How the PCAOB Fares After Five Years on the Job

It has been more than six years since the Public Company Accounting Oversight Board was created by the Sarbanes-Oxley Act, five years since the Securities and Exchange Commission declared the PCAOB operational, and four years since the PCAOB started its first inspections of registered public accounting firms. The PCAOB’s work, in combination with other changes in the capital markets, has significantly increased confidence in financial statement audits. And the PCAOB board members and staff have shown themselves to be capable, dedicated, and devoted to their important public policy role.

As could be expected, the Board has had some growing pains in its formative years and has been willing and able to adjust its policies when called for. But after five years, the PCAOB should no longer be considered a start-up, and problems can no longer simply be attributed to growing pains. The time is right for the PCAOB to consider what changes it can make to improve its work in the interests of investors and the capital markets.

Standard Setting

Auditing standards are perhaps even more difficult to craft than accounting standards, since the underlying concepts are not as concrete. Nonetheless, the PCAOB has built a capable and dedicated standard-setting staff. Although it took some time, the Board’s standard on auditing internal controls represents a significant achievement. Auditing Standard No. 5 lays out a reasonable framework for providing assurance on the effectiveness of internal controls without mandating excessive work. Although the Board was criticized for its initial standard in this area (the now-defunct Auditing Standard No. 2), we must remember that the standard on auditing internal controls was probably the most significant single auditing standard ever written.

Any concerns with the PCAOB’s standard-setting efforts, then, have little to do with the abilities of the staff. But a small staff, no matter how talented, will need help and input to do the job right. Unfortunately, the PCAOB’s standard-setting process limits input, because the PCAOB does not debate its auditing standards in public as they are being developed. Only the meeting at which the PCAOB approves the proposed standard is open to the public—and by then, all the substantive decisions have been made.

Public input to the PCAOB’s standards is limited to the formal comment period and discussions at the Standing Advisory Group meetings. But the SAG almost never discusses particular proposals that the PCAOB is considering, and the attending board members and PCAOB staff rarely discuss their own views. As such, the SAG meetings provide the Board with outside views on key topics, but not input on writing the actual standards. As a result, there is virtually no way for the Board and staff to obtain real input before a standard is proposed for public comment, or to gauge reaction to changes made in response to comments received.

Of course, the Financial Accounting Standards Board and International Accounting Standards Board also use formal comment periods and advisory groups to obtain input. So does the International Auditing and Assurance Standards Board, which sets International Standards on Auditing that are used as a base for auditing standards in many countries. But these other bodies also open their discussions and deliberations to observers during the development of the standards. This allows interested constituents to consider and discuss the standard setters’ work. Questions can be raised and difficulties can be identified before the issuance of a document. FASB, for example, has benefited from this kind of consideration on numerous occasions, by changing wording or adding clarifying guidance before publishing a standard. The PCAOB’s process does not allow these kinds of improvements.

One of the benefits of a process like the PCAOB’s is usually the ability to finalize proposals and rules quickly. The SEC employed such a process in quickly implementing the various sections of the Sarbanes-Oxley Act that required SEC action. Unfortunately, the PCAOB has not taken advantage of its process to address key issues quickly. While it is understandable that the PCAOB has focused much of its attention on internal control audits, the Board has made scant progress on other issues. It has passed only two standards relating to financial statement audits, one of which is still awaiting approval by the SEC.

Considering that the PCAOB staff, board members, and advisers have all identified several areas in which standards should be improved, much more should have been accomplished by now. In particular, I am surprised that the PCAOB has not published a standard regarding auditing for fraud.

Others, including Zoe-Vonna Palmrose, former deputy chief accountant of the SEC, have also discussed these aspects of the PCAOB’s standard setting. Palmrose has suggested that it is important for the PCAOB to converge its standards more closely to those of IAASB; PCAOB board member Bill Gradison has done the same. While I’m not as concerned about speeding convergence of auditing standards as I am about speeding the PCAOB’s standard-setting efforts and making them more transparent, the idea of convergence with the IAASB actually provides an opportunity for the PCAOB to address all of these issues.

It’s worth noting that five years ago, the IAASB was in a state of some confusion. The International Organization of Securities Commissions and others had been calling for the IAASB and its predecessor to clarify its standards for years, but the IAASB and its staff had not been able to agree on what, if anything, should be done. Further, the IAASB at the time was dominated by industry insiders and had little outside oversight. But the IAASB now includes more public interest members, and its work is overseen by the independent Public Interest Oversight Board. In addition, the IAASB’s clarity project has resulted in a focused effort to redraft standards so that the meaning is clear.

As I noted previously, the IAASB conducts its deliberations in public meetings, and it has addressed some significant issues in the past few years, while executing its clarity initiative as well.

