An Introduction to the PCAOB Enforcement Program

Through its oversight of the audit profession, the Public Company Accounting Oversight Board (“PCAOB” or the “Board”) plays a vital role in helping to ensure that investors have access to reliable and accurate financial information that is essential to making educated investment decisions.

As PCAOB Chairman James R. Doty has remarked, “The financial audit is the linchpin for investor confidence in that information, and a reliable audit is one led by an auditor that is independent, objective, and skeptical, and applies the diligence needed to meet PCAOB standards.” ¹James R. Doty, Testimony Concerning Accounting and Auditing Oversight: Pending Proposals and Emerging Issues Confronting Regulators, Standard Setters and the Economy, before the U.S. House of Representatives Committee on Financial Services, Subcommittee on Capital Markets and Government Sponsored Enterprises (Mar. 28, 2012).

One of the fundamental ways that the Board fulfills its critical mission is through a robust and active enforcement program. Its Division of Enforcement and Investigations (the “Division”) works to protect investors by identifying appropriate cases for Board disciplinary action and, where appropriate, seeking fair and reasonable sanctions. The sanctions imposed in the Board’s disciplinary proceedings punish and deter conduct that violates professional auditing standards or other applicable law, thus helping to improve the performance of auditors and the quality of the information available to investors.

This year marks the 10-year anniversary of the PCAOB, and we are taking the occasion to discuss what the Division has accomplished and how the Division does its work to carry out the Board’s mission.

Since launching its enforcement program in 2004, the Board has brought a number of notable enforcement actions involving audit failures, independence violations, failures to make filings with and pay annual fees to the Board, failures to comply with Board orders, and other matters. In 2009 and 2010, the Board issued its first adjudicated orders, which related to failures to cooperate in the Board’s inspections and investigations. ²See In the Matter of Gately & Associates, LLC and James P. Gately, CPA, Final Decision, PCAOB File No. 105-2008-001 (June 4, 2009); In the Matter of Larry O’Donnell, CPA, P.C. and Larry O’Donnell, CPA, Final Decision, PCAOB File No. 105-2010-002 (Oct. 19, 2010).

In 2011, the Board settled its largest case at that time, imposing censures and a $1.5 million penalty on the India affiliates of PricewaterhouseCoopers for audit failures concerning a billion-dollar overstatement of the assets of Satyam Computer Services. ³See In the Matter of Price Waterhouse, Bangalore, et al., PCAOB Release No. 105-2011-002 (Apr. 5, 2011). This order was issued by the Board in coordination with a parallel Rule 102(e) administrative proceeding instituted by the U.S. Securities and Exchange Commission (“SEC”) against the same audit firms. See In the Matter of Lovelock & Lewes, et al., Exchange Act Release No. 64184 (Apr. 5, 2011). The Division closely coordinates its enforcement work with that of the SEC Division of Enforcement.

In 2012, the Board issued a notable settled order regarding Ernst & Young’s (“E&Y”) audits of Medicis Pharmaceutical Corp. over three years and a related accounting consultation. ⁴See In the Matter of Ernst & Young LLP, et al., PCAOB Release No. 105-2012-001 (Feb. 8, 2012). Respondents, in connection with this and each other settled Board order referenced in this article, consented to the order without admitting or denying the Board’s findings, except for the Board’s jurisdiction. E&Y and four of its current and former partners failed to properly evaluate a material component of Medicis’ financial statements – its sales returns reserve. The Board imposed a $2 million penalty against E&Y — the largest monetary penalty imposed by the Board to date — and imposed sanctions on the four partners, including barring two from associating with registered accounting firms.

To date, due to the Division’s efforts, the Board has issued 58 disciplinary orders, imposed 44 sanctions on firms – including 28 revocations of registration, and 62 sanctions on individuals – including 52 bars and suspensions. And the Division currently has in process more than 80 informal inquiries, formal investigations, and nonpublic litigated proceedings.

The Board’s enforcement program is evolving in other ways as well. On April 24, 2013, the Board published its first formal statement concerning the potential benefits available to registered public accounting firms and individuals who provide extraordinary cooperation in PCAOB investigations. ⁵See Policy Statement Regarding Extraordinary Cooperation in Connection With Board Investigations, PCAOB Release No. 2013-003 (Apr. 24, 2013). The Division expects the issuance of this policy statement to encourage cooperation – beyond what the law requires – among firms and individuals involved in our investigations, which will assist the Board in identifying violations earlier, while also expediting our investigations, thereby allowing the Board to turn its attention and resources to other potential auditor misconduct.

