The Public Company Accounting Oversight Board has made public previously confidential quality control criticisms from its 2009 inspection of Ernst & Young LLP after finding that the firm failed to address them to the board’s satisfaction.

On Thursday, the PCAOB released the nonpublic portions of its July 2, 2010 report on the U.S. firm. The deficiencies included problems with E&Y’s audits of management’s estimates, including evaluating the reasonableness of management’s assumptions at several of the firm’s audit clients.

In addition to one engagement where deficiencies had already been made public, the PCAOB’s inspection team identified six engagements with deficiencies in auditing management’s estimates, including two engagements with more than one deficiency in this area. Specifically, one issuer used certain assumptions, including the probabilities of various outcomes and a projected growth in sales, gross margin and earnings, in its analysis of the impairment of a portion of its long-lived assets.

But the PCAOB pointed out that there was no evidence in the audit documentation, and no other persuasive evidence, that E&Y had evaluated these assumptions in light of the client’s historical results, its results for the first month of the current year, and the terms of certain initial bids for the assets, which appeared to raise questions about those assumptions.

In another engagement, there was no evidence in the audit documentation, and no other persuasive evidence, that E&Y had considered the client’s declining historical warranty claims activity and its decision not to continue accruing warranty expenses for certain of its divisions when evaluating the reasonableness of its warranty accrual.

The PCAOB inspection team also found problems with supervision and review, noting that the reported deficiencies raised questions regarding the sufficiency, rigor and efficacy of the supervision and review activities of the firm’s engagement managers, engagement partners and SEC concurring review partners, including their exercise of due care and the thoroughness with which they reviewed work papers.

However, some parts of the section were still deleted from public view.

“The inspection observations suggest the possibility that more attention needs to be devoted to supervision and review activities in connection with audits of areas involving a high degree of judgment, management estimation, * * * *” the report said, excising the rest of the sentence. “This concern stems, in part, from the significance and number of deficiencies in more complex or subjective areas where a greater degree of supervision and review would be expected, such as the auditing of management estimates, * * * * [another deletion]. In approximately 52 percent of the responses to the deficiencies raised by the inspection team, the Firm indicated that it would remediate the deficiencies by supplementing or modifying its previously archived audit work papers with additional documentation. The frequency of these incidents provides cause for concern with respect to the sufficiency and rigor of the review performed by the engagement managers and partners who completed their reviews without such additional documentation.”

The PCAOB also faulted Ernst & Young in the area of professional skepticism. “The inspection results provide cause for concern that the Firm’s system of quality control may not do enough to assure that accounting and auditing issues are evaluated with the degree of professional skepticism that is contemplated in the auditing standards,” said the PCAOB. “In numerous instances, the inspection team observed that the Firm's support for significant areas of an audit consisted of uncorroborated management's views or the results of inquiries of management. The Firm’s apparent failure to appropriately challenge management occurred in several areas, including when the Firm evaluated * * * * management estimates and assumptions related to accruals and reserves; * * * *. The Firm did not appropriately test these representations by, for example, reviewing appropriate source documentation or comparing the representations to relevant industry or other public information, including in certain cases when such assumptions were contrary to historical results.”

The PCAOB also saw cause for concern about the risk of material misstatement due to fraud. In nine engagements with deficiencies, E&Y had identified a particular fraud risk in the audit area in which the inspection team noted a deficiency, and the firm's procedures did not sufficiently address the identified risk. In one engagement, for example, E&Y identified a particular fraud risk relating to management manipulation of the work in progress inventory file to affect gross margin, but limited its tests of controls over inventory costing to verifying management’s review and approval.

The PCAOB said Thursday it had determined that as of July 2, 2011, E&Y had not addressed the criticisms in the 2010 report to the board’s satisfaction, so it made public the portions of the report dealing with those criticisms.

E&Y notified the PCAOB that it would not seek Securities and Exchange Commission review of the determination, which the firm has a right to do. However, E&Y requested that a related statement by the firm be attached as an appendix to the release. The PCAOB granted that request, cautioning that it was not endorsing, confirming or adopting any element of the firm’s statement as its own view.

“The Board today made public certain portions of Part II of our 2009 Inspection Report,” the statement said in part. “The Board determined that we did not address certain quality control matters to the Board’s satisfaction during the 12-month period following the issuance of the inspection report. We believe we took significant remedial actions with respect to all of these matters, including making significant enhancements in our resources, policies and practices. In each of the areas noted, we have provided our audit professionals with new audit tools, additional training and expanded technical guidance. These efforts have been beneficial generally and continue to improve our execution. Overall we have invested thousands of partner and staff hours on these issues and believe we approached each Board criticism seriously and responsibly. At the same time, we recognize that we can and will continue to improve. We fully respect the Board’s determination that these remedial steps have been insufficient in certain areas. We share with the Board a common objective to see continuous improvement in the quality of our work.”

E&Y also pointed out that the PCAOB has stated that it is not unusual for an inspection report to include nonpublic criticisms of several aspects of a firm’s system of quality control and that a public release is not a broad judgment about the effectiveness of a firm’s system of quality control compared to other firms. In March, the PCAOB unsealed the nonpublic portions of inspection reports on PricewaterhouseCoopers (see PCAOB Finds PwC Failed to Fix Auditing Problems). In 2011 it exposed the nonpublic parts of an inspection of Deloitte (see PCAOB Unseals Deloitte Criticisms).

Ernst & Young spokesperson Amy Call Well also emailed a statement from the firm to Accounting Today in response to a request for further comment. “The PCAOB inspection process unquestionably has led to improvements in the performance of audits by our firm and the profession generally. The actions we have taken—and continue to take—position us to deliver quality audit services in support of our mission to serve the public interest, the investor community and the companies we audit,” said the firm. “Our partners and other professionals are dedicated to quality and to our important duty to the public trust and capital markets. We look forward to working with the Board in a cooperative and constructive manner to improve audit quality.”