Report on Inspection of Grant Thornton LLP (Headquartered in Chicago, Illinois) Public Company Accounting Oversight Board

Transcription

1 666 K Street, N.W. Washington, DC Telephone: (202) Facsimile: (202) Report on 205 (Headquartered in Chicago, Illinois) Issued by the Public Company Accounting Oversight Board THIS IS A PUBLIC VERSION OF A PCAOB INSPECTION REPORT PORTIONS OF THE COMPLETE REPORT ARE OMITTED FROM THIS DOCUMENT IN ORDER TO COMPLY WITH SECTIONS 04(g)(2) AND 05(b)(5)(A) OF THE SARBANES-OXLEY ACT OF 2002 PCAOB RELEASE NO

2 205 INSPECTION OF GRANT THORNTON LLP Preface In 205, the Public Company Accounting Oversight Board ("PCAOB" or "the Board") conducted an inspection of the registered public accounting firm Grant Thornton LLP ("the Firm") pursuant to the Sarbanes-Oxley Act of 2002 ("the Act"). Inspections are designed and performed to provide a basis for assessing the degree of compliance by a firm with applicable requirements related to auditing issuers. For a description of the procedures the Board's inspectors may perform to fulfill this responsibility, see Part I.D of this report (which also contains additional information concerning PCAOB inspections generally). The inspection included reviews of portions of selected issuer audits. These reviews were intended to identify whether deficiencies existed in the reviewed work, and whether such deficiencies indicated defects or potential defects in the Firm's system of quality control over audits. In addition, the inspection included a review of policies and procedures related to certain quality control processes of the Firm that could be expected to affect audit quality. The Board is issuing this report in accordance with the requirements of the Act. The Board is releasing to the public Part I of the report, portions of Appendix B, Appendix C, and Appendix D. Appendix B consists of the Firm's comments, if any, on a draft of the report. If the nonpublic portions of the report discuss criticisms of or potential defects in the Firm's system of quality control, those discussions also could eventually be made public, but only to the extent the Firm fails to address the criticisms to the Board's satisfaction within 2 months of the issuance of the report. Appendix C presents the text of the paragraphs of the auditing standards that are referenced in Part I.A in relation to the description of auditing deficiencies there. Note on this report's citations to auditing standards: On March 3, 205, the PCAOB adopted a reorganization of its auditing standards using a topical structure and a single, integrated numbering system. See Reorganization of PCAOB Auditing Standards and Related Amendments to PCAOB Standards and Rules, PCAOB Release No (Mar. 3, 205). The reorganization was effective as of December 3, 206. In this report, citations to PCAOB auditing standards use the numbering system and titles of standards that were in effect at the time of the primary inspection procedures. A table cross-referencing the section numbers of those standards included in Part I of this report as reorganized is included at Appendix D.

3 Page 2 PART I INSPECTION PROCEDURES AND CERTAIN OBSERVATIONS Members of the Board's staff ("the inspection team") conducted primary procedures for the inspection from July 205 to September 206. The inspection team performed field work at the Firm's National Office and at 20 of its approximately 54 U.S. practice offices. A. Review of Audit Engagements The inspection procedures included reviews of portions of 34 issuer audits performed by the Firm. The inspection team identified matters that it considered to be deficiencies in the performance of the work it reviewed. The descriptions of the deficiencies in Part I.A of this report include, at the end of the description of each deficiency, references to specific paragraphs of the auditing standards that relate to those deficiencies. The text of those paragraphs is set forth in Appendix C to this report. The references in this sub-part include only standards that primarily relate to the deficiencies; they do not present a comprehensive list of every auditing standard that applies to the deficiencies. Further, certain broadly applicable aspects of the auditing standards that may be relevant to a deficiency, such as provisions requiring due professional care, including the exercise of professional skepticism; the accumulation of sufficient appropriate audit evidence; and the performance of procedures that address risks, are not included in the references to the auditing standards in this sub-part, unless the lack of compliance with these standards is the primary reason for the deficiency. These broadly applicable provisions are described in Part I.B of this report. For this purpose, the time span for "primary procedures" includes field work, other review of audit work papers, and the evaluation of the Firm's quality control policies and procedures through review of documentation and interviews of Firm personnel. The time span does not include () inspection planning, which may commence months before the primary procedures, and (2) inspection follow-up procedures, wrap-up, analysis of results, and the preparation of the inspection report, which generally extend beyond the primary procedures.

