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 The Future of Government Involvement in Public Accounting

DATE Oct. 20, 2011
SPEAKER(S): Steven B. Harris, Board Member
EVENT: Utah State University 35th Annual Accounting Conference
LOCATION: Logan, UT

Thank you for that introduction, Jared, and thank you, Ken, for inviting me to address your "Partners in Business 35th Annual Accounting Conference" here at Utah State University.

The topic of "The Future of Government Involvement in Public Accounting" is certainly timely given that next year will mark the tenth anniversary of the enactment of the Sarbanes-Oxley Act — an Act designed "To protect the interest of investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws."

Before considering what lies ahead it might be helpful to take a brief look back at what led to the need for government involvement in public accounting in the first place.

Before I begin, as a matter of policy, I should inform you that the views I express today are my own and do not necessarily reflect the views of the other Board Members or the staff of the PCAOB.

I would also like to take a moment to commend those of you in the audience who are accounting students for your career choice. The accounting and auditing profession is indispensible to the functioning of our capital markets and our economy.

Congress clearly recognized the importance of the auditing profession when it enacted the Securities Acts in 1933 and 1934 and, again in 2002, when it passed the Sarbanes-Oxley Act. Under those laws, auditors are the only professionals that a company must hire to sell its securities in the United States or to have its securities listed on an exchange. There is no requirement to hire an attorney, or even an underwriter, but it must hire an independent auditor that is registered with the PCAOB. For those of you who are accountants, your profession clearly plays a unique role in the operation of our securities markets.

In the United States, over half of all households invests in publicly traded companies — whether through direct investments in companies' securities or through a variety of other investment vehicles. Investors rely on the assurances provided by independent auditors that financial statements fairly present the financial positions of public companies. A loss of investor confidence in the integrity of financial statements or in the audit process would reduce the efficiency of the markets and add unnecessary costs to the capital formation process used by thousands of American companies to raise the funds needed to build their businesses and create jobs.

It is reassuring to see so many accounting students preparing to enter the profession that plays such a vital role in our capital markets.

History Leading up to the Passage of the Sarbanes-Oxley Act

In considering the future role of the government in public accounting, it is useful to ask why it was necessary, after almost seventy years of self-regulation, for the government to establish an independent regulator for audit firms. Most would say that the need for auditor oversight stemmed from the accounting profession's apparent failure in serving the franchise given to it by the government. Let me explain.

As I mentioned, a fundamental principle of the federal securities laws is that, in order to sell securities to the public, companies must file comprehensive financial statements with the Securities and Exchange Commission (SEC) that have been audited by an independent public accountant. In enacting the securities laws with independent auditor requirements, Congress gave the auditing profession a unique franchise that ensured public companies would hire them to perform professional services. That government-mandated franchise also gave the profession unique responsibilities to protect investors and to place the public's interests above their own financial or personal interests.

The Supreme Court confirmed this responsibility to the public when it said in United States v. Arthur Young that:

By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.[1]

This requirement to have an independent auditor certify the financial statements of every publicly traded company has provided public accountants with a steady multi-billion dollar audit business. Last year alone accounting firms reported audit fees of $9 billion, with 92 percent of those fees going to the largest four accounting firms.

In 2002, I was the Staff Director and Chief Counsel for Senate Banking Committee Chairman, Senator Paul Sarbanes. As the Committee worked on the legislation that would become the Sarbanes-Oxley Act, we learned of many cases where accounting firms failed to live up to their public responsibility to provide independent assurance about the reliability of management's financial statements.

A small sample of these cases includes, in the 1970s, the Penn Central bankruptcy, the revelations of massive financial statement frauds at Equity Funding and Continental Vending, and the discovery of hundreds of prominent companies with "slush-funds" that were used for paying bribes and other illegal purposes.

