Confucius said that a journey of a thousand miles begins with a single step. I'd like to share with you the steps that the Public Company Accounting Oversight Board (PCAOB) has taken since the appointment of our first members one year and two days ago. To us, although it seems that our journey to date has been long (and at times a bit arduous), in reality we have only just begun to effect the type of changes that Congress envisioned when it passed the Sarbanes-Oxley Act of 2002.
But first, I'd like to tell you a story.
During the course of World War II, many people gained fame in one way or the other. One man whom you may have heard of was Butch O'Hare. Butch was a fighter pilot assigned to the Lexington, an aircraft carrier in the Pacific. One time, his entire squadron was assigned to fly a particular mission. After Butch was airborne, he looked at his fuel gauge and realized that someone had forgotten to top off his fuel tank. He realized that he wouldn't have enough fuel to complete his mission and get back to his ship; his flight leader told Butch and his wingman to leave.
On their way back to the mother ship, they saw nine Japanese Zeroes headed toward the fleet to attack. With all of the fighter plans gone, the fleet was almost defenseless. Butch and his wingman had the only opportunity to distract and divert them. But, his wingman found that his gun had jammed, and he had to bail out. Single-handedly, Butch dived into the formation of Japanese planes and attacked them. At that time, American fighter planes were rigged with cameras, so that as they flew and fought, pictures were taken so pilots could learn more about the terrain, enemy maneuvers, etc. Butch dove at them and shot until all of his ammunition was gone; then he flew directly at them, trying clip off a wing or tail or anything that would make the enemy planes unfit to fly. He did everything he could to keep them from reaching the American ships. He downed five planes before the rest of his squadron was able to join him. Although a few of the other pilots witnessed some of Butch's heroics, it wasn't until the film from the camera on his plane was developed that they all realize the extent he really went to protect his fleet. Butch was awarded the first Navy "Ace" Award, as well as the Congressional Medal of Honor. Unfortunately, he was killed in combat a year and a half later. As some of you may know, the Chicago O'Hare Airport was also named after Butch.
Prior to this time in Chicago, there was a man named Easy Eddie. He worked for a man you've all heard about, Al Capone. Al Capone was not famous for doing anything heroic, but he was notorious. Easy Eddie was Al Capone's lawyer and business partner in several gambling rackets, and he was very good. In fact, because of his skill, he was able to help Al Capone make a lot of money, most of which was illegal.
To show his appreciation, Al Capone paid Easy Eddie very well. He not only earned big money, he got a lot of extra things, like a residence that filled an entire Chicago city block. The house was fenced, and he had live-in help and all of the conveniences of the day.
Easy Eddie also had a son. He loved his son and gave him all of the best things while he was growing up: clothes, cars, and a good education. Because he loved his son, he also tried to teach him right from wrong. But one thing he couldn't give his son was a good name, and a good example.
Easy Eddie decided that this was much more important than all of the material things that he had given his son. So, he went to the authorities and, as they say, "flipped." He testified against Al Capone, although he knew that by doing so Capone would do his best to have him killed. You know the story: Easy Eddie testified, and Al Capone went to jail for tax evasion. Within three years after Capone's conviction, Easy Eddie was shot and killed on a lonely street in Chicago.
These are not two unrelated stories about Chicago. You see, Butch O'Hare was Easy Eddie's son.
I'm telling you this story because it's a story of redemption. Restoring confidence in the markets will require redemption, not only of the auditing profession, but of all of the professions that played a part in the financial scandals which so seriously rocked our stock market in 2001 and 2002.
Before I begin, I should note that the views I express are my own, and not necessarily those of the Board, its other members or staff.
II. The Public Company Accounting Oversight Board
As you know, Title 1 of the Sarbanes-Oxley Act (or "S-Ox," as we affectionately call it), Congress created the PCAOB. The five-member board, on which I'm honored to sit, is charged with restoring confidence in the financial statements of companies traded in our public markets, by ensuring that those statements are audited according to the highest standards of quality, ethics and independence.
