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 Lessons from Enron: The Importance of Proper Accounting Oversight 

DATE July 26, 2006 
SPEAKER(S): Daniel L. Goelzer, Board Member 
EVENT: Tokyo American Center 
LOCATION: Tokyo, Japan 

I am very pleased and honored to have the opportunity to visit Japan and to discuss the importance of proper accounting oversight with you this afternoon.  Both Japan and the United States depend for their prosperity on free and transparent securities markets.  The efficient operation of those markets rests on the financial information that companies provide to the public.  Investors’ willingness to commit their capital depends on confidence that financial statements have not been manipulated.

Accountants are critical to maintaining that confidence.   As a result of a series of financial reporting scandals in the late 1990s, the U.S. public lost some of its trust in auditing and financial reporting.   The Public Company Accounting Oversight Board -- the PCAOB -- was created to help restore investor confidence.

I would like to outline the key characteristics of the PCAOB.  I would also like to suggest some of the lessons that we have learned and some of the challenges we still face.   Many other countries, including Japan, have also rethought how they oversee accountants.  Of course, each country needs to adapt its oversight system to its unique needs and traditions.  However, I hope that our colleagues in other countries will find the U.S. experience useful as they address the same issues.
           
Before I begin, I should note that the views I express are solely my own, and not necessarily those of the Public Company Accounting Oversight Board, its other members, or the staff.

I. Erosion of Confidence and the Passage of the Sarbanes-Oxley Act

Four years ago this week, the U.S. Congress, by a nearly unanimous vote, enacted the Sarbanes-Oxley Act.  That law created the PCAOB.  I want to start with a brief review of some of the factors that caused the legislation.

It has always been recognized in the United States that auditors have important obligations to the investing public.   Many of the financial reporting failures that led to the Sarbanes-Oxley Act seemed to suggest that auditors had forgotten their obligations to the public.  Most auditors and most accounting firms performed their work responsibly and professionally.  But, during the early part of this decade, there were a series of high-profile financial reporting failures involving major companies and a large number of restatements of audited financial reports.  As a result, billions of dollars in market value disappeared.  Investor losses caused a public outcry.  The bankruptcies of Enron and WorldCom, and the collapse of Arthur Andersen, one of the world’s most prestigious auditing firms, have become symbols of that era. 

In every case in of inaccurate public company financial reporting, the question inevitably arose, "Where were the auditors and why didn’t they uncover these problems?"  Let me list three factors that, in my view, contributed to the loss of trust in auditing: 

  • First, audit firms placed increased emphasis on performing consulting services for audit clients.  

    In many cases, clients were paying their auditors more for consulting than for the financial statement audit.  As a result, the business risks to the firm of angering the client if there was a disagreement about an accounting issue during the audit became extremely high.
  • Second, there was downward pressure on auditing fees. 

    Accounting firms faced considerable pressure to keep the audit fees low.  Companies began to view the audit opinion as merely another commodity to be purchased as cheaply as possible.
  • Third, firms placed increased reliance on cost efficient auditing.

    The tactic of using the audit to gain access to additional, non-audit work, coupled with the difficulty in raising audit fees, meant that the costs of auditing had to be controlled.  That led to less emphasis on traditional substantive testing.  This approach can have disastrous consequences if the auditor’s judgments about what to test and where the greatest risks are turn out to be incorrect. 

As I mentioned a moment ago, the U.S. Congress responded to declining public confidence by passing the Sarbanes-Oxley Act. The law made four fundamental changes in the relationship between auditors and public companies. 

  • First, it sharply restricted the auditor’s ability to render consulting services to audit clients.
  • Second, it made the company’s audit committee, composed of independent directors, rather than management, responsible for hiring the auditor. 
  • Third, the Sarbanes-Oxley Act required both management and the auditor to report to the public on the effectiveness of the company’s internal control over financial reporting.
  • Finally, the new law ended the accounting profession’s long tradition of self-regulation.  In its place, the Sarbanes-Oxley Act created the Public Company Accounting Oversight Board.  

II. Key Characteristics of the Public Company Accounting Oversight Board

I want to describe the Board by listing five of its key characteristics.   

First, the Board has some features and responsibilities of a government regulatory agency, but it is not part of the U.S. government. 

  • Instead, the Board is a private, non-profit corporation.   As a result, we have more flexibility in hiring and decision-making processes than does a government agency.  
  • But, the Board is under the close oversight of a U.S. federal agency, the Securities and Exchange Commission.  The SEC appoints the Board members and must approve the Board’s annual budget, auditing standards, and other rules before they can take effect.    

Second, the PCAOB is independent of the accounting profession and the business community.  

