Risk Management

Accounting Watchdog Raps Small Audit Firms

The PCAOB says small U.S. audit firms are underequipped.
Kathy HoffelderMarch 21, 2013

In February, the Public Company Accounting Oversight Board released a new report summarizing inspections of small U.S. audit firms. While the number of significant audit deficiencies at these firms has shrunk since the PCAOB issued its previous report on this group in 2007, the auditing overseer believes the number is still too high.

“We continue to be concerned about the level and types of significant deficiencies in the triennial firm inspections,” PCAOB board member Jeanette M. Franzel said during a press call in February concerning the report.

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The audit firms in the study were inspected between 2007 and 2010. The report showed that 44% of the firms, each of which audits 100 or fewer public companies, had at least one “significant audit performance deficiency,” meaning the deficiency resulted in the firm’s lacking enough evidence to support its opinion. By comparison, 61% had such deficiencies in the PCAOB’s 2007 study.

Most of the deficiencies in the study were found in auditing revenue recognition and other areas pertinent to smaller clients, such as share-based payments (like stock options or rights) and equity-financing instruments. Because smaller audit clients often face difficulties in raising capital or accessing credit markets, share-based payments and equity-financing instruments are more common, noted board member Jay D. Hanson during the call. Such financing may contain terms and conditions that increase the risk of material misstatements, he said.

Other deficiencies outlined in the report included auditing convertible debt, fair-value measurements, impairment of intangible assets, accounting estimates, and the ways a firm responds to the risk of misstatements due to fraud.

Why the long list of deficiencies? The report cited a lack of technical competence in an audit area, a paucity of professional skepticism, ineffective supervision, ineffective client acceptance and continuance practices that fail to consider technical knowledge called for in particular audits, and ineffective auditor engagement quality reviews. “These are just the nuts and bolts of high-quality auditing that need to be attended to,” said Franzel.

The PCAOB audits smaller audit firms once every three years, though some are audited a bit more frequently if warranted. (Audit firms with more than 100 issuers are inspected annually.) The report included 748 inspections of 578 firms, which ranged in size from those that audited just one client to others that audited more than 80 clients.