"Bloom, do me a favor. Move a few decimal points around. You can do it. You're in a noble profession. The word 'count' is part of your title."
-- Max Bialystock, a Broadway producer, to his accountant, Leo Bloom, in The Producers
To investors in Adelphia Communications Corp., Enron Corp., Global Crossing, HealthSouth Corp., Rite Aid Corp., Tyco International, WorldCom and far too many other companies, Mel Brooks's Producers offers the frisson of familiarity -- minus the laughs. Favors were extended, decimal points were moved around, and many counts turned out to be criminal. Full-blown accounting scandals at those and other corporations not only cost shareholders billions of dollars but also intensified the stock market crash resulting from the technology stock bubble and then exacerbated the economic downturn that followed. Worse, the accounting scandals inflicted long-term damage on the one critical ingredient of any successful market: investors' faith in the integrity of the participants.
Coming amid the market collapse -- the worst since the Great Depression -- the seemingly endless parade of scandals produced a public outcry over slack corporate governance and, in particular, slipshod auditing practices. "How could so many companies get away with cooking their books for so long?" fumed investors.
Lawmakers, too, expressed outrage, and did something tangible about it. Congress passed the Sarbanes-Oxley Act in July 2002 to crack down on the kind of accounting shenanigans that lay at the heart of the scandals. Now the centerpiece of that unprecedented reform legislation, the Public Company Accounting Oversight Board, is belatedly beginning to flex its ample muscles -- and auditing firms and companies alike are bracing for what promises to be a rigorous new auditing-oversight regime.
Just this month some 90 PCAOB auditors began fanning out to conduct exhaustive examinations of the top eight accounting firms, whose clients include virtually all of the Fortune 500 companies, to determine if they are being tough enough, even to the point of ensuring -- controversially -- that companies' internal financial controls are up to snuff.
The staff auditors are marching into battle well armed. In December, PCAOB issued a ukase -- Audit Standard No.1 -- and declared that its standards would supercede the generally accepted audit standards promulgated by the accounting industry's self-regulatory body, the American Institute of Certified Public Accountants.
Then in March PCAOB came out with its proposed Audit Standard No. 2, which details the work that external auditors must perform to comply with Sarbanes-Oxley's already notorious Section 404. The standard requires the auditors to certify that when companies attest to investors that they have fit and proper internal financial controls, they are telling the truth. For the auditors, this new duty will entail an enormous amount of poking and prodding of companies' innermost financial reporting processes and procedures.
For many companies, complying with Section 404 will involve cleaning up, sorting out and squaring away their internal financial operations. What's more, companies will have to pay extra for the privilege of having an auditor vouch for the soundness and integrity of their internal controls. Comcast Corp. CFO Larry Smith estimates that complying with Section 404 will cost the cable company upwards of $5 million next year when Standard No. 2 formally takes effect.
Many corporate managers, especially those of smaller public companies, are steaming over the prospect of these extensive and expensive new system audits. Dennis Stevens, internal audit director of Seguin, Texasbased Alamo Group, expects the agricultural equipment maker's audit fees to rise by 30 percent in 2005. And that, he adds, is on top of the not inconsiderable costs involved in carrying out his own assessment of Alamo's financial controls. "It was the audit firms' fault that we had the Enrons and WorldComs," grumbles Stevens. "They caused the problem, and now they're going to get rich off of it."
That view may be too cynical (though it is shared by more than a few company financial officers). Tougher audits are plainly in order. If nothing else, the creation of PCAOB should tip the traditional accountant-client balance back toward the auditor -- from Bialystock to Bloom. The board's demand for greater audit quality has given auditing firms the grounds to stand up to corporate officers who insist that 2 + 2 = 5 (if you just count hypothetical interest). Moreover, Sarbanes-Oxley specifies that a company's audit committee must now take responsibility for its relationship with outside auditors. The upshot of the reforms is that auditors are less likely to be bullied by company executives. "Corporate management used to own the auditor-client relationship," says one partner at a Big Four accounting firm. "Now we share the relationship."
Known, not so affectionately, in the corporate world as "Peekaboo," PCAOB functions in essence as the auditors' auditor. In marked contrast to the SEC, however, PCAOB is a private rather than a government agency, drawing its more than $100 million in funding not from federal coffers but from levies on domestic and foreign public companies issuing securities in the U.S. markets.
