By Carrie Johnson
Washington Post Staff Writer
Friday, August 27, 2004; Page E01

Initial reviews of the nation's largest accounting firms have turned up numerous rule violations and shoddy recordkeeping practices, as regulators embarked on a new effort to regularly examine auditors' work.

The inspections mark the first independent scrutiny of the so-called Big Four firms, which had previously operated under more than 70 years of self rule. Congress mandated the examinations in a 2002 law designed to clean up the troubled accounting industry. Accountants' lax reviews and overly cozy relationships with clients have been blamed for fueling corporate scandals that wiped out billions in investments in the past few years.

Each of the biggest audit firms -- Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, and PricewaterhouseCoopers LLP -- has presided over at least one recent accounting blowup. A fifth, Arthur Andersen LLP, collapsed two years ago after being convicted of obstructing justice related to its work for Enron Corp.

Inspectors at the congressionally created Public Company Accounting Oversight Board fanned out across the country last year to examine a small sample of the Big Four's audits. Portions of their findings, which cite lapses in accounting rules and failures to preserve documents that back up auditors' work, were released to the public yesterday.

Board officials cautioned that the reports should not be considered a widespread "negative assessment" of the Big Four's audits. Together, the four firms review the books of more than 10,000 publicly traded companies. Inspectors stressed yesterday that they had reviewed fewer than 100 audits between June and December 2003.

"Our findings say more about the benefits of the robust, independent inspection process . . . than they do about any infirmities in these firms' audit practices," Chairman William J. McDonough said.

McDonough said the results of the inspections underscore the need for independent oversight of the accounting profession. "When Congress created the PCAOB . . . they did a very wise thing," McDonough said in an afternoon conference call.

Accounting scholars and industry experts who read the reports said they were surprised at their thoroughness, especially because board inspectors were operating at bare-bones staffing levels at the time.

"This is a clear signal from the accounting board that it is not business as usual," said Charles W. Mulford, an accounting professor at the Georgia Institute of Technology. "They found a lot with these audits and this report says, I think, there is a lot more to find."

Donald T. Nicolaisen, the Securities and Exchange Commission's chief accountant, said he was disappointed with the number of problems cited in the reports. He noted that the inspections were conducted at a time when firms were adapting to a new regulatory regime.

"Ultimately, I believe that the PCAOB's process will lead to a sea change for the profession . . . which is evolving and changing in what is now a regulated environment," Nicolaisen said.

The most oft-cited problem in the reports relates to how public companies treat credit agreements on their books. Inspectors said that across each of the four firms, auditors mistakenly allowed some client companies to classify certain debts as long-term rather than as current liabilities.

That "serious error" helps companies understate their current obligations and overstate the amount of their working capital, according to George H. Diacont, the accounting board's director of registration and inspections. Twenty companies restated their financial statements based on debt issues the inspectors found.

Inspectors also cited all four audit firms for faulty recordkeeping practices, which can make it difficult to determine how stringently the auditors checked such basic things as cash reserves and inventory.

Regulators criticized one firm for mistakenly rating the bookkeeping by a client company as involving a "normal" level of risk when the inspectors said it should have been treated with greater caution. Evaluating clients properly is crucial, because auditors ask more questions, review more documents and perform more computer and hands-on tests if they deem a client company to be risky.

But some of the most serious problems inspectors discovered may never come to light.

Under the 2002 Sarbanes-Oxley Act, audit firms have a year to correct deficiencies in what are known as "quality controls," such as how they reward top performers and how they win and keep clients, before the inspectors' critiques become public. Board officials declined to describe those findings yesterday, but a news release said problems with those areas were "significant" as well.

One aspect of the quality control process -- the closeness of an auditor's relationship with clients -- already has been the focus of widespread attention this year. Ernst & Young is serving a six-month ban on accepting new audit clients after an SEC administrative judge ruled the firm had compromised its independence by selling software with then-client PeopleSoft Inc.

"We are taking all appropriate steps to address all findings and resolve any concerns," James S. Turley, Ernst & Young's chief executive, wrote in a letter posted on the firm's Web site.

Another audit firm yesterday took the unusual step of releasing a brief summary of the secret portion of its inspection report, along with the firm's response to it. Among other steps, KPMG pledged to increasingly reward and evaluate tax specialists for their work on audits rather than for their success at bringing in new business.

A federal grand jury in Manhattan has been investigating aggressive tax shelters that KPMG sold to clients.

"We remain confident that KPMG's system of quality control is sound and that none of the accounting board's comments from their limited inspection represent systemic issues," Eugene D. O'Kelly, the firm's chairman and chief executive, said in a prepared statement.

Deloitte & Touche issued a statement saying the firm would "continue to strive to restore the public's confidence in our profession through all of our endeavors."

Raymond J. Bromark, a top partner at PricewaterhouseCoopers, said the firm welcomes the "constructive criticism of certain of our practices and procedures."

New, full-fledged inspections of the Big Four already have begun. Inspectors said they are evaluating a wider range of audits and including in their review four more firms that collectively audit more than 800 clients.

"Next year will be a lot more meaningful," said Dennis R. Beresford, an accounting professor at the University of Georgia and a member of three corporate boards. "This is just sort of a preview of coming attractions, I suppose."