We are a non-profit corporation, funded primarily by fees paid by the direct users of auditing services - that is, public companies. Our budget for 2003 is approximately $68 million, which was assessed in the form of fees to 5,200 public companies and 3,300 investment companies. Because our fees are based on relative market capitalization, around 62% of these companies are paying $1,000 or less; the largest 1,000 companies make up about 87% of our budget. As some of you may know, since the PCAOB was truly a "start-up" organization, we began our operations in January of this year with a loan from the U.S. Treasury. I'm happy to report that we have fully re-paid this loan.
As you know, before the enactment of Sarbanes-Oxley, the auditing profession was - except for your oversight at the state level - largely self-regulated. Because of well-reported financial scandals - including the unforgivable act of destroying documents under subpoena - Congress determined to largely strip the profession of the self-regulatory authority that it had. Instead, the PCAOB, under the oversight of the SEC, has been given five specific responsibilities:
First: Registration. As of last week (October 22), no US auditor may provide audit services to a US traded company unless the firm is registered with the Board. The deadline for non-US auditors is in April of 2004. As of October 22, we had approved 598 of the roughly 640 firms that had filed registration applications. A list of registered firms is maintained on the Board's Web site at www.pcaobus.org. Registered firms must also provide annual reports with updated information.
Registration forms the jurisdiction for all of the Board's authority. The registration process, which is web-based, includes the identification of all accountants that participate in a public company audit (including foreign affiliates that don't separately file registrations with us); identification of all of the firms' public company clients; a copy of the firm's quality control policies and procedures; classification of fees received for audit versus non-audit services; and a description of pending litigation - civil and criminal - against the firm and certain individuals within the firm.
Second: Inspection. S-Ox requires the Board to inspect every registered accounting firm. In the case of firms that audit more than 100 public companies, inspections will take place annually, beginning in 2004. For other accounting firms, inspections must take place at least once every three years.
Even though our inspection responsibility technically only begins once a firm is registered, we reached voluntary agreements with the Big 4 to begin limited inspections early. These have been taking place during the summer, and will be complete by the end of this year.
Our inspectors are, obviously, looking at the way that firms performed some selected audit engagements. But, much of the focus of these first-year inspections is 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:
Organizations tend to adopt the culture of their leadership. We seek to determine what kind of philosophy concerning professionalism, business ethics, and commitment to the public interest exists at the highest levels of the major firms, as well as how this culture is instilled in the rank-and-file.
- Compensation and promotion practices.
Another way of getting at an organization's values is by analyzing what behavior it rewards. For example, we would like to know the role technical excellence and commitment as an auditor play in promotion and compensation decisions and how that role compares to the importance of billing and rain-making.
- Client acceptance and retention.
We are exploring how firms decide to accept new audit clients and whether to retain existing clients. We want to learn how the major firms assess risk, and how they balance audit and reputational risk against potential revenue.
If, as a result of our inspections we believe that a firm or any of its accountants have, or may have, violated the law or professional standards, we will (if appropriate) report these violations to the SEC and to each appropriate state regulatory authority (which in most states is the agency issuing a license or certification to engage in the business of accounting). In addition, when we issue our final inspection reports, we will provide copies of these reports, in appropriate detail, to these state authorities. While we may omit from these transmitted reports information that, if disclosed, could jeopardize an ongoing investigation, prosecution or disciplinary proceeding, our intent is to be as collaborative with state authorities as possible.
Third: Investigations. Of interest to many in this room will be our investigations. We are creating a team of investigators: auditors and attorneys who will work together to investigate possible violations of laws or standards, and to advise the Board as to whether it should consider (a) initiating its own disciplinary action, or (b) referring a matter to an appropriate law enforcement agency. We will initiate investigations based on issues referred from our inspectors or other regulatory bodies, from events disclosed in public filings, from media reports, and from tips or whistle-blowing. While our authority is to investigate auditors, our investigations will likely also take us to the doors of audit clients: public companies. We will seek voluntary cooperation from these people, over whom we have no jurisdiction. However, we also have the authority to seek SEC subpoenas for witnesses and documents should voluntary disclosure be refused.
