Meeting the Challenges of the Changing Global Regulatory Environment

I. Introduction

I am pleased to be here in Toronto and to be part of MRI’s annual conference. Moores Rowland brings together under one umbrella independent accounting firms from many different jurisdictions. Because of that, the people in this room have a unique perspective on the changes that are taking place around the world in your profession.[*]

In that respect, this meeting is a bit like old times for me. I spent 12 years of my career as a partner in a law firm with offices in upwards of 40 jurisdictions. Our annual meetings – perhaps like yours – afforded an opportunity to hear first-hand about the similarities and the differences we confronted as practitioners of the same profession, but in widely differing cultures. The meeting also afforded an opportunity to exhort us that, despite our different practice environments, we all needed to work together to promote the common good – an exercise that one of my partners liked to compare to trying to herd cats.

Paul Hancock asked me to make some comments about the challenges of the changing international regulatory environment. I come at these issues from the point of view of the Public Company Accounting Oversight Board, the overseer of the auditors of U.S. publicly traded companies, and that is primarily what I will talk about.

I recognize that many of you are not involved in auditing companies that file with the U.S. Securities and Exchange Commission. However, I think that the issues we face at the PCAOB have resonance for accountants that work in other parts of the profession as well. All over the world --

  • Public expectations of the learned professions, including accounting, are rising.
  • Trust that the public once had implicitly in professionals has to be re-earned.
  • The business dynamics of professional practices are changing. In a world in which mega-firms dominate, smaller practitioners are looking for ways to carve out unique niches.

I want to suggest some of the challenges that the profession and regulators like the PCAOB face in this changing environment. Of course, the views I express are solely my own, and not necessarily those of the Board, its other members, or the staff of the Public Company Accounting Oversight Board.
 

II. How Has the Environment Changed?

A. Erosion of Trust

In the United States, the challenges the profession faces, and the changes in the regulatory framework, largely revolve around the need to recapture something that accountants once had implicitly, but seem partially to have lost – the confidence of the public in their objectivity, thoroughness and professionalism.

Obviously, this is in large part a result of the fact that, beginning in the late 1990s, there were a series of high profile corporate failures and governmental investigations that called into question the integrity of public company financial reporting. However, to understand the public’s tarnished perception of accountants, the spectacular audit failures that made headlines during the past decade involving large public companies are only part of the story. Some fundamental changes also took place in the way that auditors viewed themselves. In short, auditing became more of a business and less of a profession.

In my view, three factors contributed to that shift:

  • First, the rise of non-audit, consulting, services.

    Revenues generated from audit clients for activities such as systems design, tax planning, assistance with data processing procedures, and a host of other high-margin advisory services, became increasingly important. In many cases, clients were paying their auditors more for consulting than for the financial statement audit. As a corollary, firms began to see the lower-margin audit as a foot-in-the-door to more lucrative consulting engagements.
     
  • Second, downward pressure on auditing fees.

    Firms faced considerable pressure to keep the audit fee low, or risk losing both their audit and (more profitable) non-audit relationships with clients. In a rising stock market, clients viewed the audit opinion as merely another standardized commodity to be purchased as cheaply as possible.
     
  • Third, increased reliance on more cost efficient auditing.

    The tactic of using the audit to gain entrée to other work, coupled with the difficulty in raising audit fees, meant that the costs of auditing had to be controlled. That, in turn, led to more emphasis on risk-based auditing -- the theory under which the auditor plans his or her work based on judgments about which aspects of the client’s business are the most likely sources of error or fraud. While sound in theory, this process, if not judiciously applied, can have disastrous consequences -- particularly if the underlying judgment about risk turns out to be incorrect.

As I said at the outset, my perspective is a U.S. one. Whether these kinds of changes occurred in other countries, and if they did, how that affected the public’s view of the role of the auditor, is a question that you can better answer than can I. But, it is obvious that high-profile financial reporting breakdowns have not been confined to the United States, as illustrated by Parmalat, Lernout & Hauspie, Ahold, and other cases.

B. The Sarbanes-Oxley Act

The business scandals that rocked the U.S. during the late 1990s and early 21st Century had a profound impact on the regulatory climate in which accountants live today. Congress, responding to the public outcry and falling stock prices that accompanied shaken confidence in financial reporting, enacted the Sarbanes-Oxley Act.

Outside the United States, the Act seems to often be viewed more as a deterrent to listing in the U.S. than as a model to be emulated. But, however one may view Sarbanes-Oxley -- and, in my view, it is far too early to reach meaningful conclusions -- it illustrates the high expectations that the public has for accountants and how the political system is likely to react when those expectations are disappointed.

While the Sarbanes-Oxley Act does many things, with respect to auditors, I would point to four key aspects of the law.

First, it sharply restricted the auditor’s ability to render non-audit services to audit clients. The clear message was that, as to their public audit clients, the primary business of auditors should be auditing, not business consulting. The PCAOB recently built on this list by prohibiting auditors from providing certain kinds of aggressive tax avoidance advice to audit clients.

