Careers
SubscribeRemarks of Board Member Charles D. Niemeier
It’s great to be here. The SEC and the Business Law Section of the Colorado Bar Association do a great service to the country each year by bringing together an esteemed group of securities law policy makers and practitioners to the rarefied air of Denver.
It is also a great pleasure to be among so many current and former staff from the Securities and Exchange Commission. The dedication and talent of the commissioners and staff of the SEC since its earliest days to the present time continually meet the challenge of developing and protecting a society of investors, whose confidence in the SEC’s protection has fueled our economy for most of the last century.
I want to give you a bit of an overview of what is going on at the Board and explain how the PCAOB fits into the overall regulatory framework to protect the investing public. Before I go further, however, I have to note that the views I express today are my own, and not necessarily those of the other Board members or staff.
That said, I cannot imagine that I am alone in the view that the financial reporting and auditing failures revealed in the early part of this decade severely rocked the confidence of the investing public. Indeed, concern for the effect investors’ loss of confidence could have on our economy led Congress to pass the most wide-ranging securities legislation since the 1930s – the Sarbanes- Oxley Act of 2002 – by a vote of 423 to 3 in the House and 99 to 0 in the Senate.
The Sarbanes-Oxley Act has been discussed in great depth at this conference each year since 2002. Today I’d like just to give you a brief update on the PCAOB programs it established.
I. Program Overview
For more than three years now, my fellow Board members and I, along with our heroically hard-working staff, have registered more than 1,600 U.S. and non-U.S. accounting firms that audit – or wish to audit – U.S. public companies. More than seven hundred of these firms are in countries outside the U.S., reflecting the global nature of auditing and financial reporting today.
Since 2003, we have also made substantial progress in establishing the program of inspecting the work of registered firms that the Act envisioned. For the largest nine firms, inspections are an annual event. We inspect all other firms that audit or play a substantial role in the audit of U.S. public companies at least once every three years.[1]
Our inspection program is the core of our supervision of registered firms, but these inspections take place largely outside the public view. This is because the Act allows firms one year to show that they have addressed any quality control problems before such problems may be made public, reflecting the Congress’s policy decision to use the possibility of public disclosure as an incentive to firms to fix problems.[2] In my view, our early experience with this incentive system suggests that it works very well: when we identify problems, firms take our criticisms seriously and make substantial changes within a year.
The Board also uses its inspection process to address most of the individual, or isolated, auditing problems we identify. For example, when we find individual audits that are not up-to-grade, we discuss with the firms precisely what the deficiency is. Sometimes this means a firm will perform additional audit procedures to shore up a weak audit.
In addition, from time to time our inspections identify potentially inappropriate accounting or other financial reporting by issuers. We bring such matters to the attention of the firms involved, and in most cases they will take the matters up with the company and, if necessary, with the SEC. We do not discuss accounting matters with issuers directly, although we do have a practice of notifying the SEC when we identify financial statements that appear to be materially misstated and providing relevant supporting information as needed.
When the problem relates to an individual auditor, a firm may provide additional training or oversight to the person involved or take other action the firm determines is appropriate. When firms have a cooperative, proactive attitude, we have been able to achieve significant real-time improvements, often even before an inspection is concluded.
As necessary, the Act also authorizes us to investigate auditor conduct and, as appropriate, to seek disciplinary sanctions. In circumstances of reckless conduct or worse, those sanctions can include significant monetary penalties, and also may include revoking a firm's registration (and thus preventing it from auditing public companies) or suspending or barring individuals from working on the audits of public companies.
Because auditor malfeasance may have an impact on the reliability of the financial statements the auditor was responsible for examining, our investigations will often be a component of a larger investigation of the financial reporting itself and management's role in that reporting. We work very closely with SEC investigative staff in such cases, including by sharing investigative records, coordinating the timing of testimony and other events, and providing technical advice and consultation as needed.[3]
Based on what we learn through our regulatory programs, as well as available internal and external research and discussion, we have also established a standards-setting program to consider, seek input on, and promulgate auditing and professional practice standards and other guidance to enhance the quality of audits. The Board has adopted a number of standards since we opened our doors, as well as overseen public discussion – with a Standing Advisory Group and in various other roundtable discussions – of important issues relating to auditing, auditor independence, and other topics.
