Four auditing firms examine the books of nearly every big U.S. company, in a process riddled with conflicts of interest. But federal monitoring is making a comeback under new leadership.
Federal securities law requires public companies to open their books for independent review. That’s why auditing is one of the most essential business services. And it’s become dominated by the Big Four accounting firms—Deloitte, KPMG, Ernst & Young (EY), and PricewaterhouseCoopers (PwC).
These audit firms are supposed to provide an independent opinion on companies’ financial positions, internal controls, and cash flow, usually on the basis of generally accepted accounting principles (GAAP). It’s an important public duty, as noted by the U.S. Supreme Court in 1984: “This ‘public watchdog’ function demands that the accountant maintain total independence from the client at all times, and requires complete fidelity to the public trust.”
But all too often, the relationship between audit firms and the companies they examine is akin to a game where the referees are bought and paid for. Audit firms are compensated by the same companies they evaluate, creating a classic principal-agent problem. Corporate management (the principals) hires auditors (the agents) to certify that there are no issues with their books, a dynamic that is destined to limit auditors’ ability to provide objective and independent analysis.
The failure of auditors to rise to their role of public watchdog and protect investors has been a feature of pretty much every financial catastrophe of the past 40 or so years, from the savings-and-loan crisis of the 1980s to the financial crisis of the 2000s. The adoption of the now-discontinued Regulatory Accounting Principles (RAP) allowed S&Ls to perennially ignore their losses and disguise their worthlessness. Auditors were similarly complicit as they certified financial statements that failed to flag the myriad ways Wall Street became overleveraged, misvalued assets, and committed all flavors of fraud.
While there’s enough blame to go around for those crises, responsibility for the Enron, Tyco, and WorldCom scandals of the early 2000s fell squarely within the accounting firms’ laps. In the Enron case, the decision of accounting outfit Arthur Andersen to aid and abet the defunct energy company’s corrupt practices led to the demise of both firms. But it also generated one of those rare moments where Congress decided to act.
The Sarbanes-Oxley (SOX) Act of 2002 established the Public Company Accounting Oversight Board (PCAOB) as the referee of the referees. The Board is a quasi-private, quasi-public nonprofit corporation tasked by Congress to ensure that auditors prepare “informative, accurate, and independent audit reports.” To do this, the PCAOB, funded through a special fee from public companies, adopts standards on audit quality, routinely inspects auditors, and penalizes firms and individuals who violate auditing standards.
Unfortunately, the PCAOB has weakly wielded these powers in its 22-year run, especially in the realm of enforcement and rulemaking. In a 2019 report, the Project on Government Oversight found that between 2003 and 2019, the PCAOB brought only 18 enforcement cases, despite citing 808 instances where the Big Four accounting firms conducted seriously defective audits. What’s more, those 18 cases yielded only $6.5 million in fines, chump change compared with the $1.6 billion POGO calculated the PCAOB could have fined the Big Four. In that same period, the Board fined individual auditors only $410,000, even though the SOX Act stated that individuals could be fined anything between $100,000 and $750,000 per violation.
Close watchers such as investigative journalist Francine McKenna argue that this record is due to a misalignment of missions between the Board and the SEC. In a research paper, McKenna and her co-authors noted that while the PCAOB’s mission exclusively focuses on investor protection, the SEC’s three-pronged mission—investor protection, maintenance of fair and orderly markets, and facilitation of capital formation—forces it to find a happy medium between investors, issuers, and market gatekeepers, including the audit firms. When these missions conflict and the SEC prioritizes the interests of audit firms and issuers over investors, it restricts the Board’s policy and implementation choices. Simply put, an aggressive, proactive board will run into significant roadblocks as long as the SEC is not fully supportive of its endeavors.
Another likely reason for the Board’s historically anemic attitude toward enforcement is excessive concentration. The Big Four examine the books of 99.7 percent of the S&P 500 index, which tracks the 500 largest U.S. companies. The firms also audited 52 percent of all publicly traded companies last year, according to data from research firm Audit Analytics.
This market dominance creates a cautious regulatory environment where regulators are wary of disciplinary measures that could fundamentally restructure the auditing market. Part of this is a hangover from the demise of Arthur Andersen. But with the market already being highly concentrated, regulatory sanctions that could result in further consolidation (e.g., a Big Three) are less appealing.
The Big Four love to exploit this regulatory hall pass, regularly lobbying Congress to weaken implementation of the SOX Act. Worse, there is a laundry list of scandalous and illegal activity by KPMG, PwC, EY, and Deloitte, including cheating on audit exams, theft of confidential information from the PCAOB to improve audit quality, commingling of audit and nonaudit services, and provision of clearly negligent audits.
