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 Back to the Future 

DATE Oct. 17, 2003 
SPEAKER(S): Daniel L. Goelzer, Board Member 
EVENT: University of Wisconsin School of Business 
LOCATION: Madison, WI 

I. Introduction

Legend has it that, while preparing Richard Nixon for his historic visit to China in 1972, Henry Kissinger mentioned that Chinese Prime Minister Chou En-Lai was an avid student of French history. During his trip, Nixon met with Chou En-Lai in the walled garden of the Forbidden City. As they walked slowly around the lily ponds, Nixon remembered Kissinger's comment. To break the ice, he asked Chou what he thought had been the impact of the French revolution on western civilization. Chou En-Lai considered the question for a few moments. Finally, he turned to Nixon and replied, "The impact of the French revolution on western civilization -- too early to tell."

On July 30, 2002, there was something of a revolution in the accounting profession. On that day, President Bush signed the Sarbanes-Oxley Act of 2002. At the signing ceremony, President Bush described the new law as "the most far-reaching reform of American business practices since the time of Franklin D. Roosevelt." The Act marked the end of voluntary self-regulation of public company auditors and the beginning of formal, mandatory oversight under the auspices of the Public Company Accounting Oversight Board.

When Larry invited me to speak to you here tonight, he asked me to comment on the future of the accounting profession in light of the Sarbanes-Oxley revolution. That is a very broad subject. And, my conclusion would have to be the same as Chou's -- too early to tell. I want, however, to share a few thoughts with you this evening about some of what the future might hold for public company auditors.

Before I begin, I should note that the views I express are my own, and not necessarily those of the Board's other members or staff.

II. The Impact of the Board on the Future of the Profession

Certainly, one thing we know about the future is that it will include a new acronym -- PCAOB. Congress has charged the Board with overseeing the auditors of public companies and with restoring public confidence in the audited financial statements of those companies. So, perhaps a place to begin is with a discussion of how our work will affect the profession.

1. Registration of public accounting firms.

First, auditors of publicly traded companies will have to register with the Board.

By October 22, five days from today, all accounting firms that prepare audit reports on U.S. public companies must be registered. Foreign firms that audit U.S. public companies also must register, although their deadline is next Spring. As of last Wednesday, 584 firms had filed registration applications -- out of more than 700 domestic firms that audited at least one public company last year. A list of the applications we have granted is on the Board's Web site at www.pcaobus.org.

Registration is important for two reasons. It is the predicate for all of the Board's other authority -- such as to require compliance with Board auditing standards and to conduct inspections. In addition, registration serves a filter -- albeit a crude one -- for who should and should not be engaged in public company auditing.

2. Inspections.

Second, auditors of public companies will be subject to Board inspections.

Once a firm is registered, the Act requires the Board to inspect it. In the case of firms that audit more than 100 public companies, the Act requires annual inspections. For other accounting firms, inspections must take place at least once every three years. We have already launched our inspection program, and each of the Big Four firms will be inspected this year.

The focus of these first-year inspections will be on a series of things that might be summarized as "professionalism" -- the factors that make auditing a learned profession, rather than merely a trade. These factors include:

  • "Tone at the top."

Organizations tend to adopt the culture of their leadership. We will seek to determine what kind of philosophy concerning professionalism and commitment to the public interest the highest levels of the major firms have and are seeking to instill in the rank-and-file.

  • Partner evaluation, compensation, and promotion.

Another way of getting at an organization's values is by analyzing what behavior it rewards. For example, we would like to determine the role technical excellence and commitment as an auditor play in promotion and partner compensation decisions and how that role compares to the importance of rain-making.

  • Client acceptance and retention.

We will explore how firms decide to accept new audit clients and whether to retain existing clients. The Board will seek to learn how the major firms assess risk, and how they balance audit and reputational risk against potential revenue.

Our inspectors will also look at the way that firms performed some selected audit engagements. But, much of our focus this first year will be on firm culture and commitment, rather than on audit mechanics.

3. Professional discipline.

Third, public company auditors will be under a new disciplinary regime.

I hope that most of the Board's work will be remedial -- aimed helping firms raise their standards and strengthening their quality controls. However, when serious violations of the law or professional standards are uncovered, the Board will have to act. Board Chairman William McDonough put it this way in a speech last month to the New York State Society of CPAs:

I expect that you, as members of a regulated profession, know what the rules are. I expect that you are following those rules, both in their letter and their spirit. * * * If you depart from those expectations * * * woe be unto you. There will be consequences, and they will be grave.[1]

4. Auditing standards.

Fourth, auditing standards will be set in a new way.

