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 Confronting the Challenges of Change in the World of Financial Reporting 

DATE May 4, 2006 
SPEAKER(S): Charles D. Niemeier, Board Member 
EVENT: Baruch College 5th Annual Financial Reporting Conference 
LOCATION: New York, NY 

Thank you for that kind introduction. It is very much my pleasure to join you for the third time in the five years you have put on this conference. I come back, as I’m sure many do, because you and Baruch put on such a consistently outstanding conference – from the gracious hospitality of the staff of the Zicklin Center to the high quality dialogue we’ve heard all morning. For my part of this dialogue, my remarks today are solely my own views. I am not speaking for my fellow Board members or the PCAOB as a whole.

In preparing for the conference today, I reflected on the dramatic changes we’ve witnessed in our financial reporting system, just in the five years since this conference first convened. Of course, in the first year, the issue on everyone’s mind was the rapid loss of investor confidence in the accuracy of public company reporting, and later that year the Congress responded with the most wide-ranging securities reform bill since 1934 – the Sarbanes-Oxley Act of 2002.

Since 2002, investor confidence has been steadily rebuilding. As a member of the PCAOB, I am honored to have been a part of the effort to rebuild public confidence in audits of public companies.

I. Introduction to the PCAOB

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. We did not know at the outset how many firms would register with the PCAOB. But when the Board developed its registration system, we carefully structured the system so as not to erect unintended barriers to entry into the market to offer public company auditing services.

There were approximately 750 U.S. firms associated with the profession’s self-regulatory system before the PCAOB was established, so when we surpassed that number, we felt we’d succeeded in our objective to establish an open and fair process. In addition, I have been pleasantly surprised that 700 registered firms are in countries outside the U.S., reflecting the global nature of auditing and financial reporting today.

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. Most small U.S. firms must be inspected by the end of 2007[1].

Our inspections 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, this incentive system has been immensely successful: when we identify problems, firms take our criticisms seriously and make substantial changes within a year.

No one could question that the establishment of the PCAOB as an independent regulator supervising public company auditors has imposed great change on auditors. This was, of course, Congress’s intent when it enacted the Sarbanes-Oxley Act.

The PCAOB has also played a central role in another recent change in our financial reporting system. That is, the Act’s requirements that corporate managements publicly assess their companies’ internal control over financial reporting as well as subject those internal control systems to external audit. These requirements are widely known as “Section 404.” The PCAOB’s role has been to establish the standards for and oversee auditors’ performance of attestations on the effectiveness of companies’ internal control.

II. Challenges and Benefits of Adjusting to Change

These changes, like many changes imposed on business culture before them, have presented significant adjustment challenges. To give you some comfort that these challenges are worth confronting, I’d like to recount for you the history of another era’s momentous regulatory change. Notwithstanding the distance in time, I think you will find many similarities to our own debate.

More than a hundred years ago, the only connection that a family living on a farm in America had with the world beyond the farm was through the mail. And for that matter, mail was not delivered to their homes, but to the nearest post office, which could be even a full day’s travel away. That all changed in the early 1900’s because of a program called rural free delivery (“RFD”) by which mail carriers delivered mail directly to farms.

I am reminded of RFD, because in its day it was about as controversial as Section 404 is now. Although the Postmaster General established funds to start the program in 1893, it took years for the program to be implemented because subsequent Postmasters simply sat on the funds. Critics of the program argued feverishly that RFD was too costly and would bankrupt the country. Supporters of the program pressed on nonetheless.

Once the program was finally in place, instead of bankrupting the country, RFD prompted explosive growth in our economy. RFD connected for the first time stores and manufacturers with the rural community, and businesses such as Sears & Roebuck burst into American homes and local businesses.

Rural Free Delivery also stimulated the development of our system of roads and highways. In part in order to facilitate mail delivery, local communities invested large sums of money into the road systems. This was a costly endeavor, but as a result parts of America that were previously not readily accessible became accessible, paving the way (literally) for another important cultural change – the automobile. In spite of its controversial beginnings, rural free delivery ultimately served as an important catalyst for cultural and social change for millions of Americans, the benefits of which we still experience today.