"The function of PCAOB is to restore the public's confidence in the accounting profession," proclaims William McDonough, the well-regarded former Federal Reserve Bank of New York president who was appointed PCAOB chairman last June by SEC chairman William Donaldson. "I believe the accounting profession is a noble one, and it is extremely important that it carry out its task."
McDonough himself may set corporate executives' teeth to grating. The veteran financier can be an accomplished diplomat: As chairman of the Basel Committee from 1998 to 2003 he led the push for the adoption of new global capital standards for banks, known as Basel II, demonstrating a sure touch in cajoling and prodding reluctant executives to embrace unpalatable policies. But McDonough sees his PCAOB post as a bully pulpit for speaking out on corporate governance issues, and he can be blunt when he chooses. In his frequent speaking engagements, he routinely excoriates CEOs for their excessive pay (see box below).
PCAOB'S CONTENTIOUS BEGINNINGS DID LITTLE to instill confidence in investors or legislators. Congress, aware that public mistrust of corporations had reached a crisis point, gave thenSEC chairman Harvey Pitt just 90 days from the July 30, 2002, passage of Sarbanes-Oxley to name PCAOB's chairman and four other board members. Investor advocates and corporate governance critics were already questioning whether Pitt, who had spent much of the previous decade representing big accounting firms before the SEC, was the right leader for the regulatory agency in the post-Enron era. The politically hapless Pitt, who had been in the job for just 12 months, proceeded to confirm some of his critics' worst fears.
Early speculation had it that the SEC would appoint John Biggs as head of PCAOB. He had developed a reputation as a forceful advocate of corporate governance while chairman of giant public pension fund TIAA-CREF. The American Institute of Certified Public Accountants as well as House Republicans balked; they preferred a more moderate initial chairman.
So in October, Pitt recruited William Webster, who had been a federal judge and a director of the Federal Bureau of Investigation, as PCAOB chairman. This proved to be a blunder. Though widely praised for his long record of public service, Webster, it emerged, had served on the audit committee of U.S. Technologies -- a Washington, D.C.based Internet investment company that the month before had come under investigation in connection with alleged fraud. On April 23 of this year, the company's CEO, C. Gregory Earls, was convicted of 22 counts of securities fraud. Webster's association with the company would have raised eyebrows in any event (although he was never charged with wrongdoing), but Pitt knew of Webster's involvement with U.S. Technologies before he nominated him and neglected to inform his fellow SEC commissioners. Soon after this startling revelation, Pitt submitted his resignation; Webster then quit as PCAOB chairman after just three weeks on the job.
The task of getting the wobbly PCAOB onto its feet fell to board member Charles Neimeier, a former chief accountant of the SEC's enforcement division. One of two certified public accountants that the PCAOB is required to have on its board (the other: Daniel Goelzer, formerly a partner in the Washington office of law firm Baker & McKenzie), the 47-year-old Neimeier was named interim chairman in January 2003 and served until new SEC chief Donaldson appointed McDonough, who took over as PCAOB chairman on June 10, 2003.
"Given the checkered history of getting PCAOB up and running, it was important that they found someone with a recognized name and credentials," says E. Gerald Corrigan, who preceded McDonough as president of the New York Fed and is today a managing director of Goldman, Sachs & Co. "Bill McDonough's appointment was a case of the right man at the right time." Corrigan, who co-chairs Goldman's firmwide risk committee, suggests that McDonough's supervisory experience on both national and international fronts should serve him well at PCAOB, which also oversees foreign auditors of U.S. issuers.
The 70-year-old McDonough, who spent two decades at First Chicago Corp. and was CFO when he left, will need to draw on all his resources to run PCAOB. The board's mission is to regularly and rigorously inspect, investigate and, if necessary, discipline the approximately 840 accounting firms registered with PCAOB that audit the financial statements of companies that have issued or intend to issue shares in the U.S. In addition, the board is charged with developing new auditing standards, subject to SEC approval (see box at left).
It is tempting to describe PCAOB as an SEC for auditors, but that would be only half correct. "We're an extension of the SEC safety net established in 1934," explains Neimeier. "Unlike the SEC, however, we have a supervisory model. We get close to the profession -- more like the way banking regulators operate."
The auditing firms that fall under PCAOB's purview must sign a consent form obliging them to produce documentation or give oral testimony at the board's request. The firms in turn have the right to review PCAOB's inspection reports and, if they dispute the findings, seek a review by the SEC. Moreover, PCAOB is bound by Sarbanes-Oxley not to release for 12 months any portions of an inspection report that fault an auditor, giving the firm time to correct the defects. If the firm dawdles, however, PCAOB can divulge its unresolved problems to the public -- which would be devastating. "We have immense leverage with the firms and can say, 'You've got to fix this or else,'" says McDonough.
