Monday, October 22, 2007

PCAOB Reports Significant "Triennial Firm" Audit Concerns

Under Section 104(b) of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) is required to inspect audit firms that regularly provide audit reports for fewer than 100 public companies "not less frequently than once every 3 years." On October 22, 2007, the PCAOB released a Report regarding its inspections of these so-called "triennial firms" entitled "Report on the PCAOB’s 2004, 2005 and 2006 Inspections of Domestic Triennially Inspected Firms." (here). The Report is significant because even though many of the 497 triennial firms inspected are small and may audit as few as a single public company, as a group the triennial firms "audit thousands of public companies." Because the triennial firms audit so many public companies, the PCAOB’s Report detailing its concerns regarding the firms’ audits has significant implications for those who rely on those audits.

It is important to emphasize that the PCAOB’s concerns do not relate to all triennial firms or to all triennial firms’ audits. As many as 43% of the PCAOB’s 497 triennial firm inspections did not identify any audit performance deficiencies. And it is also important to note that the PCAOB’s inspections encompass only a fraction of the audits that the triennial firms have performed.

Nevertheless the PCAOB took the opportunity to identify the frequently recurring audit deficiencies, so that the triennial firms are fully aware of the areas where they can enhance the quality of their audits. The PCAOB Report identifies 11 areas where auditing or quality control deficiencies were noted. The 11 areas are summarized on the PCAOB’s October 22, 2007 news release (here), as well as in the October 22, 2007 CFO.com article entitled "PCAOB: The 11 Things Auditors Need to Fix"(here).

While the 11 items cover a lot of ground, several of the items appear to be quite important, particularly given that among the "thousands" of public companies that the triennial firms audit are likely to be smaller or less financially stable companies. Without reading too much into it, the Report does seem to suggest that in some instances the triennial firms’ audits may represent less of an assessment of the audited companies’ financial statements than those who rely on the audits might otherwise assume.

For example, the first concern noted in the Report has to do with the triennial firms’ failure to perform adequate procedures to test the validity and/or appropriate accounting of revenue. While revenue issues are of concern with regard to all companies, revenue issues may be of particular importance regarding smaller or developmental stage companies. For these kinds of companies, investors and others may put particular emphasis on revenue because often there are not profits and there is not lengthy operating history on which to assess the company.

Another troublesome issue relates to the PCAOB’s concern that some triennial firms were not performing sufficient procedures to determine whether or not an entity can continue as a going concern. Because an auditor’s "going concern" opinion would be critically important to investors, creditors and others who might rely on the audit opinion, some triennial firms’ failure to perform the required audit procedures is potentially very troublesome, particularly since among the companies that the triennial firms audit are likely to be smaller and less financially stable companies.

A more technical concern noted relates to the proper accounting for "reverse acquisitions," where the auditor is required to determine the "accounting acquirer," without regard to the legal form. Where, for example, an actively operating private company merges with a dormant shell, the private company is the accounting acquirer, rather than the shell. So, for example, accounting comparisons across reporting periods should relate back to the private company’s previous operations than to the public shell’s. The failure of some triennial firms to get this correct again raises serious concerns.

The PCAOB’s report identifies numerous other issues, some equally as if not more important than those noted above. However, it certainly should not be assumed that all problems are avoided with a Big Four auditor; indeed, the CFO.com article notes that "each of the Big Four inspection reports so far have listed at least seven audit deficiencies," while 124 of the triennial firm inspections noted no deficiencies at all. Moreover, it would be a misinterpretation to take the PCAOB’s Report as a condemnation of triennial firms. To the contrary, the whole purpose of the Report is to help triennial firms to take steps to improve their audit quality, not to attack them.

Nevertheless, some of the issues discussed in the PCAOB’s Report are concerning. For investors, creditors, D & O underwriters and others who review and rely on public company audit reports, the PCAOB’s Report at least raises the question of the extent to which reliance on some audits could be misplaced. At a minimum, those reviewing public companies’ financial statements that have been audited by triennial firms may want to proceed cautiously and supplement their financial statement review with other inquiries.

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