PCAOB Finds Deficiencies Galore

In a review of its first four years of inspections of the eight largest U.S. audit firms, the Public Company Accounting Oversight Board (PCAOB) reveals a wide range of problems in important audit areas, including revenue testing, fair value measurements, and determination of materiality and audit scope.

The 28-page report includes criticisms that the Board previously leveled in its inspection reports on the individual firms, some of which were vigorously rebuffed by the firms at the time. In a September 2007 letter to the PCAOB, for example, PricewaterhouseCoopers took issue with some negative findings of the Board's 2006 inspection. PwC insisted that its procedures were sufficient to support its conclusions and opinion.

Still, the report makes for some eye-opening reading, not least in its claim that deficiencies may have been caused "at least in part, by the failure to apply the appropriate level of professional skepticism when conducting audit procedures and evaluating audit results."

Other causes for concern include the firms' partner evaluation and compensation processes. In some cases, technical personnel were reporting to partners whose responsibilities included growing the audit practice, raising the possibility that decisions on the technical side may have been influenced by considerations of profitability.

The most frequent areas of failure included:

Revenues. Not surprisingly, audit firms ran aground on complex revenue-generating transactions and processes such as estimated fair values of all elements in arrangements with multiple deliverables. But they also failed to observe basic principles of revenue recognition, such as the timing and booking of revenue in connection with the sale of goods.

Accounting Estimates. The firms often chose to evaluate management's estimates by testing the client's process for developing the estimate. But they sometimes failed to understand the methodology, or to test the reasonableness of the underlying assumptions or the data used.

Fair Value Measurements. The Board's inspection teams noted inadequate testing of fair value estimates in evaluations of possible impairment of goodwill and other long-term assets. And, no surprise, firms had trouble testing the fair value of financial instruments, including derivatives, loans, and securities.

Not all of the findings are negative, though. The report notes that the incidence of deficiencies has declined in some well-established audit areas such as confirmation of A/R and income tax accounts. And the Board found improvements in the majority of cases in which it reviewed a firm's practices after commenting on them in previous years.