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 Update on Issues and PCAOB Activities

DATE Nov. 17, 2006
SPEAKER(S): Mark W. Olson, Chairman
EVENT: FEI Conference
LOCATION: New York, NY

*Mark Olson presented similar remarks at the NACD meeting, Washington, DC, October 17, 2006. 

Introduction

I appreciate the opportunity to be with you this morning to provide an update on the Public Company Accounting Oversight Board’s (or PCAOB) activities and key initiatives, and discuss the need to assure that future developments in  financial reporting result in increased investor confidence in our capital markets.  The FEI has long been a leader in establishing ethical standards and education for CFOs in the United States and around the globe. I understand that the FEI will be celebrating its 75th anniversary next month.  The FEI has been a respected advocate for financial executives, and we at the PCAOB welcome your thoughtful views when we propose new standards and regulations.  As the focus of this conference is on the future of financial reporting, I look forward to hearing your views about current challenges, and in particular, how the financial reporting model should evolve.

Before I go further, I must note that the views I express today are my own, and not those of other Board members or staff of the PCAOB.

Let me begin by stressing that assuring that investors can have confidence in financial reports of public companies is at the core of the PCAOB’s mission.   Our statutory mandate under the Sarbanes-Oxley Act is to oversee auditors of public companies and further the public interest in the preparation of informative, fair, and independent audit reports.

The Sarbanes-Oxley Act of 2002

Though it has been only a few years, it is useful to recall the events leading up to the passage of the Sarbanes-Oxley Act.  For much of the 1990s, debate ensued over the limitations of GAAP accounting to capture value in an environment where the most valuable corporate assets – such as human and intellectual capital – did not appear on corporate balance sheets.  Nevertheless, it was presumed at that time that the financial reporting that did exist could be relied upon.   When Enron, WorldCom and other corporate accounting scandals shook that fundamental confidence, Congress chose to act.

In enacting Sarbanes-Oxley, Congress sought to restore investor confidence and address serious gaps in the U.S. regulatory framework that were exposed by the accounting scandals of 2001 to 2002.  Among other things, there was an increased recognition of the need to bolster internal controls over financial reporting and enhance corporate governance. 

The Sarbanes-Oxley Act enhanced the corporate governance role of corporate directors.  Through the Act, as you have experienced, Congress placed corporate governance responsibilities on boards of directors, including oversight of a company’s external auditor.  Audit committees, in particular, moved to the front-line and were charged with enhanced responsibility for the quality of financial reporting and oversight of internal and external audits within their companies.

The PCAOB

As you well know, the Sarbanes-Oxley Act also established the PCAOB as the independent auditor oversight body.  As I mentioned earlier, the PCAOB’s mission is to oversee the auditors of public companies, protect the interests of investors, and further the public interest in the preparation of informative, accurate, and independent audit reports.  The PCAOB does this through its standards setting, inspections, and enforcement programs.  Since the PCAOB opened its doors in January 2003, it has registered more than 1,700 accounting firms that audit, or wish to audit, U.S. public companies.  Once registered, these firms become subject to the PCAOB’s regulatory programs and must use PCAOB standards when they audit public companies. 

In its fourth year of operation, the PCAOB is moving from a start up to a steady state environment and thinking strategically about how the PCAOB should execute its mandates in the immediate- and longer-term.  In carrying out its mandates, the PCAOB cooperates closely with the Securities and Exchange Commission, not only because the SEC oversees the PCAOB’s activities, but because the PCAOB and the SEC share the mutual objective of investor protection. The PCAOB continues to explore ways to improve its audit requirements and their implementation by audit firms, while preserving the intended benefits.  For example, at the moment, the SEC and the PCAOB are closely coordinating work on implementing Section 404.

