Remarks at the 38th Annual Rocky Mountain Securities Conference
by Charles D. Niemeier, Board Member, Public Company Accounting Oversight Board
May 19, 2006
It’s great to be here. The SEC and the Business Law Section of the
Colorado Bar Association do a great service to the country each year by bringing
together an esteemed group of securities law policy makers and practitioners to
the rarefied air of Denver.
It is also a great pleasure to be among so many current and former staff
from the Securities and Exchange Commission. The dedication and talent of the
commissioners and staff of the SEC since its earliest days to the present time
continually meet the challenge of developing and protecting a society of
investors, whose confidence in the SEC’s protection has fueled our economy for
most of the last century.
I want to give you a bit of an overview of what is going on at the Board and
explain how the PCAOB fits into the overall regulatory framework to protect the
investing public. Before I go further, however, I have to note that the views I
express today are my own, and not necessarily those of the other Board
members or staff.
That said, I cannot imagine that I am alone in the view that the financial
reporting and auditing failures revealed in the early part of this decade severely
rocked the confidence of the investing public. Indeed, concern for the effect
investors’ loss of confidence could have on our economy led Congress to pass
the most wide-ranging securities legislation since the 1930s – the Sarbanes-
Oxley Act of 2002 – by a vote of 423 to 3 in the House and 99 to 0 in the Senate.
The Sarbanes-Oxley Act has been discussed in great depth at this
conference each year since 2002. Today I’d like just to give you a brief update
on the PCAOB programs it established.
I. Program Overview
For more than three years now, my fellow Board members and I, along
with our heroically hard-working staff, have registered more than 1,600 U.S. and
non-U.S. accounting firms that audit – or wish to audit – U.S. public companies.
More than seven hundred of these firms are in countries outside the U.S.,
reflecting the global nature of auditing and financial reporting today.
Since 2003, we have also made substantial progress in establishing the
program of inspecting the work of registered firms that the Act envisioned. For
the largest nine firms, inspections are an annual event. We inspect all other
firms that audit or play a substantial role in the audit of U.S. public companies at
least once every three years.1
Our inspection program is the core of our supervision of registered firms,
but these inspections take place largely outside the public view. This is because
the Act allows firms one year to show that they have addressed any quality
control problems before such problems may be made public, reflecting the
Congress’s policy decision to use the possibility of public disclosure as an
incentive to firms to fix problems.2 In my view, our early experience with this
incentive system suggests that it works very well: when we identify problems,
firms take our criticisms seriously and make substantial changes within a year.
The Board also uses its inspection process to address most of the
individual, or isolated, auditing problems we identify. For example, when we find
individual audits that are not up-to-grade, we discuss with the firms precisely
what the deficiency is. Sometimes this means a firm will perform additional audit
procedures to shore up a weak audit.
In addition, from time to time our inspections identify potentially
inappropriate accounting or other financial reporting by issuers. We bring such
matters to the attention of the firms involved, and in most cases they will take the
matters up with the company and, if necessary, with the SEC. We do not discuss
accounting matters with issuers directly, although we do have a practice of
notifying the SEC when we identify financial statements that appear to be
materially misstated and providing relevant supporting information as needed.
When the problem relates to an individual auditor, a firm may provide
additional training or oversight to the person involved or take other action the firm
determines is appropriate. When firms have a cooperative, proactive attitude, we
have been able to achieve significant real-time improvements, often even before
an inspection is concluded.
As necessary, the Act also authorizes us to investigate auditor conduct
and, as appropriate, to seek disciplinary sanctions. In circumstances of reckless
conduct or worse, those sanctions can include significant monetary penalties,
and also may include revoking a firm's registration (and thus preventing it from
auditing public companies) or suspending or barring individuals from working on
the audits of public companies.
Because auditor malfeasance may have an impact on the reliability of the
financial statements the auditor was responsible for examining, our investigations
will often be a component of a larger investigation of the financial reporting itself
and management's role in that reporting. We work very closely with SEC
investigative staff in such cases, including by sharing investigative records,
coordinating the timing of testimony and other events, and providing technical
advice and consultation as needed.3
Based on what we learn through our regulatory programs, as well as
available internal and external research and discussion, we have also
established a standards-setting program to consider, seek input on, and
promulgate auditing and professional practice standards and other guidance to
enhance the quality of audits. The Board has adopted a number of standards
since we opened our doors, as well as overseen public discussion – with a
Standing Advisory Group and in various other roundtable discussions – of
important issues relating to auditing, auditor independence, and other topics.