PCAOB also possesses the power to investigate the actions (or inaction) of an auditing firm or an individual auditor if it suspects that they violate Sarbanes-Oxley, PCAOB's own standards, securities laws or other relevant professional requirements. If firms or individuals are found to be in violation or refuse to cooperate, PCAOB can bar them from the profession or revoke their registration -- effectively putting them out of business. PCAOB can fine individuals up to $100,000 per violation and firms up to $2 million, subject to SEC approval. For especially egregious misconduct -- "intentional or knowing," as Sarbanes-Oxley phrases it -- the sanctions can be boosted to as much as $750,000 and $15 million, respectively. Given the inevitable intertwining of accounting and auditing wrongdoing, PCAOB's newly hired director of investigations and enforcement, Claudius Modesti, will be working closely with the SEC's enforcement division.
HAD PCAOB EXISTED FIVE YEARS AGO, WORLDCOM, for instance, would likely have found it far harder to get away with capitalizing $11 billion in expenses in what amounted to a crude act of fraud. "Why didn't the auditors find the series of journal entries for $771 million in capital expenditures? It beats me," marvels Dennis Beresford, a former Financial Accounting Standards Board chairman who is currently a member of the audit committee at MCI, as WorldCom is now known. The telecommunications company filed for bankruptcy just two weeks before Congress passed Sarbanes-Oxley. At Enron the failure of audit oversight was even more glaring. Auditors from the now-dissolved Arthur Andersen not only failed to bring the fraud to light, but they also played a key role in constructing the labyrinth of off-balance-sheet entities that hid the energy company's true risks and liabilities.
Last summer PCAOB did preliminary inspections of the Big Four auditing firms to make a general assessment of the "tone at the top," as McDonough puts it. PCAOB's inspectors looked at compensation and promotion practices in particular to make sure that audit quality, not new business development, was being properly rewarded. "My impression," says McDonough, "is that they're making progress. There's been a shift in the direction of audit quality and toward the audit's being the most important product the firms offer." The inspections that PCAOB is now conducting focus on individual audit "engagements" and whether generally accepted accounting principles are being properly applied.
The board's inspectors are looking especially hard at whether auditing firms comply with SEC Staff Accounting Standard 99 regarding material errors and the identification of fraud. "We want to make sure companies are designing and performing procedures to detect fraud," says George Diacont, PCAOB's director of registration and inspections.
Goldman Sachs' Corrigan sees "a real parallel" between PCAOB inspections and bank examinations. "The PCAOB is a start-up with no established wisdom on what an inspection program should focus on," he explains. "Having a leader like McDonough who has oversight experience is an enormous plus."
The auditors' audits have naturally aroused some grumbling within the formerly self-regulated profession. But that is tame compared with corporate executives' gripes about the cost and trouble of the new oversight regime. The complaints home in on the audits of internal financial controls. Auditors must now render an opinion not only on financial statements but also on the reporting system that generated them, from the recording of sales to the booking of expenses.
The relevant portion of the Sarbanes-Oxley Act, Section 404, is less than 20 lines long, but what it lacks in verbiage, it makes up for in impact. Of all the changes in securities laws and corporate governance rules contained in Sarbanes-Oxley, 404 is costing corporations the most and producing the sharpest criticism.
Subsection (a) of the law requires corporate managers to provide a statement of their responsibility for maintaining an effective system of internal controls over financial reporting; they must also make an annual assessment of the effectiveness of that system. It is subsection (b) where PCAOB comes into play -- and where corporate managers' costs, and hackles, tend to rise. It dispatches auditors to "attest to and report on" management's assessment of its internal financial control systems as part of the regular annual audit of the company's financial statements. This so-called attestation must be made in accordance with standards issued or adopted by PCAOB.
On March 9, PCAOB submitted a 211-page standard for the auditors' attestations to the SEC for review; the commission is expected to approve the new standard by the end of this month or early June.
As written, Audit Standard No. 2: An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements requires that an external auditor perform a significant amount of testing of a company's internal financial controls before issuing a formal opinion on the company's own assessment of those controls. The mere possibility that an auditor might issue a "qualified" opinion has many companies scrambling to shore up internal controls that could be judged lax.
