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 The PCAOB and Its Oversight Role

DATE March 9, 2004
SPEAKER(S): William J. McDonough, Chairman
EVENT: Joint Financial Management Improvement Program
LOCATION: Washington, DC

Thank you for the gracious introduction. David Walker couldn’t have known it when he invited me to address this auspicious group, but your conference coincides with one of the most important days in the world of financial management.

This morning, I was pleased to vote with my colleagues on the Public Company Accounting Oversight Board to approve an auditing standard that will change the lives of public company auditors and their clients. And if this standard is implemented as intended, it will be one of the steps that will help restore the credibility of public companies and re-inspire faith in our financial markets.

At this moment, you’re probably thinking that Bill McDonough has finally gone off his rocker, that the shock of leaving the presidency of the New York Fed and taking on the chairmanship of an upstart regulatory body has tipped him into hyperbole, if not delusions.

No. I stand before you with my faculties intact. And the PCAOB today took action that will forever change how public companies – all 12,000 to 15,000 of them – do business.

The Board today put in place a standard that requires auditors, when they audit the financial statements of public companies, to also audit the companies’ internal controls over financial reporting. From now on, it is not enough that auditors check a box indicating that management says the internal controls are “OK.”

The new PCAOB standard requires auditors to look at the internal controls themselves, even to the point of doing walkthroughs of important stages of certain controls. The auditors must be satisfied that the internal controls over financial reporting are designed and operating efficiently.

As we heard from many public companies, these requirements are tough, and they will entail extra work and cost. But the goal of the requirements is simply too important to demand any less.

The goal is to obtain the best possible assurance that a company’s financial statements are reliable. The importance of that goal is clear when we remind ourselves who relies on corporate financial statements: investors, yes, but also lenders, regulators and, indeed, anyone with an interest in the stability of our financial markets.
So, I don’t think I exaggerate when I say this is one of the most important days in the world of financial management.

I am not suggesting, however, that the Board originated the idea of auditors taking a stronger role in assessing companies’ internal control over financial reporting. The PCAOB was put in charge of writing the standard for the auditors, but the idea was contained in a bigger package of reforms of how corporate America behaves.

The package was the Sarbanes-Oxley Act of 2002 -- a law that was revolutionary in the changes it prescribed and the activities it proscribed in our capital markets.

How could such a revolution have happened? I believe that it happened because in the course of the 1990s, many American business leaders got confused and their moral compasses stopped working.

It is particularly sad that such confusion took place because American businesses responded in the 1990’s in a brilliant way to a very serious challenge. Globalization of the world economy became much more intense in the course of the decade and American companies lost pricing power. It is easy to see why a manufacturing firm in Chicago cannot increase prices if it has to compete with firms in Mexico, China, India and other countries with dramatically lower labor costs. But service firms discovered that they had the same problem. You cannot raise prices for, say, a call center in Clintwood, Virginia, if you are competing with call centers in New Delhi. Only very local services, such as health care and legal services, have been immune from this globalization-driven loss of ability to raise prices.

If you cannot raise prices and wage pressures are fairly intense because of the kind of tight labor market we had in the 1990’s, the only way to avoid funding the wage increases by reducing profits is to improve labor productivity, the output per unit of labor input.

Labor productivity had averaged an increase of about 1.5% per year from 1973 to 1995, meaning that the economy could grow only slowly without putting strong pressure on resources and forcing inflation. One of the major tenets of post World War II economic theory is that there is what I call a speed limit on the economy. That speed limit is the sum of labor force participation growth, about 1% per year, and labor force productivity. So the speed limit from 1973 to 1995 was 2.5%.

A different but related tenet is the relationship between employment and inflation, called by the mouthful of the “non-accelerating inflation rate of unemployment,” or NAIRU. Most economists agreed that the NAIRU was 6%. An unemployment rate below that would bring inflation.

And yet in 1996 and later, the economy was growing at well above 2.5% and unemployment kept heading down, eventually below 4%. Not even paranoid central bankers could see inflation anywhere.

What had happened is that American businesses solved their problem of no-pricing-power but rising wages through investment in information technology to help them run their businesses more precisely. Investing in IT was just the beginning. The way of doing business also had to change.

