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The Creation of the PCAOB: A Watershed Moment

Cynthia M. Fornelli

On January 6, 2003, the Public Company Accounting Oversight Board (PCAOB) opened its doors in Washington, D.C. Established by Congress as a nonprofit corporation, the PCAOB had a big mission: to oversee the audits of public companies. The creation of the PCAOB was a pivotal moment for the auditing profession. For the first time in U.S. history, external auditors had a dedicated regulatory agency overseeing their work. Previously, the profession had been self-regulated.

Like many watershed moments, the creation of the PCAOB was not without its challenges. The PCAOB quickly drew sharp criticism from prominent stakeholders—and even faced an existential legal threat. Overcoming those difficulties and challenges has proven worth the effort. In this observer's view, financial reporting in the United States has shown concrete signs of improvement, and the PCAOB has been an important part of that story.

Tumult at the Turn of the Century

To fully appreciate the contributions of the PCAOB, it is important to remember the circumstances of its birth: In the spring of 2000, the dotcom bubble burst, leading to the bankruptcies of once high-flying companies including Pets.com, Webvan, and eToys. Fraud and accounting scandals also helped bring about the failure of “blue chip” companies such as Enron, WorldCom, and Adelphia Communications, and high-ranking executives from those companies would eventually be imprisoned. In connection with Enron's demise, one of the largest audit firms, Arthur Andersen LLP, was convicted of obstruction of justice in June 2002. That conviction was overturned in 2005 by the U.S. Supreme Court, but by that time the firm had already collapsed.

These events, along with a spike in corporate earnings restatements, shook financial markets and investor confidence in them. The Nasdaq Composite Index dropped 78% from the spring of 2000 to the fall of 2002 ("Market Crashes: The Dotcom Crash," Investopedia).

The policy response was equally dramatic. As noted by the SEC Historical Society, a “groundswell of support” drove the reform of corporate governance standards and the passage of the Sarbanes-Oxley Act of 2002 (SOX) ("The Center for Audit Quality Gallery on Corporate Governance," Securities and Exchange Commission Historical Society, www.sechistorical.org/museum/galleries/caq/). In today's era of hyper-partisanship in Washington, the vote counts for the legislation are an anomaly: 99-0 in the U.S. Senate, and 423-3 in the House of Representatives. President George W. Bush signed SOX into law on July 30, 2002, and implementation proceeded quickly thereafter.

At the broadest level, SOX was designed to increase the reliability of financial reporting and to improve audit quality. It worked towards these goals in several ways:

  • Greater executive accountability: Under SOX, chief executives and chief financial officers must certify financial reports.

  • Independent audit committees: The law requires that public companies have audit committees that are independent of management. SOX also makes audit committees, not management, responsible for hiring, compensating, and overseeing the external auditor.

  • Enhanced auditor independence: SOX established rules such as lead engagement partner rotation, as well as the prohibition on providing certain non-audit services to audit clients.

  • The PCAOB: SOX provided a new framework of oversight of public company audits through the establishment of the PCOAB.

For its part, the public company auditing profession expressed support for the creation of the PCAOB. “Change is necessary, and we intend to be full partners in driving meaningful and purposeful change,” wrote William F. Ezzell, then-AICPA Chairman and Deloitte LLP's national managing partner of legislative and regulatory relations, in December 2002. “We will give the PCAOB our dedicated assistance and support in all its aspects and dimension” ("Chair's Corner," CPA Letter, vol. 82, issue 10, Dec. 1, 2002). Two years later, James Turley, then-Global Chairman of Ernst & Young, told Congress: “While nobody likes to be inspected by their regulator, I truly believe that Ernst & Young and the entire profession will be the better for it” ("Testimony of James S. Turley, Chairman and Chief Executive Officer Ernst & Young LLP, before the United States Senate Committee on Banking, Housing, and Urban Affairs," Sep. 9, 2004). The Center for Audit Quality (CAQ), which is affiliated with the AICPA, was created in 2007 in part to help the profession respond to and implement new standards and other policy initiatives from the PCAOB and other regulators.