4 Page 3 Certain of the deficiencies identified were of such significance that it appeared to the inspection team that the Firm, at the time it issued its audit report, had not obtained sufficient appropriate audit evidence to support its opinion that the financial statements were presented fairly, in all material respects, in accordance with the applicable financial reporting framework and/or its opinion about whether the issuer had maintained, in all material respects, effective internal control over financial reporting ("ICFR"). In other words, in these audits, the auditor issued an opinion without satisfying its fundamental obligation to obtain reasonable assurance about whether the financial statements were free of material misstatement and/or the issuer maintained effective ICFR. The fact that one or more deficiencies in an audit reach this level of significance does not necessarily indicate that the financial statements are misstated or that there are undisclosed material weaknesses in ICFR. It is often not possible for the inspection team, based only on the information available from the auditor, to reach a conclusion on those points. Whether or not associated with a disclosed financial reporting misstatement, an auditor's failure to obtain the reasonable assurance that the auditor is required to obtain is a serious matter. It is a failure to accomplish the essential purpose of the audit, and it means that, based on the audit work performed, the audit opinion should not have been issued. 2 2 Inclusion in an inspection report does not mean that the deficiency remained unaddressed after the inspection team brought it to the firm's attention. Depending upon the circumstances, compliance with PCAOB standards may require the firm to perform additional audit procedures, or to inform a client of the need for changes to its financial statements or reporting on internal control, or to take steps to prevent reliance on its previously expressed audit opinions. The Board expects that firms will comply with these standards, and an inspection may include a review of the adequacy of a firm's compliance with these requirements, either with respect to previously identified deficiencies or deficiencies identified during that inspection. Failure by a firm to take appropriate actions, or a firm's misrepresentations in responding to an inspection report about whether it has taken such actions, could be a basis for Board disciplinary sanctions.

5 Page 4 The audit deficiencies that reached this level of significance are described in Part I.A. through I.A.5, below. Effects on Audit Opinions Of the issuer audits that appear in Part I.A, deficiencies in nine audits relate to testing controls for purposes of the ICFR opinion, and deficiencies in all audits relate to the substantive testing performed for purposes of the opinion on the financial statements, as noted in the table below. 3 Four audits included deficiencies in substantive testing that the inspection team determined was caused by a reliance on controls that was excessive in light of deficiencies in the testing of controls. Number of Audits Deficiencies included in Part I.A related to both the financial statement audit and the ICFR audit Deficiencies included in Part I.A related to the financial statement audit only 9 5 Total 4 Most Frequently Identified Audit Deficiencies The following table lists, in summary form, the types of deficiencies that are included most frequently in Part I.A of this report. A general description of each type is provided in the table; the description of each deficiency in Part I.A contains more specific information about the individual deficiency. The table includes only the four most frequently identified deficiencies that are in Part I.A of this report and is not a summary of all deficiencies in Part I.A. Issue Failure to sufficiently evaluate significant assumptions or test data that the issuer used in developing an estimate. Part I.A Audits 7 Audits: A, B, C, F, J, K, and L 3 For important information concerning this table, see Part I.A.5.

6 Page 5 Issue Failure to perform sufficient testing related to an account or significant portion of an account or to address an identified risk. Failure to sufficiently test controls over or sufficiently test the accuracy and completeness of data and/or reports. Failure to sufficiently test the design and/or operating effectiveness of controls that the Firm selected for testing. Part I.A Audits 6 Audits: B, H, I, K, M, and N 4 Audits: A, D, E, and G 4 Audits: A, C, D, and K Audit Deficiencies A.. Issuer A In this audit, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinions on the financial statements and on the effectiveness of ICFR. In addition, see the deficiency described in Part I.A.5. The issuer provided a significant amount of services to its customers that were billed based on the number of transactions processed by the issuer. The Firm failed to perform sufficient procedures related to the revenue from these services. Specifically o The Firm selected for testing two controls that consisted of management's review of invoices and the related supporting documentation. The Firm's procedures to test these two controls were limited to inquiring of the control owners, observing a signature or supporting documentation attached to an invoice as evidence that a review had occurred, obtaining certain schedules used in the operation of these controls, and comparing billing rates included in the invoices to supporting documentation. These procedures did not include ascertaining and evaluating the nature of the review procedures performed by the control owners,

7 Page 6 including the criteria used by the control owners to identify matters for follow up and how those matters were resolved. Further, other than with respect to one category of this revenue, the Firm failed to identify and test any controls over the accuracy and completeness of certain data and system-generated reports that the issuer used in the performance of these controls. (AS No. 5, paragraphs 39, 42, and 44) o The Firm failed to perform sufficient substantive procedures to test a significant portion of this revenue. Specifically, the Firm failed to sufficiently test the accuracy and completeness of the quantity data that the issuer used to calculate this portion of this revenue, as its procedures were limited to comparing amounts on selected invoices to reports obtained from the same application that generated the invoices. (AS No. 5, paragraph 0) The Firm's procedures related to the valuation of goodwill and other intangible assets were insufficient. Specifically o o The Firm selected for testing one control over the issuer's analyses of the possible impairment of goodwill and other intangible assets, which consisted of management's review of the analyses. The Firm failed to sufficiently test this control, as its procedures were limited to () participating in calls between management and the valuation specialist; (2) inspecting written correspondence between management and the valuation specialist; and (3), obtaining updated drafts of the analyses, and noting signatures as evidence of review. The Firm failed to ascertain and evaluate the nature of the review procedures performed by the control owner, including the criteria used to identify items for follow up and how those items were resolved. In addition, the Firm failed to identify and test any controls over the accuracy and completeness of the data that management provided to the valuation specialist. (AS No. 5, paragraphs 39, 42, and 44) The Firm failed to sufficiently evaluate the reasonableness of the projected financial information that was a significant input into both () the issuer's analyses of the possible impairment of goodwill and