Fourth: Professional discipline. We will discipline firms for violating professional standards or securities laws, or for refusing to cooperate with our investigators. Our disciplinary authority encompasses a broad spectrum. On the one side are activities that can be considered to be "remedial": imposition of additional education and training requirements, "cease and desist" orders, or possibly even the appointment of a "special master" to oversee some corrective action by the firm. At the other end of the spectrum are the more "punitive" actions: serious monetary fines, and either temporary or permanent suspensions from public company audits. The Board is not interested in disciplinary quotas. Our mission is not to penalize as many firms as possible. Our duty is to seek to restore confidence in the integrity of the auditor's work. As Tina Turner said, we can fulfill this mission "nice, and easy," or we can do it "nice, and rough." In either event, it is the correction of behavior that we seek, not necessarily a head on a platter.
Fifth: Auditing standards. The auditing profession used to establish its own public company audit standards. Now, the Board has this sole authority, which includes not only auditing standards, but quality control, ethics and independence standards. I understand that members of NASBA will now be eligible to join the AICPA's Auditing Standards Board for purposes of setting private company standards, and I applaud you for seeking and obtaining this important opportunity. I trust that as we each implement our respective responsibilities, we will do so in a collaborative and mutually-respectful manner.
The Board has announced that, as soon as the SEC approves our proposed rules (which we hope to be next month), we will appoint a Standing Advisory Group to assist 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. Members of state boards are, of course, eligible to nominate members to, and sit on, the Advisory Group. This group will review (not draft) existing and proposed standards, and give its advice to the Board.
Candidly, it may be difficult to engage non-auditors in review of some of the nitty-gritty details of an audit standard. But, I think that it will be extremely important to bring the various users' perspective to the table. Auditing is not something that exists for its own benefit. The process of an audit, in addition to conclusions reached, must be of value to the company and, ultimately, its owners, or it is waste of time and money. The advisory group is our effort to include these often-disregarded voices in the debate.
These five responsibilities are not separate and distinct from one other; rather, they must be integrated. For example, what we learn from our inspections will feed into both our investigations and standard-setting programs. Standards cannot be established without input from both inspectors and investigators. And the content of the annual reports from registered firms will be developed based on the needs of our inspectors.
III. Restoring Trust
It is important to acknowledge that auditors were not alone in creating the environment - the public erosion of confidence - that resulted in the passage of Sarbanes-Oxley. Auditors do not create financial statements; they do not manipulate earnings nor draft disclosure statements. It is true that investors look to auditors to be on the alert for those within a company who may be tempted to "color outside the lines," and it is also true that auditors have let investors down. They are not alone, however. Let me quote a few excerpts from the Powers' Report to Enron's Board (Bill Powers was appointed to report to a Special Committee of the Enron Board, after the scandals came to light):
"Various disclosures were approved by one or more of Enron's outside auditors and its inside and outside counsel. However, these disclosures were obtuse, did not communicate the essence of the transactions completely or clearly, and failed to convey the substance of what was going on.... There was an absence of forceful and effective oversight by Senior ... Management and in-house counsel, and objective and critical professional advice by outside counsel ... or auditors....
I commend also to you the recently-released report by former SEC Chair Richard Breeden, entitled Restoring Trust. Mr. Breeden was retained as a Corporate Monitor, as part of the permanent injunction against WorldCom, and was charged with providing the court with recommendations for ensuring that the company does not again engage in the type of financial fraud that brought it to the court's steps.
