PCAOB Previews Inspection Focus

The PCAOB plans to shake up how it will inspect audit firms this year, with a specific focus on how the pandemic has challenged financial reporting and audit risks and a promise to “reduce the predictability” of this year’s inspections. 

The agency published a staff alert on Tuesday outlining its priorities for 2021 inspections, so audit firms can plan accordingly. The material is foremost relevant to audit firms themselves, but internal auditors and other corporate financial reporting executives can still glean useful insights from the document too — mostly to understand how PCAOB inspectors will be hassling your audit firm, which will then inform how your audit firm hassles you. 

Priority No. 1, apparently, is to evaluate how audit firms and their clients have handled the pandemic. 

“The COVID-19 pandemic has had a substantial impact on preparers, auditors, audit committees, and others involved in the financial reporting process,” the staff alert said. “Recognizing this change in the environment, we designed our 2021 inspection plans to directly focus on the effects of the pandemic on public companies’ financial reporting.” 

In practice, that means PCAOB inspectors will be selecting audits from industries that suffered significant disruption or elevated risks during the pandemic: transportation, entertainment, hospitality, commercial real estate, and even manufacturing. The inspections will also target financial statement items that were particularly affected by the pandemic, such as impairments, allowance for loan losses, going concern assessments, and fraud risk. 

What’s interesting for corporate executives is that if your business fits the profile described above, your audit firm should have already paid extra attention to issues such as whether you declared a goodwill impairment appropriately or implemented enhanced fraud risk procedures for everyone working remotely. The rest of us may not need to pay as much attention to this year’s inspection priorities as usual.

That is, the PCAOB’s attention to pandemic issues may well have a limited duration; if corporate life returns to normal over the course of 2021, then those heightened financial reporting and audit risks will likely fade, and the PCAOB’s focus on those risks should fade too. That’s quite different than, say, PCAOB attention to a new standard for revenue recognition — something that affects all companies permanently. 

More Inspection Unpredictability

The PCAOB also promised that more of the audits it selects for inspection this year will be chosen at random. That’s a break from past inspection practice, where the PCAOB announced its top concerns for the year — say, revenue recognition, or lease accounting, or assessment of goodwill — and then went looking for large, complex audits where those risks were especially prominent. 

Apparently we’ll see a lot less of that this year. The PCAOB will still inspect the same number of audits, and it will target pandemic-prone industries and issues as mentioned above. But it also plans to “significantly increase” the number of audits selected at random, especially for the largest audit firms. (About a dozen large audit firms are inspected every year.) 

The PCAOB also says it will select “more non-traditional focus areas” for inspection, although it didn’t identify what those non-traditional areas would be. Here’s the important part from the staff alert:

Over time, the selection of inspection focus areas may have become more predictable, such that firms are able to better anticipate areas to be inspected and place more audit emphasis on those areas, potentially at the risk of reducing attention to other important audit areas. We therefore plan to increasingly select certain non-traditional financial statement areas for review. We will, of course, also continue to target areas that we believe pose higher risks of material misstatement in particular audits…

I can see pros and cons to this less predictable approach. On one hand, by selecting more audits at random, audit firms have less ability to anticipate which parts of their work will get PCAOB attention — and therefore, presumably, the firms have more incentive to do good work across the board, rather than just where they expect the PCAOB to be nosing around. 

On the other hand, the whole point of the PCAOB using a risk-based approach to selecting audits was to find the audits that pose the most risk. That’s useful for PCAOB inspectors to know, and it’s useful for audit firms and corporate audit committees to know too. I thought using a risk-based approach was how auditors were supposed to go through life. 

People cynical about the auditing business (and there are plenty of ’em) would say this effort to “enhance the overall unpredictability” of PCAOB inspections could actually do audit firms a favor, because as PCAOB inspectors spread their attention to more parts of the audit, that’s less attention focused on known trouble areas. For example, more time talking about boring old inventory, when everyone knows that management estimates are the really dicey stuff. 

And there you have it.

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