PCAOB Enforcement: What to Expect

By Dennis K. Spillane

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Inspections

The PCAOB has the unprecedented power to conduct inspections of CPA firms to determine if the firms are in compliance with a wide array of standards. The PCAOB has issued rules (Rules 4000–4010) for these inspections. As time goes on, the collected PCAOB rules on this and other issues will be the essential guidebook certainly for CPA firms engaged in audits of public companies, and probably beyond.

Under these rules, a CPA firm that registers with the PCAOB will be subject to inspections (Rule 4000), starting in the calendar year after the calendar year in which the PCAOB registration application was approved. The frequency of the inspections will vary with the number of audit reports generated by the firm. If a firm, in the calendar year prior to the approval of the PCAOB registration application, issued an audit report for more than 100 issuers, that firm will be subject to an annual PCAOB inspection. If, in the three-year period prior to approval, the firm issued an audit report on at least one but less than 100 issuers, that firm will be subject to a triennial inspection. All these inspections will begin the calendar year after the calendar year of approval (Rule 4003). There will be two types of inspections: a “regular” inspection conducted with the frequency described above, and a “special” inspection (Rule 4000).

A regular inspection will examine the audit, supervisory, and quality control procedures of the firm. There is no stated duration of this inspection. In accomplishing these goals, the inspectors “shall take such steps and perform such procedures as are necessary or appropriate” (Rule 4001). By contrast, the scope of a special inspection is limited.

Unlike a regular inspection, which occurs every stated interval, every special inspection must by authorized by the PCAOB and is limited to an examination of the issues delineated by the board in its authorization.

In addition to allowing access to its offices and documentation for either of these inspections, the inspected firm and every associated person is under an affirmative duty to cooperate with the inspection. Such cooperation, in addition to access, involves giving inspectors the ability to copy any record in the possession, custody, and control of the firm or person and also providing information by oral interviews and written responses (Rule 4006).

If any violations are found during the course of the inspection, the PCAOB has three options that can be used singularly or in combination: report such information to the SEC, which can presumably then conduct its own investigation; report such information to each appropriate state regulatory authority [in New York, the State Education Department’s Office of Professional Discipline (OPD)]; and commence a full investigation of the violation (Rule 4004).

Investigations

Once a decision has been made to conduct an investigation, the PCAOB has to decide between the two types of investigation authorized by the rules. In deciding whether to investigate, the PCAOB is not limited to information coming from an inspection. It can receive information from any source and then decide what sort of inquiry to commence.

There are two types of investigations. One is an “informal inquiry” [Rule 5000(a)], which can be commenced when “it appears that … or to determine if” either the firm or an individual has violated any provision of the Sarbanes-Oxley Act, any PCAOB rules, any professional standards, and any provision of the securities laws relating to the preparation and issuance of audit reports and the obligations and liability of accountants thereunder. In such an inquiry, the PCAOB Director of Enforcement may request documents, testimony, and interviews. This type of investigation would be typical when the PCAOB receives a complaint alleging or indicating a violation with only minimal supporting information. If this inquiry does not lead to sufficient grounds for further investigation, the matter will be closed. If sufficient information is obtained, then it will lead to the second type, a “formal investigation.”

This investigation commences with the issuance of an “Order of Formal Investigation.” Such an order can result from a recommendation by the Director of Investigations after, for example, an informal inquiry as described above or after an inspection, or by the PCAOB members [Rule 5101(a)(1)]. At any time after such an order is issued, the PCAOB can issue another order terminating or suspending the formal investigation. As one would expect, sworn testimony can be required of the firm or an associated person by an “accounting board demand” that gives notice of such testimony and describes with “reasonable particularity” the subject of the examination [Rule 5102(b)]. During such an examination, the only persons permitted to be present are the witness, the witness’ counsel, the reporter, and “such other persons as the Board, or the staff of the Board … determine are appropriate” but “in no event shall a person other than the witness … be present” [Rule 5102(c)(3)]. This possible bar to accountants or other nontechnical experts appearing with the defendant has raised protests from the major accounting firms and the AICPA. All point to the SEC practice of allowing such witnesses to attend, and cite SEC v. Whitman [613 F. Supp. 48 (1985)] in support. (See comments from KPMG, Ernst & Young, and the AICPA, all dated August 18, 2003. The reader should note that the PCAOB publishes the comments to its proposed rules, which can be found at www.pcaobus.org under “Rulemaking.”) After such testimony, and during the overall course of the investigation, the investigatory staff has the right to inspect the books and records of the firm or associated person to “verify the accuracy of the documents or information supplied in the course of an informal inquiry or formal investigation” (Rule 5104).

