Stephen Gall


PCAOB Executive Summary

Management 3104 – Accounting Principles

Professor Glenn L. Pate, Instructor

Walden University

October 6, 2006

PCAOB Executive Summary

The Sarbanes-Oxley Act

The passage of the Public Company Accounting Reform and Investor Protection Act of 2002 (also known as the Sarbanes-Oxley Act), was a direct response to hearings held by Congress on the Enron and WorldCom accounting fraud scandals. It was realized that oversight of large auditing firm appraisers' and auditors' was not strong enough to assure that the public interest was being protected. It was felt that by establishing a system of controls and regulations that were effective at reducing corporate fraud, the public’s confidence in stock market could be regained.

Before the Sarbanes-Oxley Act was passed, discussions about internal controls where only a topic of interest to internal audit committees at some companies. However, the Sarbanes-Oxley Act has changed all that, and now an independent auditor must confirm that an organization maintains effective internal controls over the entire spectrum related to financial reporting, including financial controls, information systems controls, and corporate governance.

PCAOB Mission

The Public Company Accounting Oversight Board (PCAOB) is a private, non-profit corporation that was established in accordance with Sarbanes-Oxley under Section 101 of the Act. The PCAOB, under the direct supervision from the Securities and Exchange Commission (SEC), was established in response to this need to establish an auditing function that provides oversight and regulation of reporting activities of publicly-traded companies. The PCAOB’s mission is to review the work of auditing firms and monitor how these firms evaluated the financial health of their (publicly traded) clients. The PCAOB’s stated mission is to "protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports." [Wikipedia, 2006]

Prior to the establishment of the PCAOB, the accounting industry was self-regulated through the Public Oversight Board which was directly controlled by members that were appointed by the audit industry itself.

PCAOB Membership and Structure

The PCAOB has five members which are appointed by the SEC. Two members, but no more, are required to be CPAs (certified public accountants). It is also a requirement that the chairperson must not have practiced as a CPA for at least five years. Interestingly, when the auditing community was asked to respond to the structure and scope of the PCAOB, this requirement raised the biggest concern. The auditing community felt strongly that board members should all be required to be CPAs. [Hill, 2005]

The Board is provided an annual budget, subject to approval by the SEC, of approximately $100 million, which is funded by fees collected from stock and bond market issuers. The PCAOB board oversees a staff of over 300. Headquartered in Washington D.C., the PCAOB also has regional offices in Atlanta, Dallas, New York, Irvine, Chicago, Denver, San Francisco, and in Ashburn Virginia.

The first chairperson was William H. Webster, former director of both the FBI and the CIA. Because of irregularities in Webster's past relationships with large high-tech companies that were under investigation at the time of his appointment, he resigned soon after. The current chairperson is Bill Gradison, who has a doctorate from Harvard, and an extensive background in both business and in the public sector.

PCAOB Functions

The functional role of the PCAOB is to:

• Register public accounting firms who prepare audit reports for public companies
• Set standards for auditing practices, quality, ethics, and any function related to preparing audit reports
• Conduct inspections and examinations of its registered accounting firms
• Conduct Investigations into allegations of fraud or misconduct.
• Enforcement of standards and laws, including disciplinary action (including lawsuits) and impose sanctions for misconduct when identified in one of its registered accounting firms.

Registered firms are categorized as being big and small firms

• Big firms are those having more than 100 issuers as clients. These firms’ documented records are inspected on a yearly basis.
• Small firms are those will fewer than 100 issuers as clients. The PCAOB reviews these firms’ documented records every three years.

Inspections include the review of Sarbanes-Oxley audit documentation that has been prepared by auditing firms to show how their clients comply with the Sarbanes-Oxley Act. PCAOB documentation standards are now considered the de facto standards for all accounting documentation, especially on how to document the effectiveness of internal controls and their assessment.