Challenges and Critics Aplenty for the PCAOB

Despite the political consensus and the profession's support, the PCAOB faced more than a few hurdles during its early years. While it is hard enough to start any new organization, Washington is particularly tough terrain, given its perennial turf wars and fishbowl-style scrutiny from policymakers, journalists, think tanks, academics, trade groups, nonprofits, and the general public. Even determining what to call the new agency—which for a moment seemed at risk of acquiring the unfortunate nickname “peek-aboo”—seemed difficult. “The acronym is really awkward,” one accounting professor commented to the Wall Street Journal (Judith Burns, “Accounting Board Tackles Its Mission Amid Initial Laughs,” Wall Street Journal, Jan. 8, 2003).

While managing this terrain, the PCAOB also had to contend with having a fairly broad mandate and set of responsibilities. These included:

  • Registering public company accounting firms (as well as firms that audit securities brokers and dealers);

  • Setting auditing, quality control, independence, ethics, and other standards applicable to the preparation of such audit reports;

  • Inspecting public company auditing firms; and

  • Enforcing firms' compliance with their obligations relating to audit reports.

Adding yet another challenge, SOX set forth that the PCAOB's annual budget and support fee would be subject to annual approval by the SEC. Over the years, the relationship between the two entities occasionally has been strained when their regulatory priorities have diverged.

The PCAOB also has had plenty of loud critics. Early on, it took heat for nitpicking, inefficiency, and an unduly heavy-handed approach to inspecting smaller firms (see Diya Gullapalli, “U.S. Auditing Oversight Board Gets Red Marks for Being Picky,” Wall Street Journal, April 15, 2005). Furthermore, while some observers warned that the PCAOB could get too close to public company auditors (i.e., the “revolving door” between the public and private sectors), others claimed that PCAOB was not engaged enough with the profession. Some argued that the PCAOB was keeping accountants at arm's length, “a prescription for trouble” (Gullapalli 2005).

Criticism reached a crescendo in 2009, when Steve Forbes argued that the PCAOB was “evil,” “one of the most powerful and destructive agencies in Washington,” and “an accounting version of Nurse Ratched from One Flew Over the Cuckoo's Nest” (Steve Forbes, “Evil Agency—and It Ain't the CIA,” Forbes, June 4, 2009).

A Key Win in 2010

The negative commentary from Forbes coincided with an ominous development for the PCAOB—a legal challenge that went all the way to the U.S. Supreme Court. The central issue in the case, Free Enterprise Fund v. Public Company Accounting Oversight Board, was the constitutionality of board member appointments to the PCAOB (537 F. 3d 667, www.law.cornell.edu/supct/html/08-861.ZO.html). Some feared that a broad challenge to the validity of the PCAOB would result in the Court ruling that all of SOX was unconstitutional.

The Supreme Court did not do so. Rather, in a 5-4 decision, the justices decided that PCAOB board members could be removed from their roles by the SEC “at will.” In so doing, the Court reaffirmed all other provisions of the law, including the ongoing role of the PCAOB itself. I wrote at the time that the decision was a “win for investors” (Cindy Fornelli, “The Supreme Court's PCAOB Decision: A Win for Investors,” Huffington Post,http://www.huffingtonpost.com/cynthia-m-fornelli/the-supreme-courts-pcaob_b_628565.html).

Despite the political consensus and the profession's support, the PCAOB faced more than a few hurdles during its early years.

There are a few indications that the survival of the PCAOB and SOX has indeed proven a win for investors. One measure is financial restatements by public companies: Susan Scholz of the University of Kansas has found that the number of U.S. restatements declined significantly from 2006 to 2012. (See the Editor's Note at the end of this article for an alternative perspective on restatements) Professor Scholz also found that the number of accounting issues underlying each restatement has dropped, as have restatement reporting periods [Susan Scholz, “Financial Restatement Trends in the United States: 2003-2012” (2014, Center for Audit Quality)]. Separately, Audit Analytics research confirms that overall restatement levels are down significantly, although the number of restatements by accelerated filers has shown recent signs of ticking up from post-SOX lows (Don Whalen and Olga Usvyatsky, “2013 Financial Restatements: A Thirteen Year Comparison,” Audit Analytics, 2014).

