Application of the "Failure to Supervise" Provision of the Sarbanes-Oxley Act of 2002 and Solicitation of Comment on Rulemaking Concepts

The Release the Board is issuing today addresses two critically important objectives. The first is to remind auditors that the Board has the authority and will use it to take disciplinary action against a registered public accounting firm or its supervisory personnel, under the circumstances described in the release, for a failure to supervise. The second objective addressed in the Board's Release is to solicit comment on specific concepts for developing a rulemaking proposal that could lead to firms documenting the supervision responsibilities related to each audit, from the first line supervisor for each part of an audit all the way to the responsibilities of the managing partner of the firm.

There are, unfortunately, plenty of reasons to believe auditors may need a reminder of the Board's disciplinary authority in this area. For the protection of investors, firms and their associated persons need to be vigilant about meeting their supervision responsibilities. Particularly in the current environment where auditors on a daily basis seek to identify and address the risks of misstatements in financial statements, enhanced and more attentive supervision should result in improved audits and fewer audit failures. Appropriate supervision of firm personnel is one of the essential ingredients for an audit practice to perform engagements in accordance with PCAOB standards and rules, and other applicable law.

Since coming to the Board, I have been struck by the volume of supervisory concerns brought to our attention by our Inspections Division. For example, in the Board's December 2008 Report on Large Firm Inspections, the Board identified "inadequate supervision and review" as an important factor that allowed audit deficiencies to occur.[1] In addition to questions about the supervision and review activities of engagement managers and partners,[2] the Board identified supervision and accountability related concerns in several other areas, including partner evaluation and compensation processes,[3] concurring review policies and procedures,[4] internal inspection programs[5] and the evaluation, supervision and control of work performed by foreign affiliates.[6]

Specifically, the Board's large firm inspection report noted, in various findings:

  • Certain deficiencies raised questions about the sufficiency, rigor, and effectiveness of the supervision and review activities of engagement managers and partners, including the thoroughness with which they reviewed audit documentation. In some cases, it appeared that the engagement partners had not devoted sufficient attention to their responsibilities, or their commitment to engagements did not appear to correlate with the risk that the engagements presented. Certain of the deficiencies described above were in areas that required management's most difficult or complex judgments, and thus were in areas where the partners and managers should be devoting significant attention.[7]

The Report goes on:

  • Inspection teams identified instances where firms failed to appropriately evaluate …, supervise, and control the work performed by their foreign affiliates on the foreign operations of U.S. issuers. The deficiencies included failing to (a) resolve findings or matters identified by the foreign affiliates, and (b) obtain the required information from one or more foreign affiliates.[8]

More recently, our staff issued a practice alert that, among other things, noted situations in which it appeared that registered public accounting firms used the work of assistants engaged from outside the firm (including assistants located in another country) without complying with the PCAOB standards applicable to supervising those assistants.[9] The amendments we are adopting today to the standards governing auditor assessment and response to risk reflect some of these same concerns.[10]

Because of our findings and concerns related to inadequate supervision of audit engagements, the Board is considering whether to propose rules that would complement our disciplinary authority by requiring firms to document their assignment of supervisory responsibility, at all levels of the firm, related to audits.

In developing such a rulemaking proposal, we should keep in mind what the provisions in the Sarbanes-Oxley Act concerning "supervision" were designed to achieve.

At the very first hearing before the Senate Banking, Housing and Urban Affairs Committee on February 12, 2002, on what later became known as the Sarbanes-Oxley Act, former SEC Chairman Richard Breeden suggested that regulators adopt duties for accounting firms to supervise the conduct of their audit professionals in a manner parallel to the express duty to supervise that broker-dealers have for their personnel. This duty to supervise is a very effective tool in overseeing brokerage firms, and it creates accountability for providing oversight that works.[11]

Other witnesses gave similar testimony about the importance of supervision standards.[12] The drafters of the Sarbanes-Oxley Act accepted these suggestions and borrowed extensively from the provisions governing broker-dealer supervision in the Securities Exchange Act of 1934.