Section 404

As you have experienced first-hand, the Sarbanes-Oxley Act included provisions regarding internal control over financial reporting (or ICFR). The term “internal control over financial reporting” refers to a company’s system of checks and processes designed to ensure that it protects corporate assets, keeps accurate records of those assets as well as its financial transactions and events, and prepares accurate periodic financial statements.   Section 404 of the Act requires management of public companies annually to provide investors an assessment of their ICFR, accompanied by an auditor’s report on the same subject.  Section 103 of the Act mandated that the PCAOB issue an audit standard regarding ICFR. 

The concept of the need for internal control over financial reporting was not born with Sarbanes-Oxley.  Congress has acted in this area more than once, notably by mandating internal controls through the Foreign Corrupt Practices Act of 1977 and the FDIC Improvement Act of 1991, before adopting the Sarbanes-Oxley Act in 2002.  That said, Sarbanes-Oxley’s requirement for quarterly management certifications, annual management assessments of controls, and independent auditor attestations of those assessments raised corporate responsibilities for internal control over financial reporting to a higher level. 

Almost two years ago, the PCAOB issued Auditing Standard No. 2 (AS2), implementing Sections 103 and 404(b) of the Act.  Since its issuance, the cost of implementing Section 404 and AS2 has been – and remains - on the top of agendas from Congress to Wall Street to boardrooms in the United States and abroad.  Since I joined the PCAOB as its Chairman in July, I have had the opportunity to meet with a number of CEOs of public companies, most of which are entering their third year of compliance with section 404.  Virtually without exception, these CEOs have remarked that the internal control framework has made their companies better organizations.  But, virtually all also believe that the incremental cost to date has exceeded the incremental benefit.  It soon became clear to the PCAOB that we had to build clearer guidance into AS2 regarding efficient, risk-based, and scalable implementation. 

Improving Implementation of AS2

Since the PCAOB adopted AS2, it has been determined to make internal control audits as cost-effective as possible for companies that are required by the SEC’s rules to obtain an audit report on internal control.  Early on, it provided additional guidance to facilitate and streamline implementation.  Most recently, on May 17, 2006, the PCAOB announced formal plans to improve implementation of internal control reporting requirements.  The Board stated that it would propose and seek comment on amendments to AS2 to focus auditors on areas that pose higher risk of fraud or material error.[1]  The PCAOB also designed its 2006 inspections of registered public accounting firms to examine how efficient firms’ internal control audits have been, as measured by PCAOB’s past guidance.[2]  This allows the PCAOB to use its inspections processes to drive greater efficiency into audits.

In making internal control audits as cost-effective as possible for companies that are required by the SEC’s rules to obtain an audit report on internal control, the PCAOB is particularly focused on the burden on smaller issuers.  Accordingly, we have been sponsoring a series of meetings around the country on Auditing in the Small Business Environment.  These small business forums allow the Board and its staff to dialogue with auditors and small issuers on implementation of AS2 and other PCAOB initiatives.  The meetings have been well received, and, as a result, we are holding eight this year and plan another set for 2007.

Through our small business forums and other outreach, PCAOB has been able to monitor the experience of small companies and auditors who have gone or are currently going through the process of establishing and evaluating internal control. The PCAOB is using this knowledge in working with practitioners and with the SEC to develop implementation guidance specifically for auditors of smaller public companies.  The contemplated guidance will emphasize the scalability of internal control audits at a practical level and provide audit firms with examples of how the internal control audit process can, and should, be scaled to fit the relative sizes of small companies, from those that have accelerated filer status down to those that have merely a handful of employees. In addition, the PCAOB is exploring various means of providing training for auditors of smaller public companies on auditing internal controls.  With constructive, practical guidance, and with the SEC’s recent announcement extending the time frame for implementing the Act’s internal control requirements, the PCAOB hopes that smaller companies and their investors will be able to achieve the benefits of internal control reporting without unnecessary costs.

