September 2015 home executive summary audit deficiencies pcaob inspections methodology are still significant description of a deficiency audit deficiency trends fvm deficiencies impairment deficiencies pcaob s audit deficiencies by audit standard concluding thoughts acuitas, inc.
Executive Summary Public Company Accounting Oversight Board ( PCAOB ) inspection reports provide insight into recent audit quality trends. Acuitas, Inc. s Survey of Fair Value Audit Deficiencies ( Survey ) is intended to assist financial statement preparers, auditors, and valuation specialists in understanding the underlying causes of fair value measurement ( FVM ) and impairment audit deficiencies, as reported by the PCAOB. There are a number of key findings and trends that were gleaned from the 2008 to 2013 inspection reports. 43% of all audits inspected by the PCAOB had deficiencies in 2013. This rate has steadily increased from 2009 when the PCAOB found deficiencies in only 16.0% of the audits reviewed. FVM audit deficiencies continue to be significant, making up 21.5% of total deficiencies for annually inspected firms in 2013. The PCAOB cited substantive failures associated with AU 328 Auditing Fair Value Measurement and Disclosures in 10.3% of the deficient audits in 2013. FVM audit deficiencies are increasingly attributable to business combination engagements. The incidence FVM deficiencies related to business combinations jumped from an average of 9% for 2008 through 2011 to 45% in 2012 and increased further to 49% in 2013. This trend is likely caused by a rebound in merger and acquisition activity as the economy continues its recovery. The number of deficiencies cited by the PCAOB caused solely by failures to assess risk and test internal controls increased sharply in 2012 and remains high in 2013 at 45% of all deficiencies for the top 25 firms. These risk assessment and control deficiencies caused 45.3% of the FVM deficiencies and 32.3% of impairment deficiencies cited by the PCAOB in 2013. This is a significant shift from earlier years when FVM deficiencies were primarily caused by inadequate substantive testing of asset prices and impairment deficiencies were primarily caused by inadequate substantive testing of management s prospective financial information ( PFI ). 1
FVM Audit Deficiencies Continue To Be Significant Audit deficiencies attributable to FVM and impairment engagements continue to be significant and made up approximately one third of all audit deficiencies in 2013. The purpose of the Survey is to help financial statement preparers, auditors, and valuation specialists understand the ultimate causes of FVM and impairment audit deficiencies and failures, according to the PCAOB. The purpose is also to highlight trends in the PCAOB inspection findings, in aggregate. The information contained in the study should be of benefit not only to public entities and their auditors, but by extension, to private entities and their auditors. The survey begins with a brief overview of the PCAOB inspection process, our survey methodology and a description of an audit deficiency. It examines trends in audit deficiencies by looking at statistics over a six year period. Another section of the survey provides information about the specific causes of FVM and impairment audit deficiencies. A final section summarizes the PCAOB s break down of 2013 audit deficiencies by auditing standard. PCAOB Inspections The PCAOB conducts inspections of registered public accounting firms as required by the Sarbanes-Oxley Act of 2002. The inspections are designed to identify and address deficiencies in a firm s audit engagements and to determine whether deficiencies indicate a weakness or defect in the firm s system of quality control over audits. The annual inspection process encompasses a review of selected audits and a review of the firm s system for quality control. PCAOB reviews of selected audits are intended to identify financial statement misstatements, including failures to comply with disclosure requirements and failures to perform applicable audit procedures. When a deficiency reaches a level of significance that appears to indicate the firm failed to obtain sufficient audit evidence to support its audit opinion on the financial statements or on the effectiveness of internal control over financial reporting, the deficiency is described in the PCAOB s inspection report, which is publicly available. The PCAOB performs annual inspections of firms that regularly provide audit reports for more than 100 issuers. The largest international auditing firms, Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP and PricewaterhouseCoopers LLP ( the Big Four ) are among the nine firms inspected annually. 1 The PCAOB conducts inspections triennially (once every three years) of smaller auditing firms that audit public registrants. While the PCAOB inspection reports are silent about the financial statement dates of the audit engagements examined, the PCAOB s field work generally begins just after the audit season in February or March, and extends through October or November. Therefore, it appears likely that 2013 inspection reports relate to audits of 2012 financial statements. 1 The remaining firms are McGladrey LLP, Grant Thornton LLP, MaloneBailey, LLP, Crowe Horwath LLP and BDO USA, LLP. 2
