The topic for the research paper will be: The creation of the PCAOB by the Sarbanes-Oxley Act of 2002 dramatically changed the professional landscape for auditors. Analyze and discuss the impact of auditor registration and review, as well as any major pronouncements issued by the PCAOB since its’ creation. Based on your analysis, discuss whether you believe the profession is stronger because of SOX and the PCAOB, or could the same improvement have been achieved by working through the AICPA? In other words, was the creation of the PCAOB a necessary professional improvement or a political cover to appease votes and investors after the Enron debacle?

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Reestablish the Public Confidence in Auditors’

Profession

Lu Han

BMGT422Professor Keim

Assignment May 12, 20162609 words

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Introduction

Accounting scandals and fraud happened frequently and remarkably in 2001 and

2002 (Giles et al). The most shock scandals are Enron and WorldCom in December 2001

and July 2002 (Giles et al). Public groups’ expectations, hopes and confidence were

significantly destroyed because they blamed the U.S. government and American Institute

of CPAs (AICPA) for the failure to detect the frauds (Giles et al). Investors lost their

confidence in receiving high rate of returns because the reliability of auditors’ opinions

on financial statements was questioned. This negatively affected auditors’ profession of

their independence, due care, attestation, risk assessments and testing of quality control

(Giles et al). These auditors’ unprofessional performances had a high risk of causing

accounting deficiencies, quality control judgments and frauds (Church & Shefchik 46).

Such severe auditing issues decreased auditors’ accuracies and reliabilities of testing

financial statements accounts, self-monitoring the procedures of the quality control, and

detecting accounting manipulation. These attributes might ruin the qualities justifications

of their opinions and investors’ interests. The corresponding effect of investors’

unsupported investing decisions would disorder the entire stock exchange and securities

markets (Giles et al). The consequence was that public groups doubted the AICPA’s

efficiency in monitoring accounting deficiencies and frauds (Church & Shefchik 45). In

order to regulate securities market and provide auditors’ high-quality opinions to

investors, Congress passed the Sarbanes-Oxley Act (SOX) of 2002 and created the Public

Company Accounting Oversight Board’s (PCAOB) (Giles et al.). According to the SOX

Act from the PCAOB’s website, the purpose of the SOX Act is to increase the accuracy

and trustworthiness of companies’ disclosed information to protect investors (“SOX Act”

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745). The Act focuses on defining the PCAOB’s duties, auditor independence, corporate

responsibility and enhanced financial disclosures (“SOX Act” 745).

PCAOB Improved Auditors’ Profession

The PCAOB’s mission is to reestablish investors’ trusts and increase investors’

confidence in auditors’ profession after Enron filed bankruptcy (Giles et al.). It was

created along with the Investor Advisory Group (IAG) to better protect investors’

interests against faulty auditing financial reports (“IAG”). Five board members assigned

by the SEC served the board (“SOX Act” 750). As an external regulation and non-profit

organization, the PCAOB is empowered to create and modify standards and principles for

auditors at publicly traded companies (issuers) (DeFond 104). It monitors auditors to

ensure that the auditing reports and risk assessment are subject to the standards. Since

PCAOB’s creation, it adopted the Generally Accepted Auditing Standards (GAAS) of the

Auditing Standards Board (ASB) of the AICPA in April 2003 (“Reorganization of

PCAOB Auditing Standards” 2). It is hard to gather detailed PCAOB’s inspection

process published on the PCAOB and AICPA’s reports (PCAOB and AICPA’s reports in

2008 and 2006 for example) (Church & Shefchik 44). However, the PCAOB partially

published accounting deficiencies and frauds found once inspection reports were finished

(Church & Shefchik 45-46). It did not publish PCAOB’s investigated thoughts of public

companies’ quality control system once these companies updated their internal control

systems (Church & Shefchik 45-46). This led to the difficulty of gathering sufficient data

and detailed critiques on PCAOB’s inspection process (Church & Shefchik 45-46).

Nevertheless, Church and Shefchik’s examinations indicated decreased accounting

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deficiencies (misstatements and non-misstatements) and frauds of large and second-tier

firms and Hermanson’s report on small firms (Church & Shefchik 43).

Therefore, the consequence could be that PCAOB’s efficient inspection

stimulated public companies’ intentions and motivations of avoiding accounting

deficiencies and frauds. Although few papers stated that AICPA’s peer review benefitted

auditors of private companies, there were still suspicions and critiques about the peer

review (Church & Shefchik 45). Main reasons were accounting firms and private

companies’ biased selections of reviewers and the peer review team did not set up a

punishment system (Church & Shefchik 45). This could also refer to DeFond’s argument

that the AICPA is a self-regulator whereas the PCAOB is an external regulator (DeFond

104). Thus, the AICPA could not reach the same level of achievements as PCAOB’s

inspection, enforcement and sanction decreased frauds and deficiencies (Church &

Shefchik 45). In other words, the creation of PCAOB is necessary because it improved

the professional landscape of auditors’ profession.

