The Public Company Accounting Oversight Board staff released a report Monday on how during 2022 and 2023, several firms’ engagement teams working on audits in the banking sector did not adequately identify the risks of material misstatement ahead of the high-profile implosion of several banks.

The Spotlight report, “Bank Financial Reporting Audits, discusses the PCAOB’s inspection response to bank failures in early 2023 and the continued effects of these bank failures on the banking industry and includes an overview of survey responses outlining how dozens of U.S. firms responded to disruptions in the banking industry, including impacts from rising interest rates. It also includes some observations from the PCAOB’s inspection activities, along with a description of good practices at audit firms in key focus areas.

The PCAOB encouraged firms to consider some of the potential risks, including increased volatility in financial and commodity markets due to fluctuations in interest rates and inflationary trends in an earlier Spotlight report, “Staff Overview for Planned 2022 Inspections,” which was published in June 2022.

Then, after vulnerabilities in the banking sector were exposed in early 2023 as high-profile banks such as Silicon Valley Bank and Signature Bank went under, the PCAOB revised its inspection plan to respond in real time, including sending a questionnaire to survey 40 U.S. firms that audit at least one bank, with additional emphasis on the 13 U.S. firms that audit 10 or more banks. The survey was designed to provide insight into how firms evaluated emerging and evolving risks in the sector.

In reviewing the survey responses, the PCAOB found that over 70% of the engagement teams it surveyed did not identify a risk of material misstatement due to rising interest rates. Over 95% did not identify a risk of material misstatement related to liquidity. Over 95% did not identify a risk of material misstatement through reviewing information from short sellers, analysts, or other publicly available information, and over 65% did not identify any risk of material misstatement related to concentration risks. Finally, over 95% of the engagement teams did not identify a risk of fraud related to investments or related disclosures. A few firms indicated rising interest rates were a “business-only” risk, relating to the operations of the bank without directly influencing financial reporting.

As they reviewed the banking sector audits completed in early 2023 for financial statements dated in late 2022, PCAOB inspectors noticed a variety of deficiencies. In some instances, for example, engagement teams did not revisit initial risk assessments performed earlier in the year as interest rates continued to rise. Inspectors also observed instances of interest rate volatility being documented as an operational or business issue – with no financial reporting or internal control over financial reporting considerations.

As a result, some engagement teams did not identify in their audits certain risks of material misstatement despite changes in bank-specific or macroeconomic conditions that indicated increased risk in certain audit areas.

In response to the survey results, the PCAOB adjusted its inspection plan, telling its target team to perform procedures on interim reviews of banks in order to provide real-time perspective on important risks. Inspectors also chose additional bank audits for inspection, and worked to ensure emerging banking and economic trends, and banking issues or common deficiencies, were appropriately considered in our selections.

In addition to some common observations from the PCAOB’s inspection activities, the Spotlight report provides a description of good practices observed at audit firms that may enhance audit quality if broadly adopted. The Spotlight provides these insights in in four focus areas: investment securities, allowance for credit losses, deposit liabilities, and loans and related accounts.