acuitas, inc. s survey of fair value audit deficiencies August 31, 2014 pcaob inspections methodology description of a deficiency

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1 August 31, 2014 home executive summary audit deficiencies improve pcaob inspections methodology description of a deficiency audit deficiency trends fvm deficiencies description of fair value measurement deficiencies pcaob s report on inspections of smaller firms concluding thoughts acuitas, inc.

2 Executive Summary Public Company Accounting Oversight Board ( PCAOB ) inspection reports provide insight into recent audit quality trends. Acuitas, Inc. s Survey of Fair Value Audit Deficiencies ( Survey ) is tended to assist financial statement preparers, auditors, and valuation specialists in understanding the underlying causes of fair value measurement ( FVM ) and impairment audit deficiencies, as reported by the PCAOB. There are a number of key findings from the latest inspection reports. Over 40% of all audits inspected by the PCAOB in 2012 had deficiencies. Of the 80 available inspection reports from 2008 to 2012 for the top 25 audit firms, 51 or 63.7% cited FVM and / or impairment audit deficiencies. FVM audit deficiencies continue to be significant, making up 24.6% of total deficiencies in In year over year comparisons of firms subject to annual inspection, PCAOB inspections indicate three significant trends. The percentage of audits with deficiencies more than doubled between 2009 and 2010 from 16.0% to 33.7%, and has climbed steadily since then to 42.5% in There has been a significant shift in the causes of FVM deficiencies from financial instruments to business combinations. Prior to 2012, 86.9% of FVM deficiencies were caused by insufficient testing of financial instruments. In 2012, deficiencies relating to financial instrument dropped to 55.0% and those relating to business combinations increased to 45.0% of all FVM deficiencies. The number of deficiencies caused by failures to assess risk and failures to test internal controls increased sharply in 2012 over prior years. These risk assessment and control deficiencies caused 41.2% of the FVM deficiencies and 50.0% of impairment deficiencies cited by the PCAOB in This is a significant shift from prior years when FVM deficiencies were primarily caused by inadequate substantive testing of asset prices and impairment deficiencies were primarily caused by inadequate substantive testing of management s prospective financial information ( PFI ). 1 cies

3 FVM Audit Deficiencies Continue to be Significant Audit deficiencies attributable to FVM and impairment engagements continue to be significant and made up approximately one third of all audit deficiencies in The purpose of the Survey is to help financial statement preparers, auditors, and valuation specialists understand the ultimate causes of FVM and impairment audit deficiencies and failures, according to the PCAOB. The purpose is also to highlight trends in the PCAOB inspection findings, in aggregate. The information contained in the study should be of benefit not only to public entities and their auditors, but by extension, to private entities and their auditors. The survey begins with a brief overview of the PCAOB inspection process and the survey methodology. The next section examines trends in audit deficiencies by looking at statistics over a five year period. Finally, the survey provides information about the specific causes of FVM and impairment audit deficiency. PCAOB Inspections The PCAOB conducts inspections of registered public accounting firms as required by the Sarbanes-Oxley Act of The inspections are designed to identify and address deficiencies in a firm s audit engagements and to determine whether deficiencies indicate a weakness or defect in the firm s system of quality control over audits. The annual inspection process encompasses a review of selected audits and a review of the firm s system for quality control. PCAOB reviews of selected audits are intended to identify financial statement misstatements, including failures to comply with disclosure requirements and failures to perform applicable audit procedures. When a deficiency reaches a level of significance that appears to indicate the firm failed to obtain sufficient audit evidence to support its audit opinion on the financial statements or on the effectiveness of internal control over financial reporting, the deficiency is described in the PCAOB s inspection report, which is publicly available. The PCAOB performs annual inspections of firms that regularly provide audit reports for more than 100 issuers. The largest international auditing firms, Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP and PricewaterhouseCoopers LLP ( the Big Four ) are among the nine firms inspected annually. 1 The PCAOB conducts inspections triennially (once every three years) of smaller auditing firms that audit public registrants. While the PCAOB inspection reports are silent about the financial statement dates of the audit engagements examined, the PCAOB s field work generally begins just after the audit season in February or March, and extends through October or November. Therefore, it appears likely that 2012 inspection reports relate to audits of 2011 financial statements. 1 The remaining firms are McGladrey LLP, Grant Thornton LLP, MaloneBailey, LLP, Crowe Horwath LLP and BDO USA, LLP. 2