In fact, ever since the passage of Sarbanes-Oxley 22 months ago, corporations have been girding for a tough new internal controls standard from PCAOB. But now that they're getting an inkling of how burdensome the compliance process can be, many executives are loudly complaining that the cost far outweighs the potential benefits to investors. Of the 98 comment letters on Audit Standard No. 2 that PCAOB has received from corporate executives or business groups, almost all say the standard is too burdensome. "[It] will result in far too much redundant, valueless effort by the auditors," wrote Steven Root, director of finance administration and process at Northrop Grumman Corp. AT&T controller Nick Cyprus suggested that "external auditors should have the ability to rely more heavily on the work of independent internal audit departments." And Robert Brust, CFO of Eastman Kodak Co., put the issue in a global context. "The proposal has the potential to place U.S. companies at a disadvantage with their foreign competitors," he wrote.
At the heart of the controversy over 404 is the amount of testing that auditors must do to issue an opinion on management's self-assessment. Many managers, like Alamo's Stevens, reason that the more they do to beef up their own internal auditing procedures, the less work their external auditors should have to do -- and the lower their fees would therefore be. In reaction to the overwhelmingly negative comments from executives, PCAOB moderated its position, giving auditors more flexibility to decide how much testing to perform. The guideline is logical: The stronger a company's system of internal controls, the less individual testing is required. "We certainly don't want to discourage issuers from having a good internal audit function," says McDonough. Adds Douglas Carmichael, director of audit standards at PCAOB: "There were some legitimate cost-benefit considerations. We've tried to provide for more judgment on the part of auditors."
Nevertheless, to many financial managers PCAOB's concesson is not enough. "The final rule allows the audit firms to have more flexibility," says Robert Schneider, CFO of Jasper, Indianabased furniture maker Kimball International, "but the actual extent of testing itself was not reduced significantly."
The skeptics are not confined to corporate suites. "To the extent that [Audit Standard No. 2] helps issuers and auditors ferret out errors, it's useful," says former FASB chairman Beresford, who teaches accounting at the University of Georgia. "But it can't guarantee that there won't be more financial frauds. I don't think it's worth the cost."
A survey of 321 public companies with revenues ranging from less than $25 million to more than $5 billion by Financial Executives International found that as a group they expect to spend 35 percent more on external audit fees in 2005 than they do now, because of the internal controls provision. The 65 largest companies in the survey by the Florham Park, New Jerseybased professional association estimated that the first-year costs to accommodate the internal controls standard could exceed $4.6 million, on average. That figure is likely to decline in future years once the initial documentation is done.
Not so surprisingly, auditors find merit in the revised internal controls standard. "The principal evidence that auditors have to assemble for the review still has to come from their own work, but there's now a lot more latitude in terms of the specific procedures they perform," says Raymond Bromark, leader of the professional practices group at PricewaterhouseCoopers. He believes that companies seeking only to minimize the cost of compliance are missing the opportunity to improve their reporting processes. "We'll wind up with more effective audits of more efficient systems," contends Bromark.
PCAOB makes no apology for the extra cost that Audit Standard No. 2 will impose on companies. Says former acting chairman Neimeier: "It's significant. But compare it to the cost of executives using private aircraft -- I've got a feeling it's nowhere near as much." PCAOB board member Kayla Gillan, California Public Employees' Retirement Service's former general counsel, points out that the fundamental question behind the standard is whether auditors take management at its word or whether they need to look behind what management says.
For his part, McDonough pledges that he and the other board members will closely monitor auditors' fees to ensure that they aren't gouging companies. "The internal control assessment is expensive," he concedes. "But we don't want to make it any more expensive than it has to be."
Investors, who must ultimately shoulder increased audit costs, appear to think the money is well spent. Keith Johnson, chief legal counsel for the State of Wisconsin Investment Board, says that good internal financial controls definitely increase his level of confidence in a company's financial statements. He suggests that "companies are getting a shock [on fees] now in part because the real cost of audits has been subsidized by consulting business for a long time." Sarbanes-Oxley bars auditing firms from offering most nonaudit services to their auditing clients.
If domestic companies were upset about having to go along with PCAOB rules, the foreign companies that have issued securities in the U.S. and the non-U.S. accounting firms that audit about 1,450 U.S. companies were outraged, at least initially. They, too, are subject to PCAOB's oversight. Many such auditing firms and their home regulators viewed Sarbanes-Oxley as a solution to a distinctly American problem and resented its being imposed on them. "When most foreign companies accessed the U.S. markets, they didn't expect this," says Dixie Johnson, a partner with international law firm Fried Frank Harris Shriver & Jacobson.
