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PCAOB Report: What Auditors Miss

Jan 25

Written by: Jack Ciesielski
1/25/2007 8:22 AM

Upfront disclosure: the PCAOB is a subscriber to The Analyst's Accounting Observer. (But that doesn't mean I know any more about them than you.)

The PCAOB issued an unusual kind of report this week - not one about its findings of quality control at an auditing firm, but a sort of blanket set of observations corralled throughout all of their examinations. Their conclusion auditors don't do what they should be doing to stem fraud in six different areas. A few nuggets from their findings:

Auditor's Overall Approach to the Detection of Financial Fraud. Auditing standards require auditors to make informed judgments about the tests to perform to address risks related to fraud. Finding: "...PCAOB inspection teams have observed, however, that auditors often document their consideration of fraud merely by checking off items on standard audit programs and checklists."

Brainstorming Sessions and Fraud-Related Inquiries. PCAOB auditing standards require audit teams to hold "brainstorming sessions" to consider how badly financial statements could be warped by a dishonest management, while setting aside their existing beliefs about management integrity. Finding:"... PCAOB inspection teams have noted instances of failures to comply with this aspect of the standard. In particular, PCAOB inspectors have (1) identified audits in which the audit team was unable to demonstrate that brainstorming sessions were held; (2) identified audits in which the audit teams' brainstorming sessions occurred after planning and after substantive fieldwork had begun; and (3) identified audits in which key members of the audit team did not attend the brainstorming sessions."

Auditor's Response to Fraud Risk Factors. Auditors are supposed to respond to risk factors they've identified by customizing their audit approach to the situation. But if they aren't doing the work to identify the risks, how can they follow up? This finding of the PCAOB is even worse: "... PCAOB inspection teams have observed instances of auditors failing to respond
appropriately to identified fraud risk factors. Inspection teams also observed instances in which auditors examined transactions warranting further fraud risk consideration, but for which there was no evidence that the auditors had considered any associated fraud risk factors."

Financial Statement Misstatements. If auditors find misstatements, they're required to evaluate whether they're the possible result of fraud. Finding: "PCAOB inspectors noted instances in which auditors failed to properly calculate planning materiality ... As a result, certain uncorrected misstatements were not evaluated, or were not evaluated appropriately, both individually and in the aggregate, with other misstatements because the summary schedule was incomplete. The inspection teams also observed that some auditors did not fulfill their responsibility to investigate identified departures from generally accepted accounting principles to determine whether such departures were indicative of fraud."

Risk of Management Override of Controls. Auditors are required to examine journal entries and other adjustments to financial statements to see if they're legitimate. There's a term in financial reporting called "top-side" adjustments: the ones that take place between the published financials and the underlying internal financial reporting, and they're especially critical to an audit. They represent evidence of a management's last chance to change the recording of reality done by the financial reporting system before the statements are issued. Finding: "...some instances it did not appear that the auditor had appropriately addressed the risk of management override of controls with respect to journal entries and accounting estimates. Also: "...PCAOB inspection teams observed that some auditors have failed to test, or failed to document their testing of, management's assumptions and other aspects of issuers' accounting estimates."

Other Areas to Improve Fraud Detection. PCAOB inspection teams also found deficiencies in other important audit areas that might help detect fraud, such as confirmations (for instance, accounts receivable are confirmed by auditors with outsiders to see if they're part of real sales transactions); analytical procedures (looking for odd relationships between accounts); and review of interim financial statements.

Is their report an indictment of the auditing system? Don't think so. If all these problems were found en masse at one audit firm, yes, you'd have grounds for closing up the shop. But the report doesn't read that way: it's a collection of observations by various inspection teams, and likely issued as a reminder to audit firms at the top of the audit season to stick to their standards. Look sharp!

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Pension & Other Benefit Plans: A Look Ahead

Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.

Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.

A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.

For information about subscribing to The Analyst’s Accounting Observer, click here.