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 Third International Conference on Global Capital Markets and Corporate Governance

DATE May 31, 2012
SPEAKER(S): Steven B. Harris, Board Member
EVENT: National Council on Corporate Governance
LOCATION: Moscow, Russia

Good Afternoon. Thank you for that introduction.

As mentioned, I am a Board Member of the Public Company Accounting Oversight Board (PCAOB) in the United States and, at the outset, I must state that the views that I express today are my own and do not necessarily reflect those of other PCAOB Board members or staff.

Regulatory oversight of auditors is a global trend and I will be commenting on that later but, to begin, I have been asked to briefly give you a bit of background about the PCAOB and then outline a few of the issues currently on the Board's agenda.

Background of the PCAOB

The Public Company Accounting Oversight Board was created by the Sarbanes-Oxley Act in 2002 as a direct result of a series of scandals in the United States in which major corporations were found to have been making extensive false statements about their revenues and earnings and using complex transactions to hide their true financial position from investors, regulators and the public marketplace. You may have heard of the names of some of these companies - such as Waste Management, Enron, Tyco and WorldCom.

Investors lost billions of dollars, and tens of thousands of employees at these companies lost their jobs.

People who believed that investing in, or working at, a major, well-known company would provide an opportunity for building a safe fund for retirement, or to pay for a home, or for their children's education, saw their savings disappear almost overnight.

What the Sarbanes-Oxley Act Does

The stated purpose of the Sarbanes-Oxley Act is "to protect investors by improving the accuracy and reliability of corporate disclosures" and the PCAOB was established "to protect the interest of investors... in the preparation of informative, accurate and independent audit reports..."

Investor protection is the primary objective of our securities laws and, hence, of U.S. market regulators. It is generally recognized in the U.S. that we cannot have a vibrant, competitive financial market without honest accounting and financial reporting.

One cannot overstate the importance of the auditing profession to the capital markets. In the United States, under our securities laws, to raise money from the public, or to have securities listed on an exchange or registered with our securities regulator, the Securities and Exchange Commission, a company does not have to have to hire a lawyer or even an underwriter, but it must hire an independent public accountant to audit its financial statements.

While the Sarbanes-Oxley Act deals with corporate transparency and accountability, it also addresses conflicts of interests within:

  • the accounting profession,
  • the corporate community, and
  • the investment banking industry.

Specifically, to deal with conflicts in the accounting profession, the Act eliminated the old system where auditors regulated themselves and established the Public Company Accounting Oversight Board. The Board was given the mandate to register public company auditors, set the rules for those auditors, "audit" or inspect the auditors and, when necessary, discipline the auditors.

The Act also addressed the conflict that may arise between an auditing firm's responsibility to serve investors when providing a skeptical and unbiased audit, and the auditing firm's responsibility to serve audit clients when performing non-audit services, by prohibiting auditors from performing certain consulting services for their audit clients.

Conflicts of interests within the corporate community were curtailed by requiring that listed companies have independent audit committee members and that companies have management certifications related to the contents of their annual and periodic reports filed with the Securities and Exchange Commission.

Furthermore, the Sarbanes-Oxley Act addressed the conflicts of interests between stock analysts and their investment banking divisions by requiring that U.S. stock exchanges adopt rules prohibiting the kinds of collaboration between the two groups that might compromise the integrity of stock analysts' reports to their clients.

Corporate Governance Provisions in Sarbanes-Oxley

The collapse of Enron and WorldCom and other public companies in the United States also raised concerns that boards of directors were not exercising sufficient oversight of companies' financial reporting. In short, corporate governance needed to be improved.

As a result, the Sarbanes-Oxley Act changed public company corporate governance in a number of fundamental respects. Among other things:

  • It made independent audit committees of listed companies responsible for the appointment, compensation, and oversight of public companies' auditors, and required auditors to report directly to those audit committees. To make this requirement work, it defined what independence meant, mandated that only independent directors could sit on the audit committees, and gave the committees authority to hire their own independent advisors. And it required that at least one member of the audit committee be a financial expert.
  • It required that CEOs and CFOs certify the appropriateness of financial statements and that those financial statements accurately present the company's operations and financial condition;
  • It required management assessments and auditor reports on the effectiveness of the company's internal controls over financial reporting;
  • It barred attempts by officers or directors to influence the conduct of an audit;
  • It required CEOs and CFOs to forfeit any bonuses or incentive, or stock-based compensation (and profits therefrom) received in the first twelve months after issuance of a document that is later required to be restated because of material noncompliance as a result of misconduct; and
  • It restricted the loans that public companies can make to officers and directors.