Most likely, everyone in this audience is aware of our most famous new
standard – Auditing Standard No. 2, which implements the Sarbanes-Oxley Act’s
requirements relating to auditing and reporting on the effectiveness of public
companies’ internal control over financial reporting. Time permitting, we may
discuss some of the latest developments in the Board’s work on making sure this
implementation is as effective and efficient as possible. But first, I’d like to
highlight some important aspects of our inspection program.
The Board has hired a staff of 427 auditors, analysts, attorneys, and
others, and we plan to continue to grow to about 540 employees by the end of
this year. Today, 185 of our people are experienced accountants who perform
inspections, and we plan to grow that force to approximately 250 by year end. In
today’s tight employment market, that is a very tough goal, but in my view it is
critical that we achieve it to perform the kind of work I believe is necessary to
justify public confidence in our ability to ensure high quality auditing. Most of our
staff is based in our headquarters in Washington, D.C., but we have offices to
support inspections staff here in Denver, as well as in San Francisco, Orange
County, Dallas, Chicago, Atlanta, and New York City. We also have an office
near Dulles, Virginia, to support our significant investments in technology.
II. Board Inspections Steer Auditors to Use Good Judgment in
Performing High-quality, Independent Audits
We have now embarked on our 2006 cycle of annual inspections of the
eight largest U.S. firms and one Canadian firm, all of which audit the financial
statements of more than 100 public companies. In addition, we will inspect a
great number of small U.S. and non-U.S. firms that audit the financial statements
of at least one U.S. public company. We began the fieldwork for these
inspections earlier this month, and we will continue these inspections through
November. We will focus on, among other things, efforts to detect fraud and to
identify, evaluate, and manage risk. Also, building on work we began in our 2005
inspections of certain large firms, we will devote special attention to examining
how well firms have been able to perform audits of internal control over financial
reporting, with a view toward guiding firms to the most efficient methods available
to obtain assurance that audit clients have effectively operating internal control.
Importantly, each year our inspections include examinations of a limited
number of Fortune 500 audits. These reviews are the most resource-intensive
aspect of our inspections, because they take significant time from our most
experienced accountants. One of the most difficult judgments the Board has to
make is the amount of our inspection resources to devote to this class of audit.
To date, our primary constraint has been hiring; the tight employment market
continues to restrict our ability to review these audits.
4 Given this constraint, for
the time being in my view we are fortunate to be able to examine the limited
number of mega-audits that we do.
In the long run, though, I believe that we need to examine more of such
audits. In addition to overcoming our hiring challenges, we will also continually
need to resist the incentive to prioritize the accomplishment of easier,
measurable tasks over underlying policy goals. In our case, this incentive could
manifest itself as an over-emphasis on inspecting the numerous tiny firms subject
to our jurisdiction at the expense of inspecting Fortune 500 audits of the large
firms, which are significantly more difficult than the small firm inspections.
Inspections of large company audits are both a more effective use and a
more efficient use of our resources to protect the investing public: after all,
92.5% of the total U.S. equity market capitalization is made up of the 550 or so
companies with equity market capitalizations of greater than $1 billion.5 As we
saw time and time again in 2001 and 2002, when Enron, WorldCom and other
top companies announced major misstatements in prior period financial
statements, it is also the largest companies that provide – or jeopardize – the
foundation for investor confidence in the U.S. financial reporting system.
Fortunately for the investing public, the SEC was quick to respond to the
crisis in investor confidence by focusing its resources on the financial reporting of
the largest companies in a number of ways. For example, close on the heels of
Enron’s fall and under Alan Beller’s leadership, the SEC’s Division of Corporation
Finance instituted a program to monitor the annual reports filed by all Fortune
500 companies in 2002 as part of its reviews of financial and non-financial
disclosures made by public companies.6 In addition, in June 2002 the
Commission ordered all public companies with revenues of more than $1.2 billion
– or approximately 950 companies – to file written statements, under oath, of
their CEOs and CFOs regarding the accuracy of their companies’ financial
statements and their consultation with their companies’ audit committees.7
I also played a small role in this effort, as Chief Accountant of the Division
of Enforcement in those years, when under the leadership of Dick Walker, Steve
Cutler, and Linda Thomsen, we shifted the focus of the Division’s enforcement
efforts in the financial reporting area away from the small companies that had
been the bread-and-butter of the program to the conduct of the largest
companies as well as their advisors and auditors. In those years, I certainly
learned that large companies are not free of financial reporting errors and fraud,
and indeed that a policy of examining only smaller companies left financial
reporting problems at large companies to fester and grow with abandon. To
establish an inspection program that has the confidence of the investing public, I
believe the PCAOB needs to pay close attention to these lessons and examples.
