PCAOB International Inspections

Descriptive Evidence from PCAOB Reports

Under section 106(a) of the Sarbanes-Oxley Act of 2002 (SOX), foreign auditors with U.S. issuer clients must register with the PCAOB. SOX section 104 requires the PCAOB to conduct annual inspections of PCAOB-registered auditors with more than 100 issuer clients, as well as inspections at least once every three years for PCAOB-registered auditors with 100 or fewer issuer clients.

The PCAOB began conducting inspections of U.S. and foreign auditors in 2004 and 2005, respectively (PCAOB Release 2009-003, 'Final Rule Concerning the Timing of Certain Inspections of NonU.S. Firms and Other Issues Relating to Inspections of Non-U.S. Firms," June 2009). Daniel L. Goelzer, acting PCAOB chairman from August 2009 through January 2011, commented that international inspection was one of the PCAOB's highest priorities and challenges (Speech at U.S. House of Representatives Financial Services Committee-Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises, May 21,2010). Similarly, at the inaugural meeting of the PCAOB's Investor Advisory Group, Joseph V. Carcello listed international inspections as one of the PCAOB's top five priorities ("Suggested Priorities for the PCAOB: A Statement at the Inaugural Meeting of the PCAOB's Investor Advisory Group," Current Issues in Auditing, vol. 4, no. 2,2010, pp. A1-A6). At the end of 2012,911 foreign audit firms were registered with the PCAOB, according to its 2012 annual report. Today, international inspections continue to be a high priority ("Featured Issue: International Oversight," 2013, http://pcaobus.org/ Featured/Pages/Intemational.aspx).

But the PCAOB expressed concern about its inability to conduct inspections of foreign auditors in some jurisdictions (certain European countries and China), due to legal conflicts and sovereignty issues ("Issuers That Are Audit Clients of PCAOB-Registered Firms from Non-U.S. Jurisdictions where the PCAOB is Denied Access to Conduct Inspections," 2010, http : //pcaobus. org/Intemational/ Inspections/Pages/IssuerClientsWithout Access.aspx). In light of these regulatory concerns, it is important to provide descriptive evidence from international inspection reports to regulators, practitioners, and researchers.

The discussion below, which analyzes PCAOB international inspections conducted between January 2005 and February 2011, explores the differences between foreign auditors affiliated with the "Big She" international audit firms (Deloitte & Touche, Ernst & Young, KPMG, PricewaterhouseCoopers, BDO Seidman, and Grant Thornton) and foreign auditors unaffiliated with the Big Six. Big Six-affiliated auditors have the benefit of belonging to a global network, as well as a wealth of talent and other resources to undertake the most complex audits. Global expertise, robust audit methodologies, and superior reputations enable these auditors to conduct audits for large multinational clients (Elizabeth Carson, "Industry Specialization by Global Audit Firm Networks," Accounting Review, vol. 84, no. 2, March 2009, pp. 355-382).

Background

Existing research describes PCAOB inspections for small and large accounting firms (Dana R Herrn anson, Richard W. Houston, and John C. Rice, "PCAOB Inspections of Smaller CPA Firms: Initial Evidence from Inspection Reports," Accounting Horizons, vol. 21, no. 1,2007, pp. 137-151; Bryan K. Church and Lori B. Shefchik, "PCAOB Inspections and Large Accounting Firms," Accounting Horizons, vol. 26, no. 1, March 2012, pp. 43-63); however, these studies focus rally on U.S auditors.

In 2013, "PCAOB Inspections of International Audit Firms: Initial Evidence" examined international inspection reports and provided preliminary evidence suggesting that half of the reports identified audit deficiencies and two-thirds included quality control defects (Carol C. Bishop, Dana R. Hermanson, and Richard W. Houston, International Journal of Auditing, vol. 17, no. 1, March 2013, pp. 1-18). This article's study confirms the findings of Bishop et al. and adds further details on variations by country, the type and severity of audit deficiencies, quality control defects, and differences by type of foreign auditors involved.

Besides Bishop et al., only one available study has examined PCAOB international inspections (Joseph V. Carcello, Brian Todd Carver, and Terry L. Neal, "Market Reaction to the PCAOB's Inability to Conduct Foreign Inspections," working paper, 2011); however, it focused on the stock market response to PCAOB inspections, finding a significant negative stock market reaction when clients of foreign auditors could not be inspected by the PCAOB.

