When the Public Company Accounting Oversight Board’s auditors scrutinized Ernst & Young’s work in their latest annual inspection — zeroing in on its national office and 26 field offices — the mortgage-lending market had already begun to unravel. So when one of the four E&Y clients for which the watchdog agency found auditing deficiencies turned out to be a mortgage lender, the quality of the audit may have drawn special interest.
The PCAOB generally avoids offering much detail about individual clients whose audits are reviewed. But in the case of this review conducted by inspectors between last April and December, the board noted that “Issuer A” originates, acquires, and sells mortgage loans. And the inspectors pinged the Big Four firm for not testing whether the issuer’s repurchases of pooled loans — which jumped 600 percent over the previous year — followed the terms of their sales agreements.
For the same issuer, Ernst & Young should have evaluated whether non-affiliated entities that the issuer had financed for loan originations would be considered variable interest entities under FIN 46R, which would require them to be consolidated, according to the PCAOB. The inspectors also took issue with E&Y’s work papers of the issuer’s allowance for loans that were nearing or in default for having inconsistent numbers. The firm and the issuer later changed the amounts recorded for these loans in a 10-K filed after the PCAOB’s review.
The PCAOB’s findings on E&Y’s 2006 audits were made public on Wednesday, along with the agency’s latest report of midtier firm McGladrey & Pullen. The board conducts annual inspections of audit firms with 100 or more issuers. It keeps the identities of the firms’ clients confidential.
For this most recent review of E&Y, the board noted several instances in which the firm didn’t have enough evidence to support its audit opinion. In a letter from the auditor included in the report, E&Y acknowledged that additional work was done following the PCAOB’s feedback. However, “in no instance did these actions change our original audit conclusions or affect our reports on the issuers’ financial statements,” the firm wrote.
In fact, the firm says some of the extra work it did following the inspection didn’t matter. For example, the PCAOB thought E&Y auditors should have applied FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees for the calculation of some of an issuer’s guarantee reserves. But E&Y later determined that that amount was immaterial.
In other cases, E&Y decided not to revisit its audit work. “We believe the nature and extent of our substantive procedures performed during the 2006 audits were appropriate and responsive to our risk assessments and the results of our testing of the issuers’ internal controls where applicable,” the firm wrote.
For its review of McGladrey, the PCAOB recorded several audit deficiencies for five clients after visiting its national office and seven of its 73 field offices. One of the board’s findings led to a restatement because the auditor didn’t notice a discrepancy with generally accepted accounting principles, according to the report.
In that case, “Issuer A” had recorded a loss related to a customer’s loan at the wrong time. The customer had filed for bankruptcy after the issuer’s fiscal year had ended — which had a “significant effect” on the estimated losses the issuer figured it would swallow on that loan. Issuer A should have recorded the increase in the loss during the quarter when the bankruptcy was filed, not in the financial statements for the year under audit — a matter McGladrey had overlooked, the PCAOB noted.