The Public Company Accounting Oversight Board (PCAOB), in its Staff Inspection Brief - Preview of Observations from 2016 Inspections of Auditors of Issuers, reported lingering concerns about recurring deficiencies in three areas (audit risk assessments, and auditing internal control and accounting estimates), and other areas of inspection focus, including independence. As to independence, the PCAOB cited repeated, and even one new (to me anyway) concerns regarding firms' compliance with SEC (Securities and Exchange Commission) and/or PCAOB independence rules. The observation that was new to me was this one:
- Firms are misapplying Rule 2-01(d) of SEC Regulation S-X and wrongly concluding that a covered member's financial relationship with the audit client (or an affiliate) did not impair the firm's independence. Rule 2-01(d) is entitled Quality Controls and follows part (c) of the rule, which describes various interests and relationships that are considered to impair independence. I don't recall seeing this type of observation in previous reports (unlikely, but maybe I missed it) but this observation implies that firms that discovered a covered person's financial relationship (e.g. stock interest) with an audit client wrongly concluding that the interest did not impair the firm's independence. Firms have traditionally viewed 2-01(d) as a "safe harbor" provision that would not penalize a firm that experienced a covered person's lack of compliance if certain conditions were met (e.g., the covered member was not aware of the circumstance that put them out of compliance, and the firm corrected the matter swiftly once discovered and had an adequate quality control system in place). It would be interesting to know more details about this observation, but my hunch is (perhaps?) the firms could not demonstrate that the covered person lacked awareness or that the firm acted as quickly as the PCAOB inspectors would expect... Hard to say, and I would love more facts.
Other observations were more in line with what I think we've seen before, which were:
- Insufficient communication with the audit committee about the scope of the firm's tax consulting services, and their potential impact on the firm's independence.
- Indemnification agreements included in audit engagement letters protecting the auditor against liabilities or expenses related to the audit (strictly prohibited).
- Impermissible bookkeeping or management functions performed during the period under audit, but prior to engagement. (Independence restrictions apply to both.)
- Failure to make required communications to the audit committee about independence (required prior to appointment and annually thereafter).
- Inadequate quality control over the independence of outside auditors or firms involved in group audits.
The report also cited frequent deficiencies in firms' performance of engagement quality reviews (EQRs), including that in certain instances individuals were not qualified to perform the EQR because they had served as the audit partner during one of the prior 2 years, which violates PCAOB Auditing Standard 1220, Engagement Quality Review(par. .08).
The report was based on 2016 inspections of portions of more than 780 public company audits and quality control systems reviews performed on more than 190 firms.