Earmark Podcast | Earn Free Accounting CPE

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Maureen McNichols: [00:00:00] Eliminating the PCAOB would risk the trust that we have in our capital markets, and the fact that it allows companies to raise capital, create jobs at a low cost, and that we are the envy of the world. The trust that people have in our capital markets really does depend upon the quality of the audited financial statements.

Blake Oliver: [00:00:25] Are you an accountant with a continuing education requirement? You can earn free Nasba approved CPE for listening to this episode. Just visit earmarked in your web browser, take a short quiz and get your certificate. Hello everyone, and welcome back to earmark. I'm Blake Oliver. Today we're diving deep into one of the most significant regulatory battles facing our profession. The House of Representatives has passed legislation that would eliminate the Public Company Accounting Oversight Board, the PCAOB, and transfer its functions to the SEC. This isn't just another regulatory tweak. It's a fundamental reshaping of audit oversight that could affect every public company audit in America. I'm joined today by three of the nation's leading accounting academics who have studied the PCAOB extensively. Maureen McNichols from Stanford, is a leading researcher on capital markets and financial reporting quality and formerly served on the PCAOB Standing Advisory Group. Maureen, welcome to the program.

Maureen McNichols: [00:01:29] Thank you. Blake, it's just a privilege to be here.

Blake Oliver: [00:01:33] We've also got Nemit Shroff from MIT, whose groundbreaking research demonstrates the real economic effects of PCAOB inspections on corporate financing and investment decisions. And Nemit currently serves on the Investor Advisory Group at the PCAOB. Nemit, welcome to the program.

Nemit Shroff: [00:01:50] Thank you. Blake. It's great to be here.

Blake Oliver: [00:01:52] And finally, we've got Daniel Aobdia, currently at Penn State, who brings the unique perspective of having worked inside the PCAOB as a senior research fellow, and has studied how individual engagement inspections actually drive audit quality improvements. Daniel, welcome.

Daniel Aobdia: [00:02:09] Yeah. Thank you. Blake. I'm very happy to be here.

Blake Oliver: [00:02:12] Now, Daniel, um, and I know that both of you are currently involved with the PCAOB, so let's go ahead and give that standard disclaimer right now at the top of the program.

Nemit Shroff: [00:02:24] I'm I'm a member of the the PCAOB Investor Advisory Group. And anything I say is my own views and does not represent the views of PCAOB or the IAG.

Blake Oliver: [00:02:35] Thanks, Daniel. Anything to add to that?

Daniel Aobdia: [00:02:37] Yes, so I used to work as a senior economic research fellow at the PCAOB, and I currently do some consulting for them on questions related to the economics of auditing. The views expressed here are my own do not necessarily reflect the views of the board. Individual board members or staff of the PCAOB.

Blake Oliver: [00:02:57] Got it.

Blake Oliver: [00:02:59] So the timing of this conversation couldn't be more critical. The PCAOB just reported record enforcement activity and improving audit quality metrics, but Congress is moving to eliminate it entirely as part of the One Big Beautiful Bill act, which just passed the House by a single vote last week. So let's explore what the research tells us about the pcaob's effectiveness. What would happen if it's eliminated, and whether this represents sound regulatory reform or political expedience? For our audience of accounting and tax professionals, this could fundamentally change how public company audits are overseen and regulated. So let's get started. Maureen, thank you for setting this up. First of all, I really appreciate you bringing together this group to answer some questions that I've had for a long time as an outsider watching the PCAOB over the past decade. The House passed this bill, which includes the PCAOB getting eliminated by a single vote. Maureen, are you surprised by how quickly this move through Congress?

Maureen McNichols: [00:04:09] Before I answer that question, let me just also say, since you recognize that I brought this group together, I'm a big fan of the podcast. Uh, I feel like it's terrific, the community that you build for accountants and, um, I think we're all here because we believe in the work accountants do to contribute in so many different ways, uh, in every role, uh, you know, creating economic growth and jobs for so many people. And so, um, it's it's, uh, it's that, um, passion for the for the work that accountants do that I think motivates us all to, you know, do all the teaching and research that we do. Okay. So now turning to the to the bill. Now, that's a great question. Um, I guess at some level I was surprised, though. I think, you know, it was certainly, um. It's not my expertise. Uh, sort of the house budgetary process. Um, uh, it certainly is very concerning. Um, you know, the process, the fact that it went through so quickly, the fact that the legislation is like a thousand pages and people really didn't get a chance to get what did they get two hours to read it or something like that. So, you know, all of those dimensions, I think, um, in particularly H.R. 50002 are extremely concerning.