PCAOB International Inspection Process

Auditors must register with the PCAOB if they audit SEC-registered corporations (PCAOB Release 2007-011, "Request for Public Comment on Proposed Policy Statement: Guidance Regarding Implementation of PCAOB Rule 4012," December 2007). The PCAOB also regularly inspects U.S. and foreign registered auditors to assess their compliance with U.S. security laws and auditing standards (PCAOB Rule 4000). Inspections of U.S. auditors began in 2004, and inspections of foreign auditors began in 2005 (PCAOB Release 2009-003). The PCAOB conducts inspections annually for registered auditors with more than 100 issuer clients, and biennially for registered auditors with 100 or fewer issuer clients (SOX section 104; PCAOB Rule 4003). The PCAOB publishes reports for each inspection it conducts. Quality control defects remain private if the audit firm remediates the defects in its quality control system within one year of the report date; otherwise, the related portion of the report is made public.

Joint inspection is an important part of cooperative agreements when foreign jurisdictions have their own inspection programs (PCAOB Release 2009-003). As of the end of 2012, the PCAOB had created cooperative arrangements with 16 jurisdictions-Australia, Canada, Dubai, Finland, France, Germany, Israel, Japan, Korea, Norway, Singapore, Spain, Switzerland, Taiwan, the Netherlands, and the United Kingdom-to facilitate audit oversight cooperation. PCAOB Rule 4012 provides a framework to conduct joint inspections. It places greater reliance on systems that are more independent and rigorous (PCAOB Release 2007-011). Rule 4012 identifies five guiding principles to assess the independence and rigor of foreign audit oversight system:

* Adequacy and integrity of the oversight system

* Tbe independence of the oversight system's operation from the auditing profession

* Hie independence of the oversight system's source of funding

* The transparency of the oversight system

* The oversight system's historical performance.

At the end of 2012, the PCAOB had inspected foreign audit firms located in 40 jurisdictions, according to its 2012 annual report. Of those jurisdictions, foreign audit firms in only eight jurisdictions-Germany, Japan, Korea, Norway, Spain, Switzerland, the Netherlands, and the United Kingdomwere inspected jointly with foreign audit regulators (Keynote address, William & Mary Mason School of Business, Norfolk Southern Excellence in Financial Reporting Conference, Apr. 12, 2013). Inspections in other jurisdictions were conducted only by tiie PCAOB. Foreign audit firms in 20 jurisdictions had not been inspected, including firms that resisted inspections and those whose inspections were delayed by the PCAOB.

Authorities in certain European countries, as well as in China and Hong Kong, have opposed PCAOB inspections; thus, the PCAOB is currently prevented from inspecting the U.S.-related audit work of PCAOB-registered auditors in these jurisdictions (PCAOB 2010). Foreign auditors in these jurisdictions have not submitted the requested audit information for PCAOB inspections, due to legal conflicts with home country laws and sovereignty concerns ("New and Updated Information on PCAOB Inspections," PCAOB, 2009, http://pcaobus.org/Inspections/Documents/ New_and_Updated_Information_ Internationallnspectionsl 2-3 1 - 2009.pdf). The PCAOB has signed a memorandum of understanding with regulators from China that creates a framework to request audit documents from foreign auditors based in that country ("Memorandum of Understanding on Enforcement between the Public Company Accounting Oversight Board of the United States and the China Securities Regulatory Commission and the Ministry of Finance in China," May 13, 2013). To date, however, there has been little cooperation between the PCAOB and Chinese regulators related to actual inspections of Chinese auditors.

International inspections were initially delayed because the PCAOB had to negotiate the principles for cooperative work with foreign audit-oversight bodies, understand the oversight systems of various jurisdictions, and synchronize joint inspection schedules with other jurisdictions. Because of these challenges, the PCAOB adopted Rule 4003(g), which postponed certain inspections by as much as three years from the 2009 target date (PCAOB Release 2009-003). Under Rule 4003(g), the PCAOB established inspection targets by using thresholds based on the U.S. market capitalization of clients of foreign auditors and the number of foreign clients. Progress toward target thresholds is reviewed annually (PCAOB Release 2009-003).

Research Method

The authors examined the PCAOB inspection reports of foreign audit firms published between January 2006 and December 2011 for inspections completed between January 2005 and February 2011. (Inspection reports are available from the PCAOB's website, http://pcaob.org/ Inspections/Public_Reports/index.aspx.) There is typically a lengthy interval (20.73 months on average) between the start of a PCAOB inspection and the publication of an inspection report.

