This is a piece from Bruce’s archives left online for the curious reader.
Have a look at his current work here.
Taking Stock At The PCAOB
Contributor to Financial Executive
The accounting industry has come under withering criticism in the wake
of recent corporate scandals - not surprisingly because the accounting
scandals at Enron, WorldCom, Tyco International and elsewhere have involved
accounting fraud. The accounting firms have been accused of covering up
their clients' sins, or worse, being unable to detect the fraud in the
first place. The scandals have decimated their ranks, even claiming the
life of Arthur Andersen LLP.
In some respects, the accounting firms have been hostage to the companies
that engaged them originally for audit work. Lately, headlines have been
full of cases questioning auditor independence, arising from the sale
by audit firms of nonaudit-related services. Many of these have involved
tax shelters, later deemed fraudulent, which the firms sold to companies
and executives for whom they performed audit work. Over the last few years,
as regulators have cracked down, executives at the Big Four and other
accounting firms have been hit with a string of indictments on auditor-independence
issues and other wrongdoings.
Lots of eyes have been turning to the Public Company Accounting Oversight
Board, launched in 2003 as part of the Sarbanes-Oxley Act. The PCAOB,
which replaced the existing form of self-regulation for the industry,
is the primary regulator on audit-independence issues. It is under the
jurisdiction of the Securities and Exchange Commission (SEC).
Appointed two years ago as the PCAOB's chief auditor, Douglas R. Carmichael,
is charged with overseeing the redrawing of the nation's auditing standards.
He also counsels the board on auditing and accounting practices.
The 63-year-old former professor at Baruch College at the City University
of New York - from which he is on leave - is based in Washington, DC.
He has worked to help eliminate auditor-consultant conflicts and steadily
pushed for more transparency at accounting firms. At the PCAOB, he has
drafted several standards including one that addresses the controversial
Section 404 of SOX, which requires public companies to certify that they
have an operation system of internal controls to prevent fraud and provide
greater managerial accountability to shareholders. Other rules eliminate
certain tax services auditors can provide their audit clients. A third
sets standards for annual inspections at auditing firms.
The remaining challenges before Carmichael and the PCAOB are immense.
"PCAOB's biggest challenge is formulating techniques and training tools
for auditors to identify areas where fraud is likely to occur. The second
most important challenge is to formulate auditing standards that promote
the best practices in quality-control standards," said Melvyn I.Weiss,
a senior and founding partner at New York law firm Milberg Weiss Bershad
& Schulman LLP, who has litigated many cases involving CPA firms. "Doug
Carmichael has expressed views that seemingly will make the PCAOB a proactive
standard-setter and aggressive enforcer. The real question, however, is
whether he will be able to succeed when faced with what is likely to be
resistance from corporate America."
Carmichael talked recently with New York financial writer Bruce W. Fraser
about PCAOB's new standards, its role in carrying out mandates set by
Sarbanes-Oxley, and the challenges ahead for the auditing profession.
1. Is it different from the inside looking out? How is it different
and how similar to what you expected? How is it different from the standard
setting process you were involved with at AICPA?
There are more stateholders and more constituencies than I had expected.
That said, I expected there would be a greater interest in our standard
setting activities than had been shown in the past. in part because of
the increased focus on the importance of accounting and controls, and
the things that led up to and resulted in the Sarbanes-Oxley Act.
But it's been more intense than I expected. That's also a way in which
it has differed from activities at the AICPA. There's a much heavier public
interest and investor perspective given to what we do in standard setting
here, and there's much greater involvement of others in the process.
For example, our standard advisory group that advises us in the standard
setting area includes, in addition to practicing auditors, investors and
public companies that issue the financial statements. They are all involved
in the standard setting process. That is an improvement and something
quite different, in addition to the overall investor perspective that
the PCAOB brings to its given mission.
2. Do you believe the PCAOB has lived up to your expectations
of what you'd be able to do? If not, what do you believe has prevented
it from achieving these goals?
Well, things have certainly taken longer to accomplish. That's in part
due to the fact that we have Sarbanes-Oxley mandates to deal with, including
particularly Section 404 on internal controls over financial reporting.
But I think that things have certainly lived up to my expectations.
For example, we have integrated our inspections activity with our standard
setting so we have a continual feedback loop from which we learn from
inspections what's taking place in the field, how well the standards are
being implemented, and whether we need to change anything. We also help
inspectors understand what are standards mean and how they should be applied.
There is a continual interchange. I anticipated it would be important
and it has been important. It's certainly worked out better than I had
expected.
3. What new audit standards are you likely to back and why?
We'll be working on a new standard for engagement quality review, which
used to be called secondary partner review. This is mandated by Sarbanes-Oxley,
and also something very important in improving audit quality.
Sarbanes-Oxley also adds to existing requirements in the area of communications
with audit committees, for example, on the auditor informing the audit
committee on the quality of financial reporting. We want to expand on
that.
Our standing advisory group has indicated that detection of financial
fraud should be a high priority, and we regard it as such. We'll be working
on that, not just as a potential standard but looking at all the things
we can do to improve the auditor's ability to detect financial fraud.
4. Given Sarbanes-Oxley, do you believe that major accounting
firms are sufficiently staffed to carry out their jobs adequately?
I think everyone, public companies, auditing firms, and the PCAOB could
use more resources. Qualified accountants are a resource very much in
demand, but I think the firms are fully capable of doing quality work
and meeting their resource needs.
5. What do you see as the dangers from the reduction of the Big
Eight to only four accounting firms?
Concentration in any industry, including public accounting, can reduce
competition, and that's not desirable. You would like competition for
clients to produce excellence. PCAOB's inspections and focus on increasing
audit quality are compensating factors to some degree. They can help.