Those are the stats on the job and decisions we have ahead of us. Now
let me tell you a bit about our approach to inspections.
A. The PCAOB’s Supervisory Approach to Inspections is Designed to Identify and Address
Audit Weaknesses at an Early Stage
Our inspections are risk-biased, which means that we select
engagements, and specific areas in those engagements, that, for any number of
reasons, may present difficult challenges to auditors. For example, we may
focus on an audit of a public company whose financial disclosure consists in
substantial part of management estimates and is demonstrably opaque. The
business risk to the engagement partner of offending the client may or may not
have a bearing on the partner’s willingness to bend to a management bias in
estimation, but we will find out.
As another example, our inspectors may focus on a number of audits –
across firms – that involve application of complicated, exception-laden
accounting rules. In these cases, we will be looking to see whether auditors
have a grasp of the economic substance of the transactions or events at issue,
such that they apply the rules in a manner that leads to a fair presentation, not
just one that technically qualifies for applicable exceptions.
Indeed, if we have learned anything from the financial reporting scandals
that led to the passage of the Sarbanes-Oxley Act, it is that the quality of financial
statements is not driven by technical adherence to standards but rather turns on
a company’s attitude toward disclosure. Auditors are in a unique position to
evaluate this attitude, and a good auditor uses this evaluation to decide where to
spend his or her time and effort in an audit.
B. PCAOB Inspections Facilitate the Transition to Principles-based Accounting
In this regard, over time, the PCAOB’s inspection program will be an
important partner in the efforts of the FASB and the SEC to move toward more
principles-based – or objectives-based – accounting standards. In the SEC
staff’s 2003 study on principles-based accounting, the SEC staff noted that for a
system of principles-based accounting standards to be viable, "auditors would
need to be weaned away from the check-list mentality" and would, in some cases
be faced with the prospect of having "the rules-based security blanket removed."8
Some have expressed concern that a principles-based accounting model
would rely more heavily on auditor judgment, which can be weak-kneed in the
face of pressures like those I’ve just described, than a rules-based system does.
Others have expressed concern that the threat of second-guessing by a PCAOB
inspector may drive auditors to a checklist mentality and impede the exercise of
judgment. To my mind, these concerns are misplaced. Indeed, as the SEC staff
noted in their study, "rules-based standards [already] require significant judgment
to determine where within the complex maze of exceptions and internal
inconsistencies a transaction falls."9
Who would deny that it takes judgment to deal with the all-too-common
question from corporate managements to "show me where the accounting
literature says I can’t do that"? It takes good judgment, as well as strength of
character to get through such a challenge. The difference between the
judgments required in a rules-based system and those required in a principlesbased
system is rather that, in a principles-based system, auditors apply
themselves to settling on a presentation that achieves the objectives of the
principle as opposed to applying themselves to verifying the applicability or nonapplicability
of exceptions to a rule.
Where do our inspections fit in? Well, as the SEC staff study noted,
"some research seems to indicate that auditors might be more willing to
challenge aggressive accounting practices adopted by management in a more
‘flexible’ accounting environment than in an environment of rigid rules." The SEC
staff noted importantly, however, that "this result appears limited to situations
where the auditor is more experienced and in a ‘stronger’ firm."10
Rather than impeding auditor judgment in such situations, PCAOB
inspections will be critical to the strength required of firms and their professionals.
The precision of seeming to comply with detailed rules and checklists can mask a
decision to ignore the economic reality of circumstances or transactions, which
itself is a judgment by preparers and auditors, albeit a bad one. In such
situations, the protection of detailed rules is illusory. Time and time again we
have seen such judgments result in poor reporting and, indeed, problems for the
preparers and accountants who sought detailed rules as a form of protection.
Through our inspections, we can focus auditors’ attention on evaluating
whether the overall presentation of financial statements is fair and complete,
which is a far better protection from challenge for those involved. By
emphasizing good judgment to identify and achieve the objectives of accounting
standards, PCAOB inspections will help auditors – and, in turn, public companies
– to transition to a principles-based accounting model.