Blake Oliver: [00:05:27] It's it's it did surprise me, um, because I know there was talk about rolling the PCAOB back into the SEC or eliminating its, you know, role and and but but I didn't think it would happen this fast. I mean, I feel like those discussions just started a few months ago. Or has this been going on for a while? Like like, is this is this sudden or has this been happening behind the scenes?

Maureen McNichols: [00:05:51] Oh for sure. There's been, uh, efforts behind the scenes project 2025. Uh, you know, written what, last spring or sometime earlier? Uh, you know, basically had as one of its, uh, you know, goals to eliminate the PCAOB. So there's been an effort, you know, there have been people wanting, uh, you know, wanting to achieve this, um, and discussing it, to be sure. Figuring out how it could be done. But in terms of, uh, the process, you know, in the house, um, for sure, that's that's moved ahead very quickly. And it means many, many people did not get a chance to really process what this is about.

Blake Oliver: [00:06:30] Well, and.

Blake Oliver: [00:06:30] Can I just ask you.

Blake Oliver: [00:06:32] Like.

Blake Oliver: [00:06:33] What is your take on this? Like, is this a good idea? Is this a bad idea?

Maureen McNichols: [00:06:38] I'll give an emphatic no. I think it's a bad idea, uh, to, uh, take out, uh, you know, an independent audit regulator, basically that was put in place by the Sarbanes-Oxley act, which was passed by, you know, regular Process, an overwhelming vote in the House and the Senate in support of it. With tremendous detail, 22 pages of, uh, details characterizing what the PCAOB. Uh, you know, structure should be, how it should operate, what its responsibilities were, how it should relate to, uh, the, uh, the SEC, um, what should happen with enforcement penalties, which is to actually fund a scholarship program. So there was an incredible thought that went into how to address the problems that arose in the early 2000 because of what is really an inherent structural problem in the auditing profession, which is, you know, that companies, their audit committees, hire the auditor to carry out the work. And so while the auditors, uh, true client is the investing public, it is very easy, you know, to lose sight of that, uh, you know, agency issues, pressure, time. All of those factors can cause it to be very difficult to, um, keep that focus. And so an independent audit regulator, you know, is really there to, um, yeah, to give, uh, strength to the auditors, really to support them.

Blake Oliver: [00:08:10] I was just talking yesterday with a former auditor who now runs a technology company, Mike Whitmire of Floqast. He was a senior at Ernst and Young before he left public accounting to go do tech. And I asked him, what do you think about this situation, the PCAOB, um, you know, as an auditor yourself, were you aware of it? Did it impact your work? And he told me that, yes, they were afraid of the PCAOB that it definitely was something on their mind at all times, that the work that they were doing might be inspected. And so, he says, based on his experience, you know, without that independent regulator looking over their shoulders or, or the, the possibility of it that they might not have. Um, I don't know if those were his words, but, you know, I would I would think, yeah, maybe as an auditor I'm not as diligent or, you know, there's not as much pressure on me to do a high quality audit. Um, I'm curious what the research is to back up that, because I've heard this anecdotally from partners, folks who have worked in audit, as you know, staff managers, but I haven't really seen a lot in the way of, of of research personally, that that quantifies the impact of the PCAOB. So I would love to know what that is. So can I start with you? Nemet? I know you've done a bunch of research on on firms that get audited. If you have a clean PCB inspection report, there are there's definitely like a difference between between that and if it's if it's not clean. Can you walk me through your findings at a high level?

Nemit Shroff: [00:10:04] Absolutely. Yeah. And and before going there, even like if you just look at the broader picture, just time trends of what has happened, has there been any major public company fraud since the creation of PCB since Sarbanes-Oxley in and not really. Right. Like if if the major frauds after Worldcom and Enron are off, there's not been fraud of that scale in the US public markets for for more than two decades. But the incentives to commit fraud and the incentives that give rise to those pressures, they have not gone away. Right. And so where do we see the frauds now? And some of this is in the private markets, which is not regulated by the PCB or by, uh, by the SEC. Right. So, uh, fdx wework's. Uh, and, uh, these are prominent examples of, of instances where private companies had had fraud and they are not watched. They don't have any any the, the governance mechanisms that exist there just do not exist uh, for, for private companies. Um, coming back to what what to answer your specific question about what my research shows the the at a high level what what I tried to do is, is come up, come up with a way to see whether if a company's auditor is inspected by the PCAOB, are they do they get any capital market benefits? Are they able to raise capital on more favorable terms, and are they then able to use that extra capital to increase investment decisions? The challenge of doing this in the US is that every company's auditor is inspected by the PCAOB, as long as they're public.