Most likely, everyone in this audience is aware of our most famous new standard – Auditing Standard No. 2, which implements the Sarbanes-Oxley Act’s requirements relating to auditing and reporting on the effectiveness of public companies’ internal control over financial reporting. Time permitting, we may discuss some of the latest developments in the Board’s work on making sure this implementation is as effective and efficient as possible. But first, I’d like to highlight some important aspects of our inspection program.
The Board has hired a staff of 427 auditors, analysts, attorneys, and others, and we plan to continue to grow to about 540 employees by the end of this year. Today, 185 of our people are experienced accountants who perform inspections, and we plan to grow that force to approximately 250 by year end. In today’s tight employment market, that is a very tough goal, but in my view it is critical that we achieve it to perform the kind of work I believe is necessary to justify public confidence in our ability to ensure high quality auditing. Most of our staff is based in our headquarters in Washington, D.C., but we have offices to support inspections staff here in Denver, as well as in San Francisco, Orange County, Dallas, Chicago, Atlanta, and New York City. We also have an office near Dulles, Virginia, to support our significant investments in technology.
II. Board Inspections Steer Auditors to Use Good Judgment in Performing High-quality, Independent Audits
We have now embarked on our 2006 cycle of annual inspections of the eight largest U.S. firms and one Canadian firm, all of which audit the financial statements of more than 100 public companies. In addition, we will inspect a great number of small U.S. and non-U.S. firms that audit the financial statements of at least one U.S. public company. We began the fieldwork for these inspections earlier this month, and we will continue these inspections through November. We will focus on, among other things, efforts to detect fraud and to identify, evaluate, and manage risk. Also, building on work we began in our 2005 inspections of certain large firms, we will devote special attention to examining how well firms have been able to perform audits of internal control over financial reporting, with a view toward guiding firms to the most efficient methods available to obtain assurance that audit clients have effectively operating internal control.
Importantly, each year our inspections include examinations of a limited number of Fortune 500 audits. These reviews are the most resource-intensive aspect of our inspections, because they take significant time from our most experienced accountants. One of the most difficult judgments the Board has to make is the amount of our inspection resources to devote to this class of audit. To date, our primary constraint has been hiring; the tight employment market continues to restrict our ability to review these audits. [4] Given this constraint, for the time being in my view we are fortunate to be able to examine the limited number of mega-audits that we do.
In the long run, though, I believe that we need to examine more of such audits. In addition to overcoming our hiring challenges, we will also continually need to resist the incentive to prioritize the accomplishment of easier, measurable tasks over underlying policy goals. In our case, this incentive could manifest itself as an over-emphasis on inspecting the numerous tiny firms subject to our jurisdiction at the expense of inspecting Fortune 500 audits of the large firms, which are significantly more difficult than the small firm inspections.
Inspections of large company audits are both a more effective use and a more efficient use of our resources to protect the investing public: after all, 92.5% of the total U.S. equity market capitalization is made up of the 550 or so companies with equity market capitalizations of greater than $1 billion.[5] As we saw time and time again in 2001 and 2002, when Enron, WorldCom and other top companies announced major misstatements in prior period financial statements, it is also the largest companies that provide – or jeopardize – the foundation for investor confidence in the U.S. financial reporting system.
