Here's a warning to all audit firms: the Public Company Accounting Oversight Board has signalled that it will target securitized mortgage loans and collateralized debt offerings when it inspects 2007 annual reports.

That's come out clearly in its latest report slamming the way Ernst & Young went about auditing an undisclosed originator of mortgage loans.

The concerns raised by the PCAOB are valid given that these are the audits that are the most high risk and that Wall Street has been forced to write down billions of dollars because of the difficulties valuing securities linked to the subprime mortgage debacle.

Part of the problem is that fair value accounting requires those assets and liabilities to be based on how much they are currently worth, and not on historical values. The problem is that values can be based on a price quote in an active market. But if there's no active market, it has to be based on management's best estimate derived from mathematical models. Which means they are hard to value and that creates a headache for the audit firms.

Presumably, the PCAOB will also be looking at off-balance sheet transactions.

The PCAOB has fired a shot across the bows of all audit firms. Auditors are on notice: the PCAOB has you in its sights.