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Getting Ready for the PCAOB: How Inspections Will Differ from Peer Review

The Trusted Professional

July 2004

The Monthly Newspaper of the NYSSCPA Vol. 7, No.10

FAE to Offer Courses on PCAOB Inspections

Imagine a firm is in the middle of preparing quarterly financial statements for six public companies, when a Public Company Accounting Oversight Board (PCAOB) representative calls to say there will be an inspection the following day.

The audit partner, explaining the firm’s predicament, wins a one-week delay, then assures her concurring partner that the inspection will be “no big deal” because the firm goes through a peer review every three years.

“This is no peer review,” the concurring partner contends. “These people are not our peers. The PCAOB reports to the SEC, and they are being sent by a government that believes peer review has failed. This could be the profession’s last chance to get it right before the government appoints statutory auditors to audit the financial statements of public companies.”

The partners express two possible extreme reactions to PCAOB inspections, but the truth may lie somewhere in between. To a large degree, both peer review and PCAOB

inspections focus on the same material and look for the same deficiencies. But there are important differences that it could be perilous to ignore.

Parallax Views

The first difference is power. The American Institute of CPAs (AICPA), which has a peer review requirement, can expel members from its ranks. The PCAOB, though, has jurisdiction over CPAs who audit financial statements of U.S. public companies. The PCAOB can conduct investigations and disciplinary proceedings and impose sanctions, including prohibiting firms from auditing public company financial statements. It can refer deficiencies found in inspections to regulatory authorities and law enforcement agencies.

There is also an obvious difference between peer reviews and inspections in their focus. Peer reviews look at the adequacy of quality control and the audit engagement. The PCAOB looks at the firm itself, as well as the quality of the audit, and then weaknesses in quality controls if an inspection of statements reveals deficiencies. The PCAOB is likely to select for inspection high-risk engagements, such as companies that have undergone recent restatements or that are the subject of litigation or Securities and Exchange Commission investigations.

The PCAOB will look to ensure that firms are familiar with its audit rules and the provisions of the Sarbanes-Oxley Act of 2002. These include reconciliation of GAAP (generally accepted accounting principles) with non-GAAP measures; the “independence” of audit committees as defined by the act; rules of other self-regulatory organizations and the two main exchanges; the preapproval of permissible nonaudit services; and the extent of the involvement of the audit committee in the preparation of financial statements. The PCAOB will also look for compliance with AICPA standards in audit, quality control, ethics and independence, which the PCAOB has adopted on an interim basis.

Another significant difference between peer review and PCAOB inspection pertains to confidentiality. Under AICPA rules, peer reviewers have no access to clients’ documents that expressly prohibit their CPAs from disclosing them. The PCAOB may ignore such impediments and has made it clear that, in the matter of confidentiality, its own rules preempt the rules of any association or state.

Accordingly, not only can the PCAOB insist on access to all client documentation, but it is free to interview, and has stated that it will interview, the clients’ audit committee members or directors in order to ascertain whether they were active and effective in their role of protecting the integrity of financial statements.

Documentation is probably the most important word in the inspection lexicon. The PCAOB wants firms to fully document the audit, so that workpapers and audit memoranda speak for themselves without any need for oral explanation. A guiding principal of the PCAOB inspection is the presumption that “if it isn’t in writing, it doesn’t exist.” Thus, for example, in the absence of confirmation letters from banks, the PCAOB inspectors will presume that bank balances were not checked.

The PCAOB has adopted the New York state rule that prohibits CPAs from supplementing audit workpapers after 45 days from the release of the audit. Any supplement to the working papers thereafter must be dated the date that they are written and must contain an explanation as to why they were supplemented.

To a large degree, the PCAOB inspection is to the accounting firm what Section 404 of the act is to the public company. There is a diligent attempt in both cases to tighten controls and procedures. Firms, then, should inspect their own audit engagements and quality controls and correct the deficiencies that can legally be corrected in order to ready themselves for passing the PCAOB inspection. The firm should correct deficiencies indicated in its most recent peer review and after.

The most important principle to bear in mind is the doctrine of full cooperation with the inspectors. One must comply with all their requests and provide them with full access to records and members of staff. If not properly handled, the PCAOB inspection could morph into a government investigation.

At the end of the day, passing the PCAOB inspection is about protecting the firm. A failed inspection could lead to a damaged reputation, even to the PCAOB’s shutting the firm down.

But if the PCAOB and firms have one goal in common, it is protection of the investing public. Achieving this goal will also protect the profession.

The Foundation for Accounting Education is sponsoring a full-day course on PCAOB inspections this summer. The course is offered in New York City, Nassau/Suffolk border, Rochester and Westchester.

Visit www.nysscpa.org or call 800-537-3635 to register or for more information.


Raphael S. Grunfeld is partner in the corporate and SEC department of Carter Ledyard & Milburn LLPand can be reached at grunfeld@clm.com.

©1997 - 2004 New York State Society of Certified Public Accountants. Reprinted with permission
 


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