Auditors Say Jump… New “Appeals” Process Will Impede Timely PCAOB Inspection Reports

Did investors ask the SEC for this rule?

Who did?

Amendments to the Informal and Other Procedures, Rules of Organization and Program Management, and Rules of Practice; Interim Commission Review of Public Company Accounting Oversight Board Inspection Reports and Regulation P

From Thomson Reuters’ subscription only Accounting & Compliance Alert: The SEC issued Release No. 34-62575 to give the agency a greater role in PCAOB inspections. Audit firms can ask the SEC to review PCAOB findings. The SEC’s chief accountant can also step in and override PCAOB decisions.

The SEC on July 26, 2010, issued a final rule concerning the oversight of PCAOB inspections in Release No. 34-62575…The rule deals with the SEC’s power to review inspections done by the PCAOB, and it also grants the agency’s chief accountant extra authority to review board decisions. It will be effective 30 days after its publication in the Federal Register…

The rule caught the PCAOB off guard, although an SEC spokesman said the release was just part of the “normal course of business.”

“The board was not consulted concerning this rule and was not aware that it would be issued yesterday,” said PCAOB spokesperson Colleen Brennan.

The SEC did not issue a press release for this rule.  Chairman Shapiro did not mention it in her July 27 speech that discussed actions the SEC was taking in response to the passage of the financial regulatory reform bill.  It was not an explicit requirement of the Supreme Court decision regarding the PCAOB.

Because of this very “under the radar” approach by the SEC, no one except wonky subscription only publications like Thomson Reuters covered this change.

So where did it come from?

Why is it necessary?

Let’s look in a little more detail at what the rule – slipped in without a public comment period or even alerting the PCAOB itself – is supposed to accomplish:

Thomson Reuters again: “We believe implicit in the language of 104(h)(1) is that the firm may seek review both with respect to items to which the firm responded to the PCAOB in connection with a draft inspection report and disagrees with the assessments relating to those items contained in any final report, as well as any assessments contained in any final inspection report that was not contained in the draft inspection report provided to the firm with which the firm disagrees,” Release No. 34-62575 said.

If an audit firm does not address the quality control problems issues within a year, the PCAOB can make its findings public.

When the SEC does review PCAOB’s inspections, it will consider whether the PCAOB’s assessments were “arbitrary and capricious, or otherwise not consistent with the purposes of” Sarbanes-Oxley.

Beckstead and Watts took the PCAOB to court after an inspection team criticized the Henderson, NV, audit firm. Beckstead said that PCAOB had no constitutional standing to conduct its inspections or punish auditors who were found to be deficient.


The [SEC] chief accountant can grant requests for interim reviews, extend the time period for the PCAOB or the firm to respond, or request more information.

The rule wasn’t passed so quickly and with such stealth to simply assuage the fears of small audit firms like Beckstead who feel overrun by the Big Bad PCAOB.  I have a hard time believing the SEC would put their massive machinery to work for whiny, nickel and dime, one-public-audit firms that are not ready for prime time in the first place. What we have here, in my opinion, is a clear and obvious attempt by the SEC to placate the largest registered firms, the ones who still strongly resent being under the thumb of an “independent” rather than a peer regulator.

I believe this rule is the result of the open-door created by the Supreme Court decision allowing heavy-handed action by the SEC over their charge, the PCAOB.  Up until now, the SEC has exercised a fairly light touch, approving budgets and playing a respectful supervisory role. The PCAOB – staffed by seasoned professionals – served seemingly without fear of significant political retribution for their actions as advocates for the investor.

The Supreme Court decision gave those plaintiffs a small win but more importantly gave the SEC an opportunity to tighten governance as they see fit.  In return for nice words by the CAQ, the SEC gave the auditors effective veto power through their proxy, the SEC, over audit firm inspections.  The passage of the regulatory reform bill gave additional cover for this chess move.

The SEC’s Release No. 34-62575 is intended to please the largest audit firms.  The Big 4 – Deloitte, E&Y, KPMG, and PwC – are the ones who complain openly when the PCAOB “second-guesses” their decisions. It’s the Big 4 who will benefit from further delays in the release of inspection reports and the opportunity to negotiate down any and all exceptions that are noted. Instead of helping the PCAOB issue more reports, faster and with less interference and intransigence by the firms and by foreign regulators, the SEC has implemented a huge obstacle to timely and accurate information about audit firm performance.

From my piece published June 26, 2010: There are at least two cases where I’ve seen adequate identification and warning of poor audit processes: American Home and Huron Consulting. Slow issuance of the inspection reports, the lack of transparency caused by the secrecy provisions of the act and the overall obstinacy of the firms meant that, in these two cases, there was no warning of American Home’s failure or prevention of Huron’s restatement.

It’s been apparent to me that the audit firms don’t take the inspection results seriously, and don’t significantly change their processes as a result. In some cases they publicly embarrassed the PCAOB by openly disagreeing with them.

