The Public Company Accounting Oversight Board (PCAOB) was established as part of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). It is charged with the routine inspection of auditors of US public company financial statements, including those based outside the United States, to ensure compliance with federal securities laws and professional standards. The PCAOB has faced obstacles in inspecting foreign auditors as a result of conflicts between the PCAOB’s inspection requirements, the laws of other countries and the rules of foreign regulators.
While the PCAOB has made and continues to make progress in arranging inspections with foreign regulators, it has been unable to inspect all its registered foreign auditors. The inability of the PCAOB to inspect foreign auditors affects any US public company that retains a foreign auditor that has not been inspected by the PCAOB and the investors in that public company who rely on the protections of the PCAOB.
Section 106 of Sarbanes-Oxley provides that non-US auditors are subject to Sarbanes-Oxley and the PCAOB rules in the same manner and to the same extent as US auditors, including the requirement that foreign auditors be registered and routinely inspected.
Public companies with securities traded in the US capital markets must file, as part of their periodic reports to the US Securities and Exchange Commission (SEC), audited financial statements. Sarbanes-Oxley requires that any auditor that prepares or issues any audit report in connection with audited financial statements must be registered with the PCAOB. Sarbanes-Oxley also requires that the PCAOB regularly inspects registered auditors to assess their compliance with the US securities laws and professional standards. For audit firms with more than 100 issuer audit clients, this regular inspection must occur annually. For audit firms with 100 or fewer issuer clients, a PCAOB inspection must take place no less than every three years.
Barriers to Inspection
The PCAOB began to accept registration applications for foreign auditors on 19 July 2004. The PCAOB has, however, encountered obstacles in its inspection of these registered foreign auditors. Certain non-US countries have raised concerns about such inspections, claiming that they violate foreign sovereignty. Moreover, in some countries, compliance with inspection by the PCAOB would result in a foreign auditor violating the laws of its home jurisdiction and/or the rules of the regulators that have oversight over that auditor. In Europe, for example, inspections by the PCAOB have threatened the compliance of foreign auditors with EU data protection and privacy laws. In China, state secretary laws require a party with information relating to a Chinese company to resist foreign discovery requests or face possible criminal sanctions. Chinese law also prohibits disclosure by any accountant of information relating to a Chinese company.
In an effort to meet its requirements for inspection, the PCAOB adopted Rule 4012, which allows it to rely, to the degree it deems appropriate, on the inspections conducted by certain foreign regulators. Under Rule 4012, the PCAOB is able to comply with the Sarbanes-Oxley inspection requirement with respect to certain foreign auditors already subject to inspection by oversight regulators in their home country. It can, however, only comply to the extent that it determines the foreign regulator’s inspection meets the PCAOB standards for integrity, independence, transparency and historical performance.
As a result of continued obstacles in conducting first-round inspections of registered foreign auditors, in 2009 the PCAOB amended its Rule 4003, which sets forth the timeline for its routine inspections. It extended the deadline by which such first-round inspections would need to be completed from 2009 to 2012. This deferral of inspections expired 31 December 2012.
Since its inspection of foreign auditors began in 2005, the PCAOB has established cooperative agreements with foreign regulators in 16 jurisdictions including countries in Asia, Europe, the Middle East and North America, most recently in France and Finland in early 2013, to conduct inspections of foreign auditors. Through these arrangements, the PCAOB either conducts inspections of foreign auditors alone or jointly with the foreign regulator.
There are currently approximately 910 foreign public accounting firms located in 84 countries registered with the PCAOB. More than 240 of those firms are subject to periodic inspection by the PCAOB. As of 31 December 2012, the PCAOB had conducted inspections in 40 non-US countries, and had inspected all but 34 currently registered foreign auditors.
As of 1 February 2013, the PCAOB has been unable to conduct inspections of foreign auditors located in Austria, Belgium, China, Cyprus, the Czech Republic, Denmark, Greece, Hong Kong, Hungary, Ireland, Italy, Luxembourg, Poland, Portugal and Sweden. The PCAOB publishes and regularly updates a list identifying each issuer whose PCAOB-registered auditor is located in a jurisdiction where obstacles to PCAOB inspections exist, and a list of auditors that it has been unable to inspect in foreign jurisdictions.
The PCAOB continues to negotiate with foreign regulators in jurisdictions where it has been unable to conduct inspections, including China. Over the last decade, several hundred China-based companies have entered the US capital markets, either through initial public offerings or reverse mergers with US shell companies. Since then, a number of claims involving financial fraud and accounting issues involving China-based, US public companies have been reported. The PCAOB currently does not have a cooperative agreement with China to inspect the auditors of these companies, which comprise 5 per cent of all PCAOB-registered foreign auditors. In October 2012, the PCAOB and China reached an agreement under which PCAOB inspectors would be allowed to observe the Chinese regulators conducting their oversight activities and the Chinese regulators could observe the PCAOB at work, but such observational visits would not suffice or substitute for a PCAOB inspection.
Implications for Investors
The PCAOB’s inability to inspect foreign auditors means that investors in US public companies who rely on those firms’ audit reports are deprived of the benefits of PCAOB inspections. Without PCAOB inspections, there can be no assurance that audit firms have the requisite independence and professional standards set forth in Sarbanes-Oxley. Investors may not be aware that the audit opinions on which they rely may be based on the work of auditors that, although registered with the PCAOB, are not currently inspected by the PCAOB. In response to these concerns, the SEC has included in its comment letters that US public companies that use such auditors must include a risk factor in their periodic reports explaining the potential effects on investors of the PCAOB’s inability to inspect them.
Since its establishment, the PCAOB has made great efforts to meet the inspection requirements imposed by Sarbanes- Oxley. Through cooperative agreements or through independent inspections, the PCAOB has been able to inspect nearly all its registered foreign auditors. The risk to investors of public companies whose foreign auditors have not yet been inspected is, however, significant and has been recognised by many of these public companies as a material risk to their investors. The PCAOB’s future plans to meet its inspection requirements will be important to US public companies with foreign auditors, and to their investors.