What is the Public Interest?

It’s been about 18 years since Congress created the Public Company Accounting Oversight Board in response to widespread fraud in the financial statements of the likes of Enron and WorldCom. Given the high rate of audit deficiencies identified in PCAOB inspections of public company audits, the time is right to evaluate the pluses and minuses of the PCAOB and where we should go from here.

This matter has taken on a new urgency because of reports that the Trump administration seeks to eliminate duplication of effort by folding the PCAOB into the SEC. This is consistent with the elimination of regulations/regulators in other areas where oversight of an industry exists.

Mission of the PCAOB

The mission of the PCAOB is to “…oversee the audits of public companies, protect the interests of investors and further public interest in the preparation of informative, accurate and independent audit…”

The PCAOB was established in 2002 as an independent watchdog, essentially to audit the auditors and make sure audit quality is at the highest levels and investors are adequately protected. To be sure, it is a daunting task and the Board is underfunded.

The PCAOB inspects about 200 audit firms each year including Big-4 firms, other firms  with public company audits and foreign firms. On average, about one-third of the inspections identify audit deficiencies including those of internal controls over financial reporting (ICFR), assessment of audit risk, auditing estimates and other areas that represent deficiencies in audit quality controls and identifying material misstatements in financial statements.

Audit Deficiency Rates

The audit deficiency rates of the Big-4 firms for 2017 were: Deloitte (20%), PwC (24%), Ernst & Young (31%), and KPMG (50%).

The high rate of deficiency in KPMG warrants further attention. On January 22, 2018, it was announced that a former PCAOB staffer, Brian Sweet, who was hired by KPMG in 2015, leaked confidential information about PCAOB's plans to audit the company. Most of the leaked information concerned which audit engagements the PCAOB planned to inspect, the criteria it was using to select engagements for inspection, and on what these inspections would focus. KPMG was motivated by reducing the deficiency rate. Having inside information enabled it to tweak the workpapers and “improve” audit quality. We should question whether the Board’s own quality control standards were violated, as seems likely, and what can be done to eliminate such violations in the future.

Regulatory Responses

The Project on Government Oversight (POGO), in conjunction with other auditing watchdogs and whistleblowers, recently sent letters to the leaders of the U.S. House Financial Services Committee and its Investor Protection, Entrepreneurship and Capital Markets subcommittee encouraging them to hold a hearing on what the watchdogs described as failures of the PCAOB. They warned about the risks of those failures to the financial markets and broader economy.

Should the PCAOB be abandoned? One concern is that potential fraudsters would be emboldened if the PCAOB went away. The mere existence of an independent regulator serves as a check on fraudulent financial reporting and the independent audit.

The PCAOB has done some useful things to bolster its inspection effort including issuing audit quality indicators (AQIs) to encourage and monitor uses of AQIs by firms, audit committees and other regulators.

The Center for Audit Quality (CAQ) also issues updated auditor assessment tools that offer evaluation questions for audit committees to consider asking about certain thematic areas of audit quality.

Given the high rates of audit deficiency in Big-4 firms and concerns about audit quality, tension has risen between auditors and PCAOB regulators over the scope of inspections, particularly ICFR. One problem for the firms is they have to discuss these matters with the audit committee. These can’t be comfortable discussions and any effort to increase transparency might further divide the firms and the audit committee on what needs to be done to respond to the deficiencies. Will it cost more money to bolster audit procedures?

Reconfiguring the PCAOB

Rick Kravitz, the Editor-in-Chief of The CPA Journal, examines the historic role of the PCAOB and current issues in an essay published by the Public Interest Section of the American Accounting Association. He identifies two suggestions for reconfiguring the Board as follows.

1. PCAOB could become an NTSB (National Transportation Safety Board) type board of experts to look at each audit failure; report on exactly what occurred, determine causes for failures, make information public and call out violators. This would provide better guidance on prevention than the secretive inspections right now that don’t identify audit clients by name.
2. Develop a new board comprised of auditors, government overseers and outside investor representatives. A trial board could review audit failures, base its decision on precedent, adjudicate fairly and impartially in a public forum and have the ability to apply civil and criminal provisions. This might improve audit quality and move the results to the public domain.

Recommendations

Regardless of the changes that might be made to the PCAOB to make it better represent the public interest and improve audit quality on a long-term basis, there should be a Congressional investigation of the board because Congress established the PCAOB and hasn’t done enough to ensure it is operating as intended. It can’t be left to the SEC, which is already over-burdened with enforcing accounting and financial reporting rules.

I also believe it’s worth considering an Office of the Inspector General to oversee work of the PCAOB. The IG would aim to enforce integrity standards in the work of the board and look for fraud and waste in the audit inspections. Having an independent oversight process would have helped to investigate the KPMG-PCAOB scandal and take corrective action with respect to the Board’s own quality controls, something that does not appear to have been done.

The public relies on the PCAOB to: assure that the audits of public companies are conducted in accordance with prescribed standards; independence has been maintained; the highest of ethical standards have been upheld; and the public is protected against fraudulent financial reports. We can’t wait for another accounting scandal to occur to examine the role of standards and the regulator’s enforcement thereof as has occurred so often in the past.

Posted by Steven Mintz, aka Ethics Sage, on March 10, 2020. Dr. Mintz's Ethics Sage blog was recognized as one the top 100 in philosophy (#23) by Feedspot (https://blog.feedspot.com/philosophy_blogs/). He recently published a book, Beyond Happiness and Meaning: Transforming Your Life Through Ethical Behavior, that is available on Amazon. You can sign up for his newsletter and learn more about his activities on his website: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics.