The Public Company Accounting Oversight Board (PCAOB) recently finalized quality control (QC) standard, which is strongly opposed by auditors, and it appears to have hit a wall.
The Securities and Exchange Commission (SEC) oversees the board, and the commission must approve the audit regulator’s rule changes before they can become effective. And the commission for the second time in a row is delaying its action whether to approve, reject, or institute proceedings to determine whether the standard should be disapproved. Now the commission will decide by September 9, 2024, according to Release No. 34-100724, published on August 13.
Potential Lawsuit Causing Delay?
A delay means there are issues that need to be resolved.
While the SEC does not divulge details about exactly why it needs more time to make up its mind, it is highly likely that it is concerned about the threat of litigation by the U.S. Chamber of Commerce if the commission goes ahead and greenlights the PCAOB’s QC standard without addressing what it sees as fundamental problems with a new requirement that would apply to larger audit firms: External Quality Control Function (EQCF).
Among other things, the EQCF must evaluate significant judgments and the related conclusions reached by the firm when evaluating and reporting on the effectiveness of the QC system.
The U.S. Chamber’s concerns largely reflect the views of the Center for Audit Quality (CAQ) and larger audit firms, even if they won’t threaten with a legal action publicly. The CAQ, an affiliate of the AICPA, represents accounting firms that audit public companies.
But the U.S. Chamber has an excellent track record of winning lawsuits on rules it sees as being “arbitrary and capricious.”
Further, with the conservative Supreme Court’s recent rulings that rein in regulatory agencies actions, the SEC cannot ignore the business group’s threat of legal action.
Thorny EQCF
In particular, the EQCF applies to firms that audit more than 100 public companies. Today, there are about a dozen such firms.
In comment letters to the SEC, the CAQ, the larger firms, including the Big Four, and the U.S. Chamber noted that the EQCF is not a logical outgrowth of the PCAOB’s proposal issued in November 2022. The board adopted the rules in May.
Moreover, Tom Quaadman, an executive vice president of the Chamber, claimed that the EQCF requirement is fundamentally flawed because QC criticisms by the PCAOB following inspections are only made public if a firm does not fix QC deficiencies to the satisfaction of the board within 12 months.
“The EQCF cannot evaluate the significant judgments made and the related conclusions reached by the firm when evaluating and reporting on the effectiveness of its QC system without having the details of the nonpublic … QC criticisms and … remediation activities,” he wrote. “Yet, disclosing [the] information to the EQCF consisting of one or more independent third-parties would be considered a public disclosure, which negates the confidentiality provided by SOX for QC inspection findings and deficiencies (appropriately remediated).” SOX is the Sarbanes-Oxley Act of 2002, which created the PCAOB following accounting scandals at companies like Enron and WorldCom.
The Chamber also said that the PCAOB ’s approval bases on a cost-benefit analysis that falls short of what is legally required.
“Instead, the SEC must conduct its cost-benefit analysis of the standard with due regard of the Commission’s statutory mandate as interpreted by the courts, then publish that analysis for public comment. Failure to do so places any finally-adopted standard in legal peril,” Quaadman wrote.
When asked about the SEC’s latest move, Quaadman said: “we will just let our letter stand without any further comment.”
This is likely to impact companies as well, said Richard Chambers, senior adviser for risk and audit at AuditBoard.
“This is a great example of the corporate sector’s hesitancy around increased regulatory expense and burden,” said Chambers, who previously served as president and chief executive officer of the Institute of Internal Auditors. “While the immediate impact would be on the big accounting firms, there is a sense that the new requirements would also be costly and burdensome for their clients.”
Investor Support
With a threat of lawsuit hanging over the SEC, it faces a serious problem since investor advocates who wrote comment letters said they support the new QC standard as it will significantly improve upon the PCAOB’s interim standards, which the board adopted from the accounting profession when the board was established.
Before Sarbanes-Oxley, the AICPA wrote the rules even for public company audits. And the PCAOB has a single mission of protecting investors.
The Consumer Federation of America explained that QC systems at many firms today do not even achieve a minimally acceptable level of audit quality. Experts say that QC is foundational to audit quality.
Micah Hauptman, director of investor protection at the organization, said the PCAOB inspection regularly finds deficiencies related to auditor independence and professional skepticism.
“It is also disturbing how frequently weaknesses in quality control exist at the highest leadership levels of the firm,” Hauptman wrote. “Current quality control standards do not ensure that financial statements are free of material misstatements, that issuers maintain effective internal controls over financial reporting, or that firm personnel comply with applicable professional and legal standards.”
Former SEC chief accountant Lynn Turner, a strong investor advocate, was critical of the opposition to the QC standard.
“The firms say their audits produce” are high quality, Turner said. But “it has been found time and time and time that the auditors did not do an audit in accordance with the standards, as they said they did.”
And a fundamental problem is today’s issuer-pay model. Auditors are paid by the companies they audit, creating a fundamental conflict of interests. Turner has been advocating for reform.
“The firms simply don’t want to have to produce a quality report on the financial reporting by those who pay them,” said Turner, who serves on the PCAOB’s advisory panels. “They do not want to have to produce a bad report card on the management that’s paying them, and that’s what this quality control proposal would do.”
SEC’s Next Move?
It is unclear what the SEC will do.
Former PCAOB founding member Daniel Goelzer said that the CAQ and the Chamber’s comment letters raise issues, “but I assume the SEC is extremely reluctant to embarrass the PCAOB by starting disapproval proceedings on this major initiative.”
“There are likely negotiations going on behind the scenes between the SEC and PCAOB staffs to explore whether the board could give guidance on the EQCF requirement or take other informal steps that would make it easier for the SEC to approve QC 1000,” Goelzer said. “The board can’t address all of the issues raised in the comments without reopening its proceeding, but it could perhaps make some minor changes or agree to informal steps, like issuing guidance or holding roundtables to assist smaller firms in complying, that would put the SEC in a better position if it has to defend an approval order in court,” he added.
In Turner’s view, the QC standard is salvageable with a rather simple fix for larger firms: instead of an external ECQF, they should set up an independent board with full voting power to improve governance and transparency. This was recommended by the Treasury Department’s Advisory Committee on the Auditing Profession (ACAP) in 2008.
Unusual SEC Open Meeting
In the meantime, the SEC has scheduled an open meeting for August 20 on three non-controversial standards the PCAOB adopted in the past few months:
- Contributory Liability
- Auditing Standard 1000, General Responsibilities of the Auditor in Conducting an Audit
- Designing and Performing Audit Procedures that Involve Technology-Assisted Analysis of Information in Electronic Form
These standards largely did not generate opposition when the SEC put them out for comment.
Historically, the SEC has not held an open meeting to decide on individual PCAOB standard changes. It was voted behind closed doors, and an approval notice would be posted on the SEC’s website. Thus, this is a departure from normal practice.
It remains to be seen if the two Republican commissioners—Hester Peirce and Mark Uyeda—will discuss QC and other PCAOB activities that they find concerning, including its efforts to revise noncompliance with laws and regulations (NOCLAR), which is strongly opposed by auditors and public companies.
This article originally appeared in the August 15, 2024, edition of Accounting & Compliance Alert, available on Checkpoint.
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