The potential accounting crisis everybody seems to ignore, and the regulator fighting to fix it

Erica Williams wants the accounting industry to know that there’s a new sheriff in town, and she’s rolling up her sleeves to deal with what her organization has called a “completely unacceptable” rate of accounting errors. 

Williams is an outsider brought in to police an audit industry that collects about $5.4 billion in fees from S&P 500 companies each year, and has historically been accustomed to being overseen by friendly insiders. But Williams has brought with her a much greater willingness to lay down the law than her predecessors: the former Obama adviser spent 12 years in enforcement at the Securities and Exchange Commission, where she dismantled Ponzi schemes and worked closely with the Department of Justice to bring forth civil and criminal charges. 

Since 2022, Williams has been running the Public Company Accounting Oversight Board (PCAOB), the SEC subsidiary responsible for regulating the accounting and audit industry. For decades, observers have dismissed the PCAOB as inept; it’s been plagued by scandals and accusations that it’s been too deferential to the accounting firms it’s supposed to be policing. 

But under Williams, the first Black woman to chair the organization, the new-look PCAOB has been ringing the alarm bell on what it calls a worrying trend of “unacceptable” accounting errors that continue to rise. Mistakes showed up in 40% of the roughly 800 audits it recently released inspection reports for. 

“The goal here is deterrence—to make sure that those who are putting investors at risk are held to account,” Williams told Fortune. “We felt that audit quality had been trending in the wrong direction for the last couple of years … And so, you have seen an increase in our penalties.”

Williams’ work at the PCAOB is twofold—she has to raise the bar on standards, and help reset the agency’s checkered reputation. As a relative outsider to the industry, she carries none of the baggage of previous PCAOB board members. The PCAOB pays some of the highest salaries in Washington—as of 2021, the board members earned between $550,000 and $670,000—but that hasn’t exactly led to high performance. In 2016, a board member left after he was found to be having an affair with a staff member. In 2018, the SEC found that former PCAOB officials had leaked confidential inspection information to audit firm KPMG in order to allegedly help the firm cheat on its inspections. A previous chairman, William Dunkhe III, was fired in 2021.

“There have been good people on the [PCAOB] board, but they’ve got an ethics policy that is horrific,” said Lynn E. Turner, a former Chief Accountant for the SEC who serves on the PCAOB’s investor advisory board. “The board adopted that policy at the very beginning.”

The PCAOB was created after the fall of companies including Enron, Tyco and WorldCom, when the flimsy accounting methods that those companies relied on led to employees losing their life savings and shareholders losing billions. The aftermath prompted people to ask: Where were the auditors? Congressional leaders realized that relationships between auditors and the firms they audited might have been a little too cozy, and that auditing regulations were essentially being enforced by auditors themselves. 

The PCAOB was set up with a mandate to change the status quo—by hiring inspectors to independently evaluate the quality of auditors’ work, and to levy fines when they made mistakes. It’s no overstatement to call accounting the bedrock of capitalism: every publicly traded company depends on an accounting firm to verify its quarterly reports, and markets rely on auditors to verify that the information companies trade based on is accurate and trustworthy. A significant decline in audit quality could have serious market implications. 

And recent news, both from the PCAOB and elsewhere, has some industry watchers worried. The PCAOB found errors in 40% of the audits it reviewed for 2022. The Wall Street Journal reported last July that multiple large companies have connected material weaknesses in their financial reporting to a lack of skilled accountants, while Bloomberg recently reported on a wave of mistakes and “typos” in audited earnings reports.

Williams says enough is enough. “Some things that we’ve heard is that maybe the pandemic or the resulting economic effects of that may have impacted firms,” she tells Fortune. “But now, we’re many years out from the pandemic. And it’s really time for solutions, not excuses, on those things. You’ll see that there are some firms that have far fewer deficiencies than others.”

New standards, new disagreements

Williams was sworn in as Chair of the PCAOB in January 2022. That timing coincided with a full overhaul of the five-person board that does most of the organization’s high-level decision making. 

Under Williams, the PCAOB has made updating outdated standards a key part of its agenda, a policy that most of the industry has approved of. Since then, the PCAOB has taken a stricter stance. Last year, the PCAOB found errors, which it refers to by the industry term “deficiencies,” in a full third of all the global audits it surveyed. In a new round of annual inspection reports released last week, that number rose to approximately 40%. 

Accounting firms counter that the report’s findings aren’t as bad as they sound. PCAOB inspections aren’t intended to serve as a barometer for audit quality across the entire industry, and while deficiencies are technically up, instances of restatement—or needing to fully retract an audit report because of severe errors—remain rare. 

