PCAOB To Prevent Licensing Of Audit Firms From Certain Countries

October 2010

On October 7, 2010, the Public Company Accounting Oversight Board (PCAOB) announced it will start to refuse registration for auditors based in jurisdictions where American inspectors are not allowed to carry out inspections. This regulatory change will make it difficult on companies in these countries to use U.S. capital markets.

The PCAOB’s change in policy is caused by continuing objections by regulators throughout the European Union, Switzerland, China, and Hong Kong. Previously, based on the original Sarbanes-Oxley Act (SOX), the PCAOB was prevented from providing reciprocating information with anyone, including other governments’ regulators. This troublesome provision was amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act. With this U.S. law change, the EU provided some movement on its prior position, but left a final resolution up to individual country regulators as they deem appropriate. According to the EU decision, regulators can determine on a country-by-country basis whether they will simply transfer audit work papers to the PCAOB, give the PCAOB access to documents through joint inspections, or allow PCAOB inspectors to observe the country regulator’s work.

Since 2004, the PCAOB allowed registration of non-U.S. firms based on the assumption that inspection challenges caused by foreign regulators would be resolved in due course. With the passage of the Dodd-Frank provision that resolved previously-stated reasons for the lack of access, the PCAOB now believes that the continued non-cooperation by foreign regulators needs to change.

The PCAOB announcement describes its international cooperation, as follows:

“The PCAOB and regulatory authorities in several non-U.S. jurisdictions have worked together to overcome potential obstacles to PCAOB inspections. Since 2005, the PCAOB has inspected registered firms in 34 non-U.S. jurisdictions, including in seven jurisdictions where PCAOB inspections have been conducted in coordination with inspections by the local authority.”

The PCAOB published a list of more than 400 U.S.-registered companies whose auditors have not been inspected by the PCAOB and who thereby have escaped regulatory scrutiny. Some of these are enormous companies with billions of dollars of U.S. investment. The audit firms include affiliates of each of the Big Four accounting firms.

The PCAOB explained why this is a significant problem for investors using U.S. capital markets, as follows:

“As of April 2010, the PCAOB has conducted more than 1,300 inspections of registered firms in the U.S. and in 33 non-U.S. jurisdictions. PCAOB inspections regularly identify deficiencies in firms' audits and in their quality control procedures. Well before the PCAOB issues an inspection report, inspections often result in firms performing additional procedures that should have been performed at the time of the audit, and those procedures have often led to the audited company restating its financial statements. In addition, through the quality control remediation portion of the inspection process, inspected firms identify and implement practices and procedures to improve future audit quality.

Because of the position taken by authorities in certain European countries and in China, the PCAOB is currently prevented from inspecting the U.S.-related audit work and practices of PCAOB-registered firms in certain European countries, China, and, to the extent their audit clients have operations in China, Hong Kong. … As long as those obstacles persist, however, investors in U.S. markets who rely on those firms' audit reports are deprived of the potential benefits of PCAOB inspections of those auditors.”

Unfortunately, the ability to share information with foreign regulators, which were allowed by the Dodd-Frank Wall Street Reform and Consumer Protection Act, did not extend to audit committees, investors, and others in the U.S. that would benefit from this highly-relevant information. Consequently the PCAOB continues to be constrained by the SOX provision that keeps PCAOB findings private. This secrecy provision was inserted into the law by the accounting firm lobby. This secrecy provision has served the large accounting firms well, but no one in the investing community who has contemplated this issue thinks that such secrecy is necessary or appropriate.

Disciplinary proceedings by the PCAOB involve a production of evidence, the opportunity for the potentially-disciplined person or firm to explain why no action should be taken, a formal notice and charging process, a trial in which evidence may be presented by all parties, the right to legal counsel throughout the process, and the ability to appeal any decision to the Securities and Exchange Commission. Throughout this entire process, no public information is available about anything that is occurring. The PCAOB states that this lack of public disclosure is the most pressing issue facing its enforcement program. For this reason, the PCAOB has asked Congress to change this portion of SOX.

In recent comments, the PCAOB’s director of Enforcement stated:

“Currently under the Sarbanes-Oxley Act of 2002, these proceedings are required to be nonpublic unless the Board finds good cause to make them public and all parties consent to open them to the public. … The PCAOB is virtually unique among similar regulators in that our disciplinary proceedings are required by law to be kept confidential through charging, hearings, initial decision, and even appeal….

This nonpublic nature of Board disciplinary proceedings has serious adverse consequences for the investing public, audit committees, the auditing profession, the Board, and other interested parties, such as Congress.

First, the nonpublic feature of our disciplinary proceedings denies the public access to important information regarding PCAOB cases. During the course of the proceeding, investors, audit committees, and other interested parties are kept in the dark about a respondent's alleged misconduct — no matter how serious. …

Second, respondents have an incentive to litigate Board cases, regardless of whether they believe they will ultimately prevail. Contesting the allegations rather than seeking a settlement allows respondents to continue with their public company audit practice without any disclosure to clients or investors of the Board's charges for as long as the litigation is ongoing. …Firms and their auditors may litigate to delay disclosure of their audit deficiencies, so that whenever the deficiencies do become public, they can be portrayed as "old news" that does not reflect on the firm's current practices.

Third, the incentive to litigate rather than settle has the effect of consuming considerable PCAOB resources. …

Fourth, the public is deprived of critical information necessary to evaluate the Board's enforcement program. The current nonpublic nature of our proceedings provides no transparency into our performance or priorities. … Allowing for our contested disciplinary proceedings to be made public would certainly strengthen the Board's efforts to promote public trust in the financial reporting process.

Finally, the nonpublic nature of the contested disciplinary proceedings limits the Board's ability to use enforcement authority as a tool to improve audit quality and deter violations of the Board's rules. …Other auditors who face similar situations will not be aware of what conduct prompted the Board to take disciplinary action or the potential severity of sanctions that might result from a violation.

This is all in sharp contrast to an SEC administrative proceeding against an auditor. If the SEC were to bring the same case, alleging the same violations, against the same auditor, the SEC's charges would be disclosed at the time the Commission instituted its proceeding.”

A strong and independent auditing profession is a key ingredient to a successful U.S. capital market. The PCAOB should be fully supported, both in its dealings with other governments, and in its requested ability to operate with greater transparency.

Fulcrum Inquiry performs forensic accounting and financial investigations.