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Audit & Accounting Alert Newsletter

Issue 2 | February 2013


Gerry Herter

This issue marks the start of the second year for the Audit & Accounting Alert. In the inaugural issue last February, the results of the PCAOB inspections of the Big 4 audit practices in the United States were covered.

A year later, our first article looks at the latest inspection reports to see what has changed. Looking back over this first year of publication, much coverage has also been given to the long, challenging road toward global financial accounting standards. Two areas that will play a key role in the future effectiveness of those standards are disclosures and professional ethics. American and international boards are developing frameworks for both that are designed to provide useful roadmaps to facilitate future efforts and actions. Our second and third articles describe current projects in these two endeavors.

Editor Gerald E. Herter, CPA

In This Issue 

Audit Inspection Results in for National Firms

Deficiencies reveal ongoing need for improvement

Annual inspection reports on all Big Four audit firms have been completed, with the final one issued in December 2012. Judging by the number of deficiencies noted, little ground has been gained over the prior year. Shortcomings were found in 23% to 41% of audits selected for examination by the PCAOB, compared with rates of 20% to 45% in 2011.

The reports, available on the PCAOB website, are useful for all auditors in that they provide insights to common instances of substandard work. As expected, numerous issues were raised in the testing of the complex area of fair value determinations. However, failings in basic procedures, such as those related to confirmations and depreciation calculations, were also detected.

In all four reports, the inspectors indicated that “deficiencies included failures by the Firm to identify, or to address appropriately, financial statement misstatements, including failures to comply with disclosure requirements, as well as failures by the Firm to perform, or to perform sufficiently, certain necessary audit procedures.” A firm’s claim to have performed a procedure was not accepted in the absence of actual documentation or other persuasive evidence.

Undue reliance was placed on assumptions, both from management and external sources. Schedules and analyses provided by the client to support an assumption were at times accepted without further testing, or only by inquiry of the client, without corroboration with substantiating evidence. For example, rollforward documentation produced by the client was not sufficiently scrutinized.

In many cases, tests of internal controls were found to be inadequate. Consequently, the substantive test procedures were also deficient, since they placed a level of reliance on the internal control that was not warranted, due to the control testing inadequacy. For example, in testing the operating effectiveness of a control related to revenue and costs, the completeness and accuracy of data used in the operation of the control were not tested. Therefore, improper reliance was placed on that control when designing the substantive procedures to assess completeness, existence and valuation of revenue and costs.

The inappropriate reliance on internal controls and management assumptions was similar to concerns in the prior year, as well as a lack of understanding of valuation methods, inadequate updates of interim to year end results evaluation, and a lack skepticism The PCAOB felt that the concerns over flawed internal control audits were so significant that a separate report was issued in December to address just this issue. Similarly, the recurrent failure to apply professional skepticism led to the December PCAOB Staff Audit Practice Alert on skepticism discussed in last month’s issue.

On a global scale, the International Forum of Independent Audit Regulators (IFIAR) in December issued its first survey of audit inspection findings. The IFIAR was founded in 2006, has a membership of independent audit regulators from 44 jurisdictions, and focuses on 1) sharing related knowledge and experience, 2) promoting regulatory collaboration and consistency, and 3) providing a platform for dialogue on audit quality. The survey covered member inspection reports issued in the twelve months prior to June 30, 2012. That timing would include the US reports from 2011.

The IFIAR survey results indicate that the deficiencies in US audits are consistent with those found elsewhere in the world. The most frequent items related to fair value measurements, internal control testing, and engagement quality control reviews. Specifically for major financial institution audits, the most frequent findings related to internal control testing, valuation of investments and securities, and the audit of allowance for loan losses and loan impairments.

The lack of professional skepticism was noted, also. Furthermore, concerns with audit firm quality control systems questioned whether they provided “reasonable assurance that 1) audit engagements are performed in accordance with professional standards and legal requirements; 2) the firms have sufficient personnel with the technical competence, capabilities, and commitment to ethical principles necessary to perform audits; and 3) the firms and its personnel are in compliance with independence and ethical requirements.”

The survey report concluded: “The fact that so many findings recur year after year in the same inspection theme areas, suggests that audit firms should take steps to develop a robust root cause analysis to gain a clearer understanding of the factors that underlie these findings and take appropriate actions to remediate those inspection findings.” Apparently, the corrective steps that the audit firms claim to have taken in response to their inspection reports have so far not been effective in resolving the shortcomings. A good next step would be for audit firms to study the documents mentioned in this article for new insights.

