One on One: The PCAOB Chairman and the JofA

JofA : Regaining confidence in the capital markets is job number one. From your perspective, what will it take to get things moving again? How will the PCAOB interface with corporate America, Wall Street, lawyers and the accounting profession? What specific role do you see for the accounting profession in this process? Can you comment on your timing expectations?

McDonough: Few of us could have imagined three years ago that we would be where we are today, in a world in which accounting, auditing and corporate governance would be subject to a strict new regime under the Sarbanes-Oxley Act.

Corporate America, Wall Street, lawyers and accountants have to resist the temptation to look at the act as a proscriptive, check-off list of rules. That kind of thinking is missing the point—not of the law, but of the reality that led to the Sarbanes-Oxley Act.

Sarbanes-Oxley is not about checking boxes. It is about accountability. If you audit a financial statement, if you are CEO of a publicly traded company, indeed, if you have any role in the capital markets, you must be accountable for your actions. Accountability—not just to investors, but to the public at large, indeed, to the world—is what we must be about. We’re going to have to work at it, all of us, whether we are in the public sector or the private sector.

Auditors will take their lead from the standards we will set at the PCAOB. I think members of other professions would do well to look at the examples we will set at the PCAOB and act accordingly.

JofA : There has been much written about the need to improve corporate governance—the tone at the top. What are your ideas for addressing this issue? What will you expect from the accounting profession in helping to meet this challenge?

McDonough: Our inspectors will play a vital role in ensuring that the tone at the top of the accounting firms is what it should be. They will want to know: Does the managing partner, does the audit team leader, understand what is demanded of the accounting firm in this new era of regulation and oversight? Do they understand the standards for audits, and just as important, do they understand why those standards are in place? Do the managers lead by example, demonstrating every day the value of those standards?

The board and our inspectors want to know whether the message of “doing the right thing” is reaching the rank and file in the firms. Our inspectors will talk to the managers, but they will also talk to the least experienced members of the audit teams to find out whether the message is reaching them. We will look at how often and how well the message is delivered.

We will look at compensation and promotion. Are the best auditors rewarded for being the best auditors, or are they rewarded for something else? We will look at how clients are selected and how they are let go.

Obviously, our inspectors will look at audits as well. We will identify and examine the audits that carry the most risk, and we will sample what should be simpler, more routine audits.

JofA : What are some of the lessons you have learned from your past financial institution responsibilities that you will use in your position as chairman of the PCAOB? Which might apply specifically to the accounting profession?

McDonough: I approach my new job at the PCAOB as I approached my job as the top bank supervisor at the New York Fed.

I expect that accountants, as members of a regulated profession, know what the rules are. I expect that they are following those rules, both in their letter and their spirit. I bring those expectations, and the respect they engender, to the table when I deal with the firms as chairman of the PCAOB.

If they depart from those expectations—that is, if they break the rules, if they ignore the spirit of the law even while meeting the letter—our dealings will be most unpleasant. There will be consequences, and they will be grave.

The members of the accounting profession are going to have to prove that they have earned the people’s trust. They will have to work—not to get back to where they were before the corporate scandals—but to a better place. They will do that by living up to the letter and the spirit of the law.

JofA : What is your vision for setting auditing standards today? Do you see a different emphasis for the future?

McDonough: The Sarbanes-Oxley Act charged the PCAOB with establishing auditing and related attestation standards, quality control standards, ethical standards and independence standards. Even to the eyes of a former bank regulator, those are a lot of standards to be set! Perhaps in recognition of the magnitude of the charge, the act gave the board the power to designate or recognize any professional group of accountants to propose new standards.

Before I arrived in June, my fellow board members determined not to exercise the authority to delegate the standards setting to a professional group but instead voted to set the standards from within the PCAOB. It was a decision I heartily endorse. As sometimes happens, the law gave us an option, but in this case, the hearings and debate preceding Sarbanes-Oxley make it absolutely clear that Congress had no intention for the board to farm out the function of setting standards.

As we go about that work, the board is fortunate to have the expertise of Chief Auditor Doug Carmichael and his deputy, Tom Ray. They have assembled an excellent team, and they and the board will be drawing on the expertise of a standing advisory group. The members of that group will be selected based on individual qualifications, not the representation of particular constituencies. But make no mistake: We board members will be the ones to consider and set audit standards.

