A recent Public Company Accounting Oversight Board
The PCAOB has as its stated mission to protect investors by promoting high-quality audits of public companies and registered broker dealers. The board advances these interests by setting rules and audit standards, inspecting audits, issuing public reports on their findings — and enforcing these rules and standards through administrative proceedings imposing severe and sometimes career-ending discipline on accountants and their firms.
The major accounting firms report that they have invested billions in improving audit quality over the lifespan of the PCAOB, and most would agree that a result of being highly regulated by the PCAOB has been consistent improvement in audit quality. A recent Audit Analytics
The PCAOB sees things differently. In a series of public statements this year, its chair, Erica Williams, and other board members have pounded the profession, saying that its inspection results are "absolutely unacceptable" and that audit quality "is not where it should be."
In response, the PCAOB's chair has stated there is a "renewed vigilance" to ensure there are "consequences for putting investors at risk and that bad actors are removed," including "substantial monetary penalties and significant or permanent individual bars and firm registration revocations."
Recent enforcement activity has reflected this initiative. In 2022, the PCAOB brought more cases and collected more fines and penalties than any year in its history. In 2023, that trend has continued, with a series of announcements of record-breaking enforcement actions and a "get-tough" approach that has the entire accounting profession on edge.
Despite these enforcement trends, the PCAOB makes the claim that it needs revisions to its Rule 3502 because it doesn't today have adequate "tools" in its arsenal to hammer audit professionals as a means for improving audit quality. That is the core of its proposed amendments to Rule 3502, "Responsibility Not to Knowingly or Recklessly Contribute to Violations."
The current Rule 3502 puts individual accountants at risk for strict sanctions — censure, financial penalties and ultimately being barred from auditing public companies — for their transgressions. Accountants "shall not take or omit to take an action knowing, or recklessly not knowing" that their actions or omissions contribute to a violation of the Sarbanes-Oxley Act and related rules and standards.
The current rule is consistent with Section 105(c) of the Sarbanes-Oxley Act, which authorizes an array of penalties any time an individual engages in "intentional or knowing conduct, including reckless conduct" in violation of laws or professional standards or engages in "repeated instances of negligent conduct." It is also consistent with standards for imposing penalties for improper professional conduct under the Securities and Exchange Commission's Rule 102(e), which defines improper professional conduct to include "intentional or knowing conduct, including reckless conduct" that results in violations of applicable regulations and standards, or certain types of specified negligent conduct.
Financial statement auditors fully understand their responsibilities to the public, and their accountability for their malfeasance, and the history of regulatory enforcement activity — particularly recent blockbuster penalties — strongly suggests the PCAOB has more than adequate current authority to impose strict sanctions.
Unfortunately, the PCAOB again sees things differently; its proposal is to soften the standards under Rule 3502 so it can impose severe discipline against an accountant for a single simple act of negligence in the performance of audits.
What would that mean in practice?
The reality is that accountants serving as public company auditors are licensed professionals who make thousands of professional judgments in the course of an audit. Is an account material? Are the company's internal controls effective? Can I rely on management's representations? How large a sample should we choose to test receivable balances?
One common definition of ordinary negligence is a failure to comply with professional standards. But the PCAOB sets — and then interprets — the standards. So presumably any time the board — with the benefit of 20/20 hindsight — believes the auditor should have done something differently, that would be an indication of negligence and would subject the accountants to severe discipline for what they perceive as an error in judgment.
Is that the right standard for imposing sanctions?
Under the current Rule 3502, more is required — at least "repeated instances of unreasonable conduct" or "a single instance of highly unreasonable conduct."
The PCAOB says it needs this lower standard to align their regulatory enforcement regime with that of the SEC. It is true enough that the SEC has limited enforcement authority to penalize professionals for a single simple act of negligence — but it rarely does so. Almost without exception, the SEC uses its enforcement powers when there is a pattern of negligence or an extreme departure from professional standards.
In fact, when the PCAOB first evaluated this very issue in 2004, it proposed a simple negligence standard for sanctioning accountants. Commentators were consistent in their objections. One stated that such a low standard "would allow the board ... to proceed against associated persons who in good faith, albeit negligently, have caused a registered firm to violate applicable laws or standards."
Another commented that a simple negligence standard "would place intolerable pressure on the difficult judgment calls that those who operate in this highly technical field must make on a regular basis," noting that a simple negligence standard "is particularly ill-suited for retrospective judgments about compliance with professional standards."
Presumably in response to these concerns, in 2005 the PCAOB dropped the idea. Its release stated that "[a]fter carefully considering the comments received" the board concluded that Rule 3502 should only apply when an auditor "knew, or was reckless in not knowing" their actions would cause a violation of rules or standards.
While many things have changed since 2005, what has not changed is that accounting firms must win the war for talent and attract and retain the best and the brightest in order to perform high-quality audits. Unfortunately, our youth are voting with their feet — choosing alternative careers that require shorter periods of study, give greater near-term financial rewards, and impose far less personal risk.
There is little doubt that the role of independent auditor is becoming less attractive. PCAOB board member Christina Ho recognized this in expressing her concerns about this proposal. Citing publicly available data, Ho noted that if current trends continue, "the U.S. labor market will soon have 50% or more of the accountant openings unfilled each year."
So why then — in the guise of improving audit quality — make things worse? Should a single mistake in work that requires making innumerable significant judgmental calls cost your career? I think not.