III. Internal Control Reporting

Today, I want to talk about an issue of importance in our own era – internal control and the new reporting and auditing requirements related to it. While we are still in the early stages of implementing the new internal control requirements, there have already been many surveys about the costs, which according to any account have been significant. Like RFD, though, the ultimate question is whether the benefits justify those costs. I believe they will, and there is encouraging empirical research that supports this notion.

A. Measurable Benefits are Already Appearing

1. Research Shows Stronger ICFR Lowers Companies’ Cost of Capital and Makes Financial Reporting More Reliable

Research published in August 2005 shows that effective internal control is positively correlated with accurate financial reporting. For example, companies with material weaknesses in internal control tend to have lower quality accruals, as measured by the extent to which accruals are realized as cash flows.[3] That means, in practical terms, amounts claimed on a balance sheet as estimated unrealized future cash flows in or out of a company are less likely to be right – or reliable – if the company does not have effective internal control. As Alan Greenspan once said, “capital employed on the basis of misinformation is likely to be capital misused.” [4]

A higher level of investor confidence in the reliability of financial reporting in turn leads to lower cost of capital for those companies that have investors’ confidence. Just this month, a team of researchers led by Bill Kinney of the University of Texas reported on their findings that disclosures about the reliability of internal control have a significant effect on companies’ cost of capital.[5] Specifically, they found that when companies report they have corrected a previously reported material weakness in internal control, their cost of capital goes down on average 1.5 percent. Conversely, when companies report material weaknesses in audited financial reports after they had previously reported in unaudited statements that internal control was effective, their cost of capital goes up on average almost 1 percent (93 basis points).

2. There are Measurable Improvements in the Quality of Internal Control Reporting After ICFR Audits

Now, companies may have effective ICFR without management yearly assessing it, and auditors yearly attesting to it. But, on an overall basis, we also now know that material weaknesses tend not to be reported (perhaps because they are not discovered) until internal control is audited. Under Section 302 of the Sarbanes-Oxley Act, companies have been required to self-report on internal control since 2002. Nevertheless, only 1 in 12 companies with ineffective Section 404 controls self-reported ineffective 302 controls in the prior year.[6]

3. Companies Have Significantly Improved Internal Control and Financial Reporting After Only Two Years

With this improved reliability of internal control reporting, we have also seen internal control itself improve. Many companies have reported on the effectiveness of their internal control for two years. As of March 31, 2006, 3,710 separate companies filed ICFR assessments and audit opinions with the SEC for their first year of internal control reporting. Of those disclosures, 591 – or approximately 15.9 percent – contained an audit opinion that ICFR was not effective.[7] So far in the second year of implementation, that percentage has fallen to 6.7 percent.[8]

This is not surprising. Consistent with the adage “what gets measured gets done,” companies who now have to report material weaknesses appear to be correcting them so as not to have to report such weaknesses on a recurring basis. And these are the weaknesses we know about. Under the PCAOB’s auditing standard, significant deficiencies that do not rise to the level of being a material weakness are reported to companies’ audit committees. Behind the scenes, companies are resolving these deficiencies as well, so that they do not grow into material weaknesses.

At the same time that companies have been identifying and resolving material weaknesses in their internal control, they have also been correcting material misstatements in financial statements identified in the process as well. Indeed, the number of restatements issued by public companies in 2005 reached a record level. Approximately 1 in 12 public companies restated their financial statements in 2005 to correct material errors in the current or prior periods.[9] This is a very positive sign that companies are getting their accounting on the right path.

