The PCAOB has a plan, but it may be a day late and more than a few dollars short
Gary Gensler seems to be taking the Big 4 auditors' advice about how the PCAOB can get its mojo back. Too bad they're pushing a regulatory-lite plan that's a Trojan horse for eliminating the PCAOB.
On October 7, 2022, PCAOB Chair Erica Williams gave a speech to the UCI Audit Committee Summit where she discussed the audit regulator’s 2022-2026 Strategic Plan, issued for comment on August 16.
Williams and her colleagues are starting fresh, having arrived in a nearly clean sweep by SEC Chair Gary Gensler after he fired former SEC Chair Jay Clayton’s scandal-besieged PCAOB Chair Bill Duhnke and almost all of the rest of that crew left. That came after after PCAOB Chair Duhnke’s gang replaced former PCAOB Chair Jim Doty and his crew, who presided over the KPMG-PCAOB data theft scandal.
Williams highlighted the plan’s priorities:
This summer, the Board released our five-year strategic plan, outlining four key goals:
· One, modernizing our standards,
· Two, enhancing our inspections,
· Three, strengthening our enforcement, and
· Four, improving organizational effectiveness.
Modernizing auditing standards has first priority.
She described this effort:
First, modernizing our standards.
High standards are the foundation for quality audits.
That’s why earlier this year, the Board announced one of the most ambitious standard-setting agendas in the PCAOB’s history.
Less than a year into this Board’s term, we are working actively to update more than 25 standards within eight standard-setting projects. And we are just getting started.
SEC Chair Gensler is very supportive of the PCAOB’s priorities, and the WSJ helped him make that point:
Securities and Exchange Commission Chair Gary Gensler said the U.S. audit regulator has been slow to update its rules, in a speech marking the 20th anniversary of the law that created it.
The Public Company Accounting Oversight Board, created as part of the Sarbanes-Oxley Act, continues to work with interim standards that it was allowed to use from the American Institute of Certified Public Accountants, a professional association whose guidelines and rules are often used as fallbacks for the industry.
“The expectation was that the board would produce a more appropriate set of standards going forward,” Mr. Gensler said on Wednesday at an event hosted by the Center for Audit Quality, a U.S. accounting-industry group. “Historically, though, the PCAOB has been too slow to update auditing standards.”
Notice that these remarks were made at the Center for Audit Quality, the audit industry group that acts as a lobbyist and advocate for the largest global audit firms and which is a subordinate organization of the AICPA, the industry’s main trade association.
I was not pleased.
The largest global audit firms have been trying to get their regulator, the PCAOB, to focus on the auditing standards instead of its more adversarial activities — firm/engagement inspections and enforcement — for years. At one point the Big 4 audit firms even had allies at the highest levels of the SEC who not only made cracks about how the PCAOB was not focusing enough on the “nuts and bolts of auditing” but who tried to get Chairman-at-that-time Jim Doty fired.
“Backstabbing in Washington: The Curious Case of the PCAOB,” by John C. Coffee, Jr. September 21, 2015, in the Columbia Law School’s Blue Sky Blog:
Recall Cinderella’s two step-sisters. Drab and mediocre, they were still consumed by envy for Cinderella, while somehow convinced of their own superiority and hopeful that they could land Prince Charming for themselves. Once, the Office of the Chief Accountant at the SEC was a prestigious position, staffed by eminent persons (such as Sandy Burton, who later became Dean of Columbia Business School). Burton was one of several SEC Chief Accountants who fought notable battles against “pooling of interests” and other accounting shenanigans. But that was long ago.
More recently, the Office of the Chief Accountant has been upstaged by the PCAOB, which negotiates agreements with foreign regulators, issues auditing standards, hires world-class economists (such as Luigi Zingales) as their advisors, and generally gets all the publicity. This has not gone unnoticed at the Chief Accountant’s office, which would like to view the PCAOB as merely a subordinate vassal agency. But the media knows better and can distinguish stars from step-sisters.
