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PCAOB Issues First Inspection Reports

The PCAOB has issued reports on the limited inspections it conducted of the Big Four accounting firms in 2003. PCAOB Chairman William McDonough emphasized the benefits of the process rather than the audit and accounting problems that were revealed. SEC Chief Accountant Donald Nicolaisen issued a statement expressing disappointment in the PCAOB's findings, but adding that this first inspection report covered a period in which the firms were undergoing significant changes. The reports' emphasis on criticisms do not reflect a broad negative assessment of the firms' audit practices, according to McDonough. He lauded the firms' cooperation with the staff inspections with the goal of removing any impediments to the highest quality audit performance. McDonough noted in a news conference that Congress did a wise thing in creating the PCAOB.

Under the Sarbanes-Oxley Act, no portions of the inspection reports that deal with criticisms or defects in firms' quality control systems can be made public if they are satisfactorily addressed by the firm within 12 months. McDonough believes the confidentiality provision is a good thing. He said it imposes a form of discipline on firms, which he believes the drafters intended. Based on this limitation, the Board decided that the public portion of the inspection reports will not include any discussion of the firms' quality control systems. Any criticisms or defects cannot be discussed, so it may create a distorted or misleading impression, in the Board's view.

McDonough was asked the reason for the length of time it took to issue the inspection reports, given that the inspections took place between June and December 2003. He said the delay had a lot to do with him. It was important to get it right, McDonough said, and additional time was taken to improve the quality of the reports. The PCAOB is conducting 2004 inspections now, he added, and they will be rolled out as they are completed. The 2003 reports were a one-time event in which the PCAOB released all of the reports together for a previous year.

The reports include descriptions of the matters on which the staff focused during the inspections and of the issues identified in reviewing the firms' performance on selected audit engagements. The PCAOB advised in a news release that any descriptions of departures from professional standards are not the result of an adversarial adjudicative process and do not constitute conclusive findings of fact or violations for purposes of imposing legal liability.

While inspecting one of the Big Four firms, the staff discovered an engagement where the requirements of Emerging Issues Task Force No. 95-22 were not appropriately applied. The provisions relate to the balance sheet classification of borrowings outstanding under revolving credit agreements that include both a subjective acceleration clause and a lock-box arrangement. The staff then searched public databases to identify companies that may have had the same problem with improper application of EITF 95-22 in their financial statements. It uncovered problems in that area in engagements conducted by all of the Big Four accounting firms, and the companies that were identified issued restatements.

Ernst & Young LLP has issued an alert to its partners and staff to reemphasize the firm's guidance with respect to EITF 95-22. Deloitte & Touche LLP said that it is evaluating a process to prevent a recurrence and will modify its audit procedures and implement training once its evaluation is complete. KPMG LLP surveyed its issuer clients to determine whether others were misapplying EITF 95-22. It identified additional situations where the standard was misapplied and has issued technical guidance and practice aids to assist its professionals in meeting the criteria of EITF 95-22. PricewaterhouseCoopers LLC issued a practice alert with respect to EITF 95-22 and advised partners to consult with a subject matter expert in the national office whenever a client's revolving debt facility includes a lock-box feature.

Each of the firms' responses to their inspection reports were included. Among Deloitte & Touche's comments was a response to the documentation deficiencies the staff found in some of its engagements. Documentation is one of the most difficult challenges in the audit process, according to Deloitte & Touche. The firm is actively reviewing and revising its documentation policies and procedures to address the new PCAOB standards. However, the firm added that the emphasis on documentation should not come at the expense of improvement in the substance of the audit process.

Ernst & Young outlined a number of disagreements with the staff's conclusions about certain matters that departed from PCAOB standards or from E&Y's quality control policies. KPMG noted that in one engagement, the firm and the PCAOB did not agree on the appropriate generally accepted accounting principles and turned to the SEC for guidance. The SEC agreed with KPMG on the matter raised by the PCAOB, but questioned a different element of the treatment that ultimately required restatement by the issuer. Three knowledgeable, informed bodies reviewed the facts and reached different conclusions, according to the firm, which illustrates the complex accounting issues that registrants, auditors and regulators face.

The PCAOB advised in its news release that the inspections would provide a foundation for full-scale inspections and a baseline understanding of the firms' internal systems of quality control over auditing. PricewaterhouseCoopers wrote, however, that there was no baseline assessment of its audit quality, which was the Board's stated objective for the 2003 inspection procedures.

Nicolaisen, in his news release, said that he hoped the firms will take the findings seriously and will make a concerted commitment to improve their audit quality over the long term. He believes the PCAOB's process will lead to a sea change for the profession as it adapts to its newly regulated environment.