PCAOB Issues Long-Awaited Report On Big Four

The Public Company Accounting Oversight Board has completed its first-ever inspections of The Big Four accounting firms, and the results—though not a surprise—are not exactly pretty.

Though PCAOB Chairman William McDonough went out of his way to praise the firms for their cooperation and noted that "none of our findings has shaken our belief that these firms are capable of the highest quality auditing," the Board still found the firms missed significant audit and accounting issues in the financial statements of their clients.

According to the inspection reports (available from box at right), the firms—PricewaterhouseCoopers, Deloitte & Touche, KPMG, and Ernst & Young—failed to identify or address certain errors in the application of GAAP, and failed to catch long-term debt classification errors that in some cases led to restatements.

SEC Chief Accountant Donald Nicolaisen was one of many regulators and industry experts who voiced dissatisfaction over the Big Four's inspection results. "While I am disappointed with the findings of the reports," he said, "it is important to keep in mind that this is the first inspection which covers a period during which the firms were undergoing significant change following the July 2002 enactment of the Sarbanes-Oxley Act."

No Surprises, Grades

The reports shouldn't be a surprise to the firms or their clients.

Back in June, McDonough testified before a House subcommittee that, "Although we only reviewed a small number of engagements in 2003, we identified significant audit and accounting issues" (testimony also available from box at right).

During a media call last week, McDonough noted that the conclusions in the inspections were not complete. These initial "limited" inspections are meant to provide a baseline understanding of the firms' internal systems of quality control for future final inspections.

PCAOB Director of Registration and Inspections George Diacont also noted that the inspection reports should not be construed to be a rating system for The Big Four. "The purpose of the inspections is not to provide a grading system to measure the one firm against the other," he said during the media call. "We’re in the midst of a process that we expect to bring about meaningful changes in audit practice. It’s certainly not an effort to grade the firms."

The Inspections

The inspections, which were conducted between June and December 2003, examined compliance, quality control and selected public-company audits in the national and regional offices of the Big Four.

During reviews of the selected audits, the PCAOB claims its staffers reviewed a variety of subjects including:

Revenues;

Reserves Or Estimated Liabilities;

Related Party Transactions;

Supervision Of Work Performed By Foreign Affiliates;

Assessment Of Risk By The Audit Team; and

Journal Entries And Adjustments.

In addition, the PCAOB reviewed seven functional areas at each firm, including:

Tone At The Top (including more than a dozen document types, from meeting minutes and audit proposals to executive speeches and internal publications);

Partner Evaluation, Compensation, Promotion And Responsibility;

Independence Policies;

Client Acceptance And Retention Policies;

Internal Inspection Program;

Practices For Developing And Communicating Audit Policies And Procedures;

Policies Related To Foreign Affiliates.

Universal Problems

The PCAOB 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."

Though the number of incidents varied among firms, the language employed by the PCAOB in each of the reports was nearly identical, as is illustrated in the excerpts below:

Deloitte & Touche, Excerpt From "Observations Concerning Audit Performance"

In some of the engagements reviewed, the staff identified errors in the application of GAAP that Deloitte had either not identified or not appropriately addressed during the

audit. In addition to those engagements, the staff's prompting of Deloitte to review the potential misapplication of EITF 95-22 by other audit clients led to

identification of three additional engagements in which that GAAP error occurred, resulting in restatements in each of those cases. In addition, some of the audit

engagements reviewed were found to involve some degree of departure from PCAOB standards or Deloitte's own quality control policies.

Ernst & Young, Excerpt From "Observations Concerning Audit Performance"

In some of

the engagements reviewed, the staff identified errors in the application of GAAP

that E&Y had either not identified or not appropriately addressed during the audit.

Specifically, the staff's prompting of E&Y to review the potential misapplication of

EITF 95-22 led to identification of seven engagements in which that GAAP error

occurred, resulting in restatement in three of those cases. In addition, some of

the audit engagements reviewed were found to involve some degree of departure

from PCAOB standards or E&Y's own quality control policies or both.

KPMG, Excerpt From "Observations Concerning Audit Performance"

In some of

the engagements reviewed, the staff identified errors in the application of GAAP

that KPMG had either not identified or not appropriately addressed during the

audit. In addition to those engagements, the staff's discovery of one error

prompted a systematic review by KPMG in which it determined that its auditors

had overlooked the same error in the financial statements of other clients. In

addition, some of the audit engagements reviewed were found to involve some

degree of departure from PCAOB standards.

PricewaterhouseCoopers, Excerpt From "Observations Concerning Audit Performance"

In some of

the engagements reviewed, the staff identified errors in the application of GAAP

that PwC had either not identified or not appropriately addressed during the

audit. In addition to those engagements, the staff's prompting of PwC to review

the potential misapplication of EITF 95-22 by six other audit clients led to three of

those issuers restating their financial statements. In addition, some of the audit

engagements reviewed were found to involve some degree of departure from

PCAOB standards or PwC's own quality control policies or both.

Each of the reports provided greater detail on the audit performance "deficiencies" identified by the Board. Most were related to the presence of GAAP exceptions—all of which were "immaterial," though they may result in enhanced future disclosures—or departures from PCAOB or firm quality standards.

Documentation deficiencies were also common, although the PCAOB noted the deficiencies "did not render the audit as a whole deficient."

Response And What's Next?

Each of the Big Four received a copy of the report and submitted comments before it was released. The comments are included in the documents above, right.

In the comments, each of the firms noted that they supported the PCAOB and its process, but some were concerned that the inspections' small sampling would inaccurately reflect the firm's overall quality. "We are concerned," wrote PwC in its response letter, "that the draft report—by concentrating on a relatively few number of identified issues—does not adequately portray the overall high level of audit quality that exists within our firm."

Others used the comment letter as an opportunity to demonstrate how the firm would act on the Board's findings. For example, while all the Big Four failed to catch certain long-term debt classification errors, KPMG went out of its way to ascertain whether other engagements might have been impacted by the PCAOB's findings. "In collaboration with the PCAOB staff," the firm wrote, "KPMG immediately conducted a survey of issuer clients to determine if other issuers might be misapplying EITF No. 95-22," which is the relevant Emerging Issues Task Force pronouncement.

Ernst & Young also "issued an alert to our partners and staff" to reemphasize new guidance on the topic.

The final inspection reports will be provided to the Securities and Exchange Commission, certain state authorities and the firms themselves. The firms will have 12 months to address any of the issues raised in the reports.

In addition, if the PCAOB discovers significant problems as part of its inspections, it will refer them to proper authorities. However, the Board would not disclose whether that was the case. "As a process matter, if we find information in an inspection that warrants launching investigations or referring it to the SEC, we will do that," noted PCAOB Associate General Counsel Michael Stevenson, "but we don’t comment publicly on whether we’ve done that."

Now that the 2003 "limited" inspections are being processed, the PCAOB will be focusing on its first "full inspections" for 2004. The Big Four will be subject to those inspections, as will four additional firms: Grant Thornton, BDO Seidman and Crowe Chizek, and McGladrey & Pullen.

Firms with fewer than 100 public company audit clients will be inspected every three years.