PCAOB Enforcement of Small Audit Firms

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PCAOB Enforcement of Small Audit Firms

The establishment of PCAOB has resulted in an increase in audit fees after PCAOB inspections; however, the increase was mainly driven by audit firms without quality control deficiencies, suggesting a positive reputation effect.

Historical trend for the enforcement of small audit firms

  • The PCAOB is a private-sector, nonprofit corporation created established by the Sarbanes-Oxley Act of 2002 to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.
  • According to a study conducted regarding PCAOB inspections of triennial CPA firms, small audit firms did not correct staffing deficiencies, which were related to previous audit deficiencies determined by the PCAOB. However, deficient firms increased their audit fees significantly more following their first inspections than non-deficient firms. The process resulted in inconsistent application of greater audit effort after the inspection.
  • The implementation of PCAOB resulted in a large reduction in the number of small audit firms operating in the market. According to the journal of accounting economics, there were about 1,233 small audit firms active during 2001–2008, of which 607 exited the market.
  • The reduction of nearly 50% of small audit firms occurred in 2002–2004, coinciding with the passage of SOX, the advent of PCAOB registrations, and the beginning of inspections.
  • The registration process of PCAOB was also incrementally more costly for lower quality auditors, and the registration process also required auditors to make detailed disclosures of their quality control practices and past misconduct, which was pertinent to draw unwanted regulatory attention to low-quality auditors.
  • One of the main reasons for proportionally higher costs on low-quality auditors is that PCAOB inspections are more likely to uncover misconduct among low-quality auditors, which resulted in exposing the low-quality auditors to costly penalties, including large fines and being barred from public practice.
  • According to the journal of accounting economics report, the decline in small auditors was mainly due primarily to supply-side effects, whereby the low-quality auditors were incentivized to exit the market, or demand-side effects, whereby clients were incentivized to avoid low-quality auditors.

Recent public announcements from PCAOB

1. PCAOB announced 2020 forums on auditing in the small business environment and on auditing broker-dealers

  • In Sep 2020, PCAOB announced information regarding its 2020 forums for auditors of small businesses and auditors of broker-dealers, saying that the current year’s forums will be recorded, and the content will be available for auditors to view via the PCAOB website beginning on October 19, 2020. This announcement by PCAOB was mainly due to the COVID-19 pandemic.
  • PCAOB chairman William D. Duhnke III said that “although they are unable to conduct in-person forums this year in light of the challenges posed by the ongoing COVID-19 pandemic, their online content will provide timely educational resources for auditors of small businesses and broker-dealers”.

2. PCAOB adopted amendments to align independence requirements with SEC rules

  • In Nov 2020, PCAOB adopted amendments to its independence standards aligning the Board’s independence requirements with the U.S. Securities and Exchange Commission’s (SEC) recent revisions to its auditor independence rules.
  • According to PCAOB Chairman William D. Duhnke III, “the board’s targeted amendments were intended to avoid confusion, differences, and duplication between PCAOB and SEC independence requirements”.

3. Due to COVID-19, PCAOB provided audit firms with the opportunity for relief from inspections

  • In the light of the COVID-19 pandemic, in March 2020, PCAOB decided to provide registered audit firms an up to 45-day relief period from inspections. The relief was provided with the exception of providing audit firms with access to audit documentation for certain engagements.

Failure of the PCAOB from focusing on 2015-2020

  • The implementation of PCAOB has resulted in the finding of several audit deficiencies identified in PCAOB inspections of public company audits.
  • Every year PCAOB inspects about 200 audit firms, including Big-4 firms, firms with public company audits, and foreign firms. Research findings have revealed that about one-third of the inspections identify audit deficiencies, including those of internal controls over financial reporting (ICFR), assessment of audit risk, auditing estimates, and other areas that represent deficiencies in audit quality controls, and identifying material misstatements in financial statements.

1. PCAOB imposed sanctions on Deloitte and BDO affiliates

  • In 2019, PCAOB imposed sanctions on Deloitte, BDO affiliates, for altering audit documentation in anticipation of PCAOB inspections, as well as for related quality-control violations concerning integrity and audit documentation.
  • In the Deloitte Korea matter, Seul Hyang Wee and Hyun Seung Lee, the two former partners of the company, were sanctioned for their role in overseeing an engagement team that backdated work papers and altered hard copy work papers after anticipating its largest issuer audit would be selected for PCAOB inspection in 2014.
  • In the BDO Mexico matter, six partners of the company were sanctioned for participating in the improper alteration of audit documentation.

2. PCAOB faulted about half of KPMG US audits inspected

  • In 2017, PCAOB identified deficiencies in half of the audits it inspected at KPMG’s US firm, with concerns that there might not have sufficient audit evidence to support the firm’s opinion in some instances.
  • One of the most frequent causes for concern in audits was the KMPG's failure to sufficiently test the design and/or operating effectiveness of controls that included a review element and that the firm selected for testing.
  • The identification of faults by PCAOB resulted in KMPG releasing a statement saying that their audit quality has been and continues to be a top priority across all levels of KPMG and also said that their firm is committed to improving their performance and their system of audit quality control with significant investments in our people, technology and governance.

Changes made by PCAOB

  • In the last few years, PCAOB has focused on improving its inspections process in an effort to support the attestation process over audits of both financial statements and internal control over financial reporting.
  • In 2017, PCAOB adopted a new standard (AS 3101) to enhance the usefulness of the auditor’s report requiring changes to the basic elements of the auditor’s report, including the disclosure of auditor tenure, which is already in effect. The new standard also required the auditor to communicate CAMs arising from the audit of the financial statements that involved, among other things, especially challenging, subjective or complex auditor judgment, and the response that the auditor had to those matters.
  • In the past several years, PCAOB has also focused on recurring deficiencies related to auditor independence, including audit firms’ monitoring procedures that fail to identify independence. The board has also focused on providing auditor independence as PCAOB views the recurring deficiencies as an indicator that some firms and their personnel either do not understand applicable independence requirements sufficiently or do not have appropriate controls in place to prevent violations.
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