PCAOB Finds Slip-ups in E&Y Audits

A PCAOB inspection turns up 11 significant deficiencies in E&Y audits of eight public companies, including some errors that "appeared likely to be material to the issuer's financial statements."

In its review of Ernst & Young’s 2006 audits, the Public Company Accounting Oversight Board noted several audit deficiencies, including “some cases” where errors could be material to the financial statements of the auditor’s clients. Several times, the PCAOB notes, E&Y failed to provide proof that it had conducted necessary testing.

The report notes 11 instances where the PCAOB found significant deficiencies in E&Y’s accounting work for eight public companies. These included an instance where E&Y “failed to identify a departure from” generally accepted accounting principles in a case involving lease accounting and another case where the firm did not adequately evaluate an issuer’s claim that errors made in invoices amounted to an immaterial number, in the PCAOB’s view.

In its response letter to the PCAOB, included in the report, E&Y disagreed with four of the PCAOB’s findings. In other cases, the auditor did additional work or supplemented its documentation because of the PCAOB report. But the firm did not change any of its initial audit opinions. In addition, unlike the previous year’s inspection report, which noted one instance in which an issuer needed to make a restatement, E&Y did not adjust any of the affected issuers’ financial statements.

The regulator could be closing in on the lag time between its inspections and the publicly released reports. The PCAOB’s report, released on Wednesday, is the first of its third round of official inspection reports on the Big Four accounting firms. The E&Y report was posted on the PCAOB website just four months after its last formal evaluation of the audit firm based on 2005 audits. The PCAOB annually inspects firms that audit more than 100 issuers.

Earlier this year, PCAOB board member Charles Niemeier told CFO.com he expected the time between inspections and reports to be shortened now that the fledgling standard-setter — created by the Sarbanes-Oxley Act in 2002 — has several reports under its belt and has established a template for the wording of the documents.

The PCAOB inspected E&Y’s 2005 audits from May to November 2006. Inspectors conducted its field work at the auditor’s national office and 21 of its 80 U.S. practice offices. The regulator discourages the public from drawing any conclusions based on the number of audit deficiencies listed in the report. The board notes that the number of audits the inspectors review is a small portion of the total number conducted by each firm. However, the PCAOB will not release the total number of audits it conducts each year for each firm. “In some respects, [the number of engagements] could encourage misleading, superficial comparisons between firms,” Niemeier told CFO.com earlier this year. E&Y audits more than 2,300 U.S. publicly traded companies.

The PCAOB also redacts its conclusion about each audit firm’s quality control systems, as long as the firms make fixes within a year. In addition, the regulator omits the issuer’s name and instead refers to them by a letter. Here are excerpts from the PCAOB’s findings on E&Y 2005 audits.

Issuer A: The auditor failed to identify a departure from GAAP.

After no longer using a portion of leased office space, the issuer’s calculated liability and related costs for the operating lease was not in line with FAS 146, Accounting for Costs Associated with Exit or Disposal Activities.

Issuer C: The auditor used a testing sample that was non-representative.

The firm failed to test a sufficient portion of supplier rebates receivable, deferred rebate balances, and cost of sales adjustments during its testing when it decided to look at only large supplier contracts. By doing so, the firm could not draw a conclusion on all of the supplier contracts.

Issuer G: The auditor did not show whether it had done proper testing.

The firm needed to determine if how the issuer had reclassified the amounts of certain credit balances was appropriate.

Issuer H: The auditor failed to include an audit difference that was more than four times its posting threshold on its summary of audit differences.

Aggregate audit differences that were identified by the firm would have had an unfavorable effect on net income of 3.8 percent if recorded, but the figure would have been higher — 5.1 percent — had the firm not omitted this additional audit difference.

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