TO: William J. McDonough, Chairman-designate, Public Company Accounting Oversight Board (PCAOB)
FROM: Mike McNamee and Amy Borrus
Bill, you're on a roll. Your selection as head of the board to overhaul the scandal-plagued accounting profession is a hit. You've got stature galore and a decade of experience at the heart of the financial system as president of the Federal Reserve Bank of New York. Unlike William H. Webster, who briefly held the job back in October, you enjoy unanimous support from the Securities & Exchange Commission and kudos on all sides, from cleanup crusader Senator Paul S. Sarbanes (D-Md.) to reluctant reformer Representative Michael G. Oxley (R-Ohio). According to former SEC Chairman Arthur Levitt Jr., you're "superbly equipped to handle this job -- incisive, public-spirited, well-informed, disciplined." All that, and you even say you love accounting theory.
You've got the wind at your back, so make the most of it. As memories of scandal fade, shell-shocked certified public accountants will try to regain political clout -- at your expense. Now's the time to make good on your pledge to be a tough overseer. To meet your stated goal of assuring that investors can rely on financial statements to "present a complete, true and timely report," you must quickly get a firm grip on auditors. These are the crucial steps to take:
REWRITE THE RULES OF AUDITING. To ensure continuity, the PCAOB on Apr. 16 had no choice but to accept existing audit standards, written by the American Institute of Certified Public Accountants (AICPA) trade lobby. But the board recognized that it must overhaul many of those rules -- and you ought to speed that effort.
Current standards purposely give CPAs wiggle room to avoid responsibility when financial statements turn out to be fraudulent. New rules should emphasize auditors' roles in detecting fraud, not exempt them from liability. Boilerplate audit letters should be scrapped. Instead, as New York University accounting professor Baruch Lev suggests, audit reports should tell shareholders whether financial statements reflect reality -- and say where earnings are shaky or financial controls weak.
PUT SOME COPS ON THE BEAT. Individual accountants seldom pay the price for their financial screw-ups, thanks to the AICPA's lethargic ethics enforcement. In fact, the trade group refused to discipline its members until all SEC probes and private lawsuits were settled, a process that often took a decade.
Fortunately, your board already recognizes that it has got to move while cases are hot. "We will be very active from Day One," says Acting Chairman Charles D. Niemeier, who adds that his team is eager to dig into HealthSouth and other apparent audit failures now making headlines. But there shouldn't be any amnesty for past scandals: There's a huge backlog of cases -- some up to five years old -- on which the AICPA hasn't acted. You need a strong team of investigators and prosecutors to identify and discipline the CPAs at fault.
AUDIT THE AUDITORS -- FROM THE OUTSIDE. Niemeier and other board members have made it clear that they're dumping peer review, the old system of letting one firm bless another's work. To uncover sloppy work and the conflicts that taint accounting firms, you'll need an army of sharp, experienced auditors. They can't review everything, but they can figure out whether auditors truly represent investor interests -- and not those of corporate clients -- by taking a close look at how auditing firms pay and motivate staff. They also need to check the quality of reports that hands-on auditors make to the partner supervising them. Your first round of reviews should set the tone to put the "public" back in CPA.
PUT SOME DISTANCE BETWEEN YOUR BOARD AND THE SEC. Congress set up the board as a hybrid -- a private body that answers to the SEC for its appointments, budget, and rule approvals. But the closer you are to SEC Chairman William H. Donaldson, the more heat you'll get from politicians. Capitol Hill has long danced to the accountants' tune, thanks to their generous campaign contributions. You must ensure that the PCAOB has the independence it needs to withstand their lobbying.
By the time you're in office in late May, the board will be in business. You have a historic opportunity to restore the confidence of millions of investors. Go for it! McNamee and Borrus cover financial regulation from Washington.