Recent accounting scandals at European companies, such as Royal Ahold, Royal Dutch/Shell and Parmalat, however, have demonstrated emphatically that financial reporting fraud is not solely a U.S. phenomenon. In the past couple of years, market centers in Europe have been working on overhauling their own oversight regimes. And on March 25 the European Commission announced a plan to have all EU members create audit oversight agencies analogous to PCAOB. McDonough and European Union internal market commissioner Frits Bolkestein have pledged to cooperate on audit oversight issues. "Market regulation and corporate governance practices around the world are undergoing a harmonization," says Jay Clayton, a London-based partner at law firm Sullivan & Cromwell.
Nevertheless, Europeans remain wary of the long reach of PCAOB. And McDonough, fluent in French and Spanish, has had to use his diplomatic skills to defuse a global regulatory turf war. Notes Goldman Sachs' Corrigan, "There are some cross-border tensions here, and the international community now has a known quantity in McDonough."
The PCAOB chairman sounds positively conciliatory. "Other countries don't have to have the same audit oversight framework as we do," he points out. "After all, look at Enron. A lot of people wouldn't give the U.S. high marks for its oversight regime in the past couple of years."
PCAOB intends to gauge country by country whether non-U.S. accounting firms that audit foreign or domestic issuers in the U.S. require additional oversight. German audit firms, for example, are not currently subject to independent oversight at home, so they are likely to find that PCAOB takes a keen interest in them.
PCAOB is still gearing up for its globe-spanning mission. And running a little late: Sarbanes-Oxley envisioned the board having "the capacity to carry out [its] requirements" by April of last year. Accordingly, McDonough has had the agency on double-time since arriving 11 months ago.
Inspections director Diacont hopes to have a staff of about 150 inspectors by year-end and intends to hire more next year. It will take a small army of auditors to conduct annual inspections of auditing firms with more than 100 clients and triennial audits of the remainder. For the Big Four, PCAOB's experts will comb through work papers for about 500 audit "engagements," or approximately 5 percent of their entire corporate practices. For smaller firms, the inspectors will look at fewer engagements. Diacont is looking for CPAs with at least six years' experience in public practice. PCAOB pays significantly better than government agencies: Congress wants the new regulator to be able to compete for the best and brightest in the accounting profession.
Recruiting is getting easier, Diacont says, now that PCAOB, which has offices in Washington, New York and Alexandria, Virginia, and will soon open new ones in Atlanta, Dallas and San Francisco, is better established. He concedes, however, that "a lot of organizations are competing for the same people." Namely, the Big Four auditing firms, which are hiring again: Not only did they pick up clients from Arthur Andersen, but audit work has grown in the past couple of years. Although PCAOB will not disclose inspectors' salaries, they are competitive with those that audit firms offer -- and significantly better than the SEC salary for a similar job. (McDonough himself makes $575,000.) More than half of PCAOB's $103 million fiscal 2004 budget -- which is about one eighth the size of the SEC's -- is slated for salaries. Suggests Neimeier: "We could be heading into a golden age of auditing. Who knows, maybe it could become cool to be an auditor."
Maybe so, but from now on, auditors will have to sharpen their pencils to a finer point. "The existence of PCAOB is making the audit profession a lot more careful," says Charles Elson, a corporate governance expert at the University of Delaware. "The auditors are looking over their shoulders more, and that's a good thing."
McDonough's new mission
William McDonough was not the first choice to run the new Public Company Accounting Oversight Board. Former Federal Bureau of Investigation director William Webster preceded him -- briefly. As it turned out, Webster had been chairman of the audit committee of U.S. Technologies, an Internet investment company that became the object of a fraud investigation -- not the best qualification for someone overseeing a body dedicated to restoring confidence in the auditing profession. Webster resigned after just three weeks on the job.
In retrospect, McDonough, who was named PCAOB chairman last June, could hardly be a better candidate for that sensitive position. For a start, he brings no baggage to the job. As the longtime president of the New York Federal Reserve Bank -- which doesn't permit its members to serve on corporate boards -- McDonough has been effectively insulated from the accounting scandals of recent years. Moreover, he is a proven leader with plenty of experience in politically charged environments. He was Federal Reserve Board chairman Alan Greenspan's point man on the Fed's Open Market Committee as well as chairman of the powerful Basel Committee on Banking Supervision.