8 Page 7 other intangible assets and (2) the calculation of the amount of the impairment of certain of these assets. The issuer based its projected financial information on its current year's actual results and applied certain assumptions to these amounts to estimate financial information for future periods. The Firm's procedures to test the projected financial information were limited to comparing the current-year actual results to the general ledger and testing the mathematical accuracy of certain calculations used in developing the projected financial information; the Firm failed to evaluate the reasonableness of the assumptions that the issuer used to estimate the financial information for future periods. (AU 328, paragraphs.26 and.28) A.2. The Firm selected for testing one control over income taxes, which consisted of the review and approval of the quarterly income tax provision. The Firm's procedures to test this control were not sufficient, as they were limited to obtaining documentation used in the operation of the control, observing signatures as evidence of review, and comparing certain amounts in the income tax provision calculation to the general ledger. The Firm failed to ascertain and evaluate the nature of the review procedures performed by the control owner, including the criteria used by the control owner to identify matters for follow up and how those matters were resolved. (AS No. 5, paragraphs 42 and 44) Issuer B In this audit, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinion on the financial statements The Firm failed to perform sufficient procedures to test a significant category of revenue. Specifically o The Firm's planned approach for testing this revenue included the performance of substantive analytical procedures. Due to deficiencies in these procedures, however, they provided little to no substantive assurance. These procedures consisted of a comparison of expected gross margins, which were based on the prior-year margins, to actual gross margins and the investigation

9 Page 8 of differences; because these procedures did not include evaluating the components from which gross margins were derived, they were not sufficiently disaggregated to identify potential misstatements in the recorded revenue. (AU 329, paragraphs.05,.3, and.7) o The Firm reduced its sample size for a test of details of this revenue based, in part, on its plan to obtain assurance from analytical procedures. The analytical procedures, however, were the procedures described above, which provided little to no assurance as to revenue. As a result, the Firm's sample was too small to provide sufficient evidence. (AU 350, paragraphs.9,.23, and.23a) The Firm failed to sufficiently test the valuation of a significant account receivable with no recorded reserve. The account receivable was due from a customer that was assigned a credit rating of B or lower by multiple credit rating agencies, and the account receivable had remained uncollected for several years. The Firm's procedures to test the collectability of the account receivable were limited to reading an issuerprepared memorandum and inquiring of management, without obtaining corroboration of the information contained in the memorandum or the responses to the inquiries. (AU 342, paragraph.04) The issuer performed its annual analysis of the possible impairment of goodwill as of an interim date and recorded a goodwill impairment charge for one of its reporting units. During the period between the annual impairment test date and year end, the issuer's share price decreased significantly. The Firm failed to evaluate whether the decrease in share price represented a sustained decrease that, under generally accepted accounting principles ("GAAP"), required further analysis of possible goodwill impairment, as the Firm's procedures were limited to noting that the issuer's shares were thinly traded and that certain analysts projected a significant increase in the issuer's share price. (AS No. 3, paragraph 8)

10 Page 9 A.3. The Firm failed to perform any substantive procedures to test the existence of inventory held at customer locations; this inventory aggregated to approximately 30 times the Firm's established level of materiality. (AU 33, paragraph.0) Issuer C In this audit, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinions on the financial statements and on the effectiveness of ICFR. In addition, see the deficiency described in Part I.A.5. The Firm failed to perform sufficient procedures to test revenue. Specifically, for one of the issuer's significant categories of revenue, the Firm failed to identify and appropriately address what appeared to the inspection team to be an instance in which the financial statements were not presented fairly, in all material respects, in conformity with GAAP that it should have identified and addressed before issuing its audit opinion. The issuer recognized revenue for certain contracts using the percentageof-completion ("POC") method of accounting. For POC contracts in process at year end for which it expected to incur losses, the issuer recorded a provision to account for such losses. At the same time, the issuer also recorded the revenue that was expected to be earned related to these contracts, and the costs that were expected to be incurred, for the remaining life of these contracts. As a result, revenue and cost of sales for the year were overstated by equal amounts. (AS No. 4, paragraph 30) The Firm failed to perform sufficient procedures related to the issuer's allowance for excess and obsolete inventory. Specifically o The Firm failed to sufficiently test the control over the allowance for excess and obsolete inventory that it selected for testing, which consisted of management's annual review of an analysis of the inventory allowance. Specifically, the Firm limited its testing to () inquiring of management, (2) inspecting evidence that the analysis had been prepared and reviewed, and (3) comparing certain inventory items and amounts in reports used in the operation of the control to supporting documents and the general ledger. The Firm

