Dear PCAOB Board: Your Job Is To Serve And Protect Investors

Martin Luther King Jr.: “Morality cannot be legislated, but behavior can be regulated. Judicial decrees may not change the heart, but they can restrain the heartless.”

Cindy Fornelli, the Executive Director of The Center for Audit Quality (CAQ), leads an “autonomous public policy organization dedicated to enhancing investor confidence and public trust in the global capital markets”. The CAQ is affiliated with (and funded by) the American Institute of Certified Public Accountants, the trade organization of the accounting industry. She recently congratulated the new PCAOB Board members:

“The PCAOB is an organization of great importance to auditors, investors, and all those who see the value of high quality, independent audits of public companies. It has an important and growing mandate to meet. The three new board members bring a wealth of experience and expertise to the board.

And I’m pleased to note that each has an understanding of our complex and increasingly interconnected global markets and an appreciation of the important role that public company auditors play in protecting investors…”

I’m so glad the industry that’s being regulated by the PCAOB, the public accountants and auditors of public companies, is so pleased by the choices from the SEC’s Mary Schapiro for their regulators.

I’m not so sure investors and the public should be so thrilled. Here’s what I wrote for Forbes when the appointments were announced January 7:

Those picks do not include a single investor candidate and perpetuate a white-male, insider, auditor-friendly tone that makes me quite pessimistic. I’m less than sanguine about the possibilities for improvements and reforms needed at the PCAOB or for serious disciplinary and enforcement actions against firms and individuals for auditor failure… The SEC has, therefore, chosen two attorneys whose livelihood depends on keeping auditors out of trouble and one auditor who works for a next-tier, non-global audit firm.

The newly constituted Board, with Dan Goelzer stepping back into a member role and newly selected James Doty taking the reins of leadership, has plenty on their plate. They start their jobs February 1.

Some important things have been in the works during the last year or so while two members stayed on beyond their term expiration date while the future of the PCAOB was being decided. When the Supreme Court decision reaffirmed its existence in June, wheels were finally put in motion to select new board members. Although, for the life of me can’t figure out why, given the larger than government average remuneration, there wasn’t someone  who would take a chance and take the job earlier.

The PCAOB kicked off 2011 on January 10 with this announcement:

“The Public Company Accounting Oversight Board today entered into a cooperative agreement with the Professional Oversight Board in the United Kingdom to facilitate cooperation in the oversight of auditors and public accounting firms that practice in the two regulators’ respective jurisdictions.

This agreement provides a basis for the resumption of PCAOB inspections of registered accounting firms that are located in the United Kingdom and that audit, or participate in audits, of companies whose securities trade in U.S. markets. The PCAOB previously conducted inspections in the United Kingdom with the POB from 2005 to 2008, but has been blocked from doing so since that time.”

The agreement is critically important, not the least of which is because the PCAOB must have access to Ernst & Young UK to review the firm’s involvement in the Lehman collapse. Despite my sincere doubts about whether or not the result will be the least bit efficacious, sources have assured me the PCAOB, SEC, and Department of Justice have been investigating Ernst & Young’s role in the Lehman collapse. (And, of course, we’ll always have New York…) But the PCAOB has been hampered, unlike the other two, by this constraint.

Until now.

Ernst & Young’s Jim Turley says, “Bring it on!”

London, 10 January 2011: Jim Turley, Chairman and CEO of Ernst & Young, joined his colleagues at BDO, Deloitte, Grant Thornton International, KPMG, and PwC, in releasing the following statement.

“Over the last several years, regulation of the auditing profession has evolved substantially with independent oversight of audit firms now in place in many jurisdictions around the world. Independent oversight has made an important contribution to audit quality and investor confidence in financial markets.

The global nature of corporate activity demands that audit regulators share information and cooperate across borders. Therefore, we are encouraged by today’s announcement of a cooperative agreement between the U.S. Public Company Accounting Oversight Board and the U.K. Professional Oversight Board. We are pleased it will enable audit firm inspections to move forward and hope it will be followed by similar arrangements among other regulators which we encourage and support.

Such cooperation benefits not only the regulators and registered audit firms but also investors, whose investments today increasingly cross borders.”

The six largest audit firms in the world made a joint statement about the regulators’ cooperation agreement. They are pleased. They are encouraged. They are hopeful.

Isn’t that special?

(Six theoretically competitive private partnerships, which serve 100% of the public company market in the United States in a service mandated by regulation, join together to make a statement about that regulator. Is it just me or would this kind of “cooperation” be called something other than competitive if it came from any other industry?)

It’s time for the PCAOB Board to think about how they might respond when the audit firms are not going to be so pleased as punch. There’s much for them to address. I’ll be talking about some of those recommended changes and improvements in future posts.

But, the most important role of the PCAOB is the inspections process. Let’s take a look at how well that’s going.

Take for example the case of a sensitive inspection report, one that could blow the lid on a scam with global political ramifications, that touches on accusations of fraud, organized crime involvement, government corruption, and that may impact the judgment of whether a corporate CEO goes to jail or goes free.

I’m talking about Yukos and PricewaterhouseCoopers’ Russian member firm. But I could also be talking about Satyam and PricewaterhouseCoopers’ Indian member firm.

Mikhail Khodorkovsky was sentenced to prison on December 27, 2010 in a case against him that was strongly supported by PwC the firm but where testimony by a PwC audit partner may have exonerated him. The Russian courts did not allow that testimony, PwC did not object, and even the US State Department was involved, according to Wikileaks.