In the 1980s, government agencies alleged that accounting firms issued clean opinions on the financial statements of savings and loan institutions despite knowing of financial and accounting problems within those institutions. There were also other front-page auditing scandals, such as the collapse of E.S.M., where an auditor allegedly took a bribe not to disclose that the company had cooked its books and the case of ZZZZ Best, whose independent accountants failed to identify imaginary profits in its financial statements.

The 1990s in turn saw earnings management cases resulting in SEC enforcement actions against companies such as Cendant and Sunbeam. There also were restatements by such well-known companies as Xerox.

And finally, as everyone here is aware, the early 2000s had numerous blow-ups, including Tyco, Adelphia, Peregrine Systems, Global Crossing, and, of course, Enron, and WorldCom — all without any real warning from auditors.

Literally billions in earnings and assets were restated due to accounting errors and irregularities. These failures translated into staggering lost savings for investors and lost jobs and pensions for many American families — making it clear to the Congress that auditor self-regulation had failed.

The failure of Enron and its auditor, Arthur Andersen, is particularly illustrative of how the profession had changed over the years since the Securities Acts were first passed. Andersen himself (who headed the firm from 1913-1947) was known as "a stickler for honesty", arguing that "accountants' responsibilities was to investors, not their clients' management." During the early years, it is reputed that an executive from a local rail utility approached Andersen to sign off on accounts containing flawed accounting or else face the loss of a major client. Andersen refused in no uncertain terms, replying that there was "not enough money in the city of Chicago" to make him do it. It was his firm, however, many years later that audited companies with some of the most noteworthy financial frauds — Enron, WorldCom, Waste Management, and others. Andersen certainly was not the only firm to experience failures during this time frame, but comparing Mr. Andersen's statements with the alleged actions of his firm at Enron and WorldCom some fifty years later raises questions about how the culture and goals of the profession had evolved over time.

To some, the erosion of the auditing profession's "public watchdog" function correlated with auditors becoming too close — some would say cozy — with their clients in order to win profitable consulting and advisory contracts. The SEC found that the major accounting firms' aggregate fees from auditing services had shrunk from 70 percent of their revenues in 1977, to only 30 percent in 2000. Clearly, prior to the Sarbanes-Oxley Act, non-audit services had taken over as the major source of revenues at the firms.

By the time Enron and WorldCom imploded, in drafting the Sarbanes-Oxley Act, Congress was able to draw on numerous inquiries and testimony from hearings on accounting and auditing issues in both the House and Senate over the previous 25 years.

The Act has 59 sections. As a whole, they strengthen auditors' independence from their audit clients, clarify the reporting responsibilities of public companies and their management and audit committees, enhance the quality of financial disclosures, limit analysts' conflicts of interest, and stiffen penalties for corporate fraud and white-collar crimes.

One of the primary purposes of that Act, though, was to remind auditors that their duty under the law is to serve, first and foremost, the interests of investors — not management. The centerpiece of the Act is the end of self-regulation of the auditing profession and the establishment of the PCAOB. The Act specifically established the Board "to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports."

Responsibilities and Accomplishments of the PCAOB

With a mandate to protect the interests of investors, The Act directs the PCAOB to:

  • Register accounting firms;
  • Establish auditing standards;
  • Conduct periodic inspections of registered accounting firms;
  • Conduct investigations of possible violations by auditors; and
  • Conduct disciplinary proceedings and impose appropriate disciplinary sanctions.

In other words, the PCAOB registers the auditors, sets the rules for the auditors, "audits" the auditors, and, when necessary, disciplines the auditors. From my perspective as someone who was involved in crafting the Act, the PCAOB has achieved an impressive record of accomplishments in response to this directive.

As of the end of September, there were 2,407 auditing firms registered with the PCAOB, including 905 foreign firms. We have conducted over 1,600 inspections, and have issued approximately 1,500 inspection reports.

In the area of standard-setting, since 2003, the PCAOB has issued numerous new auditing standards, including standards related to auditing internal controls and several risk assessment standards, designed to clarify and strengthen the requirements for auditors to assess and respond to the risks of material misstatements in financial statements through planning, supervising and evaluating the results of an audit.

