PCAOB Brings Case on Audit Documentation

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The Public Company Accounting Oversight Board brought a settled action on November 13th against three outside auditors whose errors were measured not in substance, but in process. Dale Arnold Hotz, Jyothi Nuthulaganti Manohar, and Michael Jared Fadner – all CPAs and respectively a partner, director, and assurance manager at then-McGladrey & Pullen – issued a clean audit opinion for an unnamed public company’s 2009 financial statements in 2010. The PCAOB called on November 17, 2010, and announced an inspection of this particular audit that would commence on December 6th. Even then, the three auditors were fairly dormant for about two weeks. But then the scrambling started.

Facts

On December 1st a colleague recommended to Hotz that he review the audit work papers to refresh his memory before the inspection. That same day, Hotz and Manohar received a firm email reminding them to have the hard copy work paper files available for the inspection team to review. Hotz, Manohar, and Fadner planned a conference call for December 3rd to prepare for the inspection. Before that call, Manohar and Fadner reviewed the audit documentation and identified two missing documents: a signed engagement letter and a cash flow worksheet. During the call, Hotz and Manohar noticed that a fair value memorandum of financial instruments was also missing. Unfortunately, they decided to obtain or create these documents and add them to the hard copy work papers.

Fadner found an electronic copy of the cash flow worksheet on his laptop’s hard drive, but it included no tick marks or other evidence that audit procedures were appropriately performed. Manohar directed Fadner to print the document and add it to the hard copy work papers. On the morning of December 6th, the actual day of the inspection, Fadner handwrote tick marks, cross-references, footings and recalculations on the worksheet to reflect work purportedly performed during the audit. On the cover page, he wrote his initials and backdated the worksheet to March 6, 2010, and then added it to the hard copy work paper files.

Manohar contacted the client on December 3rd to request a new (signed) copy of the engagement letter, and then asked Fadner to follow up on her request. Fadner emailed the client’s corporate controller on the same day and asked that the letter be delivered early on the morning of December 6th. The letter arrived as promised on that morning, and Fadner added it to the hard copy work papers.

On the evening of Sunday, December 5th, Manohar drafted a Fair Value Memorandum for the audit. She emailed her first draft of the memo to Hotz, who commented on it and sent edits back to Manohar. Manohar then sent a revised draft to Hotz, who approved it as final. Hotz then printed the memo, initialed it, and added it to the hard copy work paper files.

Other documents were manipulated, initialed and signed, well after they were supposed to have been. In none of these instances did the auditors note the actual dates the documents were added to the work papers or the reasons for adding them, as the auditing standards require. They also did not advise the PCAOB’s inspectors that any of the documents in the work papers had been improperly created, backdated, added to the work papers, or altered in December 2010. Hotz also noted, on both the original and amended submissions of the PCAOB 2010 Inspection Period Engagement Profile, that no changes had been made to the audit documentation “subsequent to the documentation complete [sic] date.”

Standards

PCAOB Rule 4006 says:

Every registered public accounting firm, and every associated person of a registered public accounting firm, shall cooperate with the Board in the performance of any Board inspection. Cooperation shall include . . . cooperating and complying with any request . . . to – (a) provide access to, and the ability to copy, any record in the possession, custody, or control of such firm or person, and (b) provide information by oral interviews, written responses, or otherwise.

Auditing Standard No. 3, Audit Documentation, is too long to allow for easy quotation in this space. But it says in part:

“The auditor must prepare audit documentation in connection with each engagement conducted pursuant to the standards of the PCAOB. Audit documentation should be prepared in sufficient detail to provide a clear understanding of its purpose, source, and the conclusions reached. Also, the documentation should be appropriately organized to provide a clear link to the significant findings or issues.”

Needless to say, one cannot wish documents into work papers after an audit has been completed and still comply with these rules. The PCAOB thus found that the auditors had violated both Rule 4006 and Auditing Standard No. 3 and censured all three of the auditors. The Board then barred Hotz from associating with a registered public accounting firm for at least two years, after which he can petition for reinstatement. The PCAOB also suspended Manohar from associating with a registered public accounting firm for a year.

Lessons from the Case

Remarkably, given the problems surrounding the auditors’ documentation of their audit, the PCAOB did not find issues or impose sanctions related to the audit opinion itself. Though it’s cliché at this point, it wasn’t the crime, it was the cover-up. The lessons are pretty clear. If you are an auditor in this position, keep careful track of the audit work papers as you go. If you need a signed engagement letter (and you do), get one at the engagement’s outset.

Also, keep Auditing Standard No. 3 handy and refer to it often. The audit documentation should support the audit opinion by the report release date. If audit documentation is assembled for retention within the 45-day period after the report release date, as allowed by Auditing Standard No. 3, then properly document who added the documentation and reasoning. Auditing firms ought to have one or more checklists listing the more significant work papers required. This engagement team overlooked these checklists and/or did not properly complete them. Interestingly enough, the engagement quality reviewer, who is not included in this PCAOB settled action, also appears to have overlooked the missing work papers.

Finally, if required documents are missing, do not make them up after the fact to mask shoddy documentation along the way. The PCAOB will be less excited about sanctioning auditors for missing work papers than for deliberate and willful misrepresentations designed to mislead its inspectors. Accepting one’s fate in that situation will be the safest course.

–Many thanks to John Stewart, audit partner at Dixon Hughes Goodman LLP, for co-authoring this piece.