The PCAOB is positioned at the nexus of headwinds that both it and multiple accounting industry members told Fortune are negatively impacting the profession. Although they aren’t uniform across all companies, and they can partially be chalked up to a pandemic-era hangover, the increase in mistakes the PCAOB is finding are souring firms’ public image. A drop in young people taking the CPA exam is creating a looming “talent crisis” for firms that have traditionally relied on high turnover rates and cheap, young staffers. 

The revitalized PCAOB has the mandate, the data, and the bully pulpit to get its message out: there are big problems in one of the sleepiest corners of capitalism. The hard part is getting people to listen.

“Apart from maybe a shrug or two, people are going to read the PCAOB report and, sadly, move on—because they still believe the system is working,” Columbia Business School accounting professor Shivaram Rajgopal told Fortune. “I applaud the PCAOB for actually trying.”

The auditor’s auditors

The PCAOB was established in 2002 in reaction to the collapse of former accounting firm Arthur Andersen, which was precipitated by its role in energy giant Enron’s high-profile demise. Armed with a set of interim standards that were largely drafted by accounting firms themselves, the PCAOB set out to restore investor confidence in markets by keeping auditors in line through inspections and enforcement penalties. 

For the next 20 years, though, it mostly fell short. Those interim standards, originally thrown together as temporary guidelines to help the PCAOB get off the ground, weren’t touched for about two decades. 

In the meantime, the audit industry has become increasingly consolidated. After Arthur Andersen went under because of its role in the Enron collapse, the industry’s biggest remaining firms—Deloitte, EY, KPMG, and PwC—only got bigger. Known as the “Big Four,” today these massive, multinational firms audit almost all Fortune 500 companies. PCAOB data shows that the Big Four firms conducted 100% of S&P 500 audits as of 2018. Their lobbying presence in Washington, D.C. raised questions about potential conflicts of interest.

“One of the issues with industries that are this heavily concentrated is the worry about the revolving door [problem],” said Rajgopal. “For the longest time, the [PCAOB] had been [led] by an ex-Big Four person who ended up going back to the Big Four after their term was up, with a promotion.”

The new-look PCAOB

Priorities of Williams’ strategic plan include modernizing the PCAOB’s organization’s standards, enhancing the quality and rigor of its audit inspections, and strengthening its enforcement activity. It beefed up its 900-person staff, which currently includes over 500 inspectors scattered across the globe, and it expanded its authority by getting permission to inspect China-based companies in 2022. The organization has also made an effort to be more transparent and engage with the broader financial community, setting up outreach initiatives and public roundtables to discuss new proposals.

“The standards that we’d been working with were more than 20 years old,” Williams told Fortune. “They were put in when the PCAOB was founded, and it was supposed to be on a temporary basis. And those were all written by the industry. We felt that it was high time to bring those into the present time.”

The biggest headline-grabber has been the spike in audit deficiencies and enforcement penalties it’s recorded. The PCAOB fined accounting firms more than $20 million last year, a new record high. Its deficiency findings have been steadily climbing ever since Williams took over.

Reports issued last month continued the trend. Among Big Four firms, EY was the biggest offender—the PCAOB found deficiencies in almost half of the 54 audits it inspected. That was up from 21% in 2021, and 15% in 2020.

“The rate of findings does not reflect our high standards and is unacceptable to us. Since the 2022 PCAOB inspection cycle, EY US initiated an in-depth review of our audit practice,” EY wrote in a statement to Fortune.

PwC fared the best of the Big Four: the PCAOB found deficiencies in 5 of the 54 audits it inspected, a deficiency rate of 9%. That was up from 4% in 2021, and 2% in 2020. Deloitte’s deficiency rate was 17%, and KPMG’s was redacted from the report (it’s had a 26% deficiency rate for both of the past two years.) 

“Some things that we’ve heard is that maybe the pandemic or the resulting economic effects of that may have impacted firms. But now, we’re many years out from the pandemic. And it’s really time for solutions, not excuses, on those things,” said Williams. “You’ll see that there are some firms that have far fewer deficiencies than others.”

The PCAOB and some observers contend that if global deficiency rates continue to hover near 40%, that could spell trouble for investor confidence worldwide—and have big market impacts.

“If audits are perceived as ineffective, then, you know—I’m not exaggerating, they are literally the last line of defense between management and investors,” said Rajgopal.

“Learning how to be regulated”

Despite the fact that firms have recommitted to reviewing their internal practices after the PCAOB’s scathing first round of reports a few years ago, deficiency rates have continued to rise. But that’s likely because the PCAOB is still catching up with backlogged data, so it’s currently operating on a delay of about two years—the reports released last month were based on audit data from 2022. (Williams said it’s on pace to start catching up soon.) On the firm side, it can also take a while to implement new practices in the context of giant organizations with tens of thousands of employees scattered around the globe.