Both informal inquiries and formal investigations are confidential, but the PCAOB may make investigatory information available to the SEC, and at “its discretion … when determined by the Board to be necessary to accomplish the purposes of the Act or to protect investors” the PCAOB can make such information available to the U.S. Attorney General, state attorneys general, or any appropriate state regulatory authority [Rule 5108(b)]. In addition, the rule expressly authorizes the staff to “engage in discussions with the staff of state regulators concerning information obtained in an informal inquiry or formal investigation.”

Rule 5108(b) makes investigatory information “in the hands of the Board” exempt from civil discovery or “other legal process” and also confidential in the hands of any body or individual receiving this information “unless and until presented in connection with a public proceeding or released in accordance with subsection (c) of Section 105 of the Act.” The language “in the hands of the Board” was universally condemned by the major firms and the AICPA. All felt, from a litigation viewpoint, that the phrase should be either eliminated or extended to cover the source of the information, because it implies that the confidentiality would not extend to the same material in the hands of the registered firms or associated persons or counsel for the firms or persons. (See comments from Pricewaterhouse-
Coopers, Ernst & Young, and the AICPA, all dated August 18, 2003.)

Under Rule 5109, witnesses in a formal investigation have the right to be shown the Order of Formal Investigation and may also be furnished a copy at the discretion of the Director of Enforcement and Investigations. Upon request, witnesses in either an informal inquiry or a formal investigation may inspect the official transcript of the witness’s testimony and can also request a copy of the transcript and any documentary evidence provided. Nonetheless, the Director of Enforcement and Investigations can deny such requests for transcripts or copies, on a showing of good cause.

One of most debated points for firms and associated persons in the investigations area is under Rule 5109(d), which allows for “Statements of Position” to be submitted to the PCAOB that set forth “their interests and positions in regard to the subject matter of the investigation” prior to the staff recommendation to the board as to whether a disciplinary proceeding should be commenced. This is akin to a “Wells submission” in SEC practice; however, it remains at the PCAOB staff’s discretion to advise the firms and associated persons of such things as the “general nature of the investigation, including the indicated violations … and the amount of time that may be available for preparing and submitting a statement prior to the presentation of a staff recommendation to the Board for the commencement of a disciplinary proceeding.” Predictably, commentators have condemned the discretionary nature of providing the above information, because it would result in an empty option.

At the conclusion of any investigation, the PCAOB must make a decision whether a disciplinary proceeding is warranted. According to Rule 5200, a proceeding will result if a firm or associated person is alleged to have violated—

• any provision of the Sarbanes-Oxley Act;
• any Rule of the Board;
• the provisions of the securities laws relating to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect thereto; or
• any professional standard.

The scope of “professional standards” as a source of disciplinary proceedings has been the subject of some discussion. Most commentators prefer that these standards should relate only to GAAS violations and not to GAAP violations. KPMG’s comment letter protested that a firm could be subject to discipline when “the firm has acted with due professional care and/or the application of GAAP in a particular instance is debatable and no clear answer lies in the professional literature.”

There are two other, uniquely new, possible sources of a disciplinary proceeding. The first, under Rule 5200(a)(2), is the failure of either the firm or its supervisory personnel to “reasonably supervise” an associated person either “as required by the Rules of the Board relating to auditing or quality control standards, or otherwise, with a view to preventing violations of the Act, the Rules of the Board, the provisions of the securities laws relating to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect thereto, including the rules of the Commission under the Act or professional standards” when such violations occur. This source of disciplinary action is revolutionary and extremely wide in its scope. If adopted, it will be the source of much groundbreaking litigation aimed at determining what constitutes “reasonable supervision.” It will also be interesting to see how firms and audit supervisors will change audit manuals to accommodate this new development.

