The Public Company Accounting Oversight Board (“PCAOB”) recently issued PCAOB Release No. 2012-003 containing information for audit committees about the PCAOB inspection process. The formation of the PCAOB was one of the oversight changes which came out of the Sarbanes-Oxley Act of 2002 (“the Act”). The reason behind this release seems to be twofold, one is to assist audit committees in understanding the inspection process and the other is to assist them in gathering information from the audit firms about their inspections.

The Act charges the PCAOB to conduct regular inspections of audit firms under the PCAOB reporting requirements. These inspections are designed to identify and address weaknesses and deficiencies related to how a firm conducts audits. To achieve that goal, PCAOB inspections include an evaluation of the firm’s performance in selected audit engagements and evaluation of the design and operating effectiveness of a firm’s quality control policies and procedures. For every inspection performed by the PCAOB, the Act requires the PCAOB to prepare a written inspection report and allows the inspected firm an opportunity to respond in writing.

Part I of the PCAOB inspection report describes audit deficiencies where the audit staff failed to gather sufficient audit evidence to support an audit opinion. Part I findings are made public and available on the PCAOB’s web site. Part II of the report typically describes deficiencies in the firm’s overall system of quality control such that the board has doubts that the system provides reasonable assurance that professional standards are met. The Act prohibits releasing these Part II deficiencies unless the firm fails to remediate these findings to the PCAOB’s satisfaction within 12 months of the issuance of the inspection report. The audit firms themselves have copies of this part of the report and are not prohibited by law from releasing this information at any time, though there may be other reasons why they choose not to do so.

The release highlights several topics the audit committees may wish to discuss with their audit firms about their PCAOB inspection. An audit committee may wish to know if their audit was selected for inspection, which areas of the audit were inspected and whether the inspectors raised any concerns with the audit. If their audit was not selected for inspection, the Audit Committee may wish to discuss any deficiencies in other audits that were inspected that involved auditing or accounting issues similar to issues presented in their company’s audit.

The PCAOB gives three examples of canned “responses” that “should be viewed with skepticism.” The first is “it was just a documentation problem.” The PCAOB bases deficiency findings on an absence of available evidence in the audit files or elsewhere to support that adequate work was done to support an audit opinion, not just a failure to document work that was in fact done. The PCAOB points out that if an audit firm contends that a publicly reported deficiency can be explained as an instance of the audit firm having inadequately documented its work, an audit committee may want to keep in mind that any such contention by the firm has been considered and rejected by the inspection staff.

A second response that the PCAOB feels should be viewed with skepticism is “there was a difference of professional judgment” between the PCAOB and the audit firm. The PCAOB notes that the audit committee may want to explore with the audit firm what point of professional judgment the audit firm contends is at issue, how the audit firm would defend its judgment on that point, and what the audit firm understands about why the inspection staff rejected the firm’s position. The PCAOB bases deficiency findings only on failures to obtain sufficient audit evidence, not on disagreements when reasonable judgments appear to have been made about such matters.

The final response that the PCAOB feels should be met with skepticism is “the firm has addressed the criticisms in accordance with PCAOB standards.” An audit committee may want to seek clarification about whether the audit firm’s position is that its opinion was sufficiently supported at the time it was originally issued (the audit firm disagrees with the inspection report), or whether the audit firm has obtained additional audit evidence through additional auditing procedures, possibly performed in subsequent audits, that informs its position that the previously supported opinion was correct. Audit committees should understand the inspection staff found the auditor, at the time it issued its audit report, had not performed other procedures that sufficiently compensated for the deficiency.

Each audit committee will judge for itself the extent to which it wishes to explore the PCAOB inspection results with its auditor. We encourage discussions with audit committees regarding the PCAOB inspection process and inspection results. It is our opinion that an audit firm’s willingness to review and have a candid discussion with an audit committee about their PCAOB inspection results can have value in relation to the audit committee’s oversight and evaluation of the engagement generally and also in relation to the audit committee’s role in the oversight of the company’s financial reporting process. In a recent interview with Ignites, Mike Boyle, managing partner at BBD, says “we have always discussed the PCAOB findings with our mutual fund clients’ audit committees. We certainly believe audit committees have not only the right but the obligation to ask about inspection results. With this mindset, we as a common practice attempt to bring the subject matter front and center before the question is asked.”