Nemit Shroff: [00:11:51] So there are certain aspects of the way in which the PCAOB is structured, particularly the international inspection program, where I exploit where I used instances where some companies auditors were inspected by the PCAOB, whereas other companies that were similar in industry and scale and type are, but their auditor was not inspected by the PCAOB. And what I find, and this shows up in the data very clearly is, is that, uh, when a company's auditor is inspected by the PCAOB, if the content of that inspection report is clean, meaning there's no part one finding, then that company is able to raise additional capital. And they use this additional capital to increase investment, to increase their investment. Uh, the.

Blake Oliver: [00:12:43] Okay. So clean inspection, Meaning the audit was done to a high quality that leads, that correlates with companies that are able to raise more capital.

Nemit Shroff: [00:12:58] Correct. And what? When I say clean, what it means is that the challenge with auditing is, is that as as your audience probably knows, is we don't as outsiders, we don't see much about what happens with the audit process. What we get at the end of the audit process is a statement from the auditor saying whether, uh, the whether the company sort of passed or fail, right, whether they were whether there were any concerns or not. Nothing. Nothing more than that. So what the inspection report does is it paints a picture. It gives investors information about whether the auditors general processes that they follow, whether they are reasonable, you know, or were there issues that are identified by the PCAOB. Uh, the mechanism is not perfect. The system is not perfect. But this certainly provided more information. Order of magnitude more information than what investors received about the audit processes beforehand. And I think that's that is what was relevant.

Blake Oliver: [00:13:55] Okay. So basically that is sort of like an indirect way. I mean, since we can't measure it directly of, of, of supporting this argument, I mean, it supports this idea that the Pcaob's oversight, uh, benefits capital markets.

Nemit Shroff: [00:14:12] Correct. Yes. This is a way to get at that, that question.

Blake Oliver: [00:14:16] Got it. So one of my concerns that I've expressed on my podcast about the PCAOB is the and I learned this also from my interview with Christina Ho, who's a board member of the PCAOB. Is that like the way the PCAOB measures audit quality may be fundamentally flawed in that they do not randomly select audits for inspection, and because they don't randomly select audits for inspection. When we look at deficiency rates, we can't necessarily compare them from year to year or over time easily. Audits are selected for inspection based on unknown criteria. It's like a risk based approach. And so when Christina told me that it changed how I viewed this very high deficiency rate that's been advertised or. Shared in press releases for years, um, which, you know, approaches 50%. And for many firms is 100% of audits are deficient that are inspected. Um, so I was wondering, um, Daniel, you know, since you were inside the PCAOB as a, as a research fellow, do you have a take on that? Like, could the PCAOB have done a better job or could it do a better job measuring audit quality in a way that allows us to actually see that it has made an improvement? Like, because Nemitz research is so like that. That way of determining whether the what the impact is, is feels very indirect, right? It's like, well, why don't why can't we just measure this directly?

Daniel Aobdia: [00:15:57] Right. Uh, so you mentioned a lot of very good points. So I just want to be clear that I am subject to a non-disclosure agreement with the PCAOB. So everything I will mention is based on publicly available information. Just to be clear. Uh, that said, those are very good questions that you're asking. Uh, and it's interesting because I suspect internally, the PCAOB themselves have struggled about how to highlight this deficiency rate over the years, because the deficiency rate itself that comes from the inspection is something that's been more highlighted by the popular press rather than than the PCAOB themselves over the years. And for the exact reason you mentioned that, uh, inspections are risk based, so they are not meant to select a representative sample of audits for inspection. So if you look before 2010, the PCAOB did not even disclose the number of inspections they are doing for each of the big four firms. So you couldn't even compute that deficiency rate using publicly available data. They only started doing that, I believe, after 2010. And that's when popular press has started picking up on the deficiency rate. But the PCAOB has always been very transparent that because the inspections are risk based, it is very difficult to extrapolate what's happening on this deficiency rate for other average typical engagements of of an audit firm. And so in a way, it's very hard to actually understand what the true level of, uh, of deficiency in a typical form is. Also, I have to mention a little bit of my recent research on that.

