Remember Enron, the energy trading company that collapsed in a massive accounting fraud, devastating employees and investors?
For members of the transition team, the sordid story may be far from top of mind. But it could happen again on President-elect Joe Biden’s watch, diverting him from his agenda and inflicting new damage on the economy.
To prevent that from happening, the Biden administration should seize the initiative and address problems that past administrations have at best given the illusion of fixing.
There are several relatively straightforward steps the Biden administration could take. They involve the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB). Some would require legislation, and some assume the new administration can muster a working majority at the SEC.
But to really make a difference, the Biden administration will have to do more than tinker. That’s because, at its core, the auditing of corporate America is fatally compromised. It needs fundamental reform.
“Even strong regulation is a poor match for misaligned financial incentives.”
Enron was only the most famous in a long series of corporate scandals that dominated the news about two decades ago. Through creative accounting, many companies presented false pictures of their financial health. They couldn’t have done it without outside auditors who proved negligent, complicit, or merely worthless.
When audits fail and, through fraud or error, a company inflates its stock price, a lot of people and institutions can get hurt. Employees can lose jobs, benefits, and retirement savings. The company’s vendors and lenders can be left holding the bag. Individual shareholders can lose money invested through IRAs and 401(k) plans. Pension funds can lose money invested for large groups of workers such as teachers and firefighters. The ripple effects can spread through the community where the company is based and through the broader economy.
After Enron, the government put in place a new regulatory system for corporate auditors. At this point, the record is clear: The system established in 2002 should inspire little confidence if any. In some ways, it’s worse than the system it was meant to replace.
Audit firms play a crucial role in the business world. They have a duty to protect investors. If a company sells stock to the public, it is required by law to get itself audited each year.
The trouble is, the audit firms are hired and paid by the companies they audit. This time-dishonored system calls for them to bite the hand that feeds them, and, as we’ve written, that is not a reasonable expectation. The system encourages auditors to ingratiate themselves with their clients.
Even strong regulation is a poor match for misaligned financial incentives. Here, the Biden administration will inherit weak regulation and dangerous incentives.
As a reporter, I’m not in the habit of editorializing. But I’ve been covering these issues off and on since the 1990s, and all too little has changed. The story has a way of repeating itself. We at the Project On Government Oversight (POGO) have spent a lot of time investigating this important if eye-glazing subject—you can’t accuse us of covering it for clicks—and we wish we could put it in our rear-view mirror.
Perhaps the biggest compliment anyone has paid the PCAOB came from the big accounting firm KPMG. KPMG took the audit regulator seriously—so seriously that some of its top people engaged in a criminal conspiracy to cheat on PCAOB inspections. As we’ve reported, PCAOB employees angled for jobs at KPMG and divulged regulatory secrets to the audit firm. Federal prosecutions resulted in several convictions and guilty pleas. The case showed how a revolving door between the regulator and the regulated could corrupt the agency.
You might be tempted to conclude that the system works because the United States hasn’t experienced any Enrons lately. But the greatest financial disaster since the stock market crash of 1929—the financial crisis and mortgage meltdown of 2008 and 2009—unfolded under this new regime. (The coronavirus pandemic has caused economic devastation, but its origins were biological, not financial.)
The financial crisis involved a failure of audit firms, audit rules, and audit regulators, and none of them were held appropriately accountable.
There have been smaller accounting scandals in recent years, and those offer a window into the overall system. What’s more, in routine annual inspections of corporate audits, PCAOB staff have found rampant violations of auditing standards. One mark of the agency’s fecklessness is that it rarely penalizes auditors for those alleged violations. As we wrote last year:
Since the audit cop opened for business in 2003, its inspection reports have cited 808 instances in which the U.S. Big Four performed audits that were so defective that the audit firms should not have vouched for a company’s financial statements, internal controls, or both.
Yet, despite those 808 alleged failures, the audit cop has brought only 18 enforcement cases against the U.S. Big Four or employees of those firms. Those cases involved a total of 21 audits.
If the 808 audits cited as fatally flawed in the inspection reports were as bad as the reports said, it appears that the audit cop could have fined the audit firms more than $1.6 billion—that’s billion, with a “b.”
Yet, since it began working the beat, the audit cop has fined the U.S. Big Four a total of just $6.5 million, POGO found. That’s million, with an “m.”
That’s less than one half of one percent of the potential fines.
It pales beside the billions of dollars of audit fees the firms rake in each year.
We have no way of knowing what undisclosed problems auditors might be letting their clients get away with. But there is evidence that auditors have allowed companies to correct bad accounting quietly, as the Wall Street Journal has reported.
Meanwhile, around the world, new accounting scandals have been engulfing companies such as Carillion, Wirecard, and NMC Health. Those companies were audited by some of the same brand names that dominate the international accounting industry.
As recently as October, one of the most venerable companies in the United States, GE, said in a regulatory filing that it has set aside $100 million to cover the potential fallout from an ongoing SEC investigation. The probe involves GE financial disclosures, among other issues, and the SEC staff is considering recommending enforcement against the company. GE believes it has strong defenses but is exploring a possible settlement, the company said.
The PCAOB, created through the Sarbanes-Oxley Act of 2002, was part of the government’s response to Enron. This quasi-governmental agency is supposed to write auditing rules, enforce auditing rules, and audit the auditors to make sure they’re doing their job. It shares turf with but is subordinate to the SEC, and the five members of its governing board are appointed by a vote of the five SEC commissioners.
But it has been hobbled from the start, and its own leaders have further enfeebled it. The PCAOB serves largely to hide problems from the public—including matters that would be more visible if they played out at the SEC.
