Washington (Aug. 27, 2004) -- Inspections of the Big Four firms revealed that the firms often either failed to catch or didn't appropriately address misapplications of generally accepted accounting principles by audit clients, the Public Company Accounting Oversight Board said.

The PCAOB, which issued its long-awaited reports on the board’s preliminary inspections of the Big Four on Thursday, said that, in many cases, the firms failed to catch a misapplication by the issuer of an Emerging Issues Task Force pronouncement related to the classification of long-term debt that in many cases resulted in restatements. In addition to errors in the application of GAAP that the firms either hadn't identified or failed to appropriately address, the PCAOB said that some of the audit engagements reviewed "involved some degree of departure from PCAOB standards or the firm's own quality control policies."

During a conference call with reports, 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 voluntary 2003 limited inspections examined compliance, quality control and selected public company audits in the national and regional practice offices of Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers. The inspections involved 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.

In June, PCAOB Chairman William McDonough told a House subcommittee that the inspections identified "significant" audit and accounting issues that were missed by the firms and identified concerns about significant aspects of each firm's quality controls systems.

However, in making the reports public, McDonough cautioned that the reports' emphasis on criticisms "do not reflect any broad negative assessment of the firms' audit practices.” Rather, he said, “In this first year, our 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."

“None of our findings has shaken our belief that these firms are capable of the highest quality auditing,” added McDonough, who said that the board is "encouraged by the firms' demonstrably cooperative attitude toward our inspections."

The reports are available at http://www.pcaobus.org/inspections. Under Sarbanes-Oxley, the PCAOB 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.

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 a firm's audit practice and its other practices, and the relationship between a firm's national office and its 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 said during the conference call yesterday. "Our conclusions have to be tentative because of the limited size of the inspections." However, he noted that the same was not true of the other areas that the board looked at.

Prior to the issuance of the final reports, the firms are given draft reports, to which they have30 days to respond. Portions of the report that are related to certain quality control issues, such as independence issues, are kept confidential, and firms have 12 months to respond. If the firms address the issues raised during that time, the confidential portions remain confidential 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 final inspection reports are also provided to the Securities and Exchange Commission and certain state authorities.

-- Melissa Klein Aguilar

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