Daniel Aobdia: [00:17:50] So since around 2016 2017, the PCAOB has started inspecting some engagements on a random basis. On average, it's been around 20% of the engagements of the large audit firms that have been inspected randomly. And if actually you start digging into the PCAOB inspection reports, there's actually more information that is made available to the public about the deficiency rate for the random selections relative to the risk based selections. And I think that's something that hasn't been highlighted at all, uh, in, uh, even in research. I mean, except for one project I'm currently working on, uh, but but especially not, uh, in the popular press. And when you look at at the numbers and everything I'm going to mention here is based on publicly available information. So my, uh, my Courcelles and I have been finding that the random deficiency rate seems to be closer to 20% on average rather than, uh, there is based, uh, deficiency rate for the large audit firms, which is closer to to 30%. So I wanted to mention that because all of this information is actually publicly available in the report, if you look at the recent PCI inspection report of one of the largest audit firms, PCAOB will tell you how many inspections were conducted randomly, how many were conducted using a risk based analysis. And if you actually read the text of the report, they will tell you how many deficiencies were risk based deficiencies, and you can infer how many were random based on the total number and the risk based deficiencies.

Blake Oliver: [00:19:35] So you're saying that it's closer to 20% the true deficiency rate. Right.

Daniel Aobdia: [00:19:41] So the I'm looking at the average here that's been compiled by, by my coauthors that they've been digging through the inspection reports. Um, and between 2018 and 2024, they have been able, based on publicly available versions of those reports, to understand how many, uh, part one findings were random versus random inspections versus for, uh, for risk based inspections. And the rate for the random ones is closer to to 20%, 20%.

Blake Oliver: [00:20:12] That still seems very high. It feels like that's too high. You know, if I'm taking a a test to get an A, I need to answer 90% or more of the questions correctly, right? As a profession, do we really want to be getting a, you know, B-minus or a c-plus.

Daniel Aobdia: [00:20:34] If I miss something? So so I understand the concern and especially in, in the United States, uh, people look at an 80% pass rate as being very low. Where I grew up in France, I would have been really, really happy if I got 80% on a test. So I think it's in part related with, um, with the expectations that people have. But but that said, I mean, um, the the efficiency rate is, is pretty quite high. Um, I, I think we would be happy to discuss what potentially could be driving this, this high efficiency rate. Uh, but we have to keep in mind that, um, the, uh, instances where there's actually a mistake in the financial statement where eventually there's a misstatement are going to be likely lower than this deficiency rate, because you will only find a misstatement in the financial statement of a of an issuer only when the financial statements have a misstatement to begin with and the auditor fails to catch those misstatements. So a very high deficiency rate doesn't necessarily imply that 20% of a company's financial statement will need to be restated in the future.

Blake Oliver: [00:21:51] And that was something that Christina Ho pointed out in my interview with her, which is that the restatement rate is something like 5% or lower. So is that right?

Nemit Shroff: [00:22:04] It goes up to about, I think, in more recent years when the when the Spac boom took place was about 5%.

Blake Oliver: [00:22:09] Okay. But the SPACs, the SPACs are another story, right? That's that's let's leave we can leave that out of it for for now. Right. That's kind of an unusual situation.

Maureen McNichols: [00:22:19] Closer to about 4% in the very last year. Audit Analytics put out the data.

Blake Oliver: [00:22:25] Got it. So see that's that's the thing that I think is hard for me to wrap my head around, is that we have this part one, a deficiency rate overall, which is 30%, depending on the size of the firm. And then what was it overall like? Most recently, does anyone know that off the top of their head?

Daniel Aobdia: [00:22:48] Uh, I think I may have the numbers. All right. So part one finding for 2024 were around 26%, and for 2023 were around 40%. That's including both risk based and random inspections.

Blake Oliver: [00:23:06] Gotcha. 40% in a year seems like a lot. I guess the reason that I'm bringing all this up is because, well, let me go back to the point I was trying to make. So we have the 4% actual restatement rate, and then we have the 40%, you know, deficiency rate. And those part one A deficiencies are like the PCAOB defines them as so severe that the auditor should not have issued their opinion in trying to reconcile those two numbers is difficult for me because they are so far apart. And so that's why in many ways, I sympathize with the Republican legislators who are who have voted to eliminate the PCAOB because an organization that consumes $400 million a year of resources from our economy through a tax on public companies, ought to be able to justify its existence. And I feel like it has like, let me challenge you with this question. Feel free to disagree with me as strongly as you like, but it seems to me that the PCAOB in 20 years has failed to accurately measure and report on audit quality, which is like its core mission should be to do that if it if it wants to improve audit quality, should it not measure and report on in a consistent way how auditors are doing?

Nemit Shroff: [00:24:43] I can weigh in on that. There are a few different aspects of what was said. Right. So one is also just consider just stepping. Yes, the budget is $400 million, but consider the cost of a fraud. When Enron failed, it was in the hundreds of billions of dollars. When Worldcom failed was in the hundreds of billions of dollars when FTX failed. Just the investor losses. Just the money that investors put. Emily venture capitalist was 12 billion. Not to mention the money that customers would have lost an employee.

