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 The First 500 Days

DATE May 18, 2004
SPEAKER(S): Daniel L. Goelzer, Board Member
EVENT: New York Society of Security Analysts Financial Reporting Conference
LOCATION: New York, NY

[Highlights]

Thanks. It’s a pleasure to be here.

A little less than 500 days ago, the doors opened for the first workday at the Public Company Accounting Oversight Board.

On that first day, the Board was truly a start-up. With only a handful of people on-board, there were plenty of wide open spaces on the two floors we had just leased at 1666 K Street in downtown Washington. The phones weren’t connected. The post office hadn’t found us yet. And, ironically, the doors we opened on that first day lead into the offices Arthur Andersen had recently vacated.

A lot has happened in the past 17 months. The Board now has about 190 employees and is well on its way to filling those two floors. In addition to Washington, we have opened four regional offices. More importantly, we have taken a series of key steps that lay the foundation for the Board’s statutory mission of restoring investor confidence in audited financial reports.

I want to give you an overview of what we have accomplished so far and what our priorities are for the next 500 days. Analysts, as users of audited financial statements, are the intended beneficiaries of our work. I hope that you will conclude that we are meeting the goals that Congress has laid out for us.

Before I begin, I should note that the views I express are my own, and not necessarily those of the Board’s other members or staff.

I. The Board’s Mandate -- Rebuilding Public Confidence

The creation of the Board was one of the key reforms Congress enacted in the wake of Enron, WorldCom, Tyco, and a series of other financial reporting scandals that rocked the securities markets and shook public confidence during the last several years.

The Sarbanes-Oxley Act says that the Board’s mission is to oversee the audits of public companies, to protect the interests of investors, and to further the public interest in the preparation of informative, accurate, and independent audit reports. The birth of the Board signaled the end of voluntary self-regulation of the auditing profession and the beginning of compulsory, independent oversight.

Protecting the interests of investors is, of course, also the mission of the Securities and Exchange Commission, and the Board operates under SEC oversight. However, the Board is a private, not-for-profit corporation, and not part of the government.

The Board has five full-time members, who are appointed by the SEC, after consultation with the Chairman of the Board of Governors of the Federal Reserve System and the Secretary of the Treasury. While the SEC must approve the Board’s rules and standards before they can take effect, our job is to make our own, independent decisions.

The Board is funded by assessments levied against public companies. Those assessments are based on market capitalization. We are also the collection agent for the FASB, which uses the same kind of assessment formula. We have a budget of about $103 million for 2004.

II. What has the Board Accomplished?

In order for the Board to accomplish its mission, Congress charged it with four primary responsibilities:

  • Registering accounting firms that audit U.S. public companies.
  • Inspecting registered accounting firms.
  • Establishing auditing, quality control, ethics, independence, and other professional standards for accounting firms that audit public companies.
  • Conducting investigations and bringing disciplinary proceedings against registered accounting firms and associated persons for possible violations of law or professional standards.

Much of our efforts in our first 500 days have been devoted to hiring staff and creating an organizational structure that will support our mission and foster the long-term success of the organization. The Board has organized principally along functional lines. We have three major operating units:

  • The Division of Registration and Inspection supports the Board’s registration and inspection functions.
  • The Office of Chief Auditor and Professional Standards advises the Board on standard-setting.
  • The Office of Investigations and Enforcement investigates possible violations of law or professional standards and makes recommendations to the Board regarding disciplinary actions against accounting firms and associated persons.

In addition to these major units, the Board also has several critical support offices, including:

  • The Office of General Counsel, which serves as the Board’s chief legal advisor.
  • The Office of Public Affairs and the Office of Government Relations, which together coordinate the Board’s efforts to communicate its mission to the public, Congress, and other constituencies.
  • The Office of Information Technology, which is responsible for creating the technology infrastructure that supports the Board’s programs, including the flagship web-based registration system and the systems that aid the inspection staff in identifying and analyzing risks in financial reporting and auditing.
  • The Office of Internal Oversight and Performance Assurance, which conducts internal examinations of the Board’s programs and operations to help ensure efficiency, integrity and effectiveness of those programs and operations.
  • The Office of Financial and Risk Analysis, which will develop risk assessment models to enable the Board to be proactive in addressing developing audit trends and practices within the profession.

