Ramifications of Monday Morning Quarterbacking

If you go to the Web site of the Public Company Accounting Board, you can find the public version of reports describing in detail the results of the PCAOB's inspections of various accounting firms' auditing performance.

The reports are in a boilerplate format, and all describe the inspection process, as well offer as a caution against drawing conclusions about the competitive merits of firms based on the number of deficiencies found.

Two reports just came out on two of the Big Four firms. One was on KPMG, issued Sept. 29 and based on an field inspection from June to October 2004 at KMPG's National Office and at 11 of its 90 practice offices. The PCAOB found a number of deficiencies that included alleged failures by KPMG "to identify or appropriately address errors in the issuer's application of GAAP, including in some cases errors that appeared likely to be material to the issuer's financial statements."

The PCAOB identified 19 audits where it found what it considered significant deficiencies involving such issues as accounting for a sales-leaseback transaction, identification of securities as cash equivalents, accrual treatment of derivatives, too high a Summary of Unadjusted Difference threshold, and a failure to audit an issuer's goodwill impairment analysis.

KPMG's letter in response had its own boilerplate language, basically saying its respected that the PCAOB was doing a good job, and differed with some of the report's conclusions. KPMG did, however, indicate one of the companies whose audit was reviewed restated its financial statements because of what the inspection uncovered.

Deloitte & Touche's report, issued on October 6, was based on the PCAOB's field work from May to November 2004 at D&T's National Office and at 26 of its 64 practice offices. The PCAOB report states, "In some cases, the deficiencies identified were of such significance that it appeared to the inspection team that the Firm [D&T] had not, at the time it issued its audit report, obtained sufficient competent evidential matter to support its opinion on the issuer's financial statement."

The PCAOB reported on eight audits where it identified significant deficiencies involving such issues as overstatement of value for securitization transactions, failure to identify and address errors with regard to impairment charges and cash flow, improper treatment of a line of credit, misclassification of lease incentives, and an incomplete evaluation of an issuer's ability to continue as a going concern.

As was the case with the KPMG response, D&T's letter was very respectful, and indicated the firm was taking any necessary steps to address the matters in the report, and it disputed some of the PCAOB's conclusions. D&T also indicates in four of the audits the companies restated their financial statements.

It's almost like a dance with prescribed steps. The reports are all in the same format, and, until they get to the particulars of individual audits, seem to talk in generalities. The responses are also scripted, showing the proper deference and respect, acknowledging some mistakes, disputing some conclusions, and assuring everyone that improved procedures are in place to assure continued, high quality audits.

The reports are evident of the new world that audit firms live in. Besides the inspection, there is public disclosure of some of their alleged mistakes. Although the names of the public companies aren't given, great detail is provided about the exact nature of the alleged audit misdeeds.

I wonder how this going to play out. For example, is this great ammunition for a plaintiff's lawyer suing an auditor? And what about the other audited clients of the firm? Do those companies' audit committees have any duty with regard to their scrutiny and review of its audits?

Monday morning quarterbacking is easy when you talking about a coach's decision in Sunday's game and with very few ramifications except to promote heated water cooler discussion. I don't think that will be the case with the PCAOB reports. Besides the liability and corporate governance issues, I see them as being used by CPA firms in a competitive effort to dislodge another firm as the auditor of a public company that's being sought as a future client.

Time will reveal the exact ramifications of these reports. But unlike those water cooler discussions, the PCAOB's Monday morning quarterbacking might directly contribute to the economic demise of a number of firms.

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