It is an honor to be here in Atlanta to speak with you about the remarkable changes in financial reporting and auditing in the four years since the passage of the Sarbanes-Oxley Act. Among the many changes, perhaps the most fundamental are changes in the way accountants do their jobs, whether they are in public accounting or in-house. As the Sarbanes-Oxley Act recognizes, state boards play a critical role in shaping the work of accountants, including by developing and maintaining the qualifications of the accounting profession to meet the needs of the public, and in particular the needs of the investing public.
In this and many other respects the state boards are the PCAOB’s partners in protecting the public interest. Since our earliest days, the PCAOB has recognized the importance of building strong relationships among our respective organizations. Indeed, one of the Board’s first acts was to invite NASBA to participate in its February 2003 open meeting, less than two months after the PCAOB had opened its doors.
Today, I would like to examine some of the changes that have taken place in financial reporting and auditing, beginning with some causes of the devastating loss of investor confidence that led to the creation of the PCAOB. I will touch on several important reforms, and ending with a look at where we are today, and in particular where I think we could use the help of NASBA and the state boards. Before I go further, however, I must note that the views I express today are my own, and not necessarily those of the other Board members or staff.
The most obvious cause of the loss of investor confidence earlier this decade was the revelation of massive financial reporting frauds at some of our largest public companies. As astounding as the frauds themselves, though, was the exposure of numerous stress fractures in the underlying foundation of our capital markets. Investors had confidence in our markets because they were understood to be based on fairly distributed, robust and reliable information upon which investors could make decisions whether to buy or sell interests in the companies that traded on those markets. This confidence made U.S. markets the most liquid in the world. When the frauds were disclosed – not just one, but one after another after another – investors questioned whether indeed our markets ensured fairly distributed, robust and reliable information. Having lost confidence in the answer to this question, investors swiftly cut off their previously free and reliable flow of capital.
Where were the fractures in the system? There were numerous fractures, some of which we are only now beginning to see. Some, such as the IPO allocation process and, most recently revealed, companies’ stock option granting practices, ran to the fairness of the system. Others, such as weaknesses in companies’ internal control over financial reporting and weaknesses in audits, ran to the reliability of the financial reports that are the lifeblood of our system.
Weaknesses in auditing were the result of years of pressure, during which companies and auditors gradually began to treat auditing as a compliance exercise with little intrinsic value. Meanwhile, many audit firms found they could parlay client relationships developed through providing audit services into lucrative, discretionary contracts to provide a range of consulting services, and thus substantially increase the overall profitability of client relationships. These consulting services often involved engagements that were bigger, longer-term, and more leveraged from a staffing perspective, and that presented significantly lower risks than audit engagements.
Accountants who were successful in leveraging existing audit engagements into contracts to provide consulting services were encouraged in and rewarded for their efforts. Indeed, some audit plans even included consideration of what kinds of additional services a client might need. Accounting firms competed for audit engagements on the basis of price and fixed-fee commitments, notwithstanding the significantly higher risk of that work, on the theory that the more lucrative non-audit services would make up for under-pricing audits. Inevitably, the pressure on auditors to improve margins on audits led to reduction of audit effort, often justified as efficiency initiatives.
Firm business pressures also led to compromises on accounting and auditing judgments. One then-Big 5 accounting firm even allowed two companies, Avon and Pinnacle Holdings, to inflate profits by wrongly accounting for consulting fees they had paid to the firm itself. Where auditing standards required firms to identify and address risks of material misstatements in financial statements, some overrode that risk assessment, instead focusing on perceived “SEC hot buttons,” or the risk of getting caught. An error unlikely to draw regulatory scrutiny was considered to be low risk, and therefore unworthy of audit attention.