Retail trade is an obvious example. In a modern store, you check out and the bar code tells the clerk what each item costs and what your total bill is. More importantly, the same information system updates the inventory records and the order book when the inventory hits a level indicating it is time to order. What is saved, compared to an earlier era, is that you need no clerks with pencils keeping inventory records, you do not need warehouses of size because we copied the Japanese just-in-time delivery system previously used only in manufacturing, and there is a saving on the cost of financing now unneeded inventories.

These and similar systems not only financed higher wages for those working, but increased profits substantially.

Productivity at the national level averaged 2.5% from 1996 to 2000 and over 5% since then.

This was a brilliant response by American business executives throughout the country. They deserved credit for it. But it perhaps helped in getting them confused. Pundits told them it was a new economic era and the excitement went to people’s heads in a variety of ways.

Two things stand out: executive compensation and the drive for ever increasing and fully predictable quarterly profits.

In 1980, the average large company Chief Executive Officer made 40 times more than the average employee in his or her firm. Let’s assume that the multiple made sense because of the extra preparation, the risk-taking ability, the leadership skills that CEOs have to have.

By 2000, the multiple of the average CEO’s pay over that of the average worker in the firm, had risen according to some studies to 400 times and in other studies to about 550 times. Let’s be conservative and use the 400 figure. That means that, in the course of 20 years, the multiple of CEO pay went up by a factor of 10. There is no economic theory, however far-fetched, which can justify that increase. In my frequently stated view, it is also grotesquely immoral.

I should also note that I knew a lot of CEOs in 1980 and I can assure you that the CEOs of 2000 were not 10 times better—if better at all. The most famous banker and probably the most highly respected in America in that earlier era was Walter Wriston of Citibank. Walter never made as much as $1 million in any year in his entire career.

Now let’s look at earnings performance. During the 1990’s, there developed a theme in corporate America of predicting quarterly earnings, something accomplished by the people in the financial management of public companies guiding allegedly independent investment analysts to a consensus on how much the company would make in the next quarter. That morphed into a string of predictions of ever rising quarterly profits. Now there may be a time for a few companies in which profits go steadily upward, but the notion that it would go on indefinitely for lots of companies requires that you forget that there is a business cycle, a profit cycle and the law of gravity.

In this time of confusion, if a company made its forecast, the genius CEO, he or she of the 400 times the employees’ income, was truly a genius. If the forecast was missed by underperforming, the genius was a fool and his or her tenure was questioned by the pundits of the investment banking community and the financial press.

What was really going on in response to this self-created situation, was that companies were cooking the books, with the help of outsiders such as lawyers, investment bankers, commercial bankers and, yes, accountants and auditors.

The American people, that wise body politic which in times of national crisis has picked such great presidents as Lincoln, Teddy Roosevelt, Franklin Roosevelt and Harry Truman, were noticing this stuff and they didn’t like it. But until the middle of 2000, everybody was enjoying the longest economic expansion in American history and the public did not react. However, when the tech bubble broke in the second quarter of 2000 and the large market correction began and continued, the half of American households invested in the stock market began to notice that their retirement plans and mutual funds were losing value. They were getting unhappy, but they were not sure who to blame.

The scandals let them know who to blame: corporate executives. Enron was not only managed by people of questionable integrity—the CFO is about to serve 10 years in jail—but people of such shocking selfishness that they sold their stock on insider information at the same time their employee 401k plans were frozen. Lest anybody think it was just Enron, WorldCom, HealthSouth and others, financial implosions were happening with sufficient rapidity to make the American people very, very angry.

In a democracy, when citizen voters get angry, they let their elected representatives know just how angry they are. Congress and the White House responded with the Sarbanes-Oxley Act of 2002, passed by overwhelming majorities in the Senate and the House of Representatives and signed by a President who called it the most important securities legislation since 1934.

Among the prescriptions of Sarbanes-Oxley: CEOs and Chief Financial Officers have to sign the financial statements, personally certifying their accuracy. Some executives don’t like that, making me wonder what they thought their responsibilities were in the past.