Power and Authority

The PCAOB has been granted the authority by the SEC to conduct audits and review records of companies that are located anywhere in the United States without being subject to state or municipal law. Non-US public accounting firms that prepare audit reports for US public companies must also be registered with the PCAOB as of 2003. [Deloitte, 2006]

As part of its investigative powers, the PCAOB can acquire documentation and/or testimony from auditing firms at will, and has the power to suspend or bar individuals and companies from practice of public company accounting if the PCAOB can verify justifiable cause. Even if a company is not required to be registered with the PCAOB that company may still be subject to investigation via the right of the PCAOB to request the authority to investigate from the SEC. If there are issues raised from an inspection, the PCAOB has the authority to report accounting irregularities to the SEC, or to request a restatement. Penalties can include sanctions, fines, or deregistration. [Marlais, 2006]

The PCAOB Board is required to conduct inspections of registered accounting firms to establish that each firm is complying with the Sarbanes-Oxley Act and PCAOB Board rules, and is also meeting professional standards and audit performance criteria. Monitoring and punishment of unethical behavior has long been held to be the problem, not the lack of ethical standards. [Hill, 2005]

The PCAOB is required to annually inspect any firm that provides audit reports for 100 or more clients, and inspect tri-annually all other registered firms. Each inspection is documented in a report that is then made available to Commission and State regulatory authorities. Some parts of the reports are also made public (subject to disclosure rules). [PCAOB, 2006]

Recognizing Issues

The PCAOB is aware of issues that both public companies and their auditing firms face, related to complying with Section 404 of the Sarbanes Oxley Act, especially about the issues of cost and cost-effective auditing. Many public company executives have complained about overreaching audits, to which the SEC has held roundtables to identify the problems. The PCAOB has recently announced that it will audit its member firms for judicious use of auditing techniques to control costs. [Reason, 2006]

In a recent interview with the PCAOB's chief auditor, Douglas R. Carmichael, Carmichael emphasized that the PCAOB has the responsibility to listen to its stakeholders, including organizations, businesses, and individuals, before setting mandates. Under Carmichael the PCAOB has encouraged an open dialogue.

Carmichael also emphasized the need to reassess auditing standards, including audit effectiveness. Because of this effort by Carmichael, the PCAOB has received many recommendations for improving standards and processes, which it hopes to incorporate as (the PCAOB) reassesses its auditing role. In conjunction with this effort to listen to stakeholders, the PCAOB is focused on providing updated information on accounting standards and guidance, and provides online forums on many topics of interest for its members.

The PCAOB, however, remains focused on addressing major areas of long-standing concern with accounting fraud, including: 1) management overrides of the accounting system and journal entries, 2) the inability to confirm or validate account balances, 3) issues related to revenue recognition and lost revenue.

The PCAOB is also concerned with the ability to validate audit fairness and quality control. [Colson, 2004] To address this issue, the PCAOB has its own Internal Oversight and Performance Assurance Assessment to review its own performance and key program operations. A summary of the report is made public. The latest results of the review conclude that the PCAOB is succeeding in efforts to collect, assimilate, and analyze risk-related information, even though awareness and expectations of the program are still not clear to not only those who the program affects, but also internally. Even with all the efforts made by the PCAOB it is still recommended that additional resources are dedicated to communicating risk assessment information. [Office of Research and Analysis, 2006]

Managing Controversy

Until the PCAOB became empowered, auditing standards were set by the American Institute of Certified Public Accountants (AICPA). The AICPA has often been criticized for creating weak auditing standards and for being too accommodating to its membership in major accounting firms who are more interested in protecting accountants from liability in malpractice lawsuits than in providing and enforcing accounting standards that enforce accountability to shareholders. The AICPA must now pass it’s authority to set auditing standards to the PCAOB, which will focus on standards that are more in the public interest, not in the protection of auditors or their firms.

The establishment of PCAOB power is not without controversy. Recently, the Free Enterprise Institute, and its chief counsel, Kenneth Star, issued a lawsuit against the PCAOB charging that the PCAOB is an unconstitutional body, and further that its creation acts to hinder competition. The basis of the lawsuit is centered on the authority of a private corporation (the PCAOB) to oversee other private corporation's activities and enforce compliance. The lawsuit claims that the PCAOB must be a government entity and subject to Senate approval. The lawsuit aims to enforce accountability to a government agency. [Meyers, 2006] For their part, the PCAOB is asking that the lawsuit be dismissed on the grounds that the argument should be taken to the SEC, the government organization overseeing the PCAOB. Eventually, all agree, this checks-and-balances process will be worked-out.