 On a more positive note, the 2012 Annual Report of the United Kingdom’s Audit Commission disclosed that its review of audits of local governmental bodies showed that the auditors had made improvements over the prior year’s audits. Even so, even there room for improvement was called for as to professional skepticism, not sacrificing audit quality due to fee pressure, assuring independence, better communications to audit committees, and better evidence supporting auditor judgments.

For further information, see PCAOB Inspection Reports, IFIAR Audit Inspection Survey, and
PCAOB Report on Internal Control Audits

Accounting Boards Address Financial Statement Disclosures

The elusive search for optimum communication

The IASB and FASB are separately responding to the call for more effective and practical approaches that will determine financial statement disclosures. Meaningful and appropriate disclosures are key components for describing how accounting principles are applied in financial statements. Both boards intend to develop frameworks for disclosure to replace the rather piecemeal and inconsistent practices currently in place.

In July, the FASB issued an Invitation to Comment (ITC), Disclosure Framework, followed by two forums in October. The comment period for the ITC ended November 30, and a summary of the forums was released in December. The ITC observed that the preparation of financial statement notes “can be an exercise in complying with requirements instead of in communicating useful information and only useful information.” This state of affairs has resulted from the large volume of required notes, questionable relevance, and a lack of discretion in the disclosures to be included.

The ITC describes a possible framework for developing disclosure requirements that would be relevant, flexible, and employ user judgment for determining applicability. As such, a note disclosure would be required if “a) it is unique to an entity or its industry; b) it is not already apparent from financial statements or readily available from public sources to which users could be expected to have access; and c) it could make a material difference in assessments of future cash flow prospects.”

With over 80 comment letters and more than 50 participants in the forums, there was wide support for disclosure reform, but also a wide spectrum of opinions as to how to get there. While excessive disclosures can cause difficulty in locating the important issues that lie within them, at the same time other important issues may be missing altogether. Another concern is whether materiality should be used instead of, or along with, relevance as a criteria. Additionally, flexibility is considered helpful, but may need to be tempered with the need for structure in order to retain comparability and consistency.

Those in the public arena were hesitant for any recommendations to be implemented unless the SEC was involved as well, to assure compatibility in requirements. In this regard, there is hope that with recent congressional action and changes in SEC leadership, there may be a more receptive stance from the SEC for disclosure reform.

As the Disclosure Framework process continues, the FASB has proposed an Accounting Standards Update to address a disclosure concern specific to private entities. The amendment to ASU 2011-04 would exempt private entities from the requirement to disclose fair value hierarchy (Level 1, 2 or 3) for items that are not measured at fair value in the statement of financial position, but for which fair value is disclosed in the footnotes.

The IASB initiated a “Request for Views” consultation process in July 2011, regarding its future agenda, that drew 243 comment letters, and included 105 meetings, conferences and roundtables, leading to a Feedback Statement issued in December. Financial statement disclosure issues were incorporated in the discussion of the Conceptual Framework project.

The IASB process in this area trails the FASB effort by about a year. The Conceptual Framework project will focus on the reporting entity, financial statement presentation, elements and measurement, as well as disclosures. Given a high priority and targeting September 2015 for completion, the project has scheduled a Discussion Paper for June, akin to the ITC, and will also hold a multi-stakeholder forum in 2013. The forum may generate some short-term fixes while the overall project continues. The hope is that practical guidance may result that streamlines current disclosure requirements.

Input received by the IASB reflects concerns similar to those heard by the FASB. The Feedback Statement states that “Preparers have told us that they adopt a checklist approach because it is more costly to apply judgement: they first have to justify their decisions to their auditor and then, sometimes publicly, with regulators who question the absence of a particular disclosure.” Consequently, potentially irrelevant disclosures are included because that is more efficient and less hassle for the preparer.

In another development, the International Public Sector Accounting Standards Board is in the midst of preparing the Conceptual Framework for General Purpose Financial Reporting by Public Sector Entities. This Framework will address the needs of users in the public sector. Initial chapters have just been issued, with completion of the rest expected by 2014.

For further information, see Financial Statement Disclosure Effectiveness: Forum Observations Summary and
Feedback Statement: Agenda Consultation

Ethics Convergence and Codification

Code of Conduct updates parallel financial standards projects

The International Ethics Standards Board for Accountants (IESBA) was formed as an independent body by the International Federation of Accountants (IFAC) in 1977 to develop and maintain ethics guidelines that members would agree to follow. IFAC has members in 129 countries, including the AICPA, that have responsibility for audit and assurance standards in their respective jurisdictions.

