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?
1
Reestablish the Public Confidence in Auditors’
Profession
Lu Han
BMGT422Professor Keim
Assignment May 12, 20162609 words
2
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”
3
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
4
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
5
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
6
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
7
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
8
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
9
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,
10
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
11
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
12
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”).
13
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.
14
"Tips for Selecting Your AICPA Peer Review Program Peer Reviewer.” AICPA. AICPA,
n. d. Web. 1 May 2016.
15