11 Page 0 failed to evaluate whether this control operated at a level of precision that would prevent or detect material misstatements, as it failed to ascertain and evaluate the nature of the review procedures performed, including the criteria used to identify items for follow up and how those items were resolved. (AS No. 5, paragraphs 42 and 44) o The Firm failed to evaluate the reasonableness of certain significant assumptions that the issuer used in determining its allowance for excess and obsolete inventory. (AU 342, paragraph.) A.4. Issuer D In this audit, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinions on the financial statements and on the effectiveness of ICFR The issuer had operating facilities in multiple locations. For a number of the issuer's locations that, in the aggregate, presented a reasonable possibility of material misstatement, the Firm failed to perform sufficient procedures to test controls over revenue. The Firm selected for testing three controls over revenue at these locations, which consisted of the issuer's () review of each location's budget, and of the comparison of each location's operating results to its budget and prior-period amounts; (2) review of the reconciliation of each location's general ledger to the consolidated general ledger; and (3) review of the consolidated financial statements and related disclosures. The Firm's testing of these controls was insufficient in the following respects o The Firm's procedures to test these controls were limited to observing evidence that the reviews had occurred. The Firm's testing did not include ascertaining and evaluating the nature of the procedures performed by the control owners, including the criteria used by the control owners to identify matters for investigation and how those matters were resolved. As a result, the Firm failed to evaluate whether the controls operated at a level of precision that would prevent or detect material misstatements. (AS No. 5, paragraphs 42 and 44)

12 Page o Regarding the accuracy and completeness of data and reports that were used in the performance of the controls discussed above For certain locations, the Firm failed to identify and test any controls over the accuracy and completeness of the data and reports. (AS No. 5, paragraph 39) For the remaining locations, the Firm concluded that ITGCs over the application from which the data and reports were derived were ineffective. The Firm, however, failed to identify and test any other controls that would address the accuracy and completeness of those data and reports. (AS No. 5, paragraph 39) A.5. Based in part on its reliance on controls, the Firm determined that its substantive procedures to test revenue at the locations described above would consist of analytical procedures. As a result of the deficiencies in testing controls that are described above, however, these procedures, which consisted of comparing current- and prior-period revenue amounts and obtaining explanations from management for differences that exceeded a threshold, did not provide sufficient audit evidence regarding revenue at these locations. (AS No. 3, paragraphs 6, 8, and 37) Issuer E In this audit, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinions on the financial statements and on the effectiveness of ICFR The issuer had operating facilities in multiple locations. For a number of the issuer's locations that, in the aggregate, presented a reasonable possibility of material misstatement, the Firm failed to perform sufficient procedures to test controls over revenue, accounts receivable, and inventory. The Firm's procedures related to controls over these accounts at these locations were limited to testing an entity-level control, which consisted of management's monthly review of each location's () account reconciliations and (2) financial information compared to prior periods and forecasted results, and the investigation of differences over an established

13 Page 2 threshold. The Firm failed to sufficiently test controls over the accuracy and completeness of data and reports that were used in the operation of this control. Specifically o o For certain of these locations, the Firm failed to identify and test any controls over the accuracy and completeness of the data and reports. (AS No. 5, paragraph 39) For the remainder of these locations, the data and reports were derived from an IT application that operated at each of these locations, as well as at one other location where the Firm had performed procedures. The Firm had tested ITGCs over this application at this other location, but failed to evaluate whether the ITGCs that it tested were also operating over the applications in use at these remaining locations, and the Firm did not identify and test any other controls over the accuracy and completeness of the data and reports for these remaining locations. (AS No. 5, paragraph 39) A.6. Based in part on the Firm's reliance on controls, the Firm determined that its substantive procedures to test revenue, accounts receivable, and inventory at the locations described above would consist of analytical procedures. As a result of the deficiencies in testing controls that are described above, however, these procedures, which consisted of comparing the current-period amounts for these accounts to amounts for prior periods and obtaining explanations from management for differences that exceeded a threshold, did not provide sufficient audit evidence regarding revenue, accounts receivable, and inventory at these locations. (AS No. 3, paragraphs 6, 8, and 37) Issuer F In this audit of an oil and gas exploration and production company, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinions on the financial statements and on the effectiveness of ICFR The Firm's testing of controls over the valuation of the issuer's oil and gas properties was insufficient. Specifically