But generally I think an important goal of everyone with an interest in
the public accounting profession and auditing firms, is to have increased
competition and increased quality.
6. Many big accounting firms have abandoned some clients to focus
on big corporations. Are all auditing clients being adequately serviced?
How does this affect smaller and mid-sized companies?
I think it's important for a company to have a size appropriate audit
firm. There are a lot of high quality smaller firms below the Big Four
in size. Not every public company needs a large firm. I think through
some adjustments every public company can secure an auditing firm appropriate
for their size.
7. But hasn't the Big Four cutting back to concentrate on their
billion-dollar clients left a void not easily filled.
We have a total of 1,500 registered firms. Of those, approximately 900
are U.S. registered auditing firms and approximately 600 are foreign firms.
These are firms that either are auditing public companies or by their
registration with us have expressed a desire to audit public companies.
If an audit firm audits 100 or more public companies they get inspected
every year. If they audit less than 100 they get inspected at least once
every three years. So our inspectors are inspecting smaller firms that
are below the 100 or more public companies in size. Some reports from
those firms are currently available on our web site, www.pcaobus.org,
and more continue to be posted. They contain information about firms not
as large as the largest firms but very capable of doing quality audits.
8. How can the needs of smaller companies be addressed to rein
in what they believe to be excessive costs of compliance?
A lot of people are looking at that. The SEC has a small business advisory
committee that is making recommendations. I don't think we've heard the
final word on it by any means. But there are lots of things companies
can do without even considering any recommendations made.
For example, starting early in the year and building things in as part
of a process is very important. Much concern about excessive cost and
compliance is due to companies doing things on a crash or special efforts
basis, which is always more costly. There are benefits to be achieved
by improving the control consciousness within, and having operations people
recognize their responsibilities for effective controls of their own operations.
Many of those are related to the financial reporting responsibilities.
9. In July, the PCAOB issued specific rules limiting certain tax
services that auditors could provide to their audit clients. What is the
intent of the standard? Do you believe they are achieving their purpose?
We have four rules. Two are very relevant. One prohibits contingent fees
paid directly or indirectly for any services to an audit client. That's
very important because if the money isn't there nobody's going to do it.
It's one of those things where you follow the money. So prohibiting contingent
fees takes away a lot of financial incentive.
The other rule relates to what auditors can't do related to aggressive
tax positions of their clients. That rule isn't in effect yet. It still
needs to be approved by the SEC so it isn't possible to say at this point
whether its achieving its purpose.
Our ongoing principles are to have the auditor avoid auditing his or her
own work, and not to have a mutuality of interest with the client. There
are basic principles generally recognized in the independence area, and
these are specific rules that implement those in the tax area.
Another rule prohibits auditing firms from providing tax services to officers
of the company in a reporting oversight role. The purpose is to avoid
a potential mutuality of interest between the auditor and those particular
executives.
10. Do you think the ban on certain consulting services is adequate
or should it be expanded?
Right now the PCAOB has not identified any other services other than those
covered in the most recent rules on tax services that require per se a
ban or prohibition. I believe it's important for audit committees to scrutinize
all services the audit firm is engaged to provide and consider whether
in any particular circumstances there might be an impairment of independence.
I don't see at this point any further need for any overall prohibitions.
11. Do you think Auditing Standard No. 2 that deals with Section
404 (b) of Sarbanes-Oxley implementing internal controls over financial
reporting, has been effective or is it overkill for companies in terms
of cost/benefit? What feedback have you received from auditors?
Our inspections group has as part of their work an inspection of internal
controls over financial reporting work. We expect to learn more through
that process. We don't have all the results of that yet.
Our Auditing Standard No. 2 is the principle-based standard which will
be applied using judgment. On May 16 of this year we issued some staff
questions and answers to emphasize that. It provides a framework for exercising
judgment. It's not a list of particular rules. It is not a case that every
company needs to have the same set of controls.
Under the SEC's requirement, Section 404 (a), a company needs controls
that are appropriate for that company's size and complexity. The amount
of audit work that our standard requires for a particular company should
be significantly influenced by the nature of the internal controls they
have in place. It isn't a case of one size fits all set of requirements
for companies or for auditors.
Right now we only have the experience of accelerated filers, which are
the only companies that have gone through the first year of meeting these
requirements. The reports from those companies indicate a certain percentage
had material weaknesses that hadn't been disclosed before. Therefore,
the requirements are now providing new and worthwhile information about
these companies.
12. If you looked back at the breakdowns we witnessed at Enron,
WorldCom and other companies, would the steps that we've taken today likely
to have prevented these breakdowns?
As nearly as we can tell from the kinds of public reports that are available,
Enron has had a couple of investigations and reports and so has WorldCom.
I think that one of the big issues for their auditing firm (Arthur Andersen)
was the 'tone at the top' of that firm. Something our inspections have
specifically targeted from the beginning is assessing the 'tone at the
top' in auditing firms.
You're never going to be in a situation where there can be an absolute
guarantee that something like that won't happen. But I think the things
the Sarbanes-Oxley Act set in motion, which include improvements in the
standards and annual inspections of large firms are all things that would
have considerably reduced the likelihood of those problems.
13. Some critics have said a dark cloud has settled over U.S.
accounting firms. Do you agree? If so, do you think the mood is changing?
I believe the firms are taking big steps to emphasize doing quality audit
work. In part, that's because they know PCAOB inspectors will be coming
in and looking at what they've done. That's an incentive to do quality
work, but I think they had that incentive to begin with,
I think the auditor-client relationship has changed. Some people before
the Sarbanes-Oxley Act thought the relationship was too cozy. It has become
more objective. Auditors have a very important role to play as objective
evaluators of the financial reporting process of public companies. I think
auditors are stepping up to that responsibility, recognizing its importance,
and improving the quality of their work in doing it.
