Acuitas: Failure to Assess Risk and Test Internal Controls the Main Causes of Audit Failure. Fair Value Measurement Deficiencies Remain Significant

Hat tip to CFO Magazine.

Atlanta based consulting firm Acuitas recently released a survey of Fair Value Audit Deficiencies (pdf) covering the period 2009-2013.   The survey is based on an in depth analysis of PCAOB data from the same time period.    What they found is that Fair Value Measurement audit deficiencies continue to be significant, accounting for approximately one third of all audit deficiencies in 2013, and that the increase in M&A activities is a major contributor to FVM  deficiencies.  Similar to what we found in our PCAOB Quarterly Recap, failure to assess risk and test internal controls were the main contributors to audit deficiencies.  Some of the key findings include:

  • FVM audit deficiencies continue to be significant, making up 21.5% of total deficiencies for annually inspected firms in 2013. The PCAOB cited substantive failures associated with AU 328 Auditing Fair Value Measurement and Disclosures in 10.3% of the deficient audits in 2013.
  • FVM audit deficiencies are increasingly attributable to business combination engagements. The incidence FVM deficiencies related to business combinations jumped from an average of 9% for 2008 through 2011 to 45% in 2012 and increased further to 49% in 2013. This trend is likely caused by a rebound in merger and acquisition activity as the economy continues its recovery.
  • The number of deficiencies cited by the PCAOB caused solely by failures to assess risk and test internal controls increased sharply in 2012 and remains high in 2013 at 45% of all deficiencies for the top 25 firms.

Evidence for the increased scrutiny the board is giving to risk assessment and testing of controls is also seen in the standards referenced in the deficiencies, primarily AS no. 5,  Audit of Internal Controls (40.5%) and AS no. 13,  Risk of Material Misstatement (16.4%)Our takeaways:  As we discussed in our quarterly PCAOB recap, there was a significant improvement in audit quality from 2013 to 2014. However, there are still far too many deficient audits.  We believe that the best way to improve the entire financial reporting process, including audits, is with robust, continuously improving and well documented procedures.  We call for the following

  • Audit firms should develop, implement and monitor a robust set of audit quality indicators, similar to the controls used for SOX testing.
  • Audit committees should negotiate specific quality measures for each engagement with their auditors
  • Issuing firms need to focus on internal processes, documentation, and controls. Ideally the process improvement and documentation done should focus on items that are helpful to the issuing firm, and not what is required by the auditors.