The current Chief Accountant, James Schurr, is a retired Deloitte partner who seems to have taken the protection of the industry as his priority. He has publicly criticized Doty and the PCAOB as “too focused on its disclosure effort and not enough on… the nuts and bolts of conducting audits.”[11]
That is silly but revealing in its attitude. The PCAOB actually conducted a record number of examinations in 2014 and brought an increased number of enforcement proceedings (including against partners at major Big Four firms). But unlike the SEC, the PCAOB by statute cannot disclose who it is suing or for what—until all appeals are exhausted or a settlement reached. Thus, it cannot brag or celebrate its achievements.
[11] See Francine McKenna, “DOJ’s New Focus on Individual Prosecutions May Be a Response to Judicial Challenges,” MarketWatch, September 10, 2015 (quoting Mr. Schnurr).
How exactly is the PCAOB supposed to make standards its #1 priority when historically the Department of Registration and Inspections is more than half its headcount and half its spend? Is Gensler’s SEC going to approve a budget for the PCAOB that ramps up its headcount and spending on the kind of technical audit nerds needed to write new standards that have credibility with the Big 4? Where are all these people going to come from? You probably aren’t going to steal them back from the Big 4 National Offices.
This says that the PCAOB just posted an opening for a Chief Auditor and Director of its Professional Standards team three days ago. But the PCAOB has been trying unsuccessfully to recruit someone for this role for months. Barbara Vanich, who joined the PCAOB in 2009, currently serves as Acting Chief Auditor and manages the development of PCAOB standards.
Gensler has also opened the door for the PCAOB to spend its time redrafting auditor independence rules.
That is even stupider.
All the SEC, and PCAOB, need to do is enforce the auditor independence rules more than once in a blue moon. And it is no coincidence that in talking about auditing standards Gensler has picked up on language former SEC Chair Jay Clayton used to rationalize further dilution of the auditor independence standards – “modernizing”.
There have been 22 comment letters on the PCAOB Strategic Plan draft submitted since Aug. 16, including from all of the Big 4 and next tier audit firms, the CAQ, the US Chamber of Commerce and a few institutional investor representatives. Robert Conway, a retired Big Four audit partner, former PCAOB regional office leader, and Author of The Truth About Public Accounting – Managing the Risks the Auditors Bring to the Audit, also submitted a comment letter.
Conway’s letter is six pages long, but he has two very specific comments that intrigued me. First, Conway cites the AICPA 2021 Trends published in 2022 and two key pieces of data from that report:
1. The number of new CPA candidates has declined from 48,004 candidates in 2016 to 36,670 candidates in 2019 (pre-pandemic). This is a 24% decline.
2. Total annual accounting degree completions have declined from 79,854 in the 2015-2016 academic year to 72,923 in the 2019-2020 academic year, an 8.7% decline.
In an email to me, Conway wrote:
Declining enrollments in accounting programs at the college level and the declining number of newly minted CPAs (as demonstrated by statistics from the AICPA Trends Report) pose a serious threat to audit quality. The root cause is clearly the workload issues and lack of work-life balance at the Big Four that are driving people away from the profession. The PCAOB has specific opportunities to change this; but thus far, has shown little to no inclination to use the tools at its disposal (Audit Quality Indicators) to deal with this core issue.
The Investor Advisory Group to the PCAOB (including Lynn Turner and others) also submitted public comments separately that echoed some of Conway’s concerns. Jeff Mahoney, General Counsel for the Council of Institutional Investors, had similar comments on behalf of CII.
I have to ask: Why is audit not an attractive profession? Why are smart students allergic to accounting?
I am now trying to instill an interest in and aptitude for financial accounting in MBAs at Wharton. I love teaching and it has already been hugely gratifying to see the response from students to my approach. But the bias against accounting and against the external auditor as expensive, boring, and irrelevant to investing and finance is everywhere.