PCAOB’s Decrease in Accounting Deficiencies and Frauds

The PCAOB decreased accounting deficiencies mainly in non-misstatements, as

well as material misstatements related to issues like revenue, bad debt allowance, leases,

expense and income taxes from 2004 to 2009 inspection years through Church and

Shefchik’s examination on large and second-tier firms, which audited 99 percent of

issuers (Church & Shefchik 43-44). These deficiencies were decreased in small firms too

from 2005 to 2004 in Hermanson’s observations (Church & Shefchik 53). Examining

these firms might have a significant impact on the PCAOB’s further inspection process

because they have relatively high profile varies of clients, which might cover much more

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accounting deficiency issues than small firms (Church & Shefchik 44). Accounting

deficiencies include material and non-material (Church & Shefchik 47-48). Major

material deficiencies were that public companies did not restate financial statements due

to changes they made, companies’ non-GAAP-compliances or company did not adjust

their own accounting principles to GAAP, companies did not correct accounting errors or

make adjusting entries or disclose changes they made after inspection (Church &

Shefchik 47). As the table shows, most deficiencies are non-misstatements, 28% non-

evaluating issues like revenue recognition and GAAP-compliance, and 53.3% non-

sufficient analytical and substantive procedures like completeness of certain accounts and

rationality of certain assumptions in total 88.6% non-misstatements and 11.4%

misstatements (see table 1)(Church & Shefchik 51).

Table 1

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Table 1 Source: "Frequencies of Audit Deficiencies by Severity over Time", "PCAOB

inspections and large accounting firms." Accounting Horizons 26.1 (2011): 43-63.

Upon their examinations, the PCAOB decreased accounting material deficiencies

and severe deficiencies: misstatements by 44.8 percent from the number of deficiencies,

86 in 2009 to 192 in 2004 (Church & Shefchik 53) (see table 1). The results of examining

these deficiency issues are meaningful because it could increase public companies’

initiatives to comply their accounting guidelines with the GAAP and PCAOB’s standard

settings. Although the number of revenue deficiencies and misstatements is not as big as

non-misstatements’ number, decreased misstatements are still meaningful because these

could stimulate companies’ awareness of putting more efforts into avoiding revenue

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manipulations to boost their income and financial statements since PCAOB’s inspection.

PCAOB’s Inspection Vs. AICPA’s Peer Review

The PCAOB is an external regulator whereas the AICPA is a self-regulator

because that the PCAOB’s objective inspection and authorizing power of formulating

audit standards externally oversee auditors’ profession whereas the AICPA’s subjective

peer reviews internally self-regulate CPAs (DeFond, 104). The PCAOB, a non-profit

organization, adopted AICPA’s prior auditing standards and set up new standards

including auditors’ independence, quality control and attestation, in order to inspect and

investigate (sanction if needed) auditors (“SOX Act” 745). It externally monitored public

companies and ensured that they complied with security laws (“SOX Act” 745). The

PCAOB’s main duties include registration, inspection, adopted and created new

standards, and enforcement (including sanction) (“SOX Act” 745). The PCAOB

registered public accounting firms for auditing reports to public companies establish or

adopt ethics, audit quality control, independence, inspect and enforce auditors to,

corresponded to rules (“SOX Act” 745). The SEC appointed five Board members to serve

full-time for five years, without being employed by any other professional entities.

Boards have the rights to write or adopt auditing rules and standards (“SOX Act” 751).

They are committed to protect investors with their knowledge of auditors’ responsibilities

for disclosing financial information, preparing and issuing reports to public companies,

according to security laws (“SOX Act” 751). Only two Boards are CPAs and if one of

them is the chair of the Board, this person should not practice CPA for at least five years

(“SOX Act” 751).

This Boards’ limitation separated the Boards’ inspection from actively practicing

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the CPA in order to objectively inspect auditors’ reports, audit quality, and attestation

SOX Act” 751). Therefore, this PCAOB’s objectivity lost the competence of the CPA’s

practicing expertise compared to the AICPA’s sophisticated reviewers within their peer

review teams. A Private company selected one AICPA reviewer based on two methods of

the firm-on-firm review (FOF) and selecting a reviewer from the association of CPA

firms (“Tips for Selecting Your AICPA”). The selection resources are from the AICPA’s

Peer Reviewer Database or Firm-on-Firm Directory (“Tips for Selecting Your AICPA”).

