Journal of Business and Behavioral Sciences Volume 23, Number 1 issn 1946-8113 Spring 2011 inthis issue

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Altman, E (1984). ―A Further Emprical Investigation of the Banruptcy cost

Question‖ Journal of Finance Antonios Antonious, Yilmaaz Guney and Krishna Paudyal (2002). ―Determinants

of Corporate Capital Structure: Evidence from European Counties‖

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pp 63-80 Korajczyk, R., and Levy, A., (2003). ―Capital Structure Choice: Macroeconomic

Conditions and Financial Constraints‖ Journal of Financial Economics,

68, 75-109 Modigiliani F., & M. Miller (1958). ―The cost of capital, Corporate Finance and

Theory of Investment‖, American Economic Review, 48, pp.261-297 Modigiliani F.,& M. Miller (1963). ―Corporate Income Taxes and the cost of

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391No3 Rajan R. G. & L. Zingales (1995). ―What do we know about Capital Structure:

Some Evidence from International Data‖ Journal of Finance, 50, pp

1421-1446

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Journal of Business and Behavioral Sciences Vol 23, No 1; Spring 2011

The College of New Jersey

Kean University

Given that PCAOB has now been around for six years, we review the scope and results of its operations and gauge public perception of PCAOB, increased regulation and resulting impact on investor confidence. Our survey of 138 participants shows that the benefits of PCAOB are not apparent. Given the toll of the recent financial crisis, it is impossible to measure the impact of a single agency on investor confidence. Investors who consider themselves well informed had not even heard of PCAOB, let alone what it does. Sixty-one percent of the respondents in our survey participate in 401K or other stock market investment plans. However, only 38 percent view themselves as belonging to the investor class. A majority of respondents were skeptical of information companies furnish, audited financial statements, and of government‘s ability to be an effective watchdog. This is not surprising given that recent banking crisis occurred on SEC‘s (by extension PCAOB) watch.

The many scandals and irregularities that have marred corporations, accounting, and financial firms over the past ten years have risked loss of investor confidence and invited increased regulation. One consequence was the creation of an oversight board, the Public Company Accounting Oversight Board (PCAOB). Given the benefit of several years of the PCAOB existence, we seek to review the evolution of PCOAB and the scope and results of its operations. What have been the key achievements since it was established in 2003?

Some have argued that the PCAOB's audit standard-setting and inspection models as they currently exist are inefficient and dysfunctional [Glover et al, 2009]. They assert that ―the Boards ability to achieve its mission is limited by its early choices . . . its incentives, organizational composition, and structure‖ (Glover et al, 2009, p. 221). We extend this line of research by

Journal of Business and Behavioral Sciences

providing greater context, additional insights and understanding into the work PCAOB, its track record to date, and impact on public perception.

The PCAOB‘s primary mission is to improve investor confidence in financial reporting [Kranacher, 2008]. The accounting profession contributed to the crisis of confidence in the U.S capital markets and in the profession itself [Glover et al, 2009]. Certain industry practices are believed to undermine investor confidence including activities of hedge funds, private equity, and high-frequency traders. Against the background of recent financial crisis, we also examine the impact of PCAOB on public perception and (investor) confidence.

The paper proceeds as follows. The next section describes the creation of the PCAOB, its organizational structure, followed by a review of the PCAOB‘s oversight activities since inception. The last section presents the results of a survey conducted to gauge impact on investor confidence.

CREATION OF THE PCAOB

In response to the massive corporate failures of Enron, Tyco, WorldCom and others, the U.S Congress passed the Sarbanes-Oxley Act of 2002 (SOX). The law was arguably passed to address the lack of confidence of investors and creditors in audited financial statements. The lack of confidence apparently stemmed from a perceived or real lack of auditor independence and/or lack of internal controls in audited companies. SOX created a new entity, the PCAOB, and charged it with inspecting and disciplining public accounting firms. As the PCAOB explains ―it was created to protect investors and the public interest by promoting informative, fair, and independent audit reports‖ (www.pcaob.org). It replaced the system of self-regulation through the American Institute of Certified Public Accountants (AICPA), a system tarnished with well-chronicled accounting failures that contributed to the crisis in investor confidence. Has the PCAOB strengthened and restored public confidence in the auditing profession? Glover et al. (2009) suggest that it has. While providing no basis for the assertion, they state that ―SOX and the PCAOB have brought benefits to the public, the capital markets, and the profession‖ [Glover et al., 2009, p. 221].

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The Board consists of five members appointed by the SEC. Some have argued that this board is largely composed of highly paid, political appointees who lack expertise or experience in auditing, accounting, and technical standard setting (Glover et al., 2009). The lack of expertise extends beyond the Board itself, in that "most holders of the fourteen major staff positions listed on the PCAOB 's website as of August 2005 lacked meaningful experience in auditing financial statements" (Palmrose, 2006, p. 117). The law stipulates that no more than two Board members can be CPAs. As of July 2009, 41.5% (16/41) of the top management positions were held by lawyers, 33.5% by accountants, and 24 percent by others (www.pcaob.org).

SOX Section 102 prohibits accounting firms that are not registered with the PCAOB from preparing or issuing audit reports on U.S. public companies and from participating in such audits. All registered firms are required to file an annual report and pay an annual fee. The total number of firms registering with the PCAOB has grown steadily from 732 in 2003 to 1,423 (2004) to 1,591 (2005) to 1,738 (2006) to 1,828 (2007). At the end of 2009, 2,349 firms were registered. Of these, 936 are non-U.S firms. Ten firms issued audit reports for more than 100 issuers per year; of these all but one are U.S. firms. The big-4 audit 97.8% of the global market capitalization of public companies whose securities trade on U.S exchanges. Although 70% of the registered firms issued no issuer audit reports, these firms apparently deemed it necessary to register and bear the cost of registration. These firms apparently perceive some benefit to being seen as a PCAOB registrant. Only 27% of the registered firms issuing audit reports are non U.S. firms.

