Remarks of Chairman William J. McDonough

Thank you for the gracious introduction and the opportunity to join you once again. This is the third time in just two years that I have had the pleasure of addressing this gathering of Financial Executives International as Chairman of the PCAOB.

At your meeting three years ago, you were probably wondering what to make of this new organization, the inartfully named Public Company Accounting Oversight Board.

At that time, the SEC had just appointed the first Board members, and it would be another two months before the Board would assemble in office space it could call its own.

Three years ago, all you had was the Sarbanes-Oxley Act – then little more than three months old – to give you a hint of how the new world of auditor oversight was going to work and how it might affect the publicly traded companies you represent.

The Act said that your accounting firm would have to be registered with the PCAOB in order to sign off on your financial statements, but there were no rules for how accounting firms should register with this new entity. You might have noted that the Act required your accounting firms to be inspected by the PCAOB, but there was no other clue about how the inspections would be carried out.

The Act also authorized this PCAOB to set new auditing standards, but there was no signal about what standards might be in the offing, and I dare say no one was focused on a section known as 404 and what that might mean for your companies’ internal controls over financial reporting.

Look how far we’ve come. When I joined the PCAOB in June 2003, I was employee No. 42, and we didn’t begin to fill out a single floor of the office space we rented in Washington.

The PCAOB is now a vibrant institution with an outstanding Board and a superb, highly dedicated staff of more than 400 people in offices in nine cities. The supervisory approach that we have undertaken is working well, implemented by the adoption of auditing standards that make sense and an inspection process that works with auditors as they strive to improve their practices and win back the support of the public.

In addition, those of you whose companies are active in our global marketplace will be glad to know that the PCAOB is establishing productive working relationships with a variety of other countries for cooperation in auditor oversight.

From the beginning, the Board adopted a practice that may be considered unusual for regulators. We seek out the advice of investors, accountants, executives and other people who may have a stake in the rules and standards we are considering, and we do it before we write those rules and standards.

We don’t stop soliciting feedback when the rules or standards are in place. One of the most interesting and informative projects I have ever seen be undertaken by a regulator is the initiative spearheaded by Board member Kayla Gillan to conduct nationwide forums to answer questions we were hearing from small accounting firms and small public companies about how our internal control standard and our congressionally mandated inspections would affect them.

Thanks to Kayla’s efforts, our Small Business Forums have enabled PCAOB staff and Board members to meet with more than 900 representatives of small companies and small accounting firms in 10 cities across the country, from Orange County, California, to Boston, Massachusetts.

Those forums, and other meetings the Board has hosted and attended, help us know how our rules and standards will affect the real world and how to respond when either we – or the users of our standards – don’t get it quite right.

It is a remarkable record for an organization that existed only in name three years ago, but we are not done. We continue to work aggressively to hire experienced accountants to complement the ranks of our talented and accomplished inspectors.

As you know, I am about to reduce the PCAOB headcount by one, having announced that I will be stepping down at the end of this month. And even today, I must note that the opinions I express are my own and do not necessarily reflect the views of other Board members or staff of the PCAOB.

As I told my fellow Board members and the staff of the PCAOB when I spoke to them about my decision to move on, I do so with great confidence that I am leaving an organization that is well-formed, strong and ready for the many policy decisions and other challenges that lie ahead.

I am also leaving at a time when the accounting profession – if humbled after the scandals that rocked our financial markets – is wiser, stronger and ultimately more confident in its own mission than it has been in a very long time.

During my tenure, the PCAOB has played a useful role by, among other things, helping to keep the profession's collective mind concentrated on the primacy of the goal of restoring public confidence. But ultimately, it is the profession – through integrity, sound judgment, and hard work – that will restore the public’s confidence, and it is the profession that will deserve the credit for restoring that confidence.

Over the past two years, I have witnessed the accountants’ strong start toward that goal. But restoring and maintaining public trust and confidence is an ongoing mission, requiring unfailing focus and vigilance, not just on the part of the accountants, but on the part of every participant in the U.S. markets who benefits from the people’s investments.

