As public companies and their external auditors gear up for the year-end audit cycle, it will likely include some familiar, yet still uncomfortable, conversations.
“I don’t think there are any big surprises this year,” says Trent Gazzaway, national managing partner at Grant Thornton. “Some of the primary areas we have focused on continue to be the biggest challenges.”
Internal control over financial reporting, for example, continues to be a high priority at the Public Company Accounting Oversight Board, where inspectors are driving auditors to keep digging. The PCAOB recently published a brief summarizing where it focuses its inspection efforts, and the audit of internal control remains important, along with how auditors respond to risks of misstatement, and how they audit accounting estimates, including fair value. The PCAOB also warned auditors to be mindful of economic factors that might give rise to audit risks, such as merger and acquisition activity, the hunger for investment yields, and volatility in certain commodity prices.
Given volatile market conditions and continued scrutiny of estimates and internal controls, companies will be under significant pressure from auditors this year to leave no stone unturned in their defense and documentation of estimates and judgments. “When you look broadly at the economy, current economic factors in the United States are a mixed bag right now,” Gazzaway says. “The stock market is up and down frequently, economic growth continues at a moderate pace but consumer spending is still relatively strong, and international trade is slowing.” All of that will cause auditors to look closely at potential impairments and going-concern warnings, he says.
“You can rest assured auditors are going to be really focused on qualitative assessments.”
John Sullivan, Senior Managing Director, FTI Consulting
Michael Loritz, shareholder at audit firm Mayer Hoffman McMann overseeing audit methodology, says auditors will be applying more professional skepticism this year. “With increased regulatory scrutiny around skepticism, the increasing complexity of the estimates we see, increased international business transactions, this year it is a particular emphasis,” he says.
Chris Smith, partner and leader of accounting and auditing professional practice at BDO USA, says he’s cautioning auditors to step back and take in the big picture before diving into any given audit. “Before an engagement team starts thinking about anything specific, they need to take a pause and think about the risks that are attendant at that particular client,” he says. “Take a fresh look. What are the risks and where are the risks? When you are finished planning, make sure you’ve inventoried enough procedures to address the risks that are there. That’s first.”
David Middendorf, national managing partner for audit quality and professional practice at KPMG, says he’s encouraging companies and their auditors to plan early. “Constructive dialogue between a company and its auditor is important for maintaining high-quality audits,” he says. The firm has established milestones and monitoring for the timing and sequence of key engagement activities, he says, to make audits more effective. “We have accelerated select audit tasks out of the traditional January-to-March ‘busy season’ to improve audit quality and optimize work flow.”
Below are some particular areas the PCAOB expects to focus on in the coming year.
Engagement Quality Review
Inspections staff continues to focus on whether auditors complied with Auditing Standard No. 7, Engagement Quality Review , including the reviewer’s evaluation of significant judgments, identification of and responses to significant risks, and identification of significant engagement deficiencies.
Inspections staff continues to be concerned with the number of audit deficiencies noted in areas where an engagement quality reviewer reviewed, or should have reviewed, the audit work and related conclusions in the specific areas involved.
Previous years’ inspection observations have raised concerns about whether some auditors appropriately apply professional skepticism in the course of their audits.
In many of the audits reviewed, it appeared that firms sought to obtain only evidence that would support significant judgments or representations made by management, rather than to critically assess the reasonableness of management’s judgments or representations, taking into account all relevant evidence, regardless of whether it confirmed or contradicted management’s assertions. Similar concerns are raised by other audit deficiencies, such as accepting the reliability of issuer-produced data and reports as audit evidence without sufficiently testing the accuracy and completeness of such information.
As a result, Inspections staff continues to focus on whether auditors are maintaining and applying professional skepticism in all areas of their audits, particularly those that involve significant management judgments or transactions outside the normal course of business, as well as how it relates to the auditor’s consideration of fraud.
Auditing Standard No. 18, Related Parties, became effective for audits of fiscal years beginning on or after December 15, 2014. The standard supersedes AU Section 334, Related Parties, and amends other PCAOB standards. The standard and amendments address: (i) relationships and transactions with related parties, (ii) significant unusual transactions, and (iii) financial relationships and transactions with executive officers. The standard also imposes new requirements relating to the auditor’s communications with the company’s audit committee. In 2015, Inspections staff is reviewing firms’ plans to implement the new standard.
In specific audit themes, auditors will focus heavily on internal controls, says Pat Voll, vice president at consulting firm RoseRyan—although that should come as no surprise to companies. The inspection brief published by the PCAOB covered the same internal control themes regulators have been pushing for at least a few years, she says. “Make sure the electronic information you’re relying on is complete and accurate,” she says. “How do you know the report you’re using is reliable? The big push is the precision around management review controls.”
John Sullivan, senior managing director at FTI Consulting, says merger and acquisition activity will be another big focus for auditors, given the level of M&A activity of the past few years in an up-and-down market. “With the stock market and commodity pricing volatility, that all puts some pressure on whether or not you have impairment testing,” he says. Companies that might assert, based on a qualitative assessment, that impairment testing is not warranted will need plenty of evidence to back up that claim. “You can rest assured auditors are going to be really focused on qualitative assessments.”
Where companies assert that their foreign-earned profits are reinvested overseas, companies will need good evidence there as well, says Chris Wright, managing director at consulting firm Protiviti. Regulators are taking note where companies make such assertions as a way to minimize the tax impact of bringing earnings back to the United States and subjecting them to U.S. corporate income tax. “Auditors will look not only at their assertions, but their actions, and whether their actions support or undermine their assertions,” he says.
Revenue recognition is another perennial area of focus for auditors, experts say, both under existing standards and under rules yet to take effect. “While the new revenue recognition standard is a couple of years away, this will be the year for public companies where auditors will ask: What are you doing to prepare for this?” Loritz says. “Do you know what the impact is going to be? What are your plans?”
Wright also expects auditors to remain focused on existing application of revenue recognition rules as well. “Companies need to be every bit as buttoned up under the current rules as they will need to be under the new ones,” he says. “It continues to be an area of focus, and comments are across the spectrum.”
Finally, experts are warning companies that auditors are under new standards this year to take a closer look at transactions with related parties, where business dealings might somehow be tied to relationships with executives, board members, or key shareholders. The PCAOB adopted Auditing Standard No. 18 to take effect this year, telling auditors to study such transactions more closely.
“It really does put into words the fact that we need to be more active and proactive in thinking about the procedures we do first to identify related parties and then transactions with those related parties,” Smith says. “In many instances, there may be more conversations going on with more company personnel. There might be different individuals within the organization where auditors are going to want to carry on more in-depth conversations to understand significant or unusual transactions.”