4 Methodology The Survey of Fair Value Audit Deficiencies from PCAOB Inspection Reports was prepared using a three-fold approach. First, we examined the PCAOB s inspection reports for firms subject to annual inspection. In order to analyze trends in audit deficiencies, we focused on the nine firms with inspection reports available each year from 2008 through The nine firms include Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, PricewaterhouseCoopers LLP, McGladrey LLP, Grant Thornton LLP, BDO USA LLP, MaloneBailey, LLP and Crowe Horwath LLP. The PCAOB performed field work at each of these nine firms national offices and in 165 (34.6%) of the firms practice offices, and reviewed aspects of 294 audits and 6 other engagements. Our findings appear in the section entitled Audit Deficiency Trends. The purpose of the second part of our survey is to analyze the types of engagements that give rise to FVM and impairment deficiencies and to examine the causes of these deficiencies. The second part of the survey covers all of the PCAOB inspection reports available for the top 25 public accounting firms 2 for 2008 through 2012, including those subject to annual inspection and those subject to inspection every three years. Of the 80 available inspection reports, 51 (64%) had FVM and impairment audit deficiencies. The PCAOB provides a brief description of the type of audit failure and the underlying cause. For each report, the PCAOB generally presents each deficiency as a separate bullet point. Acuitas counts and categorizes each deficiency based on the type of audit failure. FVM deficiency categories include financial instruments, pension plans and business combinations, and impairment deficiency categories include those attributable to goodwill, asset groups and intangible assets. The underlying causes were tallied and audit deficiency statistics were calculated. Description of a Deficiency The individual PCAOB inspection reports themselves do not define deficiency. However, Auditing Standard No. 7 Engagement Quality Review provides a description, saying that a significant audit engagement deficiency exists when (1) the engagement team failed to obtain sufficient appropriate evidence in accordance with the standards of the PCAOB, (2) the engagement team reached an inappropriate overall conclusion on the subject matter of the engagement, (3) the engagement report is not appropriate in the circumstances, or (4) the firm is not independent of its client. 3 2 The 2012 accountingtoday Top 100 Firms, 3 PCAOB Auditing Standard No. 7 Engagement Quality Review 3

5 Audit Deficiency Trends The PCAOB inspections for annually inspected firms from 2008 through 2012 indicate several trends. First, the percentage of audit engagements with deficiencies has increased dramatically since Currently over one in three audits examined is significantly deficient. In connection with the 2012 annual inspections, the PCAOB found deficiencies in 125 issuers, or 42.5% of audits and other engagements examined. In 2009, the inspection reports for the same nine firms cited deficiencies in 61 issuers, or 16.0% of audits examined. 50.0% PCAOB Annually Inspected Firms 40.0% 30.0% 20.0% 10.0% % of Engagements with Deficiencies The percentage of audit engagements with deficiencies is not available for

6 A second trend indicates that FVM and impairment deficiencies have declined for the annually inspected firms since their peak in 2010 while other deficiencies have steadily increased. In 2010, there were 126 FVM and 40 impairment deficiencies, representing 48.4% of all deficiencies and in 2012 there were 77 FVM and 32 impairment deficiencies, representing 34.8% of total deficiencies. Deficiency Trends FVM Deficiencies Impairment Deficiencies Other Deficiencies The economic crisis was likely the primary cause of the high number of FVM and impairment audit deficiencies in Economic volatility affected entities income from underlying operations and caused other changes in fair value, which introduced additional risk and uncertainty to the audit process. Hard-to-value financial instruments like asset backed securities, collateralized debt obligations, and other collateralized mortgage obligations were at the heart of the financial crisis and pricing information was not readily available. In addition, the number of companies experiencing goodwill and long-lived asset impairment triggering events also increased during the economic crisis. Impairment testing relies on PFI which becomes more difficult to assess in uncertain times. The value of goodwill impairments for U.S. companies peaked in 2008 at $188 billion, and then dropped off dramatically to $26 billion in Impairment deficiencies were cited less frequently in 2011 and 2012 inspection reports relative to other deficiencies, which is likely due to the drop off of goodwill impairment write offs in 2009 and Duff & Phelps 2011 Goodwill Impairment Study, September 27, 2011, p.9. 5

