by Melissa Klein Aguilar and Ken Rankin

Washington — Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers were cited with a series of serious audit and accounting deficiencies in reports outlining the results of the Public Company Accounting Oversight Board’s 2003 limited inspections of the four largest U.S. public accounting firms.

The problems noted in the inspection reports — failures to identify generally accepted accounting principles exceptions, audit documentation deficiencies, departures from PCAOB standards and violations of the firms’ own internal quality control policies — did not come as a surprise to the accounting industry.

Weeks before the release of the inspection reports, PCAOB Chairman William J. McDonough told a House Financial Services subcommittee that these initial inspections “identified significant audit and accounting issues” at the four top firms, and that the board was concerned that “auditors may place insufficient emphasis on the importance of thorough documentation of audit work.”

In releasing the details of those inspections, however, PCAOB officials played down the problems encountered at the Big Four, noting that the report’s emphasis on criticisms of those firms does not “reflect any broad negative assessment of the firms’ audit practices.”

“None of our findings has shaken our belief that these firms are capable of the highest quality auditing,” McDonough stressed. “The board is also encouraged by the firms’ demonstrably cooperative attitude toward our inspections, which are designed to drive the firms to improve any aspects of their practices that may stand as impediments to the highest quality audit performance.”

Calling the inspections “unprecedented,” he added that the PCAOB’s findings “say more about the benefits of the robust, independent inspection process envisioned in the Sarbanes-Oxley Act of 2002 than they do about any infirmities in these firms’ audit practices.”

The extent of the audit and accounting deficiencies uncovered by PCAOB inspectors was not immediately disclosed, however, because certain information about “accounting errors in the financial statements of issuers” was deleted from the version of the reports made public by the board.

Under the board’s rules, inspection findings that are related to certain quality control issues, such as independence issues, are kept confidential, and firms are given 12 months to take corrective action. If the firms address the issues raised during that time, the confidential portions remain non-public forever.

Responding to criticism of that aspect of the reports, McDonough said, “It’s actually quite positive. Especially if you’re dealing with a firm of any size, 12 months is a short period of time to improve to where there’s no longer a negative comment, so it puts a discipline on the firm. To me, it makes sense.”

The PCAOB also withheld information from the reports concerning investigations, disciplinary proceedings or other enforcement actions that may have been undertaken against the accounting firms as a result of the inspections.

According to officials at the board, “If there is sufficient evidence of a violation that warrants law enforcement or disciplinary action, the board will proceed accordingly by commencing a nonpublic investigation or disciplinary hearing, or by referring the information to the appropriate [federal or state] authority.”

If a violation is eventually established, “that information will become public through the appropriate disciplinary and enforcement processes, and not through a board inspection report,” the PCAOB said.

During a conference call with reporters, director of registration and inspections George Diacont noted that one of the issues identified was a misinterpretation by issuers of an Emerging Issues Task Force pronouncement issued in 1995 that related to the classification of long-term debt. The firms failed to catch cases where issuers recorded as long-term debt what should have been recorded as short-term debt — a misclassification, he noted, that can affect a company’s liquidity ratio and inadvertently cause it to be in violation of a lending ratio.

The limited inspections of the Big Four firms were conducted between June and December 2003 on a voluntary basis in order to obtain a “baseline” understanding of each firm’s quality control procedures, and to provide the PCAOB with a foundation for the full-scale inspections that began earlier this year. The inspections involve both an examination of each firm’s policies, practices and procedures related to public company auditing, and a review of aspects of selected recent audits performed by each firm.

Under Sarbanes-Oxley, the board is required to conduct annual inspections of firms that audit more than 100 public companies. The board inspections replaced the profession’s peer review system. In addition to the Big Four, four other U.S. firms are subject to full inspections in 2004: McGladrey & Pullen, Grant Thornton, BDO Seidman and Crowe Chizek & Co. Inspections of firms that audit fewer than 100 public companies will begin next year and will be done triennially thereafter.

In addition to technical compliance with accounting and auditing standards, the inspections also look at “the business context in which audits are performed, and the ways in which that context influences firm audit practices.” Among other things, the board looks at firm culture, the relationships between its audit practice and its other practices, and the relationship between the national office and engagement personnel in field and affiliate offices.
“The purpose of the inspections was not to serve as a grading system to measure one firm against another. This was not an effort to grade,” Diacont told members of the press.

In its first review, the board looked at 16 audit engagements at each firm. “That’s a small statistical sample,” McDonough explained during the conference call. “Our conclusions have to be tentative because of the limited size of the inspections,” he added.

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