NEW YORK (Reuters) - The biggest U.S. audit firms are failing to properly test some companies’ financial controls, one of the main bulwarks against fraud, an audit watchdog group said on Monday.
In a broad review of the “Big Four” and second-tier audit firms, the Public Company Accounting Oversight Board said problems are numerous and growing in audits of companies’ internal controls - the main method used to keep accurate books.
Tests of internal controls were among the requirements of the 2002 Sarbanes-Oxley Act, which Congress passed to curb abuses after accounting scandals at Enron Corp and other companies. The Act created the PCAOB to oversee audit firms.
Controls can range from such simple procedures as checking purchase orders and invoices before making payments, to proper security procedures for computers, such as passwords and restricted access.
Audit firms are required to test controls that could have an impact on financial statements and attest that the safeguards are adequate, but in many cases the companies in which the auditors gave passing grades, the PCAOB found there was insufficient evidence to support that opinion.
Internal control checks were deficient in 22 percent of audits inspected in 2011, up from 15 percent in 2010, the PCAOB said. But, it said 2011 inspection reports have yet to be completed.
Audits of internal controls have improved financial reporting overall, but “the trend is going in the wrong direction,” PCAOB board member Jeanette Franzel told reporters.
The PCAOB looked at internal control checks by the “Big Four” audit firms - Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers - plus second-tier firms BDO Seidman, Grant Thornton, Crowe Horwath and McGladrey.
The firms either did not immediately respond to calls from Reuters seeking comment or referred questions to the Center for Audit Quality (CAQ), which represents audit firms.
The growing audit deficiencies do not mean that companies’ controls were inadequate, just that auditors were not properly checking them, said board member Jay Hanson. He discounted complaints by auditors that PCAOB inspectors had become too demanding.
“We are not by any stretch requiring busy work,” he said. In some cases, auditors were not doing things required by their own firms’ policies, he said.
CAQ Executive Director Cindy Fornelli said in a statement that the firms realized they need to improve and “devoted significant additional resources” to that area over the past year.
Internal control lapses figured in high-profile accounting problems at a number of companies in recent years, including: Diamond Foods and MF Global.
The main areas where controls were not properly tested were revenue, inventory, fair value of financial instruments, and valuation of pension plan assets, the PCAOB said. Revenue is the leading source of financial fraud.
When internal controls are unchecked, companies can more easily cover up improper accounting, the PCAOB said.
The internal controls audit was one of the most controversial parts of Sarbanes-Oxley and sparked complaints from businesses that it would drive up audit costs.
In response, the PCAOB in 2007 issued a new standard urging auditors to be more selective in how they reviewed controls. The standard allowed auditors to scale back internal control tests based on risk and rely more on broad, company-wide controls rather than test specific procedures.
Workload pressures may be contributing to the problems with control tests, the PCAOB said. In some cases where control audits were deficient, the PCAOB found that the audit firm had reduced staff.
Reporting by Dena Aubin; Editing by Howard Goller and Leslie Gevirtz