The Public Company Accounting Oversight Board (PCAOB) defended its recently finalized quality control standard (QC) in response to criticisms by auditors and businesses that the new external quality control function (EQCF) requirement for larger firms in the standard is flawed and does not meet the threshold for the Securities and Exchange Commission (SEC) to approve it. The commission oversees the board, and any significant changes to its standards must first be approved by the SEC before they become effective.
In an August 16, 2024, letter to the SEC, the PCAOB pointed out that large firms already voluntarily have in place some type of independent advisers or monitors intended to showcase how great they are doing in terms of their audit work. And “the existence and variety of those roles demonstrate that implementing the EQCF requirement is feasible rather than unrealistic,” the PCAOB said.
The PCAOB’s 28-page letter comes after the SEC on August 13 decided to delay once again its decision until September 9 about whether to approve, reject, or institute its proceedings to determine whether to disapprove the QC standard.
The decision to delay is likely due to unified opposition by large audit firms, the Center for Audit Quality (CAQ), and the U.S. Chamber of Commerce, against the EQCF. The business group has even threatened to sue if the SEC moves to approve the standard without addressing their concerns.
PCAOB: EQCF Based on ‘Extensive’ Input
The EQCF would be composed of one or more persons who are not part of the firm to promote independent oversight of QC system, which is foundational to audit quality.
The board noted that the new requirement was informed by “extensive stakeholder input over many years,” including the Department of the Treasury’s Advisory Committee on the Auditing Profession’s 2008 recommendation that the PCAOB consider “firms appointing independent members with full voting power to firm boards and/or advisory boards with meaningful governance responsibilities to improve governance and transparency of auditing firms.”
In making its case, the PCAOB said “certain firms have acknowledged the limitations of internal QC functions led by non-independent employees and have touted the benefits of independent review, which can help a firm identify areas of improvement in its QC system.”
The new QC standard does not spell out the responsibilities of the EQCF but must include at a minimum, evaluation and reporting on the effectiveness of the firm’s QC system, which auditors oppose. But the board said that independent external oversight is necessary to drive audit quality at larger firms.
“By enhancing the discipline with which a firm carries out its own QC system evaluation, the PCAOB believes that the EQCF would drive improvements in a firm’s QC system, which ultimately would benefit investors, audit committees, and other stakeholders,” said the PCAOB, which has a single mission to protect investors.
This also comes as audit quality—as measured by inspection results–needs to be improved. While the percentage of audit deficiencies found among the largest firms has plateaued, the deficiency rate remains relatively high.
Democratic Senator Sherrod Brown of Ohio, who serves as the chair of the Senate Banking Committee, in an August 15 letter to the SEC pointed out that 40% of the issuer audits inspected in 2022 had one or more deficiencies. While he did not cite the 2023 inspection results unveiled last week, the deficiency rate for last year was 46%.
In his view, audit deficiencies “can put Americans’ savings at risk if they result in inaccurate financial statements for publicly traded companies.”
“The new rules will emphasize accountability…, balance risk-based approaches to QC with required risk assessments, broaden the responsibility for monitoring and remediating deficiencies, and require a rigorous annual evaluation of each firm’s QC system,” Brown wrote. “Rather than creating confusion, the new standards clarify minimum acceptable quality control standards for public company auditors, enhancing confidence in our markets.”
QC Project
Meanwhile, the PCAOB also disputed the claim that the EQCF requirement is not a logical outgrowth of the board’s proposal. Critics said that the public was not given an opportunity to comment on the EQCF.
That’s not true, the PCAOB said.
When it first issued a concept release on QC in December 2019, some firms had appointed independent directors or set up equivalent or alternative means of external oversight. And the board sought comments on independent oversight over firm’s QC systems.
Twenty-seven commenters responded to the question, highlighting the importance of independent oversight of a QC system. The PCAOB then moved to issue a proposal in November 2022, which included a provision for larger firms that their governance structure incorporate an oversight function that included at least one person whose relationship with the firm would not “interfere with the exercise of independent judgment.”
In response, 22 commenters weighed in, and the PCAOB “reflected the comments received” in its adopting release in May 2024.
“Many commenters called for more clarity and specificity about the role of the oversight function,” PCAOB Secretary Phoebe Brown wrote to the SEC.
“In response, the PCAOB changed ‘oversight function’ to ‘external oversight function’–consistent with the Concept Release’s and Proposing Release’s references to ‘external oversight’ and with the provision’s independence requirement–to underscore that the function is to be carried out by one or more persons who are independent and, necessarily, external to the firm.”
And the PCAOB revised the provision to say that this function must evaluate the “significant judgments made and the related conclusions reached by the firm when evaluating and reporting on the effectiveness of the firm’s QC system.”
Among other problems, the U.S. Chamber told the SEC that having independent third parties “reassess” audit firm QC judgments and conclusions is unrealistic.
“But these concerns do not reflect what the EQCF provision actually requires,” the PCAOB said because the standard gives flexibility to firms to design their EQCF.
“Specifically, within the EQCF requirements of QC 1000, firms may designate different responsibilities depending on their circumstances and needs–as is the case with respect to many aspects of QC 1000,” the PCAOB said. “Nor must the EQCF ‘reassess’ the firm’s judgments and conclusions.”
In addition, the PCAOB disputed claims that firms cannot reveal QC criticisms to the EQCF.
Even “if the EQCF needs such information, disclosure of it to the EQCF would not be tantamount to public disclosure…, nor would it be inconsistent with the confidentiality provided by” the Sarbanes-Oxley Act of 2002.
“Indeed, it appears that some firms currently share such information with external advisors,” the PCAOB told the SEC.
The Sarbanes-Oxley Act “expressly contemplates that ‘independent contractors’ could be compensated by a firm or participate in activities on behalf of a firm in connection with the preparation or issuance of audit reports. The statute treats those independent contractors as ‘associated persons,’ and, like all other associated persons, they must cooperate in, and comply with PCAOB requests in connection with, inspections and investigations.”
“The commenters’ position cannot be squared with this treatment,” the PCAOB stated.
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