  • The Board is not a membership organization of accountants.  In fact, the law provides that no more than two of the five Board members may be accountants.  It is also not a self-regulatory organization like the stock exchanges.  The funds needed to operate the Board come mainly from fees charged to public companies, based on their market capitalization.   

The third key characteristic of the PCAOB is its very broad inspection authority. 

  • The accountant oversight system we replaced, called “peer review”, relied on firms to inspect each other.  Peer review did not look at audits that were the subject of litigation or investigation.  In contrast, we have a full-time staff of experienced auditors to conduct our inspections. We are able to attract very talented people because Congress authorized us to offer pay and benefits that are competitive with the firms we inspect.   
  • Further, the Board uses a risk-based approach to selecting audits for review.  This means that we look at the engagements in which the firm faced difficult auditing and accounting issues.  We also focus on internal management – that is, how the firm seeks to maintain audit quality and professionalism in its practice.  That can include such things as training, the firm’s internal inspection program, partner compensation principles, and the tone and communications of its top management.  
  • At the end of each inspection, the Board must issue a public report.  However, the part of the report that criticizes, or suggests improvements in, a firm’s quality controls is not public. 

The next characteristic of the PCAOB I would like to highlight is our responsibility to set auditing standards.

  • In many countries, the job of inspecting and overseeing accounting firms and the job of setting auditing standards are performed by two separate bodies.  In contrast, the PCAOB does both.  Therefore, we are able to learn, through our inspections, how auditing standards are being applied in practice and to use that knowledge in future standard-setting.

Finally, the PCAOB has the power to take strong enforcement action against firms that violate professional standards.

  • Firms and individual accountants must take the PCAOB seriously because the Board can impose severe penalties.  Those penalties include monetary fines and suspension or expulsion from public company auditing.  But, we also have discretion as to when to bring an enforcement action and when to rely on other means to improve audit quality. 

Since opening for business in January, 2003, the Board has made considerable progress in putting these characteristics to work.  For example -- 

  • We now have over 450 employees, including approximately 200 inspectors.  Many of these inspectors are CPAs with recent public accounting experience.
  • Over 1,600 accounting firms are registered with the Board, including over 700 non-U.S. firms located in 81 countries.  Thirteen Japanese firms have registered.  The Sarbanes-Oxley Act requires us to annually inspect the nine accounting firms that audit more than 100 public companies.  Other firms must be inspected once every three years, if they are actually engaged in auditing public companies.  
  • We have conducted nearly 400 inspections and issued over 300 inspection reports, representing reviews of over 1,800 public company audits.
  • We have brought five enforcement actions.
  • We have issued four auditing standards, plus rules on auditor independence and rules governing auditor tax services for audit clients.

III. Lessons and Oversight Challenges

The PCAOB is still new and evolving.  However, some lessons are already clear.  Also, some major challenges still face us.  I would like to outline five areas in which there are both lessons and challenges.

A. Independent Oversight Strengthens Auditing

First, I think it is clear that independent oversight strengthens the auditing profession.   The knowledge that the auditor’s work on every engagement he or she performs may be reviewed in an inspection increases the care and thought that goes into that work.  It also encourages better documentation.  Even more importantly, the fact that the PCAOB may be reviewing how tough auditing and accounting issues were resolved empowers auditors to resist management pressure to go along with questionable accounting calls or to ignore warning signs that should be pursued.    

But, along with this power to strengthen auditing comes a challenge.  It is critical that we administer our inspection program in a way that respects the role of judgment.   Auditing is based heavily on the exercise of professional judgment in response to the circumstances of the audit.  The PCAOB needs to be tough on audit failure, but to recognize legitimate areas of judgment.  We do not want to encourage over-auditing or a mechanical, checklist approach.  Similarly, it is critical that our auditing standards not become overly detailed.

B. Supervisory Approach -- Incentives to Improve

Second, we have already learned that audit quality can usually best be improved by providing incentives, rather than threatening punishment.  The vast majority of auditors and accounting firms are deeply committed to professionalism and integrity.   Oversight should be a catalyst in helping firms to identify weaknesses and strengthen their practices. 

The Sarbanes-Oxley Act contains an example of this kind of incentive to improve.  The Act prohibits the Board from making public disclosure of inspection report criticisms of a firm’s quality controls, unless the firm fails to correct the deficiencies within 12 months.  This seems to be working well.   After the issuance of the Board’s first set of inspection reports, the major U.S. firms discussed candidly with the Board’s staff how they could address the concerns we had identified.  Each firm made a detailed written submission describing its efforts in areas such as audit performance, evaluation and compensation of partners, independence, acceptance and continuance of clients, and supervision of foreign affiliates.

 The Board calls this philosophy the supervisory approach.  Under that approach, as long as an auditing firm or an individual auditor is acting in good faith and is willing to conduct audits in accordance with the PCAOB’s standards, we will generally seek to improve practice quality by making inspection recommendations, rather than by taking disciplinary action. 

