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PCAOB Mulls Changes in Inspections and Enforcement

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PCAOB Mulls Changes in Inspections and Enforcement

PCAOB is seeing some “slivers of hope” in audit quality improvement

Thursday, May 5, 2016

By Michael Cohn, Accounting Today

The Public Company Accounting Oversight Board is considering changes in its approach to audit firm inspections and enforcement, according to PCAOB board member Jeanette Franzel.

Speaking at Baruch College’s Financial Reporting Conference in New York on Thursday, Franzel said the PCAOB is seeing some “slivers of hope” in audit quality improvement. “Generally, audit firms have made significant improvements, and PCAOB inspections have helped drive those improvements,” she said.

However, she added that firms have a way to go in strengthening their quality control systems and their own monitoring to prevent audit deficiencies. “Investors would benefit if firms can up their game and strengthen quality control to prevent audit deficiencies in the first place,” said Franzel.

She noted that some firms are starting to experiment with ways to improve audit quality, particularly larger firms. “The larger firms are at different points on this journey, and unfortunately, we still find a number of smaller firms each year that just don't get it,” she said.

Franzel believes the PCAOB may need to look more closely at the area of quality control. “In my optimistic view, we could see a time when a large firm improves its quality control system so that it prevents audit deficiencies,” she said. “In such a scenario, a PCAOB inspection could change its focus from the current detailed level of inspecting aspects of individual audits to looking more deeply at that quality control system that is so critical for supporting and maintaining high audit quality. Such an approach could be highly efficient and effective at catching quality control weaknesses early, with a focus on preventing audit deficiencies. This is an aspiration at this point, albeit a worthy and achievable one.”

The PCAOB's director of registrations and inspections, Helen Munter, reported last year that overall audit quality has improved over the past 13 years, Franzel pointed out. Five key areas have shown the most improvement: firm leaders' "tone at the top;" targeted and focused training; new practice aids and checklists; coaching and support to teams; and monitoring the quality of work performed. However,

Munter also reported five areas that continue to be challenging for firms with further improvements needed, according to Franzel: recurring audit deficiencies in certain key areas; the processes at some firms for remediating quality control criticisms identified in PCAOB inspections; implementing and maintaining "root cause analyses" of audit deficiencies throughout firms and their global networks; consistent execution of audit methodology and approach around the globe by networked firms; and monitoring auditor independence issues.

Franzel said firms need to do more root cause analysis to understand their deficiencies. Project management and scheduling are often factors.

One potential change that the PCAOB is exploring is selecting audits for inspection on a broader basis than the current risk-based selection approach, potentially having random selections.

“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.”

She acknowledged she has heard differing views about the potential results of inspecting audits outside of the current risk-based selection approach. “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,” said Franzel. “Another potential future change could involve evolution in the focus of inspection procedures between inspecting individual audits and testing of a firm's quality control system. Currently, inspection staff assess whether a firm has weaknesses in its quality control system based on the number and types of deficiencies identified in individual audits, combined with the results of testing certain aspects of the quality control system.”

Franzel noted that the percentage of audit deficiencies has declined for three of the Big Four firms in the latest inspection reports. If a large firm strengthens its quality control system to the point that it has very few audit deficiencies in the individual audits inspected by the PCAOB, then it could make sense to increase the inspection focus on testing the firm's quality control system while potentially decreasing the number of audits inspected, according to Franzel.

“Such an approach could be highly efficient and effective at catching quality control weaknesses early, with a focus on preventing audit deficiencies,” she added. “I would see this as a very positive evolution in audit quality and regulatory response.”

That approach could help prevent problems rather than having the PCAOB count up the problems once they occur. However, she cautioned that this was only an aspirational proposal at this point, and all firms should be dedicating themselves to effectively preventing audit deficiencies.

Enforcement Changes
Franzel also highlighted some of the ways in which the PCAOB’s enforcement program has been changing. She noted that the PCAOB’s Division of Enforcement and Investigations, or DEI, is working with the board to apply new approaches and techniques. In 2013, the PCAOB began a new policy to give firms credit for extraordinary cooperation, such as self-reporting and taking remedial corrective actions. For the first time last year, the PCAOB applied that policy and did not commence disciplinary action against an audit firm based on that credit.