Second, the Act made the audit committee, composed of independent members, rather than management, the focal point of auditor-client relationship. This was an attempt to deal with the ultimate conflict -- while the auditor owes duties to the public, management retains and pays the auditor. The shift of power over the auditor/client relationship to audit committees and away from management is a hallmark of Sarbanes-Oxley. It is a change that is likely to have long-term consequences that are not yet fully visible.

Third, Sarbanes-Oxley did something that was much less noticed at the time and much more noticed now: It sought to strengthen financial reporting by strengthening internal controls over financial reporting. To do this, the Act requires management to test and report on those controls and requires the auditor to render a second public opinion, in addition to the traditional opinion on the financial statements, on the effectiveness of the company’s controls. This marks a sea-change in the nature and scope of the auditor’s work.

Finally, the Sarbanes-Oxley Act ended the profession’s long tradition of self-regulation and peer review. In its place, the Sarbanes-Oxley Act created the Public Company Accounting Oversight Board.

III. The PCAOB

The Sarbanes-Oxley Act says that the Board’s mission is to oversee the auditors of public companies, protect the interests of investors, and further the public interest in the preparation of informative, accurate, and independent audit reports. While the Board was established by a federal law and is overseen by the Securities and Exchange Commission, a federal agency, the members and staff of the Board are not government employees. Instead, the Board is a congressionally chartered, private, not-for-profit corporation. This may sound like a rather technical point, but, in my view, being a private organization has a profound impact on the Board’s culture and flexibility.

Congress gave the Board four primary responsibilities -- registration, inspection, investigation, and standards-setting. I want to say a few words about where we are in accomplishing each of these responsibilities.

A. Registration

Every accounting firm, U.S.-based or foreign, that issues an audit report with respect to an SEC-reporting company, or that substantially participates in such an audit, must be registered with the Board. About 1,500 firms have registered with the Board. Roughly 900 (or 60%) are U.S. firms and the remaining 600 (or 40%) or so are foreign--including, no doubt, some in this room.

There are registered firms in 80 countries. Therefore, the way that the PCAOB carries out its mandate will affect auditing firms in every corner of the globe.

B. Inspections

Once a firm is registered, the Board must inspect its U.S. public company audit practice. For firms that audit more than 100 public companies, inspections must occur annually. For the other firms that have at least one SEC client, inspections must take place at least once every three years.

The inspection process is the key to the Board’s impact on auditing. The knowledge that, in the case of any particular audit, PCAOB inspectors, who are themselves experienced auditors but who are not “peers,” may review the work-papers and form their own judgment on how well the audit was conducted has a significant effect on how auditors do their work. In these inspections, our inspectors not only look at the way firms performed some selected audit engagements, but they also focus on firm culture and commitment, such as “tone at the top” of the firm. In my view, a well-thought-out inspection is more likely to improve the day-to-day quality of auditing than are other, blunter, tools, like disciplinary actions and civil liability.

Running an efficient and effective inspections program is the Board’s single greatest challenge. Just meeting the statutory three-year inspection cycle requirement will be a major accomplishment, given the number of registered firms. Last year, we inspected 99 firms, and this year, we will inspect over 250, including several Canadian firms.

Sheer numbers aside, the diversity of the firms and their practices complicates our task. Because of variations in firms’ size, the quality control, training, and professional development systems of registered firms vary widely. We need to make sure that our inspection program recognizes the differences between firms and fosters the widest possible range of auditor choice for public companies without compromising the protection of the public.

The other major challenge of the inspections process will affect many of you. As I said earlier, there are about 600 non-U.S. firms in 80 countries that are registered with the Board. These firms, too, must be inspected. We intend to work with home country regulators to conduct foreign inspections. Developing methodologies to make that a reality is one of the major challenges we face.

The extent to which we rely on a non-U.S. regulator depends on the Board’s assessment of the independence and rigor of the non-U.S. oversight system. In some cases, we will rely heavily on the non-U.S. body. In other cases, we will work side-by-side. And in still other cases, the PCAOB inspections staff will do all of the work related to an inspection of a non-U.S. firm. Right now, in Canada, our inspectors are working side-by-side with Canadian inspectors on inspections of several Canadian firms that audit U.S. public companies. We’re also working with our counterparts in the U.K. and hope to begin inspections there by the end of the year.

C. Enforcement

Many of the specific auditing problems the Board identifies will be dealt with through comments in inspection reports. However, inevitably, situations will arise from inspections or otherwise in which merely requiring better performance in the future is inadequate. Therefore, the Board has the authority to impose fines and to order changes in how a firm practices. In more serious cases, we can suspend or completely bar firms or individual accountants from being involved in public company auditing.

The challenge here is to know when to exercise restraint and when to be aggressive. As long as we believe that an auditing firm or an individual auditor is acting in good faith and is capable of and willing to conduct audits in accordance with the PCAOB’s standards, we will generally seek to improve practice quality by using our authority to make inspection recommendations, rather than our authority to bring disciplinary actions. For firms or individuals that seem unwilling or unable to follow the rules, we will take the harsher enforcement approach.

