Washington (June 25, 2004) -- The Public Company Accounting Oversight Board identified "significant audit and accounting issues" in its preliminary inspections of the four largest U.S. accounting firms, PCAOB Chairman William McDonough told congressional leaders this week.

"As one would expect of sophisticated organizations, each of the firms has developed multiple volumes of quality-control policies, but individual engagements are the litmus test for whether the firms are in fact conducting high-quality audits," McDonough testified before a House Financial Services subcommittee Thursday. "Although we only reviewed a small number of engagements in 2003, we identified significant audit and accounting issues."

While the initial inspections were more limited than the full inspections will be, McDonough said the PCAOB "learned a great deal about quality control in the largest firms."

Under the Sarbanes-Oxley Act, the PCAOB is required to inspect firms that audit more than 100 public companies annually and to inspect the remaining registered firms with at least one public company client every three years. While full inspections began this year, the PCAOB, in an effort to earn the confidence of investors, launched its inspection program in 2003 with "limited procedures" inspections of the Big Four firms.

McDonough said the inspection reports have been made available to the four firms, which have 30 days to respond under SOX. Once the firms respond, the board finalizes its reports and delivers them to the Securities and Exchange Commission and to the appropriate state regulatory authorities. While certain portions of the reports will be made public, SOX requires the board to keep any criticisms of, or potential defects in, a specific firm's quality-control system confidential, as long as the firm corrects the problems within 12 months.

McDonough said the inspections provided "valuable information about the need for enhanced standards." "Although the limited number of engagements reviewed in 2003 prevented the board from drawing conclusions about systemic deficiencies in audits, we formed a concern that auditors may place insufficient emphasis on the importance of thorough documentation of audit work," he noted.

The focus of the first-year inspections was to conduct a "baseline assessment" of the firms' internal systems of quality control over auditing, including firm culture, the system by which partners and employees are compensated and promoted, internal controls over decision-making relating to auditing issues, and internal reviews of audit engagements.

McDonough noted that the Big Four firms audit more than 78 percent of all U.S. public companies, and that only eight U.S. firms have more than 100 public company audit clients.

The board has already begun full inspections of the largest firms and will continue those inspections through November. The inspections will focus on, among other things, efforts to detect fraud; control over compliance with independence requirements; the adequacy of documentation; efforts to identify, evaluate and manage risk; and compliance with professional auditing and accounting standards, McDonough noted.

In order to capture a significant sample of engagements at each firm, McDonough said the board will review approximately 5 percent of the Big Four firms' public company audits and 15 percent of the next four largest firms' public company audits, in addition to the small firm audits that it will select on a case-by-case basis.

-- Melissa Klein Aguilar

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