It is essence to select a reviewer because firms want to guarantee their quality control

material (QCM) in advance and may offer the reviewer a contract to conduct value-added

services in the reviewer’s expertise (“Tips for Selecting Your AICPA”). Meanwhile, they

considered the cost-benefit optimization and value-added while determining the reviewer

because that the reviewer who committed to perform the whole engagement significantly

reduced the cost of the procedure (“Tips for Selecting Your AICPA”). Since companies

had control on the procedure, they preferred selecting the reviewer who practiced similar

specialization at the company, which had similar size and industry service, with the

companies’ own backgrounds (“Tips for Selecting Your AICPA”). Therefore, the

AICPA’s peer review has a huge advantage of competence from value-added and cost

effective reviewers. Meanwhile firms chose reviewers based on identical backgrounds

(“Tips for Selecting Your AICPA”). Therefore, the peer review is lack of objectivity of

external inspection and the AICPA’s inspection’s self-regulation might be biased. Some

companies required their own administrative entities to provide committee-appointed

review teams (CARTs) from the high-qualified pool of reviewers (“Tips for Selecting

Your AICPA”). Firms had the entire control on determining the reviewer acceptance or

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rejection (“Tips for Selecting Your AICPA”). Therefore, although the AICPA established

standards for reviewers’ inspection, firms’ control could still override the standards in

order to meet their needs of reviewers’ value-added expertise in long-term. This override

would raise the risk of firms’ incentives to hide accounting scandals or potential frauds

and it would increase the difficulty for the AICPA to investigate them. Another

consideration is that the sample size and measurement methods of each AICPA’s peer

review team is questioned because that when auditors audit each other, auditors could

potentially be biased especially within the same auditors’ network. In other words, the

peer review is lack of transparency of the auditors’ inspection procedure.

Compared the PCAOB’s inspection with AICPA’s peer review, another

PCAOB’s objectivity is that the PCAOB could be given the authorization to inspect

additional engagements according to the change of regulation (“Peer Review Standards

Interpretations”). According to the article “Staff Inspection Brief” on the PCAOB’s

website, the PCAOB’s inspection decreased accounting deficiencies and increased

auditors’ incentives to improve accuracy, reliance, and high quality of opinions on the

audit report, disclosed information, risk assessment, and necessary analytical procedure

(“Staff Inspection Brief”). The article summarized the PCAOB’s inspection of auditors in

2015 that the inspected firms’ deficiencies decreased compared to the inspection from

2012 to 2014 (“Staff Inspection Brief”). Decreased deficiencies are internal control of

financial reporting, risk assessment and response of material misstatement and

accounting estimates including fair value (“Staff Inspection Brief”). Regarding to the

internal control of financial reporting, the PCAOB decreased the deficiencies of auditors’

failure of test certain controls on some material risks, effectiveness of design controls,

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and testing certain review elements (“Staff Inspection Brief”). Regarding to the risk

assessment, the PCAOB’s inspection decreased the deficiencies of auditors’ failures of

conducting the detailed procedure, testing the accuracy, completeness, and effectiveness

of the data, report and control, and supporting relevant evidence to assertions in the

financial statements (“Staff Inspection Brief”).

PCAOB’s Enforcement and AICPA’s Poor Self-Monitoring

As this paper indicated earlier, the PCAOB’s inspection is more objective and

efficient in decreasing accounting deficiencies and frauds than the AICPA’s peer review

team (“Staff Inspection Brief”; Peer Review Standards Interpretations”). PCAOB’s

another major improvement is the enforcement, sanction and inspection authority and

empowerment to decrease the increasing accounting frauds and restatements and enhance

AICPA’s prior poor self-regulation (Coates 96-97). SOX Act created the PCAOB as a

better commissionaire for enforcement (Coates 97). Before PCAOB’s creation, AICPA’s

self-monitoring was very inefficient because a federal agency did not exist to monitor

auditors and different CPA licensing states had different regulations. The inefficiency

was also because of the increased competition and heavy reliability on lawsuits (Coates

94-97). In order to better conduct PCAOB’s enforcement, Congress increased funding to

the SEC from $437 million in 2002 to $776 million in 2003 (Coates 95). This new

enforcement would increase auditors’ initiatives and incentives to avoid providing

fraudulent opinions on financial statements and improving the testing of quality control.