Besides hiring staff and putting an organizational structure in place, the Board’s time and effort during the past 17 months have been devoted chiefly to three tasks -- registering accounting firms, launching an inspection program, and establishing auditing standards. I want to touch on what the Board has accomplished in each area.

A. Registration of Public Accounting Firms.

Since October 22, 2003, it has been illegal for any U.S.-based accounting firm to issue an audit report with respect to an SEC-reporting company unless the firm is registered with the Board. Non-U.S. firms that engage in this type of activity have until July 19, 2004 to register. Registration is important because it is the basis for the Board’s authority over the profession -- such as requiring compliance with Board auditing standards and conducting inspections.

Enabling firms to register by October 22, 2003 required designing, testing and implementing a sophisticated registration system. During the first months of the Board’s existence, we proposed and adopted registration rules, which were approved by the SEC on July 16, 2003. Our Office of Information Technology built from the ground up a completely new proprietary, web-based registration system. Within days of SEC approval of the Board’s registration rules, the Board turned the switch on that system and was accepting registration applications.

The registration staff processed and the Board reviewed hundreds of applications during the Fall, and by December 31, 2003, the Board had approved 735 of them. Registration is not automatic. In the review process, each registration application is carefully scrutinized, and those with such things in their background as failed AICPA peer reviews, disciplinary proceedings against firm principals, or unusually high ratios of SEC clients to CPAs employed at the firm were individually considered and discussed by the Board. To grant approval, the Board must determine that registering the applicant is consistent with the Board’s responsibilities to protect investors and to further the public interest in the preparation of informative, fair, and independent audit reports.

Today, more than 840 firms are registered with the Board. Four of those firms -- the so-called Big Four -- audit over 78 percent of all public companies and nearly 99 percent of public company sales revenue. There are an additional four U.S. firms (and two Canadian firms) that have at least 100 audit clients that are SEC registrants. The great majority of the remaining registered firms have fewer than 10 public company clients, and about 150 registrants have none at all.

A list of registered firms is on the Board’s Web site at www.pcaobus.org. In addition to the registration process, firms will eventually be subject to annual reporting requirements. Therefore, Board filings are potentially a fascinating new source of public information concerning the auditors of America’s public companies.

B. 2003 Limited Procedure Inspections.

Once a firm is registered, it is subject to Board inspection. In the case of the ten firms that audit more than 100 public companies, these inspections must be annual. For the other registered firms that have at least one SEC client, inspections will take place at least once every three years. The Board also has the authority to conduct special inspections as is necessary or appropriate to address issues that come to the Board’s attention. Performing inspections will be the most resource-intensive Board activity. Once we are fully staffed, roughly half of the Board’s personnel will be engaged in inspections.

Although the regular inspection cycle will begin this year, we launched our inspection program in 2003 with “limited procedure” inspections of the Big Four firms. The focus of these first-year inspections was on both how the largest firms conducted selected audit engagements and on what I call their “professionalism” -- including the “tone at the top” that management seeks to infuse into the organization, how partners are compensated and promoted, how the firm internally inspects its own practice, and similar matters. The Board’s inspectors also looked at how these firms performed some selected audit engagements.

The Board’s inspection teams are comprised of senior auditors, who have an average of 12 years of auditing experience. These teams are led by either an Associate Director or a Deputy Director of the Board’s Division of Registration and Inspection, who are former partner-level employees of the major accounting firms and have an average of 22 years of auditing experience. The Board’s ability to implement meaningful and robust inspections is a direct reflection of its inspections teams’ high caliber and significant experience.

A couple of points may be of special interest concerning the 2003 inspection process--

  • As part of reviewing audit engagements during inspections, the Board looked at how the auditors made tough calls on the application of accounting principles in client financial statements. Thus, inspections may affect both auditors and, indirectly, their clients.
  • The inspection teams interviewed audit committee chairs to assess the accounting firm’s relationship and communications with the committee. These interviews, usually conducted by telephone, have focused on such matters as the frequency and nature of discussion between the auditor and the audit committee; the audit committee’s expectations and evaluation of the auditor; and auditor communications regarding critical accounting judgments, including revenue recognition policies and related party transactions.