14 Page 3 o o For proved properties, the Firm failed to identify and test any controls over the reasonableness of the assumptions, and the accuracy of the data, that the issuer used in its impairment analysis. (AS No. 5, paragraph 39) For unproved properties, the Firm failed to identify and test any controls over the issuer's process for evaluating these assets for possible impairment. (AS No. 5, paragraph 39) The Firm failed to perform sufficient substantive procedures to test the valuation of oil and gas properties. Specifically o o For proved properties, the issuer inappropriately excluded certain relevant cash flows from the impairment analysis it used to calculate a recorded impairment loss. The Firm failed to perform any procedures to evaluate the effect of the exclusion of these cash flows. (AS No. 4, paragraph 30) For unproved properties, the Firm failed to perform any substantive procedures to test the issuer's analysis of potential impairment, beyond inquiring of management regarding the future plans for these assets and reading drilling plans and budgets. (AU 342, paragraph.) A.7. Issuer G In this audit, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinions on the financial statements and on the effectiveness of ICFR. For one significant category of revenue, the issuer determined the quantity of services provided based on customer-usage data that it received from an external party that measured the usage. The issuer used the data as an important input in determining the amount of revenue recognized for this category. The Firm's procedures related to this revenue were not sufficient. Specifically The Firm identified a significant deficiency related to the controls over the accuracy and completeness of the customer-usage data. The Firm identified and tested a control that it determined was related to the accuracy and completeness of the data. This control consisted of () a

15 Page 4 comparison of the current-period data to prior-period data, (2) an analysis of changes in monthly billings to customers that exceeded an established threshold, and (3) a procedure to determine whether data were provided from each of the external party's locations. This control, however, was designed to address only certain aspects of the completeness and accuracy of the customer-usage data, and the Firm failed to identify and test any other controls that would address the completeness and accuracy of the customer-usage data. (AS No. 5, paragraph 39) The Firm's substantive procedures to test this revenue were not sufficient. Specifically The Firm designed its substantive procedures including its sample size based on a level of control reliance that was not supported due to the deficiency in the Firm's testing of controls that is discussed above. As a result, the sample size the Firm used to test this revenue was too small to provide sufficient evidence. (AS No. 3, paragraphs 6, 8, and 37; AU 350, paragraphs.9,.23, and.23a) The Firm failed to test the accuracy and completeness, or (as described above) to sufficiently test controls over the accuracy and completeness, of the customer-usage data that it used in its substantive testing of this revenue. (AS No. 5, paragraph 0) A.8. Issuer H In this audit, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinions on the financial statements and on the effectiveness of ICFR. The issuer had investments in multiple entities and it determined that many of these were variable interest entities ("VIEs"). The Firm's procedures related to the issuer's investments in VIEs were insufficient. Specifically The Firm failed to identify and test any controls over () the identification of investments in VIEs, (2) the determination of the initial method of accounting for those investments, and (3) the identification and

16 Page 5 evaluation of reconsideration events that could potentially result in a change in accounting method for the relevant VIEs. (AS No. 5, paragraph 39) A.9. The Firm's substantive procedures to test VIEs were limited to inquiring of management, reading board of directors' and certain committee meeting minutes that noted investment-related transactions and events that had occurred during the year, and, for three investments that the issuer had identified for further consideration, evaluating the issuer's analysis and conclusions regarding the method of accounting for those investments. The Firm failed, however, to perform any procedures to () test whether the issuer had identified all of its investments in VIEs and (2) except for the three investments noted above, evaluate whether the method of accounting for identified investments in VIEs was appropriate. (AS No. 3, paragraph 8; AS No. 4, paragraph 30) Issuer I In this audit, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinions on the financial statements and on the effectiveness of ICFR The issuer was self-insured for certain liabilities, and it used service organizations to administer the related claims. The issuer provided its external actuary with the claims data processed by these service organizations, and the external actuary used the claims data to calculate the issuer's self-insurance liabilities. The Firm failed to sufficiently test the self-insurance liabilities, as it failed to perform sufficient procedures related to the claims data. Specifically o The Firm obtained service auditors' reports that described controls that needed to be implemented by the user in order to address certain risks related to the accuracy and completeness of the claims data provided by the service organizations. The Firm, however, failed to identify and test any controls that addressed these risks. (AS No. 5, paragraph 39)

17 Page 6 o The Firm failed to perform any substantive procedures to test the accuracy of the claims data. (AU 336, paragraph.2) The Firm failed to perform any substantive procedures to test the existence of one category of supplies; the recorded balance of this category was over six times the Firm's established level of materiality. (AS No.3, paragraph 8) A.0. Issuer J In this audit, the Firm failed to obtain sufficient appropriate audit evidence to support its audit opinion on the financial statements. The issuer recognized revenue from contracts using the POC method. The Firm identified a fraud risk related to the estimation of the cost to complete open POC contracts; the cost to complete is a significant input to the calculation of the related revenue. The Firm's testing of revenue recognized using POC was not sufficient because the Firm failed to sufficiently evaluate the estimated cost to complete contracts that were open as of year end. Specifically, the Firm's testing of the estimated cost to complete was limited to the following procedures, which in the aggregate did not provide sufficient evidence regarding this significant assumption (AU 342, paragraph.) The Firm attended two monthly meetings in which the progress of all open projects over a threshold was reviewed and cost estimates were approved by management. While this procedure provided the Firm with an understanding of the issuer's process for evaluating the estimated cost to complete, it provided the Firm with little substantive assurance, since the Firm did not evaluate the reasonableness of the judgments and assumptions that management used to estimate the cost to complete. The Firm selected for testing contracts with changes in contract value, estimated costs, or profit margin from quarter to quarter that were over certain thresholds. For these contracts, the Firm's procedures were limited to inquiring of management and obtaining evidence to support certain changes in total contract revenue, without testing changes in estimated contract costs.