B. Costs of Audited Internal Control Reporting Are Already Declining and Have Not Impaired the Competitive Advantage of U.S. Markets

Like the economic benefits of the rural free delivery system, the improvements in our financial reporting system have required significant cost. Estimates have varied, but one thing that is clear is that they have declined significantly after the first year of implementation of management’s and the auditor’s requirements.[10]

There are various reasons for the size of the initial investment and the subsequent decline in costs. For example, as the PCAOB reported in November 2005, many companies faced significant deferred maintenance costs in the first year.[11] In addition, the regulatory deadline for filing the first management assessments and accompanying audit reports with the SEC was fairly short, and the crunch was seriously compounded by the lack of trained professionals – both in-house and at audit firms – available to do the necessary work.[12]

Some have claimed that the work required to achieve the Act’s internal control reporting objectives has encouraged any company that can get out of the requirements to do so. As evidence, they point to the number of large new IPOs choosing to list on non-U.S. markets as well as the growth in the London Stock Exchange’s Alternative Investment Market for smaller companies.

To my mind, the facts confirm the continued competitive advantage of U.S. markets because of the significant valuation premium for companies that can meet the requirements of U.S. listings. As the Head of Nasdaq’s International Listings office has said, “The key reasons companies are still coming to the U.S. remain the same. International listing activity is still driven by U.S. valuations.”[13] The New York Stock Exchange has estimated this valuation premium at 30 percent. [14]

To be sure, stock exchanges’ marketing efforts have become global, and companies around the world now enjoy listing options not available even in the recent past. For example, the top five IPOs last year were privatizations of state-owned entities in China and France. Not surprisingly, those companies listed on the local Hong Kong and Euronext markets, respectively. Notwithstanding the significant valuation premium in the U.S., the political, cultural and other influences on such companies to list locally will continue, requiring U.S. investors to invest directly abroad if they want to purchase securities of formerly state-owned Chinese and other entities. I do not believe that sacrificing disclosure and governance quality requirements could attract these companies, but it would likely significantly reduce the U.S. valuation premium for all other companies listing in the U.S.

With respect to the LSE’s AIM market, as of December 2005, only 270 of its 2,220 listed companies were domiciled outside the U.K.[15] And, in 2005, only 19 U.S. companies listed on the AIM market.[16] I’m not aware of any study of whether such companies could have listed in the U.S., but anecdotally we know that small U.S. companies tend to see the AIM market as an alternative to private financing as opposed to an IPO on a U.S. public capital market. [17]

C. ICFR Audits Can and Should Be Efficient

Just because we have high quality investor protection standards does not mean investors should pay for such standards at any cost. However great the benefits of internal control are, we should do what we can to minimize their cost.

For this reason, last May, after the first year of implementation of the Act’s internal control requirements and spurred by Chairman Bill McDonough’s leadership, the PCAOB issued guidance specifically developed to make ICFR audits as efficient as possible.[18]

We also found, in our inspections and other monitoring, certain areas in which auditors should be able to make their audits more effective and efficient in the future, and we reported our findings on November 30, deliberately ahead of the second-year audit season, in order that firms could benefit from additional guidance on efficient approaches we identified.[19]

The Board continues to focus on ways to make internal control auditing as cost-effective as possible, and to that end we will be holding a roundtable discussion on second-year experiences next week.

1. Audit Guidance on ICFR in Small Companies Could Help Ease Implementation Burdens on Small Companies

I am also very interested in recent private-sector initiatives to develop case studies and tailored guidance for small public companies’ management assessments and independent audits of ICFR. Both companies and their auditors need practical, real-life examples to follow in achieving the objectives of the Act’s internal control requirements in a manner well-suited for their size.

To my mind, one of the most important things the PCAOB can do to help auditors of small companies prepare for Section 404 is to develop or facilitate development of clear, practical guidance on tailoring audits of internal control to fit the needs and limited resources of small public companies. Based on the experience of small companies and auditors who have been – and are currently going – through the process of establishing and evaluating internal control, this guidance could provide firms a selection of examples of how the ICFR audit process can be scaled to fit the relative sizes of other small companies, from those that are on the cusp of accelerated filer status down to those that have merely a handful of employees. I have no doubt that with constructive, practical guidance, and with enough time and regulatory support, small companies and their investors will be able to reap benefits from good internal control that justify their efforts.

