Failing Grades for E&Y, KPMG

PCAOB inspections reveal the Big Four auditors were tripped up on auditing procedures related to run-of-the-mill GAAP items.

The Public Company Accounting Oversight Board issued its 2005 inspection reports on Ernst & Young and KPMG on Thursday, citing multiple failures in audits by the two Big Four audit firms. The report on E&Y identifies 10 companies for which audits were deficient, and says that in “some cases” the errors appeared “likely to be material to the issuer’s financial statements.” The report on KPMG identifies 11 deficient audits, and says that in “one case” the result was likely to be material.

In 2005 the PCAOB reviewed portions of more than 365 audits performed by the nine largest firms and 623 audits performed by 272 smaller firms. A PCAOB spokesman told CFO.com that the regulator does not release information on the number of inspections it conducts on each individual firm.

The PCAOB, created by the 2002 Sarbanes-Oxley Act, inspects public accounting companies to identify and address weaknesses and deficiencies related to how a firm conducts audits. Part of the inspection is based on how the auditors conform to the highly contested Auditing Standard No. 2 (AS2), which focuses on a public company’s internal controls. The PCAOB is planning to replace AS2 with AS5, a new standard released for comment on December 19. In its reports, the board concedes that AS2 is not working well. “Audits performed under the difficult circumstances of the first year of implementation of AS No. 2 were often not as efficient as the standard intends,” wrote the inspectors.

However, 20 of the 21 deficiencies cited in the E&Y and KPMG reports were not directly related to controls problems. Instead, the board reported problems with the firms’ audits of run-of-the-mill accounting issues. Among the problems the PCAOB took the auditors to task for were poorly conducted audits related to lease and tax accounting, as well as revenue recognition and goodwill impairment testing. In fact, PCAOB inspectors concluded that both E&Y and KPMG failed “to identify or appropriately address errors in the issuer’s application of GAAP.” Those errors, it noted, were likely to have resulted in material misstatements by one of KPMG’s clients and several of E&Y’s clients.

In some cases, the deficiencies identified “were of such significance” that PCAOB inspectors deduced that at the time of the audit, E&Y and KPMG “had not obtained sufficient competent evidential matter to support [their opinions] on the issuer’s financial statements.” The PCAOB emphasized, however, that when an audit firm is cited in an inspection report for having a deficiency, it does not mean the problem remains unaddressed. In fact, under PCAOB standards, audit firms must take appropriate action to assess the deficiency and support its existing audit opinion.

Response letters from E&Y and KPMG issued as part of the reports noted that both firms responded to the criticism by performing added audit procedures and improving documentation. In a general response that covered all of KPMG’s deficiency notices, the auditor asserted that judgment plays a part in the auditing process and that reasonable professionals might differ on what specific tests and documentation are needed. Meanwhile, E&Y stated that while it did not always agree with the regulator’s assessment of its audits, it recognized the report as having a “constructive” intent. E&Y itemized its responses, answering each PCAOB charge separately.

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