Wednesday, December 10, 2008

PCAOB Issues Audit Practice Alert on Economic Crisis Highlighting Fair Value and Derivatives

The PCAOB staff has issued an audit practice alert dealing with a number of issues spawned by the ongoing financial crisis, including the adequacy of disclosures, auditing accounting estimates, going concern considerations, and fair value accounting and derivatives. Recent events in the financial markets may have implications for audits of financial statements and internal control over financial reporting, said the Board. Audit risks identified previously may have become more significant or new risks may exist due to current events affecting credit and liquidity. Among other things, the current uncertainties in the market may create questions about the valuation, impairment, or recoverability of assets and the completeness or valuation of liabilities reflected in financial statements. This is the third in a series of staff audit practice alerts.

The practice alert builds on an earlier alert dealing with the important and controversial area of fair value accounting. The new PCAOB guidance comes in light of recent amelioration of fair value accounting standards due to the ongoing financial crisis. According to PCAOB staff, it will be particularly important to auditors considering fair value estimates of financial instruments to consider the extent to which fair value accounting applies, the choice and complexity of valuation techniques and models, judgments on significant assumptions, and the extent of disclosure in the financials about measurement models.

Derivatives, especially credit derivatives, pose a special problem for fair value accounting. The staff advised that the downturn in the credit markets can have a significant effect on the fair value of a company's credit derivatives. Credit derivatives are valued through the use of internally developed models or by pricing services, noted the staff, and the assumptions used in models can be highly subjective, sensitive, and complex.

The staff cautioned auditors that a slight difference in assumptions could result in a significant change in the valuation of the derivative. Auditors should obtain evidence supporting management's assertions about the fair value of derivatives measured or disclosed at fair value. In addition, they should evaluate whether the presentation and disclosure of derivatives are in conformity with GAAP.

The current crisis may also entail more auditor attention to the effective operation of internal controls over financial reporting, including the company's entity-level controls, such as controls related to the control environment, and the company's risk assessment process. Additional attention also may be warranted on the controls related to significant accounts and disclosures and their relevant assertions, such as controls over the development of inputs and assumptions for the valuation of significant assets and liabilities; controls over the identification and review of assets for recoverability or impairment; and controls over the company's use of external valuation specialists.

In addition, some companies are responding to the current economic conditions by eliminating jobs. The Board cautioned that the loss of employees integral to the operation of internal controls may increase the risk of deficiencies in internal control over financial reporting because of, for example, lack of segregation of duties or lack of effective monitoring controls.

Given that the auditor has a responsibility to communicate to the audit committee, said the staff, some of the required communications that may be affected by current economic conditions include discussions about accounting estimates as well as the company's accounting principles. With respect to accounting estimates, auditors should determine that the audit committee is informed about the process used by management in formulating particularly sensitive accounting estimates and about the basis for their conclusions regarding the reasonableness of those estimates.

Moreover, auditors should discuss with the audit committee their judgments about the quality, not just the acceptability, of the company's accounting principles as applied in its financial reporting. The discussion should include such matters as the consistency of the company’s accounting policies and their application, as well as the clarity and completeness of the company’s financial statements, which include related disclosures. The discussion also should include items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements, such as the selection of new or changes to accounting policies, and estimates, judgments, and uncertainties, as well as unusual transactions.

Going concern issues have emerged in both the US and the EU. In the current economic environment, said the staff, some companies may face challenges in their ability to continue operating as a going concern. For instance, sources of liquidity may be strained because of reduced availability of lines of credit from financial institutions. Also, companies may encounter limited access to the commercial paper markets, a decrease in valuation of collateral, difficulty restructuring loans, and delays in payment from customers.

The staff reminded auditors that they have a duty to evaluate whether there is a substantial doubt about the company's ability to continue as a going concern for a reasonable period of time. The auditor's evaluation is based on knowledge of relevant conditions and events, including negative trends and other indications of possible financial difficulties.

If auditors believe that there is substantial doubt about the company's ability to continue as a going concern, said the staff, they should obtain information about management's plans to mitigate the effect of such conditions or events and assess the efficacy of such plans. If, after considering management's plans, the auditors conclude that there is substantial doubt about the company’s ability to continue as a going concern, they must consider the effects on the financial statements and the adequacy of disclosure and include an explanation in the audit report.