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E&Y, KPMG, and the Meaning of Failure

Posted by Tim Reason | CFO.com | US

January 15, 2007 11:18 AM ET

We were surprised on Friday to get a strongly worded note from a reader objecting to the headline of Marie Leone's article on Failing Grades for E&Y, KPMG. The PCAOB, our reader noted, never said Ernst & Young or KPMG "failed the inspection." Well, that's true. And neither did CFO.com, for that matter.

But the PCAOB did use direct variations on the word "fail" (e.g., "failed," "failure") more than 25 times in each report — about the equivalent of once per page.

In both cases, the PCAOB also found that the firms failed to catch errors that "were likely to be material to the issuer's financial statements." We think the investors in those companies, at least, would be comfortable with our headline.

More surprising to us was that the PCAOB said it reviewed 365 audits by the nine largest firms. Chances are the larger firms underwent more reviews, but the PCAOB wouldn't tell Marie the exact numbers when she called to ask. (We're at a loss as to why this information ought to remain a secret from the press, investors, or public companies, but never mind that for now.)

Let's just say for sake of argument that the PCAOB did roughly 40 reviews per firm. E&Y and KPMG were found to have problems in 10 and 11 of the audited reviews, respectively. That would mean that, for just the random sample selected by the PCAOB, those firms had problems with 25 percent of their audits. (Perhaps our reader's point was that 75 percent correct is considered a passing grade in most grammar schools?)

If that back-of-the-envelope calculation is even close to right, it's pretty shocking, especially since so many of the failures seem to be related to ordinary GAAP issues rather than the contentious issue of internal controls. On the other hand, it's tough to know what to make of any of this. After all, these are year-old reports from a fledgling regulator that has been under heavy pressure to ease up on internal control audit requirements. Of course, that's exactly what the overtaxed and gun-shy world of auditing firms was focusing on last year. In the ideal world, the PCAOB would have a controls assessment help steer the focus of the GAAP audit. The reality seems to be that it detracted from it.

Comments (4)

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To me the key is not if the PCAOB, in their typically grandiose manner has used the word "failure" 25 times or 100 times, it is whether or not the opinions stand as issue. In fact, from what I can tell, nothing changed. That is, none of the audit opinions on those financial statements needed to be changed. Which is really what those firms were saying, again, that auditing procedures and the nature, timing and extent of those procedures are the subject of auditor judgment. And reasonable people can have different judgment. However, PCAOB has never been reasonable in its short life. They are always right, and seasoned judgment is to them a cover story for doing shoddy work.

These "findings" continue to demonstrate one stark truth, too often lost in all the rhetoric. Financial Statements, my friends, are FULL of estimates and judgements. Except for maybe the cash line item, EVERYTHING else is open to judgment, estimate, assumption and intrepretation.....auditing that perfectly is a no win situation. 10 companies will have 10 different results for the same thing, just the way it is. Doesn't necessarily mean its wrong, just means that management sees the business differently and has different judgment. As PCAOB, it is very easy to take fault with that.

I am not defending the auditors, their approach in the 1990's and early 2000's brought this situation on themselves. They are reaping what they sowed. But the PCAOB and its heavy handed approach are not the way to inspire change. Auditors will just tick even more boxes than usual to make the PCAOB happy.

Posted by Phil Klein | January 16, 2007 12:54am

Tim Reason's comments are very logical.

His comments (and those of the original article) are consistent with my own views that the auditors are more concerned with maximizing the contribution margin on audit billings from their diversified client portfolio by maximizing both audit billing rates per hour and work efficiency than with audit effectiveness of collecting sufficient appropriate audit evidence to support the unqualified audit opinions typically rendered.

The comments by a reader suggesting Tim Reason's comments are incorrect since financial statements are comprised of estimates and subject to auditor professional judgment are only partially true.

While estimates and professional judgment do exist, that does not necessarily mean that these should be open to manipulation to suit the needs of the business and the auditor. Those estimates are supposed to be rigorous such that they are a representationally faithful approximation of economic reality. Similarly, auditor professional judgment must be rigorous insofar as to be founded upon an ethical basis.

The problem remains that most auditors are more concerned with quantitative measurements and outcomes, even if they deny that fact by promulgating "strength beyond numbers", and this quantitative focus comes at the expense of not enacting virtuous ethical behaviours. A simple case in point is the business school student and auditor view of the Faculty of Arts. Philosophy, sociology, and psychology are important topics taught in that Faculty of Arts, which if understood by the business school student and the auditor, can provide great insight into the operation of labour, capital, and bond markets.

Instead, business school students and auditors denigrate the Faculty of Arts, with the sole exception of the acceptance of the quantitative subject matter of economics that is taught therein.

Posted by David Newman | January 16, 2007 07:31am

To be fair, it's worth pointing out that the PCAOB follows a risk-based methodology when selecting which audits to review. So saying they "failed" 25% of the inspected audits does not imply that sucha statistic should be projected to the whole population of their audits. Each of the audits covered was at the high end of the risk spectrum, at least in the PCAOB's opinion.

Posted by Chris Cornett | January 16, 2007 02:59pm

I think Tim's comments are certainly valid, although I would have to disagree with his approach to grading these firms at a 75% pass rate. Because the PCAOB does not share information on how many audits it selects from each firm, we really can't come up with a valid "pass" rate. We should look at each of these findings and whether any real issues arose (ie restatement) as a result of the PCAOB review. For KPMG, 2 out of the 11 issues resulted in a restatement. For E&Y, 1 out of the 10 issues resulted in a restatement. Since the PCAOB certainly reviewed more audits than what were identified in their findings, then these firms are still continuing to do their jobs.

Posted by Ryan Andersen | January 17, 2007 01:27am


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