This is not the way to treat a regulator. Although the inspection process is intense, time consuming and very expensive for the audit firms to comply with, they are clearly paying it only lip service. They view it as a necessary evil rather than a constructive or a deterrent force. This must change if the PCAOB is ever going to be an effective tool for protecting the investor public.

It’s a well-known secret that the audit firms prefer disciplinary proceedings regarding their partners and the firms themselves to be addressed by the PCAOB rather than the SEC.  The audit firms benefit from the privacy provisions of Sarbanes-Oxley that protect them from any disclosure of an ongoing investigation or draft findings until the sanctions are negotiated and final.  The firms do not enjoy similar protections from the SEC, although SEC investigations of auditors and their sins take just as long or longer to be resolved.

The audit firms are now lobbying hard to have at least one of the open PCAOB commissioner positions filled by a retired Big 4 partner.  In general, this is not such a bad idea.  Who better understands how the firms can and should respond to audit quality issues than a partner who now most likely has been living under the PCAOB inspection process for a while and can not return to his firm, Tom Ray-revolving door style. But we have to be careful that this person is not a wolf in sheep’s clothing, undermining the other Commissioners and protecting his brethren rather than supporting the PCAOB mission.

In anticipation of the Supreme Court decision on the PCAOB, I made several recommendations for improvements to the PCAOB and the Sarbanes-Oxley law that would have actually helped them do their job faster and protect investors better:

1. Eliminate the revolving door

2. Eliminate obstacles to inspections of international firms

3. Make Part 2 of the inspection reports public in all instances

4. Enforce stronger sanctions on a more timely basis and more clearly delineate responsibility for sanctions between the PCAOB and SEC

5. Give the PCAOB the power, under law, to review or stop mergers and acquisitions by the firms that may not be in the public’s interest or may cause independence violations

6. Put bigger teeth into the inspections process

It was great to see that the Dodd-Frank bill addressed a couple of key PCAOB issues. The bill facilitates the PCAOB’s ability to share information with foreign auditor oversight authorities and closes gaps in the Board’s authority to oversee audits of brokers and dealers. However, the regulatory oversight of broker-dealers may turn out to be a pantomime horse.

The SEC’s new rule accomplishes the exact opposite of the improvements in accountability and transparency I recommended.

One case that may be influencing the SEC to slow things down and create a black hole where all auditor bad acts can be watered down, negotiated out and eventually disappear is Satyam.

The PCAOB has been issuing inspection reports at a furious pace in the last several months, trying to reduce their backlog and to do as much as they can in spite of obstacles, in some cases, from foreign regulators.

However, it’s been more than two and a half years since the PCAOB admittedly visited India to conduct inspections of registered firms. There were reports at the time the Satyam scandal broke that said Satyam was one of the Price Waterhouse India engagements reviewed in March of 2008.

Since that time, the Satyam allegations have made it to lawsuits and the PCAOB has issued sanctions against two low level staff of the PwC India firm for obstructing their investigation.  The SEC has visited India at least three times for Satyam-related investigations work.

We still have no report of the March 2008 PCAOB inspections of Indian registered audit firms.  Is it possible PwC is afraid of the findings?  Could it be that they have successfully delayed the release of this inspection report in their quest to first quash any and all lawsuits that may be able to take advantage of the findings?

PwC has a pending motion to dismiss the Satyam case against them filed in a New York Court.  A recent Supreme Court decision regarding “f-cubed” cases may also impact the kinds of plaintiffs who can file claims in US courts when the company, any of its investors and the exchange where transactions occurred reside outside of the US.  In addition, the Satyam class action may be curtailed or dismissed altogether based on a claim of  “forum non conveniens”.

The ongoing delay of the issuance inspection report is a no-win for the PCAOB and a travesty of regulation for investors.   Either the PCAOB saw problems with PwC audits of Satyam in early 2008 or prior and were unable to prevent or mitigate the fraud that was finally admitted by the Satyam CEO in January of 2009 or the PCAOB inspectors missed red flags that PwC was either complicit, incompetent, or both.

None of these hypotheses is positive.

A thorough, timely India inspection report, with evidence that either or both the PCAOB or PwC were fighting against the fraud perpetrated by Satyam and alleged to have been enabled by Price Waterhouse partners would have given us all hope.  The continued delay of the PCAOB India report instead implies regulatory impotence.

Why in the world does the SEC want to implement rules that exacerbate the perception of regulatory impotence they’ve saddled with ever since Madoff?

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  2. […] SEC Rule 104(h)(1), adopted quietly with no comment or press release in the fall of 2010, builds in an additional delay before publishing potentially controversial reports. Although the rule keeps the SEC process private, and the PCAOB is not allowed to discuss whether any particular audit firm appealed to the SEC over its report, the delay allows time for an audit firm to seek SEC redress. […]

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