SEC Approves Tougher Standards for Auditor Liability

The Securities and Exchange Commission has approved a proposal from the Public Company Accounting Oversight Board intended to make it easier for the regulatory agency to hold an individual responsible when that person “directly and substantially contributes to” a registered public accounting firm’s “violations of the laws, rules and standards that the PCAOB enforces.”

Specifically, the PCAOB in June adopted an amendment to Rule 3502, Responsibility Not to Knowingly or Recklessly Contribute to Violations, that lowered the standard of liability in such cases from recklessness to negligence. SEC Chair Gary Gensler has favored moving away from the stricter standard of recklessness.

“When firms violate their obligations, the associated persons who directly and substantially contributed to such violations should be held to the same standards of accountability by the PCAOB,” Gensler said. “By updating the PCAOB ethics rules, today’s proposed amendments would encourage accounting professionals to be more deliberate and careful in fulfilling their duties.”

In a result that should surprise no one, though, the SEC’s vote was split along party lines, with Republican-appointed commissioners Hester Peirce and Mark Uyeda voting against the change. Peirce suggested the new version of the rule could contribute to the brain drain currently afflicting the sector as talented accountants seek brighter prospects in other fields. She noted the PCAOB’s own analysis of the rule change projected that it would result in only two or three new enforcement cases each year.

“The benefits are therefore likely limited, but the costs are likely to be high because audit professionals could be overcome by risk aversion as they fear being second-guessed by a PCAOB enforcement regime armed with the clarity found only in hindsight analysis,” Peirce commented. “It adds yet one more reason for people to leave or never join the audit profession or to refuse to take on roles in important areas like quality control.”

Peirce’s criticisms probably don’t carry much weight with the PCAOB, which, of late, has been far from impressed with the work of major accounting firms. The board’s latest round of inspections of audits conducted by the Big Four accounting firms found an overall deficiency rate of about 25%, the same as a year earlier. In other words, roughly one in every four of their audits lacked adequate evidence to support the firms’ opinions.

The rule change seems likely to boost an already aggressive enforcement campaign by the SEC and PCAOB. A recent study by the Brattle Group, a regulatory research firm, showed enforcement activity by the SEC and PCAOB in the first half of 2024 significantly outpacing the enforcement actions undertaken by the regulatory agencies in recent years. The PCAOB’s enforcement actions in that six-month period alone were higher than its full-year totals from 2018 to 2021.

Whether you’re in the Gensler camp or the Peirce/Uyeda camp when it comes to the need for lowering the liability threshold in PCAOB Rule 3502, one thing we can all agree on is that accounting firms are likely to bear a burden they haven’t felt in several years.