So far, the Board has publicly announced one enforcement case, but you can assume that a number of investigations are pending.

D. Setting Auditing Standards

The Public Company Accounting Oversight Board is unlike most other auditor oversight bodies in one respect: Congress charged the Board not just with inspecting how auditors do their work but also with establishing the auditing and other professional standards (such as quality control and ethics) that govern public company audits. This gives us the unique advantage of being able both to set the standards by which audits are conducted and to conduct inspections to see how those standards are being applied in practice. Our inspections authority also gives us the ability to spot emerging issues in auditing before they turn into problems. In fact, the Board has established a unit, the Office of Research and Analysis, tasked with anticipating trends and problems in auditing so that we can respond to them quickly.

We have already issued new standards in important areas such as audit documentation and internal control auditing and have adopted new rules governing independence and tax services. We also have several new standards in the pipeline. Possible topics include such critical matters as engagement quality review, communications with audit committees, fraud detection, and audit risk assessment. Our primary challenge in the standards-setting area is developing guidance that provides for clarity as well as flexibility in auditing public companies of different size and complexity. 

IV. The Challenges We All Face

So far, I have spoken largely about the challenges regulators face. I want to end by listing some of the challenges we all face. While I am sure that the list is long, several things stand out.

A. Adjusting to External Oversight

Auditors have traditionally been self-regulated, and inspections -- if they occurred at all -- have been peer reviews. For good or ill, that has changed in the United States and it is changing elsewhere as well. Other countries have established or are considering establishing PCAOB-like inspection bodies. The days of unfettered self-regulation are coming to an end.

This change in the regulatory climate raises a host of challenges, some of which I have already touched on. For the regulators, the challenge is to discharge their responsibilities in a way that does not turn auditing into a mechanistic, check-the-box exercise, or stifle the flexibility and reliance on judgment that have always been the hallmarks of the profession. For auditors, the task is to recognize that a corollary of the responsibilities they owe to the public is the public’s right to require they perform their work in a way that permits a second, external look. Defensive or antagonistic relations with the regulator won’t serve the professions interests in the long run.

B. Making the Auditor’s New Role in Internal Control Work

A second challenge is to adjust to the new responsibilities that have been added beyond financial statement attestation.

In the United States, Sarbanes-Oxley audits of internal control have added an important and complex new dimension to the auditor’s work. The auditor is required to develop a more complete understanding of the strengths and weaknesses of the client’s financial reporting systems than would necessarily be required in a financial statement audit. In the long run, I believe this focus on controls will profoundly strengthen the reliability of financial reporting and of public confidence.

Internal control auditing may or may not spread to other countries. In my view, however, greater auditor expectations for the reliability and integrity of the controls systems that support financial reporting will become a reality in other parts of the world. However, nothing good is free, and internal control auditing has come at a price. The auditing profession needs to redouble its efforts to ensure that it focuses on real risks, not merely on endless testing of process-level controls so that the promise of this new requirement can be achieved on a cost-effective basis.

C. Serving Small Clients Efficiently

A third challenge is to promote access to quality audit services for mid-sized and smaller clients. Two defining characteristics of the accounting profession that serves public companies in the United States are size in terms of the number of firms involved and concentration in terms of the percentage of total market capitalization served by only a handful of those firms. In fact, four accounting firms audit about 99 percent of the sales revenues of all SEC registered companies.

While size has its advantages, the structure of the profession does not always work to the benefit of smaller clients. Both data gathered in Board inspections and published figures show that the largest firms have “fired” some smaller clients in order to concentrate on clients that generate more revenue. Also, in some cases, smaller clients that remain with very large firms accuse their auditors of treating them as second class citizens.

The SEC has appointed an advisory committee to analyze the problems that smaller public companies face, and the nature of the auditor/client relationship is a focus of that group’s work. In the United States -- and, no doubt, in many other countries -- economic prosperity heavily depends on the health of smaller businesses. Making sure that these firms have access to quality services at reasonable prices should be a priority.

D. Dealing With Globalization

The final challenge is one that you are most familiar with -- dealing with a world in which businesses operate across borders and accountants must do the same. For accountants, this means finding new ways of offering services across borders, such as through associations like Moores Rowland. For regulators, it means being sensitive to the costs imposed by standards and rules that change each time a border is crossed.

At the PCAOB, we are mindful of the long term importance of bringing together U.S. and international auditing standards. It seems to me that it should be possible to agree on the fundamentals of how audits should be conducted, regardless of where the company or the auditor is based. Considerable progress is already being made on the convergence of US accounting principles and international GAAP. We support convergence efforts in the auditing area. Such efforts generally result in higher quality auditing standards throughout the world. 

V. Conclusion

I want to conclude by suggesting that, ultimately, we all 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 the public’s trust and confidence is the common denominator. Our markets and our economies are critically dependent on reliable financial information. The auditor’s role is too important not to get right.

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

Endnotes

[*] 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.