The authors' data, collected in May 2012, covered 243 inspection reports for 178 foreign auditors. Each report was coded by hand and verified by an experienced practitioner, with a focus on such items as the date of the report; the presence and nature of audit deficiencies and quality control defects; and the number of offices, partners, professional staff, and clients.

Research Results

International inspections. Exhibit 1 provides an overview of the international inspection reports. It presents the frequency of countries where foreign auditors are located: Canada had the highest number of reports (28%), followed by Israel (7%) and Australia (5%). Of the 243 international inspection reports, 139 (57%) identified audit deficiencies and 167 (69%) featured quality control defects. Of the 178 foreign audit firms, 100 (56%) had audit deficiencies and 121 (68%) had quality control defects. Details about quality control defects were not published in 95% of the cases, suggesting that most were remediated by the foreign auditors in a timely manner. The audit deficiency and quality defect rates of foreign inspection reports are comparable to those of U.S. triennially inspected auditors, as reported by Hermanson, Houston, and Rice (2007, p. 141). The audit deficiency rate of foreign audit firms is also comparable to that of U.S. triennially inspected auditors, as reported by the PCAOB (PCAOB Release 2013-001, "Report on 2007-2010 Inspections of Domestic Firms That Audit 100 or Fewer Public Companies," Feb. 25, 2013).

Audit deficiencies are positively associated with quality control defects. In other words, when the PCAOB cites a firm for an audit deficiency, a quality control defect is also cited. Only one of 76 audit firms with effective quality control had an audit deficiency, and 138 of the 139 audit firms with audit deficiencies had quality control defects, similar to the result reported by Hermanson et al. (2007, p. 141).

Exhibit 1 shows a noticeable upward trend in the number of international inspections since 2007. As a result, the number of observed audit deficiencies and quality defects has also increased {Exhibit 2). During 2004-2005, the PCAOB conducted inspections on auditors located in countries with close political and diplomatic ties with the United States (e.g., Argentina, Brazil, Canada, Chile, Israel, Mexico, and the United Kingdom). The PCAOB has subsequently expanded the number of countries where it conducted inspections, but this list still does not include mainland China and several major European economic powers, due to complex regulatory, legal, and geopolitical issues (http://pcaobus.org/Intemational/Inspections /Pages/062012_intended_inspections.aspx).

A closer look at the data in Exhibit 1 reveals which countries have the highest proportion of audit deficiencies and quality control defects. All of the inspection reports for auditors fiom Japan and Hong Kong cited audit deficiencies and quality control defects. The vast majority of foreign inspection reports were for Canadian auditors; approximately 75% of inspection reports for Canadian auditors cited audit deficiencies and 87% cited quality control defects. Other countries with high rates (above 70%) of audit deficiencies and quality control defects include the Philippines (100% and 67%), India (80% and 70%), Israel (76% and 82%), and Mexico (75% and 75%).

There were 60 foreign auditors that received at least two inspection reports. The rates of audit deficiency (52%) and quality control defects (60%) in the first report were lower than the second report (57% and 68%, respectively). This finding is different fiom studies on U.S. triennially inspected auditors, which conclude that the second inspection reports have fewer audit deficiencies and quality control defects (Dana R. Hermanson and Richard W. Houston, "Evidence from the PCAOB's Second Inspections of Small Firms: Driving Improvements in Auditing and Quality Control," The CPA Journal, February 2009, pp. 58-60; PCAOB Release 2013-001).

As expected, Big Six-affiliated foreign auditors had fewer audit deficiencies and quality control defects than foreign auditors not affiliated with the Big Six {Exhibit 3). This is consistent with prior research, which documented that large glob-al auditors provide higher audit quality than their counterparts, both in the United States and globally (Connie L. Becker, Mark L. DeFond, James J. Jiambalvo, and K.R. Subramanyam, "The Effect of Audit Quality on Earnings Management," Contemporary Accounting Research, vol. 15, no. 1, Spring 1998, pp. 1-24; Jere R. Francis and Dechun Wang, "The Joint Effect of Investor Protection and Big 4 Audits on Earnings Quality around the World," Contemporary Accounting Research, vol. 25, no. 1, Spring 2008, pp. 157-191).

Using the categories in Exhibit 4 to classify auditors' responses to PCAOB inspections, the authors found that firms without audit deficiencies generally either provided no response or stated that they were pleased with the findings. Twenty-seven firms with audit deficiencies disagreed and provided a specific defense (19.5%); six firms with audit deficiencies disagreed without providing a specific defense (4.3%). This finding is quite similar to those reported by others (Hermanson et al. 2007, p. 141).