C. PCAOB Inspections Reduce the Risk of Major Financial
Reporting Failures by Identifying and Correcting Problems at
an Early Stage
Of course, another important attribute of PCAOB inspections – whether
testing application of rules or principles – is that by reviewing audits before
problems erupt, we focus auditors on fixing them before they lead to, or fail to
prevent, large misstatements in financial statements. Unlike traditional
enforcement models that focus on punishment after financial reporting and
auditing failures become exposed, our inspections provide new tools to identify
and resolve problems early in their development.
These tools are achieving demonstrable results. On a quantitative level,
misstatements have already been identified through our inspections and
corrected, early enough to escape the devastating consequences that descend
on companies that don’t address problems early. Some have argued that
correcting small problems before they’ve grown into scandals is not important to
investors and therefore not worth the expense to identify and correct them.
These critics point to evidence that stock prices have not consistently shown
material reactions to the record numbers of restatements in our financial system
in the last couple of years. I think that view is misguided. Indeed, to my mind,
that evidence shows that correcting problems early in their development helps
companies get on the right track and avoid devastating, and significantly more
costly, consequences later on.
And on a qualitative level, ask any auditor, and you will likely hear that
there is no question that they believe their firm is doing higher quality audits than
before the Sarbanes-Oxley Act. Among the critical generation of professionals
who are now rising to the senior ranks in firms, in many cases they will say they
are back to auditing the way they were when they started at their firms, before
the 1990s when many firms relegated audit services to low-cost leader status.
Now that is positive change. We need to keep it up to justify investor
confidence that our financial reporting system is reliable, but I will say that I
believe we have already significantly reduced the risk of misstatements being
missed in registered firms’ audits.
Thank you. Now I’d be happy to get into some questions.
1 Under PCAOB Rule 4003, the mandatory three-year inspection cycle for a smaller firm
(100 or fewer issuer audit clients) begins the year after the first year in which the firm, while
registered, issues or plays a substantial role in preparing an audit report on a U.S. public
company.
2In order to give the public an understanding of how this incentive works, the Board
recently described its experiences in monitoring firms’ efforts to address problems identified in the
first year of inspections. See PCAOB Release No. 104-2006-078, Observations on the Initial
Implementation of the Process for Addressing Quality Control Criticisms within 12 Months After
an Inspection Report, March 21, 2006, available at http://www.pcaobus.org/Inspections/Public_Reports/2003/2006-03-21_Release_104-2006-078.pdf; see also PCAOB Release No.
104-2006-077, The Process for Board Determinations Regarding Firms’ Efforts to Address
Quality Control Criticisms in Inspection Reports, March 21, 2006, available at http://www.pcaobus.org/Inspections/2006-03-21_Release_104-2006-077.pdf.
3Board inspection and investigative materials are subject to strict confidentiality
restrictions under the Act. Specifically, under Section 105(b)(5) of the Act, the Board may share
such materials only with a limited list of government agencies, including the SEC, the Justice
Department, appropriate federal banking regulators, state attorneys general investigating criminal
matters, and appropriate state regulatory authorities such as state boards of accountancy.
4"Even though enrollment in accounting programs has risen over the past few years, the
demand for CPAs currently outstrips supply by as much as 20 percent." The People Who Count,
CFO.com (April 2006).
5See SEC Office of Economic Analysis, Background Statistics: Market Capitalization and
Revenue of Public Companies, Table 2 (April 6, 2006), included as Appendix E, Table 2, in the
Final Report of the Advisory Committee on Smaller Public Companies to the United States
Securities and Exchange Commission (April 23, 2006). This report is available at
http://www.sec.gov/info/smallbus/acspc/acspc-finalreport.pdf.
6See Summary by the Division of Corporation Finance of Significant Issues Addressed in
the Review of Periodic Reports of the Fortune 500 Companies, available at
http://www.sec.gov/divisions/corpfin/fortune500rep.htm.
7See Order Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the
Securities Exchange Act of 1934, SEC Release No. 4-464 ) (June 27, 2002), available at
http://www.sec.gov/rules/other/4-464.htm.
8See Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the
Adoption by the United States Financial Reporting System of a Principles-Based Accounting
System, SEC Staff (July 25, 2003), available at http://www.sec.gov/news/studies/principlesbasedstand.htm#P528_122602.
9Id. at note 100.
10Id. (citing Nelson, Mark W., "Behavioral Evidence on the Effects of Principles- and Rules-
Based Standards," Accounting Horizons, March 2003).
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