Another area not yet free of controversy is the registration of foreign firms. From the perspective of foreign firms, it appears that the U.S. is unilaterally imposing regulatory requirements without having negotiated an equitable agreement with foreign governments and foreign firms.

Another area of concern involves disclosure requirements of auditor misconduct and criminal offenses no matter how unrelated to the auditor’s ability to perform an auditing function.

There are other issues mainly related to broad definitions of powers and authority. Eventually these scoping issues and control issues will be addressed in the interests of fair and effective oversight. And of course, the PCAOB inherits many of the ongoing issues related to actual accounting practices that arise as they are discovered.

Final Thoughts on SOX

An incredible amount of time and effort has been spent on understanding and complying with the Sarbanes-Oxley Act (SOX). Preparing for a SOX audit, however, can be an opportunity if the enterprise stops thinking in terms of minimum requirements and starts thinking about maximizing benefits. As part of an overall company strategy, SOX can be a catalyst for reducing waste, creating more efficient business processes, and for implementing new technologies, business models, and related business/social architectures.

Moving the focus to a process-based, control-based environment can be difficult. It means managing business processes as well as people, and knowing how to follow documented business processes instead of following ad hoc procedures. This is turning-out to be a significant change for many enterprises.

Surviving in today’s markets means that the organization must manage in an environment where stockholders and customers are becoming smarter and are doing business faster. Business success may depend on having smarter conversations, which starts with having the right conversations. By analyzing and documenting business processes and integrating controls into those processes, the organization will be able to have better, more precise and smarter conversations about how it does business, both internally and with stockholders and customers.

The accounting profession has shifted dramatically from self-regulatory to direct government oversight. There is little disagreement that the importance of the PCAOB will continue to grow as the inspection process and enforcement measures are increased. Today we are only at the first round of PCAOB inspections, and the issues related to preparing documentation, auditing, and inspecting are still being discovered. All participants agree that the PCAOB is essential to the health of the public company accounting and reporting process to ensure that investors are presented with fair and accurate accounting information. [Farrell, 2005]

Bibliography

Wikipedia, 2006, search term “PCAOB” http://en.wikipedia.org/wiki/Public_Company_Accounting_Oversight_Board

Hill, McEnroe, and Stevens, "Auditors' Reactions to Sarbanes-Oxley and the PCAOB," The CPA Journal Online, Nov. 2005, http://www.nysscpa.org/cpajournal/2005/1105/special_issue/essentials/p32.htm

Marlais, Don, "Sarbanes-Oxley, Revisited One Year later, an Update," American Bar Association Annual Meeting, 2003, http://www.abanet.org/adminlaw/annual2003/SarbanesOxley.pdf

PCAOB, “Inspections,” PCAOB.org, 2006, http://www.pcaobus.org/Inspections/index.aspx

Deloitte Touche Tohmatsu, "Registration of Foreign Public Accounting Firms," IAS Plus, 2006, http://www.iasplus.com/restruct/pcaob.htm

Reason, Tim, "PCAOB: Auditor Judgment under Scrutiny," CFO.com, May 2006, http://www.cfo.com/article.cfm/6878293

Colson, Robert, "Auditing Standards in Transition," The CPA Journal Online, Sept. 2004, http://www.nysscpa.org/cpajournal/2004/904/infocus/p20.htm

Myers, Stephanie, "Lawsuit Challenges Constitutionality of PCAOB," The Trusted Professional, vol. 9, # 5, March 2006, http://www.nysscpa.org/trustedprof/306a/tp2.htm

Office of Research and Analysis, PCAOB Performance Review, Sept. 2006 (IOPA-2006-003), http://72.14.253.104/search?q=cache:XAVFYIOLbZ0J:www.pcaobus.org/About_the_PCAOB/Internal_Oversight/Review_Summaries/2006/Office_of_Research_and_Analysis.pdf

Farrell and Shadab, "The Focus of Future PCAOB Auditor Inspections," The CPA Journal Online, June 2005, http://www.nysscpa.org/cpajournal/2005/605/perspectives/p9.htm


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