For line auditors, the pressure to accommodate clients’ desired financial presentation was heavy. Well-known examples of auditors making career-altering judgments to push back on clients only increased this pressure. For example, at Enron’s request, Arthur Andersen removed its technical accounting expert assigned to the Enron audit, even over the top technical partner’s objection. At Xerox’s request, after challenging management’s desired accounting, KPMG’s engagement partner was famously removed from KPMG’s Xerox audit and relocated to Helsinki, Finland.
In this environment, some accountants shifted their own focuses from auditing to those other services, and many accountants even left the accounting profession entirely to apply their skills to the burgeoning consulting industry. The number of college graduates entering the auditing profession also declined, reflecting in my view the general perception that auditing was a tedious and largely unimportant compliance function. While each of these developments might have started as a hairline fracture, over time, they contributed to a lack of preparedness by U.S. capital markets for managing the explosive growth in household equity investment in the late 1990s.
At the same time, corporate reporting faced its own weaknesses. Although U.S. companies have been required to have internal control over their accounting since the Congress enacted the Foreign Corrupt Practices Act in 1977, by the 1990s many companies had still failed to establish or maintain effective controls. I’m not talking about controls over the minute details of insignificant accounts. I’m talking about controls that would ensure integrity in the preparation of the overall financial statements by, for example, preventing management from hiding material changes to the financial statements.
In the early 1990s the Congress attempted to bolster controls in the banking sector at least, by requiring in the FDIC Improvement Act of 1991 that certain financial institutions provide federal banking regulators with assessments of, and auditor attestations on, their internal controls. This was in response to the savings-and-loan crisis and recommendations at the time that better internal control systems could have avoided the failures. For example, the GAO advised – in a report called Failed Banks: Accounting and Auditing Reforms Urgently Needed and related congressional testimony – that “internal control weaknesses [were] a significant cause of bank failures” and that “[h]ad these problems been corrected, [certain] banks might not have failed or their failure could have been less expensive to the” bank insurance fund. The GAO also noted in particular that internal control weaknesses might not be detected because, under then-existing standards, auditors “need not thoroughly evaluate nor test internal accounting controls.”
FDICIA required auditors to evaluate the accuracy of banks’ assessments of their internal controls. There was little guidance on how to do so, though, and so in practice implementation was weak. Some auditors resorted to minimal testing of controls, sometimes even on a rotational basis every three years. And as Federal Reserve Governor Susan Bies reported about bank audits in 2003, even when some auditors were aware of them, they “ha[d] a tendency to gloss over internal control deficiencies or simply ignore significant control deficiencies.”
Corporations that were not subject to FDICIA had similarly ineffective controls, costing investors significant loss of value. As a number of high-profile cases revealed years later, given poor internal control, senior corporate managers were able to – and some did – manipulate official reported financial results to make them look better than they were. Indeed, some managers at even blue-chip companies brazenly kept two sets of financial reports – one set for consumption by the company’s investors and the other for management’s use in operations. As the SEC charged in a consented action filed against Xerox in 2002, as early as 1995 top managers at Xerox regularly directed that financial reports from subsidiary operations be changed to reflect different revenue trends than applicable accounting standards would have required and thus to prevent the company’s investors from knowing its true operating performance.
Weakened by these fractures and others, investor confidence in the financial reporting system collapsed beginning in late 2001 with what appeared to the investing public to be a spontaneous implosion of two of the United States’ largest companies – Enron and WorldCom – and one of the world’s premier accounting firms, the venerable Arthur Andersen.
I know I need not describe for you how the scandals led to the passage of the Sarbanes-Oxley Act. No matter where you were on the globe in 2002, if you were involved in the financial markets you were acutely aware. What I would like to discuss with you today, though, is the new paradigm, established through a combination of the Act’s reforms. The Act has effectively and, I believe, as intended checked the power of corporate managers, many of whom formerly had near absolute discretion over their companies’ financial reports and their auditors. The result is more reliable financial reporting to investors.