Fortunately for the investing public, the SEC was quick to respond to the crisis in investor confidence by focusing its resources on the financial reporting of the largest companies in a number of ways. For example, close on the heels of Enron’s fall and under Alan Beller’s leadership, the SEC’s Division of Corporation Finance instituted a program to monitor the annual reports filed by all Fortune 500 companies in 2002 as part of its reviews of financial and non-financial disclosures made by public companies.[6] In addition, in June 2002 the Commission ordered all public companies with revenues of more than $1.2 billion – or approximately 950 companies – to file written statements, under oath, of their CEOs and CFOs regarding the accuracy of their companies’ financial statements and their consultation with their companies’ audit committees.[7]
I also played a small role in this effort, as Chief Accountant of the Division of Enforcement in those years, when under the leadership of Dick Walker, Steve Cutler, and Linda Thomsen, we shifted the focus of the Division’s enforcement efforts in the financial reporting area away from the small companies that had been the bread-and-butter of the program to the conduct of the largest companies as well as their advisors and auditors. In those years, I certainly learned that large companies are not free of financial reporting errors and fraud, and indeed that a policy of examining only smaller companies left financial reporting problems at large companies to fester and grow with abandon. To establish an inspection program that has the confidence of the investing public, I believe the PCAOB needs to pay close attention to these lessons and examples.
Those are the stats on the job and decisions we have ahead of us. Now let me tell you a bit about our approach to inspections.
A. The PCAOB’s Supervisory Approach to Inspections is Designed to Identify and Address Audit Weaknesses at an Early Stage
Our inspections are risk-biased, which means that we select engagements, and specific areas in those engagements, that, for any number of reasons, may present difficult challenges to auditors. For example, we may focus on an audit of a public company whose financial disclosure consists in substantial part of management estimates and is demonstrably opaque. The business risk to the engagement partner of offending the client may or may not have a bearing on the partner’s willingness to bend to a management bias in estimation, but we will find out.
As another example, our inspectors may focus on a number of audits – across firms – that involve application of complicated, exception-laden accounting rules. In these cases, we will be looking to see whether auditors have a grasp of the economic substance of the transactions or events at issue, such that they apply the rules in a manner that leads to a fair presentation, not just one that technically qualifies for applicable exceptions.
Indeed, if we have learned anything from the financial reporting scandals that led to the passage of the Sarbanes-Oxley Act, it is that the quality of financial statements is not driven by technical adherence to standards but rather turns on a company’s attitude toward disclosure. Auditors are in a unique position to evaluate this attitude, and a good auditor uses this evaluation to decide where to spend his or her time and effort in an audit.
B. PCAOB Inspections Facilitate the Transition to Principles-based Accounting
In this regard, over time, the PCAOB’s inspection program will be an important partner in the efforts of the FASB and the SEC to move toward more principles-based – or objectives-based – accounting standards. In the SEC staff’s 2003 study on principles-based accounting, the SEC staff noted that for a system of principles-based accounting standards to be viable, "auditors would need to be weaned away from the check-list mentality" and would, in some cases be faced with the prospect of having "the rules-based security blanket removed."[8]
Some have expressed concern that a principles-based accounting model would rely more heavily on auditor judgment, which can be weak-kneed in the face of pressures like those I’ve just described, than a rules-based system does. Others have expressed concern that the threat of second-guessing by a PCAOB inspector may drive auditors to a checklist mentality and impede the exercise of judgment. To my mind, these concerns are misplaced. Indeed, as the SEC staff noted in their study, "rules-based standards [already] require significant judgment to determine where within the complex maze of exceptions and internal inconsistencies a transaction falls."[9]
Who would deny that it takes judgment to deal with the all-too-common question from corporate managements to "show me where the accounting literature says I can’t do that"? It takes good judgment, as well as strength of character to get through such a challenge. The difference between the judgments required in a rules-based system and those required in a principlesbased system is rather that, in a principles-based system, auditors apply themselves to settling on a presentation that achieves the objectives of the principle as opposed to applying themselves to verifying the applicability or nonapplicability of exceptions to a rule.
Where do our inspections fit in? Well, as the SEC staff study noted, "some research seems to indicate that auditors might be more willing to challenge aggressive accounting practices adopted by management in a more ‘flexible’ accounting environment than in an environment of rigid rules." The SEC staff noted importantly, however, that "this result appears limited to situations where the auditor is more experienced and in a ‘stronger’ firm."[10]
Rather than impeding auditor judgment in such situations, PCAOB inspections will be critical to the strength required of firms and their professionals. The precision of seeming to comply with detailed rules and checklists can mask a decision to ignore the economic reality of circumstances or transactions, which itself is a judgment by preparers and auditors, albeit a bad one. In such situations, the protection of detailed rules is illusory. Time and time again we have seen such judgments result in poor reporting and, indeed, problems for the preparers and accountants who sought detailed rules as a form of protection.
