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below is a selection from SEC
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PCAOB Issues Audit Practice Alert on Economic Crisis
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, 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. Audit risks that were previously
identified 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.
According to the PCAOB staff, it will be particularly important for 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, and 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.
Some companies are responding to the current
economic conditions by eliminating jobs. The Board cautioned that the loss of
employees who are integral to the operation of internal controls may increase
the risk of deficiencies in internal control over financial reporting because
of, for example, the lack of segregation of duties or the lack of effective
monitoring controls.
Given that the auditor has a responsibility to
communicate to the audit committee, the staff said 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.
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, and the clarity and completeness of the
company's financial statements. 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,
estimates, judgments, uncertainties and unusual transactions.
Going concern issues have emerged in both the U.S.
and the EU. In the current economic environment, the staff said that 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. 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, the staff said they
should obtain information about management's plans to mitigate the effect of
such conditions or events and assess the efficacy of the 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.
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