Ask any auditor, and likely you will hear that there is no question that their firm is doing higher quality audits than before the Sarbanes-Oxley Act. Auditors from the critical generation of professionals who are now rising to the senior ranks in firms will tell you they are back to auditing the way they were when they started at their firms, before many firms relegated audit services to low-cost leader status. Now that is positive change. We need to keep it up to justify investor confidence that our financial reporting system is reliable, but Sarbanes-Oxley reforms have already significantly reduced the risk of misstatements being missed in registered firms’ audits. Let me describe some of the changes.
Auditors are back to auditing, in part due to Sarbanes-Oxley’s limitations on non-audit services firms may provide to their audit clients. This means that audit partners are no longer responsible for marketing consulting services. In addition, whereas in the past, auditing was one of perhaps four or five business lines, and in many cases not even the dominant line with representation at the top of the firm, audit services are again the core business of audit firms.
In addition, auditors can no longer be fired by management. Rather, the audit committee, composed of independent directors, is now responsible for hiring, compensating, overseeing, and if necessary, deciding to change auditors.
In addition, firms have strengthened their own quality controls. We have seen significant changes in our three years of inspections, as described in a Board report last March. For example, firms are more closely tying partner compensation to technical competence, rather than marketing skills. Also, firms have strengthened processes for consulting others on difficult accounting questions, so partners can’t risk their firms to save their client relationships.
Given the decline in new auditors entering the profession in the 1990s, the demand for auditors today exceeds many firms’ needs. To compete for the limited talent pool, firms are paying more, and those costs are being passed on to their clients. I think this is a temporary situation, which I hope will be alleviated as more auditors enter the profession. NASBA and the state boards can and should play a role in addressing this demand. Nevertheless, auditors are also auditing more. This increase in effort was intended, and so some increased costs were to be expected.
Unlike the FDICIA audits that Fed Governor Bies lamented as ineffective, the reforms in corporate controls and related auditor attestations spurred by Sarbanes-Oxley have produced real and measurable benefits. I reported on these benefits in May at Baruch College’s Zicklin Center for Corporate Integrity, and my remarks there are available on the PCAOB Web site. As I explained there, costs associated both with company preparedness and the audit have also been steep, although there is evidence that those costs are coming down with experience and alleviation of staffing and other resource constraints.
Costs ought to come down, but there is no question that the benefits to investors are worth the effort. After six more months, we have even more evidence confirming these benefits. In particular, we have new evidence showing that the Act’s internal control provisions are working, as intended, to spur companies to perform long-deferred maintenance on their internal control structures, as well as to assist corporate managers, boards and auditors to predict the risk of future financial reporting failures and address that risk before it manifests in harm to investors.
In the first year of internal control reporting, close to 16 percent of our largest companies – that is, “accelerated filers,” in SEC terms – reported material weaknesses in their internal control. In other words, they reported that it was reasonably possible that their systems of internal control will fail to detect or prevent a material misstatement in their financial statements. (Interestingly, the accounting firm Grant Thornton pointed out in a letter to the SEC earlier this year that the proportion of FDICIA banks with material weaknesses was barely better than companies in other industries, notwithstanding their previous FDICIA audits under pre-Sarbanes-Oxley attestation standards.)
Importantly, more than half of the companies that reported material weaknesses in Year 1 reported in Year 2 that they had corrected their weaknesses. Thus, the percentage of reporting companies that still had not corrected material weaknesses fell to 7.4 percent, of those companies that have now reported on the effectiveness of their internal control for two years.  Sunlight is the best disinfectant.
Some interesting trends are emerging from reports of material weaknesses. The percentage of reported material weaknesses that are associated with restatements of past financial statements has dropped significantly from 50 percent in Year 1 to 37 percent in Year 2. This tends to confirm that many companies suffered from deferred maintenance of controls that indeed had failed to detect or prevent material misstatements.