Also last year, for the first time, the PCAOB issued an order in which a settling respondent admitted to a disciplinary order's facts, findings and violations. All prior PCAOB settled orders have noted that the settling respondents neither admitted nor denied the PCAOB’s findings. That precedent was in keeping with the SEC’s efforts to avoid settlements in which a party does not admit or deny any wrongdoing.

During the past year, Franzel noted, the DEI also focused on conducting a number of critical enforcement sweeps, specifically for independence and engagement quality reviews. The PCAOB has recently announced settled disciplinary orders related to these efforts.

In addition, the DEI is also making use of data analytics technology to help identify potential violations and prioritize and coordinate cases with the SEC and other regulators.

“Since launching its enforcement program in 2004, the Board has brought a number of notable enforcement actions involving audit failures, independence violations, and failures to comply with Board orders and rules,” said Franzel. “Through March 31, 2016, the Board has publicly announced the resolution of 160 enforcement proceedings—including 125 sanctions against firms, with 64 revocations of firm's registrations with the Board and 112 sanctions against associated persons, resulting in 86 bars and 11 suspensions.”

Of the 64 revocations of firm registrations, 36 are permanent and 29 include the right to petition the PCAOB to terminate the revocation, she noted. To date, the PCAOB has not acted on any petition to terminate a revocation. Of the 86 bars against individuals associating with a registered firm, 29 are permanent and 57 include the right to petition the Board to terminate the bar. To date, the PCAOB has granted only two petitions to terminate a bar.

Franzel noted that the PCAOB is also making cross-border audits a priority. “As a result of globalization, audits have become more complex, and with complexity come additional risks,” she said. “The Board's enforcement proceedings included 18 with respondents outside the United States in countries including as Australia, Denmark, Hong Kong, India, Indonesia, Israel, Italy, Japan, Malaysia, Nicaragua and Spain.”
Another major concern is improper alteration of audit documents. “Enforcement staff has recently uncovered evidence of instances of misconduct involving improperly deleting, adding, or altering audit documentation at a range of firms, including firms affiliated with global networks,” said Franzel. “Addressing these matters is a higher priority.”

Just two weeks ago, she noted the PCAOB issued Staff Audit Practice Alert No. 14, Improper Alteration of Audit Documentation , articulating staff concerns about auditors improperly altering audit documentation in connection with PCAOB inspections or investigations.

The PCAOB also has concerns about auditors of broker-dealers. Franzel noted that a recent interim report on audits of broker-dealers showed horrendous results. Many firms had independence problems.
While many of the auditors of broker-dealers are small firms, she sees a place for smaller auditing firms than the Big Four, however. “Getting the right auditor with the right client can reduce audit risk,” she said.

In the area of standards, Franzel revealed that the PCAOB plans to soon issue a reproposal on changes in the auditor’s reporting model. In addition, the PCAOB is working on coordinating more closely with the IAASB, the International Auditing and Assurance Standards Board, which has issued its own proposals for changing the format of audit reports.

Franzel also discussed the work of the PCAOB’s Office of Research and Analysis, which has been researching how firms’ business models might be increasing risk.

The PCAOB has also been developing audit quality indicators, although Franzel said the board probably won’t mandate the use of them. However, it wants to encourage firms to use them. After her speech, she told Accounting Today they would probably be issued in the form of a white paper rather than as a required standard.

“We would encourage people to continue experimenting,” said Franzel. “A lot of committees are already starting to do this stuff.”

One of the groups developing audit quality indicators is the Center for Audit Quality. The CAQ issued a statement from executive director Cindy Fornelli in reaction to Franzels’ remarks on the PCAOB’s inspections approach.

“The CAQ welcomes comments from Board Member Franzel regarding potential areas to evolve the PCAOB’s inspection process as part of the Board's mission to enhance audit quality,” said Fornelli. “Over the years, firms have invested—and will continue to invest—heavily in quality control at the firm and engagement levels, which is demonstrated by higher levels of audit quality. Just as the public company auditing profession is built on a commitment to a continuous cycle of improvement, it is important for the inspection process to evolve and continue to benefit investors and the capital markets. As the PCAOB explores changes to the inspection process, it will be critical to continue to engage in a robust dialogue with the profession and the public about how the Board is inspecting and evaluating the work of public company auditors.”

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