Sarbanes-Oxley gave the PCAOB a long list of tasks to address, but it also gave it the authority to determine new standards on its own. One of the biggest, and most controversial, issues it is expected to confront in the coming months is auditor independence, and specifically whether it should limit or even ban audit firms from selling tax services to their clients, despite the fact that it is one of the few consulting services allowed under Sarbanes-Oxley, subject to audit committee approval. Another thorny issue that has already stirred debate is whether the PCAOB should tighten the existing standard on consideration of fraud in a financial statement audit (Statement on Auditing Standards (SAS) 99), including adding forensic procedures to the existing standard. All that is in addition to its role in the coming convergence of international auditing standards. This dog has teeth.

"We don't want this to be a Washington bureaucracy," says William J. McDonough, the PCAOB's chairman, in a recent interview with Treasury & Risk Management. "We want this to be a start-up where people are thinking and saying what they think." McDonough is not an accountant or lawyer by training, but he was already a storied regulator when he was tapped to lead the agency just over a year ago. As president of the New York Fed from 1993 to 2003, he was one of the chief watchdogs for the U.S. banking sector during a period of sweeping consolidation and served as chairman of the Basel Committee on Banking Supervision. He was at the epicenter of efforts to mitigate the effects of Long-Term Capital Management's collapse in 1998 and the World Trade Center attack of 2001. Now, at 70, he sees his mission and that of the agency he leads as nothing short of restoring confidence in the accounting profession in the eyes of the investing public.

TOO FEW AUDITORS IS A BAD THING?

After monitoring the banking industry through the 1990s, McDonough is once again responsible for the oversight of a profession undergoing dramatic change. He sees the shrinking number of large international accounting firms as "the single most difficult" public policy issue facing the profession, but it is also one that the PCAOB has done little thus far to address. The Big Four firms, PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte & Touche, audit more than 78% of U.S. public companies, whose sales comprise 99% of annual public company sales, according to a July 2003 report by the Government Accountability Office (GAO). Some argue the PCAOB should be doing more on the issue of concentration. "At the level of the bully pulpit, it has been very quiet," says Joel Seligman. "This is an area about the stability of the industry over time."

McDonough is adamant about sticking to the same principle that guided him as a central banker: No one is too big to fail. "If we say to a big accounting firm, 'Don't sweat it, the PCAOB will take care of you,' we just de facto nationalized that firm and since everyone thinks the Big Four are equal, we just de facto nationalized the accounting industry. That clearly is not in the public interest." He says he spends time with auditing firms stressing that their future depends on their own acts and that the perception of the public is crucial.

McDonough is confident enough to take a stand on issues that do not fall directly under his purview, such as executive pay, which he manages to bring up in almost every speech he gives. He has called the widening pay gap between large company CEOs and average workers "grotesquely immoral" and laments the slow speed at which most companies are addressing it. "I feel that the anger level of the American people is very high on executive compensation, " McDonough says. " This is certainly what I'm hearing from a variety of senators and congressmen, and they know what their constituents are thinking."

STATE. DON'T RESTATE

The first big job the PCAOB undertook after it opened its doors last year was registering all accounting firms that audit the books of public U.S. companies. The agency decided to go with an innovative approach from the start, establishing a Web-based registration system despite recommendations by some that it start with a paper-based system. "This [level of early innovation] is not heard of in government circles," says Charles D. Niemeier, one of five PCAOB board members and a former chief accountant in the Securities and Exchange Commission's division of enforcement. The goal, he says, is to create a "state-of-the-art database" that will include inspection information and analytical tools and that will help the staff identify accounting issues and potential problems across companies and industries. Although the PCAOB has no direct authority over corporate issuers (that's the SEC's turf), it has already had a considerable influence over the reporting operations of all U.S. public companies and some non-U.S. ones. It began making serious waves in March with the release of far-reaching guidelines for auditing practices under Section 404 of Sarbanes-Oxley, which requires auditors to issue an opinion on corporate internal controls each year along with the audit of financial statements. Those guidelines sent companies, and the firms that review their books, scrambling. All eyes will be on the number of "adverse" opinions of internal controls that audit firms begin to generate after the November 15 cutoff and how the marketplace reacts. For the auditing firms themselves, the bigger test will be the pace of financial restatements that follow and what those say about the quality of completed reviews the audit firms have approved. "If there is a financial statement restatement, it would call into question whether the auditor had complied with the PCAOB's auditing standards, including those on internal control," says Laura Phillips, associate chief auditor at the PCAOB, who chairs two staff working groups on internal control implementation issues.