The staff has also issued several audit alerts that provide guidance on current auditing issues, such as audit risks in emerging markets and audit considerations during the economic recession. With respect to the financial crisis, the alert highlighted the need for auditors to focus on, among other things, fair value measurements, accounting estimates, adequacy of disclosures and the company's ability to continue as a going concern. Another alert issued earlier this month addressed the need for heightened awareness of risks of fraud when performing audits of companies with operations in emerging markets.

With respect to enforcement activities, by statute, most of what the PCAOB does in the enforcement area remains confidential. However, our proceedings so far have addressed a broad range of audit issues, including a firm's failure to assure that audits are staffed appropriately; an auditor's failure to act when confronted with evidence of illegal acts by a client; and an auditor's failure to be independent from his audit client.

Since the enforcement division was established in 2004, the Board has authorized approximately 80 formal investigations and settled 38 disciplinary orders. Disciplinary actions to date have included revocations of registrations, and barring of individuals from working within the profession. The Board's largest settlement so far was with Deloitte & Touche LLP in 2007 for violations of auditing standards during a 2003 audit and included a $1 million civil money penalty.

The Board is currently considering new auditing standards in the areas of modernizing the auditor's report; enhancing auditor independence, objectivity and skepticism; and improving transparency. I will go into more of the details of these initiatives a little later in my remarks.

A measure of the PCAOB's success since the passage of the Sarbanes-Oxley Act is that governments around the world have also adopted measures to oversee and regulate auditors. Over 30 countries and jurisdictions have embraced our system of auditor oversight since 2003. Notably, there was virtually no independent oversight of auditors throughout the world before the Sarbanes-Oxley Act was enacted in the United States.

Future of Government Involvement in Public Accounting

Now turning to the future, the financial crisis has caused regulators and policy makers all over the world to aggressively question the future role, relevance and value of the auditor.

The European Union

Both the PCAOB and our foreign counterparts are considering regulations that could fundamentally change the accounting and auditing profession — all with the goal of improving audit quality, enhancing the public's confidence in financial reporting and protecting investors.

In the United Kingdom and Europe, policy makers are considering several ambitious proposals. For example, in the UK, reports have emerged detailing auditors' failure to challenge managements' assumptions, lack of independence, and inadequate disclosures to investors in the lead up to the financial crisis.

More specifically, the UK's Audit Inspection Unit found that in the context of the financial crisis "[f]irms sometimes approach the audit of highly judgmental balances by seeking to obtain evidence that corroborates rather than challenges the judgments made by their clients."[2]

The House of Lords — the upper house of the UK Parliament — also issued a highly critical report as a result of an inquiry concluding that the complacency of bank auditors during the financial crisis contributed to the need for government bailouts of the banks. In their report, they voiced concerns that market domination by a small number of firms damaged competition and asked for a detailed investigation by the Office of Fair Trading.

Stephen Haddrill, the Chief Executive of the Financial Reporting Council, the PCAOB's counterpart in the UK, has asked if there is "…a need to change the form of the audit report to make it more useful" with more information being provided "… in the front of the report about risks" and the auditor providing "greater assurance about such [risks]."[3]

In the European Union, the European Commissioner for Internal Market and Services, Michel Barnier, has also begun an inquiry into the future of the auditing profession. The European Commission (EC) has published a "Green Paper" on audit policy, the stated purpose of which is to launch a "debate on the role of the auditor, the governance and the independence of audit firms, the supervision of auditors…and the international co-operation for the supervision of global audit networks."[4]

Commissioner Barnier told the Financial Times last month that while auditors play an essential role in financial markets "[t]here are weaknesses in the way the audit sector works today [and the financial] crisis highlighted them."[5]

Since the Green Paper was issued, Commissioner Barnier has suggested: audit only firms, mandatory audit rotation, and joint audits for the largest companies. Recently, in a speech to the Federation of European Accountants, he said, "When many companies use the same audit firm decade after decade — or for more than a century — that damages the profession… we need to consider the benefits of making it obligatory to change auditing firms after a certain time period. We have to find the right balance between changing too often, which would damage the quality of the audit, and ensuring auditors' independence."[6]

Commissioner Barnier said his "ambitious" proposals would have one key objective: "ensuring robust and completely independent audits".[7] He also indicated in no uncertain terms that the "status quo is not an option".[8]

The EC's formal legislative proposal is expected to be presented to the Parliament next month in November.

