Audit, Auditing, Audit Quality

While there’s no evidence that audit firms can predict which audits the Public Accounting Oversight Board will choose to inspect, the PCAOB is taking steps that will limit the chance that a firm could manage to the risk of the inspection process.

In remarks before the annual Baruch College Financial Reporting Conference last week, PCAOB board member Jeanette M. Franzel revealed that the board is embarking on a “randomization” project that goes beyond selecting audits for inspection based on risk.

“In recent years, we’ve been adding some non-risk based selections and random selections to the mix of inspected audits,” Franzel told the audience.

Later on in her speech Franzel said that “incorporating an element of randomization may increase audit quality by limiting the ability of firms to predict — and therefore, potentially seek to game — which of their audits the PCAOB may select to inspect.”

Her remarks come at a time when there is some concern about audit firms knowing beforehand which of their public company audits will face inspection by the PCAOB. That concern arose from a revelation in mid-April that six KPMG auditors had improperly received advance information from an employee of the Public Company Accounting Oversight Board about upcoming inspections of the firm.

Franzel said the randomization project was designed to provide a more accurate, broader picture of overall audit quality across the industry, and, especially, at the Big Four audit firms. She said the PCAOB’s Center for Economic Analysis (CEA) has been working with the Division of Registration and Inspections (DRI) “to assess what we can learn regarding audit quality across a firm’s audits by applying statistical methods throughout the selection process and analysis of inspection results.”

This is a definite shift from what the PCAOB has done in previous years.

As Franzel explained to the audience, “PCAOB inspections at the large firms are mainly risk-based. Individual audits and audit areas selected for inspection are generally selected on a risk-weighted basis and not randomly. Areas of focus vary among selected audits but often involve audit work on the most difficult or inherently uncertain areas of financial statements.”

Added Franzel: “The risk-based approach was designed as a remedial approach intended to encourage firms to address identified weaknesses and related quality control issues within their audit practices, while keeping the number of inspected audits to a manageable level.”

But now the PCAOB is looking for a more complete picture of audit quality, to get a “statistically generalizable result.”

Statisticians have assisted PCAOB staff in developing methods to estimate overall deficiency rates at individual firms subject to inspection, with a current focus on the large firms, Franzel said. “These methods could also be used to estimate deficiency rates across a group of firms or for given categories of audits.”

A reliable estimate of the overall deficiency rate at a firm “may be helpful in assessing the quality and effectiveness of our risk analysis and we might be able to further hone our risk-based inspection selection process. We might also be able to track trends in firms’ estimated compliance levels over time,” she said.

Franzel said the board has been provided with some preliminary results of the randomization project, and said she looks “forward to future iterations of this approach to arrive at statistically valid inferences about the overall deficiency rates at the large firms.”

“As [audit] deficiency rates come down, it seems logical we would move to some other kind of approach,” Franzel concluded. “We need to have a better idea of the state of audit quality.”

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