Controversy has arisen recently about the pace of PCAOB standards setting, and the inspections process remains a work in progress with room for improvement.

Another important data set is polling on investor confidence. Since 2007, the CAQ has commissioned an annual survey of U.S. “Main Street” investors as part of its efforts to enhance understanding of and confidence in capital markets. In 2014, confidence in investing in U.S. public companies reached an all-time high of 80%. In addition, 73% of retail investors said they have some, quite a bit, or a great deal of confidence in U.S. capital markets, an increase of four percentage points from 2013 and the highest level since 2009 ("The CAQ's 8th Annual Main Street Investor Survey: Focus on Weathering the Risk," Center for Audit Quality, 2014).

Looking Ahead

These metrics do not signal the end of the story. The public company auditing profession has made great strides since 2002, but PCAOB inspectors continue to find audit deficiencies, and—given their risk-based approach—they always will. The slight rise in restatements by accelerated filers also bears watching closely. Thus, the profession's focus on continuous improvement remains essential to stay abreast of increasingly complex business transactions, fraud risk, the challenges of globalization, the swift pace of technological change, and the ongoing need to attract the best and brightest.

While these challenges are daunting, the profession will rise to meet them in many ways. As executive director of the CAQ since it was founded in 2007, I have witnessed firsthand the profession's vigorous and widespread efforts in the following areas, all of which will remain critical to future improvement and building investor confidence.

Engaging constructively with the PCAOB and other policymakers

The profession has engaged with policymakers in the United States and overseas on key policy initiatives such as developing audit quality indicators and updating the auditor's report. By commenting on proposals and in regular face-to-face meetings with policymakers, the profession has stayed abreast of regulator concerns, offered constructive input, and advocated for effective, practical standards setting and rulemaking.

Developing resources

Through bodies like the AICPA and the CAQ, the profession continues to develop new resources and guidance to help public company auditors enhance their independence, objectivity, and professional skepticism. Recent CAQ member alerts, for example, have addressed issues such as the auditor's role in cybersecurity, and key risk areas for auditors.


Since 2002, the profession worked closer than ever with its key partners and stakeholders across the financial reporting supply chain to produce information and tools aimed at improving financial reporting, the integrity of capital markets, and corporate governance. These collaborative efforts include new initiatives such as the Anti-Fraud Collaboration and the Audit Committee Collaboration. (For more information on these efforts, see www.AntiFraudCollaboration.org and www.AuditCommitteeCollaboration.org.)

Fostering research

In addition to producing its own research, the profession has interfaced heavily with independent academics to deepen our collective understanding of audit quality and to grapple with emerging topics that may inform the audit of the future.

Meanwhile, the PCAOB itself continues to face its share of challenges. Controversy has arisen recently about the pace of PCAOB standards setting, and the inspections process remains a work in progress with room for improvement. On the global stage, recent developments related to audit quality in China and the new regulatory framework developing in the European Union both underscore how policymaking increasingly demands robust global coordination.

In looking ahead, one can refer to the chapter of the creation of the PCAOB. This chapter contains lessons and qualities that have been important for the profession over the past 85 years: embracing change, engaging in the policy process, staying focused on the needs of issuers and investors, and, ultimately, increasing confidence in our markets.

Editor's Note: Financial restatements rose by 12.8%, from 750 to 846, during 2009-2013 (Nicholas J. Mastracchio Jr., Carlos Jiménez-Anguiera, Ildiko Toth, “The State of Ethics in Business and the Accounting Profession,” The CPA Journal, March 2015, pp. 48-52).

Cynthia M. Fornelli. Former Securities Attorney. The Executive Director of the Center for Audit Quality since its establishment in 2007. She is the former deputy director of Investment Management at the SEC and former senior vice president at Bank of America.

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