18 Page 7 The Firm performed a look-back analysis, in which it compared the issuer's profit margin that was forecasted at the inception of the contract to the actual profit margin for contracts that were completed during the year. For any completed contract for which the change exceeded a threshold, the Firm limited its procedures to using the results of the procedures described in the preceding paragraph, or inquiring of management, to evaluate the appropriateness of the change in profit margin. The Firm selected for testing contracts for which the estimated cost to complete had changed after year end in an amount that was over a threshold. The Firm's procedures related to these contracts were limited to noting that decreases in the estimated cost to complete those contracts were consistent with its expectation that the remaining estimated costs would be less than the costs estimated at year end. The Firm, however, did not evaluate whether the amount and timing of the change was appropriate. A.. Issuer K In this audit, the Firm failed in the following respects to obtain sufficient appropriate audit evidence to support its audit opinions on the financial statements and on the effectiveness of ICFR, as it failed to perform sufficient procedures related to inventory. Specifically A significant portion of the issuer's inventory was subject to cycle counts, and the issuer used system-generated reports that specified which items to count each day. The Firm's procedures to test the existence of, and controls over the existence of, this inventory were insufficient. Specifically, although the Firm tested ITGCs over the inventory system that produced the reports, in determining that the cycle-count procedures that the issuer used for this inventory were sufficiently reliable, the Firm failed to determine the extent of the inventory items counted and the frequency of the counts that were specified in the system-generated reports. (AS No. 5, paragraphs 42 and 44; AU 33, paragraph.) The Firm failed to sufficiently test the issuer's allowance for excess and obsolete inventory. Specifically, the Firm's procedures were limited to

19 Page 8 inquiring of management regarding the methodology used to estimate the allowance; testing the mathematical accuracy of the issuer's calculations; and, for one subsidiary, comparing the current-year allowance to the prioryear allowance, noting that the balance did not change significantly. The Firm, however, failed to evaluate the reasonableness of the significant assumptions that the issuer used in determining its allowance for excess and obsolete inventory. (AU 342, paragraph.) A.2. Issuer L In this audit, the Firm failed to obtain sufficient appropriate audit evidence to support its audit opinion on the financial statements. The issuer asserted that earnings from certain of its foreign subsidiaries would be permanently reinvested outside of the U.S., and it therefore did not include those earnings in the calculation of its deferred tax liabilities. The Firm failed to sufficiently evaluate management's assertion, as its procedures were limited to inquiring of management and reading an issuer-prepared memorandum that described management's plans for permanently reinvesting earnings outside of the U.S. In performing these procedures, the Firm failed to evaluate the feasibility of management's reinvestment plans for those foreign earnings. (AS No. 3, paragraph 8) A.3. Issuer M In this audit, the Firm failed to obtain sufficient appropriate audit evidence to support its audit opinion on the financial statements, as its procedures to test capitalized costs for internally developed software were insufficient. During the year, the issuer capitalized certain payroll costs related to software development associated with several projects. To test whether it was appropriate to capitalize these costs, the Firm obtained an issuer-prepared memorandum that indicated that the projects associated with the payroll costs that were capitalized were in the application development phase. The Firm, however, failed to ascertain the nature of the software developers' activities related to those costs and to evaluate whether the activities were directly related to these projects. (AS No. 3, paragraph 8) A.4. Issuer N In this audit, the Firm failed to obtain sufficient appropriate audit evidence to support its audit opinion on the financial statements, as its procedures to test the