The accounting profession was deemed particularly culpable because of the blatant cooking of the books at the scandalous companies. Accountants lost their right to self-govern their profession, and the Public Company Accounting Oversight Board was created.

Let us stop for a moment and ask ourselves why the Congress and the President and the American people did not decide that the scandals were few in number, just bad apples in an otherwise healthy business community. The reason, my friends, is above all else the executive greed which was extraordinarily widespread and the cooking the books phenomenon I described earlier. The American people thought that the business leadership in general, and accountants in particular, needed a sharp lesson.

The accountants, long thought by the public to be among the most honorable professionals, so lost the confidence of the people that they now have the PCAOB and me as its chairman to oversee them, particularly in their audits of public companies.

This is one of the revolutionary changes I spoke of earlier. Before the Sarbanes-Oxley Act, there was no national oversight of accounting firms outside of what the firms did themselves. That changed with the creation of the PCAOB.

The PCAOB is a private-sector, non-governmental body. All five of us Board members are appointed by the Securities and Exchange Commission, and our rules and budget must be approved by the SEC. But there, the government ties end.

We are not taxpayer-funded. Our source of funding is the public companies that benefit from independent audits. We have just mailed invoices to some 8,800 companies and mutual funds who will support our $103 million budget this year.

Most of our budget will be spent on staff. After 14 months of operation, the PCAOB employs almost 160 people, and we expect we will be at 300 within the next year.

Since last October, no domestic accounting firm can audit a publicly traded company if the accounting firm is not registered with the PCAOB. As of today, 772 have registered.

Registration is a prerequisite for accounting firms to continue their work as auditors of public companies. Registration is also the foundation, established in the Sarbanes-Oxley Act, for the PCAOB to perform its important functions of inspection and enforcement.

The Board recently approved our rules for investigations and hearings. The Board has also approved our inspection rules, and those are awaiting SEC approval. In the meantime, we commenced limited inspection procedures at the Big Four firms with an experienced team of auditors.

Soon, we will launch the regular inspections called for in the Sarbanes-Oxley Act. Regular inspections will occur every year for firms with more than 100 audit clients. All other firms will be inspected once every three years. And when the Board thinks circumstances warrant, we can order a special inspection, regardless of timing.

To facilitate inspections of more than 200 firms per year, we have opened regional offices in New York, San Francisco, Dallas and Atlanta.

Our inspectors will be looking for the compliance required in the Sarbanes-Oxley Act, that is, compliance with the Act, the rules of the Board and the Securities and Exchange Commission and professional standards.

Our inspectors will look for the "tone at the top" of the firm. Does the managing partner, does the audit team leader, understand what is demanded of the accounting firm in this new era of regulation and oversight? What messages are being communicated by the leadership of the firm to its partners and professional staff? Do these messages evidence an understanding of the demands of the firm in this new era of regulation? Is it clear that audit quality is the firm’s number one priority?

The Board and our inspectors want to know if the message of "doing the right thing" is reaching the rank and file in the firms. Our inspectors will talk to the managers, but they will also talk to the least experienced members of the audit teams to find out if the message is reaching them. We will look at how often and how well the message is delivered.

We will look at compensation and promotion. Are the best auditors rewarded for being the best auditors, or are they rewarded for something else? We will look at how clients are selected and how they are let go.

Obviously, our inspectors will look at audits as well.

The inspections will also inform us as we go about the task of setting auditing standards. The Sarbanes-Oxley Act charged the Board with establishing auditing and related attestation standards; quality control standards; ethical standards, and independence standards.

Even to the eyes of a former bank regulator, those are a lot of standards to be set!

The Act also gave the Board the power to designate or recognize any professional group of accountants to propose new standards. The Board determined not to exercise the authority to delegate the standards-setting to a professional group but instead voted to set the standards from within the PCAOB.

Our standards-setting staff hail from a variety of backgrounds, including academia, professional practice and government. The Board will also be drawing on the expertise of a standing advisory group that we are in the process of establishing. The group will be composed of individuals with experience in auditing, financial statement preparation, corporate governance and investing, as well as other relevant fields.