Although fewer material weaknesses are associated with restatements, a considerable portion of material weakness reports continue to be associated with actual, identified misstatements. This tells us that at many companies – but fewer than a year ago – controls still fail to detect and prevent material misstatements. Specifically, 69 percent of the material weaknesses reported in Year 2 were associated with material year-end adjustments, up from 53 percent in Year 1. This concerns me, and is something I think companies, auditors and policymakers should continue to focus on.
When accountants audit internal control, they are expected to find conditions that could result in controls failing to detect or prevent a material misstatement. This allows auditors to adjust their financial-statement audits to account for internal control problems before providing investors reasonable assurance that the financial statements are fairly presented. Auditors do not provide absolute assurance that audited financial statements are fairly presented, especially in the face of internal control weaknesses. But auditors’ reports on the effectiveness of internal control help to bridge the gap between reasonable assurance and absolute assurance by providing investors important information about the risk of material misstatement notwithstanding the audit.
In addition, an auditor’s opinion that a company’s internal control is not effective also provides both outside investors and insiders (the board and management) critical new information about the risk of a problem in a company’s future financial statements. If internal control weaknesses are discovered early enough, companies should have time to address the risk before a material misstatement actually occurs – that is, before investors receive and act on materially wrong information.
In cases where material year-end adjustments arise, controls have failed to detect or prevent material misstatements. Internal control reports in such situations provide important information about the risk that a company’s controls will fail to detect or prevent other material misstatements, but to be most effective such reports should identify the risk before the controls actual fail.
The Refco failure recently demonstrated how control deficiencies can be a predictive indicator of financial reporting problems. As New York Times columnist Floyd Norris recently reported, although Refco filed audited financial statements with its initial public offering, it also disclosed to potential investors two significant deficiencies in its internal control over financial reporting. One was the need to increase its finance department to be able to prepare timely financial statements in compliance with SEC requirements. The second was the company’s failure to have formalized procedures for closing its books. One can see fairly easily how these disclosures can be useful information to investors.
As I mentioned, at the same time that companies have been identifying and resolving material weaknesses in their internal controls, they have also been correcting material misstatements in past financial statements. Indeed, the number of restatements by public companies reached a record level in 2005. Approximately 1 in 12 public companies restated their financial statements in 2005 to correct material errors in current or prior periods. This is a very positive sign that companies are getting their accounting on the right path.
Restatements are expected to reach another high in 2006, but a deeper look at this year’s restatements reveals an interesting trend. As one would expect given the decline in reports by second-year filers of material weaknesses associated with identified material misstatements, although the overall rate of restatements has risen in 2006, restatements by companies audited by the largest accounting firms peaked in 2005 and have declined in 2006.Whereas the eight largest accounting firms were associated with 65 percent of the restatements in 2005, they were associated with less than half of public company restatements in the first half of 2006. Smaller firms’ clients’ share of restatements, on the other hand, has more than doubled, with 497 restatements in the first half of 2006 compared to 185 restatements in the first half of 2005. I would expect this trend to continue until smaller companies make up for deferred maintenance on their internal control structures.
The new internal control reports are designed to help investors make more informed decisions. They also provide companies, regulators and others important information about trends in corporate practices. In particular, there is one aspect of these reports that I think state boards should be acutely focused on, and that is the information internal control reports provide about the adequacy of accounting personnel. A leading cause of reported material weaknesses in corporate controls is a problem with in-house accounting personnel resources, including competency, training, and experience. In both of the last two years approximately one-half of companies that have reported material weaknesses did so because of such personnel problems. This is additional evidence that companies were facing deferred maintenance of accounting staff adequate to meet their needs.
This evidence should also serve as a wake-up call to consider, on a broad level, whether we are training and qualifying accountants adequately and sufficiently to meet the needs of our economy. I encourage you to consider this information. State boards, together with NASBA, are in a position to identify and as needed drive changes in education requirements and training to improve the quality of financial reporting.