The Sarbanes-Oxley Act allows the PCAOB to designate another body to develop auditing standards that the Board would then adopt after deliberation as the Board deems appropriate. After adopting existing AICPA standards as its interim standards in 2003, the Board chose to develop standards on its own. Perhaps it’s time to re-evaluate that decision. The Board could rely on the work of the IAASB as a base for its standard setting, supplementing those standards where appropriate to account for differing requirements and circumstances in the United States. (The Auditing Standard Board, which sets standards for audits of private companies in the United States, already does essentially the same thing.) This would, in one move, increase transparency, allow the PCAOB to take advantage of the expertise of the IAASB members, and ensure that U.S. auditing standards keep up with international developments in auditing standards.

Inspections

The PCAOB inspects large firms that audit more than 100 registrants every year, and smaller firms every three years. As there are well beyond 1,000 registered firms out there, the amount of work and coordination required is daunting. But the inspections seem to be effective, based on what I’ve seen as I work with clients to resolve accounting issues. Auditors are asking more questions, requesting more support for accounting conclusions, and are generally more engaged and rigorous than in the past.

After five years, the PCAOB should no longer be considered a start-up … the time is right for the PCAOB to consider what changes it can make to improve its work in the interests of investors and the capital markets.

But auditors’ responses to PCAOB inspections are not always for the better. I have written before about the unwillingness of preparers and auditors to apply professional judgment when assessing accounting policies. PCAOB inspectors’ questions and findings are one of the things that auditors have blamed for their unwillingness to consider alternative accounting treatments, particularly ones that are harder to audit using objective methods. In addition, I’ve seen instances in which auditors have refused to accept a particular method of accounting because they believe the PCAOB would consider accepting that treatment an audit deficiency, regardless of how much audit work the firm performed. Discarding an accounting treatment because it is more difficult to audit is not the way to achieve transparent accounting.

My reviews of PCAOB inspection reports suggest that the auditors’ fears may be well founded. I’ve seen instances where the PCAOB seems to have suggested a firm’s audit was deficient because the firm accepted an accounting treatment the PCAOB inspection team disagreed with. Certainly, when the inspector believes that auditor has done insufficient work to conclude as to the acceptability of an accounting method, the inspector should raise that concern. But where the inspector’s objection is to the accounting method rather than the audit work, citing this as an audit deficiency is not appropriate.

On a similar point, PCAOB inspection reports often point out deficiencies that, in the mind of the PCAOB inspectors, suggest that “the firm, at the time it issued its audit report, had not obtained sufficient competent evidential matter to support its opinion on the issuer’s financial statements.” Yet responses from audit firms suggest that they often do not agree with or understand the PCAOB’s conclusions. This suggests a distressing lack of common understanding between the PCAOB and the firms regarding the level of work that should be done in an audit.

These are problems the PCAOB should work to correct. What’s more, the SEC’s Advisory Committee on Improving Financial Reporting has already given a rationale to do so, with its recommendation that the PCAOB develop a policy statement regarding how it assesses judgments made by auditors. Such a policy statement could go a long way to making sure auditors and the PCAOB work from a common understanding of how audit decisions should be made and evaluated. It could also help the public understand what should be made of PCAOB inspection reports.

This policy statement should clearly indicate that the PCAOB would not consider an audit conclusion to be incorrect simply based on the PCAOB’s discomfort with the underlying accounting. The statement should indicate that the inspectors will ask questions about accounting treatments they do not agree with, and that firms should, as part of their public policy responsibility, consider whether restatements are warranted in these areas. But if the firm continues to conclude that the accounting is acceptable, the PCAOB should not then raise the issue as an audit deficiency.

Most importantly, however, the policy statement should explain how the PCAOB inspectors and Board evaluate compliance with auditing standards. Specifically, the statement should stress how inspectors evaluate the use of alternative procedures, the importance to the auditor’s ability to issue an opinion of an individual deficiency in audit procedures, and the auditor’s conclusions regarding materiality in designing its audit procedures; those considerations are not the same as those involved in assessing the materiality of an identified error. While differences in view between the PCAOB and audit firms are inevitable, both the PCAOB and the firms need to work to reduce the frequency of these differences. As it stands now, investors in the capital markets are left to wonder how seriously to take the PCAOB’s inspection reports.

Continuous Improvement

Much of this column has focused on deficiencies I see in the PCAOB’s processes. As is the case with the PCAOB’s inspection reports, there is a risk that this focus could be seen as a suggestion that the PCAOB is doing a poor job—so I’ll restate again that I have great respect for the PCAOB’s work and its staff. The Board has a huge task and goes about its work in a professional manner. But the PCAOB has a responsibility to investors to make its work as efficient and effective as possible, and the time is right for the PCAOB to be aggressive in improving its processes, and to take advantage of opportunities that exist to improve its work and the quality of financial reporting.