The Division’s Investigative Process

Audit firm counsel and others in the auditing profession often ask us to provide greater transparency into our enforcement program. Under the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act” or the “Act”), the Board is required to conduct its disciplinary proceedings confidentially. ⁶See 15 U.S.C. §7215(c)(2); see also Claudius Modesti, Remarks at AICPA National Conference on SEC and PCAOB Developments (Dec. 8, 2010) (available at http://pcaobus.org/News/Speech/Pages/12082010_ModestiSpeech.aspx). As a result, although we strive to be as transparent as possible, given legal constraints, it can be difficult to provide a comprehensive picture of our program.

The lack of public disclosure concerning our disciplinary proceedings does not merely make it difficult for the Board to discuss its work; it also delays providing meaningful information to those who rely most upon the audits – investors, audit committees, audit firms, and other market participants – about the results of our investigative process. While a disciplinary proceeding is pending against an auditor, the auditor may continue issuing audit opinions and acquiring and retaining clients who are unaware of the serious allegations against the auditor.

Investors who review financial statements audited by the auditor will be in the dark as well. This “information gap” between what our investigations have uncovered and what we can say hurts investors and public companies, impairs the transparency of the Board’s work, and erodes the deterrent effect of our enforcement activities. The cloak around Board disciplinary proceedings also feeds misimpressions about the level of activity in the Board’s enforcement program. The Board has asked Congress to make Board disciplinary proceedings public. ⁷Bipartisan legislation was introduced in 2011 to make PCAOB disciplinary proceedings open to the public. See H.R. 3503, 112th Cong.; S. 1907, 112th Cong. The legislation was recently reintroduced in the Senate. See S. 848, 113th Cong.

Although there is much we are unable to discuss as a result of these legal restrictions, there are some things we can discuss about the Division’s processes and procedures for determining the scope of investigations and considering potential resolutions of proceedings. These processes and procedures ensure that, in every case, the evidentiary record is scrupulously examined and all relevant issues are carefully considered before the Division decides whether to recommend Board action.

The Division conducts focused yet thorough investigations. The investigative process at the PCAOB is designed to ensure that careful attention is given to the scope and thoroughness of its investigations and the efficient use of the Division’s resources. We capture the relevant facts to assess the conduct of auditors and firms. Our approach provides a holistic picture of the audit. It is the foundation on which we make informed judgments throughout the investigative and disciplinary process.

The Informal Inquiry

An investigation typically begins as an informal inquiry, the goal of which is to determine in short order whether there is a sufficient basis to believe that serious misconduct may have occurred and that significant Division resources should be devoted to the matter. The Division also considers at this stage to what extent an inquiry reflects significant investor protection considerations. Currently, the Division is prioritizing audit matters involving a lack of professional skepticism, objectivity or independence, as well as matters threatening the Board’s processes such as non-cooperation during a Board inspection or investigation.

Informal inquiries arise from various sources. Many develop from findings made by PCAOB inspection teams during the course of their work. Others come from news reports, corporate announcements and filings, or other public sources of information. The Board also receives tips from the public, ⁸Tips may be submitted to the PCAOB at: http://pcaobus.org/Enforcement/Tips/Pages/default.aspx. To date, the Board has received over 1,400 tips and referrals. referrals from fellow regulators, including the Securities and Exchange Commission (the “SEC”) and the Financial Industry Regulatory Authority, and self-reports from registered firms.

In appropriate instances, we may request at the outset of an informal inquiry that a firm make a presentation to the Division regarding the relevant audits under scrutiny, focusing on areas of concern identified by Division staff. The presentation can be an initial step in the inquiry, aiding the Division in determining if and how best to proceed with its inquiry, including its appropriate scope.

Division Recommendation for Formal Investigation

In numerous cases, we determine to close an inquiry at its initial stage because we do not find a sufficient basis for committing additional resources to the matter. In others, the Division recommends that the Board issue a formal order of investigation.

In recommending a formal investigation, the Division lays out specific facts, typically identifying specific audits, areas of concern in the performance of the audits, financial statement assertions at issue, and individuals involved. The Division’s recommendations include specific PCAOB audit standards or other applicable law that may have been violated, theories of liability, potential evidence to support those theories, and the parties from whom testimony or documents may be obtained.

In considering the Division’s recommendations, board members typically engage deeply in the issues, ask probing questions, and test the strength of the Division’s preliminary factual and legal theories.

The Scope of the Formal Investigation

If the Board approves the opening of a formal investigation, Division staff develops an investigative plan that defines the investigation’s anticipated scope. The scope of an investigation is determined in large part by (i) the nature of the potential violations, (ii) the breadth of the relevant documentary work paper record, and (iii) witness testimony that is likely to be required.