Blake Oliver: [00:25:16] That's a fair point.

Nemit Shroff: [00:25:17] Fair point.

Blake Oliver: [00:25:18] Okay.

Nemit Shroff: [00:25:19] That's one. The other is also you think about the regulatory model that the PCAOB has. I think I listened to the interview with with board member. And there are two ways to look at what the PCAOB does. Right? One is is the There's the primary function to provide information to investors to assess audit quality. Or is the role of the PCAOB is the regulatory model to incentivize auditors to do a more thorough job of of auditing clients? And let's go back to the example that you said that you gave initially. Right. For that with this this audit professional whom you were speaking to about the PCAOB. And, and when they have the PCAOB overlooking what they're doing, then the incentive structure changes. As Maureen said, initially, the the current structure is, is uh, boards or committee members of, of boards. They are the ones who hire audit firms. But the ultimate consumer of audited financial statements are investors. But but the this this creates this natural incentive conflict where auditors are answerable to the company whose financial statements they're auditing. Are absent the PCAOB. That's that is the structure that's in place, right? So to the extent that PCAOB serves a deterrence role and incentivizes auditors to do a more thorough job, uh, I would argue that that would be a more appropriate way or a different way of of looking at how effective they are. Coming to your point about the inspection, the high inspection deficiency rates. And, Maureen, please to weigh in, uh, in a minute as well. But the, the there are a few aspects of the, of the deficiency rate that sort of gets lost. Uh, one is, is the, the areas of focus for inspections. They change from time to time, uh, as there are certain current issues.

Nemit Shroff: [00:27:21] So for example, a few years ago, uh, goodwill impairments were a big thing and there was an area of focus prior to that. Internal controls were a big, big area of focus. And those the inspection process sort Start to focus on that. So when there are high deficiency rates that a key issue, there are key areas that the inspectors are focusing on and the deficiency the deficiency rates stem from those specific areas. So it's not like, you know, I keep looking at the same exact same issue year after year after year. And the deficiency rate in those exact same areas stay high. The other part of this is, I mean, imagine if you're going to a doctor for a, you know, for a, for a physical. There are two aspects, right? To there are two outcomes to look at. One is is what exactly is the doctor doing to check how healthy you are, what tests they're running, what are what exactly they're doing. And the other is the results of those tests. What elements do you have? What do those test results reveal? Restatements are like the latter. They tell you what ailments that you have, but they do not give you a sense for how well did the auditor do their job? Uh, forming the orbit. And what the PCAOB is looking at is the former. So if I was going to evaluate the quality of health checkup based on the number of ailments the doctor found, then I would say that's that's not the right way to think of, of of what the PCAOB deficiency rates are. I'll pause there. Maureen. Please do. Please do.

Maureen McNichols: [00:28:54] Yeah. So I'll just go to the the gap between the restatement rate and the deficiency rate. The restatement rate reflects the fact that a company has a material error in their financial statements that the auditor did not detect. And so one question is what is that underlying level of material errors in the in the financial statements. How high is that for you to get? Say, you've got a sample of audits that have 20% deficiencies to have a restatement rate of 20%? You're kind of assuming every company has a material error and you know and that the that the audits that don't have deficiencies push back on those errors and the ones that did have deficiencies let them through. So it's like they are two different things. Restatements require an underlying material error on the financial statements coming from the company before the auditor does their work. And so they are fundamentally different metrics. And the fact that the overall restatement rate is so low at present, I think, is a positive sign on the deterrent effect that PCAOB inspections have had. When you go back to your initial comment about your conversation with the former partner, um, I think they were acknowledging the the challenge in that relationship. One study that I think is particularly telling was done by, uh, Preeti Chowdhury, Ken Merkley and Katherine Schipper on audit adjustments. And basically what they found is that by looking at inspections, they were able to access the frequency that an auditor proposes an adjustment and the frequency that the client accepts that adjustment in a high fraction of audits. Auditors are proposing adjustments and clients are turning them down. And when the clients waive more adjustments, there's a higher likelihood of restatements. So it's basically kind of going to that tension in the audit relationship between the client and the auditor. And the Pcaob's role is to come in and help by basically inspecting so the auditor can say to the client, you know, I'd love to go with lower cost tests, but we're not going to meet the standard. And, you know, and it will be there's a risk that it would be inspected.

Blake Oliver: [00:31:27] Right. It's it gives the auditor. It gives the auditor a good reason to push back. It gives the auditor strength. Is what you're saying?

Maureen McNichols: [00:31:39] Yes.