“The PCAOB serves largely to hide problems from the public—including matters that would be more visible if they played out at the SEC.”
Here’s a plan to make oversight of corporate audits more effective:
1. Choose an SEC chair who is committed to protecting investors—and one who is not disqualified from participating in matters that involve the PCAOB. Currently, Allison Herren Lee, one of two commissioners who hold Democratic seats on the five-member SEC, must stay out of broad categories of SEC activity related to the PCAOB. That’s because she is married to J. Robert Brown Jr., one of five PCAOB board members. Of late, Brown has been a lonely voice for pro-investor reform at the PCAOB. Lee’s recusal could limit the new administration’s ability to change direction on auditing.
If Biden has trouble getting an SEC chair confirmed by the Senate, Lee’s recusal could leave Republican-aligned SEC commissioners in control on PCAOB matters by a 2-to-1 split. If Democrats under Biden gain a 3-to-2 majority at the SEC, Lee’s recusal could still tie their hands. It could leave the SEC paralyzed 2-to-2 on certain PCAOB matters, and it could leave the PCAOB in the hands of a chair and governing board appointed under the Trump administration—not the likeliest agents of the change that is needed. Lee’s ethics agreement would prohibit her from voting to reappoint her husband to the PCAOB when his term expires next October—though, by our reading, it would not prevent her from voting on the appointment of other people to seats on the PCAOB’s governing board.
(Rule of thumb: People who have to recuse themselves from major areas of responsibility may not be the best choice for top jobs.)
2. Appoint people to the PCAOB’s governing board who are independent and committed to protecting investors. All too often, it appears that the PCAOB is trying to protect auditors from investors. What’s more, the PCAOB’s outsized compensation—its chair is paid more than $670,000 per year—has made it a magnet for what look like patronage appointments.
3. Free the SEC’s Office of the Chief Accountant—which oversees accounting, auditing, and the PCAOB—from the grip of industry. It’s hard to imagine a more egregious example of the revolving door anywhere in government. Leaders of this office routinely come from and rejoin big accounting firms. In addition, the office is staffed with so-called professional accounting fellows. Historically, many of these fellows have stepped away from the big firms to serve a stint at the SEC. As we’ve reported, one former chief accountant went from the big accounting firm PwC to the SEC to PwC to the SEC to PwC, where he is now listed as vice chair.
4. Make the PCAOB more transparent. First, when PCAOB inspections find that audits were botched, the agency should publicly identify the corporations whose audits were botched. Second, when the PCAOB takes enforcement action against auditors for auditing violations, the agency should in all instances publicly identify the corporations whose audits were involved. Third, when the PCAOB issues an inspection report on an audit firm, it should release the entire report—including the content that is currently withheld from the public. The last of those points would require a change in law.
5. When the PCAOB charges individual auditors or audit firms with wrongdoing, it should make the charges public. As it now stands, charges can remain under wraps for years while cases play out slowly; the hearings that serve as the equivalent of trials can take place behind closed doors; and, if no settlement or sanctions result, the entire process can remain forever hidden from the public. That contrasts with standard legal practice. For example, when at the end of an investigation the Justice Department files civil or criminal charges against a defendant or the SEC initiates an enforcement action, the charges and ensuing trials unfold in public. That allows the public to view the evidence and judge it for themselves. It puts the public on notice about potential wrongdoing. It also allows the public to hold the authorities accountable for doing their job appropriately. For criminal prosecutions, public trials are enshrined in the Constitution. In the past, the PCAOB itself has asked Congress to lift the veil over its enforcement proceedings.
6. The PCAOB should commit to following the Sunshine Act, the Freedom of Information Act, and the Administrative Procedure Act, as board member Brown has urged. Though Congress fashioned it as a weird quasi-governmental nonprofit corporation, for all practical purposes it serves as a federal regulatory agency. It should act like one.
7. The PCAOB should get serious about enforcement. As POGO has detailed, its enforcement actions are too few and too feeble to provide meaningful deterrence and accountability.
8. Putting politics and foreign policy considerations aside, the government should stop allowing Chinese companies listed on U.S. stock markets to flout U.S. audit requirements. The meltdown at Luckin Coffee, which had been traded on the Nasdaq stock market, showed the danger. The Trump administration has talked tough, but the plan the President’s Working Group on Financial Markets announced in August would allow a weak substitute for actual compliance. It would perpetuate a double standard for Chinese companies. The Senate and House have now passed legislation to do what the SEC and PCAOB should have done long ago. If President Donald Trump doesn’t sign it, the Biden administration should require Chinese companies to comply with the audit rules or get booted from U.S. stock markets.
9. The Biden administration should reverse measures taken by the SEC and PCAOB during the Trump administration to weaken so-called auditor independence requirements. Auditors are supposed to remain independent from the companies they audit. As discussed above, that’s a polite fiction: Audit firms are entirely dependent on the companies they audit for their audit revenue. But the government has long attempted to mitigate other conflicts of interest, such as lending relationships between auditors and their clients, and loosening standards was a step in the wrong direction.
10. Require companies to change audit firms periodically. If an audit firm puts its stamp of approval on financial statements that contain fraud or error and only belatedly discovers the problem, it has a perverse incentive not to force a correction. Disclosing the fraud or error could expose the audit firm to liability. However, a new audit firm could have the opposite incentive. Unless it forces a reckoning, it, too, could own the problem.
The suggestions listed above would improve the oversight of corporate auditors. But unless and until the government eliminates the conflict of interest inherent in having companies hire their own auditors, any reforms will be fighting the tide. Sooner or later, the levees will fail.