The PCAOB Takes Aim at Negligent Auditors

By Dan Goelzer

The Public Company Accounting Oversight Board has proposed to amend its rule governing the liability of a person associated with an accounting firm whose conduct causes the firm to violate a professional standard. The Board’s proposal would lower the level of conduct that can result in an individual’s “contributory liability” for a firm’s violation from recklessness to negligence. If the change is adopted, the PCAOB would be able to bring disciplinary proceedings against an individual auditor (and potentially bar him or her from public company auditing) for failing to exercise reasonable or ordinary care. Under its current rules, the Board would have to show that the individual’s conduct was intentional or reckless, not merely negligent.

In a statement, Chair Williams explained that the proposal would strengthen individual accountability because “firms don’t make the decisions or take the actions that lead to these violations on their own. People participate in these decisions and actions. * When they fail to exercise the reasonable care or competence entrusted to their profession, and that failure directly and substantially contributes to a violation by a firm, investors expect there to be consequences.” She also noted that the SEC is already able to seek civil money penalties in its enforcement actions against associated persons who negligently cause firm violations. The proposal would put the PCAOB’s enforcement program on the same footing.

These arguments certainly have some force. There is no doubt that in some circumstances an individual auditor’s negligent mistake could result in the failure to detect a misstatement and cause harm to investors. But, considering the PCAOB’s overall mission and the other tools at its disposal, it is far from clear that lowering the contributory liability standard and exposing more auditors to enforcement action is an effective way to improve audit quality. When the PCAOB addressed this issue in 2005, as a Board member I said in my statement supporting recklessness as the standard: “In my view, violation-causing conduct that is only negligent can best be dealt with through our inspection program and our ability to require firms to strengthen their quality control and other internal procedures.” I still feel the same way.

A fair amount of judgment is involved in auditing. It is easy to allege in hindsight that a particular judgment was unreasonable, especially when it turns out that there was an undetected error in the financial statements. After the fact, it may seem clear that, if only one or more engagement teams members had made different choices at some point in the audit, the error would have been uncovered and that the failure to do more was careless or unreasonable — i.e., negligent. However, at the time that the challenged decision was made, it may have been one of scores of judgments that had to be made during the audit and may well have seemed to those involved quite routine. By hypothesis, the team and its members were not aware of the financial statement error and were not acting intentionally, recklessly, or in bad faith.

In his statement on the current proposal, Board member Duane DesParte made a similar point by quoting a commenter in the 2005 proceeding:

“One commenter noted that a negligence standard ‘would place intolerable pressure on the difficult judgment calls that those who operate in this highly technical field must make on a regular basis. A ‘negligence’ rule is particularly ill-suited for retrospective judgments about compliance with ‘professional standards,’ and such a rule would operate as an invitation for after-the-fact attacks on conduct that was, at the time, objectively reasonable.’”

Individual auditors should not of course be free to disregard pertinent facts or professional standards. The existing recklessness standard captures situations in which an auditor acts in a way that suggests disregard for or obliviousness to misstatement risks or professional norms. But if the Board can’t fairly characterize an individual’s conduct as at least an extreme departure from ordinary care — reckless — it should be addressed by means other than enforcement action focused on that individual.

The PCAOB has tools to address negligent auditing, including inspection findings, an expectation that firms engage in root cause analysis, criticism of the firm’s quality control procedures, and required quality control remediation. Moreover, the PCAOB can already charge audit firms for negligent violations of the auditing standards. Firms have a responsibility to design and maintain quality control systems and to assure that their personnel comply with the requirements of those systems. They can be held responsible when they fail to do so.

When an individual auditor negligently deviates from the auditing standards, the root cause is often in the quality control framework in which the individual was operating. PCAOB inspections focus on firm quality controls and the Board has proposed to substantially strengthen the quality control requirements. Improvements in auditing are more likely to result from stronger QC standards than from negligence-based enforcement actions against individuals.

In addition to these concerns, negligence-based enforcement against individuals may turn out to undermine the PCAOB’s efforts to improve audit quality. This new risk could potentially contribute to the reluctance of prudent people who are trained in accounting to pursue public company auditing as a career. The fact that an ordinary mistake can potentially have career-ending consequences might certainly lead cautious people to consider whether there are better career options than public company auditing. Board member Christina Ho made this point in her statement at the PCAOB public meeting. She noted that an unintended consequence of the proposal could be that junior professionals might choose to leave the public company auditing. “If this unintended consequence comes to fruition, investors will in the long run be harmed if, as the proposal notes, less cautious or less qualified individuals rise to fill ‘important audit roles.’”

Individuals who cause violations of the auditing standards by acting recklessly (or worse) should be forced to find something else to do. But investor protection does not require bringing the weight of PCAOB enforcement to bear on individual auditors who make mistakes that do not rise to the level of recklessness.