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 The PCAOB and Small Business Auditors 

DATE Feb. 27, 2006 
SPEAKER(S): Daniel L. Goelzer, Board Member 
EVENT: PCAOB Forum on Auditing in the Small Business Environment 
LOCATION: Fort Lauderdale, FL 

I. Introduction

Good morning. I would like to welcome you to the PCAOB Forum on Auditing in the Small Business Environment.

Since late 2004, the PCAOB has held forums like this one in ten cities across the United States. This session in Fort Lauderdale is the second of eight we plan to hold this year. Today’s program is aimed at smaller auditing firms. Tomorrow, we will hold a similar meeting for directors and CFOs of smaller public companies.

The purpose of these forums is to inform the small business community about the Board’s work, and to open an avenue for discussion and dialogue. These sessions are an opportunity for us to provide a broad group of smaller firms and their clients with insight into the Board’s inspections process and its standards-setting agenda. In the course of the prior forums, Board members and staff have met with more than 1,000 representatives of companies and accounting firms.

While we hope to give you some useful information about our work, these events are not intended as a one-way street. Your comments assist us in understanding how our work affects smaller firms. We encourage you to ask questions.

Before we turn to the substance of the program, I would like to take a few minutes to touch on some of the ways in which the Board seeks to take into account the unique circumstances of smaller firms and public companies. Before I do that, I want to note that the views that my colleagues and I express today are our own, and not necessarily those of the Board’s other members or staff. Much of what we say will be based on official Board statements. But, when we venture into expressing opinions, we are speaking only for ourselves

II. The PCAOB and Small Business.

Two defining characteristics of the accounting profession that serves public companies in the United States are its size and its concentration. There are over 1,600 firms registered with the Board. That is a far higher number than we originally anticipated, and it reflects the breadth of the public company audit practice in this country. However, in terms of concentration, a very high percentage of the total public company market capitalization is audited by only a handful of firms. In fact, a 2004 GAO report found that just four firms audit nearly 99 percent of the revenues of all SEC registered companies.

The profile of the profession poses some significant issues for the Board. We do not have any direct authority over matters of industry concentration and competition. However, we strive to make sure that our regulatory activities take into account the differences between firms and their practices and that they do not use a one-size-fits all approach in those areas where it is not appropriate.

These small business forums are one step in that direction. I would also like to mention three other things that may be of interest to this audience --

  • Our efforts to tailor our inspections program to the size and nature of accounting firm.
  • Our efforts to solicit input from smaller public companies and smaller accounting firms in standards-setting; and
  • Our participation in the work of the SEC’s Advisory Committee on Smaller Public Companies.

A. Tailoring the PCAOB’s Inspection Program to Smaller Firms

Let me turn first to inspections.

There are currently about 960 U.S.-based firms registered with the Board, while the remaining 660 or so registrants are located outside the U.S. Nine of those 1,600-plus firms -- eight in the U.S. and one Canadian firm -- audit 100 or more SEC registered clients. The remaining firms vary widely in size (including numbers of partners, issuer clients and offices), nature of their practice, and degree of centralized control.

Given the diversity of the registered firms, it is difficult to generalize about the small firm inspection procedures. The Board holds both small and large firms to the same standards, as we believe Congress has required. That having been said, we try to customize each firm’s inspection to take into account the firm’s size and practice complexity. As a result, some aspects of a small firm inspection are different from the large firm inspections. For example --

  • A small firm inspection involves a smaller PCAOB inspection team. In some cases, the team may consist of only two people; while in the case of a large firm, many more may be involved.
  • A small firm inspection focuses on a smaller number, but higher percentage, of the inspected firm’s public company audit engagements than at a large firm.
  • The quality control review is tailored to the nature of the firm. Obviously, a firm with one or two partners and one or two public company clients does not face the same issues in assuring uniformity in its audit practice as does a firm with hundreds of partners and clients scattered across dozens of offices around the country.

Our efforts to tailor the inspection to the firm have led to the concept of the “PCAOB-based” inspection. Under this approach, in some cases the Board’s inspection staff dispenses with field work altogether and conducts the inspection by reviewing work papers and other documents furnished by the firm at the Board’s offices. While not appropriate in every case, where they make sense, PCAOB-based inspections save time and money for both the Board and the firm.

Being inspected is, I suppose, not exactly pleasant. However, I hope that smaller firms will regard it as an opportunity, rather than solely as a burden. The inspection process could even be seen as a way of promoting competition by giving public companies more confidence that the audit services of a wider range of registered firms are reliable.

B. Input in the Standards-Setting Process

You will be hearing a lot more about the small firm inspections program later today. I want to turn next to another challenge: making sure that we understand the viewpoint of small firms and small issuers when we set auditing standards or make new rules. The largest accounting firms have Washington staffs that specialize in dealing with regulators and communicating the firm’s views. We have tried hard not to let those be the only voices we hear.

As many of you are probably aware, the Board has formed a group to advise it on auditing standard issues. We call this body the Standing Advisory Group, or “the SAG.” The SAG is composed of 31 highly qualified members representing the auditing profession, public companies, investors, and others.

