PCAOB observed problems during audits of SPACs

The Public Company Accounting Oversight Board's target team of inspectors focused on special purpose acquisition companies, fraud, going concern issues, cash and cash equivalents during its inspections of auditing firms last year, according to a new report.

The report, released Wednesday, noted that the target teams look more closely at emerging audit risks and topics the inspections staff believes could have important implications for audits. One of the focus areas was SPACs, also known as blank-check companies, which are basically shell companies whose purpose is to do a reverse merger with another company to accelerate the process of going public. The Securities and Exchange Commission has highlighted some of the problems with SPACs, proposing new rules in March for disclosures, marketing practices, sponsors and conflicts of interest. In early April, the SEC also issued a statement on the proper accounting for warrants used to attract SPAC sponsors (see story). SPAC activity has declined steeply this year as the market for them has dropped amid the increased regulatory scrutiny and a wave of financial restatements.

The PCAOB is also apparently taking a closer look at the firms that audit SPACs. The target team tried to get an understanding of the emerging risks related to SPACs by inspecting the interim reviews of the companies' quarterly financial information. They focused on assertions for SPACs and de-SPAC transactions such as the accounting treatment and valuation of warrants, the accounting treatment of reverse mergers, interim financial statement presentation and disclosures, and restatements related to redeemable shares, warrants and other accounts.

They observed instances where the audit engagement teams didn't point out that the public company's equity statement did not agree with its accounting records, nor consider whether the presentation and disclosures of the interim financial statements conformed with U.S. GAAP, or identify an error in the public company's financial statement fair value disclosure where the public warrants were incorrectly included in the fair value rollforward.

On the other hand, the PCAOB did see some good practices like bringing in specialists. "An audit firm's national office tracked de-SPAC transactions and reached out to engagement teams to facilitate discussions on financial instruments that may require engagement teams to involve auditor-employed specialists with financial instrument expertise," said the report. "The audit firm identified available specialists and connected them to the engagement teams."

The PCAOB target team also looked for instances of fraud at various types of public companies during its audit inspections. In general, it found the auditors demonstrating professional skepticism in response to increased fraud risks. 

"The audit team's response to the risk of fraud was a key area of focus for every audit the target team reviewed in 2021, given the potential increased risk of fraudulent financial reporting due to the current economic environment," said the PCAOB. "This risk may manifest, for example, in management's use of more aggressive assumptions and estimates, improper revenue recognition, and/or misleading disclosures." 

Among the good practices it saw was an engagement team that tried to identify potential related-party transactions by querying a database of companies registered as businesses in a particular state to determine if any other businesses were associated with the company's employees. Another engagement team expanded its inquiries to include 20 questions addressing a particular company's specific facts and circumstances, with open-ended questions on the financial reporting process, vendor relationships, internal compliance policy, interactions with immediate supervisors, and the impact of COVID-19 on controls and resources. Many audit firms also implemented a new requirement to involve their forensic staff in the engagement team's fraud risk-assessment procedures for all public company audits in the retail and lodging industries to guard against fraud risks related to revenue recognition.

The target team also looked at going concern evaluations, assessing whether auditors appropriately evaluated if there was substantial doubt about a company's ability to continue as a going concern in light of the economic environment. However, the PCAOB inspectors saw multiple audits where the engagement teams didn't perform sufficient procedures to evaluate whether there was substantial doubt about the company's ability to continue as a going concern. 

The PCAOB also uncovered problems with audits of cash and cash equivalents. "Elevated audit risk could arise from arrangements for holding cash and cash equivalents, such as those involving the use of trustees, restrictions on cash balances, offshore accounts, and complex terms and conditions," said the report. "In 2021, the target team focused on fact patterns seen in recent high-profile events involving cash, which can raise questions about audit firms' procedures to address the audit risks associated with cash and cash equivalents."

In some cases, the engagement team didn't perform sufficient procedures to support the validity of the confirmations received, such as contacting the purported sender by phone or other means to confirm the cash confirmation email response was actually sent by an authorized respondent, and in other cases the audit work papers didn't adequately document the confirmation procedures.