The decline in students studying accounting and the legal and ethical lapses of those who have passed the CPA exam at all the firms is not for want of a lot of dedicated and well-meaning teachers. My feeling has been for a long time that the audit firms get students earlier and earlier and focus too much on commercialism instead of professionalism, grind them up, and then spit them out when the economy turns such as during the financial crisis.
I am grateful to have had great mentors at KPMG, in particular, and to have learned a ton during my two Big 4 tenures. Those experiences have enabled me to make a post-Big 4 life using accounting five times over.
Conway also wonders why ICFR restatements as a result of deficiencies noted in PCAOB inspections remain relatively constant across two four-year periods, 2012 to 2015 and 2016 to 2019, while the number of GAAP restatements prompted by PCAOB inspections dropped sharply across the same two four-year periods.
Conway’s conclusion is that PCAOB inspections are a promising source of GAAP restatements because of the unique information the PCAOB has access to in the auditor workpapers but its inspectors may be taking the easy way out and citing ICFR issues instead.
In an email he explained:
There are two types of restatements to correct errors that people in the accounting world follow: “Big R” and “Little r” restatements. There is a third category of restatements we unfortunately know nothing about – material errors that never got corrected. Let’s call them “missed restatements.” There are a number of holes in the system that give rise to missed restatements.
One troubling scenario is that the issuer or auditor is aware of a material error in a prior period, but one or the other decides to do nothing (the “let sleeping dogs lie” scenario). Speaking up about the need to restate is a bit of a self-inflicted wound. For an auditor, it might lead to losing the account or discipline. For a controller or CFO, it might be career limiting to admit a mistake.
Whistleblowers who have the fortitude to step forward have played a key role in drawing attention to material uncorrected errors in prior periods. However, not all potential whistleblowers have the fortitude to blow the whistle. Additionally, the SEC has limited resources, so not every promising whistleblower referral gets the attention it deserves.
The SEC comment letter process has also been a fruitful source of restatements. But it has its limitations, too. First, the comment letter process is a desktop review. Except in some limited cases, the SEC will not seek evidence to corroborate issuer responses. The SEC is also vulnerable to issuers who write responses that are accurate word for word, but are misleading in total.
The PCAOB is in a unique position because it has the benefit of audit workpapers that generally provide a complete fact pattern to evaluate whether issuer accounting is GAAP compliant. For this reason, the PCAOB should not leave any stones unturned when it comes to GAAP compliance. After all, the first thing that investors want to know is “Are the numbers right?”
In my research team’s latest working paper, “Deconstructing the PCAOB: Using Organizational Economics to Assess the State of a Regulator,” we mention that the PCAOB’s ambitious risk-based inspection program grew rapidly, especially
during and immediately after the financial crisis of 2008-2009.
In a 2015 interview by GoingConcern.com’s Caleb Newquist with PCAOB Director of Registration and Inspections Helen Munter — who led the division from 2011 to 2018— Munter says the PCAOB inspections division began hiring mid-career audit professionals to meet this need. That was a change from the retired or career-changer Big 4 partners it sought when it was first established in 2003. By 2015, most PCAOB inspectors were former managers (or above) hired from the Big Four firms with a minimum level of experience of only five years, according to Newquist’s interview.
I think less experienced inspectors likely had fewer technical skills and less confidence to challenge Big 4 partners on GAAP issues. They had been called out as adversarial “gotcha” types for doing so! So, maybe, the inspectors decided to take an easier path to finding something to say about the audits. But that something — deficiencies in ICFR assessments — does not resonate as a value add for investors the same way that highlighting GAAP-related deficiencies that lead to restatements does.
Conway brought to my attention a comment posted by a reader in the October 4, 2022 issue of GoingConcern.com following an article about Erica William’s comments at the CII Conference about enforcement.
Conway’s book has some data about what he considers an excess focus by the PCAOB on ICFR to the detriment of GAAP compliance.