From my Forbes article dated December 30^th, 2010: In 2007, PwC withdrew all audit opinions from 1994-2003 for the Russian oil company. PwC’s move in the Yukos case has been repeatedly attributed in media reports, and by US diplomats in cables released by Wikileaks, as potentially the result of coercion by the Russian government.

On January 13, 2011, the PCAOB posted twenty (20) inspection reports to its website, including four (4) expanded reports. (Pursuant to PCAOB Rule 4009(d), the PCAOB makes public additional portions  – Part 2 – of previously issued inspection reports when a firm did not address timely certain quality control issues to the satisfaction of the Board.)

One of those was the inspection of ZAO PricewaterhouseCoopers Audit, the PwC audit firm headquartered in Moscow.  The final report is dated October 29, 2010. The inspection was completed during a twelve (12) day period in June of 2009 for audits of subsidiaries of US issuers in 2008. In the past the PCAOB issued the reports of their inspections very close to the date of the final report.  (The date of ZAO PricewaterhouseCoopers Audit’s response to their draft report is October 4, 2010.)

So why did it take so long, until January 13, 2011, to make this report public?

On its face, the report looks fairly benign. The cover tells us ZAO PricewaterhouseCoopers does not audit any Russian-based US issuers, only 34 issuers where,  “audit work [was] performed by the Firm in engagements for which the Firm was not the principal auditor, including audits, if any, in which the Firm plays a substantial role as defined in PCAOB Rule 1001(p)(ii).”

The PCAOB, however, does not make a determination if the number of direct issuers self-reported by the Russians – zero – is correct. “The number of issuer audit clients shown here is based on the Firm’s self-reporting and the inspection team’s review of certain information for inspection planning purposes. It does not reflect any Board determination concerning which, or how many, of the Firm’s audit clients are “issuers” as defined in the Act.”

So, what happened between October 4 – when the firm responded to the draft inspection report – and January 13, 2011?  I suspect the SEC told the PCAOB to hold the report until the Khodorkovsky verdict was final and any media focus on PwC’s potential role in the case was off the front page. Someone made sure the PCAOB didn’t add to the tension until the Russian courts handed down the verdict. A negative inspection report on the PwC Russian firm, issued while the media was still focused on PwC’s role in the Yukos audit, may have been disruptive.

SEC’s Rule 140, adopted quietly with no comment or press release last fall after the PCAOB Supreme Court decision, now builds in an additional delay in publishing potentially controversial reports. Although the SEC rule makes their process nonpublic, and the PCAOB can’t discuss whether any particular firm appealed to the SEC over its report, there’s a delay to allow time for a firm to seek SEC redress, which delays the report issuance process even if the firm doesn’t seek it.

(The SEC also recently gave its chief accountant, Jim Kroeker a former Deloitte partner, authority to reject PCAOB regulator proposals. Release No. 34-63699 joins a series of rules the SEC has issued in recent months, with no request for comment or fanfare, dealing with its oversight of the PCAOB. Release No. 34-63699, Delegation of Authority to the Chief Accountant, was announced on January 12, 2011. As a result, a PCAOB proposal can be rejected or temporarily suspended, provided the chief accountant gives the commissioners five days notice.)

What did we end up with, after waiting for a conclusion to a process that took more than two years after the audits were performed?

The inspection procedures included a review of aspects of the Firm’s audit work on four issuer audit engagements (out of 34 possible) in which it played a role but was not the principal auditor… The inspection team identified what it considered to be audit deficiencies. The deficiencies included deficiencies of such significance that it appeared to the inspection team that, in two of the audits performed by the Firm in which the Firm played a role but was not the principal auditor, the Firm did not obtain sufficient competent evidential matter to fulfill the objectives of its role in the audits.

That’s it. The response to the draft report from ZAO PricewaterhouseCoopers was typically fluffy and bland. The amount of time that’s passed since the audits, almost three years, allowed PwC to pull out the tried and true, “That was in the past, everything is fine now,” retort.

Which brings me back to the PCAOB inspection report of Indian firms from March 2008? Will there ever be a regulatory reaction to the Satyam fraud and the role of PricewaterhouseCoopers’ Indian member firm in the fraud?

From the Financial Times: US audit regulators raised concerns with Price Waterhouse, an affiliate of PwC, about its audit of Satyam after they visited the firm last spring, it emerged yesterday. The visit was one of a series conducted by officials from the Public Company Accounting Oversight Board to Indian auditors with clients registered in the US, including Satyam.

The regulator said: “The PCAOB has conducted inspection work in India. We do not disclose, however, the names of issuers reviewed in the course of our inspections.” PwC Global declined to comment.

January 7, 2011 was the second anniversary of erstwhile Satyam CEO Ramalinga Raju’s confession to the $1 billion plus Satyam fraud. Price Waterhouse India and PwC’s global firm have been feeling the pain ever since. They’re being sued in New York by shareholders. The new company, Mahindra Satyam, announced in October, when its restated financial statements were finally published, that the SEC had issued a Wells Notice to the company back in 2009, threatening civil action.

The Satyam executives and PwC partners involved in the audit of the firm are on trial now in India, in a slow moving Bollywood-style tragicomic soap opera that, to the outside observer, defies logic at times. We’ve heard nothing from the SEC or PCAOB with regard to disciplinary actions against the firm or the two Price Waterhouse partners who are accused of being complicit in the fraud and were in jail for almost a year.

It’s been almost three years since the PCAOB inspected Indian registered audit firms. The audits the inspectors looked at were even older than that. How much longer do we have to wait for this report? Will it bear any resemblance to the scope and findings for the work that was actually done?

How much of the delay is based on politics and the desire of the SEC to avoid “disrupting” PwC?