Pressing Issues Facing the Auditing Profession Today

 

Regulators Finally Begin to Question Use of Non-GAAP Metrics

For some time now, onlookers (including this one) have been warning about the increasing use of non-GAAP information by registrants in IPOs and periodic SEC filings. Why? The practice appears to continue drifting toward the highlighting of hand-picked, biased financial results in presentations to investors in order to overshadow actual operating results determined in accordance with generally accepted accounting principles. In the extreme, these results become misleading to investors.

It’s no coincidence that non-GAAP results are always better than GAAP numbers — and that company management’s justifications for the use of non-GAAP results often lack credibility. But regulators finally appear to be taking note. At the annual AICPA/SEC/PCAOB conference this past December in Washington, D.C., SEC chair Mary Jo White cautioned preparers to ask themselves challenging questions regarding the proper use of non-GAAP measures. White raised the issue of whether current SEC rules are “significantly robust in light of current market practices.” And in his March budget presentation to the SEC, PCAOB chairman James Doty cited proliferation of the use of unaudited and non-GAAP metrics as a “warning sign.”

What’s interesting to me is that I can remember when the SEC discouraged the extensive use of non-GAAP information. Somewhere along the line that attitude changed, and the SEC took the pressure off. We see the results. For example, check out ConocoPhillips’ use of a non-GAAP metric based on out-of-date oil prices or Groupon’s exclusion of certain marketing costs.

The examples are many, and the trend is clear. It’s time for the SEC to step up its enforcement of existing rules and examine whether tougher rules are needed.

Change in Classification of Internal Control Weaknesses Might Be Needed

I have previously argued for the PCAOB to consider whether it’s time to eliminate the “significant deficiency” classification for internal control weaknesses; it’s not really practical to make an objective determination between a significant deficiency and a “material weakness.” There’s too much room for “prove me wrong” judgments, which can lead to important internal control failures not being disclosed to investors. We can now see a dramatic example of that concern in the recent SEC administrative proceeding in the Matter of Wayne Gray, CPA. In this case, the external auditor determined that “there is not adequate internal control over financial reporting due to inadequate and inappropriately aligned staffing” at his client. Notwithstanding this clear conclusion, the auditor classified the control weakness as a significant deficiency, which avoided disclosure to investors.

The auditor was appropriately sanctioned, but thanks for making my point. It is time for the PCAOB to consider a change to internal control deficiency classification in its rule-making process.

The Saga of the PCAOB and China

In PCAOB Chairman Doty’s 2016 budget presentation to the SEC, he also briefly addressed the issue of inspections in China, stating that, “We are also considering appropriate courses of action to achieve access to inspect the audits of PCAOB-registered firms in China.” I take that to mean efforts to date have failed. This is an issue that hasn’t received enough attention, most likely because it presents a major international political problem. Nevertheless, it’s time for more sunlight on the issue.

The bottom line is that firms located in China (and a few other jurisdictions) that audit all or portions of U.S. public companies are openly violating U.S. law under the Sarbanes-Oxley Act of 2002 by not permitting the PCAOB to inspect their audits of U.S. registrants. Yet the SEC continues to accept their audit opinions.

The PCAOB posts a list of these auditors and their clients online, but I doubt the list gets viewed or considered too often by investors. Check it out: Some of the names might surprise you. You also need to recognize that the audits of subsidiaries of huge multinational U.S.-based companies located in China are also denied inspection, even though the U.S.-affiliated auditor relies on the audit work performed by the Chinese firm as an integral part of opining on the consolidated financial statements. Often, the results not subject to inspection constitute a substantial portion of the consolidated numbers.

I understand this is a tricky problem with the potential to disrupt global financial markets, but it’s time for the PCAOB and the SEC to step up pressure on China to allow inspections and to better inform investors on options for resolving this critical issue.

What’s the point of having a law if it isn’t enforced?

 

About The Author

Jeff Johanns

Jeff Johanns is an accounting lecturer at the McCombs School of Business. He is a former U.S. Assurance Risk Management Leader...

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