The challenge here is to know when to exercise restraint and when to be aggressive.  Some violations of the auditing standards are too serious to rely solely on promises to improve in the future.  We have brought enforcement actions in cases where we did not think more limited steps would work.  In those kinds of situations, the Board must take the harsher enforcement approach.  But deciding when to use inspections reports to encourage improvement and when to use enforcement to punish violations requires careful judgment.        

C. Internal Control Auditing  

The third area of lessons and challenges is internal control auditing.  This topic is one that may be of special interest, in light of the internal control reporting requirements that J-SOX would create in Japan.

I mentioned earlier that one of the things that Congress did to restore investor confidence was to require management and auditor reporting on the effectiveness of company internal control over financial reporting.  To make that new responsibility work, Congress required the PCAOB to issue an auditing standard on this new aspect of the auditor’s responsibilities.  One of the lessons we have learned is how difficult it is to balance costs and the benefits in this area.  

The good news is that internal control seems to be improving.  In 2005, nearly one in 12 public companies filed restatements and almost 16 percent of the companies subject to internal control reporting concluded that their controls were not effective.  In 2006, through May 15, that percentage had fallen to about 8 percent.  A recent study suggests that the securities markets place a premium on effective controls.  It finds increases in capital costs of about one percent for companies that report material weaknesses and comparable decreases in those costs when reported weaknesses are corrected. 

However, internal control reporting has come at a high cost.   One study has found that, in the first year of reporting, the average total cost of compliance was $8.5 million for large companies with market caps over $700 million and $1.2 million for small.   While costs fell substantially in the second year, they are still significant and may be unsustainable for smaller companies.  We do not want internal control reporting costs to drive small companies out of the securities markets.

Making sure that the benefits of internal control auditing can be achieved on a cost-effective basis is one of the greatest challenges the PCAOB faces.  

We intend to take several steps.

  • The Board has announced that it will amend its internal control auditing standard.  We want to make sure that the auditor’s work focuses on the controls that prevent or detect the highest risks of material misstatements in financial reports.  We also want the financial statement audit and the internal control audit to be integrated -- that is, performed as a single process.  We are also looking for other ways to make sure that internal control audits are as efficient as possible.
  • The Board has also announced that the 2006 inspections of large firms will focus on how firms are conducting internal control audits.  We know the inspection program is a powerful tool.  We want to make sure that we are using it to encourage auditors to do this new job effectively and efficiently.
  • We recognize that small audit firms may need training to help with the process.   The Board plans to develop guidance for auditors of small companies. 

D. The Auditor-Audit Committee Relationship

The fourth lesson we have learned is that external accounting oversight cannot be fully effective if the company itself is not committed to fair and accurate financial disclosure.  In that regard, the relationship between the company’s auditor and its independent audit committee is key.  

The PCAOB does not oversee public company audit committees.  However, the Board wants to strengthen the auditor-audit committee relationship.  We periodically hold educational forums for small company audit committee members, and we interview audit committee heads as part of our inspections in order to understand how the committee and the auditor are working together.  The inspection program also looks at the information that auditors provide to audit committees. 

E. Auditing as a Global Profession

The final lesson I would like to mention is one that was, of course, clear from the beginning.  Auditing is a global profession.  Therefore, it is critical for the Board to work with other auditor oversight bodies.  The Board recognizes that the oversight of the roughly 700 non-U.S. firms that audit SEC registered companies raise complex issues, including potential conflicts between our laws and those of other the countries. 

To address those issues, the Board will rely, to an appropriate degree, on the work of non-U.S. accounting oversight systems.  Exactly how we inspect firms in other countries will be determined in consultation with the home country regulator on a case-by-case basis.  Right now, we are working with our counterparts in many countries around the world.  Here in Japan, we have established an excellent working relationship with the CPAAOB.

Dealing with a world in which businesses and their auditors operate across borders will be a continuing challenge.  It will require us to be sensitive to how we approach our responsibilities when borders are crossed and to the sovereignty of other countries.  However, I am very optimistic about the benefits we can derive from working with other auditor oversight bodies.

IV. Conclusion

I want to conclude by suggesting that, ultimately, all of us accountants, public company officials, or regulators face the same challenge:  to foster and maintain public confidence in financial reporting.  

Those responsible for investor protection and auditor oversight in other countries may have different approaches than does the U.S., and those who practice in other countries may face different problems than do U.S. auditors.  However, for all of us building the public’s trust and confidence is the goal.  Our markets and our economies are critically dependent on reliable financial information.  Therefore, the auditor’s role is too important not to get right.

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



*/          The views expressed herein are solely those of the author and are not necessarily those of the Public Company Accounting Oversight Board or any of its other members or staff. 

 

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