“It’s taken a little bit to learn how to be a regulated entity,” said a senior partner at a Big Four accounting firm. “Big changes take a while to filter through the system. They don’t immediately cause a reduction in [deficiencies].”

An increase in deficiencies also doesn’t necessarily indicate that audit quality has been getting worse, either within individual firms or across the industry. The PCAOB itself states in a disclaimer on all of its reports that its findings “are not an assessment of all of the firm’s audit work” and “[do] not constitute a representative sample of the firm’s total population of issuer audits.”

Big Four firms have pushed back on the PCAOB’s findings. One senior partner at a Big Four firm pointed out that the reports were inherently “black-and-white” and didn’t reflect areas of subjective disagreement between PCAOB inspectors and firms. (As part of the investigation process, firms have the opportunity to contest the PCAOB’s findings, but those disagreements don’t make it into the public report.)

“Whether fines are up or down doesn’t tell us whether the system of disclosure and audits is working or not any more than whether speeding tickets are greater or lesser [tell you] whether you’ll be safe and traveling the highway. It’s related, but it doesn’t enable you to infer that the highway system overall is safe or unsafe,” said a senior partner at a Big Four firm. “It would be too far of a leap to take to jump from enforcement results to a conclusion about the system overall.”

All of the Big Four firms also voluntarily release reports of their own, which generally outline their audit quality practices and describe deficiencies. This past year, they were all released months before the PCAOB issued its official reports, and often disclosed information that went beyond what was included in the PCAOB’s report on the firm. Those reports show that many deficiencies hardly constitute fraud: for example, PwC reported a technical violation where an employee’s spouse had a balance on Venmo while the employee was auditing Venmo’s parent company PayPal.

“Is that a systemic problem? No, but it’s kind of like a foot foul,” said Julie Bell Lindsay, CEO of the Center for Audit Quality, a trade organization representing public company auditors, in an interview with Fortune.  “The overarching question is, what percentage of [PCAOB] comments…are foot fouls? What percentage are more systemic issues?”

Falling on deaf ears

There’s one thing everyone can agree on though: audit quality is an important issue, and errors need to be minimized. But for the PCAOB, perhaps the biggest challenge of all is simply getting the broader business community to pay attention. 

As massive asset managers such as BlackRock and Vanguard have eaten up more and more market share, interest in inspecting audited financial statements has waned, says Rajgopal: an average passive investor who has a stake in a company through a mutual fund in their 401(k) is less likely to go to the effort of scrutinizing corporate financials. Further, Rajgopal continued, the Big Four have formed what essentially amounts to an oligopoly over the accounting market, which has diminished incentives for quality-based competition.

“Investors are blissfully unaware,” said Rajgopal. “Once [the PCAOB’s] reports [came] out, did anything change? Did the stock prices of companies audited by these four [accounting firms] fall? No…[Investors] just assume the system works.”

When it comes to the impact of the PCAOB’s audit quality findings, the proof is in the pudding, said one senior partner at a Big Four firm. The PCAOB’s uptick in enforcement activity and calls for action to improve audit quality for American firms have had no discernible impact on investor confidence in American markets.

“Companies [are] listing their securities in the US because the system is strong, and investors are participating in the flow of capital with confidence as the ultimate test. Our system is unmatched,” said the senior partner. “The closest is the UK. And in the US, we are multiples of the UK in terms of listings, volume, and market capitalization.”

In terms of audit quality across the board, things could be getting better. Williams told Fortune that she and her team were seeing “glimmers of improvement” in deficiency data for 2023, which they’re currently reviewing. 

“We’re not going to stop making clear to the firms that investors deserve high audit quality…because when audits fail, people get hurt,” said Williams. “We really want the firms to be out there competing on quality. That’s what the capital markets really count on—competition.”

Audits and people

Williams’ term as PCAOB chair is up in October. It’s likely that the same SEC that appointed her will renew her term, but longer-term, both her and the entire PCAOB’s prospects could depend on who wins this fall’s presidential election.

“Different administrations have viewed the PCAOB differently,” said Rajgopal. “Under Trump, I think it’s probably public knowledge that they were doing nothing.”

No matter what happens in the future, though, Williams told Fortune that she wanted people to know the PCAOB is always working for them—even if they don’t know it.

“[People] don’t necessarily need to know who [we] are, but they need to know that we are out there, thinking about them every day: making sure that auditors are doing their job, so that they can have confidence…when they are investing their money,” Williams said.