Boosting Auditing Firm Scrutiny Would Expose Emerging Conflicts

The business model for public accounting firms is changing rapidly as they search for outside investors and private equity firms rush to the front of the line.

Regulations need to change to match. In response, the Public Company Accounting Oversight Board has drafted a rule that the accounting firms can have public trust or private financials—but they can’t have both.

Public accounting firms operate in a unique space in our society. They’re private entities specifically designed to serve the public interest. The audit opinions they issue typically have meaning and value because the firms operate with public trust. Without public trust, the opinions aren’t worth the paper they are written on or the PDFs they are contained in.

One of the best ways to maintain that trust is through transparency. In the public company audit arena, this transparency is maintained through PCAOB inspections of auditors. The PCAOB inspects the work of the inspectors (auditors) who are inspecting the books of listed companies.

But what about the books of the auditor? How do regulators and the public know that accounting firms are operating with the best interests of the public at the forefront of their work, as they are expected to do? Right now, they don’t.

Yet this shows why the new draft disclosure rule from PCAOB would require listed public accounting firms to disclose “cyber breaches, material threats to their business, changes in firm ownership, and significant financing” is needed.

When you serve the public, particularly in the financial sector, few things can create conflicts of interests and threats to independence—whether perceived or real—quicker than financial entanglements. Elected officials generally disclose their personal financials. Not-for-profit organizations and governmental entities must do the same.

But auditors acting on behalf of the public? Their financials remain private without this rule. With the rise of private equity firms investing in public accounting firms and firms looking for new ways to raise capital, this rule is needed now more than ever.

Imagine a scenario where a sovereign wealth fund in a country that relies heavily on commodity revenues invests directly in an accounting firm that audits a substantial number of companies in that commodities space. Or imagine a situation where a private equity firm with heavy industry concentration invests in an accounting firm with the same concentration of clients.

Now, even if the clients didn’t overlap, wouldn’t this seem important information to the regulators judging whether the firm is acting independently and putting the best interest of shareholders first? One would think so.

As noted, the draft rule would require the firms to disclose changes in ownership and significant financing obtained, presumably including financing from private equity firms. These firms have come under recent scrutiny from the Department of Health and Human Services, the Department of Justice, and the Federal Trade Commission for investing in private health-care companies, arguing such transactions can lead to worse quality of care.

FTC Chair Lina Khan noted that the commission “will continue scrutinizing private equity roll-ups, strip-and-flip tactics and other financial plays that can enrich executives but leave the American public worse off.” Khan was speaking about health care, but one could easily see a similar quote about accounting firms.

If firms only financed themselves through debt and partners’ equity, as they have historically done, the need for additional disclosures doesn’t match the threats, as few exist. Regulators need to know where the money is coming from and what impact that money may have on the quality of the product that accounting firms deliver.

Firms will fight it and argue they don’t need more oversight. They made similar arguments when the PCAOB was established after Congress passed the Sarbanes-Oxley Act of 2002 to protect investors from corporate financial reporting fraud. And like with SOX, shareholders and future shareholders will be better off once the rule is finalized.

As the late Supreme Court Justice Louis Brandeis once said, “sunlight is said to be the best of disinfectants.” This draft rule brings accounting firms into the sunlight.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jack Castonguay is a CPA and an assistant professor of accounting at Hofstra University and vice president of content development at KnowFully Learning Group.

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