The AICPA for the past twelve years has been in the process of converging the AICPA Code of Professional Conduct with the IESBA Code of Ethics for Professional Accountants. Convergence has been a consideration during the AICPA’s four year Ethics Codification Project which is nearing completion. (An Exposure Draft is planned for April). Similar in concept to the accounting standards codification project, the Ethics Codification is designed to pull together relevant material into a topical format that is clearer and easier to use.

The conceptual framework is part of the convergence effort taking place within codification. According to the AICPA, the conceptual framework “provides a system for identifying and evaluating threats to compliance with ethical standards (e.g., independence) and determining whether safeguards would eliminate threats or reduce them to an acceptable level (e.g., such that they no longer impair independence).” The framework comes into play where there is no specific guidance for an ethics question that arises. In such cases, a member is expected to apply the conceptual framework approach.

While finishing touches are put on the expected Ethics Codification Exposure Draft, the AICPA continues to propose ethics interpretations. A current proposal would revise Interpretation No. 102-4, “Subordination of Judgment by a Member” under Rule 102, Integrity and Objectivity. (The Comment Period ended January 16). The proposal broadens the current interpretation to include members in public practice as well as private, performing services for a client, employer, or as a volunteer. Also, the scope is expanded, from disagreements over the preparation of financial statements or the recording of transactions, to cover differences of opinion with a supervisor related to the application of accounting principles, auditing standards, or other relevant professional standards, including standards applicable to tax and consulting services, or applicable laws or regulations.

If a member perceives a threat from a difference of opinion, the member should assess, using research or consultation, whether the difference represents a failure to comply with professional standards, and if so, creates a material misrepresentation of fact or a violation of applicable laws or regulations. A failure to comply that is not material nor a violation, would not be considered significant, but should be discussed with the supervisor. A failure to comply that is material or a violation would be significant, requiring a discussion with the supervisor to resolve. If not resolved, higher level management should be consulted, and if still not resolved, other safeguards and obligations should be considered, including resignation. A member can resign at any time, but that in itself does relieve the member of responsibility for any required actions.

The IESBA currently has an Exposure Draft pending with some similar elements that draws a different conclusion. “Responding to a Suspected Illegal Act” was proposed in August for which comments were due by December 15, 2012. When a suspected illegal act (including fraud) is encountered, the accountant is required to seek appropriate resolution through progressively higher levels of management. However, if ultimately the response is not appropriate and the accountant’s judgment is that disclosure would be in the public interest, then disclosure of certain illegal acts to an appropriate authority is required if the accountant is providing audit services to the client. If not the auditor, the accountant is required to disclose the matter to the entity’s external auditor, and possibly to appropriate authorities. Resignation may also be appropriate, but also does not absolve the accountant of required action.

The AICPA issued a detailed Comment Letter to the IESBA that, among other things, disagrees with the requirement to disclose suspected illegal acts to external authorities unless “required of an accountant by a national regulator, pursuant to a law or regulation that also incorporates “safe-harbor” provisions that protect the accountant from potential liability for allegedly unauthorized or unjustified disclosures.” Otherwise the accountant could be put “at risk of violating his or her legal or contractual duties of confidentiality to a client or employer.”

Since the Comment Period for both the IESBA and AICPA proposals has ended, the outcome of how the differences are handled may be forth coming in the near future.

 For further information see AICPA Ethics Codification Project, Subordination of Judgment by a Member and Responding to a Suspected Illegal Act

Additional A&A News

The following links provide a selection of current articles devoted to highlighting other A&A topics currently making news.

  1. AICPA committee withdraws compilation, association ED
  2. Sir David Tweedie: Audit upheaval a "wonderful opportunity"
  3. The Question of Mandatory Audit Firm Rotation 
  4. SEC’s New Chief: Dodd-Frank, JOBS Act Top SEC’s Priority List
  5. Integrated Reporting and Sustainability in South Africa
  6. FASB Focuses on Nonpublic Companies

Audit & Accounting Alert is a publication of Integra International intended to highlight emerging issues in the profession. The goal is to give Integra members an awareness of developments impacting the practice of Audit & Accounting, enabling them to stay on the forefront of industry trends.

Editor Gerald E. Herter  •  HMWC CPAs & Business Advisors, 17501 E. 17th Street, Suite 100, Tustin, CA 92780-7924
 •  Tel: 1 714 505-9000  •  Fax: 1 714 505-9200  •  Email: [email protected]