PCAOB: KPMG Fell Behind on Testing

Deficiencies in finding and addressing fair-value problems and stock-option accounting were also cited.

The Public Company Accounting Oversight Board has released the results of its 2006 inspection of KPMG and has cited the accounting firm for 14 audit deficiencies. The faults occurred at seven of KPMG’s clients and included failures to identify accounting errors and material weaknesses in internal controls over financial reporting.

In response to the PCAOB’s findings, KPMG performed additional procedures for some of its clients’ 2005 audits. In one instance, KPMG uncovered an audit deficiency just before the PCAOB began its inspection and subsequently reissued its internal-controls report to reflect a material weakness. The firm had initially missed that the issuer did not properly test its indefinite-lived intangible assets for impairment.

In its July 12 response letter to the PCAOB, included in the report released Friday, KPMG acknowledged the change it made to the internal-controls report for that particular client. Still, the audit firm noted that nothing the PCAOB found in its report required any financial statements to be reissued.

As the oversight body of the accounting firms for U.S. publicly traded companies, the PCAOB conducts periodic reviews of all the firms, including annual inspections of those that have more than 100 issuers. The first half of the reports outlines any significant deficiencies the inspection team found, listed by issuer. However, the reports keep the issuers confidential and discourages readers from drawing conclusions on the number of deficiencies noted. The PCAOB conducts its inspections with a risk-based approach, meaning the board does not pull the audits it decides to review on a random basis.

The second half the inspection team’s findings is redacted. The PCAOB conducts a review of each audit firm’s quality-control system but agrees not to release its findings as long as the firm addresses the board’s concerns within a year.

What the PCAOB did include in its 2006 report shows that KPMG auditors should have done more work to supplement their opinions. The PCAOB also noted an instance in which KPMG could have better verified its client’s use of fair-value accounting. The board has been giving the matter particular attention as companies expand their use of fair-value accounting and worry that auditors do not have extensive training in valuation techniques to verify companies made the right choices, as PCAOB chairman Mark Olson noted earlier this summer. In KPMG’s 2006 report, the board noted that the firm did not test whether information provided to a valuation specialist was “complete, accurate, and relevant.”

For another issuer, KPMG “failed to identify and appropriately address” a departure from generally accepted accounting principles. In that case, the issuer’s accounting for how it modified vested stock options did not follow APB Opinion No. 25, Accounting for Stock Issued to Employees, and FAS 44, Accounting for Certain Transactions Involving Stock Compensation. The PCAOB said the firm would have noted this mistake if the auditors had evaluated the effects of the change.

What follows are other excerpts from the inspection report:

Issuer A: The firm failed to do proper testing and failed to identify a significant error.

KPMG did not test the accuracy of a recorded purchase price of an acquired entity’s assets by, for example, comparing the amount to the final purchase and sale agreement. It also did not test controls related to the reliability of source data for the capitalization of costs in the issuer’s inventory system.

In another matter for the same company, the firm did not find a significant error in certain line items reported for operating activities on the Statement of Cash Flows nor did it test the amounts reported for investing and financing activities on that statement. The issuer later changed the statement in subsequent financial statements.

Issuer E: The firm failed to evaluate the appropriateness of its client’s use of hedge accounting for forecasted commodity purchases with forward contracts.

KPMG did not obtain evidence to verify management’s assertion of the hedges’ effectiveness. After conducting additional procedures following the PCAOB inspection, the firm determined one of the hedges was indeed inappropriate.

Issuer G: The firm did not do enough testing of the issuer’s self-prepared schedules of income tax liabilities.

KPMG knew of potential issues with the issuer’s income tax accounts, including misstatements in previous years’ financial filings, and should have made sure the schedules were complete and accurate beyond reconciling them with recorded amounts, discussing them with the issuer, and performing internal consultations. After the PCAOB inspection, the firm identified additional misstatements. In addition, the firm did not identify a previous year’s material weakness in internal control having to do with income taxes.

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