In August, the PCAOB is expected to release results of its 2003 inspections of 64 "high-risk" audits by Big Four firms. Portions of those limited inspections will be made public and in his recent testimony before Congress, McDonough described them as having uncovered "significant audit and accounting issues." The PCAOB's inspections staff has already begun more extensive audit reviews for 2004. The plan is to review about 5% of Big Four public company audits, more than 500 audits in total, plus 15% of the audits of the next four largest firms, another 150 audits. Small firm audits will be done on a case-by-case basis and the agency can conduct spot inspections at will. The process promises to be the most thorough examination of U.S. auditing processes and practices ever. "This is something superior," says board member Niemeier. "We have the ability, through our inspections, to see problems in their early stages, hopefully in time to address them before they develop into a major implosion, such as an Enron or a WorldCom." The results of those inspections, along with advice from its Standing Advisory Group, will direct, to a large extent, where the PCAOB goes next.

Its regular review of public company audits and auditing firms will likely be where the PCAOB makes its greatest impact. The audit firms themselves will be reviewed on a regular basis on such soft issues as how promotions and compensation are set and the "tone at the top" that could influence auditing decisions. "A partner [at an audit firm] has to feel comfortable that if he stands up to a big client and loses that client, that that is not going to have a negative effect on him," says Doug Carmichael. "And therefore you have to look both at how well people are doing audits and what kind of environment the firm has created to foster good decisions." In their reviews of financial statements, PCAOB inspectors are looking at the auditing firms' work papers in addition to the final audit results. The work papers are expected to give inspectors for the first time a layer of insight into early questions and uncertainties that are noted by a company's external auditors but remain invisible in the final product. Congress gave the PCAOB authority to set standards for public company audit reports, which had previously been the domain of the American Institute of Certified Public Accountants (AICPA). The AICPA still sets standards for non-public company audits, including non-profits and state and local government entities. The first order of business for the PCAOB's Standing Advisory Group is to review and make changes to existing generally accepted public company auditing standards (GAAS) previously issued by the AICPA, as well as those explicitly mandated in Sarbanes-Oxley like the Section 404 auditor attestations. In July, the agency held its first roundtable on auditor independence issues related to the selling of tax services by an auditor and the PCAOB's chief auditor also has his eye on existing rules on fraud detection (SAS 99). "One of the things we have to evaluate is whether SAS 99 on fraud detection went far enough or whether more needs to be done," says Doug Carmichael.

THE BACKLASH OVER COSTS

In some ways, the PCAOB resembles its main overseer, the SEC, and more than a few former SEC employees inhabit the agency's upper and middle ranks. Five board members sit at the top of the organization and must approve by majority vote all rule changes. In addition to McDonough and Niemeier, the board members are Kayla Gillan, a former general counsel to the California Public Employees' Retirement System (Calpers), Bill Gradison, a former nine-term congressman from Ohio and Daniel Goelzer, a former SEC general counsel. Other key figures are Carmichael and Claudius Modesti, director of investigations and enforcement, who has also worked in enforcement at the Department of Justice and the SEC. But there are important ways the PCAOB differs from the SEC. It was established as a private-sector non-profit organization, not a government agency. Among other things, that non-governmental status gives the group a better ability to compete with law and accounting firms to fill its ranks, rather than being limited by government pay scales as the SEC so often is. As a private organization, it is also less tied to the political process, which could be used to influence or impede its efforts were it established as a government agency. The SEC must approve its budget and rules, as well as its board members, but the PCAOB has wide freedom when it comes to setting its own agenda.

At the same time, it must walk the line between putting through tough measures and keeping an open ear to the business community, where a backlash has already emerged. Perhaps the most surprising criticism, however, came from a fellow regulator, John Thain, chief executive of the New York Stock Exchange. In a recent speech at the Economic Club of New York, Thain focused on the complaints he has heard from executives at NYSE-listed companies. "CEOs are expressing deep concern over steeply rising costs, complexity and delays."

