Protecting the Public Interest

I recently participated in the Ethics Symposium at the Annual Meeting of the American Accounting Association. A colleague of mine, Sri Ramamoorti from the University of Dayton, had very important comments about the Public Company Accounting Oversight Board (PCAOB),that regulates audits and auditors. In other words, is the PCAOB living up to its mandate to regulate the audits of public companies and protect the public interest.

Two weeks ago, I posted a blog on this very issue using Dr. Ramamoorti's work. As luck would have it, I made a mistake and referred to partners from KPMG as being with PwC--David Middendorf and David Britt. As the younger generation says today, "my bad." I'd also like to thank Patrick McNamee, who is on the faculty of the University of Maryland - Robert H. Smith School of Business, for identifying the same mistake. I have made the necessary correction below and I am re-posting the blog.

Auditors as Gatekeepers

Auditors have been called the ‘gatekeepers’ in the sense that they must ensure that audit independence exists and there are no conflicts of interest, for example, if a firm played fast and loose with the audit requirements due to pressure from a client. And, if they compromised their professional judgment to make it more likely their clients would sign them up to do more lucrative consulting services. The PCAOB must be on the alert for the possibility of fraud in the financial statements that goes undetected.

About the PCAOB

 Here are some brief facts about them PCAOB:

• The PCAOB was created by the Sarbanes Oxley Act of 2002 to provide oversight of the auditing profession and an audit inspection process that would be more independent than the previous program.

• The goal, by making auditing a “regulated profession,” was to shore up public confidence and allow the profession time to reclaim its prestige and credibility.

• The Board inspects the audits of public accounting companies to ensure they are protecting the public.

• It is important to note that the deficiency rates in audits inspected by PCAOB are large and concerning.

• Assuming the rates are accurate, then we could say the Board is meeting its mandate to protect the public

• An interesting sidelight is the deficiency rates decreased significantly from 2019 to 2020 and we should wonder whether the Big 4 firms have finally got it right. The second-tier firms, not so much.

• Here are those results:

PCAOB Audit Inspections

• The results for 2020 regarding Deloitte and especially PwC seem counterintuitive. Results in the single digit category almost never occur. It’s possible that PCAOB inspections during the relevant time-periods were affected by COVID?

Questionable Actions by the PCAOB and Staffers

The work of the PCAOB is not without fault. There was a scandal a few years back that I blogged about where KPMG hired former PCAOB staffers to help them determine targets of audit inspections. The motivation was because a high deficiency rates on audits inspected.

Before 2019, the last time KPMG did not have the worst audit deficiency rate among the Big 4 was 2013’s inspection reports, when KPMG had an error rate of 46% but EY did worse at 49%. The last time KPMG had a better deficiency rate than PwC was 2012’s inspection reports, when KPMG had the second-lowest deficiency rate at 34%, followed by PwC at 39% and EY at 48%.

According to a SEC investigation, in 2015, Brain Sweet, then a director at the PCAOB, used a thumb drive to take “sensitive inspections-related documents” to his new job at KPMG. Others from the Board also provided confidential information to KPMG after leaving the Board and joining the firm.

In his first week at the audit firm, at a lunch with KPMG defendants David Middendorf and David Britt, Sweet was allegedly asked whether a specific audit would be the target of inspection. Middendorf allegedly told Sweet “to remember where [his] paycheck came from and to be loyal to KPMG.”

An important question is whether there is a revolving door between PCAOB staffers and the Big 4 firms. What about professionals from the Big 4 going to the PCAOB? Perhaps more importantly, why hasn't the PCAOB acted in a way that enhances ethical leadership on the profession?

What Is Regulatory Capture?

Regulatory capture is an economic theory that says regulatory agencies may come to be dominated by the industries or interests they are charged with regulating. The result is that an agency, charged with acting in the public interest, instead acts in ways that benefit incumbent firms in the industry it is supposed to be regulating.

A recent research study reported the following findings:

• The number of PCAOB employees hired by large audit firms is positively related to the number of deficiencies reported in their prior inspection reports,

• The number of deficiencies reported in firms’ future inspection reports is negatively associated with the number of former PCAOB employees hired.

• However, the authors found d no significant association between the number of former PCAOB employees that a firm hires and improvement in audit quality.

• These findings suggest that former PCAOB personnel possess valuable knowledge about how to perform and document audit procedures to satisfy PCAOB reviewers

• However, this expertise does not necessarily have direct implications for the accuracy and reliability of clients’ financial reports.

Turmoil at the PCAOB

The following events seem to support the idea that turmoil exists at the PCAOB.

There was a wholesale replacement of Board members in December 2017, post-the KPMG scandal. There was a complete overhaul of the Board again in June 2021. 

The leadership of former PCAOB Chairman, Bill Duhnke, was questionable at best now that he is himself under investigation.

One question is what constructive steps the new PCAOB might take to restore its emphasis on audit quality.

The research previously cited indicates that there was no significant association between the number of former PCAOB employees that a firm hires and improvement in audit quality.

Are We Being Too Harsh with the Criticisms of the PCAOB?

 Here are some of the positives that come from the work of the Board.

• Audit deficiency rates are going down.

• Quality control criticisms of firms that failed to remediate satisfactorily were cited in 300 cases – approximately 10 percent of inspection reports. This has led to the firms tightening up on these critical standards to ensure the firms have strong internal audit controls and can protect the public interest.

• The result has been that firms devote substantial time and resources to addressing the deficiencies in their systems of quality control cited in their inspection reports, and those systems are stronger today.

• Inspection programs strengthen “the SOX requirement that auditors assess and report on the effectiveness of the audited company’s ICFR.”

Some argue that the PCAOB has been too aggressive, that auditors are now motivated largely by fear of PCAOB inspectors, and that a keep-the-regulator-happy mentality drives up audit (and internal control) costs out of proportion to any benefits.” While the latter may be true, it does not lessen the importance of the work of the PCAOB.

Blog re-posted by Dr. Steven Mintz, The Ethics Sage, on August 9, 2022. You can sign up for Steve’s newsletter and learn more about his activities on his website  (https://www.stevenmintzethics.com/) and by following him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.