At the end of each inspection, the Board will issue a report of its findings, and within the next few months, the Board will issue inspection reports describing the results of the 2003 Big Four inspections. However, the Act prohibits the Board from disclosing criticisms of a firm’s quality controls, unless the firm fails to correct those deficiencies within 12 months. There is likely to be considerable interest in the reports. Avid readers are likely to include audit committees that must make decisions regarding the hiring or retention of the inspected firm.

C. Auditing Standards.

In addition to registering and inspecting audit firms, Congress charged the Board with establishing the auditing and other professional standards that govern public company audits. Before Sarbanes-Oxley, that task was the province of the accounting profession itself, acting primarily through the Auditing Standards Board of the American Institute of Certified Public Accountants. Now the Board has this responsibility.

One of the Board’s first decisions was that it would not exercise its authority under the Sarbanes-Oxley Act to designate or recognize any professional group of accountants to propose auditing and related professional practice standards that govern U.S. public company audits. Instead, we chose to form a staff of expert accountants to develop auditing and related professional practice standards. We recruited a team of highly-regarded and talented professionals with a variety of backgrounds, including academia, professional practice, and government to form our standard-setting group. This team will manage the Board’s standard-setting mission. For the first time, the individuals developing auditing standards will have access to robust empirical and anecdotal evidence from the inspections and enforcement activities to set priorities and identify the need to develop or amend standards.

The Board has already embarked on implementing an aggressive agenda for the Board that is aimed at shoring up auditing standards and restoring investor confidence in the reliability of public company financial statements.

First, we adopted interim auditing standards. In effect, the Board adopted generally accepted auditing standards as they existed on April 16, 2003 as standards of the Board. At the same time, the Board announced that it would review all of the interim standards and would determine, standard by standard, whether they should be modified, repealed, or made permanent. This will, of course, be a long-term project.

Second, the Board has also adopted two new auditing standards and proposed a third.

  • PCAOB Auditing Standard No. 1 will require the auditor’s opinion to refer to the Board’s authority. Instead of the familiar statement in the opinion that the audit was conducted in accordance with generally accepted auditing standards, future audit opinions will say that the review was conducted in accordance with the standards of the PCAOB. The SEC approved PCAOB Auditing Standard No. 1 on May 14 and it will take effect on May 24.
  • PCAOB Auditing Standard No. 2 governs the auditor’s review of internal control over financial reporting. Section 404 of the Sarbanes-Oxley Act, and the SEC rules implementing it, require management to issue annually a report on the effectiveness of the company’s internal control over financial reporting. The company’s outside auditor must, in turn, report on management’s conclusions. Sections 103 and 404 direct the Board to adopt standards telling the auditor how it should conduct this review.

    The internal control review standard is one of the most critical and far-reaching auditing standards the Board will ever adopt. Public internal control reporting will mark a sea-change in the auditor’s responsibilities. PCAOB Auditing Standard No. 2 is now being reviewed by the SEC, which has solicited public comment. I expect the SEC to approve the standard in mid-June.

  • PCAOB Auditing Standard No. 3 has been proposed but not yet finally adopted by the Board. This standard will govern audit documentation. Under that proposal, work papers must contain enough information so that an experienced auditor, having no previous connection with the engagement, can understand the work performed, who performed it and when, and the basis for the conclusions reached.

III. Challenges Facing the Board in 2004

While a lot was accomplished in the first 500 days, there is much more to do in order for the Board to fulfill the objectives Congress has laid out. How will the Board go about bolstering investor confidence in audited financial reporting? A complete catalog of the Board’s agenda would run well into the afternoon. I would like to touch on just four critical areas.

A. Cross-Border Auditing.

One problem we will have to solve in 2004 is developing workable ways of overseeing an auditing profession that is multi-national in scope. The Board’s responsibilities are not limited to U.S.-based companies and auditors. Congress charged the Board with oversight of all auditors, wherever they are located, that audit or participate in the audit of SEC-registered companies.