Thain, who has been at the NYSE for just seven months, added that the internal control standards in Section 404 of Sarbanes-Oxley were at least partly responsible for the low number of foreign listings on the exchange recently. "There's a fair bit of concern about how much [Section 404 compliance is] costing," says McDonough, but he adds that the large companies now having to remake their controls documentation are beefing up processes that should have been in place anyway. "Where we have been concerned is the effect on small and medium-sized companies," he adds. Here, he promises the agency will keep a close eye on whether auditing firms are creating unnecessary work in their controls reviews or charging unreasonable fees, and remind them that not every company needs the scale of review that, say, a General Electric requires. "It's very difficult for us to say you [the outside auditor] ran up the bill for the sake of running up the bill, but on the other hand the fact that they are aware we are concerned about cost hopefully will have some positive benefit," McDonough says.

Board member Kayla J. Gillan also expresses concerns about unintended negative consequences. Having served at pension fund Calpers, she has a deep background as an investor advocate and she spends much of her time talking to investors and investor organizations. One area of concern for Gillan is how the markets will react as companies release material weaknesses in financial controls statements, which has already begun. "I think it's important for all of us involved in this area, issuers, auditors and regulators, to have a discussion about what it will mean to the investing public as these disclosures become more voluminous," says Gillan. "I think there may be a tendency for some analysts to perhaps react in a knee-jerk reaction, that every time there's a disclosure of a material weakness, that per se must mean a negative thing as far as the stock value. I think that would be a shame if it's perceived that way."

The new regulator must also work within certain existing structures. The Financial Accounting Standards Board (FASB) for instance, is the long-established independent body that sets many of the standards that accountants follow and its role has not changed with the emergence of the PCAOB. "[The FASB] sets the standards for what goes into the financial statements and we set the standards for how auditors audit those financial statements," says PCAOB chief auditor Carmichael. "We need to…look at what the FASB is doing and figure out what the implications are for auditors and implement that in what we are telling auditors they have to do." Part of the challenge is to anticipate audit problems that could result from accounting changes before they emerge in practice, which requires a close working relationship between the two organizations, says Carmichael.

PLAYING WELL WITH OTHER AGENCIES

Outer-agency cooperation will also be key for the PCAOB's enforcement division. In May it filled the last major missing piece in its top administrative team with the appointment of Modesti as enforcement and investigations director. Like the SEC, the PCAOB has civil but not criminal prosecutorial powers. Modesti, who has worked as an assistant U.S. Attorney for the Eastern District of Virginia, a trial attorney for the Department of Justice and in the SEC's enforcement division, says he expects to have a close working relationship with the SEC and DOJ as cases develop. He says the PCAOB is already working on some open investigations but declined to be more specific. Modesti adds that the PCAOB's enforcement powers will be a useful addition to existing regulatory efforts. "If we receive production of documents from accounting firms, and want to confirm the accuracy of the production, we're allowed to go in and inspect the books and records of audit firms," says Modesti. "The SEC doesn't have that specific authority."

The PCAOB was quick to adopt a decentralized structure, with four regional offices, in New York, Atlanta, Dallas/Fort Worth and Palo Alto. The regional offices are used mainly to facilitate the hiring of experienced inspection staff who may be unwilling to relocate to Washington. At least one more office, in Chicago, is expected to be added. Jonathan Hamilton, editor of the Atlanta-based Public Accounting Report, calls the regional office set-up a "brilliant master stroke." According to Hamilton, many of the smaller regional accounting firms were worried that the PCAOB inspection process would focus too much on the Big Four firms, leaving them to be measured according to a model that is wholly different from their smaller-scale operations. "There was concern that [the regional firms] were going to be big-timed and that the [PCAOB was] going to kowtow to the Big Four," says Hamilton. In Atlanta, many of the new inspectors are being hired from the local firms, so there is a feeling among the audit firms there that they will be reviewed by people who understand their businesses, Hamilton adds.

To Bill McDonough, the real test of the PCAOB's success will be less about indicators like a sharp decline in the number of corporate financial restatements and more a matter of hard-to-measure qualities. Changes he hopes to see include rising interest in the accounting profession from high-caliber university grads and audit committees that are better able to take the lead when interacting with management and outside auditors. "I think the winning back of the American people is something that is very difficult to quantify," he says. "You've either got their confidence or you don't. It's sort of like believing, either you do or you don't…Investors should by that time have a very much higher degree of confidence that financial statements actually tell the truth."