Blake Oliver: [00:31:40] Interesting. I hadn't thought about it that way.

Nemit Shroff: [00:31:42] One other aspect of the deficiency rate is, is, uh, you know, the it conducted a survey with one of my colleagues, had conducted a survey of inspectors, uh, not just PCAOB, but several different international audit regulators as well. And, uh, one of the questions was just to try and understand what is why is the deficiency rate high? Uh, some of it is just that the the auditors have not documented processes that they claim to have done. Uh, so this is not to minimize what the deficiency means, but if if the auditors do not show proof of work, then how is the inspector supposed to accept that they performed the job right.

Blake Oliver: [00:32:31] Ah I see.

Nemit Shroff: [00:32:32] And some of the deficiency rate is just that. I mean, in all likelihood, the auditors probably did the job, but.

Blake Oliver: [00:32:39] They didn't document it.

Nemit Shroff: [00:32:40] Yeah, they just didn't document it. And that and that is traditionally been a source of, of uh, I want to say conflict between, uh, at least from what I've observed between auditors and the PCAOB, uh, it does not minimize every deficiency. But the thing is, there are instances where it's just a documentation where it is a documentation. Yeah.

Blake Oliver: [00:32:59] Well, and I can totally sympathize with auditors or an audit partner who is confident that there is no issue with a particular matter in the audit and decides to sign off on it and skips doing the documentation. I mean, this happens all the time in the medical profession, right? Doctors are busy. They don't have time to chart everything out. And so if you come in and you expect them to have written down their thought process on everything they do, that's unrealistic, you know. And it's.

Nemit Shroff: [00:33:29] It's great. As long as as long as there's no problem. Right.

Blake Oliver: [00:33:33] Right.

Nemit Shroff: [00:33:33] Even in the medical space, if there is, if something happens to the patient eventually, then I bet they wish.

Blake Oliver: [00:33:39] Then it becomes an issue. Yeah. So yeah. That's okay. That helps me understand more this gap between the restatement rate and the deficiency rate. So. And I think this is something that is hard for the public to understand, because it's hard for me as a CPA to understand it. Right. It is very it is, it is it is a very nuanced distinction. So the deficiency rate is is is a rate that is based on this hypothetical ideal of how to do an audit. And the PCAOB is coming in inspecting an audit and finding, in many cases, in many audits that something wasn't documented, something was not substantiated. And so therefore the audit opinion isn't supported, even though that opinion was did not result in any financial restatement. So it's sort of like like looking back.

Nemit Shroff: [00:34:35] We don't know the latter. So we don't know the extent to which the inspection actually leads. And Daniel might be able to speak to this more the extent to which, how many restatements were triggered by an inspection. I don't think we we know that Daniel can tell us.

Daniel Aobdia: [00:34:51] Yeah, that that part is a bit tricky to to answer. I just wanted to because I agree with you. It's it's very difficult to to understand and and assessing regulation effectiveness is always difficult because you don't know what you don't see. Uh, but perhaps an analogy could help, which is what I was trying to think about as, as I've been listening to this conversation. So one way to think about the PCAOB is, in a way, they're kind of a cop on the side of the road, uh, and they're trying to prevent speeding. And so there's two things that could happen. So perhaps they never catch anyone because they are so visible that everybody makes sure they're slowing down when they're driving next to the cop. But does that mean the cop is not effective? Absolutely not. It's because the cop is there that you don't find any kind of issue to begin with. And the alternative.

Blake Oliver: [00:35:48] I want to point out, that is something I think I mentioned at the beginning of this interview, which is in 20 years, we have not had a major public company collapse like Enron, which, which, which is what we should remind everyone is the reason we have the PCAOB.

Daniel Aobdia: [00:36:05] Right? Right. So so that's the deterrence effect of of the PCAOB. And then they have a second effect, which is more about detection. When somebody is speeding they're going to catch that person speeding. Uh, I like the analogy because at the end of the day is speeding really bad for society and everything. Well, if somebody speeds and everything's okay, perhaps nothing's going to happen. But the problem is that it's a risk of accident for the person who's speeding and for others who are on the same road. So in my mind, I mean, the restatement rate is the accidents that occur. The speeding is the issues that are done by the auditor. And the PCAOB is pretty much the cop on the side of the road. I think that that provides an analogy. If you don't get speeding, it's not that the PCAOB is not doing their job, it's actually they're doing their job so well that everybody is going to make sure they don't speed. If there are still some speeding detected, uh, well, there's a question eventually of why the PCAOB, uh, why people still speed. One reason could be, as I mentioned, is that the PCAOB changes the location where they're going to be looking at potential speeding. So that's essentially, uh, the, uh, focus areas that the risk based type of inspection. That's also randomization, where there's some unpredictability about where the PCB is going to look at. But eventually we don't have as many accidents as there are people who are speeding, thank goodness. And that's essentially the difference between restatement and PCAOB part one findings.