Through our inspections, we can focus auditors’ attention on evaluating whether the overall presentation of financial statements is fair and complete, which is a far better protection from challenge for those involved. By emphasizing good judgment to identify and achieve the objectives of accounting standards, PCAOB inspections will help auditors – and, in turn, public companies – to transition to a principles-based accounting model.
C. PCAOB Inspections Reduce the Risk of Major Financial Reporting Failures by Identifying and Correcting Problems at an Early Stage
Of course, another important attribute of PCAOB inspections – whether testing application of rules or principles – is that by reviewing audits before problems erupt, we focus auditors on fixing them before they lead to, or fail to prevent, large misstatements in financial statements. Unlike traditional enforcement models that focus on punishment after financial reporting and auditing failures become exposed, our inspections provide new tools to identify and resolve problems early in their development.
These tools are achieving demonstrable results. On a quantitative level, misstatements have already been identified through our inspections and corrected, early enough to escape the devastating consequences that descend on companies that don’t address problems early. Some have argued that correcting small problems before they’ve grown into scandals is not important to investors and therefore not worth the expense to identify and correct them. These critics point to evidence that stock prices have not consistently shown material reactions to the record numbers of restatements in our financial system in the last couple of years. I think that view is misguided. Indeed, to my mind, that evidence shows that correcting problems early in their development helps companies get on the right track and avoid devastating, and significantly more costly, consequences later on.
And on a qualitative level, ask any auditor, and you will likely hear that there is no question that they believe their firm is doing higher quality audits than before the Sarbanes-Oxley Act. Among the critical generation of professionals who are now rising to the senior ranks in firms, in many cases they will say they are back to auditing the way they were when they started at their firms, before the 1990s when 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 I will say that I believe we have already significantly reduced the risk of misstatements being missed in registered firms’ audits.
Thank you. Now I’d be happy to get into some questions.
[1] Under PCAOB Rule 4003, the mandatory three-year inspection cycle for a smaller firm (100 or fewer issuer audit clients) begins the year after the first year in which the firm, while registered, issues or plays a substantial role in preparing an audit report on a U.S. public company.
[2] In order to give the public an understanding of how this incentive works, the Board recently described its experiences in monitoring firms’ efforts to address problems identified in the first year of inspections. 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.
[3] Board inspection and investigative materials are subject to strict confidentiality restrictions under the Act. Specifically, under Section 105(b)(5) of the Act, the Board may share such materials only with a limited list of government agencies, including the SEC, the Justice Department, appropriate federal banking regulators, state attorneys general investigating criminal matters, and appropriate state regulatory authorities such as state boards of accountancy.
[4] "Even though enrollment in accounting programs has risen over the past few years, the demand for CPAs currently outstrips supply by as much as 20 percent." The People Who Count, CFO.com (April 2006).
[5] See SEC Office of Economic Analysis, Background Statistics: Market Capitalization and Revenue of Public Companies, Table 2 (April 6, 2006), included as Appendix E, Table 2, in the Final Report of the Advisory Committee on Smaller Public Companies to the United States Securities and Exchange Commission (April 23, 2006). This report is available at http://www.sec.gov/info/smallbus/acspc/acspc-finalreport.pdf .
[6] See Summary by the Division of Corporation Finance of Significant Issues Addressed in the Review of Periodic Reports of the Fortune 500 Companies, available at http://www.sec.gov/divisions/corpfin/fortune500rep.htm.
[7] See Order Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934, SEC Release No. 4-464 ) (June 27, 2002), available at http://www.sec.gov/rules/other/4-464.htm.
[8] See Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System, SEC Staff (July 25, 2003), available at http://www.sec.gov/news/studies/principlesbasedstand.htm#P528_122602.
[9] Id. at note 100.
[10] Id. (citing Nelson, Mark W., "Behavioral Evidence on the Effects of Principles- and Rules- Based Standards," Accounting Horizons, March 2003).