A key feature of the broker-dealer model of supervision is that accountability for supervision extends all the way to the top of the firm. As Professor John Coffee explained at a meeting of the Board's Standing Advisory Group ("SAG"), on February 27, 2008, "final responsibility for proper supervision rests with the firm's president or chief executive," which creates incentives for senior executives to minimize their own liability by making sure they have qualified compliance and supervisory personnel in place and by responding appropriately to red flags that suggest misconduct may be occurring.

At the same SAG meeting, Barbara Roper, Director of Investor Protection for the Consumer Federation of America noted:

I think it is absolutely clear, from the context in which this came up in the Sarbanes-Oxley discussion, that it was the intention to create a more robust system than existed at the time, and that that system was intended to include accountability all the way up to the top of the firm. … One of the frustrations at the time — was …the inability to hold people at the top of the chain accountable for problems that had occurred on their watch.[13]

As these Congressional witnesses and SAG discussions suggested, the drafters of the Sarbanes-Oxley Act looked to the broker-dealer model of supervision. The drafters understood how effective this kind of accountability could be in keeping all levels of management personnel of registered public accounting firms consistently focused on their responsibilities to protect investors and to serve the public interest through the performance of high quality audits. The drafters, therefore, stated clearly in the law that supervisory personnel are accountable for failing reasonably to supervise the firm's associated persons as required by the Board's rules relating to auditing or quality control standards, or otherwise.

The text and legislative history of the Act, the comments made at the Board's February 2008 Standing Advisory Group discussion, together with the Board's numerous inspection findings and other experiences to date, as noted for example in the Large Firm Inspection Report, confirm that there are good reasons for the Board to explain and use its disciplinary authority and to promulgate supervision rules that would reinforce accountability at all management levels of registered public accounting firms.

There is no question in my mind that the drafters of Section 105(c)(6) of the Sarbanes-Oxley Act of 2002 contemplated rulemaking in this area and I hope that the Board acts expeditiously to clarify who within a firm is accountable for various supervisory responsibilities that bear on the quality of the firm's audits.

I am pleased to vote in favor of this Release, view it as a much needed, welcome first step, and look forward to considering the comments.

I know that a number of offices were involved in working on this release but I would like to particularly acknowledge the contributions of Michael Stevenson, Mark Kaprelian, Claudius Modesti, Bella Rivshin and Carole Yanofsky.


[1] PCAOB, Report on the PCAOB's 2004, 2005, 2006, and 2007 Inspections of Domestic Annually Inspected Firms, PCAOB Release No. 2008-008 at 20 (December 5, 2008)

[2] Id.

[3] Id. at 21.

[4] Id. at 20.

[5] Id. at 22.

[6] Id. at 23.

[7] Id. at 20.

[8] Id. at 23.

[9] PCAOB Staff Audit Practice Alert No. 6, Auditor Considerations Regarding Using The Work Of Other Auditors And Engaging Assistants From Outside The Firm (July 12, 2010).

[10] See PCAOB, Auditing Standards Related To The Auditor's Assessment Of And Response To Risk And Related Amendments To PCAOB Standards, PCAOB Release No. 2010-xxx (xxxx xx, 2010), proposed Auditing Standard No. 10 and the Note added by amendment to AU § 543.01.

[11] Legislative History, The Sarbanes Oxley Act of 2002, Hearings Volumes 1 & 2, at 66.

[12] See Testimony of Professor Joel Seligman, Id. at 533, 579 ("Particularly in firms with as many offices as the leading public accounting firms, a clearly delineated supervision standard strikes me as vital to effective law compliance."); Testimony of Bevis Longstreth, Id. at 800 ("Of particular importance in achieving wide-spread compliance with the rules of professional conduct is the power of both the SEC and the SRO to discipline either or both the supervisory personnel and the firm for a failure to supervise employees who misbehave. To avoid sanction the firm must have in place procedures to deter and detect rule violations and a system for the effective implementation of those procedures. It is hard to exaggerate the importance of this "duty to supervise" in respect of its prophylactic effects.").

[13] SAG transcript, February 27, 2008, p. 130