Blake Oliver: [00:37:42] Maureen, what about your research? Um, you focused on earnings management, financial reporting quality. What is your research say about audit oversight and how that's changed since the PCAOB was created?

Maureen McNichols: [00:37:58] So, I mean, there's my own work and there's the work of many others who have looked at the relationship between, uh, accounting quality, reporting quality and capital market effects. Um, uh, I'll mention one, uh, one set of studies. It kind of ties into, um, other topics about, you know, how helpful are, you know, audited financial statements to investors. Um. Uh, a study I've been involved in looks at the extent to which investors respond to the information when earnings are announced. And, um, essentially what the finding is, is that since since the early 2000, the magnitude of that response has increased very significantly. Some studies have looked very carefully around, uh, the implementation of PCAOB inspections, sort of before and after for firms that got them or didn't. And there as well, there's sort of evidence that investors view the information in terms of their incorporation of the information into price and reflecting it in their valuations, um, as, um, as more credible. And so one factor, one factor in the research is that there's just a very significant increase, um, in, in how investors are relying on accounting information. It is a major source of information for valuation. So that's why all of this is so vital. Um, if if investors didn't use financial statements to value companies, this would be much less significant. But because, you know, the PCAOB is regulating, you know, $50 trillion worth of US equities or listed equities, um, sort of the fact that investors are relying on the financial statements, relying on earnings announcements means it's very important that there's a lot of credibility behind those. Um, and for sure, um, you know, the evidence supports, uh, increasing use of that information. It's not irrelevant. Uh, despite the fact that, you know, we've gotten increasingly a knowledge economy, um, with many intangibles, not completely on the books, but basically, um, overall, the evidence suggests that the financial statements are increasingly informative and that the quality has improved through, uh, through the implementation of Sox and PCAOB inspections.

Blake Oliver: [00:40:33] Let's assume that this bill passes and the PCAOB is eliminated. What happens at the SEC? Does the SEC have the capabilities to replicate what the PCAOB is doing?

Nemit Shroff: [00:40:48] Uh, from from what? What I know right now is that they're not clear in terms of there's no additional as far as what I understand, there's no additional budget that the SEC is going to receive, uh, to absorb the PCAOB. So, uh, so then it's it's the the bill is currently vague about what will happen, except for saying that the that the functions will be absorbed by the SEC. Now, why would this be difficult? Because, you know, let's say the SEC could basically do everything that the PCAOB does. So what would still be a constraint? Well, a few things. So the structure of the PCAOB is a nonprofit gives it a few benefits. One is, is the PCAOB can pay higher salaries than what the SEC can. Because the SEC is subject to government salary caps. And this allows the PCAOB to attract certain talent that that's harder to do in the SEC unless people are coming into the SEC as a high level talent is coming in with the hopes of, of, of rotating out and eventually going back to the private sector. So that is one, one potential weakness. The other is, is the. Over the past two decades, the PCAOB has entered into several MoUs with foreign governments to allow the PCAOB to inspect the work of foreign auditors. Uh, who who audit clients or participate in the audits of clients that are listed in US capital markets. Uh, all those all those agreements were done on the basis of the PCAOB being a nonprofit entity that's not a US government agency.

Nemit Shroff: [00:42:32] Uh, importantly, particularly the one with, uh, the People's Republic of China. And, uh, if PCAOB is subsumed by the SEC, then that agreement will not stand any longer. And it's unlikely that the SEC will be able to renegotiate this agreement. Uh, and another sort of subtle point is, is, again, that the PCBs model works based on deterrence. We've spoken about part one findings, but they also have something called part two findings. So if auditors resolve the issues related to quality control that the PCAOB inspectors raise, then the PCAOB will not publicly disclose those findings. And this is supposed to give auditors incentives to address these issues and the publicly available data suggests that auditors vary. Most, most. Very, very frequently address the issues raised by the PCAOB. So if the PCAOB is subsumed by the SEC, then it would be subject to FOIA Freedom of Information Act requests, which the PCAOB is not subject to. And so the current model that the PCAOB has of deterrence would again have to change. So I mean, in theory, it feels like a lot of the current structure would have to change if the PCAOB goes back to the SEC and none of those details are laid out. In fact, what it seems like is we'll just be going back to a system of of pre Enron.

