In July 2016, the PCAOB issued a staff inspection brief to provide information about the plan, scope and objectives of PCAOB inspections in 2016 of registered audit firms and their audits of issuers. Translation: watch out for these potential landmines when preparing, auditing, or reviewing your firm’s financial statements.
The 2016 guidance comes on the heels of an April 2016 brief that gave a preview of observations from the PCAOB’s 2015 inspection cycle. In that report, the most frequent audit deficiencies continue to be related to:
- Internal control over financial reporting
- Assessing and responding to risks of material misstatement
- Auditing accounting estimates, including fair value measurements
The PCAOB has previously stated that accounting estimates usually warrant more audit attention because they often involve complex methods, including models, subjective factors, and judgments, which make them susceptible to management bias.
The audit deficiencies most frequently identified during the 2015 inspection cycle included:
- Testing estimates arising from the valuation of assets and liabilities acquired in a business combination (ASC 805)
- Evaluating impairment analyses for goodwill and other long-lived assets (ASC 350 and 360)
- Other less frequent deficiencies included those relating to financial instruments, revenue-related estimates and reserves, allowances for loan losses, inventory reserves, and tax-related estimates.
Some of these topics are [unfortunately] of no surprise to those that have followed the evolution of fair value accounting. In a recent issue of the Harvard Business Review, in an article entitled Where Financial Reporting Still Falls Short, authors David Sherman and David Young cite the difficulties in applying fair value principles consistently to value intangible assets. The HBR piece also comments on the lack of useful disclosures regarding of how such assets are valued and what assumptions were made in generating fair value estimates. Even on this blog, we’ve documented these deficiencies numerous times.
Ongoing concern about the broadening application of fair value measurement and a perceived lack of consistency in the valuation work product has even led to development of a new shared professional credential by the American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA), and the Royal Institution of Chartered Surveyors (RICS).
But back to the issue at hand – what will the PCAOB be focusing on in 2016? As always, the PCAOB begins with audit areas where deficiencies have been identified in previous inspection cycles. There will also be a consideration of areas potentially affected by current economic factors. One of these factors is the effect of increasing M&A activity on fair value measurement auditing. The Staff Inspection Brief notes the following risk areas:
- Increasing transaction activity may increase the risk of improper valuation of assets acquired and liabilities assumed given larger deal sizes
- Heightened risk of improper valuation due to greater transaction complexity
- Risks of material misstatement associated with the proper identification of all intangible assets
- Improper assignment of goodwill to reporting units
- Risk of misstatements in connection with contingent consideration fair value measurements
The PCAOB staff also noted that fair value measurements involve the potential for management bias, and that in many cases auditors have not historically applied an appropriate degree of professional skepticism when testing estimates. As an example, the inspections staff observed instances in which auditors did not sufficiently evaluate or consider contradictory or potentially inconsistent information. Of course, greater PCAOB scrutiny eventually flows down to preparers of financial statements in the form of more comprehensive examination (and questions) from the auditors regarding these issues. In our own practice, we have witnessed increased auditor willingness to delve deeper into the assumptions underlying fair value estimates as well as management’s support for prospective financial information. As valuation specialists that regularly provide fair value measurements, we at Mercer Capital completely understand these concerns because best practices pertaining to professional skepticism and analytical judgment apply to us, too.
Mercer Capital has a long history of working with management teams of both public and private companies to produce independent valuation analyses necessary to meet financial reporting requirements, and avoid common pitfalls. Call one of our valuation professionals today to discuss your situation in confidence.
Where have you observed the most auditor scrutiny in the past 12 months?
— MercerFairValue (@MercerFairValue) August 15, 2016
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