Methodology The Survey of Fair Value Audit Deficiencies from PCAOB Inspection Reports was prepared using a twofold approach. First, we examined the PCAOB s inspection reports for firms subject to annual inspection. In order to analyze trends in audit deficiencies, we focused on the nine firms with inspection reports available each year from 2008 through 2013. The nine firms include Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, PricewaterhouseCoopers LLP, McGladrey LLP, Grant Thornton LLP, BDO USA LLP, MaloneBailey, LLP and Crowe Horwath LLP. The PCAOB performed field work at each of these nine firms national offices and in 172 (35.8%) of the firms practice offices, and reviewed aspects of 308 audits and 6 other engagements. Our summary of PCAOB findings appears in the section entitled Audit Deficiency Trends. The purpose of the second part of our survey is to analyze the types of engagements that give rise to FVM and impairment deficiencies and to examine the causes of these deficiencies. The second part of the survey covers all of the PCAOB inspection reports available for the top 25 public accounting firms 2 for 2008 through 2013, including those subject to annual inspection and those subject to inspection every three years. Of the 96 available inspection reports, 64 (66.7%) had FVM and impairment audit deficiencies. The PCAOB provides a brief description of the type of audit failure and the underlying cause. For each report, the PCAOB generally presents each deficiency as a separate bullet point. Acuitas counts and categorizes each deficiency based on the type of audit failure. FVM deficiency categories include financial instruments, pension plans and business combinations, and impairment deficiency categories include those attributable to goodwill, asset groups and intangible assets. The underlying causes were tallied and audit deficiency statistics were calculated. Description of a Deficiency The individual PCAOB inspection reports themselves do not define deficiency. However, Auditing Standard No. 7 Engagement Quality Review provides a description, saying that a significant audit engagement deficiency exists when (1) the engagement team failed to obtain sufficient appropriate evidence in accordance with the standards of the PCAOB, (2) the engagement team reached an inappropriate overall conclusion on the subject matter of the engagement, (3) the engagement report is not appropriate in the circumstances, or (4) the firm is not independent of its client. 3 2 The 2015 accountingtoday Top 100 Firms, www.digital.accountingtoday.com. 3 PCAOB Auditing Standard No. 7 Engagement Quality Review 3
Audit Deficiency Trends The PCAOB inspections for annually inspected firms from 2008 through 2013 indicate several trends. First, the percentage of audit engagements with deficiencies has increased dramatically since 2009 4 and remains high. In connection with the nine 2013 annual inspections, the PCAOB found deficiencies in 132 issuers, or 42.9% of audits and other engagements examined which is similar to 2012 inspections. In 2009, the inspection reports for the same nine firms cited deficiencies in 61 issuers, or 16.0% of audits examined 50.0% PCAOB Annually Inspected Firms 40.0% 30.0% 20.0% 10.0% 0.0% 2009 2010 2011 2012 2013 % of Engagements with Deficiencies 4 The percentage of audit engagements with deficiencies is not available for 2008. 4
A second trend indicates that FVM and impairment deficiencies have declined for the annually inspected firms since their peak in 2010 while other deficiencies increased and remained high. In 2010, there were 126 FVM and 40 impairment deficiencies, representing 48.4% of all deficiencies and in 2013 there were 70 FVM and 31 impairment deficiencies, representing 31.0% of total deficiencies. Deficiency Trends Number of Deficiencies 220 200 180 160 140 120 100 80 60 40 20 0 2008 2009 2010 2011 2012 2013 FVM Deficiencies Impairment Deficiencies Other Deficiencies A third trend is the increase in the number of deficiencies cited by the PCAOB caused by failures to assess risk and test internal controls. These risk and control deficiencies increased sharply in 2012 and remain high in 2013. Risk assessment and control deficiencies caused 45.3% of the FVM deficiencies and 32.3% of impairment deficiencies cited by the PCAOB in 2013 for the top 25 audit firms. FVM and impairment deficiencies are discussed at length in the next sections of the survey. The PCAOB s recent emphasis on risk assessment and testing internal controls can also be seen in the breakdown of audit deficiencies for other types of audit failures. Substantive testing failures alone account for only 26% of audit failures while risk assessment and control testing failures contribute to 74% of audit failures. 2013 Other Deficiency Causes 26% 26% 48% Risk Assessment & Control Testing Substantive Testing Both 5
FVM Deficiencies In all six years, FVM deficiencies were primarily attributable to financial instruments; however the percentage decreased from 80% in prior years to 51% in 2013. Business combinations were the source of an average of 17% of FVM deficiencies in prior years; however, deficiencies related to business combinations increased substantially to 49% of all FVM deficiencies in 2013. These trends are likely caused by audit improvements for financial instruments that resulted from the PCAOB inspection process and by increased merger activity in recent years. 2013 FVM Deficiencies 2008 to 2012 FVM Deficiencies 3% 49% 17% 51% 80% Financial Instruments Business Combinations Financial Instruments Business Combinations Pension Plans While pricing deficiencies and failures to adequately perform substantive tests were the primary causes of FVM failures in earlier years, a new deficiency trend was observed in 2012 and 2013. In recent inspection reports, there were many instances where the PCAOB cited audit deficiencies relating to testing internal controls over FVM without citing a related substantive testing deficiency. This internal control trend for FVM is consistent with all other aspects of financial reporting. In the 2013 inspection reports, the PCAOB indicated that 45.3% of FVM deficiencies, 32.3% of impairment deficiencies and 48.0% of other deficiencies were primarily caused by failures to assess risk and identify and / or test internal controls. The following are typical examples of deficiencies related to internal controls cited by the PCAOB. The Firm selected for testing only one control, a review control, over the valuation of investment securities. The Firm s procedures to test this control were limited to observing the evidence that the review had occurred, without evaluating whether the control operated a t a level of precision that would prevent or detect material misstatements related to the valuation of the investment securities. 6
