PCAOB: Deloitte Fails on Fair-value Testing

In its 2006 inspection report, the regulator raps the Big Four firm for trusting management's assertions.
Sarah JohnsonJune 18, 2007

In its latest evaluation of Deloitte & Touche, the Public Company Accounting Oversight Board takes the firm to task for not properly testing its clients’ fair-value calculations.

In four instances during its 2005 audits, Deloitte should have done more to confirm management’s assertions by doing more testing, the PCAOB investigators said. In three of those instances, the PCAOB said, the firm may have conducted the appropriate evaluations but showed no evidence of doing so.

The Deloitte report comes on the heels of comments by PCAOB chairman Mark Olson expressing growing concern about whether audit firms have the ability properly audit fair-value accounting at companies. The PCAOB has a meeting scheduled Thursday with its advisory council this Thursday to consider changes to its guidance for auditing fair-value accounting.

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Released on Monday, the PCAOB’s report on Deloitte marks its third official inspection of the firm’s work. In the publicly released portion of the report, the PCAOB noted several significant audit deficiencies at eight of Deloitte’s clients, including “some cases” where errors could be material to those companies’ financial statements.

In its response letter to the PCAOB’s claims, Deloitte acknowledges that its auditors conducted additional auditing procedures at six of the eight companies following the inspectors’ findings. But the firm has not changed any of its original audit opinions.

However, one of Deloitte’s clients has issued a restatement following the PCAOB’s inspections. In that case, Deloitte had not noticed the company had departed from generally accepted accounting principles by applying a block sale discount when determining the fair value of warrants issued to purchase common stock.

For its review of Deloitte’s 2005 audits, the PCAOB inspectors spent time from May to November of last year in the firm’s national office and 20 practice offices. Other than those numbers, the PCAOB does not reveal publicly the total numbers of audits its inspectors conducted for Deloitte, or any other firm. The regulator discourages the public from drawing any conclusions based on the number of audit deficiencies listed in the report and notes that the number of audits the inspectors review is a small portion of the total number conducted by each firm.

Still, this year’s review of Deloitte is remarkably different than last year’s. In its 2005 inspection report, the PCAOB noted audit deficiencies at 17 of Deloitte’s clients, including instances the firm did not appropriately address errors in those companies’ use of GAAP. In the firm’s response letter last year, Deloitte disputed many of the PCAOB’s claims, many of which had to do with proper documentation. Deloitte said at the time that, based on the PCAOB’s standards, the nature and extent of documentation should be based on an auditor’s judgment.

Also on Monday, the PCAOB released its inspection reports for 21 other audit firms, including its review of mid-tier firm McGladrey & Pullen’s 2005 audits. (The PCAOB conducts inspections of firms with more than 100 issuers annually and every three years for smaller firms.) In McGladrey’s report, the PCAOB noted four instances where the firm did not show its auditors had performed procedures to support its audit opinion for one company. The firm did not dispute the PCAOB’s findings in its response letter.

By finding fault with the audits at only one issuer, the PCAOB’s 2006 inspection of McGladrey marks a departure from its prior reviews of the firm. The regulator noted audit deficiencies at five companies in its 2005 report and 11 companies in the 2004 report. In its first review, the PCAOB said McGladrey failed to “identify or appropriately address errors in the issuer’s application of GAAP, including, in one case, errors that appeared likely to be material to the issuer’s financial statements.”

The PCAOB redacts its conclusion about each audit firm’s quality control systems, as long as the firms make fixes within a year. In addition, the regulator omits the issuer’s name and instead refers to them by a letter.

However, the regulator does provide some insight into each significant audit deficiency its inspectors find at each firm. Here are excerpts from the PCAOB’s findings on Deloitte’s 2006 audits:

Issuer B: The auditor failed to test management’s fair-value calculations.

Deloitte limited its scrutiny of the company’s assertion that there was only a remote possibility that the fair values of certain business units had declined below their book values (as part of its goodwill-impairment testing). By relying only on management’s documentations and its auditors’ conversations with management, the firm did not do enough to make sure the company’s calculations accounted for whether those business units would be sold — even though the company was exploring whether to sell or spin off some of these business units.

Issuer C: The auditor did not have proof that it had conducted proper testing on management’s outlook.

While evaluating the company’s ability to continue as a going concern, Deloitte did not test significant elements of management’s plans for addressing the company’s working capital deficit and its two consecutive years of net losses, negative cash flows from operations, and declining gross margins. The firm also did not show evidence of testing the fair value of an intangible asset or evaluating whether it was recorded properly.

Issuer F: The auditor had no evidence that it had tested information given to a valuation specialist.

The firm could not show whether it had tested any of the data or assumptions that the issuer had given to the expert to estimate the fair value of acquired intangible assets.

Issuer H: The auditor failed to detect significant errors in disclosures.

The PCAOB claims these errors — involving aspects of the income tax provision and deferred income tax assets — caused the potential tax benefits to be “significantly overstated.” However, Deloitte said this disclosure error did not affect the issuer’s balance sheet and is “not quantitatively or qualitatively material.”