The Division Targets the Most Relevant and Significant Issues.

The potential violations presented in an investigation are the primary driver of its scope. When an investigation arises from a PCAOB inspection, the investigation is typically focused on audit deficiencies identified in the inspection. In other instances, an investigation may focus on a particular account that has been restated, transaction, or other concern. However, depending upon the facts and circumstances, an investigation – particularly one involving an audit of a large public company – often begins with broad parameters. That is because serious audit deficiencies call into question the foundation of the audit opinion upon which investors relied and must be thoroughly investigated.

Such an investigation often involves several years of financial statements and numerous audit team members and other personnel involved in the audit. The staff must extensively explore interrelated audit issues that run across the auditor’s testing of various financial statement assertions and audit years. And, unlike many other kinds of investigations conducted by law enforcement authorities and other financial market regulators relating to publicly traded companies, audit firms rarely conduct their own internal investigations of potential audit failures and share the results of such investigations with Division staff. ⁹The Board’s recently issued policy statement on cooperation makes clear, however, that substantial assistance in a Board investigation – such as by conducting a thorough, objective internal investigation and reporting the results to the Board’s staff – may result in significant benefits for the audit firm.

Although our investigations often involve multiple audits and areas of concern, witnesses and their counsel typically have a very good sense of the focus of the investigation from their own records. Upon request, the witnesses and counsel receive a copy of the Board’s order of formal investigation. When the Division seeks testimony, we usually are relying on documents that are already within the possession of the audit firm, and an overwhelming majority of documents used to question witnesses come from the audit firm that employs them. Moreover, many of the Division’s investigations are prompted by issuer restatements or Board inspection findings that are available to the auditors and their counsel.

In addition to these common characteristics of investigations involving audit failures, there are several other drivers of investigative scope.

Development of New Issues During Investigations: Investigations can expand in scope beyond what was originally anticipated as a result of witness testimony or other developments, such as information obtained from a parallel investigation by another regulator. Auditors may testify about undocumented conversations with audit team or firm members, or client management, which gave them comfort over an audit area in question. Or they may point to audit procedures and audit evidence from a seemingly unrelated part of the audit at issue, or even from a prior year’s audit.

In these instances, the Division must expand the scope of the investigation to these new areas, potentially including several additional years of audits, in order to determine the credibility of the witness’s claims.

Need to Prepare for Litigation: Additional investigative steps are particularly appropriate in cases that are likely to be litigated – as are many disciplinary proceedings brought by the Board. Since the Board’s contested disciplinary proceedings are nonpublic by law, some respondents see little incentive to settle – and abundant incentive to delay public knowledge of a proceeding and forestall the imposition of any sanctions that may ultimately be imposed by prolonging the litigation.

While the Division builds a solid evidentiary case before recommending that the Board initiate a disciplinary proceeding whether a matter is likely to settle or not, a matter that is more likely to be litigated demands different preparation. Investigators must focus all the more on gathering additional documents and testimony that could become relevant at a potential hearing. The Division currently is litigating proceedings against 19 respondents.

International Enforcement: Our enforcement program increasingly crosses international borders as well. Over 900 non-U.S. audit firms from more than 85 countries have registered with the PCAOB. As a result, a growing number of our investigations involve audits of foreign-based issuers performed by foreign-based auditors, sometimes from a number of affiliated firms in different jurisdictions. Work papers and other documents may be in many different languages.

The Division uses the Board’s cooperative agreements with its foreign regulatory counterparts to coordinate investigations, including to obtain documents and other information. While cross-border cases often require additional investigative work due to language differences, procedural complexities, and other issues, it is essential to the Board’s mission that it exercise its enforcement authority with respect to foreign firms to the same extent as to domestic firms.

Failures to Cooperate: Matters involving potential failures to cooperate with Board inspections or investigations are a priority of the Division. These matters can also require intense investigative effort to determine whether misleading information was provided to the PCAOB staff. Many such cases focus on intentional attempts to improperly supplement or alter the audit work papers and evidentiary record, and it can thus be particularly difficult to uncover the facts. And these cases often involve multiple audit personnel with varying levels of knowledge and involvement. They also may require the staff to delve deeply into a firm’s internal processes, procedures, and organizational structure.

The Division Calibrates Its Document Requests With the Circumstances.

Financial statement audits of large public companies generate significant volumes of work papers. ¹⁰Work papers, or audit documentation, are the written records of the basis for the auditor’s conclusions that provide the support for the auditor’s representations in the auditor’s report or otherwise. They include records of the planning and performance of the work, the procedures performed, evidence obtained, and conclusions reached by the auditor. See PCAOB Audit Standard No. 3, ¶ 2. When the Division requests documents, it tailors the request to the matters under investigation and the investigative avenues to be explored. Where possible, the Division limits demands to specific work paper areas or specific issues, but that is not always feasible.