In addition to developing competent accountants in sufficient force, to my mind we should consider the kinds of competencies accountants need today and will need tomorrow. Clearly skills in developing and maintaining financial controls are important to enhance. In addition, not only do we need more accountants trained in current accounting and auditing methods, but we also increasingly need accountants trained in new specialties, such as financial valuation. Accounting standards-setters are decidedly shifting financial reporting toward a fair value model. At this time, in my view the accounting profession is ill-prepared for such a change.
I also encourage you to continue to focus accountants on maintaining a strong sense of ethics. The Sarbanes-Oxley reforms have done much to restore integrity in accounting and auditing, but there can be little doubt that there will be new challenges ahead. When confronted with such challenges, accountants need a deep foundation in ethics to make the best judgments, and that foundation starts with good education and qualification standards.
Finally, accountants need training in how to assess risk. Sarbanes-Oxley has shifted accountants’ focus to the risk that counts – that is, not the risk of getting caught in an error but rather the risk that financial reports to investors are materially misstated. But there is still more work to be done to train accountants how to evaluate that risk.
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The PCAOB and state boards of accountancy share a responsibility to promote high quality auditing and financial reporting — and I am proud to be your partner in our efforts to do so. Thank you for inviting me, and thank you for all you do achieve this goal.
 The number of U.S. accounting graduates (bachelor level) has declined or been flat in every year in the period 1991 through 2002, except 1994 (up 7 percent) and 2001 (up 2 percent). In 1999, 2000 and 2002 there were significant declines of 21 percent, 10 percent, and 8 percent, respectively. See AICPA, The Supply of Accounting Graduates and the Demand for Public Accounting Recruits – 2005, at 4, available athttp://ceae.aicpa.org/NR/rdonlyres/11715FC6-F0A7-4AD6-8D28-6285CBE77315/0/Supply_DemandReport_2005.pdf .
 See U.S. General Accounting Office, Failed Banks: Accounting And Auditing Reforms Urgently Needed (GAO-91-43, April 1991), available at http://archive.gao.gov/d20t9/143697.pdf. Quoted passages are from Testimony of Charles A. Bowsher, Comptroller General, Accounting and Auditing Reforms are Urgently Needed and Essential to Any Plan for Recapitalizaing the Bank Insurance Fund or Deposit Insurance Fund, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives (GAO/T-AFMD-91-3, April 23, 1991), available at http://archive.gao.gov/d48t13/143683.pdf .
 Id. at 13.
 See Conference Report on the Federal Deposit Insurance Corporation Improvements Act of1991, House Rept. 102-330 (Nov. 19, 1991) (stating that Section 112 of the FDICIA required “[a] separate report prepared by an independent public accounting attesting to the accuracy of managements annual assessment of financial reporting, internal controls, compliance with applicable laws and regulations and other areas contained in managements statement of responsibilities”); see also Senate Report 102-167 Part A, stating that:
The GAO’s April, 1991, study of 39 failed banks concluded that “internal control weaknesses continue to be a significant cause of bank failures.” Of the 39 banks, “33 had serious internal control problems which regulators cited as contributing significantly to their failure. Had these problems been corrected, the banks might not have failed or their failure could have been less expensive to the Fund.”
 See Letter dated April 3, 2006 from T. Gazzaway (Managing Partner-Corporate Governance, Grant Thornton) to N. Morris (Secretary, SEC) (“Grant Thornton Letter”), available at http://www.sec.gov/spotlight/soxcomp/grantthornton040306.pdf .
 See “Restoring Our Confidence in Bank Controls and Financial Statements,” Remarks by Governor Susan Schmidt Bies Before the Conference of State Bank Supervisors, Asheville, North Carolina (May 30, 2003), available at http://www.federalreserve.gov/boarddocs/speeches/2003/ 20030530/default.htm. Governor Bies exhorted standards-setters to improve the quality of internal control attestations:
“Currently, the standards don't require auditors to perform any independent testing of controls. Under the current standards, auditors can simply rely on the work of internal audit as the basis for issuing an attestation report on management's report on the effectiveness of internal controls. There is virtually no guidance on the criteria auditors should use to issue a qualified opinion. We have long argued that the professional standards in this area need to be more robust.”
