SEC Conference – What is an audit failure?

One of the topics mentioned a number of times at the recent SEC/PCAOB developments conference by representatives from the PCAOB was the “alarming” increase in the number of audit failures that were being detected in their review process.  If the number of audit failures they were referring to actually led to misstated financial statements then I would think we would being seeing a dramatic increase in the number of restatements required by the SEC, but that simply isn’t supported by the facts.  The facts are that the number of restatements has been declining in recent years not increasing.

So that got me thinking, what really is an audit failure?  Misstated financial statements are a clear indication of an audit failure, but I think most would agree just as it is possible to have a perfect audit and a misstatement goes undetected, it is even more possible to have a problem in the audit, but the financial statements are perfectly good.  That is, there wasn’t a problem, but even if there had been one, the deficient audit would not have detected it.

On the other hand maybe the term audit failure is being used to broadly.  Just because an audit deficiency occurred, does not necessarily mean an audit failure occurred.  Maybe there was some problem in how the work was documented.  That is, the right procedures and judgments were performed, but somehow it was not adequately documented in the workpapers.  Auditing standards require documentation so the lack of documentation is a deficiency, but if the work was adequately done, can it really be considered an “audit failure.”

That leads me to the conclusion that an audit failure is somewhere between the publication of materially misstated financial statements and a minor error in the audit.  That sounds simple, but it gets even more complicated when you consider the position of James Doty, PCAOB Chairman, on what are and are not misleading financial statements.  He stated that “just because you comply with GAAP does not mean financial statements are not misleading.”  I really don’t know where to go with that statement.  One of the cornerstones of the audit opinion is that the financial statements “present fairly the financial position of the company in conformity with U.S. GAAP.”  If auditors are being held to a standard higher than that, then no wonder we have so many audit failures that are not leading to restatements.

That leads me to one of three conclusions:

  1. The number of audit failures is being grossly overstated by the PCAOB (for some reason).
  2. We have an alarming number of audit failures, but it is the integrity, ethics, and objectivity of the professional accountants who prepare the financial statements that are keeping the financial statements from being misstated.
  3. The PCAOB is using the wrong measuring stick to determine an audit failure and they need to go back to the basics of the audit opinion to determine what an audit is intended to accomplish before proposing rules to fix a problem that may not exist.
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