VideoWilliam J. McDonough has a particularly tough job: as chairman of the Public Company Accounting Oversight Board (PCAOB), he is charged with policing an industry unused to outside regulation and under fire as never before.
But judging from his first year on the beat, McDonough won't hesitate to crack down if necessary. The PCAOB's initial inspections of Big Four audits found "significant accounting issues," McDonough recently told Congress. The inspections also identified instances in which they failed to follow generally accepted accounting principles, or GAAP (see "Audits: How Bad Is Bad?" at the end of this article). The 70-year-old former president of the Federal Reserve Bank of New York insists that it is the responsibility of the firms, particularly the Big Four, to "win back the confidence of the American people." But given the depths of the problems and the power of his position, he isn't shy about forcing them to.
McDonough is heavily armed for his job. The PCAOB, for example, is responsible for auditing the largest accounting firms annually and all other firms every three years. And its options range from "giving quiet advice to putting them out of business" if they don't perform to acceptable standards. In addition, the board, through its registration process, has final say over who gets to audit public statements. By the end of June, 976 U.S. and foreign firms had been registered and one had been rejected.
That power will only increase as the board's mission is refined. This year the PCAOB is setting audit standards, creating an enforcement program, and staffing up to full capacity. At the agency's full strength, McDonough expects to oversee some 300 employees and add Chicago and Southern California to its growing network of offices. Meanwhile, the accounting firms continue to demonstrate that oversight is a necessary evil: Ernst & Young LLP, for example, is waiting out a six-month ban on new clients because it violated independence rules, while KPMG LLP continues to be dogged by problems with tax-shelter advice.
McDonough, who describes himself as "painfully straightforward," lays much of the real blame on fundamentals. In the limited inspections that the PCAOB conducted, he says, "we noticed that a fair amount of audits were really not very well done." Given the thoroughness of the current inspections as well as new requirements under Section 404 of the Sarbanes-Oxley Act — calling for audits of internal controls as well as financial statements — it's clear that poor-quality audits will no longer be tolerated. Moreover, he considers the idea that auditors are not responsible for detecting fraud to be nonsense. "With relatively few exceptions," he says, "they should find it."
McDonough recently sat down in his Washington, D.C., office — ironically, in the same building that Arthur Andersen once occupied — with CFO deputy editor Lori Calabro to discuss the ongoing audits, the impact of 404, and why increased due diligence by auditors will ultimately restore investor confidence.
You've been the PCAOB's chairman for just over a year. How has your perception of the auditing profession changed during that time?
I know the auditing profession considerably better now. However, having been a chief financial officer at First Chicago and then president at the Federal Reserve Bank of New York, I was already familiar with what auditors do. So [the last year has been] more about getting to know the key people in the profession.
The board had an inauspicious start. The first designated chairman, William Webster, withdrew because of alleged conflicts of interest, and that ultimately led to the resignation of then-Securities and Exchange Commission chairman Harvey Pitt. Did that upheaval handicap you?
No. There's an external view that the board got off to a rough start, [because certain things] happened and therefore the board did not have a permanent chairman until I arrived. But I'm not sure that's true. When I arrived, I felt that the board had not made a single decision with which I disagreed — and I looked at all of them. I was also extremely happy with the people they had hired. So while you might think it was high risk to enter an institution and immediately become its most visible face, it turned out that everything had been done so well that I had nothing but admiration for [their] work.
You've described your role as imparting "tough love" on auditing. In this situation, how do you define tough love?
My background is that of a banking supervisor in the largest financial institutions in the United States. If the managers ran a safe and sound institution in the public interest, as well as that of the shareholders, I, as their supervisor, would be supportive and helpful. If, on the other hand, they did something that was not in the public interest, I would be an extraordinarily difficult supervisor. Since the PCAOB represents the public interest, we cannot be only supportive of the accounting profession; that would make us just cheerleaders. The best way for accountants to win back the confidence of the American people is to do it voluntarily. But if they won't do it voluntarily, we will make them do it. That's the tough part of tough love.
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