One of the fundamental changes that occurred upon passage of the Sarbanes-Oxley Act of 2002 is that the audit profession is no longer allowed to be self-regulatory. Now, the Public Company Accounting Oversight Board (PCAOB) has the authority to assess whether audit firms are conducting high quality audits. To make that assessment, the PCAOB conducts formal inspections of audits completed by audit firms registered with the PCAOB, and the result of those inspections is made public on the PCAOB's web site (http://www.pcaobus.gov and follow the links to inspection reports).The inspection teams select certain higher-risk areas for review and inspect the engagement team's work papers and interview engagement personnel regarding those areas. In addition, the inspection teams analyze potential adjustments to the issuer's financial statements that had been identified during the audit but not recorded in the financial statements.
The reports that have been released to the public contain a variety of examples of audit engagements in which auditors have had difficulty in dealing with potential adjustments to client financial statements. One example of such an audit quality problem is evident in the inspection report of Ernst & Young LLP (November 17, 2005), which states:
The Firm proposed a judgmental audit adjustment (which the issuer recorded) to increase the issuer's reserve for excess and obsolete inventory, even though the Firm's work papers did not include documentation supporting percentages used to estimate this reserve. After the Firm proposed this audit adjustment, the issuer's chief executive officer proposed an adjustment to increase the value of inventory received in a bankruptcy settlement, which was contrary to the issuer's earlier conclusion that the bankruptcy settlement accounting would result in no gain or loss. This adjustment was equal to and offset the excess and obsolete inventory adjustment described above. The Firm failed to assess, or failed to include evidence in the work papers that it assessed, whether the offsetting adjustments described above and another set of offsetting year-end adjustments relating to the accounting for major construction contracts (which in total approximated 24% of the issuer's pre-tax income) indicated a bias in management's estimates that could result in material misstatement of the financial statements, and/or a need for the Firm to reevaluate planned audit procedures.
a. Comment on the PCAOB's inspection process, focusing on (1) why it may be needed to assure audit quality and (2) how it may improve audit quality.
b. Review the issue outlined in the inspection report above. Summarize the actions of the client, and the corresponding actions of Ernst & Young. Discuss the income statement implications of the journal entries that are at the center of this inspection comment.
c. Why do you think that the PCAOB was concerned about this issue?
d. Assume that you were the audit manager on the Ernst & Young audit engagement detailed in the inspection report. Assume also that you knew that the audit partner had agreed to allow the client to pursue the offsetting series of journal entries that are the subject of this case. Using the ethical decision-making framework (which is based on Utilitarian Theory and Rights Theory) from Chapter 3, develop an appropriate course of action to pursue.