The audit planning, risk assessment, and audit evidence for the same financial statement assertion are not necessarily conveniently located in one place in the work papers. It is also difficult or impossible in the early stages of an investigation to isolate precise subsets of a set of work papers that are likely to be relevant or irrelevant.

Moreover, in describing their roles in one audit area, witnesses often cite work papers relating to another audit area. In the end, obtaining all work papers often streamlines and speeds an investigation for the PCAOB and the auditors by reducing the likelihood that additional, time-consuming document or testimony demands will become necessary later.

PCAOB rules require firms to maintain all work papers associated with audits, so the burdens of complying with requests for all work papers for a particular audit should be minimal. And the Division works with firms to accept electronic productions in native formats, including productions on laptop computers configured by the firms. A firm’s challenges in gathering the relevant materials often derive from unique characteristics of the firm’s information technology systems and identifying all custodians with relevant information. The Division takes those challenges into account in setting document production deadlines, but still requires that such productions occur within a reasonable time frame.

The Division considers suggestions by defense counsel to narrow a document demand. Unfortunately, based on our experience, a narrow production of relevant work papers and other documents is rarely appropriate or sufficient. Moreover, it can be difficult to negotiate terms of such a request that are satisfactory to both the Division and opposing counsel.

The Division’s Testimonial Processes Are Thorough and Fair.

In determining the breadth and significance of potential misconduct, the staff must identify the audit personnel responsible for it and question them in testimony.

While we strive to keep the testimonial stage of each investigation as focused and streamlined as possible, the nature of our investigations and of the testimonial process itself requires a comprehensive approach. Among other factors:

• The period relevant to a particular investigation often spans several years of financial statement audits, each of which may involve numerous audit team members and other personnel. ¹¹For instance, the February 2012 settled proceeding against E&Y involved the firm’s audits of three years of Medicis’ financial statements, as well as a consultation stemming from an internal E&Y audit quality review of one of the audits. The Board also took action against four partners at E&Y for the audit work at issue. See supra n. 4.

• Many witnesses will have knowledge about numerous issues in an investigation, which can necessitate multiple days of testimony and the use of voluminous records.

• As noted above, witnesses sometimes point to other areas of an audit or prior audits to support their views.

• Witnesses often testify that, due to the passage of time since the conduct at issue, they cannot recall some of the most significant aspects of the audit. In such an instance, the Division staff wants to have ready the relevant audit work papers and related information to assist the auditors in answering the Division’s questions.

To address all of these situations appropriately, sometimes the line of questioning and use of documents in testimony must be exhaustive. Nevertheless, in conducting testimony, the Division strives to minimize burdens on witnesses by accommodating their schedules and conducting testimony in mutually agreeable locations, wherever possible.

In sum, the Division must exercise appropriate diligence throughout the investigative process, especially when taking testimony, to identify, as definitively as it can, the procedures actually performed, the audit evidence actually obtained, and the auditor conclusions actually reached to support the relevant financial statement assertions.

The Charging Letter

The Board’s Rules and the Division’s Practices Ensure That Potential Respondents Have Abundant Opportunities to be Heard.

PCAOB rules afford persons involved in Board investigations an opportunity to address the Division’s tentative decision to recommend a disciplinary proceeding. The Division typically notifies audit firms and their personnel, in the form of a charging letter, as to the factual and legal allegations the Division intends to incorporate in a recommendation to commence disciplinary proceedings. Potential respondents then have the opportunity to lay out their views in a statement of position to the Board.

The Division’s charging letter can be quite detailed and serves dual and complementary purposes. First, the process to generate the letter requires careful evaluation of the evidentiary record and a measured analysis of whether serious misconduct occurred. This internal deliberative process helps the Division’s staff refine its thinking about the case.

Second, the letter provides potential respondents with the details they need to address the Division’s allegations with their own view of the evidence and applicable law. They may provide their own statements of position. The notice provided in the charging letter is sufficiently detailed that auditors can use it as the basis for expert reports that may be submitted along with their statements of position.

At the time of the charging letter, the auditors may request to meet with Division staff. The Division typically accommodates these requests. ¹²Generally, the Division has found that substantive meetings with counsel earlier in investigations are often not useful because the Division’s staff has not yet completed its investigation or had the opportunity to review and consider all the evidence. Such requests will nevertheless be accommodated when the staff believes a meeting will be productive. The Division then carefully considers and weighs statements of position and any other information received in making a final decision about whether to recommend charges to the Board.

