Regulators are making a new push to forearm audit committees with information that will help them prod their audit firms to ask more questions and dig deeper into risky issues.
The Public Company Accounting Oversight Board has offered some new tips to audit committees on questions they should be asking their external auditors, focused not coincidentally on the issues the PCAOB most often identifies as trouble spots through its inspection process. The cheat sheet also offers suggested questions for audit committees on emerging market risks that the PCAOB has put on its radar for consideration in this year’s audit inspections.
While the PCAOB has no regulatory authority over audit committees, the board does want to engage audit committees as stronger advocates for investors at the companies they serve. “We hope these insights will be useful to audit committees in your 2015 oversight activities,” the PCAOB says in its guidance, dubbed the “Audit Committee Dialogue.” “You may also find these insights useful in your interactions with management. You are key stakeholders in strengthening audit quality.”
The guidance summarizes the top issues that have peppered inspection findings across all the major audit firms for the past several years: the audit of internal control over financial reporting; auditing of fair value and other accounting estimates; and auditors’ assessment of, and responses to, risks of material misstatements in financial statements. It also addresses market risks such as the rise in mergers and acquisitions, falling oil prices, undistributed foreign earnings, and concerns about audit quality as the major firms pursue growth opportunities in consulting services.
“If you’re a true financial expert, you most likely have already thought about many of these topics,” says Arnie Hanish, chairman of the audit committee for Omeros Corp. “But many audit committees are not comprised of true financial experts with deep accounting and financial reporting background. This really helps put things in perspective and frames the discussion points around the audit approach.”
PCAOB inspection reports on audit firms can be “opaque,” says Phil Wedemeyer, chairman of the audit committee at Atwood Oceanics and a former auditor, because the PCAOB does have limits on what it can disclose publicly under the Sarbanes-Oxley Act. For example, audit committees can’t easily read an inspection report of their own audit firm to determine how many of the findings might apply to their own company. Hence the PCAOB wants to be more helpful via other means, such as this new guidance.
“To their credit, they’re trying to make this useful,” Wedemeyer says. “But only in the context of not getting very specific about what they’re talking about.” He gives the example that audit committees still aren’t sure how often the PCAOB’s stated concerns are focused primarily on major audit firms, or extend into smaller firms and smaller companies as well.
“In places like China, the PCAOB cannot inspect, but there’s a lot of activity there. Audit committees in that instance might have more oversight of external auditors.”
Chris Wright, Managing Director, Protiviti
Going Where PCAOB Cannot
Chris Wright, managing director at consulting firm Protiviti, says his reading of the guidance suggests the PCAOB wants to do more than simply inform audit committee members, and perhaps to enlist them to serve as an adjunct of the PCAOB’s regulatory arm. The report provides some insight, for example, into where the PCAOB sees problems in cross-border audits. That includes instances where the principal audit firm refers portions of the audit work to an affiliate in another country where the company has operations.
The PCAOB says that in 2013 inspectors found “significant problems” in more than 40 percent of such engagements at the six largest audit firms. While 2014 results are still under evaluation, “inspections continued to identify deficiencies in referred-work engagements,” the report says. The PCAOB is still prohibited by some countries from performing inspections at firms whose work flows into U.S. capital markets through such cross-border audit arrangements.
“In places like China, the PCAOB cannot inspect, but there’s a lot of global activity there,” Wright says. “Audit committees in that instance might have more visibility, more influence, and more oversight of external auditors than the PCAOB. The audit committee is not only welcome, but probably obligated, to question the auditors about the audit quality. The audit committee as a body has a greater ability to affect the quality control, or at least be advised of it, than the PCAOB in those countries.”
DEFICIENCIES IN NON-U.S. REFERRED WORK
Of all referred work engagements inspected, below the PCAOB identifies the percentage in which inspections staff identified deficiencies that resulted in the firm failing to fulfill the objectives of its role in the audit.
Larry Rittenberg, chairman of the audit committee at Woodward Inc., says he sees auditors becoming more active on many issues the PCAOB raised in the guidance to audit committee members, including the oversight of global affiliates and the work they provide. “We wanted to make sure they were in China for the audit of one of our units there that was undergoing its first year of SOX testing,” he says. “It was considered high risk for us, and they already had it scheduled for the U.S. principal to be there because they saw it as high risk as well.”
Hanish agrees that the best approach to managing cross-border audits is for U.S. firms to provide more physical presence in other countries where audit work is originating. “You have to impress on local partners the critical nature of the client, the risks and the challenges,” he says. “Some firms do a better job than others in terms of global coordination of affiliate operations.”
The PCAOB’s recent guidance to audit committees brings into focus the importance for companies of having sophisticated, well-educated audit committee members, says Fred Lipman, a partner with law firm Blank Rome and president of the Association of Audit Committee members. “You’ve got to get the best-quality people who are familiar with what they should be asking,” he says.
Lipman says he finds many auditors are becoming more active about the issues raised in the PCAOB outreach to audit committees and voluntarily provide such information in their presentations to audit committees. “It really depends on the sophistication of the audit committee,” he says. “Some are asking all the same questions and more.”
Brian Markley, a partner at consulting firm SolomonEdwards, says audit committees often focus on both the effectiveness and efficiency of the audit. “To strive for an efficient audit, one done on a timely, cost-effective basis, that doesn’t always produce the most effective audit,” he says. “The effort of the PCAOB here is to bring more attention toward the effectiveness side of the scale. The focus of this should be more accurate financial statements, with fewer restatements, and better audit quality.”