2. PCAOB Inspections Can Improve Efficiency in ICFR Auditing

Another step the PCAOB is taking to continue to drive efficiencies into internal control auditing is an enhanced focus in our 2006 inspections on promoting efficiency. This week, the PCAOB announced the start of its 2006 inspection cycle and described in detail its program for inspecting ICFR audits.[20]

As the Board reported last November, our work with firms involved in the first year of implementing the new internal control requirements resulted in some significant changes in firm methodologies. These changes, together with the natural benefit of more experience in both companies and firms in the second year, have resulted in significant cost reductions already. I am interested to hear examples and additional suggestions of ways to improve the effectiveness and efficiency of internal control audits at next week’s roundtable discussion.

IV. Preparing for the Next Generation of Financial Reporting Challenges

While we at the PCAOB have focused much of our attention on implementing the Act’s internal control requirements, none of us can ignore the fact that the world has not stood still to wait for companies and auditors to make the transition needed to comply with the new SEC and PCAOB rules. Indeed, problems in financial reporting present themselves much like moso bamboo plants. For five years, these plants do not appear to grow at all, and then after five years they grow explosively, sometimes a foot and a half a day. What people don’t see is that during the first five years the plants are developing a vast root system that is incredibly strong by the time they begin to show growth.

In the financial reporting world, usually by the time we figure out there is a problem, the problem’s roots are already well-developed – witness the recent dotcom boom and bust, in which investors poured their funds into companies that had shown little ability to make money. Once the boom took hold, other, more traditional, companies too got caught up in the promise of dotcoms’ claims of double-digit growth. By the time the investing public realized that these promises were elusive, the system that allowed the unfulfilled claims was well-developed – in the form of “hot” IPOs based on pro forma, non-GAAP earnings statements.

The two panels you’ve teed up for this afternoon – on fair value accounting, pensions and leases – take on some of the most pressing accounting and auditing issues we face today. While today’s focus on ICFR implementation challenges is understandable and appropriate, I am concerned that we not lose sight of the fact that we face many other important issues like these as well. We need to do more to anticipate problems in their early stages. So, in that regard, I commend the Financial Accounting Standards Board for considering these important issues as part of its overall agenda.

These are issues that could shake the confidence that investors have in our financial reporting system. For example, fair value accounting presents certain challenges as we move away from financial information based on historical cost that may be more readily verifiable. This is not to disregard the fact that fair value may be more relevant to investors, but it is important that we also consider whether and how auditors can assure such information, in order to maintain investor confidence as we move to a new financial reporting model.

Fortunately, unlike the days of the dotcom boom, today the Sarbanes-Oxley reforms – serving as our own moso bamboo plant – establish a strong root system that provides investors significant protection, and I believe those protections will help regulators and others as the financial reporting model evolves. That is, the difference between today and the pre-Sarbanes-Oxley world is that today effective ICFR requires companies to focus on building measurement methodologies that are fair and free of bias. In addition, our inspections go a long way toward identifying situations in which auditors give in to management bias.

This is considerably more protection than investors had previously and, I hope, will allow regulators, companies, auditors, researchers and others time and information to build the new financial reporting model in the manner that best serves investors. Thank you.


[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.

[2] In 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; 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.

[3] Doyle, Ge and McVay, Accruals Quality and Internal Control Over Financial Reporting (August 2005).

[4] Remarks by Federal Reserve Board Chairman Alan Greenspan at the 2002 Financial Markets Conference of the Federal Reserve Bank of Atlanta, Sea Island, Georgia (via satellite) May 3, 2002, available at http://www.federalreserve.gov/boarddocs/speeches/2002/20020503/ default.htm.