Ethical concerns are also a key issue, since the revolving door is baked into the structure of the Board, with two positions reserved for accountants, usually former Big Four staff. Similarly, the SEC’s Office of the Chief Accountant, which oversees the Board, has regularly been staffed by Big Four alumni. This also extends to mid- to senior-level staff, creating scenarios where Board staff end up inspecting and investigating former employers. The problem also goes in the other direction—staff may be tempted to appease potential future employers, especially when PCAOB inspector work experience is framed to early-stage accountants as a stepping stone to partnerships at the Big Four.
FORMER BOARD CHAIR JAMES DOTY CLASHED with the industry and the SEC as he worked to make the Board and accounting profession more transparent with a disclosure-based approach toward regulation. His replacement William Duhnke, a former aide to Sen. Richard Shelby (R-AL), was hired in 2019 based on his loyalty to the influential former senator. Duhnke focused on gutting the audit regulator’s capacity to fulfill its mission. The Board ousted the heads of the four primary divisions, the general counsel, chief auditor, and director of information technology. He then left the enforcement director and general counsel positions vacant for 16 months. In addition to gutting the staff, Duhnke’s Board reduced the regulator’s budget, weakened inspection requirements and auditor independence policies, and disregarded obligations to hold Board meetings and publicize its agenda.
Duhnke’s disastrous reign came to an end after SEC chair Gary Gensler heeded calls from watchdog groups and Sens. Bernie Sanders and Elizabeth Warren to dismiss him and his enablers. Erica Williams is now at the helm and seems to be more similar to James Doty—they’re both alumni of the SEC and BigLaw firms with a surprising public-interest mindset. With a more supportive SEC this time around, Williams may just succeed in creating a more muscular Board.
Since her appointment by Gensler in November 2021, Williams has stepped up enforcement and standard-setting activity. A few months into her role, Williams remarked that “we intend to use every tool in our enforcement toolbox and impose significant sanctions, where appropriate, to ensure there are consequences for putting investors at risk and that bad actors are removed.” In her first year on the job, the Board issued 42 public enforcement actions, which doubled the previous year and stood as the highest single-year figure since 2017. These 42 sanctions yielded over $11 million in civil penalties, a record. And in 2023, the PCAOB collected over $20 million in penalties, even as enforcement actions only rose slightly.
Individuals have not been exempt from the Board’s new oversight drive—last year, the PCAOB imposed fines of $2 million or more in five separate enforcement cases, another Board record.
Williams has also publicly shared concerns about the downward trend in audit quality. PCAOB inspectors found that 40 percent of the audits they reviewed in 2022 were deficient—that is, audit firms certified financial statements without obtaining sufficient evidence. The audit deficiency rate was 34 percent in 2021 and 29 percent in 2020. Williams argues that transparency is one way to buck this trend, which is why her Board introduced a new section on auditor independence in its inspection requirements.
The PCAOB has also finalized rules clarifying lead auditors’ responsibilities when supervising the work of others, and auditors’ duty when obtaining evidence to confirm information in financial statements. Another proposal aims to position PCAOB staff to inspect audits sooner and reduce wait times for the public by requiring audit firms to document audit reports in 14 calendar days rather than the current 45-day period.
The Board’s attempt to strengthen auditors’ obligations to identify, evaluate, and communicate instances of companies’ noncompliance with laws and regulations (NOCLARs) has inspired the most serious industry pushback. Under the proposal, auditors will be required to identify and evaluate NOCLARs that could materially affect a company’s financial statements, and communicate to the company’s audit committee before and after evaluation. It’s a modest improvement from the current standard, but as critics such as former SEC chief accountant Lynn Turner have noted, its impact is likely to be minimal as it does not compel auditors to inform the public and investors.
Public-interest groups Americans for Financial Reform and Public Citizen have laid out recommendations to strengthen the Board and auditors’ approach toward fossil fuel companies that routinely exploit GAAP principles to materially misstate liabilities related to their extractive projects. These are recommendations the Board should take seriously as it continues to work to enhance audit quality.
Accounting’s technical jargon makes the industry obscure to most Americans. It’s likely your next-door neighbor has no idea of the PCAOB’s activities, its responsibility to protect investors, or its history of negligence. That’s expected, but chair Williams is now working to turn the ship around to fix the shortcomings of one of America’s most consequential oligopolies, and it will improve the economic lives of an unaware public.