We have sought to make sure that the SAG has strong small firm and small business representation. Currently, the membership includes two small auditing firm partners and the CEO of a smaller public company, along with representatives of the larger firms and some Fortune 500 companies.

There are of course only a limited number of SAG seats, so in order to make sure we hear all perspectives, the SAG meetings don’t just consist of discussion among the SAG members. We have also included on the SAG agenda panel presentations by representatives from smaller companies and smaller accounting firms. These panels have addressed a wide variety of issues, ranging from internal control auditing to the practical problems of second partner review. They provide the SAG with input it would not otherwise hear.

I encourage you to also participate in the PCAOB’s standards-setting. While it obviously isn’t possible for every firm or every company to be represented on the SAG, it is possible for anyone who wishes to do so to participate in standards-setting via the public comment process.

C. SEC Advisory Committee on Smaller Public Companies

Finally, I want to mention what is probably the most ambitious effort underway in Washington today to address the problems of smaller businesses: the SEC Advisory Committee on Smaller Public Companies. That group’s recommendations, while in some cases controversial, would, if adopted by the SEC, have far-reaching effects on smaller public companies and their accounting firms. Some of those recommendations may be especially relevant to this audience.

First, some background: The SEC established the Advisory Committee in March 2005 to assess the current regulatory system for smaller companies under the securities laws, including the impact of the Sarbanes-Oxley Act. During the past year, the Committee held a series of public hearings. Last week, it voted to publish a draft report for public comment, and that report should be released in the next few days.

The Advisory Committee’s draft report will contain recommendations in many areas. I want to highlight a few of its suggestions in two fields -- internal control reporting under Section 404 of Sarbanes-Oxley and accounting issues.

As I am sure most of you are aware, Section 404 of SOX requires the SEC to adopt rules that provide for all public company managements to annually assess, and publicly report on, the effectiveness of the company’s internal control over financial reporting. Section 404 also requires all public companies to file with the Commission a report from their auditor on management’s assessment. Other parts of SOX require the auditor to express an opinion directly on the controls. These requirements took effect last year for the largest 50 percent or so of companies. SEC has delayed implementation for smaller companies, the non-accelerated filers, until mid-2007.

The Committee is recommending a broad series of exemptions that would prevent many companies that are not yet subject to this requirement from ever having to assess their controls and report on them. The Committee is also urging that some smaller accelerated filers be relieved of the auditor reporting requirements. More specifically, the Committee proposes that --

  • Unless a framework for assessing the internal controls of micro-cap companies is developed that recognizes the special characteristics and needs of those companies, they should be exempt from Section 404. Micro-cap companies are those with market caps below $128 million. In order to use this exemption, these companies would have to meet certain corporate governance requirements, such as an independent audit committee, and could not have annual revenue over $125 million.
  • Similarly, unless an internal control assessment framework is developed, companies with market capitalization below $787 million would be exempt from the part of Section 404 that requires auditor reporting on controls. Company management would still have to assess and report, but there would be no auditor involvement.

These exemptions would affect over 70 percent of all public companies. The Committee recognizes that the Commission may not be prepared to go that far. As a fall-back recommendation, it proposes that, for small and micro-cap companies, auditors should only be required to opine on the design and implementation of controls, not on their operating effectiveness.

I also want to mention a few of the Committee’s accounting-related recommendations. I found four particularly interesting --

  1. The SEC should develop a “safe-harbor” that would protect “well-intentioned” preparers from regulatory or legal action when they make mistakes in applying accounting principles.
  2. The SEC should implement a de minimis exception to its auditor independence rules, so that some breaches of the rules would not prevent the auditor from rendering an opinion.
  3. Together with the PCAOB, the SEC should promote competition by including non-Big Four firms in committees, public forums, and other venues in order to increase awareness of these firms in the marketplace. As I have mentioned, we already strive to do this.
  4. To increase competition by increasing confidence in the abilities of smaller firms, all auditors that wish to practice before the SEC should be required to meet annual continuing professional education requirements covering topics specific to SEC practice.

Although the Advisory Committee’s recommendations are addressed to the SEC, not the Board, many of them would affect our work, and we are following the Advisory Committee’s activities closely. As I said earlier, some of its proposals -- particularly those related to internal control reporting -- are bound to be controversial. Some investor groups have already said that the 404 exemptions would be contrary to Congress’s intent and to investor protection. If you have thoughts on the SEC’s Advisory Committee’s recommendations, you should share your views with the Committee.

And, with respect specifically to internal control reporting, the PCAOB and SEC will be holding a roundtable on May 10 to discuss second-year experiences with the reporting requirements of SOX Section 404. This will be another opportunity to let the regulators know your views. Both the SEC and PCAOB are seeking written feedback in advance of the roundtable on auditor and issuer views and experiences with Section 404 compliance.

III. Conclusion.

In conclusion, the Board has sought to shape its programs in a way that takes into account the diverse profession we regulate. We have also sought to make sure that our decision-making is informed by the perspective of both large and small firms.

This forum is part of those efforts. We hope you will find it useful, but we are also counting on learning a lot from you. Your input helps us make sure our programs reflect the unique characteristics of your practices.