20 Page 9 issuer's liability for unpaid insurance claims were insufficient. The issuer used an external actuary to calculate the liability, and it provided the actuary with historical insurance claims data as a significant input to the calculation. The Firm failed to sufficiently test the accuracy of an important element of the historical claims data. Specifically, for the sample of claims that the Firm selected to test accuracy, there was no evidence in the audit documentation, and no persuasive other evidence, that the Firm had performed any procedures to test the claims payment information, beyond comparing the claims payment amounts to system-generated reports that it did not test. (AU 336, paragraph.2) A.5. Deficiencies Related to Substantive Testing of Revenue In one audit, 4 plus two additional audits included in Part I.A above, 5 due to deficiencies related to testing revenue, the Firm failed to obtain sufficient appropriate audit evidence to support its audit opinion on the financial statements. In these audits, when determining the size of the sample to test certain revenue amounts, the Firm considered certain factors, but did not appropriately take into account tolerable misstatement for the population. The resulting sample was too small to provide sufficient evidence. (AU 350, paragraphs.6,.8,.8a, and.23) The table on page 4 does not include the one audit for which the only deficiency relates to determining the sample size used to test revenue. The tables on pages 2 through 24 do not include the deficiencies related to sampling in either this or the two additional audits. B. Auditing Standards Each deficiency described in Part I.A above could relate to several provisions of the standards that govern the conduct of audits. The paragraphs of the standards that are cited for each deficiency are those that most directly relate to the deficiency. The deficiencies also may relate, however, to other paragraphs of those standards and to other auditing standards, including those concerning due professional care, responses to risk assessments, and audit evidence. 4 5 Issuer O Issuers A and C

21 Page 20 Many audit deficiencies involve a lack of due professional care. AU 230, Due Professional Care in the Performance of Work, paragraphs.02,.05, and.06, requires the independent auditor to plan and perform his or her work with due professional care and sets forth aspects of that requirement. AU 230, paragraphs.07 through.09, and AS No. 3, The Auditor's Responses to the Risks of Material Misstatement, paragraph 7, specify that due professional care requires the exercise of professional skepticism. These standards state that professional skepticism is an attitude that includes a questioning mind and a critical assessment of the appropriateness and sufficiency of audit evidence. AS No. 3, paragraphs 3, 5, and 8, requires the auditor to design and implement audit responses that address the risks of material misstatement. AS No. 5, Audit Evidence, paragraph 4, requires the auditor to plan and perform audit procedures to obtain sufficient appropriate audit evidence to provide a reasonable basis for the audit opinion. Sufficiency is the measure of the quantity of audit evidence, and the quantity needed is affected by the risk of material misstatement (in the audit of financial statements) or the risk associated with the control (in the audit of ICFR) and the quality of the audit evidence obtained. The appropriateness of evidence is measured by its quality; to be appropriate, evidence must be both relevant and reliable in providing support for the related conclusions. The paragraphs of the standards that are described immediately above are not cited in Part I.A, unless those paragraphs are the most directly related to the relevant deficiency. B.. List of Specific Auditing Standards Referenced in Part I.A The table below lists the specific auditing standards that are referenced in Part I.A of this report, cross-referenced to the issuer audits for which each standard is cited. 6 For each auditing standard, the table also provides the number of distinct deficiencies for which the standard is cited for each of the relevant issuer audits. This information identifies only the number of times that the standard is referenced, regardless of whether the reference includes multiple paragraphs or relates to multiple financial statement accounts. 6 For important information concerning this table, see Part I.A.5.

22 Page 2 PCAOB Auditing Standards Audits Number of Deficiencies per Audit AS No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements Issuer A Issuer C Issuer D Issuer E Issuer F Issuer G Issuer H Issuer I Issuer K AS No. 3, The Auditor's Responses to the Risks of Material Misstatement AS No. 4, Evaluating Audit Results AS No. 5, Audit Evidence Issuer B Issuer D Issuer E Issuer G Issuer H Issuer I Issuer L Issuer M Issuer C Issuer F Issuer H Issuer A Issuer G AU 328, Auditing Fair Value Measurements and Issuer A Disclosures AU 329, Substantive Analytical Procedures Issuer B AU 33, Inventories Issuer B Issuer K AU 336, Using the Work of a Specialist Issuer I

23 Page 22 PCAOB Auditing Standards Audits Number of Deficiencies per Audit Issuer N AU 342, Auditing Accounting Estimates AU 350, Audit Sampling Issuer B Issuer C Issuer F Issuer J Issuer K Issuer B Issuer G B.2. Financial Statement Accounts or Auditing Areas Related to Identified Audit Deficiencies The table below lists the financial statement accounts or auditing areas related to each deficiency included in Part I.A of this report and identifies the audits described in Part I.A where deficiencies relating to the respective areas were observed. 7 AS No. 5 AS No. 3 AS No. 4 Impairment of goodwill and A B A intangible assets Income taxes A L Insurance reserves I I, N Inventory and related reserves C, E, K E, I B, K C, K Investment securities H H H Property, plant, and F M F F equipment Revenue, including accounts receivable, deferred revenue, and allowances A, D, E, G D, E, G C A, G B B, J B, G AS No. 5 AU 328 AU 329 AU 33 AU 336 AU 342 AU For important information concerning this table, see Part I.A.5.

