The Big Four accounting firms, misinterpreting a nine-year old rule, wrongly let corporate clients understate liabilities and distort their financial health, the regulatory body for auditors said in a new report on Thursday.
The Public Company Accounting Oversight Board (PCAOB), in its first-ever inspection of the audit industry, also said the Big Four accounting firms failed to spot other audit and accounting problems in 2003 client audits.
The problems included inadequate documentation, wrong calculation of common stock and deferred taxes and underestimation of some contingent liabilities.
The PCAOB, created two years ago to tighten governance to the industry after several accounting scandals rocked Corporate America, assessed audits by PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte & Touche.
The group, appointed by the U.S. Securities and Exchange Commission, has the power to regulate and discipline U.S. audit firms.
The regulator, which examined policies, practices and procedures in auditing clients books, found the firms allowed clients to incorrectly classify some debt as a long-term liability.
By not properly classifying the debt, companies understated current liabilities and overstated working capital, distorting the financial position of the company to look stronger than it should have.
The guideline, set in place nine years ago, relates to revolving lines of credit agreements under which a company's balances are classified as current liabilities if the agreement contains certain clauses.
In several cases, the PCAOB staff asked the audit firms to convince their clients to restate financials statements during the inspection. PCAOB did not name the audit firms' clients.
The U.S. audit industry came under harsh scrutiny after audit firm Arthur Andersen collapsed when it was discovered Anderson did little to stop accounting fraud at bankrupt energy trader Enron Corp.
The PCAOB, headed by William McDonough, a former chief of the New York Federal Reserve Bank, has sought to impose more accountability on the industry.
Audit firms were also asked to inspect internal controls systems of their clients to ensure that all revenues and costs were properly documented and the risk of fraud was minimized, said the PCAOB, which will inspect methods used by audit firms.
In a statement McDonough said all four firms cooperated with the inspections. "None of our findings has shaken our belief that these firms are capable of the highest quality auditing," McDonough said.
The inspections were done between June and December 2003 and around 16 audit assignments were chosen. The PCAOB is also broadening the net to cover all audit firms that have at least 100 publicly-listed clients.
The Big Four said they agreed with the regulator's comments. "We view their observations as opportunities for improvement, which we are committed to implement," said Eugene O'Kelly, KPMG's chairman and chief executive.