These observations are corroborated by a sharp decline in the number of Big Four financial statement restatements resulting from PCAOB inspections over the last three years. During the four inspection years from 2012 through 2015, there were a total of 14 restatements of financial statements by the Big Four (arising from PCAOB inspections), an average 3.5 restatements per year.[i] However, the last three inspection cycles (2016, 2017 and 2018) yielded only one Big Four financial statement restatement, an average of only 0.3 restatements per year.[ii] This 91% decline occurred without any significant change in the number of issuer inspections conducted. Yes, restatements overall have been trending downward; but I am left wondering if the PCAOB’s focus on GAAP compliance has suffered at the expense of the PCAOB’s focus on ICFR.
Being sure that the accounting is correct is a critical part of auditing and internal control. Good internal control should include processes that lead to the conclusion that the company’s accounting methods are GAAP compliant…
The PCAOB inspection reports tally the number of times individual auditing standards are cited to describe deficient audits reported in the public portion (Part 1) of the PCAOB inspection reports. There are about 17 individual unique auditing standards that are frequently referred to in the Big Four inspection reports.
Just one standard (AS2201) pertains exclusively to audits of internal controls. However, that one standard on internal control accounts for 54% of all deficiency citations in the public portion of the Big Four inspection reports for inspections conducted during 2018. The frequency of ICFR deficiency citations has increased from 45% in 2016, to 48% in 2017, to 54% in 2018.
In fairness to the PCAOB, ICFR represents the highest frequency of deficiencies identified because the audit firms have been slow to master audits of internal controls. The audit firm business model is likely undermining the ability of the Big Four audit firms to master the intricacies of the PCAOB’s expectations for internal controls. However, the anecdotal information from partners who have recently undergone PCAOB inspections has me wondering if the PCAOB is adequately focused on GAAP compliance.
There may be other factors that contribute to the high frequency of internal control findings from PCAOB inspections. Internal control findings are low hanging fruit for inspectors, in part because the PCAOB has very prescriptive expectations for internal controls that the audit firms have had difficulty convincing their clients to embrace.
There may also be some bias toward audits of internal controls because the PCAOB owns the internal control standards while the SEC is the final arbiter on the application of GAAP. More effort (also meaning more time) is required by the PCAOB to advance GAAP findings because of the need for the PCAOB to collaborate with the SEC (not to mention the downside that the PCAOB might be embarrassed if the SEC agrees with the auditors’ conclusion on a GAAP issue). The additional time to collaborate on GAAP findings poses a threat to getting inspection reports out quickly. The inability to issue inspection reports in a timely manner has been a thorn in the PCAOB’s side since its inception. Not surprisingly, ICFR findings may have emerged as the fastest track with the lowest risk of embarrassment to the PCAOB.
(Details supporting these calculations are presented in Conway’s book in Appendix C.)
I can think of one big case off the top of my head, Mattel, where both the company and its auditor tried very hard to avoid a restatement, allegedly colluding to cover up the need for one. There was a news report that the PCAOB was investigating auditor independence issues that Mattel itself admitted to but that was nearly three years ago and the PCAOB has done nothing. There was also a report two years ago that the SEC and DOJ were also investigating but crickets. That’s despite the fact the WSJ published a scathing report from a whistleblower and Mattel executives, auditor PwC and the lead engagement partner have settled a shareholder lawsuit regarding the episode.
There is also a pandemic of “cakeism” in academia on the subject of the decline in financial restatements. When it is useful to say more restatements mean auditors are doing a better job because they eventually caught the error, then restatements are a sign of audit quality. When it serves the thesis to say fewer restatements means SOX and auditors have worked so hard and so well that accounting fraud is negligible, then that’s the way the argument goes.
We have been invited to present our paper, “Deconstructing the PCAOB: Using Organizational Economics to Assess the State of a Regulator,” in November at CFEA 2022 at Georgia State University and at the 2023 Hawai’i Accounting Research Conference, an annual global accounting conference held at the University of Hawai’i at Mānoa in early January.
© Francine McKenna, The Digging Company LLC, 2022