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Failing Grades for E&Y, KPMG

PCAOB inspections reveal the Big Four auditors were tripped up on auditing procedures related to run-of-the-mill GAAP items.
Marie Leone, | US
January 12, 2007

The Public Company Accounting Oversight Board issued its 2005 inspection reports on Ernst & Young and KPMG on Thursday, citing multiple failures in audits by the two Big Four audit firms. The report on E&Y identifies 10 companies for which audits were deficient, and says that in "some cases" the errors appeared "likely to be material to the issuer's financial statements." The report on KPMG identifies 11 deficient audits, and says that in "one case" the result was likely to be material.

In 2005 the PCAOB reviewed portions of more than 365 audits performed by the nine largest firms and 623 audits performed by 272 smaller firms. A PCAOB spokesman told that the regulator does not release information on the number of inspections it conducts on each individual firm.

The PCAOB, created by the 2002 Sarbanes-Oxley Act, inspects public accounting companies to identify and address weaknesses and deficiencies related to how a firm conducts audits. Part of the inspection is based on how the auditors conform to the highly contested Auditing Standard No. 2 (AS2), which focuses on a public company's internal controls. The PCAOB is planning to replace AS2 with AS5, a new standard released for comment on December 19. In its reports, the board concedes that AS2 is not working well. "Audits performed under the difficult circumstances of the first year of implementation of AS No. 2 were often not as efficient as the standard intends," wrote the inspectors.

However, 20 of the 21 deficiencies cited in the E&Y and KPMG reports were not directly related to controls problems. Instead, the board reported problems with the firms' audits of run-of-the-mill accounting issues. Among the problems the PCAOB took the auditors to task for were poorly conducted audits related to lease and tax accounting, as well as revenue recognition and goodwill impairment testing. In fact, PCAOB inspectors concluded that both E&Y and KPMG failed "to identify or appropriately address errors in the issuer's application of GAAP." Those errors, it noted, were likely to have resulted in material misstatements by one of KPMG's clients and several of E&Y's clients.

In some cases, the deficiencies identified "were of such significance" that PCAOB inspectors deduced that at the time of the audit, E&Y and KPMG "had not obtained sufficient competent evidential matter to support [their opinions] on the issuer's financial statements." The PCAOB emphasized, however, that when an audit firm is cited in an inspection report for having a deficiency, it does not mean the problem remains unaddressed. In fact, under PCAOB standards, audit firms must take appropriate action to assess the deficiency and support its existing audit opinion.

Response letters from E&Y and KPMG issued as part of the reports noted that both firms responded to the criticism by performing added audit procedures and improving documentation. In a general response that covered all of KPMG's deficiency notices, the auditor asserted that judgment plays a part in the auditing process and that reasonable professionals might differ on what specific tests and documentation are needed. Meanwhile, E&Y stated that while it did not always agree with the regulator's assessment of its audits, it recognized the report as having a "constructive" intent. E&Y itemized its responses, answering each PCAOB charge separately.

In every case but one, E&Y took additional action. Neither auditor changed any of its audit opinions as a result of the PCAOB report or additional work.

Although the PCAOB did not identify audit clients by name, it did break down the deficiencies on a case-by-case basis. What follows are excerpts and details from the regulator's reports.

From the Ernst & Young PCAOB Inspection Report

Issuer A: The auditor failed to appropriately address departure from GAAP.
The issuer revised its inventory standard costs "to include certain indirect costs that it had previously expensed when incurred." Instead of recognizing the effect of the accounting change, company chose to "amortize the effect of the accounting change into net income on a straight-line basis over a six-year period."

Issuer B: The auditor failed to appropriately address the company's departure from GAAP.
The issuer "incorrectly classified a gain on the sale of an interest" in a joint venture as part of operating income.

Issuer C: The auditor failed to test the operating effectiveness of information-technology controls.
The issuer's technology-intensive business includes processing large volumes of customer data. The auditor failed to test "the completeness and accuracy of computer-generated information that it used to perform audit procedures on revenue and accounts receivable." In addition, the auditor did not perform "sufficient substantive audit procedures with respect to revenue, including unbilled revenue."

Issuer D: The auditor failed to document evidence that it performed sufficient audit procedures with regard to tax contingencies.
The matters in question included the issuer's basis for accruing certain significant income tax contingencies, its policy on releasing reserves for income-tax contingencies, and its conclusion that no reserve was required for certain items identified as disallowed in an Internal Revenue Service audit.

Issuer E: The auditor failed to obtain sufficient evidence to support its audit opinion.
The issuer exchanged certain debt for debt with a lower interest rate and extended maturity, plus cash. However, there was no evidence that the auditor performed procedures to test the issuer's accounting for the debt exchange. Also, related to a merger, the issuer assumed convertible debt securities, and certain terms and features of the hybrid securities were changed. "The auditor failed to evaluate the effect of the changes on the accounting for the securities."

Issuer F: The auditor failed to provide evidence that it had performed sufficient procedures to evaluate valuation models used for goodwill impairment testing.
There was no evidence that the auditor evaluated the overall appropriateness of the valuation model, or had tested certain significant assumptions.

