The Focus of Future PCAOB Auditor Inspections

By James J. Farrell and Houman B. Shadab

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JUNE 2005 - While the Public Company Accounting Oversight Board (PCAOB) inspections of 2003 were limited to a few dozen engagements of the Big Four accounting firms, the PCAOB is in the midst of conducting full-scale inspections of not only the Big Four but also mid-size and smaller accounting firms. With the PCAOB’s anticipated growth to 300 full-time employees and seven regional offices across the country, and an increase in its budget from $103 million in 2004 to $137 million in 2005, the inspection process is set to become a permanent feature for auditors.

Going forward, the impact of the PCAOB inspections cannot be underestimated. As the limited 2003 inspections showed, the PCAOB may extensively examine many GAAP principles, ranging from minutiae to material events. Indeed, as public comments by PCAOB officers indicate, “high-risk” clients and fraud detection are likely to be the focus of future inspections. In an August 2004 interview with, PCAOB Chairman William McDonough stated that inspections “will be slanted heavily toward high-risk engagements.” PCAOB member Daniel L. Goelzer, in a May 2005 interview with BNA, said that he hoped that auditors would learn to apply a more risk-based approach to auditing corporate controls during the give-and-take of the inspection process itself.

Fraud detection by auditors might also be reviewed, as McDonough reiterated that auditors have the duty to detect fraud and will be held accountable for failing to do so. PCAOB Chief Auditor and Director of Professional Standards Douglas Carmichael likewise underscored, in “ACFE Conference Highlight: PCAOB’s Director Urges Auditors to Do More to Find Fraud” (Business Wire, July 14, 2004) and in “PCAOB: 2004 Inspections to Focus on Fraud, Documentation” (WebCPA, September 16, 2004), that “the real focus [of audits] should be on detecting fraud.”

Independence issues are also likely to be the focus of future inspections. In a July 2004 WebCPA article, SEC Chief Accountant Donald T. Nicolaisen encouraged the PCAOB to take the lead on auditor independence issues by “expanding its role and becoming the primary standard-setter and the primary source of advice and guidance” on independence issues. Of particular concern to the PCAOB is the mass-marketing of certain tax shelters where the auditor takes a percentage of the tax savings as its fee: The PCAOB proposed an auditing standard specifically dealing with such issues on December 14, 2004. Additional issues likely to be the focus of inspections are documentation and high-profile deficiencies such as off–balance sheet entities (including special purpose entities) that significantly affect investors. PCAOB Director of Registration and Inspections George Diacont also stated that the new section 404 internal control standards for public companies will be the subject of inspections. This should come as no surprise in view of the provisions of PCAOB Auditing Standard 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements, issued in September 2004. The PCOAB’s plan to issue new standards, including those relating to auditing third-party transactions, fair value measurements and disclosures, communications with audit committees, and the confirmation process, suggests likely areas of concern for future inspections. PCAOB Deputy Director for Inspections Chris Mandaleris recently stated that quality-control assessments and engagement review would be the primary focus of his inspectors, with an audit firm’s “tone at the top” and culture under scrutiny.

PCAOB Enforcement for Failing to Remedy Deficiencies

The PCAOB has a separate investigation and enforcement process that includes sanctions ranging from civil penalties to a permanent revocation of a firm’s ability to audit public companies. The potential impact of inspections on enforcement actions was noted by former SEC Chief Accountant Lynn Turner, who told Securities Law Daily (August 27, 2004) that “the PCAOB has to use these inspections to drive changes in the [auditing] rules and, quite frankly, get tough on enforcement.” Looking high and low for any “hot tip,” the PCAOB has even established online and telephone systems for anonymous tips and complaints.

The Increasing Importance of the PCAOB

The public accounting profession has shifted from self-regulatory mechanisms (such as peer review and AICPA Quality Control Inquiry Committee investigations) to extensive government oversight through the PCAOB. Over time, the importance of the PCAOB will only increase. In October 2004, McDonough stated that more issuer restatements should be expected as the result of the 2004 inspections.
Inspections and investigations and enforcement actions are here and are likely to grow in number and significance. The manner in which audit firms respond to PCAOB enforcement measures will significantly impact their exposure to regulatory action and liability down the road, including the potential for plaintiffs to seize upon negative findings by the PCAOB as evidence of wrongdoing. As the first round of inspections has proved, no issue is too small to be the subject of PCAOB scrutiny. After several years of annual inspections, significant portions of an auditor’s practice will be reviewed, and auditing firms must therefore be prepared to respond to a wide variety of issues. Effective understanding of all facets of the PCAOB inspection and enforcement regime is absolutely essential.

James J. Farrell, Esq., is a partner in the litigation department, and Houman B. Shadab, Esq., is an associate, both in the Los Angeles office of the law firm Latham & Watkins, LLP.




















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