7 FVM Deficiencies In all five years, FVM deficiencies were primarily attributable to financial instruments; however the percentage decreased from 86.9% in prior years to 55.0% in Business combinations were the source of 9.0% of FVM deficiencies in prior years, and increased to 45.0% in These trends are likely caused by audit improvements for financial instruments that resulted from the PCAOB inspection process and by increased merger activity during the recent economic recovery FVM Deficiencies 2008 to 2011 FVM Deficiencies 4.1% 9.0% 45.0% 55.0% 86.9% Business Combinations Financial Instruments Financial Instruments Business Combinations Pension Plans While pricing deficiencies and failures to adequately perform substantive tests were the primary causes of FVM failures in prior years, a new deficiency trend was observed in In recent inspection reports, there were many instances where the PCAOB cited audit deficiencies relating to testing internal controls over FVM without citing a related substantive testing deficiency. In the 2012 inspection reports, the PCAOB indicated 41.2% of FVM deficiencies and 50.0% of impairment deficiencies were caused by failures to assess risk, identify and / or test internal controls. The following are typical examples of deficiencies related to internal controls cited by the PCAOB. The Firm selected for testing only one control, a review control, over the valuation of investment securities. The Firm s procedures to test this control were limited to observing the evidence that the review had occurred, without evaluating whether the control operated at a level of precision that would prevent or detect material misstatements related to the valuation of the investment securities. The Firm s tests of certain review controls over the accounting for business combinations were insufficient. Specifically, the Firm s procedures were limited to observing evidence of reviewer sign-off, without evaluating whether the controls operated at a level of precision that would prevent or detect material misstatements. 6

8 This emphasis on internal controls is consistent with other recent PCAOB actions. In October 2013, the PCAOB issued Staff Audit Practice Alert No. 11: Considerations for Audits of Internal Control over Financial Reporting to highlight deficiencies in auditing internal controls encountered in the inspection process. It emphasizes that identifying and testing internal controls is particularly important when auditors rely on controls to reduce substantive testing of financial statement accounts and disclosures also saw an increase in the number of deficiencies caused by the failure to test assumptions in prospective financial information. Because this type of failure is often associated with business combinations, it is consistent with the increase in FVM deficiencies related to business combinations. More specific descriptions of these FVM audit deficiencies taken from the PCAOB inspection reports are provided in the insert on the following page FVM Deficiency Causes 2008 to 2011 FVM Deficiency Causes 17.5% 41.2% 16.3% 18.8% Pricing Failure to Test Disclosures Risk Assessment/ Controls PFI Assumptions 3.8% 5.3% 15.4% 10.1% 24.4% 41.0% Pricing Failure to Test Disclosures Risk Assessment/ Controls PFI Assumptions 6.2% OTTI Classification 7