It is not a project that can ever be considered "finished." You must maintain your focus on that goal, and the PCAOB must continue to play its role in keeping that goal front and center.

Those of you whose companies operate internationally will attest to the fact that the importance of investor confidence to financial markets is not uniquely an American phenomenon.

The more confidence that investors have in the financial information about the issuers of securities, the more resources those investors will pour into our businesses, both large and small, to fuel the growth and competitiveness of our economy.

The Sarbanes-Oxley Act has had a profound effect on the integrity of financial reporting in our capital markets and the reliability of public company audit reports. The Act has touched virtually every aspect of the financial reporting process, from preparers’ certifications of accuracy to the independence of third-party analysis, covering the integrity of gatekeepers such as lawyers and auditors in between.

One of the most challenging but also most promising provisions of the Act is the requirement that public companies annually provide investors an assessment of the quality of their internal control over financial reporting. That assessment must be accompanied by an auditor’s attestation on the same subject. The PCAOB’s Auditing Standard No. 2 set out the steps that auditors must take to support their attestation.

Companies have been required to have internal control over their accounting since the Congress enacted the Foreign Corrupt Practices Act in 1977. There is no doubt, however, that the Sarbanes-Oxley Act’s requirement for annual assessments, and auditor attestations to those assessments, took corporate responsibilities for internal control over financial reporting to an entirely different level.

This should increase investor confidence in the reliability of reported financial results. And that, in turn, should reduce the cost of capital for companies with effective internal control over financial reporting.

The first year of applying Sarbanes-Oxley was enormously challenging for all involved and there is every reason to expect that auditors and companies alike will learn how to make their respective work more effective and efficient in the future. Specifically, Section 404 of the Act has prompted the biggest change in how audits are conducted in 70 years.

Although public attention to the work of the PCAOB has recently focused most intensely on the PCAOB’s role in implementing Section 404 and our rules for audits of companies’ internal controls, the more significant, long-term effects of our work will be the product of our oversight activities.

PCAOB oversight has already changed the environment of registered public accounting firms and their partners and staff that participate in audits, and it has triggered a profound shift in the overall character of public company auditing. Most important, our oversight has changed auditors’ attitudes toward their accountability.

Under the old system, which relied primarily on the enforcement tools of federal and state regulators after a problem had already occurred, the risk that an auditor’s failure to identify and address a financial reporting error would come to the attention of regulators was relatively low.

If such a problem did come to a regulator’s attention, the consequences were grave – often ending the careers of auditors involved if not the practice of the firm itself. The risk of detection, however, was too often not sufficient to motivate firms and auditors to take the tough stance necessary to head off potential misstatements in financial reports.

This was especially true when the firm and the issuer could, at least in the early going, rationalize the problem away as involving only immaterial amounts.

Under the new system, auditors understand that their work is much more likely to be reviewed within months or even weeks by the PCAOB’s well-experienced, full-time inspectors.

In 2004, the Board conducted inspections of the eight largest U.S. accounting firms and of 91 smaller accounting firms. In 2005, the Board is again inspecting the eight largest U.S. accounting firms, in addition to the Canadian affiliate of KPMG that counts more than 100 U.S. companies as audit clients. We also expect to inspect about 280 smaller firms this year. Our inspectors are in the field as I speak, completing their work on the PCAOB’s 2005 inspections.

In 2004, we reviewed portions of more than 500 audits performed by the largest eight firms. We chose those audits, and the particular aspects we reviewed, on the basis of our own assessment of the risk of material misstatements or significant auditing deficiencies.

The inspection team reviewed aspects of selected audits performed by each firm, choosing the engagements to review according to the Board's criteria. No firm is allowed an opportunity to limit or influence the engagement selection process or any other aspect of the review.

For each audit engagement selected, the inspection team reviewed the issuer's financial statements and certain SEC filings. The inspection team selected certain higher-risk areas for review and, at the practice offices, inspected the engagement team's work papers and interviewed engagement personnel regarding those areas.

The areas subject to review included, but were not limited to, revenues, reserves or estimated liabilities, derivatives, income taxes, related party transactions, supervision of work performed by foreign affiliates, assessment of risk by the audit team, and testing and documentation of internal controls by the audit team.