Revising AS2

Since its announcement last May that I just mentioned, the PCAOB has been working hard to prepare a new standard to replace the current AS2 that will be released for public comment shortly.  In undertaking this work, the PCAOB has four goals:   

  • First, the PCAOB plans to propose changes to make the standard simpler to read, easier to understand and more clearly scalable to companies of any size.  At the same time, by emphasizing core principles, the new proposal is expected to focus auditors on the areas of greatest importance.
  • Second, the PCAOB is critically evaluating every area of the audit to determine whether the existing standard encourages auditors to perform procedures that are not necessary to achieve the intended benefits of the audit.
  • Third, the PCAOB plans to propose changes that would make explicit in the standard the PCAOB’s past guidance on how to make internal control audits as efficient as possible.
  • Fourth, the proposal should emphasize the importance of a company’s control environment, and how it can impact the risk of financial reporting fraud or other material failure, in order to focus auditors on what really matters, which is identifying material weaknesses in a company’s system of internal control before those weaknesses result in material misstatements in the company’s published financial statements.

I mentioned a moment ago that AS2 and Section 404 of the Sarbanes-Oxley Act are areas where the PCAOB and the SEC are collaborating closely.  While the PCAOB has been working on amendments to AS2, the SEC has been developing risk-based management guidance for implementing Section 404.  The SEC recently announced that it will hold an open meeting on December 13th to consider recommendations regarding Section 404.  Because there is great deal of value in these two initiatives being available for public consideration concurrently, the PCAOB is coordinating its release of amendments to AS2 with the SEC so that the comment periods for the PCAOB’s revised AS2 and the SEC’s management guidance have sufficient overlap.

Trends in ICFR Reporting

Over the last few years, as auditors of large, established public companies – which the SEC refers to as accelerated filers - have been required to assess and obtain an audit of ICFR, we have seen  companies preparing to comply with the internal control and other related provisions of the Act.[3]  We understand that many of you have made significant investments in order to come into compliance with these requirements.

For the first time, information on the quality of internal controls over financial reporting and disclosures is available to the public.  This information is available because of Sarbanes-Oxley’s requirements for quarterly certifications by management, and annual management assessments of internal controls over financial reporting and independent audits thereof.[4] 

The problems identified by accelerated filers in the first two years of reporting tell us a great deal about the progress made already.  Our analysis of these data indicates encouraging trends:

  • The overall rate of opinions on ICFR that describe material weaknesses in ICFR has declined from 15.8 percent of all opinions filed for the first year to an estimated 9.6 percent for the second year. 
  • Although the number of qualified ICFR opinions that reference either restatements or material year-end adjustments continues to be high as a percentage of total qualified ICFR opinions, there has been a shift from those referencing restatements of previously issued financial statements to those referencing current year errors. This may imply that errors are being identified earlier than in the past. 

While these results are promising, it is worth taking a look at the nature of the material weaknesses that are being reported.  The areas of staffing, training or competence continue to be the most commonly reported weaknesses.  The qualified ICFR opinions that included material weaknesses related to these staffing areas, as a percentage of total qualified ICFR opinions, increased from 48.1 percent in the first year to 52.8 percent in the second year.[5]  In addition, exceptions related to improper segregation of duties remained high at a total of 14.3 percent of all qualified ICFR reports.  

In terms of the types of errors in accounting referenced in ICFR reporting, the percentages have not changed significantly in the two years. Revenue recognition, tax accounting and inventory accounting issues remain the highest in frequency. 

PCAOB Inspections and the Supervisory Model

Sarbanes-Oxley requires the PCAOB to conduct annual inspections of any registered accounting firm that audits more than 100 public companies, and to regularly (at least once every three years) inspect other registered firms that audit public companies.  Inspections are risk-based and designed to identify auditing problems at an early stage and focus firms on correcting them.  In short, we are taking a supervisory approach to our inspection program.  Our approach emphasizes a constructive exchange between the firm and the PCAOB, and concerns that our inspectors identify during inspections are often promptly addressed by the firm being inspected.

