April 2013

On February 25, 2013, the Public Company Accounting Oversight Board (PCAOB) issued its summary report on smaller accounting firms. The PCAOB described its inspections and related reporting here as follows:

“This report covers domestic audit firms that audit the financial statements of issuers, and that regularly issue 100 or fewer audit reports each year. Such firms must be inspected at least once every three years (“triennially inspected firms”). This report describes inspection findings from 578 firms and 1,801 individual audits that were inspected in 2007-2010. … This report summarizes observations resulting from inspections of triennially inspected firms that took place from 2007 through 2010.”

Overall, the report showed a higher-than-acceptable rate of audit deficiencies, but improvement over the prior results. The PCAOB summarizes:

“The Board previously issued a report in October 2007, addressing observations from inspections of triennially inspected firms from 2004 through 2006 (“the 2007 report”). Overall, the results in this report compared to the 2007 report show a reduced rate of reported significant audit performance deficiencies. Approximately 44 percent of the audit firms inspected between 2007 and 2010 had at least one significant audit performance deficiency compared to the 2007 report where approximately 61 percent of the audit firms inspected between 2004 and 2006 were reported as having at least one significant audit performance deficiency. …

With respect to the inspections conducted from 2007 through 2010 that are the subject of this report, firms have remediated quality control deficiencies described in Part II of the inspection report to the Board’s satisfaction in approximately 90 percent of those cases in which the Board has concluded on the firm’s efforts. Firms’ remediation activities to address specific quality control deficiencies have encompassed a range of actions, including enhancements of quality control policies and procedures, developing technical guidance targeted to specific issues, developing and requiring training targeted to specific issues, developing new audit tools, and requiring additional audit procedures.”

The deficiencies covered a broad range of topics. The list of deficiencies was not changed much from the prior report and currently includes the following audit areas:

  1. Revenue recognition;
  2. Share-based payments and equity financing instruments;
  3. Convertible debt instruments;
  4. Fair value measurements;
  5. Business combinations and impairment of intangible and long-lived assets;
  6. Accounting estimates;
  7. Related party transactions;
  8. Use of analytical procedures such as substantive tests; and
  9. Material misstatement due to fraud.

Specifically in regard to the valuation of intangible assets, the PCOAB states:

“Goodwill and other intangible assets that are not subject to amortization are required to be evaluated for impairment annually, or more frequently when events or changes in circumstances indicate that the asset might be impaired or that the fair value of a reporting unit had fallen below its carrying value.… Inspections staff have observed instances where firms’ procedures to test and conclude on the valuation of goodwill, other indefinite-lived intangible assets, and other long-lived assets were inadequate. In numerous cases in which the issuer was a small operating company or development stage enterprise, the firm concluded that there was substantial doubt regarding the issuer’s ability to continue as a going concern, and the issuer had earned minimal revenues, incurred significant net losses, and/or reported negative cash flows from operations. Inspections staff observed instances in which, despite the presence of that combination of factors, firms accepted the issuers’ conclusions that the intangible assets and/or long-lived assets were not impaired without performing procedures to test the process the issuer used to reach that conclusion or performing an independent impairment analysis.”

In 2011, these goodwill impairment tests became easier, as described here. However, the tests still need to be done, and benefit from outside valuation expertise.

Importantly, in an accompanying press conference, PCAOB member Jay Hanson indicated that the small firm deficiencies were no worse than what is seen with the larger firms. Mr. Hanson stated:

“Among the very smallest firms, we have inspections with no findings as well as inspections that reveal significant audit failures. Likewise, inspectors have encountered medium-sized and larger firms, even those with sophisticated clients that have billions of dollars reported on their balance sheets, with few or no findings, while multiple failures have been observed at other firms of similar sizes. Thus, we have no evidence of any correlation between the size of a firm and its ability to perform an audit that complies with PCAOB standards.” (Emphasis added)

Fulcrum Inquiry performs forensic accounting and business valuation services.