The first standards to come from the board will be those prescribed in the Sarbanes-Oxley Act relating to auditors’ attestation to management’s assessment of internal controls. The board proposed those standards at a public meeting October 7, and we intend to have final rules in place by early next year to allow public companies to prepare for the deadline set by the SEC for assessing internal controls.

Our next set of standards will relate to audit documentation, drawing on ideas we received at a roundtable discussion we held in late September. As for other audit standards, the board adopted certain existing standards on an interim basis. Those are in place and enforceable as board rules while we conduct an exhaustive review of what’s on the books now and set our priorities for issuing new standards.

JofA : Needs of users of private company audits are much different than public companies. Do you believe the PCAOB will coordinate, where possible, over core standards?

McDonough: The Sarbanes-Oxley Act charged the PCAOB with setting standards for auditors of public companies. That said, we intend to work closely with the standards-setting bodies for private companies to minimize differences and avoid confusion in our capital markets.

JofA : Have you given any thought to the possible impact the work of the PCAOB might have on small companies trying to enter the capital markets today? If yes, can you expand upon your answer?

McDonough: The PCAOB is committed to seeing that small and medium-sized businesses are not unduly burdened by new auditing standards. I believe that the board made that abundantly clear in the standards proposed for auditors’ attestation to management’s assessment of internal controls. Companies with less complicated operating structures will not require the same testing of internal controls that we expect at larger, more complex companies. We will be watching closely to see that auditors do not require unnecessary bells and whistles.

JofA : Will new regulations disrupt the capital markets? What will the PCAOB do to protect small companies?

McDonough: The capital markets can only benefit from clearer and more reliable financial statements. Through our oversight of auditors, the PCAOB will do its part to see that those statements provide the information that market participants need to make informed decisions.

Small and medium-sized companies are the backbone of our capital system. The PCAOB will be very mindful that our rules and standards do not adversely affect those companies.

JofA : What do you think is the most important thing the PCAOB can or should do to help protect against another significant business failure? Do you think there will be another major failure?

McDonough: The requirement that public accounting firms undergo regular inspections by the PCAOB is the most significant change to come out of the Sarbanes-Oxley Act. Congress’s hope, and our goal, is that an independent examination of firms’ practices and audits will help catch corner cutting and even outright fraud before it snowballs into the kinds of accounting scandals we have seen at Enron, WorldCom, HealthSouth and other companies.

That said, no amount of regulation or oversight will stop a crook hell-bent on breaking the rules for his or her own gain. That is where our strict disciplinary powers will be used to their utmost.

JofA : The accounting profession has publicly stated many times that it looks forward to having a “spirit” of cooperation in working with the PCAOB. Are you satisfied that this spirit is being demonstrated? Is there any message at this time you’d like to convey to the profession?

McDonough: I am very encouraged by what I have heard in my meetings with the profession. If the actions of the firms match what they are telling me, then we will be a long way toward restoring the faith of the American people in the profession.

At the same time, I have not been shy about telling members of the profession that we expect a lot of them and that they will have to work harder than they could have imagined before Sarbanes-Oxley. Through a succession of scandals, the entire profession came to be judged harshly, but the Sarbanes-Oxley Act did not merely judge them—it gave them a meaningful shot at redemption. In my mind, facilitating that redemption, and not just punishing miscreants, is a key objective—one that the board must not lose sight of even when we are, as we will need to be, tough on the profession.

Mr. McDonough has had a long and distinguished career in the financial world. He joined the PCAOB after serving 11 years with the Federal Reserve Bank of New York where, for the last 10 of those years, he was president and CEO. He also served as vice-chairman and permanent voting member of the Federal Open Market Committee, as a member of the board of directors for the Bank for Settlements and as chairman of the Basel Committee on Banking Supervision.

At the First Chicago Corporation, he had a 22-year career where he was vice-chairman of the board of directors from 1986 until his retirement in 1989. Before joining First Chicago, he had served as an adviser to several domestic and international organizations.

Currently Mr. McDonough is a member of the board of directors of the Council on Foreign Relations.