I believe that the three rounds of inspections that have occurred in the same number of years have helped the auditing profession evolve over that short period of time.  The PCAOB supervisory model fundamentally is based on a dialogue between the PCAOB and the supervised firm.  This interaction has helped firms of all sizes to better understand what is required of them in the current auditing environment. This realization, along with other market forces, has helped firms better mesh their specialties with the needs of public companies.  Just as importantly, the inspections process has made some firms realize that public company auditing may not be a right focus of their business model in the new environment.

In addition to the constructive exchange and progress that occurs during an inspection, the PCAOB also carries out the important task, required by the Act, of preparing a report on each inspection.  To date, the PCAOB has issued more than 300 inspection reports, including two reports on each of the four largest firms.  To comply with restrictions set out in the Act, Board inspection reports frequently include portions that the Board does not disclose publicly.  Publicly available portions of the reports, however, are posted on the Board's Web site and provide a summary description of any significant deficiencies identified by the Board's inspectors in the audits they reviewed.  Nonpublic portions of a report include, among other things, criticisms of a firm's quality control system.  If the nonpublic portion of any particular report does include quality control criticisms, the Act allows the firm 12 months to address those criticisms, and provides as incentive a statutory requirement that those criticisms must remain nonpublic if the firm adequately addresses them in those 12 months.[6]  These prudential measures and the complexity of the inspection process has caused the issuance of  some inspection reports, particularly for the largest firms  to take longer than we and the firms would like, and we are working on ways to improve the process.

I encourage directors, particularly audit committee members, CFOs and other senior officers to discuss the results of PCAOB inspections with their auditors.  Such a dialogue can assist you and audit committee members to better understand your audit firm’s quality controls.  If quality control criticisms are identified, the audit committee should inquire whether the firm has remedied them or what the firm is doing to remedy them.    

You should also be aware that PCAOB inspectors may select the audit of your company as part of a routine inspection of an auditor.  The focus of these inspections is on the quality of the audit performed and, in most cases, the inspector's comments will be targeted at areas where the auditor's performance of the audit was not satisfactory.  In some cases, however, audit committees have found that they are faced with accounting issues as a result of questions raised by the PCAOB inspection team.  Over the last few years, a number of restatements have resulted from GAAP issues identified in PCAOB inspections, or from auditing deficiencies that, when remedied by the auditor, focused the auditor and the issuer on a GAAP error.

It is important to stress that the PCAOB is not the authority on disclosure or GAAP issues in SEC filings – that is the purview of the SEC.  However, our inspections must look at how and why the auditors made the calls they did on difficult accounting issues in client financials, which may lead to the identification of potential GAAP issues.  In such circumstances, the inspectors will review the potential issues with the audit firm.  If it appears to the PCAOB that financial statements may materially depart from GAAP, or were prepared by an auditor that was not independent, the PCAOB will describe that in the inspection report and inform the SEC. 

Market Data

It has been four years since the corporate scandals that led to the passage of the Sarbanes-Oxley Act.  Many in business, government and academia are busy evaluating the cost and overall impact of Sarbanes-Oxley.  Some are focusing their research on the extent to which investors are recognizing improvement in the reliability of financial reporting by U.S. public companies.  Others are looking at whether Sarbanes­-Oxley has adversely affected capital markets and capital formation in the United States.  Studies of these issues are difficult to conduct and, as a result, the conclusions can be misleading or contradictory. 

For example, we continue to hear concern that the costs associated with Section 404 of Sarbanes-Oxley are leading some capital-seeking companies away from U.S. securities markets.   On this point, critics look to the recent growth in non-U.S. markets.  

To be sure, many markets outside of the United States have risen to become global players. As a result, companies today are presented with more options when they are determining where to raise capital, whether it be on a non-U.S. market or through private capital.  The U.S. markets have never been the low cost alternative, however.  Therefore, we should bear in mind all the factors that impact the competitiveness of the U.S. capital markets.  Increasingly, many are viewing private litigation as the most significant force working against U.S. competitiveness.  Also, a recent study conducted on behalf of the London Stock Exchange observed that relatively higher costs of issuing equity in the United States were mainly due to the systematically higher underwriting fees charged for U.S. transactions.[7]

The same LSE study observed that regulatory and corporate governance frameworks can have a positive effect on investors.  It is important for regulators, including the PCAOB, to achieve the right balance of oversight and regulation in order to protect the reliability, stability and depth of U.S. capital markets, so they can continue to attract investors and issuers worldwide.