The other new source of discipline is provided by Rule 5110, “Non-cooperation with an Investigation.” Under this section, which is incorporated as a source of discipline in Rule 5200(a)(3), a firm or an associated person may be subject to discipline if they “may have failed to comply with an accounting board demand, may have given testimony that is false or misleading or that omits material information, or may have otherwise failed to cooperate in connection with an investigation.” What constitutes “material information” or “failed to cooperate”? Ernst & Young’s comment letter asked that the “omits material information” phrase be eliminated because it was “unnecessary and confusing.” PricewaterhouseCoopers’ letter said that it “would impose an unusual and unfair duty on the witness because it would require the witness to volunteer all information that the witness believes might be material. Normal practice is for the witness to answer the questions asked.” This new enforcement weapon is more powerful than the previous options of a contempt proceeding or a criminal perjury charge.

Hearings and Adjudications

If the PCAOB decides to discipline a firm or associated person under one of the above criteria, it will issue an order instituting proceedings and assign a hearing officer to preside over the proceeding and eventually issue an initial decision [Rule 5200(b)]. Under Rule 1001(h)(i), a hearing officer is defined as “a panel of Board members constituting less than a quorum of the Board, an individual Board member, or any other person duly authorized by the Board to preside at a hearing.” Given the wide breadth of who can be a hearing officer, comment letters called for more specific requirements. Others asserted that the PCAOB should follow the SEC’s example and require that the individual overseeing the hearing be an administrative law judge or a functional equivalent (comments from KPMG and Deloitte & Touche LLP).

After the hearing, the hearing officer prepares an “Initial Decision” with findings, and, if there is a finding of guilt, proposed sanctions, that is filed with the Secretary of the PCAOB. This decision will be final unless the respondent files a timely “Petition for Review” or the board wishes to review the decision (Rule 5204). No final PCAOB disciplinary sanction will be effective, however, until the later of an SEC action to dissolve the stay provided by section 105(e) of the Sarbanes-Oxley Act or the expiration of the time period during which the SEC may [on its own motion, or upon application pursuant to Section 19(d)(2) of the Exchange Act] institute review of the sanction (Rule 5206). This ability of the SEC to review and possibly overrule the sanction troubled one commentator, who felt that it rendered the process inefficient or even subjected the respondents to a kind of “double jeopardy” (comment of Shaun F. O’Malley, Chairman, on behalf of Freddie Mac, dated August 14, 2003).

An “Offer of Settlement” provides a mechanism for settling a case before a hearing. If such an offer is made and accepted by the PCAOB, the respondent waives, among other things, any judicial review of the case (Rule 5205).

There are two sets of sanctions. One is for every violation described above, except the failure to comply with an accounting board demand, the giving of false testimony, and the failure to cooperate with an investigation. This set includes, beyond the usual suspension and revocation, some original enforcement options not usually seen. For example, the PCAOB can require a registered firm to hire an independent monitor to “observe and report” on the firm’s future compliance with various specified areas that were the subject of the disciplinary action [Rule 5300(a)(7)]. Because a PCAOB investigation could commence from any source, a negative report from such a monitor could presumably trigger an investigation. It will be interesting to see how the firms cope with such oversight. Another of the board’s sanction options is to require a firm to “engage counsel or another consultant to effectuate compliance” with various concerns [Rule 5300(a)(8)]. In addition, the PCAOB has the power to levy fines up to $100,000 per violation per person and up to $2 million per violation per firm [Rule 5300(a)(4)]. If the monetary penalties are not paid, the board has the power to summarily suspend the registration of a firm or associated person. If the fine is not paid within 90 days after the summary suspension, the PCAOB can summarily bar an associated person. In the case of a firm, the suspension will be lifted only after payment of the fine plus interest, and filing and approval of a new application for registration [Rule 5304(a) and (b)].

