PCAOB Issues Guidance to Audit Committees on Audit Firm Inspection Process SUMMARY The Public Company Accounting Oversight Board has issued a release to assist audit committees in: understanding the PCAOB s inspection process of audit firms; and gathering useful information from their external audit firms about such inspections. The PCAOB intends the release to better equip audit committees to engage in meaningful discussion with audit firms about the results of inspections. The release also highlights several areas that audit committees may wish to address in inspection-related communications with its auditors, including: whether the company s audit was selected for PCAOB inspection; whether the PCAOB identified deficiencies in other audits that involved auditing or accounting issues similar to issues presented in the company s audit; the audit firm s responses to the PCAOB s findings; and the audit firm s remedial efforts in response to any PCAOB-identified quality control deficiencies. While the PCAOB is statutorily prohibited from publishing certain portions of the inspection report, the release stresses that there is nothing preventing audit firms from discussing this information with, or providing copies to, audit committees. Audit committees should consider whether to take the PCAOB guidance into account in structuring their discussions with the external auditors, with a view toward putting the audit committee in a position to understand inspection findings and remediation efforts of auditors and to evaluate the potential implications for the company. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
BACKGROUND On August 1, 2012, the PCAOB issued Release No. 2012-003, Information for Audit Committees about the PCAOB Inspection Process, largely in response to concerns that the nature and amount of inspection-related information that audit firms provide to audit committees vary, and that some audit firms decline to discuss their PCAOB inspection results with audit committees or downplay any adverse findings in such reports. The release seeks to provide audit committees with clarity about the PCAOB inspection process and the meaning and significance of reported inspection results, and guidance to enable audit committees to initiate meaningful discussion with audit firms about the results of inspections. PCAOB INSPECTIONS OF PUBLIC COMPANY AUDITORS Under the Sarbanes-Oxley Act of 2002 (the Act ), the PCAOB is required to conduct regular inspections of public accounting firms that provide audit reports for SEC-reporting companies for the purpose of assessing compliance with applicable laws, rules and professional standards. For every inspection, the Act requires the PCAOB to prepare a written report and allow the inspected audit firm to respond in writing to a draft of the report. If the audit firm submits a response, the PCAOB makes public, as part of the final report, any portion of the response that the audit firm chooses to have made public. A PCAOB inspection of an audit firm examines in depth: certain aspects of a limited number of audits performed by the audit firm; and certain elements of the audit firm s system of quality control over its audit processes. PCAOB inspections are designed to identify and address weaknesses and deficiencies related to how an audit firm conducts audits. Areas of focus vary among selected audits, but often involve audit work on the most difficult or inherently uncertain areas of financial statements. The PCAOB cautions against extrapolating broader conclusions about the frequency of deficiencies throughout an audit firm s practice from the results presented in the public portion of a report, but notes that this information can be a useful starting point for discussion about the inspection between an audit committee and the audit firm. PCAOB inspection findings are contained in two of the four parts of an inspection report: Part I Describes audit deficiencies where inspection staff found that the auditor failed to gather sufficient audit evidence to support an audit opinion. Part I findings are made public and are made available on the PCAOB s web site. Part II Typically describes deficiencies in the audit firm s overall system of quality control such that the PCAOB has doubts that the system provides reasonable assurance that professional standards are met. 1 The PCAOB is prohibited by the Act from publicly releasing these findings unless the audit 1 The PCAOB notes that an audit performance quality control criticism typically focuses on a specific aspect of a firm s audit work, but may also include a discussion of issues that, at a more general level, affect audit performance across various aspects of the audit firm s audits, such as concerns -2-
firm fails to remediate these findings to the PCAOB s satisfaction within twelve months of issuance of the inspection report, and cannot compel an audit firm to disclose non-public inspection information to an audit committee. The audit firms themselves, however, are not prohibited by law from releasing this information at any time, nor are audit committees prohibited from asking for this information. INSPECTION-RELATED COMMUNICATIONS WITH AUDIT FIRMS Although each audit committee should judge for itself how it wishes to discuss PCAOB inspection issues with its auditor, 2 an audit firm s candid discussion of its PCAOB inspection results with an audit committee, in the PCAOB s view, can have value not only in relation to the audit committee s oversight and evaluation of the audit engagement generally, but also in relation to the audit committee s role in the oversight of the company s financial reporting processes. 3 The release notes that the PCAOB routinely communicates inspection information to the SEC, on an issuer-specific basis, including information about auditing deficiencies, possible material misstatements in the financial statements, possible material weaknesses in internal control over financial reporting, potential auditor independence violations, and other issues, all of which inspectors usually will have first raised with the inspected audit firm, and which the audit firm is free to discuss with the audit committee. The PCAOB indicates that an audit committee may benefit from having an understanding with its audit firm through which the audit committee receives timely information (both during the inspection and when the PCAOB has issued a final inspection report) about: whether the company s audit is selected for review in an inspection; if so, the audit committee may wish to be kept informed during the course of the inspection about the areas being reviewed and any concerns raised by the inspectors concerning the audit or the company s financial reporting; whether anything has come to the audit firm s attention suggesting the possibility that an audit opinion on the company s financial statements is not sufficiently supported, or otherwise reflecting negatively 2 3 about the audit firm s approach to supervision and review, or