PCAOB inspection reports that have been released to the public contain a variety of examples of audit engagements in which auditors have had difficulty 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 provide reasonable assurance about audit quality and (2) how it may improve audit quality.
b. Review the issue outlined in the preceding inspection report. 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. What were the major concerns of the PCAOB 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 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 framework for ethical decision making from Chapter 4, develop an appropriate course of action to pursue.