Issuer G: The auditor failed to perform sufficient procedures with respect to using the findings of a fair-value specialist.
Regarding the fair-value calculation of in-process research and development, there was no evidence that the auditor obtained an understanding of certain critical methods and assumptions used.

Issuer H: The auditor failed to perform sufficient procedures to evaluate the financial statement classification of the issuer's reversal of a contingent tax accrual.
The issuer had disposed of a business and included the net gain on disposition in discontinued operations. But there was no evidence that the auditor had performed sufficient procedures, such as analyzing whether the components of the reserve related to the sold business or to other matters; or whether the reversal of the contingent tax accrual should have been reported as continuing operations or discontinued operations.

Issuer I: The auditor failed to perform procedures to evaluate whether the amount of a recorded pension liability was appropriate.
The issuer retained a liability for postretirement benefits of certain former employees of businesses it had sold. Although the auditor tested the amount recognized for the year, it did not perform procedures to evaluate whether the amount of the recorded liability was appropriate.

Issuer J: The auditor failed to perform sufficient procedures with respect to using the findings of a fair-value specialist regarding in-process research and development.
The auditor failed to appropriately evaluate the issuer's accounting related to a lawsuit settlement with another company.

From the KPMG PCAOB Inspection Report

Issuer A: The auditor failed to identify whether tax savings could be recognized under GAAP.
The issuer was unable to obtain the necessary support for a deduction on its tax return, and therefore did not recognize any of the tax savings in its 2004 financial statements. After a tax adviser issued an opinion letter, the issuer recognized 100 percent of the tax savings in the first quarter of 2005.

Issuer B: The auditor failed to obtain sufficient evidence to support its audit opinion.
The auditor did not conduct evaluation of whether vendor-allowance accounting errors spread to other contracts. In addition, there was no evaluation of whether the issuer's "reliance on historical cash flows to produce goodwill impairment estimates" was appropriate.

Issuer C: The auditor failed to provide evidence of evaluation of the issuer's lack of disclosure about accounting and tax changes.
The issuer changed its method of accounting for certain inventories, which had the effect of "reducing the income taxes by over ten percent and increasing net income by over three percent." The issuer did not disclose the change or tax savings.

Issuer D: The auditor failed to obtain evidence that it addressed a discrepancy in "average remaining useful lives" estimates.
The issuer calculated depreciation "for most of its property, plant, and equipment using the composite method," but used the same ARL estimates in 2004 that it used in 2003.

Issuer E: The auditor failed to obtain sufficient evidence to support its audit opinion.
The issuer determined that "its allowance for doubtful accounts had been understated in prior years." The company corrected the error, but the auditor "incorrectly concluded that the adjustments represented a change in estimate," and therefore failed to evaluate whether the error had a material effect on prior years' financial statements. Also, the auditor failed to sufficiently evaluate modifications to seven leases, and its journal-entry testing (used to address fraud risk) did not comply with auditing standards.

Issuer F: The auditor failed to obtain sufficient evidence to support its audit opinion.
The issuer operated in more than 250 locations, but the auditor analyzed revenue at the companywide level. To test accounts receivable, the auditor performed substantive analytical procedures rather than sending confirmation requests. The auditor also "did not test inventory transactions between the dates of the interim physical inventory observations and year end, nor did it compare interim balances with the year-end inventory balances."

Issuer G: The auditor failed to provide evidence that it had evaluated revenue-growth assumptions issuer used in financial forecasts.
The issuer prepared a goodwill impairment analysis for each of its four units using a third-party valuation specialist that relied, in part, on financial forecasts prepared by the issuer. However, future revenue growth was inconsistent with issuer's historical performance, and the audit documentation indicated that previous forecasts for these units had been adjusted downward.

Issuer H: Given the significant risk of material misstatement associated with revenue, the auditor did not obtain sufficient evidence that analytical procedures met requirements for substantive analysis.
The auditor procedures to test a significant portion of the issuer's revenue "consisted primarily of tests of controls, high-level analytical procedures, clerical reconciliation procedures, journal entry testing, and testing a sample of transactions that were recorded in the last five days of the year for proper sales cut-off." However, the auditor failed "to examine subsequent cash receipts, shipping documents, or other evidence that would allow it to evaluate the existence of accounts receivable."

Issuer I: The auditor failed to provide evidence that sales contracts were evaluated and met revenue-recognition criteria.
Sales of land represented approximately 26 percent of the issuer's revenue for the year.

Issuer J: The auditor failed to test accounts receivable that had not been collected.
The auditor concluded that the confirmation of accounts receivable at a significant division of the issuer "would not be effective." But the auditor did not perform appropriate alternative procedures because it "did not select a sample of the accounts receivable to test; it selected a sample of recorded cash."

Issuer K: The auditor failed to perform sufficient procedures to test the data and assumptions that the issuer provided.
Based on data provided by a valuation consultant, the issuer concluded that an adjustment to a subsidiary's carrying value was not required. The auditor's procedures consisted "primarily of obtaining and relying upon representations from management regarding the appropriateness of the data and assumptions without assessing their reasonableness."

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