This presentation looks at the various regulators that continue to influence the scope and extent of the audit effort, impacting the audit of income taxes:
- Public Company Accounting Oversight Board (PCAOB)
- Standard setting
- Policy and agenda matters
- Inspections
- Securities and Exchange Commission (SEC) matters
- Other regulatory influences
Working with your financial statement auditor: the effect of PCAOB regulation of your audit firm
1. 22nd Annual Health Sciences
Tax Conference
Working with your financial statement auditor:
the effect of PCAOB regulation of your audit firm
December 5, 2012
2. Disclaimer
► Any US tax advice contained herein was not intended or
written to be used, and cannot be used, for the purpose of
avoiding penalties that may be imposed under the Internal
Revenue Code or applicable state or local tax law
provisions.
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4. Presenters
► Dave Courtney ► Angela Evans
Ardent Health Services Ernst & Young LLP
Nashville, TN Atlanta, GA
+1 404 817 5130
angela.evans@ey.com
► Doug Rabe
Tenet Healthcare Corporation ► Wade McGregor
Dallas, TX Ernst & Young LLP
Nashville, TN
+1 615 252 2045
wade.mcgregor@ey.com
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5. Regulatory influences on the audit
► Various regulators continue to influence the scope and
extent of the audit effort, impacting the audit of income
taxes:
► Public Company Accounting Oversight Board (PCAOB)
► Standard setting
► Policy and agenda matters
► Inspections
► Securities and Exchange Commission (SEC) matters
► Other regulatory influences
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6. PCAOB background
► The PCAOB is a nonprofit corporation established by Congress through
the Sarbanes-Oxley Act of 2002 (the Act). It oversees the audits of public
companies in order to protect investors and the public interest by
promoting informative, accurate and independent audit reports. The
PCAOB also oversees the audits of broker-dealers.
► The five members of the PCAOB, including the chairman, are appointed
to staggered five-year terms by the SEC after consultation with the
Chairman of the Board of Governors of the Federal Reserve System and
the Secretary of the Treasury.
► The SEC has oversight authority over the PCAOB, including the approval
of its rules, standards and budget.
► The Act established funding for PCAOB activities, primarily through
annual fees assessed on public companies in proportion to their market
capitalization and on brokers and dealers based on their net capital.
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8. PCAOB standard setting — recently issued
standards
► Engagement Quality Review (EQR)
► Was effective for 2010 audits and interim reviews (Ernst & Young
LLP (EY) adopted early in mid 2009)
► Expanded EQR’s focus and review of the audit approach, high risk
areas and Internal Controls over Financial Reporting (ICFR)
► Requires expanded documentation of EQR review
► Risk Assessment Standards
► Were effective for 2011 audits
► Expand auditor’s documentation requirements for auditor’s
assessment of business and financial statement risks
► Additional test of details and assessment of personnel
► Added emphasis on auditor’s assessment of disclosures
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10. PCAOB policy and agenda matters
► Auditor’s reporting model (concept release)
► Mandatory firm rotation (concept release)
► Transparency of the audit (proposed standard)
► Communications with audit committees (proposed
standard)
► Related parties and related amendments (proposed
standard)
► Other planned agenda items
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11. PCAOB policy and agenda matters —
other planned agenda items
► Part of the audit performed by other auditors
► Assignment and documentation of firm supervisory responsibilities
► Quality control standards
► Codification of PCAOB standards
► Auditing fair value measurements
► Auditing accounting estimates
► Specialists
► Confirmations
► Going concern
► Subsequent events
► Audits of broker-dealers
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13. PCAOB inspections
► In addition to standard setting, the PCAOB defines audit
quality through its rigorous annual inspection process.
► Part 1 (public) and Part 2 (non-public) sections of inspection
reports
► As a result of inspection findings, EY often modifies its
policies and procedures in response.
► Additional training, additional mandated audit procedures, changes
to EY guidance or revision to EY tools and enablers
► In recent years, all of the Big Four accounting firms have
experienced increases in the number of Part 1 findings.
► Auditing fair value estimates of hard-to-value securities
► Testing and precision of internal controls
► Testing electronic evidence, such as management reports
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15. SEC matters
► International Financial Reporting Standards (IFRS)
► SEC has deferred decision. It has indicated completion of the
majority of fieldwork related to its IFRS Work Plan and the need for
a few additional months.
► SEC has discussed concept of endorsement approach.
► Financial Accounting Standards Board and International
Accounting Standards Board said current model of joint
deliberations is not sustainable.
► SEC has suggested endorsement process and retention of US
generally accepted accounting principles (GAAP) rather than
adoption of IFRS mandate.
► SEC staff could recommend to Commission in the coming months.
► EY continues to support the goal of a single set of high-quality,
globally accepted accounting standards.
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16. SEC matters
► Use of pricing service information
► SEC and the PCAOB have stressed management’s
responsibility to understand and be able to support valuation
assertions for investments that are not exchange traded and
for when companies use a third-party pricing source.
