Income Tax Accounting, Controls, and Consulting Services are High on the PCAOB 2015 Inspections Agenda

Income taxes continue to be a primary area of focus for the Public Company Accounting Oversight Board (PCAOB).  

This will be reflected in PCAOB inspections of 2015 public company audits, and in PCAOB inspections of the firms performing those audits. Accordingly, public companies should expect audit firms to place more emphasis on income tax matters in upcoming audits. 

The PCAOB was organized by Congress through the Sarbanes-Oxley Act of 2002 to oversee the audit firms of public companies. The PCAOB establishes quality control, independence, and other standards relating to public company audits and conducts inspections, investigations, and disciplinary proceedings of the firms conducting those audits.

Of specific importance to tax practitioners and those responsible for income tax reporting, the PCAOB October 2015 Staff Inspection Brief (the October Brief) Vol. 2015/2 announced that:

1. Accounting for income taxes will continue to be an area of focus for PCAOB inspections of the registered audit firms and their audits in 2015;
2. Auditing of internal controls over financial reporting (including those related to income taxes) remains a major point of PCAOB concern; and
3. The PCAOB believes that non-audit services provided by audit firms to their audit clients may represent an audit quality risk.

Note that the PCAOB did not specifically identify tax services as a non-audit service provided by audit firms that may impact audit quality. However, given the PCAOB focus on income tax accounting and the frequency with which audit firms continue to provide income tax consulting services to their audit clients, it is reasonable to expect that tax services rendered by audit firms to their audit clients will be an issue garnering regular attention from the PCAOB inspection teams.

Continued PCAOB scrutiny of public company audits and audit firms

The October Brief reflects the ongoing efforts of the PCAOB to improve the quality of public company financial reporting, financial reporting controls, and the independent audit of public company financial reporting and controls. The Board annually selects for inspection public company annual reports audited by each of the largest audit firms and reports its findings for each audit firm in a two-part inspection report. Audits for which a financial reporting issue (or issues) is not adequately addressed by the audit firm are identified as audit failures in Part I of the inspection reports. Based on data compiled and illustrated in the chart below, PCAOB inspection reports through 2014 of the largest audit firms do not indicate a sustained decrease in the percentage of failures identified in public company audits conducted by those firms.

Audit firm-level deficiencies are initially reported only to the examined audit firm in Part II of the annual inspection report. If a firm does not demonstrate to the PCAOB sufficient remediation of the root causes of firm-level deficiencies as communicated in Part II of the report, that portion of the report is publicly released. To date, Part II of 12 inspection reports from prior years for the largest firms have been issued.

Income taxes reporting an area of focus

According to the October Brief, growing risks in the audit of income tax accounting have led the PCAOB to place additional focus on this area. As an example of these growing risks, the Brief highlights the income tax accounting and disclosures related to operations in foreign jurisdictions, particularly when significant undistributed earnings exist. Indefinite reinvestment assertions related to undistributed foreign earnings are expected to draw significant attention in the 2015 inspection process.

It is anticipated that the issuance by the Organization for Economic Co-operation and Development (OECD) of the Base Erosion and Profit Shifting (BEPS) final report in 2015 will elevate attention by PCAOB to other international aspects of income tax reporting. Scrutiny in the often complex and subjective areas of financial reporting relative to income tax valuation allowances and to uncertain tax positions should also be expected to continue.

Income taxes and internal controls

The October Brief also states that the PCAOB will be taking a close look at the auditing of internal controls over financial reporting in the 2015 inspection cycle. This is one of three general areas (together with material misstatement risk assessment and response, and auditing accounting estimates) where, according the PCAOB, inspectors found significant deficiencies in the past several years. Historically, public companies have identified inadequate levels of staffing, training, and oversight as being among the most prevalent issues leading to material weaknesses in income tax-related internal controls.

The Board’s interest in internal controls should not be surprising. According to Audit Analytics, more than 80% of public company annual report restatements in 2014 involved companies that had previously reported (without disagreement from their audit firms) that the companies’ internal controls were effective. The PCAOB is understandably concerned that material control weaknesses existed, but were not identified, at the time of the initial annual report’s issuance.

The PCAOB will expect audit firms to devote more resources into identifying these control weaknesses before they lead to the need for restatements. Future PCAOB inspections will evaluate audit firms’ ability to target particular recurring deficiencies so as to improve audit quality.

Non-audit services provided by auditing firms to their audit clients

In the October Brief, the PCAOB also observed that a number of audit firms have experienced significant growth in their consulting practices. Often, the Brief notes, a firm’s consulting services have been provided to audit clients of that firm. The PCAOB’s observations and concerns are consistent with reports that the audit firms have experienced a 10% average growth rate of non-audit services in recent years, relative to the modest 4% audit services average growth rate during that timeframe.

According to the PCAOB, shifting the focus to these non-audit services has shown to be a potential distraction away from audit objectives, as firm leaders emphasize promotion of new business over audit quality. In a speech earlier this year, PCAOB board member Steven B. Harris expressed concern that some types of non-audit services create inherent conflicts which can detract from auditor objectivity.

Action to be taken by public companies now

The PCAOB’s continuing focus on income tax issues relative to the audits of public companies will likely lead to greater scrutiny of those issues by the firms auditing those companies. Public companies should examine their policies, procedures, and controls related to income taxes to prepare for this heightened scrutiny. In addition, public companies should continue to carefully monitor the non-audit services provided by their audit firms.