Smaller audit firms are making progress in reducing their audit failure rates, but the rates are still too high to satisfy the Public Company Accounting Oversight Board.

In a report summarizing the board's observations after reviewing inspection data from 2007 through 2010 for smaller audit firms, the board says 44 percent of smaller audit firms had at least one “significant audit performance deficiency” compared with 61 percent from 2004 through 2006. Of the individual audits inspected, 28 percent had at least one significant performance deficiency, or audit failure, in the most recent three years compared with 36 percent in the prior three years. The PCAOB considers a significant deficiency to be an audit opinion that is not adequately supported by audit evidence.

The report focuses solely on the 500 or so U.S. firms that audit fewer than 100 publicly listed entities, and therefore are subject to PCAOB inspection only once every three years. According to the PCAOB, those firms collectively audit more than 4,600 public companies with a combined market capitalization of approximately $115 billion. The report also suggests firms made some improvements from their first inspection to their second, with a reduced number of firms showing problems on their second inspection compared with their first inspection.

The board is concerned that while the failure rate is dropping, it's not dropping fast enough or far enough. “Even though we are seeing the trend go down, these are significant,” said PCAOB member Jeanette Franzel in a briefing to the media. Franzel noted that 2011 inspection data provides no evidence of any further improvement from the three years of data contained in the report. She said the board will continue to monitor inspection results, and “to the extent we do not see improvements, the board will need to take further actions to improve the audits of public companies for the protection of investors.”

Despite the call for improvement, the PCAOB doesn't define a target failure rate that it would consider satisfactory. “We're not there yet,” said Franzel. “Certainly the current level is too high.” PCAOB member Jay Hanson, also speaking at the media briefing, added the board has not set a “pre-ordained number” for what it would consider acceptable, although “we have no illusions we'll ever hit zero.” Hanson said the board is encouraged that many firms exhibited very few failure findings. “If we could get more firms in that bucket, we would feel a lot better about it,” he said.

The board recently published a separate report summarizing its inspection findings regarding the largest firms and their challenges in auditing internal control over financial reporting, and it made a similar call for improvements. Later this year, the PCAOB plans to publish another report summarizing observations of the largest firms and their audits of financial statements, Franzel said.