I asked Howell about auditor rotation and what it means. Howell explained that the basic concept of auditor rotation is simply to keep fresh eyes on things because auditors may become complacent over time. Simply put auditors can get too familiar, too cozy with the clients. Yet the converse can also lead to problems as Howell noted, “almost every time there has been a fraud that has gone undetected or a major failure that has gone undetected for long periods of time, that has resulted from the fact that the auditors didn’t have enough experience to find the kinds of weaknesses that they’re talking about. That often happens when a new auditor is involved. That’s when things seem to go wrong.”
It is a loss of institutional knowledge that can cause problems. An auditor needs to be asking probing, independent questions and being independent in attitude as well as on paper. Howell noted the “other thing that you lose is that sense of deep understanding of the kinds of transactions, the history, and how things flow together. I think that balance is hard to draw, but it really points to the need that the client has to have a clear understanding of their processes themselves and how those processes are going to effect the controlled environment.”
For the compliance practitioner this can be where an auditor fails because there is fraud or some other form of collusion which could generate a pot of money to fund a bribe, there are going to be telltale signs or evidence somewhere, but those red flags might be missed because the client is not thinking clearly about how those red flags would be monitored and how they could detect them.
Inspection Focus is another area that the PCAOB is concerned about and while it may not immediately appear applicable to the compliance department I believe it can have a significant impact. This area focuses on judgments clients make, most generally around revenue recognition or more simply “rev rec”. Howell began by noting, the “number of mistakes are very high and often they’re challenging because when you somehow mischaracterize the top line, the rest of the financial statements change their character because of a number of things that have keyed off of what your revenue is. The other thing that’s true is that it also causes the rest of the financial statements to become questionable just because that most important number was not right.”
The rules that evolved in the 1990’s and early 2000’s made revenue recognition increasingly more complicated. Now companies are gearing up to transition to a new revenue recognition methodology that is a more principles-based practice that is going to affect all industries the same, meaning we no longer have separate revenue recognition approaches for different industries.
This transition is going to also create a lot of opportunities for mistakes and worse, fraudulent accounting to hide evidence of bribery and corruption. This could be through strategies as diverse as channel stuffing to evaluation of long-term contracts. Rev rec is an area that the compliance function needs to depend more highly on the auditing function to help detect either over-rides of internal controls or more simple failures.
This ties into Howell’s next point, which was accounting estimates. Typically, goodwill is perhaps the most challenging when you acquire a company and you have an excessive payment over what the assets that you identified as tangible assets. Howell said, “You end up with this intangible number goodwill, which needs to be tested for impairment. You can’t go judge the fair value of goodwill other than by an accounting estimate at one point in time when you made an acquisition, but the accounting rules now require that you go back and reassess that value from time to time and put an impairment charge against it if you feel that it’s not what you paid for to begin with.”
I found this analysis interesting as Matt Kelly raised this same issue in a blog post, entitled “Impairment Data Hints at Problems Ahead”, on his site, Radical Compliance. Matt and I also explored this issue in greater depth in our podcast “Compliance Into the Weeds – Episode 6”. Kelly’s basic thesis was that goodwill impairment would negatively impact compliance particularly after an acquisition, when the value of the acquired entity can drop significantly or even propitiously. Witness the HP goodwill impairment charge around its acquisition of Autonomy of nearly $5.5 billion.
This ties into Howell’s concerns from the auditing perspective because, “You can’t say what goodwill is based upon today without understanding that, “Hey, it’s based upon the value I’m going to receive over a period of time in the future.” That means that the auditors have to look to the work that’s being done by the people who prepare those projections and those are usually the Financial Planning and Analysis (FP&A) folks”, who typically do not have an appropriate level of documentation to support their analysis of goodwill value.
Moreover, FP&A is actually trying to drive behavior through these projections. Howell said they typically cannot provide either the specific documentation of analysis or even a history of results over time. This is because they “frequently are developing these projections to be aspirational. They’re trying to drive business behavior, not really trying to predict it. You end up with some issues that are creating strain in accounting organizations around the world.” Such an approach would certainly raise issues in a compliance realm.
From the compliance perspective around audit, a loss of institutional knowledge that can cause problems.Click to tweet
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© Thomas R. Fox, 2016