Inspection characteristics. Exhibit 5 presents descriptive statistics of inspection characteristics. The PCAOB varies the duration of inspections based upon whether it finds audit deficiencies. On average, an inspection lasts about 21 days if there is an audit deficiency, but only about 9 days if the inspectors identify no deficiency (Exhibit 5, Panels A and B). Thus, it takes 12 days longer, on average, to inspect a foreign auditor when the PCAOB finds an audit deficiency during an inspection; similarly, it takes about 9 days longer when PCAOB inspectors find a quality control defect. These differences are consistent with the expectation that inspectors will employ additional effort and time to address audit and quality control issues observed during the course of an inspection (Hermanson et al. 2007).

Panels A and B of Exhibit 5 show that the PCAOB publishes inspection reports approximately 20 months, on average, after the inspection is completed (report lag). Both a quality defect and an audit deficiency add an average of one month to the report lag, but those differences are not statistically significant (all of the other measures discussed here are statistically significant). The group with both audit deficiencies and quality control defects had tie longest inspection period and report lag (Exhibit 5, Panels C and D). Although Big Six-affiliated foreign auditors have fewer audit deficiencies and quality control defects than foreign auditors not affiliated with the Big Six, file inspection period and report lag are significantly longer for Big Six-affiliated foreign auditors (Exhibit 5, Panel E). This suggests that audit deficiencies of Big Six-affiliated foreign auditors are more complicated and that it takes longer to address audit issues during the inspection and prepare complex inspection reports.

Audit firm characteristics. Exhibit 6 provides the characteristics of 178 inspected foreign auditors, focusing on the median because of the wide disparities between firms. The authors found that firms cited for either audit deficiencies or quality control defects have fewer partners, professional staff, and total professionals; however, they do have more audit clients than firms without audit deficiencies and quality control defects (Exhibit 6, Panels A and B). This suggests that the level of resources available to a firm is an important driver of negative findings (audit deficiencies or quality control defects) during PCAOB inspections.

The authors next examined several ratios in order to further explore this issue. The ratio of total partners to total professionals is higher for firms with deficiencies or quality control defects than for those without (Exhibit 6, Panels A and B). Other research has found that firms with the highest levels of deficiencies and defects are relatively topheavy and have fewer available profession- als to conduct fieldwork (Hermanson et al. 2007). Other ratios, such as total partners to total clients and total professionals to total clients, further support this observation.

Foreign auditors not affiliated with the Big Six have significantly fewer partners, professional staff members, and total professionals. But no statistical difference exists between the number of audit clients served by Big Six-affiliated foreign auditors and those unaffiliated with the Big Six (Exhibit 6, Panel C). Foreign auditors not affiliated with the Big Six were cited with audit deficiencies and quality control defects in 80% and 91.8%, respectively, of all inspections among that group (Exhibit 6, Panel D). As suggested by prior research (Hermanson et al. 2007), resource constraints among foreign auditors not affiliated with the Big Six is an important driver of deficient audits, both in tie United States and internationally.

Nature of audit deficiencies and financial statement accounts impacted. The authors followed Church and Shefchik's method for coding the severity of audit deficiencies. First, deficiencies were divided into two broad categories (deficiencies that resulted in a financial statement misstatement and those that did not) and then further categorized based upon their severity. Deficiencies were coded as misstatementrelated if an inspection report indicated that clients restated their financial statements ("Restate"), the audit firm failed to address a departure from GAAP ("Non-GAAP"), or the audit firm failed to address an accounting error ("Error"). Deficiencies unrelated to misstatements were also coded when the audit firm failed to either test an accounting assertion ("No-Tesf'), evaluate an accounting issue ("No-Eval"), or perform sufficient audit procedures ("No-Suff'). The authors coded "Principal Auditor" when a foreign auditor was inappropriately determined to serve as principal auditor, and as "Materiality" when a foreign auditor failed to consider materiality in planning and performing the audit and in evaluating the results of the audit.