[5] See Ashbaugh-Skaife, Collins, Kinney and LaFond, The Effect of Internal Control Deficiencies on Firm Risk and Cost of Equity Capital (April 2006). In addition, the researchers found that companies with the lowest expected probability of reporting internal control problems – i.e., companies that investors expected to have better internal control – exhibit a greater cost of capital increase (125 basis points on average) when they reported internal control problems, than companies that investors anticipated had internal control problems (49 basis points on average). This indicates that, even before internal control reporting became required, companies with poor internal control were paying more for access to capital than they would if they had effective internal control.

[6] The Lord & Benoit Report: Bridging the Sarbanes-Oxley Disclosure Controls Gap (March 2006), available at
http://www.sec.gov/rules/other/265-23/rbenoit8977.pdf . Nine out of every 10 companies with ineffective Section 404 controls self reported ineffective 302 controls in the same period end that an adverse Section 404 was reported.

[7] See Audit Analytics, Section 404 Internal Control Material Weakness Dashboard: Results for the First Full Year of Section 404 Disclosures Based on Filings as of March 29, 2006 (“First Year Dashboard”).

[8] See Audit Analytics, Section 404 Internal Control Material Weakness Dashboard: Results for the Second Full Year of Section 404 Disclosures Based on Filings as of April 15, 2006, at 4 (“Second Year Dashboard”). Even taking into consideration likely material weakness disclosures by companies that have missed their filing deadline in 2006, the rate of material weakness disclosures is not expected to rise above 10 percent.

[9] See Glass Lewis & Co., Getting it Wrong the First Time, March 2, 2006, at 1.

[10] See CRA International, Sarbanes-Oxley Section 404 Costs and Implementation Issues: Spring 2006 Survey Update (available at http://www.s-oxinternalcontrolinfo.com/), reporting that total 404 costs, including internal costs, third party costs and fees for the internal control audit, declined 43.9 percent for a statistically valid sample of Fortune 1000 companies, and 30.7 percent for companies with market capitalization ranging from $75 million to $700 million. Of the total 404 costs in year two, CRA’s Spring 2006 Survey Update reported that internal control audit fees declined an average of 22.3 percent for the Fortune 1000 companies and 20.6 percent for the smaller companies.

[11] PCAOB Release No. 2005-023 , Report on the Initial Implementation of Auditing Standard No. 2, November 30, 2005 ("November 30 Report"), available at http://www.pcaous.org.

[12] Id.

[13] Remarks of Charlotte Crosswell, Head of International Listings, NASDAQ, printed in Ernst & Young, Accelerated Growth: Global IPO Trends 2006, at 24.

[14] Remarks of Noreen Culhane, Executive Vice President, Global Corporate Client Group, New York Stock Exchange, id. at 26 (An "underlying motivation for most companies listing in the U.S. is the valuation premium (average 30 percent) that accrues as a result of adhering to high standards of governance.").

[15] See http://www.londonstockexchange.com/en-gb/products/companyservices/ourmarkets/ aim/;

See also http://www.londonstockexchange.com/en-gb/products/companyservices/our markets/aim/aimus.htm (“In 2005, the London Stock Exchange attracted a record 19 companies from the US to AIM, raising a combined total of $2,126 million. There are now a total of 29 companies from the US quoted on AIM.”).

[16] Institutional Investor, While Graham at AIM Bets on Growth, April 17, 2006.

[17] See “Small U.S. Firms Take AIM in London,” Wall Street Journal, April 17, 2006, at C5.

[18] PCAOB Release No. 2005-009 , Policy Statement Regarding Implementation of Auditing Standard No. 2, May 16, 2005, available at http://www.pcaobus.org.

[19] November 30 Report.

[20] See PCAOB Release No. 104-2006-105 , Statement Regarding the Public Company Accounting Oversight Board’s Approach to Inspections of Internal Control Audits in the 2006 Inspections Cycle, May 1, 2006, available at http://www.pcaobus.org.

 

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