The Firm s tests of certain review controls over the accounting for business combinations were insufficient. Specifically, the Firm s procedures were limited to observing evidence of reviewer sign-off, without evaluating whether the controls operated at a level of precision that would prevent or detect material misstatements. More specific descriptions of these FVM audit deficiencies taken from the PCAOB inspection reports are provided in the insert on the following page. 2013 FVM Deficiency Causes 2008 to 2012 FVM Deficiency Causes 45% 15% 13% 19% 8% Pricing Failure to Test Disclosures Risk Assessment/ Controls PFI Assumptions 22% 4% 7% 9% 23% 35% Pricing Failure to Test Disclosures Risk Assessment/ Controls PFI Assumptions OTTI Classification 7
Descriptions of Fair Value Measurement Deficiencies Pricing Includes failure to understand the methods, models and assumptions used by pricing services or valuation specialists; using the same pricing service to corroborate prices that the issuer used when measuring fair value; failure to investigate significant differences between prices from different sources; failure to investigate pricing differences identified by internal audit; failure to investigate adjustments made to third party prices by issuers; and inappropriately applying the yield or discount rate from one population to test securities prices or values in the test population without assessing the comparability of the two groups. Failure to Test Includes relying on interim testing and failing to test the assertion there was no material change in value; relying on interim testing and failing to perform procedures at year end; failing to perform sufficient substantive procedures when significant risks are identified; failing to perform year end tests when broker quotes were older than 30 days; failing to perform substantive tests when too much reliance is placed on internal controls or internal audit; failure to assess whether all assets and liabilities had been identified in a business combination; failure to test data provided to outside valuation specialist; failure to test the accuracy and completeness of data that valuation specialists relied on; failure to test fair value when requested pricing information was not received; failure to test all items in a selected sample; and outright failure to test certain assets and liabilities. Disclosures Includes failure to identify and test controls over FVM hierarchy disclosures; failure to test FVM hierarchy classification as Level 2 or Level 3; and failure to assess whether an input is observable or unobservable when testing the FVM hierarchy classification. Risk Assessment / Controls Includes the failure to identify and test controls over inputs to FVMs; setting risk thresholds so high that material errors are not detected; failure to investigate controls over resolution of pricing differences; failure to identify weakness due to lack of supervision by qualified personnel in the testing of hard-to-value financial instruments; failure to test controls over the budgetary process; and failure to test controls over the classification of securities as available for sale. Projected Financial Information (PFI) Assumptions Includes failure to evaluate the reasonableness of assumptions relating to revenue growth rates, capital expenditures, terminal growth rates and the discount rate; failure to assess the reasonableness of improved margins; failure to consider industry growth rates; erroneously using PFI from a period prior to a reorganization; failure to evaluate customer attrition rates; failure to evaluate the risk premium in the issuer s weighted average cost of capital; failure to evaluate a significant difference between value indications from the market and income approaches; and failure to assess a change in weights assigned to various indications of value. Other Than Temporary Impairment (OTTI) Includes failure to test controls over the classification of securities as OTTI; failure to test the issuers evaluation of securities as potentially OTTI; and failure to evaluate the assumptions, calculations and completeness of the issuer s OTTI test. 8
Impairment Deficiencies While the number of impairment deficiencies has remained relatively flat since 2011, they were dominated by those related to goodwill impairments with 48.4% in 2013, and 54.4% in 2008 to 2012. Most of the remaining impairment deficiencies relate to long lived asset groups. The incidence of deficiencies relating solely to the impairment of intangible assets was 16.1% in 2013. 2013 Impairment Deficiencies 2008 to 2012 Impairment Deficiencies 16% Goodwill 11% Goodwill 36% 48% Long Lived Asset Groups Intangible Assets 35% 54% Long Lived Asset Groups Intangible Assets The underlying causes of audit deficiencies related to impairment testing highlights the PCAOB s recent emphasis on risk assessment and testing internal controls. In 2013, 32.3% of impairment deficiencies were caused by failures to assess risk and test internal controls. The graph for 2008 to 2012 understates this trend as 50% of impairment deficiencies were caused by internal control failures in 2012, up from 21% in all previous years. The PCAOB s focus on internal control deficiencies for impairment testing is similar to the trend observed for FVM deficiencies. More specific descriptions of these impairment audit deficiencies taken from the PCAOB inspection reports are provided following the Impairment Deficiency Causes graphs. 2013 Impairment Deficiency Causes 2008 to 2012 Impairment Deficiency Causes PFI Assumptions 5% PFI Assumptions 32% 36% Risk Assessment/ Controls Failure to Test 24% 43% Risk Assessment/ Controls Failure to Test 32% 28% Asset Mismatch 9