This presents the Board with a number of thorny legal and practical problems. To solve them, we intend to cooperate with non-U.S. accounting regulators in a way that respects their authority, but that also permits the Board to discharge its inspection and enforcement responsibilities in the case of auditors outside the U.S. Last year, the Board proposed rules under which it would rely on the work of foreign regulators based on a “sliding scale” that takes into account the similarities and differences between the foreign regulator and the Board. During 2004, the Board will have to address the issues raised in the comments on that proposal and begin the process of registering non-U.S. auditors

B. 2004 Inspection Program.

A second major challenge that will occupy the Board’s time and attention during 2004 will be scaling up the inspection program.

Having just completed the 2003 limited inspections, the Board’s staff must start the process over and perform full inspections of the four largest firms. In addition, we will inspect an additional 150 or so firms. Those firms vary widely in their size and sophistication -- and in the size and sophistication of their SEC clients. This will truly be a Herculean task -- even for the 90 or so highly experienced auditors that we hope to have on the inspection staff this year.

The fieldwork for these 2004 inspections will be conducted from approximately May to October 2004. We will focus on efforts to detect fraud, the adequacy of documentation, the evaluation of firm risk assessments, and compliance with professional auditing and accounting standards. We also expect to continue our focus on “tone at the top” and other professionalism issues that were the subject of limited procedures in 2003.

C. Standard Setting.

The third 2004 challenge is to build a program for setting auditing standards that will have the confidence of issuers, investors, and the accounting profession, but will also be flexible and nimble enough to respond rapidly to emerging issues.

The key to this goal will be the Board’s Standing Advisory Group -- or the SAG. The Board recently announced the appointment of a 30-person advisory group to assist it in standard setting. The SAG members include practicing auditors, financial statement preparers, and investors. The Board received over 170 SAG nominations, including many prominent and highly experienced people. The SAG will convene its first meeting this June.

The SAG will have its work cut out for it. As I mentioned earlier, the Board has already announced that it will review all existing auditing standards. Further, while the Board has made significant strides its first year in crafting a process for setting standards, it still faces a challenging future agenda. The Board, its staff and the SAG expect to discuss certain of the following standards in the upcoming year:

  • Communications and relations with audit committees -- to incorporate requirements mandated under the Sarbanes-Oxley Act into the audit and related professional practice standards.
  • Reasonable assurance -- to examine and reevaluate the level of assurance that the auditor should provide in a financial statement audit.
  • Quality control and independence standards, which Congress specifically addressed in the Sarbanes-Oxley Act.
  • A rethinking of the principles of auditor independence and how they apply to particular non-audit services, such as tax services, in the post-Sarbanes-Oxley environment.

D. Enforcement.

The final 2004 challenge I want to mention is the establishment of a vigorous and credible investigation and enforcement program.

I believe that many of the auditing problems the Board identifies will be dealt with through a combination of inspection reports and standard setting. However, inevitably, situations will arise in which those tools are inadequate. There will be cases in which there are serious violations of Board standards or the securities laws by auditors under our jurisdiction. In those cases, the Board will not hesitate to act through its power to conduct investigations and to seek disciplinary sanctions, which can include fines, and suspensions and bars from auditing public companies.

In September 2003, the Board laid the groundwork for it enforcement program by adopting detailed rules to govern the investigatory and disciplinary processes. These rules draw from the procedural rules of the SEC, the National Association of Securities Dealers, and the federal district courts. The Board believes that it has created a solid platform for a fair adjudication process.

Earlier this month, another key building block was put in place: Claudius Modesti began work as the Board’s Enforcement Director. He has experience as an attorney in the Enforcement Division of the SEC and as a financial fraud prosecutor in the U.S. Attorneys office in the Eastern District of Virginia. Claudius has a reputation as a “no-nonsense” enforcer. There will, I suspect, be no shortage of matters for him to turn his attention to at the Board.

While the Board’s disciplinary authority extends only to accountants, our inspections and investigations will also affect public companies. Obviously, in order to determine whether the auditor did his or her job properly, it will often be necessary to review the audit client’s records and possibly to talk to its personnel. In practice, therefore, our investigations may often look at both the public company’s financial reporting and its auditor’s work. Congress anticipated this. The Sarbanes-Oxley Act provides that the SEC can issue subpoenas to public companies and their employees to compel them to cooperate with Board inquiries. At the end of a Board investigation, we will take any necessary action against the accountants. We will turn our findings regarding the company’s financial reporting over to the SEC.