Critics of Sarbanes-Oxley often point to the growing percentage of IPOs issued outside of the United States.  That claim needs to be considered in historic context.

At the start of the 1990s, the U.S. markets were on an upward trend.  Markets for equity securities, particularly in the United States, experienced an unprecedented increase in value and activity.  There also was a significant spike in the number of IPOs that peaked in the United States in 1996.  Then things began to turn at a rapid rate through 2001.  A number of factors, including the dot.com bubble and the terrorist attacks of September 2001, led to a slowing of the economy and an increase in equity risk premiums, which enhanced the attractiveness of short-term savings instruments.  The enhanced attractiveness of the low cost and highly liquid capital markets led to an increase in highly-leveraged private equity transactions that continues to this day.  It is important to point out that these developments occurred well before the Enron or WorldCom failures or the Sarbanes-Oxley legislation. 

This perspective helps in scrutinizing some of the data that is being used to implicate Sarbanes-Oxley.  For example, while we, the PCAOB, are mindful that IPO volume is a signal of the overall strength of a market, with regard to the downward trend in U.S. IPOs that is frequently associated with the burden of Sarbanes-Oxley, we should take a closer look.  It is true that the largest IPOs in the last three years have chosen to list on non-U.S. exchanges, however, analysis of these listings indicates that most of them have resulted from privatization of large state-owned companies through sales of minority interests.  It should not be a surprise that the choice of jurisdiction may be more limited for IPOs of state-owned companies.  We also should not lose sight of the fact that the U.S. share of world IPO activity has been on a downward trend since 1996, which I mentioned a moment ago.  This evolution of IPO markets in other countries is not only attributable to changes within U.S. markets but is also a signal of the relative strength and competitiveness of markets overseas.  This is something that merits further study. 

In contrast, while IPO numbers may appear unfavorable, listings on U.S. markets continue to command a valuation premium.[8] Indeed, in the two years since companies have been reporting and obtaining audits on their internal control, the amount of capital raised by non-U.S. companies on U.S. exchanges has grown, not shrunk as it did in the years directly after the scandals.[9]  The liquidity and depth of the U.S. markets remain unsurpassed.  I expect that we will see a continued dominance of U.S. capital markets, particularly in the long term.

Financial Reporting

Last week I attended an international Global Public Policy Symposium sponsored by the six largest global audit firms.  The theme was “Investor Needs and the Role of the Auditor.”  Discussants included colleagues from the PCAOB, other regulators, investors, and, of course, members of the auditing profession and myself.  There was a lively interchange covering a wide range of issues.

Similar to the issues you are discussing, there was a considerable amount of debate about how to make financial reporting more relevant and timely; the value of point-in-time reporting versus the need to provide more forward-looking information; and, pressure from some parts of the investing community to report information on a real-time basis through electronic channels.  As I mentioned at the outset of my remarks, this is an issue that has been under consideration since the 1990s, and there are no easy answers.  I look forward to your group’s contribution to thinking in the area of financial reporting.  I can tell you that the audit community is thinking hard about the challenges of incorporating forward-looking, non-financial information into financial reports.

Another issue that was discussed and that cannot be ignored is the importance of competition among audit firms, which has become highly sensitive since the fall of Arthur Andersen.  Since then, firms have become increasingly risk adverse.  There is no quick solution to the high level of concentration that we currently have, and it is a global issue.  Many large, multinational issuers realistically are limited in their choice of auditor, and the potential for conflicts of interest has increased.  However, I am encouraged by the growth in size and skill taking place in firms following the “Big 4.”  Their investment is good for our markets and should allow the market – in particular for small, medium …and even some larger issuers -– to have additional choices, which I believe is critical for the resilience of the audit profession. 

