Remarks on Current Financial Reporting and Auditing Risks

Leventhal School of Accounting
University of Southern California

It is a real pleasure to be here at USC’s Financial Reporting Institute again this year. I have come to this conference for many years now, both as a presenter and as an attendee. I come back, as I’m sure many do, because it’s such a consistently outstanding conference – from the gracious hospitality of Bill Holder and the faculty and staff of the Leventhal School to the high quality discussion we heard this morning. I also very much appreciate that the Institute has invited PCAOB members and staff each of the years since the PCAOB’s inception in 2003 to present an update on PCAOB development and activities.

I also want to thank the PCAOB group with me today. Most of this group joined the PCAOB in its earliest days. They have unique perspectives and insights on the PCAOB’s development as well as new issues in financial reporting and auditing. I want to leave you with a few additional remarks on current policy issues from my perspective as a Board member. As the PCAOB’s Chief Auditor Tom Ray said at the outset for all of us, I am of course speaking for myself and not any of my fellow Board members or the PCAOB as a whole.

I. Recent Reforms Have Reduced Financial Reporting Risk and Resulted in Economic Benefit to the U.S., But New Risks Continue to Threaten Our Financial Reporting System.

In preparing for this conference, I looked back over my notes from previous years’ conferences and was struck by the evolution of the issues that have been discussed here. A few years ago, the focus was on the increase in the number and signficance of SEC enforcement cases, and on particular accounting and reporting problems, such as round-tripping, channel stuffing, quality of earnings, and structured transactions. With the passage of Sarbanes-Oxley, the focus shifted to implementation issues related to the reforms, such as what to expect from inspections of audit firms and SEC and PCAOB requirements on internal control. In more recent years, the focus has shifted again, to concerns about the burdens of regulation, and whether the United States is losing its seat as the financial leader in the world.

To my mind, the reforms, including the much maligned Section 404 of Sarbanes-Oxley, were an important catalyst to reevaluate financial reporting risk. This reevaluation reflected a lower tolerance for financial reporting risk, as demonstrated by the restatement trend, with restatements increasing during 404 implementation and since 2005 dropping substantially for the accelerated filers once the new tolerance level was achieved. Lower financial reporting risk reduces the risk of investor loss, which in turn reduces the cost of capital. As research led by Bill Kinney of the University of Texas has shown, when companies report they have corrected a previously reported material weakness in internal control over financial reporting, their cost of capital goes down on average 1.5 percent.[1]

This is an important point. A lower cost of capital allows companies to undertake new projects, which leads to more jobs and thus helps the economy overall. That is, not only do strong securities laws and enforcement protect the retirement and other savings of investors in U.S. securities, but they also increase employment by fostering more new development projects.

Based on this evidence, I would like to stand here today and say, "Mission Accomplished." It would be satisfying personally, given the effort I and my colleagues have put into making the reforms a success. But it would not be a fair statement. Despite these improvements, there are still risks facing our financial reporting system, including new risks.

First, although the reforms have generally increased the risk associated with getting caught with misleading reporting, we have not dealt with the underlying cause of the problem. As long as we have individuals and companies that are incentivized to go the limits of, and beyond, our accounting standards and reporting rules, we will have problems with financial reporting. We need to look no further than the current sub-prime problems to see how strong the effect of incentives can be.

Second, the most readily available response to novel or aggressive accounting is disclosure. But unfortunately, we don’t do disclosure well. Disclosure is probably the weakest part of our financial reporting system. It is often treated as being less important than the numbers. And in any event it is usually most opaque in areas where it is most important.

Third, the risk related to reporting incentives could be intensified by current policy proposals ostensibly intended to attract foreign companies to list on U.S. exchanges. In my view, we should have serious doubts about whether such initiatives will benefit U.S. investors, companies that list in the U.S., or the U.S. economy as a whole. As Paul Volcker recently said, "competition in regulatory laxity cannot be a tolerable approach."[2] On the accounting side, these initiatives would give companies more discretion, when we haven’t yet figured out to how to manage the discretion that currently exists in our system. On the auditing side, they would defer to local regulation, undermining the primary benefit to investors and companies when companies list here. Unfortunately, these initiatives appear to be proceeding with undue haste.

II. The PCAOB’s Proposal to Place "Full Reliance" on Inspections of Non-U.S. Auditor Oversight Bodies Is Likely to Reduce Economic Benefits Both in the U.S. and Abroad.

One of the proposals comes from the PCAOB. Specifically, in December 2007, the PCAOB proposed a new policy on inspections of non-U.S. firms, which among other things would allow the Board to place “full reliance” on inspections by non-U.S. auditor oversight bodies that meet certain criteria.[3]

As Helen mentioned, we have registered 860 non-U.S. firms from about 85 countries. Under the Board’s rules, only those firms that have actually issued an audit report within a specific time period are subject to PCAOB inspections, which is less than 300 of the 860 non-U.S. registered firms. But many of these firms are affiliates of a global accounting network and audit the largest companies in the world, presenting significant exposure to investors.

Anticipating the challenges of overseeing firms based abroad, in 2004 the PCAOB adopted rules relating to oversight of non-U.S. firms, including Rule 4012, which permits the Board to leverage the work of local regulators through joint inspections, with varying degrees of reliance based on the independence and rigor of the other regulatory systems. The PCAOB is only in the early stages of conducting those required inspections, whether joint or otherwise. But I am cautiously optimistic that joint inspections are proving to be beneficial.