"The board was very fortunate to attract someone of McDonough's stature and political savvy," says J. Michael Cook, who retired in 1999 as CEO of Deloitte & Touche. "It needed a leader who wouldn't be challenged for what he'd done in the past."
Why would a 70-year-old who had already had a distinguished career take on the enormous challenge of establishing the PCAOB as the newest regulator in the U.S. capital markets? "Maybe it's my Jesuit upbringing," suggests McDonough, who did his undergraduate work at the College of the Holy Cross in Worcester, Massachusetts, before earning a master's degree in economics at Georgetown University. "It rendered me incapable of refusing public service."
Contributor Andrew Osterland spoke with McDonough in the chairman's modest office on K Street in Washington.
Institutional Investor: What is the mission of PCAOB?
McDonough: The function of PCAOB is to restore the public's confidence in the accounting profession. The job needs to be done and done well by people who believe in the mission. I do. I believe the accounting profession is a noble one, and it is extremely important that it carry out its task in the capital markets.
How do you see your role?
The position had to be filled by somebody with a balance between two extremes. If you had a zealot who believed that all accountants should be burned at the stake, the accounting profession and public issuers would become so risk-averse that it would be an obstacle to economic growth. On the other hand, you want someone who will take on the mission with sufficient zeal. Our specific responsibility is for the oversight of the audit profession. However, I've been encouraged by members of Congress to view the mandate more broadly in the general area of corporate governance. It's that broader vision that has made me so vocal on the issue of executive compensation.
What are your views on that subject?
There's been almost no progress in rationalizing executive compensation. A recent Towers Perrin survey put the average CEO's pay at 500 times that of the average worker. We seem to still be in the same atmosphere of greed that we've been in for a while. The model has to be broken. I advocate doing a serious study to value what a CEO's job is worth, and if CEOs don't agree, we're better off without them. I can find all kinds of qualified people willing to be a CEO for reasonable remuneration. If overpaid CEOs go pout on the golf course, it won't bother me.
Have companies improved their financial reporting and corporate governance practices?
We can see a good deal of progress establishing better internal controls. Audit committees are taking their responsibilities more seriously. They understand that it's their responsibility to hire the auditors and work with them and that they're not the mouthpiece of management. They are there to police management in the interests of shareholders.
Do you see corporate managers supporting these changes?
We want management teams that run businesses for the long haul -- strategically rather than on a quarterly basis. The notion that companies are supposed to have an ever-rising quarterly trend is pernicious, and it will take an education of the market to change it. That's why I want the strongest companies to do it first. It will take some real guts on the part of people running even the strongest companies to say, "We are going to run ourselves this way." Warren Buffett has done it, and if ten other great companies were also to do it, it would set a great example.
PCAOB did preliminary inspections of the Big Four accounting firms last summer. What did you learn?
It's a little early to tell how far the firms have come, but my impression is that they're making progress. There's been a shift in the direction of audit quality and toward the audit's being the most important product the firms offer. In due course, we'll put out a broader think piece on what we've learned about all four firms.
How much information about your inspections of auditing firms will be made public?
We haven't yet decided. The statute [Sarbanes-Oxley Act] says that critical comments are to be held confidential between PCAOB and audit firms for one year, and if the problems haven't been corrected in that time, then the information will become public. We haven't determined to what degree that may inhibit the fullness of the reports. The extreme conclusion is that we could end up only saying good things about the audit firms. The positive thing about this is that we have immense leverage with the firms and can say, "You've got to fix this, or else." On the other hand, we also have to inform the public. We have to strike a balance between these two objectives.
PCAOB also oversees foreign auditors whose clients are issuers in U.S. markets. How will you do that?
Our present plan is for foreign audit firms [which audit about 1,450 U.S. companies] to register and have the same requirements for the internal control attestation as domestic audit firms. It's really the responsibility of the issuer. Management has to certify their disclosures, and auditors have to conduct an audit and attest that 1) internal controls are strong enough and 2) that management has done enough to make its attestation.
How are your relations with European regulators?
There are rules about how we deal with reciprocity. Countries have different laws and traditions. They don't have to have the same oversight framework as we do, but it needs to be good and independent oversight. If the country has no audit overseer, we will have to inspect the firms ourselves. If oversight is weak, we'll do more work, and if it's strong, we would want to have just one or two people involved, because we know more about U.S. generally accepted accounting principles. I think the problem is essentially behind us.