► SEC continues to issue comment letters requesting further
information on the controls in place by management,
especially regarding third-party pricing sources.
► Regulators are interested in how auditors evaluate
management valuation assertions and related controls.
► EY had revised its audit guidance in this area to address
views of the SEC and PCAOB.
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18. Other regulatory influences
► European Commission (EC) — legislative proposals
► Published on 30 November 2011
► Stems from EC Green Paper
► Includes:
► Measures to strengthen audit committees
► Mandatory audit firm rotation
► Enhanced tendering requirements
► Significant restrictions on non-audit services
► Audit-only firms
► Measures to remove barriers for smaller firms
► Enhanced auditor reporting
► Will be a lengthy process (several years)
► EY supportive of proposals that will enhance audit quality but concerned
with certain proposals that would increase costs with no added value
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19. Other regulatory influences
► Committee on Sponsoring Organizations of the Treadway
Commission (COSO)
► COSO recently released for public comment an update to the 1992
Internal Control Integrated Framework.
► Committee would codify the 1992 framework into 17 principles and
supporting attributes.
► Current framework has been recognized by SEC for purposes of
management’s evaluation of ICFR.
► SEC’s reaction to updated framework is not yet known and will be
key driver on whether new framework will be allowed, prohibited or
required.
► Comment period ended 31 March 2012. Plan was to release final
framework in the fall of 2012 but recently extended to Q1 of 2013.
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21. Impact of regulatory influences on the audit
of income taxes
► The expected level of precision related to auditing of
income and other taxes continues to increase
substantially.
► Increased detail testing is required.
► Increased documentation of various tax positions (e.g.,
remitted earnings, recoverability of deferred tax assets
(DTAs)) is required.
► Increased level of persuasive audit evidence is required.
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23. Recent income tax accounting quality-related
occurrences
► Quality issues continually problematic for financial
reporting
► Restatements
► SEC comment letters
► Internal control deficiencies
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24. Recent income tax accounting quality-related
occurrences
► Accounting for income taxes continues to be a challenging
area for both companies and auditors, and errors in
accounting for income taxes were the leading cause of
annual restatements in 2011 at EY as well as at many
other large firms.
► 20% of the 2011 restatements by public companies
audited by the largest firms were related to income taxes.
► Recently, one in three EY engagements for which income
taxes were reviewed (either by Assurance Quality Review
or PCAOB) had a finding related to income taxes. The
level of income tax findings has increased over the past
several years.
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25. Recent income tax accounting quality-related
occurrences
► The reasons for quality occurrences related to accounting
for income taxes include:
► Accounting for income taxes requires knowledge of both technical
tax matters and financial accounting — a unique challenge as this
is not a common trait often possessed by a single employee or
department.
► The accounting model under Accounting Standards Codification
740, which includes a number of requirements and exceptions that
must be considered, is complex.
► Detailed accounting records of the tax basis of all assets and
liabilities (i.e., a tax basis balance sheet) must be maintained.
Computing the tax basis requires technical understanding of the
tax law, including for multiple taxing jurisdictions.
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26. Recent income tax accounting quality-related
occurrences
► Common problem areas include:
► Incorrect tax basis calculations
► Application of attribute rules (carrybacks, §382, etc.)
► Insufficient support for DTA realizability
► Outside basis differences
► Support for timing of uncertain tax position (UTP) and other
changes
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28. Sample audit procedures and quality review
programs
► Supplemental audit guidance — firm specific
► Substantive procedures
► Quality review programs (internal and peer reviews)
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29. Sample audit procedures and quality review
programs
► Sample substantive procedures:
► Obtain a summary of the entity’s significant tax accounting methods,
basis for permissibility and acceptance of such methods by the tax
authorities. Review for consistency with previous years. Determine if
impermissible methods are used and, if so, the potential implications
on accrual for UTPs and on the current-year income tax
provision calculation.
► Evaluate whether the entity has taken into account current tax
legislation, including effects of any uncertainty in foreign income
taxes.
► Obtain and review the entity’s analysis and documentation of
indefinite investment plans (or evidence of tax-free liquidation),
including confirming that the parent entity’s domestic needs are not
inconsistent, or in conflict, with the indefinite foreign investment
assertion.
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30. Sample audit procedures and quality review
programs
► Agree and cross reference the current-year tax provision amount
to the tax provision workpapers. Prove that the ending payable
balance is the amount of income taxes payable or refundable for
the current and prior years.
► Evaluate the appropriateness, consistency and reasonableness of
the unit of account used to evaluate the tax position for
recognition. In EY’s evaluation, we consider whether the selection
of other acceptable unit of account measures would result in
significantly different recognition and measurement outcomes.
► Evaluate whether appropriate evidence exists (e.g., from new
information or some other triggering event, such as the lapse of
the applicable status of limitations) for management’s conclusions
to subsequently recognize a previously unrecognized benefit, de-
recognize a previously recognized benefit or make a change in the
measurement of a previously recognized benefit.
