When Congress created the Public Company Accounting Oversight Board (PCAOB) as part of the Sarbanes-Oxley Act of 2002, lawmakers concluded what many had been saying for years: It's time for radical surgery to fix a badly broken accounting industry.
Congress' solution was to end, once and for all, the industry's self-regulatory powers and to subject auditors to the supervision and disciplinary powers of the new PCAOB. The board's chairman, former New York Federal Reserve Bank President William J. McDonough, is now deep in the process of getting the new body up and running. In August, he sat down with BusinessWeek Senior Writer Paula Dwyer and gave his first in-depth interview since taking over the PCAOB. Edited excerpts of their conversation follow:
Q: Why did you take the job?
A:There were two main motivations: If you have spent more than half your life in public service, as I have, there has to be a certain streak of patriotism in you. And I did share the very strong negative attitudes of the American people about the corporate scandals and the more general question of leadership of the private sector, and decided that the chairmanship of the PCAOB was a very important function.
The more I thought about it, the more I thought that I could do it reasonably well. [It was] a combination of Puritanism and patriotism.
Q: Why is it important for accountants to be regulated rather than self-regulated?
A:The history of self-regulation of the industry is one which most accountants now believe didn't quite work. The peer-review process had merit -- it certainly was nowhere a complete failure. But a peer review can't do what a publicly created body can do.... Our job is to represent the American people in general and investors in particular, and that gives us a degree of objectivity.
I believe accountants feel very strongly that the rather low opinion, reflected in the polls, of their profession hurts their feelings and hurts their ability to attract the best people, and therefore is something that needs to get fixed.
Q: What are your goals, and how will you measure success?
A:We should be seeking to enhance the reputation of the profession so that it's at a higher level than it has ever been. Success will be measured when very good students at very good universities want to be accountants.
Q: As you move along in registering firms, as required by the statute, and establishing the rules of the road, are you seeing resistance from audit firms?
A:They can and should debate and comment on our rules. We're finding their comments thoughtful, positive. I don't find anything in their comments where they are saying we don't think this should happen, but rather, it's a fact of life.
These are intelligent people. There's nothing in it for them to fight the system now that the system is in place.... If the profession wishes to restore its reputation, it should see the PCAOB as its mentor-cum-ally, which makes it more likely that the goal will be achieved. If on the other hand, we had a relationship which was one of our being very suspicious of them and they in turn of us...that does not have a tendency to lead to quick progress.
Q: Some of the Big Four audit firms resisted the board's attempt to get a list of legal proceedings against auditors, going back 10 years. Where does that stand?
A:We agreed to go back five years, and we limited the number of people whose records we want. It has all been resolved. We are reasonable people.
Q: How soon will you be able to issue your own audit standards?
A:The first standard we'll be coming up with, by the end of the year, is the attestation of internal controls.... We thought this the simplest, most important thing to do first because it's required under the statute, to improve the reliability of financial reporting. And auditors have to attest to that assurance by management [that internal controls are working].
Then we will come up with our priorities for the next best things for us to work on.... We're not sure how long it will take, but it won't be many years.
Q: Explain how you will conduct reviews of the Big Four this year, as you've announced will be done. And why the initial focus on the Big Four over the thousands of smaller firms?
A:An inspection of [Ernst & Young, Deloitte & Touche, PricewaterhouseCoopers, and KPMG] will be a test, really, of whether those four firms have received the message from the American people in Sarbanes-Oxley and whether the message that we are hearing from the leaders of the firms is in fact widely held and actually being applied. The inspections will be very thorough. It is not peer review.
The big four firms are a much higher priority than anybody else, but that comes from their market share and not that we have any conviction that they are more [problematic]. You assume they are innocent until proven otherwise.
Q: Where do you come down in the debate over whether an auditor is supposed to detect fraud?
A:There's a difference of opinion within the profession as to just how responsible they are for finding fraud, with some auditors being very dogmatic that they really ought to be able to find it, and others believing we cannot always be expected to find it every time. The truth is probably somewhere in the middle. But I think a good audit should be done with a degree of questioning that would make the detection of fraud highly likely.
The main thing that would make that more likely is that the auditors aren't hired to represent and defend the management. They are picked by the audit committee, and their responsibility is to shareholders and the broader public. If the management doesn't like what they're doing, that's tough. It isn't their function to make management happy. Their job is to make sure that those financial statements, which are the responsibility of management, are in fact accurate, they say what they mean, and that an average human being can understand them.
If management isn't happy with them, then the audit committee ought to be saying, "Why is that? If we're satisfied the auditors are doing a good job, and management doesn't like it, that's telling us a lot about management."
Q: Why do you think we continue to see so many restatements and audit failures?
A:It takes a while for management, audit committees, and auditors to respond to new demands by the public that say you simply have to do a better job of running companies honestly, cleanly, transparently. So I don't find it unusual that the passage of time continues to reveal problems.
If you have good, demanding audit committees and good, demanding auditors, you will always turn up some problems. One would hope that the attitude toward running a company that became prevalent in the latter part of the 1990s will be put behind us -- that if you beat your earnings target by a penny you're a genius and if you miss it by a penny you're a fool. That's crazy. The nature of the market economy is that there are fluctuations in flows of income and expenses.
I think we're in an era in which excess of creativity -- a euphemism for cooking the books -- is going to be replaced by telling the truth. I'm encouraging people in the private sector to compete through virtue because I think that will pay off.
Edited by Patricia O'Connell