjustments, misclassifying certain costs as restructuring charges, excluding loan origination costs when determining gains and losses on the sale of mortgage loans, not expensing earn-out payments in excess of the originally agreed amounts, and improperly accounting for a counterparty position in a forward sales commitment.
Many statements and interpretations published by the Financial Accounting Standards Board (FASB) require certain disclosures by the corporations; however, issuers have been slack with several of these disclosure requirements. The PCAOB noted a number of undisclosed or improperly disclosed items by companies, and they dealt with guarantees related to certain leases, the determination of goodwill impairment, and the effects of certain types of regulation.
The good news is that a common response by the large accounting firms to most of these problems is that the financial statement effects are immaterial. On the other hand, let’s keep in mind that the rationale for the materiality principle is to avoid administrative and bookkeeping costs of proper accounting, as might be incurred if one were to depreciate the costs of a pencil sharpener over its useful life. The rationale is not to provide cover for bad accounting.
With respect to attestation practices, the PCAOB discovered a number of snags. In some cases, the auditor did not obtain evidence to support various assertions or assumptions, such as whether it could rely on the work by internal auditors. In one situation, the auditor did not confirm accounts receivable. One engagement team failed to report its findings to the audit committee of the corporation. Some management representation letters did not have all of the required signatures.
The PCAOB also found little or no documentation on a host of topics. These matters include not documenting the adequacy of a new ledger system, no documentation on the audit work pertaining to various account balances, and no documentation of the reliance on the work of others, whether external auditors, internal auditors, various experts, or third-party providers. They also include the lack of documentation of an inventory count, for a net operating loss carryforward, or for a receivable due to an environmental remediation. In addition, the PCAOB discovered that some misstatements by issuers did not appear on the summary of unadjusted audit differences.
One set of problems concerned an issuer for which the engagement team perceived had issues with its status as a going concern and with the valuation of long-term assets (a number of them appeared impaired). Amazingly, the auditors deemed the engagement risk as normal. I agree with the PCAOB that such risk minimally was above normal. Also, the engagement team kept these concerns within the local office. While that decision is not surprising, given its risk assessment, I believe that the PCAOB is correct in chastising them for not taking the matter to the national office and obtaining the opinions of those with more expertise.
Part II of these reports is not public. Part III contains the response by the audit firm. Like Part I.A, I shall leave these responses for the reader to peruse if he or she wishes to.
Overall, I am struck with the thoroughness and the candor of the reports. While the PCAOB performed a limited review and sampled some of the issuers audited by each of these auditing entities, the PCAOB did a good job looking into the facts and reporting the problems it unearthed. If the board continues to execute its responsibilities at this level, the investment community will have much confidence in its work and increased trust in the auditing profession.
It is much more difficult to evaluate the Big Four; as the PCAOB stated, these reports do not provide a balanced evaluation of how they are doing. The reports only present the problems and the areas of concern. My hope is that that they will respond to these reports with changes in structure and purpose and human resources so that their audits are better in the future. Auditing is quite a complex business already, and the firms need ways to cope with these intricacies.
J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals, and columnist of The Accounting Cycle for SmartPros.com.