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31. Sample audit procedures and quality review
programs
► Examine support for (i.e., vouch) balances, changes and other
movements (e.g., tax effects of share-based payments,
investments, pensions), cross reference to the audit workpapers,
and evaluate and document the reasons for material changes in
the differences.
► Cumulative deferred income tax reconciliation has been performed
by management, and all significant deferred items have supporting
documentation. That is, the entity maintains book-basis and tax-
basis reconciliations and has reconciled the differences of
individual assets and liabilities in determining the related deferred
income tax asset or liability. Simply rolling forward book and tax
differences is not adequate.
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32. Sample audit procedures and quality review
programs
► Sample quality review questions:
► For the indefinite reinvestment assertion, the working papers indicate the
reliance on the representation and “positive evidence.” The company’s
memorandum does provide support for the conclusion reached, but we do
not appear to have obtained the cash flow projections to support the
conclusion. Are the cash flow projections contained elsewhere in the
company’s file?
► For a captive insurance company, consider documenting that the company
meets the qualifications (risk diversification, etc.) under the tax regulations
to be considered a captive. Risk is both permanent (states exemption for
captives) and temporary (timing difference on loss reserves).
► What is the event that caused management to de-recognize the position?
It looks odd for calculations showing closed years supporting the reserve
versus fewer years and a higher disallowance as suggested by a memo.
► Management asserts that inside basis is equivalent to outside basis in
operating limited partnership. How have we tested management’s
assertion?
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34. Increased regulatory interest in audit of ICFR
► PCAOB inspections of late focus on the extent and
nature of internal controls
► Tax processes do not always fit easily into the internal control
framework and are therefore viewed as an area of PCAOB
inspection risk.
► Auditors are likely to require precise documentation around
internal controls.
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35. Increased regulatory interest in audit of ICFR
► Significant focus area of inspections
► 43% of the PCAOB’s 2010 Part 1 inspection findings for the Big
Four firms resulted in a view by the PCAOB that auditors failed to
support the opinion on ICFR.
Part 1 findings related to failing to support ICFR opinion
Issuer audits that failed to support ICFR opinion* 32
Total issuers in Part 1 inspection report* 75
(42.7%)
* Per the PCAOB’s 2010 Part 1 Inspection Reports of Big Four Firms
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36. Increased regulatory interest in audit of ICFR
► Selecting controls to test and testing design effectiveness of controls
► Expect more challenging of design and documentation of controls,
including more robust understanding of, and documentation in, systems
narratives, flowcharts and walk-throughs to determine:
► Competence and authority of persons performing the control
► When and how often the control is performed
► What information technology applications, data, reports or other files are used
► What physical evidence of the control operation, if any, is produced
► How misstatements are prevented or detected and corrected
► Expect more thorough walk-throughs to verify flow of transactions and
design of controls
► Additional probing questions and requests for documentary support
► More supervision and review of walk-throughs performed by internal auditors or
others
► Additional focus on design and effectiveness of group-wide controls,
management review controls and controls over non-routine and estimation
processes
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37. Increased regulatory interest in audit of ICFR
► Testing operating effectiveness of controls
► Additional focus on gathering sufficient evidence to evaluate attributes of
controls relevant to their design
► Competence, level and authority of persons performing the control
► Inputs and underlying data
► Precision or sensitivity of the control
► Performance of a mix of procedures to support effective functioning of
controls (e.g., inquiry, observation, inspection, re-performance)
► Additional evaluation and testing of the precision of monitoring and of
management review controls
► Is the data used to perform the control complete and reliable?
► Does the control ever identify errors? Their nature? Examples?
► Does the control trigger follow-up? In what circumstances? Examples?
► Is there contradictory evidence the control is not sufficiently precise (e.g.,
examples of when the control failed to identify misstatements)?
► Additional probing questions of control owners and requests for supporting
documentation to evidence operating effectiveness of controls
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38. Increased regulatory interest in audit of ICFR
► Roll-forward of interim tests of controls
► More focus on risks associated with controls in addition to length of
intervening period
► Performance of a mix of procedures in addition to inquiry
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39. Increased regulatory interest in audit of ICFR
► Identification and evaluation of control deficiencies
► Shared/consistent definition of control deficiencies and their
implications
► Greater focus on root-cause analysis
► Nature and precision of compensating controls
► Re-evaluation of control risk assessment and scope of substantive
procedures
► More thorough aggregation and evaluation of deficiencies
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40. Increased regulatory interest in audit of ICFR
► Using the work of internal auditors or others
► More extensive challenging of internal auditor objectivity (e.g., to
whom does auditor report and how often does reporting take place)
► Closer coordination of audit planning and nature and scope of work
and work programs
► More focus on processes for updating process and control
documentation
► Supervision and review of walk-throughs
► Challenging use of internal auditors in areas with:
► Higher risk of material misstatement
► More subjective controls
► Re-evaluation of competence and objectivity throughout the audit,
considering quality of work and sufficiency of review procedures
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