9 Description Of Fair Value Measurement Deficiencies Pricing Includes failure to understand the methods, models and assumptions used by pricing services or valuation specialists; using the same pricing service to corroborate prices that the issuer used when measuring fair value; failure to investigate significant differences between prices from different sources; failure to investigate pricing differences identified by internal audit; failure to investigate adjustments made to third party prices by issuers; and inappropriately applying the yield or discount rate from one population to test securities prices or values in the test population without assessing the comparability of the two groups. Failure to Test Includes relying on interim testing and failing to test the assertion there was no material change in value; relying on interim testing and failing to perform procedures at year end; failing to perform sufficient substantive procedures when significant risks are identified; failing to perform year end tests when broker quotes were older than 30 days; failing to perform substantive tests when too much reliance is placed on internal controls or internal audit; failure to assess whether all assets and liabilities had been identified in a business combination; failure to test data provided to outside valuation specialist; failure to test the accuracy and completeness of data that valuation specialists relied on; failure to test fair value when requested pricing information was not received; failure to test all items in a selected sample; and outright failure to test certain assets and liabilities. Disclosures Includes failure to identify and test controls over FVM hierarchy disclosures; failure to test FVM hierarchy classification as Level 2 or Level 3; and failure to assess whether an input is observable or unobservable when testing the FVM hierarchy classification. Risk Assessment / Controls Includes the failure to identify and test controls over inputs to FVMs; setting risk thresholds so high that material errors are not detected; failure to investigate controls over resolution of pricing differences; failure to identify weakness due to lack of supervision by qualified personnel in the testing of hard-to-value financial instruments; failure to test controls over the budgetary process; and failure to test controls over the classification of securities as available for sale. Projected Financial Information (PFI) Assumptions Includes failure to evaluate the reasonableness of assumptions relating to revenue growth rates, capital expenditures, terminal growth rates and the discount rate; failure to assess the reasonableness of improved margins; failure to consider industry growth rates; erroneously using PFI from a period prior to a reorganization; failure to evaluate customer attrition rates; failure to evaluate the risk premium in the issuer s weighted average cost of capital; failure to evaluate a significant difference between value indications from the market and income approaches; and failure to assess a change in weights assigned to various indications of value. Other Than Temporary Impairment (OTTI) Includes failure to test controls over the classification of securities as OTTI; failure to test the issuers evaluation of securities as potentially OTTI; and failure to evaluate the assumptions, calculations and completeness of the issuer s OTTI test. 8

10 Impairment Deficiencies While the number of impairment deficiencies increased modestly in 2012, they were dominated by those related to goodwill impairments in all five years with 53.1% in 2012, and 54.8% in 2008 to Most of the remaining impairment deficiencies relate to long lived asset groups. The incidence of deficiencies relating to impairment of intangible assets increased to 15.6% in Impairment Deficiencies 2008 to 2011 Impairment Deficiencies 15.6% 31.3% 53.1% Goodwill Long Lived Asset Groups Intangible Assets 9.6% 35.6% 54.8% Goodwill Long Lived Asset Groups Intangible Assets The underlying causes of audit deficiencies related to impairment tests shown in the following graphs highlight the PCAOB s recent emphasis on risk assessment and testing internal controls. In 2012, 50% of impairment deficiencies were caused by failures to assess risk and test internal controls, up from 21.2% in all previous years. The PCAOB s focus on internal control deficiencies for impairment testing is similar to the trend observed for FVM deficiencies. More specific descriptions of these impairment audit deficiencies taken from the PCAOB inspection reports are provided following the Impairment Deficiency Causes graphs Impairment Deficiency Causes 28.1% 50.0% 21.9% PFI Assumptions Risk Assessment/ Controls Failure to Test 2008 to 2011 Impairment Deficiency Causes 5.8% 23.1% 21.1% 50.0% PFI Assumptions Risk Assessment/ Controls Failure to Test Asset Mismatch 9

11 Descriptions of Impairment Deficiencies PFI Assumptions In addition to the PFI assumption deficiencies mentioned for FVM, a deficiency relating to the failure to test the model, inputs and assumptions used to value a loan portfolio in connection with a goodwill impairment analysis was identified. Risk Assessment / Controls Additional deficiencies were failure to assess the issuer s methodology for determining fair value of reporting units, failure to identify deficiencies in controls relating to triggering events; and failure to assess whether the timing of impairment charge was appropriate. Failure to Test An additional deficiency was failure to test the issuer s assertion that assets were not impaired and ignoring evidence that triggering events had occurred. Asset Mismatch Including failure to identify a mismatch between the group of assets being tested for impairment and the group of assets included in the calculation of carrying value; and failure to identify an issuer s departure from GAAP by allocating goodwill to reporting units. 10

