The Housecleaning at the PCAOB: Why it Matters
On June 16, I was a guest on Tom Selman’s podcast, Two Minutes with Tom. We discussed the SEC’s decision to replace the members of the Public Company Accounting Oversight Board. You can listen to our conversation here. This blog post expands on comments I made during that podcast and adds some predictions about priorities of the new PCAOB.
* * *
On June 4, the SEC announced that it had removed William Duhnke from his position as Chair of the Public Company Accounting Oversight Board. One of the other Board members, Duane Desparte, was appointed Acting Chair. The SEC simultaneously announced that it intended to seek candidates to fill all five PCAOB board positions, signaling that Mr. Desparte and the other two sitting board members would likely also soon be removed, even though their terms do not expire until 2023, 2024, and 2025, respectively. Prior to Mr. Duhnke’s ouster, the five-member board had one vacancy.
The SEC’s decision to appoint a new PCAOB board is significant for two reasons. First, it seems to portent that appointments to the PCAOB are becoming explicitly political. This is not a positive development for confidence in the Board’s work. Second, it will likely result in new policy directions at the PCAOB. While predictions about the new Board’s agenda are speculation until it is appointed, there are several issues that should be priorities.
Presidential Politics and PCAOB Board Seats
In 2017, at the beginning of the Trump Administration, the SEC, under Chairman Jay Clayton, replaced the entire PCAOB board. While the circumstances were arguably somewhat different, the bottom line was appointment of an all-new the Board. Now, Chairman Gensler has taken the same action, ironically over the written objections of the two Republican SEC Commissioners.
These clean sweeps of the Board are the result of a 2010 Supreme Court decision. Under the Sarbanes-Oxley Act, as Congress passed it, PCAOB board members served for fixed, 5-year, terms and could only be removed by the SEC for cause – some type of malfeasance or misbehavior in office. However, in 2010, the Supreme Court held that the “for cause” limitation on board member removal was unconstitutional. The Court reasoned that this removal pre-condition violated the principle of separation of powers – that is, by including it in SOX, Congress had infringed on the ability of the President or his appointees (in this case, the SEC Commissioners) to control the Executive Branch of the federal government. To cure the problem, the Court in effect struck the “for cause” limitation from the statute, permitting the SEC to remove a PCAOB member at any time.
The decision of the Gensler SEC majority to remove PCAOB Chairman Duhnke is not in itself surprising; the Chair of the SEC changes with the Administration, and it makes sense that the same would occur at the PCAOB. However, removing the entire Board for a second time seems to establish – or confirm – that Board turnover as standard operating procedure when control of the White House shifts. Against this background, PCAOB board spots may be seen as political plums, up for grabs when the Administration changes. In the long run, that is likely to detract from confidence in the objectivity and professionalism of oversight of public company auditing.
Of course, the fact that the Supreme Court held that the SEC could remove a PCAOB member before the end of his or her term for any reason – or for no reason at all – does not mean that the SEC must do so when a new President takes office. And the current PCAOB members can re-apply for their seats; perhaps one or two will even be re-appointed. But, now that the removal power has been used it twice, once by each party, following consecutive Presidential transitions, it is likely to become the norm.
New Policy Directions at the PCAOB
The second reason the SEC’s action is significant is because it seems to signal a reset in the PCAOB’s philosophy and priorities. In the statement announcing Mr. Duhnke’s removal, Chairman Gensler said that the “PCAOB has an opportunity to live up to Congress's vision in the Sarbanes-Oxley Act" and that he looked forward to setting the PCAOB “on a path to better protect investors." We do not yet know specifically what that means, but it could foreshadow significant changes in the PCAOB’s agenda.
Some things to watch for include:
The new PCAOB will likely revive its Standing Advisory Group and Investor Advisory Group, hold more public Board meetings, and, in general, become more transparent than has been the case in recent years and more open to input from investors and other users of audited financial information. This would be a healthy development.
It is also likely that, consistent with Chair Gensler’s priorities at the SEC, the PCAOB will explore the potential role of auditors in considering ESG risks as part of the financial statement and internal control audits and in reviewing, and perhaps reporting on, company ESG disclosures. ESG is currently the hottest topic in public company disclosure. The PCAOB should take the initiative in considering the role auditors can play in providing investors with confidence in this type of information.
The new Board may ask Congress to make PCAOB enforcement proceedings public. Under the Sarbanes-Oxley Act, PCAOB enforcement actions against auditors and accounting firms are confidential unless and until the Board imposes sanctions and those sanctions become final. In the past, the Board has asked Congress to change this provision and open its enforcement cases to public view, like those the SEC brings. However, the Board has said nothing about this issue during the last several years. The new Board should renew the request. Public proceedings would give the PCAOB more leverage to bring and settle cases, remove incentives for respondents litigate with the Board and delay disclosure of its charges, and add more transparency to its work.
In 2019, the PCAOB issued a concept release on audit firm quality control standards, but no specific proposals have been published. The new Board will almost certainly re-activate that project and make it a priority. In the long run, improving audit quality requires firms to continuously improve their quality control mechanisms. The foundation for stronger quality control is stronger quality control standards, particularly standards that incentivize firms to think proactively about emerging risks to audit quality. Modernized quality control standards should be developed as soon as possible and the new standards should be integrated into the Board’s inspections program.
Chairman Gensler’s decision to start from scratch with new PCAOB board members is an unfortunate step down the road of politicizing audit oversight. But it may also present and opportunity to take some new policy directions at the Board. Those involved in public company reporting and auditing will have a lot to assimilate during the coming months.