The fees and annual budgets provide another measure of the PCAOB‘s scope of operations and how they have grown over the years. For fiscal year 2009, total operating revenues were $157 million ($178 million expected for 2010) and total operating expenses were $149 million (budgeted $183 million for 2010). The revenues and expenses represent a tremendous growth over the past years. Since 2003, revenues have increased by approximately $102 million, representing a growth rate of 187%, while operating expenses increased by approximately $120 million, representing a 413% increase. The operating budgets and fees are understandably lower in the first years of any agency‘s operations than subsequent years.

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In its first six years of existence, the PCAOB issued six auditing standards (AS No.1 to AS No. 6). Five remain in effect as AS No. 2 was superseded in 2007 by AS No. 5. Three are minor standards that address relatively narrow issues (AS No.1, AS No. 4, and AS No. 6). Only two significant, in-force auditing standards have been issued. These are AS No. 3 on Audit Documentation and AS No. 5 on Audit of Internal Control over Financial Reporting. The board has also proposed a set of "risk standards," all borrow significantly from preceding standards. There seems to be a lack of initiative, innovation, and urgency to improving quality auditing standards on the part of PCAOB. As Glover et al. point out ―PCAOB‘s actions have effectively forfeited to the IAASB…the U.S. role as the world‘s audit standards leader‖ (2009, p. 224).

Besides establishing standards for audit practice, the PCAOB uses three separate means of enforcement to ensure compliance: inspections, investigations and disciplinary actions. It has the power to: (1) perform inspections of registered public accounting firms, (2) conduct investigations, and (3) hold disciplinary hearings and impose sanctions. Seven years into the new regime, the question of whether the PCAOB has led to an improvement in the quality of audits is not yet settled.

Inspections: The law (SOX 2002, section 104) requires all public accounting firms to be inspected, once each year for larger firms and at least once every three years for smaller firms. Large firms are those that audit more than 100 issuers annually, while small firms are those that audit fewer than 100 issuers

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The inspection process involves not only reviewing specific audits but also assessing the quality control environment of the registered firms. It covers a broad range of activities from the evaluation of an audit firm's tone-at-the-top, partner evaluation and compensation, practices for client acceptance and retention, consultation on non-audit matters, training, policies, communication, compliance with professional codes of conduct, and conformance with technical standards, to proper application of audit procedures and documentation as well as assessing the sufficiency and appropriateness of the audit evidence collected. Following an inspection, a report is issued for each registered firm. Audit deficiencies that exceed a certain threshold are summarized in the public portion of the board's report.

The PCAOB's inspection program began in 2003 with the Big-4 accounting firms, each of whom audit between 10 to 18 percent of the total number of U.S.-based public companies (PCAOB, Release 2008-0088). The Board conducted sixth cycle of annual inspections of accounting firms in 2009 and many smaller firms experienced their second round of triennial inspections. During 2009, the Board inspected 82 non-U.S. firms in 26 jurisdictions. As of August 2010, PCAOB had issued 1156 inspection reports. Of these, 79 reports include quality control criticisms. Portions of an inspection report involving criticisms of, or defects in, a registered firm's quality control systems are not made public unless (1) the Board determines that a firm's efforts to address the criticisms or defects were not satisfactory, or (2) the firm makes no representation to substantiate its efforts addressing the weaknesses.

In its Report on 2004, 2005, 2006, and 2007 Inspections of Domestic Annually Inspected Firms (PCAOB, Release 2008-0088), the PCAOB noted insufficient exercise of professional skepticism as a contributing factor to a continuing trend of audit deficiencies in critical areas. Common deficiencies fell into one of three categories: (1) departures from GAAP, (2) auditing deficiencies, (3) deficiencies in certain quality control functional areas.

At first glance, inspection process seems to be working. For example, the number of inspection reports disclosing quality control criticisms initially increases (19 in 2005, 30 in 2006), but dropped dramatically in the last two years (11 in 2008, 7 in 2009). In our review of inspection reports, we found these reports follow a check list approach and often lacks clarity. Although publicly available, the public is no wiser as to significant inspection issues and matters of honest differences of opinion. In a similar vein, Palmrose notes that ―there appears to be less publicly available information for gaining insight into the practice of auditing under government regulation than under self-regulation‖

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There has been some criticism of PCAOB inspection feedback. Glover et al (2009) contend that the inspection feedback is exceedingly slow and ineffective, and that ―a report released in late 2005 relating to a 2003 audit was too late to affect the firm‘s 2004 audits… or even 2005 audits‖. As such, some of the same deficiencies that were identified in the first years were repeated in the inspection reports released in later years. This argument, however, may be unduly harsh as it ignores the significant improvement made in timeliness over the years.

Given the paucity of disciplinary action taken, one may conclude that the board is not effective because enforcement is lacking or that the violations do not result in serious consequences or that the firms are aware of the PCAOB inspection process but do not worry about penalties that could be levied. Alternatively, it is possible that the number of disciplinary actions has decreased because the PCAOB is effective and firms do appreciate that violations will result in disciplinary actions. We next explore whether there are benefits from PCAOB‘s activities in terms of investor confidence.

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