The PCAOB

The PCAOB is looking at a number of these issues as well including, as I mentioned, revising the auditor's report, enhancing auditor independence, objectivity and skepticism and improving transparency.

Auditor's Reporting Model

Earlier this year in June, the Board issued a concept release on changing the auditor's reporting model. Based on input from investors, including a survey conducted by the PCAOB's Investor Advisory Group and another survey by the Certified Financial Analysts, investors clearly do not believe the current three paragraph, largely boilerplate, binary audit report is either sufficiently informative or serves their needs. The Sarbanes-Oxley Act states, as I have mentioned, that the purpose of the PCAOB is "to protect the interest of investors and further the public interest in the preparation of informative, accurate and independent audit reports…"

To some, the events of the last few years have been a case study of the inability of auditors to provide investors with any meaningful signal about increases in financial reporting risks when management assessments or estimates change dramatically, or when debates over significant accounting issues become difficult or contentious.

Generally, investors are not looking for more audit work to be performed by auditors but for a public discussion of those things that should be obvious to an auditor following a well-performed audit. At a basic level, investors want auditors to ask themselves what is it that, if they were investing in the company, they would want to know — and for the auditors then to highlight or provide that information. Investors also want to know those issues that came up during the audit and "kept the auditor up at night."

Possible alternatives for changing the auditor's reporting model, as described in the concept release, include —

  • An Auditor's Discussion and Analysis;
  • Required and expanded use of emphasis paragraphs in the auditor's report;
  • Auditor assurance on other information outside the financial statements such as, assurances on Management's Discussion and Analysis, non-GAAP information, and earnings releases; and
  • Clarification of language in the standard auditor's report such as, the meaning of reasonable assurance; the auditor's responsibly for fraud; the auditor's responsibility for financial statement disclosure; management's responsibility for the preparation of the financial statements; the auditor's responsibility for information outside the financial statements and auditor independence.

In my view, the issue is how best to provide the information that investors want in a cost effective and efficient way. Because investors are asking for information that auditors already know, I am hopeful that we will be able to find a way for that information to be provided in a relatively easy and cost effective manner.

Investor representatives have also made clear to the PCAOB that they do not understand how, during the height of the financial crisis, virtually all companies that received government assistance, or went bankrupt, were given clean audit opinions and they remain concerned with the lack of progress at the FASB, PCAOB and SEC in modernizing the standards relating to "going concern" opinions.

Enhancing Auditor Independence, Objectivity and Professional Skepticism

Under the leadership of Chairman Jim Doty, the PCAOB is also focused on ways to improve auditor independence, objectivity and professional skepticism. Over the years, PCAOB inspectors have raised numerous concerns about professional skepticism in their inspections of both large and small firms. Notably, the 2010 inspections have generated more issues than in prior years, with a troubling increase in the volume of significant issues. By way of example, these significant issues include auditing management's estimates and assumptions, fair value of hard-to-value instruments, revenue, allowances for loan losses and goodwill as well as inappropriate use of the work of others and inadequate substantive testing.

Other regulators have found similar problems, with inspection reports from Australia, Canada, Germany, the Netherlands, Singapore, Switzerland and the United Kingdom citing similar deficiencies in professional skepticism as persistent problems at audit firms.

In short, these concerns are identified too often to ignore.

In August, the PCAOB issued a concept release to solicit public comments on ways that auditor independence, objectivity and professional skepticism can be enhanced, including through mandatory rotation of audit firms.

