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The US Public Company Accounting Oversight Board (PCAOB) proposes to amend Rule 3502, Responsibility Not to Knowingly or Recklessly Contribute to Violations, to widen its reach. The Rule governs the liability of associated persons who contribute to a registered public accounting firm’s primary violation.

Constraints of the current rule

• The Rule adopted in 2005 incorporated a recklessness standard; however, the Rule proposed in 2004 favoured the negligence standard, which due to comments, was not adopted.
• The inherent limitation of the Rule is that to establish liability of associated persons, ‘an extreme departure from the standard of ordinary care for auditors’ must be established.
• The other limitation is the meaning of the term associated person. The Rule states that to establish liability, the associated person of the registered public accounting firm responsible for the violation must have acted knowingly or recklessly.

Basis for the proposed change

The main purpose of the PCAOB is to protect the interest of the investors, and hence, all the amendments made by the PCAOB are directed towards it. The following points describe why the proposed changes further strengthen the motive of the PCAOB:

Harmonizing Rule 3502 with the Board’s Enforcement Authority

The Board has previously explained that natural persons who serve as agents, including associated persons, are the means through which a registered public accounting firm can act. The actions of the natural person can render the firm primarily liable and the person secondarily liable. If there is a violation, the firm should be primarily liable for negligence, and the natural person secondarily liable for negligence. But, this is not the case with Rule 3502, and the Board intends to fix this incongruity. As per the current Rule, the firm is primarily responsible on the basis of negligence, and the natural person is held liable on the basis of recklessness, which dissuades natural persons from being more careful, thereby risking the quality of audits.

Enhancing strategies based on the Board’s accumulated experience

The Board has experienced limitations in implementing action against firms that have violated PCAOB standards due to the current formulation of the Rule. For example, the design and implementation of QC policies and procedures under applicable QC standards involve multiple individuals who hold decision-making positions in the firm; however, when there is a violation, it is difficult to establish recklessness by these individuals, while negligence is easier to establish as it is an absence of reasonable care.

Reinforcing the underlying mission

The PCAOB has introduced the strategic 2022-2026 plan, through which the PCAOB has expressed improved efforts focussing on the PCAOB’s investor protection mandate and stated its intent to modernize its standards to make them more relevant. Today, audits are multi-faceted, and many firms contribute towards an audit report based on their expertise. Fixing liability on natural persons of the audit firms is paramount. The current Rule fixes responsibility on the associated person of the firm that has violated standards, but given the nature of modern audit functions, the PCAOB intends to extend the liability to component audit firms and other entities involved in an audit.

KNAV’s opinion

In order to safeguard the interests of investors, the PCAOB is diligently addressing and eliminating any potential gaps in the standards, regulations, and laws it enforces. This proposed amendment will leave no scope for auditors, agents, or anyone closely related to the audit conducted by the registered public accounting firm to evade accountability, as the language of the proposed Rule aims to be extensive. Additionally, senior executives will be held responsible for any lapses in their oversight duties within the quality control system. The PCAOB’s drive is towards aggressive enforcement to ensure maximum protection to investors by eliminating all the shields currently in place in the existing Rule.

If adopted, the proposed Rule will call for stringent actions by registered public accounting firms. They will need to tweak processes to ensure that reasonable care, as mandated, is tantamount to exercising the utmost care in practice. The testimony for utmost care is documentation. Hence, it is imperative to lay emphasis on detailed audit documentation and robust quality management.