The Truth About Public Accounting, Part III: The ‘A’ In PCAOB Stands For ‘Accounting’

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An article titled “PCAOB Inspections: Public Accounting Firms on Trial” describes the results from an academic study and survey about the effects on auditors who have been subject to PCAOB inspections. One of many good observations from that academic study is repeated below:

Respondents collectively perceive that audit quality has improved as a result of PCAOB inspections. In fact, some partners perceive that they have become so good at auditing that there exists a concern that being a good auditor has come at the expense of being a good accountant owing to the focus on developing expertise in auditing standards (i.e., internal controls and documentation) over expertise in accounting standards (e.g., revenue recognition), particularly at ranks below manager.

(2018 Article in Contemporary Accounting Research by Westermann, Cohen, and Trompeter)

My conversations with audit partners corroborate this observation and leave me questioning whether the PCAOB’s focus has been uniform across all elements that contribute to audit quality. One audit partner with a Big 4 firm shared his experience with the PCAOB’s inspection of his audit of a large company rich in accounting complexity. In so many words, the audit partner said, “Bob, the PCAOB had a five-member inspection team here for three full weeks inspecting one of my audits. Not once did they ask me or my audit team an accounting question. Not once! Everything was about internal controls. I have spent decades working to become an expert in the complexities of GAAP, yet all they asked about was ICFR.” More recently, a partner at a next-tier audit firm confirmed a similar experience, noting that the inspection team’s focus was almost exclusively on ICFR.

A close look at the type of inspection deficiencies during the inspection years from 2016 through 2019 revealed that Big 4 ICFR deficiencies outnumbered financial statement audit deficiencies by a margin of nearly two to one.

There has also been a sharp decline in the number of Big 4 restatements of audited financial statements resulting from PCAOB inspections. During the four inspection years from 2012 through 2015, Big 4 audited financial statements were restated 14 times due to PCAOB inspections compared to only three Big 4 restatements during the four inspection years from 2016 through 2019 (with the 2019 inspection year being the most recent inspection year for which inspection reports are currently available). This 79% decline in restatements arising from PCAOB inspections occurred without any significant change in the number of Big 4 audits inspected by the PCAOB.

Comparably computed statistics from Audit Analytics show that restatements overall declined by 29% (from the first four-year period of 2012 to 2015 to the second four-year period from 2016 to 2019). That leaves 50% of the decline in restatements from PCAOB inspections unexplained.

I also considered the PCAOB’s small reduction in risk-based selections from about 95% to about 75% of inspection selections (with a corresponding increase of random selections). However, in the grand scheme of things, it is unlikely that this small shift in how inspection selections are made would have much effect on the PCAOB’s ability to surface problems that cause issuers and their auditors to restate financial statements.

So what is going on here? Does the PCAOB’s focus on ICFR mean a decreased focus on substantive auditing and making sure the reported numbers are correct?

Implications to investors

First and foremost, investors using financial statements want to know if the numbers are right. It is hard to imagine how the PCAOB is protecting the interests of investors if they are not sufficiently evaluating compliance with generally accepted accounting principles. After all, the “A” in PCAOB stands for “Accounting.”

There may be other factors that contribute to the high frequency of internal control findings from PCAOB inspections. Yes, both issuers and auditors have had difficulty applying the internal control standards. A significant portion of this difficulty stems from lack of implementation guidance from both the PCAOB and the SEC. In the accounting world, think about all the guidance from the Transition Resource Group on the new revenue recognition standard. Also, think about the existence of the FASB’s Emerging Issues Task Force to sort out issues that may not be addressed in the Accounting Standards Codification. There is nothing comparable from the standard setters in the ICFR world beyond the volunteer efforts of a group at the Financial Executives Institute (Committee on Corporate Reporting) that has attempted to fill a portion of the void in comprehensive guidance left by the PCAOB.

Another significant portion of the audit firm and issuer difficulty with ICFR stems from the issues I discuss in my first two articles on Going Concern: the mismatch of the audit firm staffing model (heavy workloads, high turnover, low year-over-year continuity, low experience levels, and low levels of supervision) with the complexity auditors are expected to master in the ICFR world.

Perhaps other factors may be in play. Could it be that internal control findings are low-hanging fruit for inspectors, in part because the PCAOB has very prescriptive expectations for internal controls that the audit firms have had difficulty convincing their clients to embrace? Might there also be some bias toward audits of internal controls because the PCAOB owns the internal control standards while the SEC is the final arbiter on the application of GAAP? More effort (also meaning more time) might be required by the PCAOB to advance GAAP findings because of the need for the PCAOB to collaborate with the SEC (not to mention the downside that the PCAOB might be embarrassed if the SEC agrees with the auditors’ conclusion on a GAAP issue). The additional time to collaborate on GAAP findings poses a threat to getting inspection reports out quickly. The inability to issue inspection reports in a timely manner has been a thorn in the PCAOB’s side since its inception. Not surprisingly, ICFR findings may have emerged as the fastest track to inspection findings with the lowest risk of embarrassment to the PCAOB.

Audits of internal controls are important; but like everything else in life, there needs to be balance with other things that are important.

I recently published The Truth About Public Accounting to draw attention to these and other issues confronting the profession. My book identifies everything I wish I understood when I first entered the profession. There is no shortage of conflicting pressures that can make your head spin and undermine good judgment. Whether you are an auditor, prospective auditor, investor, audit committee member, or regulator, it is important that you understand the Truth About Public Accounting. You can learn more about my book on Amazon by clicking here.

About the author:

Robert Conway is a retired Big 4 audit partner and former leader of a PCAOB regional office. He currently provides expert witness services in controversies pertaining to GAAP and PCAOB compliance. Mr. Conway’s website is at www.TheTruthAboutPublicAccounting.com and his email address is [email protected].

Related articles:

The Truth About Public Accounting, Part I: How the Sausage Is Made and Those ‘Best Places to Work’ Surveys
The Truth About Public Accounting, Part II: PCAOB Inspection Hysteria — How to Fix It

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