Conclusion

In conclusion, it is worth taking another look at the four years since scandals rocked investor confidence and led to the passage of the Sarbanes-Oxley Act to gauge the extent to which investors are recognizing improvements in the reliability of financial reporting by U.S. public companies.  In some ways, the Act codified best practices that had begun to emerge immediately following the scandals.  The Act ensured that boards of public companies and their auditors would reassess the roles of audit committees and the integrity of financial reporting and assign responsibility for assuring that internal control over financial reports would be discharged in a meaningful way.  I look forward to participating in a continued, robust dialogue about the future of financial reporting.  It is important that investors of all classes understand the breadth and the limitations of what is contained in financial reports.  And, it is equally important that if changes to financial reporting are made, that the responsibility of the audit profession is clearly articulated.

Thank you again for your time today. 


[1] Previous guidance has included five sets of interpretive guidance issued by the PCAOB staff in the form of answers to frequently asked technical questions on the implementation of AS2. These questions and answers are available at http://www.pcaobus.org.  Guidance has also included a policy statement issued by the PCAOB on May 16, 2005, describing ways auditors can make their internal control audits as effective and efficient as possible, adding an emphasis, among other things, on risk-tailoring the audit, using a top-down approach, and using the work of others.  See PCAOB Release No. 2005-009, Policy Statement Regarding Implementation of Auditing Standard No. 2 (May 16, 2005).  With regard to the May 17, 2006 announcement, See PCAOB News Release, Board Announces Four-Point Plan to Improve Implementation of Internal Control Reporting Requirements (May 17, 2006), available at
http://www.pcaobus.org
.

[2] See PCAOB Release No. 104-2006-105 , Statement Regarding the Public Company Accounting Oversight Board’s Approach to Inspections of Internal Control Audits in the 2006 Cycle (May 1, 2006), available at http://www.pcaobus.org.

[3] The initial assessments and audits for accelerated filers were required by SEC regulations to be included in their annual Form 10-K filings for fiscal years ending after November 14, 2004.

[4] Data compiled by Audit Analytics for reports on internal controls filed as of August 14, 2006 indicate that 2874 issuers have filed their second report on ICFR.  An additional 374 issuers have filed their first report, bringing the total to 3,248 filers. These filers are primarily those required to file as a result of their qualification as U.S. accelerated filers. Accelerated filers are those issuers with market capitalizations in excess of $75 million.

[5] Source: Audit Analytics. 

[6] See Section 104(g)(2) of the Act.  The legislative approach reflected in Section 104(g)(2) rests on the premise that firms could be genuinely motivated to improve their quality controls by the prospect of keeping the Board’s criticisms confidential.  The Board’s early experiences with the process generally validate the wisdom of that premise.  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; see also PCAOB Release No. 104-2006-077 , The Process for Board Determinations Regarding Firms’ Efforts to Address Quality Control Criticisms in Inspection Reports, March 21, 2006, available at http://www.pcaobus.org.

[7] See Oxera Consulting Ltd., The Cost of Capital: An International Comparison (June 2006), at 4, available at http://www.londonstockexchange.com/NR/rdonlyres/B032122B-B1DA-4E4A-B1C8-42D2FAE8EB01/0/Costofcapital_full.pdf .

[8] Remarks of Noreen Culhane, Executive Vice President, Global Corporate Client Group, New York Stock Exchange, printed in Ernst & Young, Accelerated Growth: Global IPO Trends 2006, at 26 (An “underlying motivation for most companies listing in the U.S. is the valuation premium (average 30 percent) that accrues as a result of adhering to high standards of governance.”).

[9] See Cowan, Lynn, “Foreign Companies Cash in on U.S. Exchanges, Wall Street Journal, August 28, 2006, at C6.

 

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