By James Hamilton, J.D., LL.M.
In its first disciplinary proceeding against a Big Four audit firm and one of its former engagement partners, the PCAOB censured Deloitte & Touche and imposed a $1 million penalty against the firm. Without admitting or denying the Board’s findings, the firm also agreed to implement changes to its quality control policies for identifying and addressing potential audit quality concerns regarding the performance and deployment of its audit partners. (In the Matter of Deloitte & Touche, LLP, Release No. 105-2007-005). Similarly, without either admitting or denying the Board’s findings, the engagement partner was barred from associating with a PCAOB-registered firm for at least two years. (In the Matter of Fazio, Release No. 105-2007-006).
In an interesting development, Deloitte established a Leadership Oversight Committee, consisting of senior members of its audit practice and firm leadership to address at the national level deployment and supervision issues relating to audit partners about whom quality or other audit performance concerns have been identified. This committee has the duty and the authority to subject personnel to special oversight of their audit work, refer individuals for counseling or additional training, restrict individuals from serving audit clients in specific capacities, or seek an individual's separation from the firm.
Claudius B. Modesti, Director of the Division of Enforcement, emphasized that firms must take reasonable steps to assure that their audit partners and other audit professionals are competent to conduct public audits. When concerns about an auditor’s competency arise, he noted, a firm must act with dispatch to protect audit quality.
The proceedings centered on the revenue recognition policies of a client company with a right of return. The Board found that, during the audit, the partner failed to perform adequate audit procedures related to reported revenue from sales of products for which a right of return existed and failed to adequately supervise others to ensure the performance of such procedures.
Audit procedures did not adequately take into account the existence of factors indicating that the company’s ability to make reasonable estimates of product returns may have been impaired. Moreover, in evaluating the reasonableness of the company’s estimates of future returns, the partner failed to take into account the extent to which the company had consistently and substantially underestimated its product returns.
In auditing reported revenue, the Board found that the partner failed to evaluate these factors with the due care and professional skepticism required under the circumstances. He also failed to identify and appropriately address issues concerning the company’s policy of excluding certain types of returns from its estimates of future returns and the adequacy of disclosure of this accounting policy.
In the Deloitte order, the Board found that, before the firm issued its audit report, management was aware of facts and circumstances that raised questions about the partner’s ability to lead public company audit engagements. Members of Deloitte’s management concluded first that the partner should be removed from public company audits and ultimately that he should be asked to resign from the firm. Yet the firm left him in place as the engagement partner and did not take meaningful steps to assure the quality of the audit work before issuing its audit report.
More than a year after the audit, the company restated its financial statements because its recognition of revenue from product sales upon shipment was not in accordance with GAAP. The Board concluded that the firm’s quality control system did not function effectively to cause the audit to be appropriately staffed and led by a practitioner-in-charge with the necessary competencies. Further, in order to evaluate whether the recognition of revenue upon product delivery complied with GAAP, the firm was required to assess, among other things, whether the company had the ability to make reasonable estimates of future product returns. Without this ability, companies that sell products with a right of return cannot, consistent with GAAP, recognize revenue from these sales until the right of return substantially expires or a reasonable estimate of the returns can be made.
Various factors, such as the newness of a product and lack of actual return history, may impair a company’s ability to make reasonable estimates of future product returns. Here, the Board found that Deloitte's audit personnel documented the existence of each of these factors but did not adequately analyze whether they impaired the company’s ability to make reasonable estimates of returns.