Ten Years Later

Since 2002, the U.S. audit regulatory regime, the PCAOB, has grown from a start-up organization to more than 700 employees today. More than 2,500 auditing firms are registered with the Board and, last year alone, the staff inspected portions of more than 825 audits.

Unfortunately, the number of concerns raised by our inspection staff is on the increase, and we are seeing a troubling rise in the volume of significant audit deficiencies in important areas. These include auditing internal controls, inventory, revenue and expense recognition, valuation of goodwill, and fair value measurements. The increase in findings may be due to added complexity in financial reporting, or it may be that we are improving our inspections approach. Either way, our findings confirm that improvements in the auditing of financial statements are still needed.

While initially the Sarbanes-Oxley Act was viewed as addressing issues strictly at American companies, clearly the problems were not restricted to just the United States as witnessed by the financial reporting failures of companies throughout many other parts of the world, including Parmalat, Vivendi, Hollinger, Ahold, Royal Dutch Shell, China Aviation and others.

Today, more than 40 countries and jurisdictions have adopted similar systems to oversee and regulate auditors and, while some of those systems differ in structure and approach from ours, the goal is the same - to improve audit quality for the protection of investors. U.S. law requires the PCAOB to conduct periodic inspections of all firms that are listed on American exchanges and, to date, the PCAOB has conducted inspections of over 190 non-U.S. audit firms located in 38 foreign jurisdictions. Many of those inspections were conducted jointly with the local oversight authority.

Protection of Investors

With our mission to protect the interests of investors in mind, the PCAOB established an Investor Advisory Group in 2009. Worldwide, a similar investor group has been established at the International Forum of Independent Audit Regulators (IFIAR). IFIAR is an organization consisting of 43 independent audit oversight bodies who share the common goal of improving audit quality globally. I chair both of these investor advisory groups and they serve to provide both the PCAOB and the members of IFIAR with investors' views on areas of concern with respect to financial reporting and related auditing practices.

Largely as a result of the financial crisis, investor representatives from around the world are currently asking regulators to consider, among other issues:

  • The role, relevancy and value of the audit;
  • How to improve auditor independence, objectivity and professional skepticism in the context of an issuer pay model - where the corporation pays the auditor to conduct its own audit;
  • How to make the audit report more informative and user friendly;
  • Whether to clarify the standards governing auditors' evaluations of a company's ability to continue as a going concern, particularly in light of the number of companies that either failed or received government assistance shortly after receiving clean opinions from their auditors;
  • The regulatory gap in the oversight of the large firm global networks;
  • And, maybe most fundamentally, who is the primary client of the auditor - the investor, management, or the audit committee.

Each of these are highly challenging questions with regulators, the profession and investors alike seeking solutions, while recognizing that the status quo is not an option.

The PCAOB has undertaken initiatives in a number of these areas and is also actively considering recommendations relating to, among other things: additional transparency about engagement partners and audit firms involved in an audit; expanded communication requirements to audit committees of significant information obtained by the auditor during the course of the audit; and greater focus by auditors regarding related party transactions.

Finally, since this is an international forum, I would note the progress that has been made with respect to cooperation on the international front among regulatory regimes that oversee the auditing profession. Given the global nature of the capital markets, the PCAOB is committed to cooperation on cross-border oversight, which is critical to the improvement of audit quality. The PCAOB has signed cooperative agreements with its counterparts in 13 non-U.S. jurisdictions - including jurisdictions in Europe, Asia and the Middle East. We are working to conclude additional cooperative agreements in the near future.

The recently enacted Dodd-Frank legislation in the United States now permits the sharing of confidential inspection information with our international counterparts, and there is cooperation on a wide variety of additional fronts.

For example, IFIAR issued a press release after its plenary meeting in Busan, Korea this past April. As stated in the release, "IFIAR Members provided an update on inspection findings in their jurisdictions. Areas were identified where findings were common to a number of jurisdictions.... Examples of frequently identified issues found during inspections include[d] matters relating to:

  • Auditors' professional skepticism;
  • Group audits;
  • Revenue recognition;
  • Engagement quality control review;
  • Testing of internal controls;
  • Auditing accounting estimates;
  • The linkage of audit quality to partner remuneration;
  • Auditor independence;
  • The use of auditor's experts; and
  • Applying clarified International Standards on Auditing."

These findings demonstrate how much work needs to be done to improve audit quality and how important it is that the cooperation and sharing of information among audit regulators continue.

Again, thank you for inviting me. I am happy to discuss any of the PCAOB's initiatives and answer any questions during the panel discussion throughout the afternoon.

 

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