What do you say to critics who complain that PCAOB's rules make audits of internal financial controls too costly?
The internal control assessment is expensive. But we don't want to make it any more expensive than it has to be. Either the auditor will pay no attention to what management has done [on its assessment] and do everything itself, or it will rely on management for some of the work. It's a balancing act. We certainly don't want to discourage issuers from having a good internal audit function. It requires some judgment from the auditor.
How much are accounting rules to blame for the breakdowns we have seen in financial reporting?
The accounting standard for derivatives [FAS 133] has about 800 pages of prose to it. The reason is because the Financial Accounting Standards Board kept accumulating more and more guidance to cover every possible situation. If you're a malefactor, it seems to me that within those 800 pages you can find a way to do just about anything you want to do.
A pure principles-based system cannot be achieved. On the other hand, getting from 800 pages to something more sensible is much to be desired. We're moving in the direction of principles-based accounting.
Setting the standards
Douglas Carmichael is the conscience of the Public Company Accounting Oversight Board -- and a prickly one, at that. As the director of the Center for Financial Integrity at Baruch College in New York City from 1983 to 2003, Carmichael consistently warned that the quality of audits of public companies was progressively deteriorating.
"The problems were a long time building," he contends. "Over time there was a loss of the public-interest perspective in standard-setting."
Now, as PCAOB's director of audit standards, Carmichael is making those standards considerably tougher in keeping with the agency's mandate to restore faith in a discredited accounting profession.
He will be getting some help in that endeavor from a 30-person audit standards advisory board, which was named on April 15. Its chief task, says Carmichael, will be to take inventory of existing standards and help determine which ones ought to be improved. All PCAOB standards require the ultimate approval of the Securities and Exchange Commission.
PCAOB's standing advisory group comprises six corporate executives -- among them, Pfizer CFO David Shedlarz and General Electric Co. operating controller John Morrissey -- as well as six partners from different auditing firms, four representatives of pension funds (including TIAA-CREF) and 14 lawyers, academics, consultants and former securities regulators.
The group's first meeting, which will be observed by representatives of the Financial Accounting Standards Board, the General Accounting Office, the International Auditing and Assurance Standards Board and the SEC, is scheduled for June 21 at PCAOB's K Street headquarters in Washington. It is open to the public.
It didn't take Carmichael long to accept PCAOB's job offer, even though it meant that he would be spending far fewer weekends at his farm in Lumberville, Pennsylvania. "My wife said the job description read like it was written for me," says Carmichael, 62. Carmichael was in charge of standard-setting at the American Institute of Certified Public Accountants from 1969 to 1983, an experience he describes as "frustrating." He then left to became an accounting professor at Baruch.
Long before Carmichael arrived at PCAOB in March 2003, the big accounting firms had reconciled themselves to the idea that their days of self-regulation were numbered. They hoped, however, that standard-setting might remain in the hands of practitioners rather than regulators. And the Sarbanes-Oxley Act of 2002, which created PCAOB, did allow for that task to be delegated to an outside party, such as the AICPA. But soon after he took the job, Carmichael let it be known that he and PCAOB would be calling all the shots, subject to SEC approval.
"It's just not feasible for AICPA to set standards in the public interest," Carmichael says matter-of-factly.
The very first standard that the PCAOB board adopted, in December 2003, changed the fundamental language of the audit opinion. Audit Standard No. 1 requires that auditors perform their work "in accordance with the standards" of PCAOB, not the generally accepted audit standards developed over the years by the AICPA. For the time being, PCAOB has adopted GAAS as its interim standards until Carmichael and PCAOB can accept, amend or replace them one by one.
In one dramatic change, PCAOB in March issued Audit Standard No. 2, establishing new rules for the auditing of companies' internal financial controls. Carmichael and the board appropriated and modified an AICPA working group recommendation that had never been implemented.
Howls from the business lobby about the cost of compliance persuaded PCAOB chairman William McDonough to moderate the proposed standard, which will take effect next year. Auditors will be given more flexibility in deciding the extent of systems testing.
Carmichael insists, however, that auditors still have to conduct walk-throughs of all major classes of transactions to make sure that they are being performed consistently and are authorized by the appropriate persons.
"Internal controls are not a complete solution to management fraud," Carmichael says, "but the things we've done make it more difficult to commit." -- A.O.
