Are balance sheets unauditable?

Is it possible that current accounting rules make a modern balance sheet so complex and judgment filled that it is essentially unauditable?

The answer is a hesitant yes, if I’m correctly reading Grumpy Old Accountant Anthony Catanach’s column Is FASB Killing the Auditing Profession?

He contrasts two parts of the PCAOB reports on inspections of PricewaterhouseCooper (PwC).  The PCOAB released two consecutive inspection reports for the firm.

My understanding is the confidential portion gets released if you don’t fix the issues by the next inspection. That means to get two consecutive reports released means the problems identified during inspection one weren’t fixed before inspection two and still had not been resolved during inspection three. Ouch.

Reduce partner time on complex audits

Prof. Catanach combines two issues.

First, the firm’s response says the issues involved are

…some of the most complex, judgmental and evolving areas of auditing. Our actions relating to those areas, during the 12 months following issuance of the  comments and thereafter, have included providing our audit professionals with enhanced audit tools, training and additional technical guidance to promote more consistent audit execution.

This means these are extremely difficult issues. Prof. Catanach suggests the second comment implies the staff didn’t quite have enough training to take them on.

Second, apparently a number of partners are spending minimal amount of time on supervision.

The professor has a struggle with firms that allow partners to spend low amounts of supervision on engagements that have the most complex, judgmental, and evolving areas of audit complexity. Seems to me the professor has a good point – those are the audits where the partner should be hanging out all the time.

Level of partner involvement

My guess is that insufficient partner involvement is probably a wider issue than just this report for just this firm.

My limited range of exposure is at two international firms and one national firm. My years in those firms showed me one only one of those firms where the partners actually spent a significant amount of time on substantive audit and accounting issues. It may just be a reflection on the low number of firms I’m familiar with, but my experience left me unsurprised by the PCAOB comment.

GAAP complexity

The article surveys some of the extremely complex and highly judgmental audit issues that have to be addressed in-depth on most audits today.

Two illustrations –  You have to have some serious experience to evaluate management’s assertion of recovery of goodwill on a huge acquisition. You cannot skeptically evaluate recoverability at the senior or even a light manager level. That takes someone with hard-core experience. You know, like those partners who are aren’t in the field.

My favorite story of the complexity of GAAP is from a few years ago. There’s a EITF position that if you use a lockbox to collect customer’s payments and if the lockbox is run by your lender and if your lender is allowed to apply some portion of the lockbox payments to your loan with that lender, then the entire balance of your loan with that lender is current.

When some staffer at PCAOB tripped across that then-old rule, all the Big 4 firms got dinged on that point in the next round of inspections. They had to restate the engagements under inspection, had to look for other clients in the same situation, and had to restate several other reports.

That’s a really obscure point in GAAP. Which was missed by all the Big 4 firms, by the way. I would have certainly missed it. Since then, the concept shows up every year on the disclosure checklist in my purchased third-party practice tools. Perhaps that is why the disclosure checklists are over a hundred pages long.

Combine the issues

Professor Catanach suggests the now ancient pyramid-shaped staffing model with a few partners, lots of managers, tons of seniors, and rooms filled with juniors doesn’t work when you’re routinely dealing with fair value analyses of goodwill recoverability and software recognition for multiple deliverables on complex products.

You combine that ancient staffing model with FASB’s headlong rush into complexity and you have the formula for disaster. That’s one of the professor’s main points in the article, thus the title.

If you’ve read this far in my post, you will want to read his full discussion. Pay particular attention to the blame he allocates to FASB.

On the other hand…

In his article, The PCAOB’s Inspection Reports Nibble at PwC – A Reader Asks, “Where’s the Beef?”, Jim Peterson isn’t too concerned about the information revealed by the reports. His concerns run deeper to the very core of the PCAOB oversight model and the entirety of the current audit model. My short summary is that he challenges the foundational substance of PCAOB oversight.

Post continued and wrapped up here.