The inspection team also analyzed potential adjustments to the issuer's financial statements that had been identified during the audit but not recorded in the financial statements. For each engagement, the inspection team reviewed written communications between the firm and the issuer's audit committee.

With respect to certain engagements, the inspection team also interviewed the chairperson of the issuer's audit committee. When the inspection team identified a potential issue, it discussed the issue with members of the audit engagement team and the personnel from the firm’s national offices.

If the inspection team was unable to resolve the issue through this discussion and any review of additional work papers or other documentation, the inspection team ordinarily requested the engagement team to consult with the firm’s national offices.

We also often select additional audits during the course of the inspection, enabling our inspectors to follow leads to the root causes of poor auditing. For example, if we find a poor quality audit that passed the muster of a firm’s own internal quality control reviews, we will review additional work performed by the same audit partner and engagement team.

We will also review other work performed by the internal reviewers who missed the reviewed partner’s errors. Not surprisingly, we have found that this approach leads to uncovering additional problems. It also gives auditors a good bit more anxiety, and correspondingly greater incentive to stay on their toes, than a mere random sample of engagements.

Another important catalyst for change in the new system is that, 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.

First, when our inspectors find potential material accounting errors or significant auditing deficiencies, we invite the auditing firm to comment on the accounting and auditing work involved. This assessment process not only helps us to verify our own assessments, but it also helps the firm to identify the causes and scope of the problem.

Second, throughout this comment process, our inspectors discuss the problems we identify with representatives of the firm, including members of the engagement team, the firm representative responsible for the firm’s handling of the inspection, national office experts, and ultimately, the managing partner or chief executive of the firm.

Although serious problems that we identify are ultimately described in our inspection reports, it is our discussions with the firms that drive them to redress the problems on the spot, through performing missed auditing procedures, enhancing internal quality control requirements, discussing the problem with the client involved, and other actions.

A substantial portion of the Board's criticisms of a firm – specifically those dealing with the firm's quality control system – and the Board's dialogue with the firm about those criticisms occurs out of public view, unless the firm fails to make progress to the Board's satisfaction in addressing the shortcomings that we have identified.

But much of the report on a firm’s inspection is made public – as required by the Sarbanes-Oxley Act. To date, we have issued 120 inspection reports. More reports are appearing on almost a weekly basis.

The Board generally does not disclose otherwise nonpublic information, learned through inspections, about the firm or its clients. Accordingly, information in those categories generally does not appear in the publicly available portion of an inspection report.

Two years of inspecting the audits of the largest eight accounting firms has done nothing to shake my view that these firms, operating at their best, are capable of the highest quality auditing. But it has also done nothing to shake my view that the Congress acted wisely in creating independent oversight of the profession to help move firms in the direction of consistently operating at their best.

Through our inspections, we have already identified, and encouraged appropriate resolution of, numerous accounting and auditing problems. And we feel confident that we are, as the Congress intended, helping to move the profession steadily in the right direction – toward reducing the risks of material misstatements or unreliable auditing.

I cannot say – and I do not believe that you would expect to hear – that after only two inspection cycles we have identified and uprooted all the causes of recent auditing failures and all the risks of future auditing failures.

Nor would it be prudent, given the time that regulatory, judicial, or law enforcement processes can take, to assume that auditing firms are necessarily beyond the possibility of repercussions for pre-Sarbanes-Oxley failures.

But we have plainly made a start that amply vindicates the decision the Congress made in creating the inspection process.

Although our inspections work to date has focused primarily on the largest firms’ annual inspections, over the last year, we have devoted considerable effort to developing appropriate oversight that takes into account the diversity of the auditing firms that have registered with the Board.

As of this week, we have registered more than 1,586 firms, including the nation’s largest firms, hundreds of medium-sized regional firms and small firms, and 640 non-U.S. firms. We are working hard to structure our inspections program so that it is equipped to efficiently and effectively address this universe.