The Act directs the Board to establish auditing, quality control, and ethics standards for registered public accounting firms. These tasks have traditionally been the province of the profession itself, acting through the American Institute of Certified Public Accountants' Auditing Standards Board and other bodies. Now, however, the Board will establish the professional standards that govern public company audits.

The Board has announced that, later this year, it will appoint an advisory group to assist it in standard-setting. The advisory group will be comprised of approximately 25 members selected from a variety of backgrounds, including practicing auditors, financial statement preparers, and investors. I view the advisory group as a bit of an experiment, since it may be difficult to interest non-auditors in the day-in, day-out details of auditing standards. I believe, however, that the combination of the Board's top notch professional staff and sophisticated outsiders on the advisory group will help build public confidence in the way auditing and other professional standards are set.

III. The Profession's Changing Role

As this brief review suggests, the Board's impact on the future of auditing is likely to be far-reaching. Fundamentally, however, the Board's mission is not to register firms, to conduct inspections, to set standards, or to discipline those who fail to live up to their professional obligations -- although we will certainly be doing all of those things. At the most basic level, our job is to help the profession to strengthen its capacity to furnish the service that most justifies its existence -- the ability to instill public confidence in financial reporting.

Perhaps then, in considering the profession's future, the next question to ask is what changes are occurring that will accomplish that goal. While it is indeed too early to tell, I think change is occurring in at least three areas.

1. A return to auditing for auditing's sake.

First, it is clear that auditing will once again become the primary focus -- the raison d'etre -- of public accounting firms that specialize in serving public company clients.

In the 1980s and 1990s, revenues from non-audit activities, such as systems design, tax planning, assistance with data processing, and a host of other advisory services, became increasingly important to the major firms. In many cases, clients were -- and in some cases still are -- paying their auditors more for consulting than for the financial statement audit. As a corollary, some firms began to see the audit as something akin to a loss-leader -- a foot-in-the-door to more lucrative consulting engagements. Conversely, clients began to see the audit as simply a commodity, to be purchased at the lowest possible price.

The Sarbanes-Oxley Act sought to reverse these trends. Congress believed that auditors needed to get back to auditing. The Act prohibits accountants from providing nine categories of non-audit services for public company audit clients. Services that are not on the prohibited list may still be performed, but only if approved in advance by the client's audit committee and publicly disclosed.

One area that has remained controversial is tax services. The Act does not prohibit tax services that are pre-approved by the company's audit committee. In adopting rules to implement the non-audit services prohibitions of Sarbanes-Oxley, the SEC noted that there had been considerable debate regarding whether an accountant's provision of tax services for an audit client could impair the auditor's independence. However, the SEC distinguished traditional services, such as tax compliance, tax planning, and tax advice, from the marketing of novel, tax driven, financial products.[2] The Commission's release referred favorably to the recommendation of the Conference Board's Commission on Public Trust and Private Enterprise that, as a "best practice," auditors not provide advice on "novel and debatable" tax strategies and products.[3]

The Sarbanes-Oxley Act gives the Board the authority to add to the list of prohibited non-audit services. While I have no reason to think we will be doing that in the short-term, all of the members of the Board place great emphasis on both the fact and appearance of auditor independence. In order to help us understand whether we should take further action, the Board's inspection staff is focusing on the impact of non-audit services during its inspections this year. I suspect, however, that this is an area in which audit committee reluctance to approve extensive non-audit services, including aggressive tax services, may turn out to be the best answer.

2. A role in corporate governance.

A second change which is likely to occur is that the independent auditor will increasingly be seen as, not only an expert on the application of accounting principles, but also as a source of independent advice and judgment on corporate governance practices.

Quite clearly, one of the themes of the Sarbanes-Oxley Act is the strengthened role of the audit committee in corporate governance. Audit committees are struggling with their newly-enhanced responsibilities, and auditors may be uniquely positioned to help them. The major firms deal with hundreds of audit committees and therefore have an ability few others share to compare and contrast performance and to develop expertise concerning best practices.

