Abstract: In October 2021, the PCAOB published a report that highlights common areas of audit deficiencies for public companies. Private companies face similar challenges when reporting their financial results. Internal accounting personnel and external auditors can use this report to identify high-risk areas in financial reporting that may warrant additional attention. This article identifies top areas of concern and key takeaways.
2020 findings
The PCAOB recently inspected portions of financial statement audits for 510 U.S. public companies and 107 foreign entities, which had fiscal years that ended during 2019 and the first half of 2020. The findings were published in a new PCAOB Spotlight report, Staff Update and Preview of 2020 Inspection Observations.
Many of the deficiencies found in 2020 are in areas that are inherently complex and, in turn, have greater risks of material misstatement. Common financial statement deficiency areas include:
- Revenue and related accounts,
- Inventory,
- Business combinations,
- Goodwill and intangible assets,
- Allowance for loan losses,
- Investment securities,
- Long-lived assets, and
- Cash and cash equivalents
The most common deficiencies in auditor attestation of internal control over financial reporting involved:
- Revenue and related accounts,
- Allowance for loan losses,
- Inventory,
- Business combinations,
- Investment securities,
- Long-lived assets,
- Information technology,
- Goodwill and intangible assets, and
- Income taxes.
Auditors may find this information useful as they plan and perform their audits. Likewise, managers and in-house accounting personnel may benefit from a review of these findings to help improve financial reporting, minimize audit adjustments and use as a reference point when engaging with external auditors.
Spotlight on revenue
Many deficiencies found by the PCAOB relate to revenue recognition. The accounting rules for reporting revenue from long-term contracts underwent a major overhaul in 2014. Though the changes went into effect for public companies in 2018, many continue to struggle with the complexity. It also presents challenges to private companies that have only been required to use the new rules for annual reporting periods beginning after December 15, 2019, and interim reporting periods within annual reporting periods beginning after December 15, 2020.
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), brought significant changes to the way companies report their revenue. It replaced 180 pieces of individual, industry-specific revenue guidance in U.S. Generally Accepted Accounting Principles (GAAP) with a single, principles-based, five-step process by which businesses calculate the top line in their income statements.
The FASB recently performed a post-mortem implementation review of the updated guidance. Issues that were flagged during the FASB’s review include:
- Determining if an entity is a principal or agent in a revenue arrangement,
- Identifying when a license is distinct from other services in the contract, such as software with updates,
- Estimating variable consideration for contracts with sales or usage-based royalties that aren’t licenses of intellectual property,
- Evaluating whether short-cycle manufacturing contract revenue should be recognized over time or at a point in time,
- Improving disclosures by providing more specificity around disaggregated revenue and remaining performance obligations,
- Estimating standalone selling prices, especially when a new performance obligation has never been sold on a standalone basis or has little or no cost basis (or an undeterminable cost basis),
- Identifying performance obligations, including assessing the nature of a promise and whether or not goods or services are distinct, and
- Determining which incremental costs of obtaining a contract should be capitalized and the period over which those costs should be amortized.
Other areas of concern
The PCAOB’s report noted that accounting estimates — such as the allowance for loan losses, the fair value of long-lived assets and goodwill impairment — involve assumptions and measurement uncertainty. As a result, reliance on these estimates elevates the risk of material misstatement.
Critical audit matters (CAMs) are another area of concern reported by the PCAOB. CAMs relate to accounts or disclosures that are material to a company’s financial statements and involved especially difficult judgment from the auditor. They’re essentially the most complicated issues that arose during the audit. Auditing Standard (AS) 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, requires auditors of public companies to add a discussion of CAMs to the audit report.
Auditors of large accelerated filers — public companies with market values of $700 million or more — have been required to report CAMs for fiscal years ending on or after June 30, 2019. Smaller public companies began reporting CAMs for fiscal years ending on or after December 15, 2020. The PCAOB report covered about 200 audits in which auditors were required to communicate CAMs. The most common issues auditors reported in 2020 were revenue recognition, business combinations, and goodwill and other intangible assets.
Key takeaways
Regardless of whether they’re public or private, companies should take proactive measures to ensure their financial reporting is accurate and transparent. That may include providing accounting personnel with additional training and assistance, increasing management review and staff supervision, and beefing up internal audit procedures in these high-risk areas.
Also, expect external auditors to focus on these areas. As audit season approaches, get ready to provide additional documentation to back up your estimates, reporting procedures and account balances for high-risk items.
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