Early after the enactment of the Sarbanes-Oxley Act, some people expressed concerns that the Act’s requirements for oversight of accounting firms might pose a barrier to small firms’ ability to compete for public company audit clients. In fact, however, a number of these small firms have actually increased the number of public companies that they audit, as the larger firms have reduced their number of smaller public company clients.

Accordingly, we expect to see smaller firms seizing opportunities to expand their business by taking on new clients appropriate to the size and sophistication of the firms’ practices.

At the same time, we know that for that growth in their business to be fully successful, the firms must understand, and know what is expected of them within the Sarbanes-Oxley and PCAOB framework. We recognize that, for smaller firms, the adjustment to that framework gives rise to many issues and questions that are different from those confronting the larger firms.

Although non-U.S. firms are subject to the Act and to the rules of the Board "to the same extent as a public accounting firm that is organized and operates under the laws of the United States," oversight of the audits of U.S. public companies conducted by non-U.S. firms poses unique challenges.

To address such challenges, we have developed a framework under which the Board may conduct its oversight in cooperation with local regulators, and we maintain a constructive dialogue with relevant regulators in certain key non-U.S. jurisdictions.

Specifically, the oversight rules adopted by the Board set forth a model for inspections of non-U.S. firms under which the Board may rely on the work of the home-country regulator. Non-U.S. registered firms are subject to PCAOB inspections in the same manner as U.S. firms: annual inspections for firms with more than 100 public company audit clients and inspections at least once every three years for firms with one or more public company audit clients.

The degree of reliance on home-country inspections will be based on the independence and rigor of the home-country system of oversight and agreement between the PCAOB and the home-country regulator on the inspection work program for individual firms. The more independent and rigorous the home-country system, the more the Board may rely on it to conduct an inspection of a PCAOB-registered firm.

The Board has also demonstrated its willingness to assist non-U.S. authorities in their oversight of U.S. firms that are registered with the PCAOB and are also within the regulatory jurisdiction of non-U.S. authorities. The oversight rules provide for the Board to assist non-U.S. regulators on inspections and investigations of U.S. firms subject to dual oversight.

In addition to working with its counterparts in oversight of accounting firms, the Board supports efforts of non-U.S. regulators and professional bodies to develop high-quality professional standards for auditing. The Board believes these efforts lead to the use of improved standards throughout the world, resulting in higher audit quality and more reliable financial reporting. This will benefit financial statement users everywhere, including those in the United States.

Together with our counterparts, we hope to do what we can to reduce overall risk to investors in securities markets throughout the world.

I came to the PCAOB in June 2003 to help it fulfill the great responsibilities assigned to it by the Sarbanes-Oxley Act.

As I have acknowledged in other settings, it was a highly unlikely law – considering its birth in a Senate with a bare Democratic majority, its passage in a Republican-led House, and its signature into law by a Republican president.

The Act was most unlikely because it is a highly prescriptive law, containing directives to companies and their executives that are rarely seen in this democracy that so tightly embraces its market economy.

And yet, behind the prescriptions and proscriptions, the heart of the Sarbanes-Oxley Act is a recognition that the key player in our market economy – the investor – had been betrayed by business leaders and advisors. The Act was a clarion call for change in the treatment of investors, and it was a call that struck a deep chord in me.

I would like to acknowledge here the enormous debt that investors – and that includes you and me – owe to the two men for whom the Act is named. Senator Paul Sarbanes of Maryland and Congressman Mike Oxley of Ohio not only shepherded a tough piece of legislation through their respective houses of Congress, but more importantly, they stood up for the law and its principles when criticism reached a crescendo.

Like me, both Senator Sarbanes and Congressman Oxley have announced their retirements. Like me, their plans for the future are not known. Whatever we do, I hope we will be remembered for doing our very best to make the world a better place for investors.

But in the end, neither lawmakers nor regulators can force the kind of behavior that will inspire investors’ confidence in our markets. The honesty and fair-dealing that investors deserve can come only from market participants – the executives, directors and accountants who are supposed to safeguard investors’ interests.

In other words, it’s up to you. And although I will no longer have oversight responsibilities in my new career, I’ll be watching.

Make me – make yourselves – proud.

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