Again, let me excerpt:
"...[B]oards of directors, outside auditors and outside counsel are the gatekeepers of behavior standards who are able to prevent damage before it occurs, if they are alert, and above all if they are willing to act when necessary. A common denominator in many of the major frauds has been the failure of these gatekeepers to stop improper practices at the outset. Sometimes the gatekeepers were unaware of the details of what management was doing .... Other times the gatekeepers were too trusting in accepting management rationalizations for practices that proved far more risky than the board might appreciate. Still other times, typically in the compensation area, boards simply went along with unnecessarily large programs that created powerful incentives for managing or inflating reported earnings. Finally, all too often the judgment and actions of outside accountants and counsel were tempered due to the magnitude of fees generated by powerful clients...."
In recognition of the multi-headed nature of the beast that must be bested if we are to restore confidence in our markets, many different actors have joined forces. Let me run through those that I think are principal:
Congress. Through its many hearings and the adoption of Sarbanes-Oxley, Congress clearly stepped up to the plate.
With the financial scandals of 2001 and 2002, real people lost real money, real jobs, and real retirement security. Stock prices during 2002 fell by more than 23%, and corporate profits fell by 4%, while median CEO pay grew by 6%. This disparity contributed to such public anger, such mistrust of institutions with responsibility for market integrity, that Congress was pressed to adopt what many consider to be the most far-reaching securities legislation since the Exchange Acts of '33 and '34.
In addition to creating the PCAOB and related new responsibilities for and restrictions on independent auditors, S-Ox addressed the role and expertise required of Audit Committees. Significant components of revenues or expenses, as well as matters that will have an impact on a company's future operations must now be reported. S-Ox prohibited certain insider loans, and strengthened criminal penalties for certain misconduct.
Congress continues to closely monitor both the progress of those of us with new responsibility under S-Ox, as well as whether additional legislation may be necessary.
The SEC. This agency's activities during the past year are too numerous to describe, particularly in the time that I have remaining, so let me just highlight a few:
- CEOs and CFOs are now required to certify their companies' financial reports and disclosure controls and procedures, with a potential $5 million fine and up to 20 years in prison for violations.
- Beginning in 2004, companies must report (on both an annual and a quarterly basis), much more timely than ever in the past.
- Management must now assess, and independent auditors must attest, as to the effectiveness of the company's internal control over financial reporting.
- Attorneys are now clearly responsible to the corporation, as the client, rather than to management.
- Investment Analysts are subject to new requirements designed to prohibit conflicts of interest.
The Exchanges. Although recent events have revealed that there is much to be done to reform the NYSE's own governance, both the NYSE and NASDAQ have taken significant strides toward mandating corporate governance "best practices" within their listing standards. In my mind, even though I continue to believe that both of these exchanges' recognition of "best practices" can and should be further refined, listing standards represent an important tool for changing corporate behavior on a macro level. Some issues (e.g., separation of the CEO and Chair positions, one share-one vote) are outside the scope of the SEC's authority because they are protected by state corporate laws. The exchanges can address these issues on a national level.
State Boards & Legislatures. I don't need to tell you what has been done at the state level, and in fact I hope to learn from you in the next day and a half. I do know that your work in setting and enforcing educational and examination requirements for accountants operating in your states, as well as your work to ensure quality assessments of firms' non-public company audit services is essential to protecting the integrity, and ensuring the stability, of our national economy.
To truly restore investor confidence, we must work together. Let me give you an illustration: during our review of the nearly 700 registration applications that I mentioned earlier, we took particular care to look at situations in which the firm or one of its accountants had been disciplined. I cannot tell you the number of instances in which a firm explained to us that we should not be concerned with past problems of Mr. or Ms. Auditor "because that auditor has been reassigned out of public company work." Firms should not be able to avoid oversight simply by shifting problem people from one practice area to another. Working together, we can seek to avoid these types of regulatory gaps.
