Stop using “audit failure” term in PCAOB reports, Hanson says

The PCAOB’s use of the term “audit failure” in its inspection reports of audit firms appears to have caused confusion and misunderstanding about the severity of inspection findings among investors, audit committees, and others, PCAOB member Jay Hanson said Wednesday.

Hanson said he is troubled by the PCAOB’s use of the term “audit failure” in inspection reports. He wants the board to stop using the term in the reports. Hanson made the remarks during a speech at the CBI Pharma/Biotech Accounting & Reporting Congress in Philadelphia.

The PCAOB uses the term to identify cases in which the auditing firm failed to obtain sufficient appropriate evidence to support its audit opinion, Hanson said. This does not necessarily mean that the financial statements are misstated, Hanson said. Instead, it means that the auditor did not do enough work to know whether they are misstated, he said.

In other contexts, “audit failure” is understood to mean that the company’s financial statements are misstated, and that the auditor did not identify relevant problems during the audit, Hanson said. He cited the example of a U.S. Government Accountability Office study that defined the term “audit failure,” in part, as “audits for which audited financial statements filed with the SEC contained material misstatements whether due to errors or fraud.”

“I don’t believe it is necessary or appropriate for us to deviate from this more commonly understood definition of ‘audit failure’ by using the term to refer to our inspection findings—which are deficiencies in the firm’s work but not necessarily representative of problems in the audit client’s financial statements or internal controls,” Hanson said.

PCAOB spokeswoman Colleen Brennan said in an email that the board is aware of the concerns that some have expressed about the terminology in its reports.

“Whether we use the expression ‘audit failure’ or not, what we put in Part 1 of the inspection reports are situations where our inspectors have found that the audit report was unsupported and not reliable,” Brennan said. “Also, it’s worth noting that we have always made clear in our reports that an audit failure does not necessarily mean the financial statements are materially misstated.”

Cindy Fornelli, the executive director of the Center for Audit Quality (CAQ), said in an email that the CAQ and the public company audit profession recognize the importance of the PCAOB inspection process and view it as a valuable input for continuous improvement in audit quality. But the CAQ believes investors, auditors, and audit committees could benefit from more clarity and context in PCAOB inspection findings.

“We share board member Hanson’s concerns about the use of the term ‘audit failure’ in PCAOB inspection reports, because the term can be misleading,” Fornelli said. “As board member Hanson pointed out in his speech, ‘very few [PCAOB] inspection findings … can be linked to a problem in the company’s financial statements, and restatements arising out of [the] inspection process are rare.’ ”

The CAQ is affiliated with the AICPA.

The publishing of “rates” of audit failures based on the PCAOB’s public reports also is misleading, Hanson said. Some media have analyzed firm inspection reports and published a rate or percentage of “audit failures” for firms calculated by dividing the number of “audit failures” reported by the total number of audits the PCAOB analyzed.

Hanson said audits are selected for review based on risk and that PCAOB reports are not “balanced scorecards” with respect to any particular firm or across firms.
 
“The risks associated with each audit, and each firm’s audit practice, are unique,” Hanson said. “Presenting ‘rates’ of audit failures, then, which inevitably will be utilized to compare one firm to another, may be misleading at best and harmful at worst.”

Hanson also would like the PCAOB to consider classifying inspection findings by severity level in order to provide more context for those who review inspection reports. Currently, reports provide no information about which deficiencies are relatively minor and which indicate a significant problem with the audit.

Hanson also said the board should consider adding information in inspection reports indicating the size and industry of the company whose audit was reviewed, as well as the risks the staff used to decide to review the particular audit or audit area.

“While routinely providing this information in inspection reports likely would present implementation challenges to our inspection staff, I believe the board should add this to its list of potential improvements to consider,” Hanson said.

—Ken Tysiac (ktysiac@aicpa.org) is a JofA senior editor.