The Board's proposed standard on the audit of internal control builds on this idea.[4] The proposal states that an ineffective audit committee is a significant internal control deficiency and may be a material weakness. Therefore, in order for the auditor to form an opinion on the company's internal control over financial reporting, the auditor must determine whether the audit committee is effectively discharging its responsibility to oversight of the company's external financial reporting and internal control over financial reporting. The proposal lists seven specific factors that the auditor should consider in assessing audit committee effectiveness, including whether audit committee members act independently from management.

Legitimate questions can be raised about whether auditors should be expected to assess the effectiveness of the committee that has the power to retain or discharge the auditor. However, I think the more fundamental point is that the proposal illustrates that auditors are well-positioned to evaluate and monitor the governance processes related to financial reporting of their public company clients. I think clients and auditors will begin to more clearly realize this and to look to the auditor for his or her recommendations, just as they have with respect to the more traditional aspects of internal control.

3. Fraud detection and client legal compliance.

A third change is also already underway. Auditors are increasingly called upon to take responsibility for identifying illegal or fraudulent client activities that affect the financial statements and to make sure there is disclosure when the client fails to correct the problem.

While auditing standards have long dealt with illegal acts and with the detection of fraud, several things have happened during the last several years to sharpen the auditor's responsibilities in this area. Enron, WorldCom, and a series of other spectacular financial reporting frauds are, of course, the most obvious. However, two more technical developments have laid the groundwork for these new responsibilities.

First, in 1995, Congress enacted Section 10A of the Securities Exchange Act. Section 10A requires an auditor who becomes aware that an illegal act may have occurred to notify management and to ensure that the board of directors or the audit committee is adequately informed. In some circumstances, Section 10A requires the auditor to report directly to the board of directors or audit committee. And, if the likely illegal act has a material effect on the financial statements and appropriate remedial action is not taken, the audit committee or the auditor must notify the SEC.

Second, in October 2002, the AICPA issued a revised auditing standard on the detection of fraud, Statement on Auditing Standards No. 99. While SAS No. 99 did not change the auditor's basic responsibilities, it provided more detailed guidance on how to respond to risks of material fraud and more specific fraud detection procedures. SAS No. 99 was adopted by the Board as an interim standard, along with the other existing auditing standards, last April.

The inevitable questions are now being asked about how these new requirements are working in practice. A General Accounting Office report issued last month found that, in the seven and a half years since Section 10A took effect, a total of 29 reports have been filed with the SEC.[5] During that same period, the Commission brought hundreds of cases involving false financial reporting. In a recent letter to the Chairman of the SEC, John Dingell, the ranking Democrat on the House Energy and Commerce Committee, comparing those numbers, asked rhetorically, "Where are all the missing 10A reports?"[6]

A GAO report of this type and a letter emphasizing its findings are often a prelude to increased government attention to a particular area. I suspect that, during the coming months, auditor legal responsibility for fraud detection and "whistle-blowing" are likely to receive increased professional, SEC, and Board attention.

IV. Conclusion

In conclusion, the most fundamental change that I believe is likely to occur in accounting is the one I mentioned earlier -- the auditor's ability to lend confidence in financial reporting and to instill public trust will once again become the profession's stock-in-trade. This may be a case of "back to the future." The primacy of auditing and the value of trust and integrity are the original foundations of public accounting.

I also believe that the Board's aggressive implementation of the blueprint Congress laid out in the Sarbanes-Oxley Act will go a long way toward returning to those basics. Ultimately, however, rebuilding public confidence is something that the profession itself must do. I see the Board and the profession as partners, allies, in accomplishing that goal. But, we cannot wait 200 years to see whether or not we succeed. Perhaps the jury really is still out on the French revolution, as Chou En-Lai apparently thought. For the accounting profession however the future has arrived.

Thank you.

Endnotes

[1] William J. McDonough, Speech before the Foundation for Accounting Education, New York State Society of Certified Public Accountants (New York, September 9, 2003).

[2] Securities Act Release No. 8183 at ยง II.B.11 (January 28, 2003).

[3] Id. at note 112.

[4] Proposed Auditing Standard -- An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements, PCAOB Release No. 2003-017 (October 7, 2002).

[5] Review of Reporting Under Section 10A, GAO-03-982R (September 3, 2003).

[6] Letter, dated October 7, 2003, from John D. Dingell, Ranking Member, House Committee on Energy and Commerce, to William H. Donaldson, Chairman, Securities and Exchange Commission, and William J. McDonough, Chairman, Public Company Accounting Oversight Board.

 

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