Blake Oliver: [00:44:01] So I take it that you are in favor of keeping the PCAOB.

Nemit Shroff: [00:44:06] Yeah. For, for for a variety of reasons. I mean, I can I listen to the, the interview that you had with the discussion you had with board member ho and, and she raises many very reasonable points. So there could could the PCAOB be do could they do things more effectively? Could they do things? Could they improve their processes? Without doubt, of course. But, uh, is is the current proposal in the House? Uh, that's then this big, beautiful bill. Is that is that seem like a step forward from at least everything that I've heard and seen and doesn't seem like.

Blake Oliver: [00:44:41] Daniel? I don't think I've directly asked you that question, so I'm going to give that one to you as well. Should the PCAOB be preserved?

Daniel Aobdia: [00:44:49] I believe so, yes. Uh, and I concur with with what Namit mentioned. So, uh, there's a couple of things that I'd like to highlight, and I agree with everything what Namit said. So, uh, I think the Freedom of Information Act is one of the crucial difference between the PCAOB and the SEC. So from a research standpoint, actually, uh, if the PCAOB were to be folded into the SEC, I would send a lot of Freedom of Information Act requests. So I get all the information that the SEC is doing in terms of inspecting the audit firms. But keep in mind that the audit firms are aware of that. And so how would they cooperate with the SEC in the same way as they can with the PCAOB, knowing that whatever they're giving to the SEC could be FOIA by somebody like me? And that's where, uh, things would get very tricky. And I suspect lawyers would get involved very quickly. And those inspections would become extremely adversarial in nature, which was not meant to be the purpose of this inspection. The aim of these inspections is for the PCAOB to come in and understand what went well and what didn't go so well. Uh, and without thinking about interference from others who may look at the work papers or lawyers being involved and everything. All of that would, would go away. So, so that's, uh, one of the, the issues that that I'm having right now is with the current proposal.

Daniel Aobdia: [00:46:19] Something else also which which hasn't been considered enough, I think is, uh, Congress, when they passed Sarbanes-Oxley, were very concerned about potential regulatory capture of the new regulator. So regulatory capture is when a regulatory entity gets captured by the regulated entities. And it happens because regulated entities have a very strong stake into making sure that the regulator is not too harsh to them. Uh, however, the rest of the public doesn't have as much incentives to monitor the regulator carefully and therefore, um, therefore, uh, usually the regulator can end up being captured by, uh, by the regulated entities. So to prevent this from happening, uh, Sox made sure that out of the five board members at the PCAOB, two would have expertise, there would be CPAs, but three would not have CPS to preserve a mix between expertise and independence of the entity. Now, if the PCAOB were to be folded into the SEC, would they become under the office of the Chief accountant, who is typically an audit partner who's only from the firm and is going to supervise the PCB? It feels like things would go back. Very much like the peer review system before. Uh, if, uh, people at the SEC end up, um, well, being a little bit more captured, I would say than, than people at the PCAOB. So, so for those reasons, I think the PCAOB should hopefully remain independent.

Blake Oliver: [00:47:55] Maureen, you expressed your point of view on this earlier. Is there anything you'd like to add, uh, as we close out?

Maureen McNichols: [00:48:05] For sure. I think, uh, eliminating the PCAOB would, uh, risk the the trust that we have in our capital markets, and the fact that it allows companies to raise capital, create jobs at a at a low cost, and that we are the envy of the world. Uh, the trust that people have in our capital markets really does depend upon the quality of the audited financial statements. And eroding that at a time when, uh, crypto is coming online, I is posing all kinds of fascinating opportunities, but for sure, significant challenges, uh, private, uh, investments are being proposed to be, you know, made available to individual investors. And, uh, all of these things, I think, say, uh, you know, the it's not like the work is done and we can hand it over to somebody, you know, who just, you know, capitalizes on that. The work will be always there and evolving. And and you need the seasoned expertise, the independent regulation, the magnitude of the budget of 2% relative to, say, $1,919 billion of audit fees, it's like 2%. The $400 million, 2% of what we pay auditors to audit the audit these companies. And dwarfed by the, you know, epsilon loss of confidence. And when confidence is lost, it does not come back. It is very hard to build that back.

Blake Oliver: [00:49:38] Maureen, thank you again for helping to set this up. I learned a lot. I have been speaking with Maureen McNichols from Stanford, Nemit Shroff of MIT and Daniel Ayodhya of Penn State. Thank you all so much for your time and your insights on this really important and critical issue facing the profession.

Maureen McNichols: [00:49:59] Thank you. Thank you for having us.

Daniel Aobdia: [00:50:01] Thank you.