The other set of sanctions can be levied for the failure to comply with an accounting board demand. The PCAOB can require a firm to “engage a special master or independent monitor, appointed by the hearing officer, to monitor and report on the firm’s compliance with an accounting board demand or with future accounting board demands and to rule on future disputes, if any, related to such demands” [Rule 5300(b)(2)]. The board can also authorize the hearing officer to retain jurisdiction to monitor, among other things, compliance with future board demands [Rule 5300(b)(3)].

The PCAOB’s broad sanctioning powers were strongly questioned by international organizations. Foreign commentators were uniformly against the idea of this U.S. regulatory entity having jurisdiction over their firms and individuals. The Japanese Institute of CPAs said that its country’s laws were sufficient to enforce any audit failures. The German Institute of Public Auditors and the Swiss Institute of Certified Accountants further commented that enforcing the PCAOB rules would violate provisions of their laws.

Perhaps the most unique kind of sanction provision ever seen in enforcement is provided by a “note” to Rule 5300, which indicates that the enumerated sanctions are not exclusive and do not “preclude the imposition of any sanction, on consent, in the context of a settlement, notwithstanding that the sanction is not listed in the Rule.” This allows the PCAOB to fashion an unlimited array of sanctions tailored to the individual facts of a case. The only limitation is that the respondent must agree, but that does not take away from the distinctive nature of this power.

Another innovative aspect of PCAOB enforcement is the way that the funds generated by these monetary penalties will be used. These funds are not going to finance the board but are being put into a “merit scholarship program for undergraduate and graduate students enrolled in accredited accounting degree programs, administered by the Board or by an entity or agent identified by the Board” (Rule 5303). This use of such funds is unprecedented in enforcement, but is in keeping with the PCAOB’s mission to further the public interest.

The proposed rules also dictate the effect of these sanctions on a registered firm and an associated person. Rule 5301(b) prohibits a firm from hiring or retaining a person that it knows “or in the exercise of reasonable care should have known” has been suspended or barred from being associated with a registered firm without the consent of the PCAOB. If, on the other hand, an associated person is so disciplined while employed by the firm or is hired from the outside with PCAOB consent, such a person cannot “in connection with the preparation or issuance of any audit report (i) share in the profits of, or receive compensation in any other form, from such firm, or (ii) participate as agent on behalf of such a firm in any activity of the firm. This prohibition includes paying or crediting any salary, or any bonus, profit or other remuneration that results directly or indirectly from any other audit fees, that the person might have earned during the period of the suspension or bar” [Rule 5301(b)].

This rule will have a significant effect on the way firms hire and compensate audit staff. In order to comply with this rule, every employment application for a registered firm will have to ask if the applicant has ever been disciplined by PCAOB or is currently the subject of a PCAOB informal inquiry or formal investigation. If a registered firm elects to retain or even to hire (with PCAOB consent) a person who has been suspended or barred, it will have to construct a financial “firewall” around the person with regard to audit-related fees. In addition, the firm will have to determine what an “indirect” association with such fees involves, because any compensation from that source is also barred by the rule.

If a firm’s registration is revoked by PCAOB, the PCAOB can permit the firm to reapply for registration after the passage of a certain period of time [Rule 5302(a)]. Individuals that have been barred by the PCAOB from associating with a registered firm must instead file a petition to terminate the bar after the passage of a certain period of time. If the board determination does not specify a time period for a reapplication or petition, then such a document may be filed with the permission of the board “for good cause shown” at any time [Rule 5302(c)].

A petition filed by an individual must contain certain specified items, and the petitioner “shall make a showing satisfactory to the Board to be able to determine that the proposed association would be consistent with the public interest” [Rule 5302(b)(3)]. It is interesting that one of the factors to be considered by the board in examining a petition to lift a bar is “any restitution or similar action taken by the petitioner to recompense any person injured by the misconduct that resulted in the bar” [Rule 5302(b)(4)(ii)].

The presence of such a delineated factor contributes to both a furtherance of the public service mission of the PCAOB and the unique nature of so many of its rules. The PCAOB’s many and unique enforcement powers will make it the single most important national entity when it comes to policing the accounting profession. It is hoped that its mission to protect the public and its willingness to both communicate and interact with the accounting community will stand the test of time.