Regulators handed out blistering reviews to Big 4 audit firms PwC and KPMG in their latest inspection reports, flagging a dramatically increased number of failed audits and uncovering problems that led to at least two restatements.

The Public Company Accounting Oversight published inspection findings for PwC and KPMG, the first reports for major firms from the 2010 inspection cycle, listing problems with 28 of 75 audits analyzed at PwC and 12 of 54 audits scrutinized at KPMG. The inspections were conducted in 2010 to study audit reports issued on 2009 financial statements, and it included a handful of audits where the firms participated but were not the principal auditor. By comparison, the PCAOB criticized only nine of 76 PwC audits inspected in the prior year and only eight of 60 KPMG audits in the prior year.

For both firms, inspectors noted numerous instances of problems with the testing and disclosures related to fair value measurements and hard-to-value financial instruments and with goodwill impairment. In KPMG's case, the reports notes a number of concerns about allowances for loan losses, receivables, and payables, all frequently identified as judgment-laden, hard-to-define areas in accounting and auditing rules, especially through the financial crisis and economic downturn.

Close calls aside, however, the reports also note some audit problems in areas that aren't typically flagged with great frequency in major firm reports – like excessive reliance on management representations, entity-level controls, valuation specialists, internal auditors, and even foreign affiliate audit firms. The PCAOB even flagged one instance where PwC failed to challenge manual journal entries that could be indicative of fraud. The report on PwC says two of the firm's clients restated their results as a result of inspection findings, and one made substantial adjustments.

The PCAOB cautions against extrapolating failure rates because of the board's risk-based process for selecting audits for inspection, meaning inspectors know where they are most likely to find problems so they plan their inspections accordingly. However, even PwC acknowledges the increase in the number of problem audits, which jumped from 12 percent of audits inspected in the 2009 report to 37 percent in the 2010 report. “We are focused on the increase in the number of deficiencies in our audit performance reported in the 2010 PCAOB inspection over prior years,” said Robert Moritz, PwC chairman and head partner, in a written statement. "We are working to strengthen and sharpen the firm's audit quality, including making investments designed to improve our performance over both the short- and long-term.”

For KPMG, the number and percentage of troubled audit also rose in its most recent cycle, from 13 percent of audits in 2009 to 22 percent in 2010. “I couldn't say why the number has gone up this particular year,” says firm spokesman George Ledwith. “Some years it has gone up and others it has gone down. However, I do know that we have taken a series of steps to address any deficiencies identified by the PCAOB.” That includes enhancing guidance and tools related to the auditing of fair value measurements as well as disclosures of financial instruments where fair values are not easily determined, he said.

In their response to the PCAOB, Moritz and US assurance leader Tim Ryan said the firm is taking remedial measures to reinforce tone at the top, stressing independence, objectivity, professional skepticism, and accountability for audit quality. The firm is requiring seasoned partners to spend more time on audits and tasking them to help improve audit methods. The firm is getting more full-time auditors involved in internal inspections, enhancing training in areas involving complex judgments, and modifying its performance review and compensation models to “more explicitly recognize individuals for achieving our audit quality objectives,” Moritz and Ryan wrote.

Lynn Turner, former chief accountant at the Securities and Exchange Commission and an adviser to the PCAOB, says the inspection results suggest firms relaxed their audits a little too much after the initial fury and push-back over Sarbanes-Oxley implementation. “They've lowered their audit fees and are getting competitive all over again,” he says. “They went out and did a bang-up job in the middle part of the last decade, and companies went ballistic. So the response to that is you get what you ask for.”