In addition, we intend to seek the views and involvement of small- and medium-sized firms and preparers in our own standards-setting projects – through the standing advisory group and through ad hoc task forces. I believe very strongly that we must do what we can to encourage small- and medium-sized businesses, because they are the true drivers of our economy.

While the Sarbanes-Oxley Act requires auditors to follow our auditing standards only when they are performing public company audits, we hope that – like FASB's accounting standards – they will provide appropriate guidance in other contexts. While some public companies do go private, in many, many more cases private companies go public. In addition, stakeholders other than public investors – such as lenders – have already begun to require auditors to provide audit reports according to our standards.

The standard we adopted today was required by the Sarbanes-Oxley Act. Before we set out to write the standard, we examined the existing standard for audits of internal control, we held a roundtable discussion, we examined the requirements set for banks in the Federal Deposit Insurance Corporation Improvement Act of 1991, and, dare I say, we examined our hearts to make sure we were doing the right thing for the right reasons.

We proposed the standard in October, and we received robust feedback – 193 comment letters in all. We took the time necessary to digest these comments carefully because as I said at the beginning, internal controls are simply too important to treat lightly.

That’s one reason the Board determined that it was not enough to simply ask auditors to attest to and report on management’s assessment of a company’s internal controls. The Act clearly required more: that auditors determine for themselves that the internal controls are adequate to support reliable financial statements.

Our standard requires that an auditor perform the audit of the financial statements and the audit of internal control as part of one engagement – not so much as a cost- and time-saving measure but because each audit could have consequences for the other.

On another issue, auditors’ ability to rely on the work of others, the Board tried to strike an appropriate balance between the work that an auditor must do himself or herself, and the work performed by management, internal auditors and others that the auditor may use to support his or her opinion.

We require that an auditor obtain the principal evidence supporting his or her opinion through procedures performed by the auditor, including walkthroughs. That in no way says an internal auditor’s work lacks value, and we certainly do not want to discourage internal auditors from testing and evaluating internal controls, especially those related to the timely prevention and detection of fraud.

This approach should provide a strong incentive for companies to create strong and independent internal audit and compliance departments.

We expect internal auditors to possess a high degree of competence and objectivity with regard to internal control, and, subject to an appropriate evaluation of those factors, the outside auditor should be able to place a high degree of reliance on the internal auditors’ work.

Finally, the standard requires that auditors should make note of the effectiveness of the corporation's audit committee, including whether the committee is independent of management.

Some commentators suggested that such a requirement would place auditors and audit committees in an untenable conflict: because an audit committee must approve the outside auditor, no auditor would dare question the committee's judgment.

There may be a conflict, but it is not untenable. In fact, auditors have to confront similar conflicts every time they must make a judgment that disagrees with management. Experienced auditors can do this.

Furthermore, longstanding frameworks for internal control make it clear that the audit committee is an integral part of the control environment and that the committee plays a vital role in monitoring a company’s internal control. In the Board’s view, any evaluation of internal control would be incomplete without a review of the audit committee.

Again, we carefully assessed the comments on these and other portions of the proposed standards for audits of internal control. And we think the standard today accomplishes what Congress and the American public expect of us.

You may be wondering why, after many satisfying years in the private and public sectors, that I would take on the chairmanship of a fledgling organization with such a huge amount of work ahead of it. I was amenable for a lot of reasons, not the least of which was a Jesuit upbringing that rendered me incapable of refusing public service.

I took this job because of the opportunity to make a difference, to do my part to help restore some of the confidence that people lost in our markets and our public companies. Yes, the PCAOB is going to require more work than I intended to be doing at this stage of my life, but the opportunity was undeniable.

In the wake of Enron and Arthur Andersen, the participants in our public markets were weighed and found wanting, but they were also given a shot at redemption. As Chairman of the PCAOB, my goal is to point accounting firms toward redemption, and help them take the steps to get there, if they aren’t inclined to seek redemption on their own.

What's at stake for all of us is the trust of the American people in our markets and the companies that drive our economy. We have an opportunity to reclaim that trust. I, for one, am delighted to grab that opportunity. I hope you will join me.

Thank you. 

 

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