12 PCAOB s Report on the Implementation of Engagement Quality Reviews 6 A report covering the 2011 inspections of audit firms was made public by the PCAOB in December The report covers firm compliance with Auditing Standard No. 7, Engagement Quality Review ( AS 7 ) and is based on inspections of 213 firms and reviews approximately 820 audit engagements. The PCAOB s overall conclusions were that firm s methodologies were consistent with AS 7, but that audit deficiencies and related deficiencies in engagement quality reviews continue to be high. AS 7 requires that an engagement quality review be performed for every audit engagement and for engagements to review interim financial information. The quality review must be performed by a partner or equivalent from inside or outside the firm having competence, independence and integrity. The objective of the review is to evaluate the significant judgments and conclusions made by the engagement team. The reviewer must consider engagement planning and the engagement team s assessment and response to risks. The quality reviewer must also evaluate whether the engagement documentation indicates that the team responded appropriately to significant risks and that conclusions were supported. Finally, after performing the review with due professional care, the engagement quality reviewer may provide concurring approval of issuance if he or she is not aware of a significant engagement deficiency. The PCAOB s report concluded that in numerous instances where the audit opinion was insufficiently supported, the audit deficiencies should have been identified by the engagement quality reviewer. The PCAOB inspected 213 firms in 2011, and performed evaluations of compliance with AS 7 for 141 of those firms including seven large domestic firms. Of the 111 audits where the PCAOB inspectors concluded that an audit deficiency had occurred, 39% were also found to have deficient engagement quality reviews. Deficiencies in engagement quality reviews are primarily attributable to insufficient evaluation of significant judgments including risks and insufficient evaluation of the conclusions reached in support of the overall conclusion in the audit report. The PCAOB inspectors also identified what they considered the primary causes of AS 7 deficiencies. In many instances, incomplete or inadequate audit completion documents did not provide sufficient information for the engagement quality reviewer to identify audit deficiencies. 6 Observations Related to the Implementation of the Auditing Standard on Engagement Quality Review, PCAOB Release No , December 6,

13 Concluding Thoughts Based on information in the PCAOB s report on engagement quality reviews and our own analysis of PCAOB inspection reports, it is apparent that the number of audits with deficiencies remains high. Consistent with our findings in prior surveys, a significant number of these deficiencies relate to the auditing of fair value measurements and impairments. In past years, the fair value measurement of financial instruments was the overwhelming cause of most audit deficiencies (86.6%). Measuring the fair value of financial instruments became increasingly difficult during the economic crisis and inspection reports indicated these audit deficiencies were primarily caused by pricing problems and the failure to adequately test the value. The most recent inspection reports indicated a significant drop in deficiencies related to financial instruments to 55.0% and an increase in the number of deficiencies related to business combinations to 45.0%. As economic recovery has increased the pace of merger and acquisition activity, the number of deficiencies noted by the PCAOB relating to business combinations has increased. As in prior years these deficiencies are primarily attributable to failures to properly test management s prospective financial information. The number of impairment deficiencies increased slightly in the 2012 inspections but the relative numbers of goodwill, intangible asset and asset group impairment deficiencies cited has remained fairly constant. What has changed is the number of deficiencies caused by failures to properly assess risks and to test the company s controls. While professional judgment is required in both the audit engagements and the PCAOB inspection process, professionals may reach different conclusions as to the adequacy of the audit process. PCAOB inspection deficiencies relate to the audit process where the deficiencies were of such significance that the firm failed to obtain sufficient appropriate audit evidence to support its audit opinion on the financial statements and/or the effectiveness of internal control. This survey is a summary of publicly available information, the purpose of which is to hightlight trends in audit deficiencies related to fair value measurements and impairments. A more complete presentation of the underlying data can be found in the inspection report themselves. Acuitas, Inc. Acuitas, Inc. is an Atlanta, Georgia based valuation and decision consulting firm. Additional information about our firm can be found at For more information about how Acuitas, Inc can help address your valuation-related issues, please contact Mark Zyla, Managing Director at or mzyla@acuitasinc.com. 12