At this juncture, the Division may elect to close an investigation without further action based, in part, on its review of a statement of position. If that happens, Division staff notifies parties who have received charging letters that the formal investigation is being closed.

On the other hand, if the Division continues to believe that a disciplinary proceeding is warranted, the statement of position is forwarded to the Board together with the Division’s recommendation.

Upon request from a potential respondent, the Division also presents any offer of settlement, even if the Division is not recommending acceptance of the offer. In this way, respondents have numerous opportunities to make their arguments and present their defenses, both to the Division and to the Board.

Sanctions

When Appropriate, the Division Recommends, and the Board Imposes, Sanctions That Are Tailored to the Conduct and the Violations.

The Act vests the PCAOB with the authority to impose a spectrum of sanctions, ranging from censures to monetary penalties to suspensions and bars. The Division’s goal, when considering what sanctions it will recommend to the Board in a settlement, is to recognize the seriousness of the conduct while giving appropriate weight to any mitigating factors, such as the firm or individual auditor’s cooperation in the investigation. ¹³While the Board recently issued its first formal statement concerning cooperation, see supra n. 5, the Board has always recognized cooperation where appropriate. Indeed, the Board made clear in one of its very first settled orders that it would consider a respondent’s cooperation when evaluating sanctions. See In the Matter of Alan J. Goldberger, CPA and William A. Postelnik, CPA, PCAOB Release No. 2005-011 (May 24, 2005) (noting that, in assessing sanctions, the Board considered the respondents’ “voluntary disclosure” of their misconduct and “affirmative steps to provide Enforcement with all relevant information and documents”).

This assessment is guided by criteria that are widely known and available. The Act, and rules enacted by the Board under the Act, set forth the framework for PCAOB sanctions. For instance, Section 105 of the Act provides that certain sanctions are available only when the conduct was intentional, knowing, or reckless, or when it involved repeated instances of negligence. And the Act and PCAOB rules specify certain additional sanctions that are available in cases involving failures to cooperate with Board investigations.

In assessing civil penalties, the Board also considers the factors that govern the imposition of such penalties in analogous SEC proceedings. The Securities Exchange Act of 1934 (the “Exchange Act”) enumerates several criteria to govern that assessment: (1) whether the misconduct involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement; (2) resulting harm; (3) unjust enrichment; (4) prior disciplinary history; (5) the need for deterrence; and (6) such other matters as justice may require. ¹⁴See In the Matter of Davis Accounting Group, P.C. and Edwin R. Davis, Jr., CPA, Final Decision, PCAOB File No. 105-2009-004 (Mar. 29, 2011); In the Matter of the Application of R.E. Bassie & Co. and R. Everett Bassie, C.P.A., Final Decision, PCAOB File No. 105-2009-001 (Oct. 6, 2010). The SEC has approved the PCAOB’s reliance on these factors. ¹⁵See In the Matter of the Application of R.E. Bassie & Co. and R. Everett Bassie, C.P.A., Accounting & Auditing Enforcement Release No. 3354 at 21 (Jan. 10, 2012) (SEC decision affirming sanctions imposed by PCAOB).

In addition to the framework laid out in the Sarbanes-Oxley Act, the Exchange Act, and PCAOB rules, factors bearing on the reasonableness of sanctions are set forth in published case law, including settled and adjudicated SEC matters with comparable fact patterns. The Division also considers these when recommending sanctions. Of course, particularly in matters involving deficient auditing, each case has unique facts and circumstances that influence the Division’s recommendation and the Board’s decision regarding sanctions. No rigid formula would be appropriate.

Some have suggested that more cases would settle if the Division were more open to settlements involving censures, or even deferred prosecution or non-prosecution agreements. Because the Division is focused on investor protection and what it views as serious misconduct, however, a censure alone is rarely a proportional and adequate sanction. The same holds true for other dispositions, such as deferring or forgoing prosecution by mutual agreement.

To the contrary, the real impediment to settlement is the statutory requirement that the Board conduct its litigated proceedings confidentially, which gives some respondents incentive to delay public disclosure of the proceeding as long as possible through protracted litigation.

The PCAOB’s enforcement program is vital to the Board’s mission to protect investors and further the public interest in the preparation of informative, accurate, and independent audit results. In support of this mission, the Division undertakes focused, thorough investigations and recommends sanctions, when necessary, that are fair and appropriate to the conduct at issue. In this way, the Division contributes to the protection of investors in U.S. capital markets by ensuring that auditors are fulfilling their gatekeeping role.