IV. Conclusion

The year 2003 was a busy one for the PCAOB. However, to paraphrase Winston Churchill, we are only at the end of the beginning. Much remains to be done, and 2004 holds some formidable challenges.

I would like to conclude with a point I mentioned at the beginning. Analysts, as users of audited financial statements, are the primary intended beneficiaries of our work. While the details of how audits are conducted may be of only limited interest to those outside of the profession, the results are of great interest. If investors, both professional and individual, don’t have confidence in audit financial statements, one of the basic premises on which people are willing to commit their capital to the markets is lost. And, there is, I think, little doubt that, over the last several years, that basic trust has been severely strained.

For that reason, I hope that each of you will feel that you have a real stake in our success. We want suggestions and comments from financial statement users. We need your support, and we need you to tell us when we are on track and when are off. Through public meetings, roundtables, comment periods, and our speaking at conferences like this, the Board is trying to be as open and transparent as possible. We want to hear from you.

Thank you. I would be happy to answer any questions.

Highlights from the First 500 Days

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2003

 
January 9
Board holds first public meeting and adopts Bylaws
March 4 Board proposes registration rules
March 13
Board proposes rules on accounting support fee
March 31
Board holds roundtable on oversight of foreign accounting
firms
April 16
Board adopts rules on accounting support fee; Board adopts interim auditing and related professional practice standards, effective April 16, 2003; Board proposes rule on advisory groups; Board proposes Ethics Code
April 23
Board adopts registration rules; Board approves a budget of $68 million for fiscal year 2003
April 25
Board amends Bylaws; SEC approves Board’s interim auditing and related professional practice standards; SEC determines that the Board has the capacity to carry out its responsibilities under the Sarbanes-Oxley Act
May 21
SEC approves William J. McDonough as Chairman of the PCAOB
June 30
Board adopts Ethics Code; Board adopts rules on compliance with auditing standards and advisory groups
July 16
SEC approves Board’s registration rules
July 17
Board launches registration system
July 23
SEC approves Board’s Bylaws
July 28
Board proposes rules on investigations and adjudications, inspections, and withdrawal from registration
July 29
Board holds roundtable on internal control standard
August 1
SEC approves Board’s rules on accounting support fee and Board’s budget for fiscal year 2003
August 4
Board issues notices of 2003 accounting support fee
August 7
Registration system begins accepting registration applications
September 22
Board repays U.S. Treasury for advances made for Board’s start-up expenses
September 29
Board adopts rules on investigations and adjudications and withdrawal from registration; Board holds roundtable on audit documentation
October 7
Board adopts inspection rules; Board proposes internal control standard; Board proposes rule regarding certain terms used in auditing standards
October 31
SEC approves rules on compliance with auditing standards and advisory groups
November 6
Board solicits nominations for Standing Advisory Group
November 7
SEC approves Board’s Ethics Code
November 10
SEC approves Board’s temporary hearing rules (a subset of the Board’s rules on investigations and adjudications)
November 12
Board proposes audit documentation standard; Board proposes auditing standard on references in audit report to the PCAOB; Board proposes technical amendments to interim standard rules
November 25
Board approves a budget of $103 million for fiscal year 2004
December 9
Board proposes rules on oversight of non-U.S. firms
December 17
Board adopts auditing standard on references in audit report to the PCAOB (Auditing Standard No. 1); Board adopts technical amendments to interim standards rules
December 31
Board approves 735 registration applications by year end
 
 

2004

 
February 20
SEC approves Board’s budget for fiscal year 2004
February 23
Board issues notices of accounting support fee for fiscal year 2004
March 9
Board adopts internal control standard; Board adopts deadline extension for the registration of non-U.S. firms
April 15
Board establishes and announces membership of the Standing Advisory Group
April 28
SEC approves Board’s technical amendments to interim standards rules
May 13
SEC approves Board’s rules on withdrawal from registration
May 14
SEC approves Board’s rules on investigations and adjudications; SEC approves Board’s auditing standard on references in audit report to the PCAOB (Auditing Standard No. 1)
 

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