 See Complaint Against Xerox Corp. (April 11, 2002), available at http://www.sec.gov/litigation/complaints/complr17465.htm (“In most cases, application of ROE was a ‘top-side’ adjustment directed by corporate headquarters. Operating units allocated lease cash flows . . . according to long-established procedures. Before the financial results were reported publicly, Xerox's regional headquarters, using data supplied by corporate, recalculated these allocations to insure that Xerox's financing operations realized no more than a 15 percent return, regardless of its own capital or administrative costs or the interest rates paid by the customer to lease a copier. Initially, use of the ROE formula was limited to the United States and to Xerox Brazil, where the formula was implemented by at least 1995. As the pressure to meet earnings targets grew, and competition made selling copiers more difficult, ROE was expanded to Xerox Europe in 1998.”). Xerox agreed to settle the SEC's complaint by consenting to the entry of an injunction by a federal district court in New York.
 See PCAOB Release No. 104-2006-078 , Observations on the Initial Implementation of the Process for Addressing Quality Control Criticisms within 12 Months After an Inspection Report, March 21, 2006, available at http://www.pcaobus.org.
 For a discussion of indications that internal control reporting is producing real benefits, see my address at Baruch College’s Zicklin Center’s Fifth Annual Reporting Conference, available at http://www.pcaobus.org. Among the benefits is that investors are willing to provide capital in exchange for equity interests at a cheaper rate if a company can show that has corrected any material weaknesses in its internal controls. Specifically, earlier this year, a team of researchers led by Bill Kinney of the University of Texas reported on their findings that disclosures about the reliability of internal control have a significant effect on companies’ cost of capital. See Ashbaugh-Skaife, Collins, Kinney and LaFond, The Effect of Internal Control Deficiencies on Firm Risk and Cost of Equity Capital (April 2006). They found that when companies report they have corrected a previously reported material weakness in internal control, their cost of capital goes down on average 1.5 percent. Conversely, when companies report material weaknesses in audited financial reports after they had previously reported in unaudited statements that internal control was effective, their cost of capital goes up on average almost 1 percent (93 basis points).
 See Audit Analytics, Second Year 404 Dashboard: Third Quarter Cumulative Results, August 15, 2006 Review, at 2 (“Second Year 404 Dashboard”).
 See Grant Thornton Letter, Attachment at 4. Based on data from Audit Analytics and S&P, approximately 13 percent of commercial banks reported material weaknesses in internal controls in the first year of internal control reporting under Sarbanes-Oxley.
 Second Year 404 Dashboard, at 2.
 Second Year 404 Dashboard, at 2.
 Id. at 9.
 Id. at 9.
 See Norris, F., Refco Creditors Take Their Losses, New York Times (Sept. 14, 2006).
 See Glass Lewis & Co., Getting it Wrong the First Time, March 2, 2006, at 1.
 See Audit Analytics, Financial Restatements Dashboard: Annual Results for 2001 to 2005 and Analysis of First Six Months of 2006, at 2-2 (“Financial Restatements Dashboard”).
 I should also point out that, after monitoring the first year of accounting firms’ implementation of the new internal control reporting requirements, the PCAOB issued a report on the implementation effort and found that accounting firms were severely constrained by insufficient trained personnel as well. See PCAOB Release No. 2005-023 , Report on the Initial Implementation of Auditing Standard No. 2 (November 30, 2005), available at http://www.pcaobus.org.
 Id. at 9. Specifically, 48.1% of Year 1 filers that reported material weaknesses cited personnel issues as a reason, compared to 52.8% of Year 2 filers that reported material weaknesses.