Corporations. It is harder to be a corporate director, and corporate officer, than in any time (at least in my past). I believe that the behavior of a small number or directors and officers is responsible for the scandals for which the larger community is paying. From what I've seen, I think corporations are responding wonderfully to the challenges they are now facing. But, no legislature, no regulatory agency, and no oversight body can stamp out greed. Let me share with you a story about business ethics:
In the early days of the The Pennsylvania Gazette a contribution was brought into Benjamin Franklin's office for publication. Franklin reportedly asked that the piece be left until the next day, when he would decide whether to publish it. The next day, the author of this piece returned at the appointed time and received from Franklin this communication: "I have perused your piece and found it to be scurrilous and defamatory. To determine whether I should publish it or not, I went home in the evening, purchased a two-penny loaf at the baker's, and with water from the pump made my supper; I wrapped myself up in my great-coat, laid down on the floor, and slept till morning, when, on another loaf and a mug of water, I made my breakfast. From this regiment I felt no inconvenience whatever. Finding I can live in this manner, I have formed a determination never to prostitute my press to the purposes of corruption, or abuse of this kind, for the sake of gaining a more comfortable subsistence."
Unfortunately, there are still some who have yet to experience their two-penny loaf and mug of water.
Investors. Investors have played, and I believe will continue to play, an important role in curbing the type of corporate behavior negatively impacts the market. But, investor options are limited. Please don't misunderstand me: I worked for an activist investor for 16 years, and am proud of the work that CalPERS and other organizations have done to improve corporate accountability. But investors can only see, evaluate and respond to public events and decisions. By the time that an investor knows of a misdeed, the harm has already been done. While the knowledge that investors will react sternly may be a sufficient disincentive for some, it is not for many, many others. For this reason, regulators and legislators cannot become too complacent, expecting that an "efficient market" will always be able to correct itself in a manner that is best for the public interest.
The Accounting Profession. Right now, the accounting profession, rightly or wrongly, is not perceived by investors, let alone the public at large, as being trustworthy. I'm a lawyer; I know what it's like to be part of a profession whose members' integrity is questioned simply by being a member of the profession. It's not pleasant, and it's not fair. The best advice that I can give accountants is to echo the comments of Bill McDonough, the chair of my board, in a recent speech to the New York State Society of CPAs. He said:
"You, the members of the accounting profession, are going to have to prove that you have earned the people's trust. You do that by exceeding the expectations that you will live up to the letter and the spirit of the law."
"If you do not," he said, "woe unto you."
The Educational System.During my 10 months on the Board, I have been encouraged to see the number, depth and quality of educational programs concerning business ethics in general, and Sarbanes-Oxley in particular, that are available to active members of the profession. I am concerned about students in undergraduate and post-graduate programs, however.
I am not suggesting that the educational opportunities available in our colleges and universities are somehow inadequate. I worry, however, that they are not attracting enough of the best and brightest students. Any profession will stagnate and decline if it is not refreshed with new thoughts, new minds, new approaches. We all must work together to find ways to rejuvenate accounting as a chosen field of study.
One opportunity for my Board comes directly from Congress. Under S-Ox, all monetary fines that we collect must only be used to fund a merit-based scholarship program for undergraduate and post-graduate accounting students. We have not yet structured such a program, but would be interested in any views or recommendations you might offer.
I started my comments by referring to our mutual journey. I hope I've conveyed to you my belief that this journey will likely be never-ending, with many turns and twists in the road. In conclusion, let me switch from Confucius and leave you with some thoughts by Robert Frost, my favorite American poet:
Whose woods these are I think I know.
His house is in the village, though;
He will not see me stopping here
To watch his woods fill up with snow.
My little horse must think it queer
To stop without a farmhouse near
Between the woods and frozen lake
The darkest evening of the year.
He gives his harness bells a shake
To ask if there is some mistake.
The only other sound's the sweep
Of easy wind and downy flake.
The woods are lovely, dark and deep,
But I have promises to keep,
And miles to go before I sleep,
And miles to go before I sleep.