Transparency

Finally, with a goal of improving transparency about the audit process for the benefit of investors, on October 11, 2011 the PCAOB issued a proposed standard that would require certain disclosures about key participants in the audit. This proposed standard was developed after reviewing comments received on a concept release the Board issued in 2009 seeking input on whether the Board should require that the audit report include the engagement partner's signature in addition to the firm's signature. There are those who argue that such a requirement would also increase the sense of accountability of the lead partner in any given audit engagement.

The proposed amendments issued would:

  1. require registered public accounting firms to disclose in the audit report the name of the engagement partner,
  2. amend the Board's Annual Report Form to require registered firms to disclose in that Form the name of the engagement partner for each audit report issued by the firm, and
  3. require disclosure in the audit report of other independent public accounting firms and other persons that took part in the audit

With enhanced transparency in mind, I have also voiced my continued support for the 2008 Treasury Department's Advisory Committee on the Auditing Profession recommendation that, beginning in 2011, the larger auditing firms submit audited financial statements to the PCAOB. The co-chairs of that committee specifically recommended that, at least, the largest auditing firms make their audited financial statements available to the public.

They stated, "Issuance of audited financial statements provides greater transparency and increases discipline and helps sharpen focus, accountability and trust."[9]

Many find it ironic that auditing firms in the United States, whose business

is providing assurance about the transparency provided by others, resist publicly providing their own financial statements and I believe there is no apparent reason that the auditing firms that act as gatekeepers to our securities markets should not be as transparent to investors as the companies they audit.

These are some of the many issues regulators here in the United States and abroad are grappling with in the accounting and auditing areas.

Clearly, there is no lack of topics that need to be addressed by audit regulators and therefore it is my view that governments around the world will continue to consider various alternatives to overseeing the profession.

Conclusion

In conclusion, I would like to leave you with this thought. While there is an obvious need for continued, independent, regulation of public company accounting and auditing, I believe we must keep in mind that too many, overly complex regulations and standards, may not be in the best interest of investors. My goal as a regulator is to oversee a targeted, effective, cost-efficient, regulatory process.

And, finally, to reiterate, the statutory mission of the PCAOB, first and foremost, is to protect the interest of investors — and that must be yours as well.

Auditors in the United States have been granted an extremely valuable government franchise. Our government in turn has a responsibility to prudently and effectively regulate the activities of that franchise.

As I said at the outset, to those of you who are accounting students — investors and our capital markets need you. Notwithstanding that some change is in the air, you are developing much needed and highly valuable skills.

Thank you for your attention. I would be pleased to take your questions.


[1] 465 U.S. 805, 817-818 (1984).

[2] Financial Reporting Council, The Professional Oversight Board Audit Inspection Unit, "2009/10 AIU Annual Report," (July 21, 2010), 4, available at http://www.frc.org.uk/pob/audit/reports.cfm.

[3] Financial Reporting Council, "Press Notice: FRC Chief Executive says it is time to review whether the value of the audit can be enhanced," (April 29, 2010) available at http://www.frc.org.uk/press/pub2272.html.

[4] European Commission, "Green Paper,Audit Policy: Lessons from the Crisis," (October 13, 2010) 5.

[5] Alex Barker and Jennifer Hughes, "Big audit firms face Brussels onslaught," Financial Times, September 26, 2011.

[6] Michel Barnier, Speech at Meeting of the Federation of European Accountants (June 30,2011) available at http://ec.europa.eu/commission_2010-2014/barnier/docs/speeches/20110630_fee_en.pdf .

[7] Alex Barker and Jennifer Hughes, "Big audit firms face Brussels onslaught," Financial Times, September 26, 2011.

[8] Gavin Hinks, "Audit must change — Barnier," Accountancy Age, February 11, 2011.

[9] U.S. Department of the Treasury, "Final Report of the Advisory Committee on the Auditing Profession to the U.S. Department of the Treasury," (October 6, 2008), II:9, available at http://www.treasury.gov/about/organizational-structure/offices/Pages/acap-index.aspx .

 

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