Descriptions of Impairment Deficiencies PFI Assumptions In addition to the PFI assumption deficiencies mentioned for FVM, a deficiency relating to the failure to test the model, inputs and assumptions used to value a loan portfolio in connection with a goodwill impairment analysis was identified. Risk Assessment / Controls Additional deficiencies were failure to assess the issuer s methodology for determining fair value of reporting units, failure to identify deficiencies in controls relating to triggering events; and failure to assess whether the timing of impairment charge was appropriate. Failure to Test An additional deficiency was failure to test the issuer s assertion that assets were not impaired and ignoring evidence that triggering events had occurred. Asset Mismatch Including failure to identify a mismatch between the group of assets being tested for impairment and the group of assets included in the calculation of carrying value; and failure to identify an issuer s departure from GAAP by allocating goodwill to reporting units. 10
PCAOB Audit Deficiencies by Audit Standard In its reports, the PCAOB emphasizes that deficiencies represent circumstances when the firm failed to obtain sufficient appropriate evidence to support its opinion that; 1) the financial statements were presented fairly, in all material respects, in accordance with applicable accounting principles, and/or 2) the issuer maintained, in all material respects, effective internal controls over financial reporting. Furthermore, the PCAOB indicates that audit deficiencies involve the lack of due professional care in the planning and performance of audit work. According to the PCAOB, audit failures are caused by a critical absence of due professional care which requires that auditors apply professional skepticism to assess the appropriateness and sufficiency of audit evidence taking into consideration the risk of material misstatement, the risk mitigated by controls and the relevance and reliability of audit evidence. In connection with its 2013 inspection reports, the PCAOB provides references to specific auditing standards for each deficiency cited. These references to auditing standards are summarized in the following graph. 2013 Audit Deficiencies by Auditing Standard AS No. 5 - Audit of Internal Control 3.6% 2.9%2.7% 3.9% 6.0% 10.3% 11.5% 16.4% 40.5% AS No. 13 - Risk of Material Misstatement AU 350 - Audit Sampling AU 328 - Auditing FVM & Disclosures AU 342 - Auditing Estimates AS No. 14 - Evaluating Audit Results AU 329 - Substantive Analytic Procedures AS No. 15 - Audit Evidence AU 322 - Considering Internal Audit AS - Other AU - Other 11
Concluding Thoughts Based on our analysis of PCAOB inspection reports, it is apparent that the number of audits with deficiencies remains high. Consistent with our findings in prior surveys, a significant number of these deficiencies relate to the auditing of fair value measurements and impairment testing. In early PCAOB inspection reports, audit failures were primarily attributable to deficiencies in the fair value measurement of financial instruments caused by pricing problems and failure to adequately test the value. More recent inspection reports indicate a significant drop in deficiencies related to financial instruments to 51.4% and an increase in the number of deficiencies related to business combinations to 48.6%. Meanwhile, there has been a significant shift in the primary cause of FVM deficiencies. FVM failures are now primarily attributable to failures to assess risk and test internal controls. The number of impairment deficiencies and the relative numbers of goodwill, intangible asset and asset group impairment deficiencies cited by the PCAOB has remained fairly constant for the last three years. However, the number of deficiencies caused by failures to properly assess risks and to test the controls related to impairment has increased since 2011, consistent with our observations for FVM risk assessment and controls. While professional judgment is required in both the audit engagements and the PCAOB inspection process, professionals may reach different conclusions as to the adequacy of the audit process. PCAOB inspection deficiencies relate to the audit process where the deficiencies were of such significance that the firm failed to obtain sufficient appropriate audit evidence to support its audit opinion on the financial statements and / or the effectiveness of internal control. This survey is a summary of publicly available information, the purpose of which is to hightlight trends in audit deficiencies related to fair value measurements and impairments. A more complete presentation of the underlying data can be found in the inspection report themselves. Acuitas, Inc. Acuitas, Inc. is an Atlanta, Georgia based valuation and decision consulting firm. Additional information about our firm can be found at www.acuitasinc.com. For more information about how Acuitas, Inc. can assist with valuation-related services, please contact Mark Zyla, Managing Director at 404-898-1137 or mzyla@acuitasinc.com. 12