The enforcement was important also because investors would not only sue companies’

poor internal control system, but also PCAOB’s failure of sanctioning auditors’ frauds

and unqualified opinions (Coates 101). PCAOB’s main improvements of this

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enforcement were disclosing weakness of material and testing those disclosures by

providing agreeing and disagreeing opinions in SOX Act’s section 404 (Coates 102). In

order to efficiently conduct the section 404, PCAOB created new auditing standards of

testing companies’ internal control system, providing testing results, investigating other

material weakness, which companies had not discovered, and providing reasonable

opinions on whether the companies’ system were efficient or not (Coates 102). However,

some professionals doubted the accuracy of PCAOB’s tests of material weakness (Coates

102). They thought that if PCAOB did not conduct cost benefit analysis before testing,

the PCAOB might unconsciously overstate the material weakness (Coates 102). This

might also occur because of PCAOB’s limited budget and it might unnecessary took long

time to do the cost benefit analysis if the PCAOB had enough budget. On the other hand,

the PCAOB increased auditors’ incentives by threatening the lawsuits if auditors did not

fix the discovered material weakness (Coates 103). The result was very pleasant that

auditors put a lot more effort in investigating and fixing material weakness even a small

weakness was discovered by the PCAOB (Coates 103). Meanwhile, the PCAOB helped

companies to reduce or compensate extra costs of investigating and fixing material

weakness (Coates 104). Lastly, in order to better motivate PCAOB’s investigators,

Congress amended that if these investigators failed to detect companies’ undiscovered

material weakness, investigators might be in crime (Coates 105). Therefore, the PCAOB

utilized the inspection authority to empower PCAOB’s investigators’ initiatives of

examining undiscovered material weakness, verifying discovered weakness, and

enforcing companies’ auditors to fix all weakness. This is also PCAOB’s advocate of

non-tolerating any companies’ excuses of not discovering material weakness, sanctioning

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auditors and investigators’ failure of detecting, fixing and investigating weakness.

Therefore, the AICPA’s shortages of inspection authority, empowerment of enforcement,

external (objectivity) regulation and transparency of conducting the enforcement proved

that the AICPA could not reach these achievements as the PCAOB did.

Conclusion

The purpose of the PCAOB’s creation includes the political cover of appeasing

voters to vote to the Senators and House of Representatives because Congress created it

(Giles et al.). The PCAOB’s regulation role well established Congress’s image of

regulating and stabilizing the security industry, stock and capital markets after Congress

created the U.S. Securities and Exchange Commissions (SEC) (Giles et al.). However, its

mainly purpose is to provide auditors’ reasonable and justified opinions to investors by

monitoring auditors’ duties and obligations (“SOX Act” 745). Meanwhile, the PCAOB

will publish reliable, trustworthy and disclosed information to public groups (“SOX Act”

745). The PCAOB’s creation improved auditors’ profession, which is mainly audit report,

audit quality, and risk assessment, by the inspection, investigation, and sanction (“Staff

Inspection Brief”). This impact increased investors’ expectation, faith and confidence in

auditors’ reports for public companies (“Staff Inspection Brief”). The PCAOB essentially

improved auditors’ profession and auditing quality in audit reports and risk assessment to

better protect investors’ interests than the AICPA (“Staff Inspection Brief”).

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Work Citied

Coates, John C. "The goals and promise of the Sarbanes-Oxley Act." The Journal of

Economic Perspectives 21.1 (2007): 91-116.

Church, Bryan K., and Lori B. Shefchik. "PCAOB inspections and large accounting

firms." Accounting Horizons 26.1 (2011): 43-63.

DeFond, Mark L. "How should the auditors be audited? Comparing the PCAOB

inspections with the AICPA peer reviews." Journal of Accounting and

Economics 49.1 (2010): 104-108.

"Frequencies of Audit Deficiencies by Severity over Time", "PCAOB

inspections and large accounting firms." Accounting Horizons 26.1 (2011): 43-63.

Giles, Jill P., Elizabeth K. Venuti, and Richard C. Jones. "The PCAOB and convergence

of the global auditing and accounting profession." The CPA Journal 74.9 (2004):

36.

“IAG.” PCAOB. PCAOB, n. d. Web. 1 May 2016.

" Peer Review Standards Interpretations." AICPA. AICPA, 14 April. 2016. Web. 1 May

2016.

“Reorganization of PCAOB Auditing Standards.” PCAOB. PCAOB, n. d. Web. 1 May

2016.

Sarbanes Oxley Act of 2002. Pub. L. 107-204. 116 Start.745-810. 30 July. 2002. Web.

“Staff Inspection Brief.” PCAOB. PCAOB, n. d. Web. 1 May 2016.

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"Tips for Selecting Your AICPA Peer Review Program Peer Reviewer.” AICPA. AICPA,

n. d. Web. 1 May 2016.

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