One of the founding fathers of the US accounting regulator left the watchdog on Wednesday. William McDonough had been chairman of the Public Company Accounting Oversight Board for almost two-and-a-half years.

The PCAOB was created by the 2002 Sarbanes-Oxley law on accounting and corporate governance, as part of efforts by lawmakers to restore investors’ confidence in companies’ financial statements.

Mr McDonough played a significant part in enabling the accounting profession to begin to regain public trust after a raft of corporate scandals highlighted how auditors failed to blow the whistle on financial reporting frauds such as Enron, WorldCom and HealthSouth. He and his staff ensured the big accounting firms once more made auditing their number one priority.

During the 1990s, the big firms transformed themselves into multidisciplinary organisations that switched focus from auditing to lucrative consulting work. Lawmakers concluded in the Sarbanes-Oxley law that the only way to restore the integrity of auditing was to abolish the profession’s system of peer review and impose, in the form of the PCAOB, an independent watchdog.

Mr McDonough, a former president of the New York Federal Reserve Bank, leaves the PCAOB running at almost full capacity. When he arrived in June 2003, he was employee number 42. Today, it has a staff of more than 400. He cites two main achievements. First, putting together the PCAOB’s “superb staff”. Second, the establishment of a “supervisory model” for the accounting firms, in which “we work with the profession”.

Rather than simply wave a big stick at the firms, Mr McDonough urged them to work with the regulator to raise the quality of auditing. And in all of his exhortations he struck a strongly moral and religious tone. Taught at school by Jesuit priests, Mr McDonough urged accountants to “restore their reputations and save their souls”. The firms’ leaders responded positively, and he believes their stance has enabled the profession to make faster pro-gress with efforts to regain public confidence.

Mr McDonough admits, however, that investors’ faith in the accuracy of audited financial statements has not been fully restored. The alleged securities fraud at Refco, the futures brokerage group that collapsed last month after admitting investors had not been told about how its former chief executive owed it $430m, shows “there is much work still to be done”, he says.

He argues it should take companies and auditors no more than another two years to ensure that investors have confidence in financial statements: “If we have not restored public confidence and investor confidence by another couple of years there will be a real questioning of whether this free-market system . . . really works.”

Mr McDonough is sceptical about the case for placing new responsibilities on auditors to state that companies’ accounts are free of misstatements stemming from fraud. Such responsibilities could significantly raise the costs of auditing, and Mr McDonough says even the best auditor is “highly unlikely” to spot collusive fraud that involves a small number of people.

The PCAOB’s main function is to inspect the quality of auditing done by accounting firms at a selected number of companies each year. In recent weeks the regulator has highlighted “significant deficiencies” in several audit engagements done by the big four firms – Deloitte, Ernst & Young, KPMG and PwC – during 2003, including some that led companies to restate their accounts.

“They are not achieving that very high degree of auditability in all cases,” says Mr McDonough.

The regulator’s other big task is setting modus operandi standards for auditors, and the PCAOB has run into controversy with its flagship 2004 rule on how they should audit companies’ internal controls, which are supposed to ensure good accounting. The big four saw their audit fees double at the first batch of US companies that last year had to comply with section 404 of the Sarbanes-Oxley law, which requires companies to report on the quality of their controls.

The PCAOB’s rule complements section 404, but Paul Atkins and Cynthia Glassman, two commissioners at the Securities and Exchange Commission, the chief US financial regulator, have questioned whether it is driving up companies’ costs unnecessarily. They say auditors are reviewing too many internal controls, even after the SEC and PCAOB issued guidance in May that stressed they should take a selective approach.

Mr McDonough rejects the case for rewriting the PCAOB’s rule in response to the concerns about costs, although he adds that does not rule out redrafting it at some stage. He suggests companies and auditors are coping better with section 404 this year compared with 2004, “but only a fool would think year three will not have some additional opportunities for improvement”.

In its other signature piece of rulemaking, the PCAOB enabled the accounting firms to persist with their multidisciplinary business model. The regulator decided the firms should be able to provide some tax services to audit clients, although it did introduce restrictions. But the firms were delighted with the PCAOB’s rule, given that a complete ban on the supply of tax services to audit clients could have undermined their second biggest source of revenues.

Mr McDonough takes great pride in how he used diplomatic skills honed at the state department to defuse a transatlantic dispute over the Sarbanes-Oxley law. It requires the PCAOB to inspect the work of auditors based outside the US if they have clients with New York stock market listings. Mr McDonough brokered a deal with the European Commission under which the PCAOB will ask the foreign auditors’ home-country regulator to inspect the work, as long as that watchdog is independent of the profession.

As he leaves the PCAOB, Mr McDonough is convinced corporate America has changed for the better after the scandals. But he remains frustrated at the disconnection between the level of executive pay and the performance of some chief executives, and warns of the risk that the public will demand legislation to solve the problem.

“The American people are demonstrably still very unhappy about the level of executive compensation,” he says. “The one thing they do not understand is paying for failure.”

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