24 Page 23 B.3. Audit Deficiencies by Industry 8 The table below lists the industries 9 of the issuers for which audit deficiencies were discussed in Part I.A of this report, and cross-references the issuer to the specific auditing standards related to the deficiencies. 0 AS No. 5 AS No. 3 AS No. 4 AS No. 5 Consumer E E Discretionary Consumer Staples D D Energy F F F Financial H H H N Services Industrials C, I, K B, I C B B, K I B, C, J, K B Information Technology A, G G, L, M A, G A G AU 328 AU 329 AU 33 AU 336 AU 342 AU The majority of industry sector data is based on Global Industry Classification Standard ("GICS") data obtained from Standard & Poor's ("S&P"). In instances where GICS for an issuer is not available from S&P, classifications are assigned based upon North American Industry Classification System data. 9 Where identifying the industry of the issuer may enhance the understanding of the description of a deficiency in Part I.A, industry information is also provided there, unless doing so would have the effect of making the issuer identifiable. 0 For important information concerning this table, see Part I.A.5.

25 Page 24 C. Data Related to the Issuer Audits Selected for Inspection C.. Industries of Issuers Inspected The chart below categorizes the 34 issuers whose audits were inspected in 205, based on the issuer's industry. Information Technology 26% Industries of Issuers Inspected Telecomunication Services 3% Industrials 26% Consumer Discretionary 9% Health Care 6% Consumer Staples 3% Energy 2% Financial Services 5% Industry Number of Audits Inspected Percentage Consumer Discretionary 3 9% Consumer Staples 3% Energy 4 2% Financial Services 5 5% Health Care 2 6% Industrials 9 26% Information Technology 9 26% Telecommunication Services 3% C.2. Revenue Ranges of Issuers Inspected The chart below categorizes, based upon revenue, the 34 issuers whose audits were inspected in This presentation of revenue data is intended to provide information about the size of issuer audits that were inspected and is not indicative of classified. See Footnote 8 for additional information on how industry sectors were 2 The revenue amounts reflected in the chart are for the issuer's fiscal year end that corresponds to the audit inspected by the PCAOB. The revenue amounts were obtained from S&P and reflect a standardized approach to presenting revenue amounts.

26 Page 25 whether the inspection included a review of the Firm's auditing of revenue in the issuer audits selected for review. >$ billion 8% >$500 million - $ billion 4% Revenue Ranges of Issuers Inspected (in US$) $0 - $00 million 8% >$00 million - $500 million 50% Revenue (in US$) Number of Audits Inspected Percentage $0 - $00 million 6 8% >$00 million - $500 million 7 50% >$500 million - $ billion 5 4% >$ billion 6 8% D. Information Concerning PCAOB Inspections that is Generally Applicable to Annually Inspected Firms Board inspections include reviews of certain portions of selected audit work performed by the inspected firm and reviews of certain aspects of the firm's quality control system. The inspections are designed to identify deficiencies in audit work and defects or potential defects in the firm's system of quality control related to the firm's audits. The focus on deficiencies, defects, and potential defects necessarily carries through to reports on inspections and, accordingly, Board inspection reports are not intended to serve as balanced report cards or overall rating tools. Further, the inclusion in an inspection report of certain deficiencies, defects, and potential defects should not be construed as an indication that the Board has made any determination about other aspects of the inspected firm's systems, policies, procedures, practices, or conduct not included within the report.

27 Page 26 D.. Reviews of Audit Work Inspections include reviews of portions of selected audits of financial statements and, where applicable, audits of ICFR. For these audits, the inspection team selects certain portions of the audits for inspection, and it reviews the engagement team's work papers and interviews engagement personnel regarding those portions. If the inspection team identifies a potential issue that it is unable to resolve through discussion with the firm and any review of additional work papers or other documentation, the inspection team ordinarily provides the firm with a written comment form on the matter and the firm is allowed the opportunity to provide a written response to the comment form. If the response does not resolve the inspection team's concerns, the matter is considered a deficiency and is evaluated for inclusion in the inspection report. The inspection team selects the audits, and the specific portions of those audits, that it will review, and the inspected firm is not allowed an opportunity to limit or influence the selections. Audit deficiencies that the inspection team may identify include a firm's failure to identify, or to address appropriately, financial statement misstatements, including failures to comply with disclosure requirements, 3 as well as a firm's failure to perform, or to perform sufficiently, certain necessary audit procedures. An inspection of an annually inspected firm does not involve the review of all of the firm's audits, nor is it designed to identify every deficiency in the reviewed audits. Accordingly, a Board inspection report should not be understood to provide any assurance that a firm's audit work, or the relevant issuers' financial statements or reporting on ICFR, are free of any deficiencies not specifically described in an inspection report. 3 When it comes to the Board's attention that an issuer's financial statements appear not to present fairly, in a material respect, the financial position, results of operations, or cash flows of the issuer in conformity with the applicable financial reporting framework, the Board's practice is to report that information to the Securities and Exchange Commission ("SEC" or "the Commission"), which has jurisdiction to determine proper accounting in issuers' financial statements. Any description in this report of financial statement misstatements or failures to comply with SEC disclosure requirements should not be understood as an indication that the SEC has considered or made any determination regarding these issues unless otherwise expressly stated.