concerns about the sufficiency of the audit firm s emphasis on the application of due care and professional skepticism. Other quality control criticisms may relate to aspects of the audit firm s management of its audit practice, such as how the audit firm s management structure and processes and partner management practices affect audit quality, how the audit firm considers and addresses risks in connection with client acceptance and rejection decisions, and how the audit firm seeks to ensure compliance with independence rules. Existing SEC rules, PCAOB rules and auditing standards, and a pending proposed standard, address the question of what communications an audit firm must have with an audit committee, but they do not include requirements for firms to disclose inspection information to audit committees. For a discussion of the pending PCAOB proposal, see our memorandum, dated March 1, 2012, entitled PCAOB Reproposes Auditing Standard Related to Communications Between Auditors and Audit Committees. Audit committees of New York Stock Exchange listed companies must annually obtain and review a report by the auditor describing, among other things, any material issues raised by the most recent internal quality-control review, or peer review, of the firm, or by any inquiry... by governmental or professional authorities, within the preceding five years, respecting one or more independent audits carried out by the firm, and any steps taken to deal with any such issues.... NYSE Listed Company Manual, Section 303.A.07(b)(iii)(A). -3-
on the audit firm s performance on the audit, and what, if anything, the audit firm has done or plans to do about it; whether a question has been raised about the fairness of the company s financial statements, the adequacy of disclosure or the auditor s independence relative to the company; whether any of the matters described in the public portion of the inspection report involve the company s audit or, even if they do not, whether they involve issues and audit approaches similar to those that arise or could arise in the audit of the company s financial statements; to the extent any such similarity exists, whether and how the audit firm has become comfortable that the same or similar deficiencies either did not occur in the audit of the company s financial statements or have been remedied; how issues described by the PCAOB in general reports summarizing inspection results across groups of firms relate to the audit firm s practices, and potentially the audit of the company s financial statements, and how the audit firm is addressing those issues; what changes the audit firm has been making to its policies and procedures to address quality control issues indicated by deficiencies in the audit of the company's financial statements or to reduce the chance that types of deficiencies identified in other audits will arise in audits of the company's financial statements; the inspected years about which the PCAOB has made a final determination about the audit firm's quality control remediation efforts and the nature of that determination; whether the PCAOB has provided initial indications that the audit firm may not have sufficiently remediated any items; and the progress of the quality control remediation process, including a discussion of any submissions made to the PCAOB as part of that process, and, on an ongoing basis, any changes in status of the quality control remediation process, including any determinations by the PCAOB. The PCAOB stresses that the Act does not prohibit audit firms from disclosing or discussing the nonpublic portions of the report, and cautions audit committees against accepting any audit firm's assertion otherwise. PCAOB GUIDANCE WITH RESPECT TO CERTAIN AUDIT FIRM ASSERTIONS Part I, the public portion of an inspection report, includes any portions of an audit firm s response to the draft report that the audit firm chooses to have made public. In the PCAOB s view, these public portions of audit firms responses may in some cases make assertions that create uncertainty or confusion in the reader s mind concerning the nature and significance of the reported deficiencies. The release discusses three assertions the PCAOB believes audit committees should view with skepticism: Assertions that characterize PCAOB criticisms as documentation deficiencies rather than as deficiencies in the performance of procedures to obtain audit evidence. The PCAOB states that audit firms sometimes assert or imply that the audit firm performed procedures to obtain the necessary audit evidence and that the criticism arises only because the firm did not sufficiently document its procedures. However, the PCAOB bases deficiency findings on an absence of available evidence in the audit files or elsewhere to support that adequate work was done to support an audit opinion, not just whether such work was documented. Assertions that characterize PCAOB criticisms as differences in professional judgment. According to the PCAOB, audit firms sometimes assert or imply that audit deficiencies cited by PCAOB inspectors reflect differences between the inspection staff and the audit firm within a range of acceptable professional judgments. The PCAOB views such assertions with skepticism because the -4-
PCAOB bases deficiency findings only on failures to obtain sufficient audit evidence, not on disagreements when reasonable judgments appear to have been made about such matters. Assertions that the audit firm has addressed PCAOB criticisms in accordance with PCAOB standards. The PCAOB states that, in response to an inspection report criticism that an audit firm had not obtained sufficient evidence to support an audit opinion, audit firms sometimes assert broadly that they have considered and complied with AU sec. 390. 4 According to the PCAOB, audit firms asserting compliance with AU sec. 390 frequently do not indicate whether they have performed additional procedures in response to the finding or in subsequent audits, or whether they disagreed with the finding that additional procedures were necessary. An audit committee may wish to seek clarification about whether the audit firm s position is that its opinion was sufficiently supported at the time it was originally issued, or whether the audit firm has obtained additional audit evidence through additional auditing procedures, possibly including procedures performed in subsequent audits, that informs its position that the previously expressed opinion is supported. * * * Copyright Sullivan & Cromwell LLP 2012 4 AU sec. 390, Consideration of Omitted Procedures After the Report Date, provides that an auditor should assess the importance of the omitted procedure to the auditor s ability to support the previously expressed opinion. This assessment may include a review of the working papers, discussions with engagement personnel, and a re-evaluation of the scope of the audit, including the existence of compensating procedures. -5-
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