I dissented from the proposal on full reliance, though, for several reasons. First, few if any countries spend as much on – or devote as much intensity of effort to – enforcement of financial reporting and auditing as the U.S. does. Variation in local enforcement intensity can dramatically affect reporting quality. Yet the proposal would effectively balkanize inspections of audits, undermining a key mechanism to enforce consistency and quality in reporting.

Moreover, I don’t believe we have adequate experience to defer so completely to the work of other oversight bodies. The PCAOB conducted 16 non-U.S. inspections in 2005[4] and only 15 more in 2006.[5] Reports on these inspections are only just now being issued. The PCAOB continued to conduct non-U.S. inspections in 2007, but none of those inspections has reached the report stage. In my view, this is not an adequate record on which to base a new policy of full reliance on other entities’ work. And even this limited experience has demonstrated there are important differences between our inspections and those of other regulators, including that other regulators face scope limitations and other challenges that the PCAOB would not countenance.

Second, to my mind the proposal is not consistent with the flexibility intended in Rule 4012. When the PCAOB conducts joint inspections with other regulators, it can manage its own work to make up for differences in intensity, scope and resources. The proposal would unnecessarily limit the PCAOB’s ability to do so going forward. In addition, ironically, the conditions set forth in the policy statement would effectively establish a model for regulation that squeezes out different policy choices.

Third, I am not comfortable with all the criteria set forth in the draft policy statement’s model for when a home country regulator should qualify for full reliance. Independence from the profession remains one of the stated principles underlying our policy. But the proposal would permit full reliance, even if only “a majority of the governing body of the non-U.S. overisight entity” were independent of the auditing profession. That is not independence. Rather, it would be a dangerous step backward, inconsistent with the lessons of our failed experience in the U.S. with self-governance of the profession.

Unfortunately, many countries still cling to a self-regulatory model. For example, the European Commission recently announced new guidance to member states on how to implement EU requirements for auditor oversight.[6] That guidance expressly provides that “[p]rofessional associations should be allowed to assist in inspections” by EU oversight bodies.[7] This is a disappointing development, which I suspect will make international cooperation more difficult and less effective.

Finally, the proposal fails to explain how non-U.S. oversight bodies could be expected to check for compliance with U.S. standards and rules, including many important reforms unique to U.S. securities, such as an internal control audit and tough auditor independence rules. It’s not realistic to think that non-U.S. authorities will have the ability or inclination to enforce such U.S. requirements. The proposal is also silent on these requirements, leaving one to wonder how, or whether, they would be enforced.

II. Conclusion

I do not doubt the benefits of global cooperation among regulators. But the PCAOB proposal on full reliance is not about cooperation. Joint inspections are cooperation. Rather, the proposal promotes non-cooperation by acquiescing to calls for non-participation.

Notwithstanding the pressure to blend with the rest of the world, we should not overlook the fundamental reasons why our financial system is different. We have the lowest cost of capital, and we have the strongest system of investor protection in the world. There’s a cost to regulating like everyone else. Lessening the rigor of our system won’t attract more companies, it will only make other countries’ markets more attractive by comparison.

More important, though, if we lessen the rigor of our system, the low cost of capital our own companies enjoy will be at risk. If capital becomes more costly, some projects will not occur, and related jobs will be forgone. Investors, which make up half of all American households, will lose too. We do not invest because we are gamblers; we invest for our retirements. If an egg breaks in a retiree’s basket, it cannot be restored. As baby boomers move into retirement, we have more at risk each year.

It’s easy to listen to the conventional wisdom today about fears that regulation may hurt American competitiveness. The evidence doesn’t support it, though, and meanwhile more real threats are building. I’ll be happy to answer any questions during the Q&A or afterward.

Endnotes

[1] See Ashbaugh-Skaife, Collins, Kinney and LaFond, The Effect of Internal Control Deficiencies on Firm Risk and Cost of Equity Capital (Feb. 2007). 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.

[2] Remarks by Paul A. Volcker at a Luncheon of the Economic Club of New York (April 8, 2008).

[3] See PCAOB Release No. 2007-011 (Dec. 5, 2007) . As a condition of full reliance, the policy would also require qualifying entities to agree to provide the Board certain information necessary for the Board to comply with its statutory responsibilities and to participate in joint inspections during a transition to full reliance. After the transition, PCAOB inspectors could periodically observe the other bodies’ inspections. But the proposed policy statement expressed an intent that our observation would be limited and that requests for work papers would be made only in exceptional circumstances.

[4] The 2005 non-U.S. inspections were all in Canada or the U.K. See PCAOB 2005 Annual Report  at 23.

[5] In 2006, the PCAOB’s non-U.S. inspections included joint inspections in Canada and the U.K. and independent inspections in five other countries that do not have auditor oversight bodies that regularly conduct inspections. See PCAOB 2006 Annual Report  at 8-9.

[6] See Commission Recommendation 2008/362/EC on External Quality Assurance for Statutory Auditors and Audit Firms Auditing Public Interest Entities ((May 6, 2008), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2008:120:0020:0024:EN:PDF .

[7] Commission Recommendation on external quality assurance for statutory auditors and audit firms auditing public interest entities: Frequently Asked Questions.