PCAOB and SEC on reform: Changing hearts and minds

The two regulatory "missionaries" responsible for bringing religion to the accounting profession - the Public Company Accounting Oversight Board and the Securities and Exchange Commission - told House lawmakers that their tandem efforts are paying off.Oversight of auditors by the three-year old PCAOB "has already changed the environment of registered public accounting firms," and the board's regulatory presence has "triggered a profound shift in the overall character of public company auditing," PCAOB Chairman William J. McDonough said in remarks before the House Financial Services Committee.

"More important," he said, "our oversight has changed auditors' attitudes toward their accountability," because they now "understand that their work is much more likely to be reviewed within months or even weeks by the PCAOB's well-experienced, full-time inspectors."

Meanwhile, Securities and Exchange Commission Chairman William H. Donaldson struck a similar chord in his testimony to the committee, noting that new SEC rules mandated by the Sarbanes-Oxley corporate reform law are encouraging auditors to stick to the straight and narrow.

Citing recent SOX-related rulemaking to discourage improper influence by audit clients and require greater audit record retention, thereby enhancing auditor independence, Donaldson said that these actions "have begun to have a beneficial effect in strengthening the integrity of the independent audit."

In addition to raising the level of auditor integrity, the SEC chairman suggested that his agency's post-SOX reforms have also helped many audit clients see the light.

Thanks to the new rules, "we have also seen that audit committees are taking their responsibilities seriously, and that they are much more sensitive to auditor independence issues," Donaldson told Congress.

Part of the credit for the improvement of audit integrity over the past year belongs to the rigorous inspections conducted by the PCAOB's field agents, McDonough said.

During 2004, the board's inspectors reviewed more than 500 audits performed by the eight largest U.S. accounting firms, and many of those reviews prompted the PCAOB to focus additional scrutiny on the firms involved in order to uncover "the root causes of poor auditing."

Rather than reviewing "a mere random sample of engagements," he said, "if we find a poor-quality audit that passed the muster of a firm's own internal quality control review, we will review other work performed by the same audit partner and engagement team. We will also review other work performed by the internal reviewers who missed the reviewed partner's errors."

Because this rigorous inspection strategy tends to uncover additional problems, "it gives auditors a good bit more anxiety, and correspondingly greater incentive to stay on their toes," McDonough testified.

Good news for smaller firms

While the PCAOB's rigorous oversight appears to be encouraging more diligence among accountants, it doesn't seem to be squeezing smaller firms out of the audit business. Indeed, just the opposite appears to be taking place, the PCAOB chief told the House panel.

In contrast to warnings that the accounting oversight requirements imposed by SOX would "impose a barrier to small firms' ability to compete for public company audit clients," it has been the major CPA firms that have experience slippage over the past two years, McDonough said.

A number of small accounting firms "have actually increased the number of public companies that they audit, as the larger firms have reduced their number of smaller public company clients," he told the committee.

One study that was cited by the PCAOB chairman reported that the Big Four accounting firms experienced a net loss of 400 audit clients throughout 2004, while the next four largest firms added 117clients, with smaller accounting firms posting a net gain of 217.

That study, conducted by proxy researcher Glass, Lewis & Co., concluded that "the larger firms appear to be more selective these days in accepting smaller companies to audit," while smaller firms "may be one of the largest beneficiaries of" SOX.

In view of this, McDonough said, "We expect to see smaller firms seizing opportunities to expand their business by taking on new clients appropriate to the size and sophistication of the firms' practices."

Although the PCAOB's rules are likely to create special challenges for smaller accounting firms engaged in public company audits, the board is moving to address these issues through "an aggressive outreach effort," McDonough testified.

Since last fall, he said, the PCAOB has conducted six two-day discussion sessions for small firms and their audit clients around the country, and at least four more of these forums will be held soon in Denver, Pittsburgh, Orlando, Fla., and Boston.