An inspection report hides its toughest finding for a year

The record

The Public Company Accounting Oversight Board inspects registered public accounting firms under authority the Sarbanes-Oxley Act gives it, and its own Basics of Inspections page states that inspections review portions of a firm's issuer audits and evaluate elements of its system of quality control, using both risk-based and random selection, with firms auditing more than 100 issuers inspected annually and smaller firms inspected at least every three years. Each inspection produces a report. PCAOB staff's own Guide to Reading the PCAOB's New Inspection Report describes that report as having five main parts, including an inspection observations part and a quality-control observations part, plus the firm's response.

What the documents establish

The staff guide is explicit about the two parts a reader most needs to distinguish. Part I.A covers deficiencies serious enough that the inspection team believes the firm lacked sufficient appropriate audit evidence to support its opinion at the time it was issued; Part I.B covers other instances of noncompliance with PCAOB standards or rules that do not rise to that level. Part II, by contrast, covers criticisms of or potential defects in the firm's system of quality control, and the guide states plainly that Part II is not publicly disclosed when a report is first issued. A PCAOB news release dated 1 June 2020 confirms this reformatted report was first used for the largest firms' 2018 inspection cycle. The Basics of Inspections page separately states that an inspection report is not a rating tool and that including a deficiency does not by itself mean an issuer's financial statements are materially misstated.

The operating read

Read as an editorial matter, a founder or board member evaluating an audit firm should treat a public inspection report as a partial picture: what is visible on issuance is Part I, the firm's issuer-specific deficiencies, while Part II quality-control criticisms stay confidential unless the firm fails to satisfy the Board within twelve months of the report's issuance, at which point that part is reissued publicly. A firm with a clean-looking public report may still be carrying an unresolved Part II criticism that has not yet reached its twelve-month deadline, so the absence of a public Part II is not proof of a clean quality-control record.

What to check before you decide

Before relying on a firm's inspection history as a proxy for audit quality, check the following against PCAOB's own published materials:

• Is the firm inspected annually or triennially, and how recent is its most recently published report?
• Does the published report include a Part II, and if not, has twelve months passed since issuance without one being added?
• Do any Part I.A deficiencies relate to audit areas relevant to this company's own accounting, such as revenue recognition or fair value estimates?

An inspection report is a snapshot of selected audit work and a firm's quality-control system as PCAOB assessed it, not a comprehensive verdict on every audit the firm has performed.