The results are provided in Exhibit 7. The most frequent subcategory is failure to perform sufficient audit procedures (NoSuff, 55%). This is followed by failure to test an accounting assertion (No-Test, 21%) and failure to evaluate an accounting issue (No-Eval, 9%). The difference in the proportion of total deficiencies for each nonmisstatement subcategory between Big-Six affiliated foreign auditors and other auditors is not statistically significant; moreover, the difference in the proportion of total deficiencies for each misstatementrelated subcategory, Principal Auditor and Materiality, between the two is also not statistically significant. Overall, GAASrelated deficiencies are more frequently cited than GAAP-related deficiencies in foreign inspection reports, and there is no statistically significant difference between Big Six-affiliated foreign auditors and those not affiliated with the Big Six for these deficiency subcategories.

Exhibit 8 presents the financial statement accounts identified in the descriptions of audit deficiencies. Revenue issues were most frequently cited (58), followed by inventory and cost of goods sold (27); business combination, reverse merger, and goodwill (26); notes receivable and allowance (24); fixed asset (23); and equity (21). Hermanson et al. (2007) and the PCAOB (Release 2013-001) also found that revenue issues were the most frequently cited topic in inspection reports for U.S. auditors; the PCAOB observed similar areas of deficiencies in its U.S. triennial inspection reports for 2007-2010. In "Featured Issue: International Oversight," the PCAOB identified revenue, share-based financing and equity financing instruments, convertible debt instruments, fair value measurements, business combinations and impairment of intangible and long-term assets, and accounting estimates. Although filis study used a somewhat different classification method, a great deal of similarity exists between the deficiencies observed here and those noted by the PCAOB.

Quality control defects. The authors examined each inspection report for references to quality control defects. Of the 243 reports, 167 (69%) cited quality control defects; however, 952% of these defects have not been publicly disclosed. The PCAOB disclosed the nature of only eight (5%) defects, which related to such matters as the design of the auditor's quality control system, audit performance, audit procedures related to revalues and doubtful accounts, and consideration of fraud in conducting the audit. This finding is comparable to results reported by Dana R. Hermanson et al. (2007) and Dana R. Hermanson and Richard W. Houston ("Quality Control Defects Revealed in Smaller Firms' PCAOB Inspection Reports," The CPA Journal, December 2008, pp. 36-39). This finding is also comparable to results reported by the PCAOB (Release 2013-001). The PCAOB also reported that about 90% of U.S. triennial audit firms with quality control defects identified during inspections from 2007 to 2010 addressed all quality-control criticisms to the PCAOB's satisfaction. Thus, it is evident that the PCAOB is following its own guidelines and does not disclose defects that have been remediated.

Lessons Learned

This study contributes to the understanding of international inspection reports and provides stakeholders with insight into the broad outcomes of PCAOB international inspections. The 243 reports examined contained 369 audit deficiencies, an average of about 1.52 deficiencies per inspection report. About 51% of those deficiencies are associated with audits conducted by foreign auditors not affiliated with the "Big Six" international audit firms. As mentioned, the level of resources available to a firm is an important driver of the number of audit deficiencies or quality control defects reported by the PCAOB.

Although the present findings are generally similar to prior examinations of inspections of U.S. auditors (Hermanson et al. 2007; PCAOB Release 2013-001), the international inspection setting offers additional insight. For example, Big Six-affiliated foreign auditors have fewer audit deficiencies and quality control defects than other firms. On the other hand, the duration of inspec- fions and the report lag are longer for Big Six-affiliated foreign auditors.

The most frequently cited financial statement accounts in international inspections with audit deficiencies are revenue, inventory, and cost of goods sold. The PCAOB seldom publishes details about quality control defects; the few defects disclosed by the PCAOB revolve around such matters as the design of the auditor's quality control system, audit performance, audit procedures related to revenues and doubtful accounts, and consideration of fraud in conducting the audit.

The authors observed country-specific variations. Foreign auditors with the highest proportion of deficiencies and quality control defects came from Canada, Hong Kong, India, Israel, Japan, Mexico, and the Philippines. This does not necessarily imply that these countries have lower audit quality than other countries; because these countries have close political and diplomatic ties with the United States, it is comparatively easier for the PCAOB to investigate the work of auditors there. Because of the relatively short history of PCAOB inspections and the small number of inspections that have been conducted in individual countries, additional research is needed to make conclusive statements about comparative audit quality. Yet, the present results indicate initial differences that should capture the attention of the profession and regulators.

Rie PCAOB has noted several causes for deficiencies in audit quality, including file following (Release 2013-001):

* Lack of due professional care and inadequate levels of professional skepticism

* Lack of technical competence when complex accounting or industry specialization is involved

* A heavy work overload for partners and professional staff

* Ineffective client portfolio management