The Impact of Financial Regulation: Current Policy Issues Impacting the Audit Profession


First, I want to say thank you to the Chamber, and Tom Donohue, for inviting me to participate in this important conference. It is a great pleasure to speak to you this morning – between Barney Frank and Chris Cox, two leaders in our national debate over the competitiveness of U.S. capital markets.

The issue of competitiveness has been at the forefront of financial policy debates over the last several months, and I am pleased that policy makers and the public at large are focused on the subject. I am equally pleased that recent reports are starting to look at the issue broadly.

Just this week the Chamber unveiled its report on capital market competitiveness, which contributes to our understanding the views of the business community.

Please note that the views I express today are my own, and not necessarily those of other Board members or staff of the PCAOB.

Several recent reports and a number of public figures have identified the U.S. regulatory structure, approach and requirements as presenting key challenges to the competitiveness of U.S. capital markets. More specifically, the requirements of the Sarbanes-Oxley Act have been observed by some recent studies as causing foreign companies to avoid listing on U.S. capital markets.

That is one view. Reports also have pointed to other important factors such as the U.S. legal environment, and the availability of skilled professional workforce. Some reports have also recognized the impact that the strengthening of foreign equity markets has had on the U.S. exchanges’ percentage of total world market capital. From other corners, we hear arguments that U.S. market competitiveness is not at risk due to the advantage the U.S. markets continue to have over others and that they will continue to dominate due to their depth and resiliency.

Regardless of whether you believe the U.S. markets are thriving or critically at risk, you will likely agree that policy makers should work to ensure that regulations in the United States protect investors and enhance the health of our markets...not create unnecessary obstacles, particularly those that might divert listings on U.S. exchanges or drive investors abroad. The health of our markets compared to others is a complex subject that we could debate with great intensity today (or all week if we had the time). Instead, let me focus on the PCAOB’s area of oversight and how it fits into this debate: that is, the role of auditors of U.S. listed companies.

Studies have factored auditors into the issue of U.S. competitiveness. Among other reasons, this is because, for publicly traded stocks, auditors of public companies play a central role in assuring investors that, among other things, financial statements are accurately stated. In the aftermath of Enron, WorldCom and other recent corporate scandals, Congress passed the Sarbanes-Oxley Act that created the PCAOB and required a number of corporate governance reforms. Reassuring confidence in financial reporting was determined to be critical. While the dust has now begun to settle from that crisis in confidence, we should not lose sight of why those reforms were necessary, or why their implementation should be effective and balanced.

The PCAOB is the independent body created by the Sarbanes-Oxley Act to set audit standards and oversee the auditors of public companies. I will explain how the PCAOB seeks to balance its objectives. Because of the public focus on Section 404 of Sarbanes-Oxley, that is, the requirement for internal control over financial reporting, I will specifically address recent steps taken by the PCAOB with regard to its audit standard over internal control. I will also address some additional policy issues concerning the audit profession.

The Sarbanes-Oxley Act

First, a bit about Sarbanes-Oxley. The Act transformed the dynamic between public companies and their auditors, enhanced the role of audit committees, and established the PCAOB. While most provisions of the Act have now been implemented, the PCAOB and the SEC understand that there is more work to be done in order to assist companies and their auditors to fully transition to the post-Sarbanes-Oxley environment.

We often hear from people, who are critical of certain areas of the Act’s implementation, that they support the core objectives behind Sarbanes-Oxley – which are, increasing management accountability, strengthening internal control over financial reporting, and facilitating fair and reliable disclosure for investors. I have heard from a number of companies during the short time that I have served as the PCAOB Chairman that they are better companies due to the requirements of Sarbanes-Oxley. However, they are quick also to observe that the costs to date far outweigh those benefits.

Striking the Balance

Due to the global nature of our market place and the potential for unnecessary burden, it is essential that financial regulators work to effectively carry out their mandates while being mindful of the need to eliminate unnecessary costs. Based on this challenge, the PCAOB works to monitor its requirements and their implementation on a near-constant basis. This is facilitated by the fact that the PCAOB is both a standard setter and a supervisor with inspection authority. The inspection process provides the PCAOB with a lens on how audit firms are effectively implementing requirements, and the supervisory dialogue that occurs through inspections serves to address problems at early stages.

I will focus this part of my remarks on actions the PCAOB has recently taken with regard to Section 404 of the Act. The responsibility for implementing Section 404 of the Act is shared between the SEC and the PCAOB. For its part, the PCAOB is responsible for establishing the standard for the audit of internal control over financial reporting. 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. Investors can have much more confidence in the reliability of a corporate financial statement if corporate management demonstrates that it maintains adequate internal control over bookkeeping, the sufficiency of books and records for the preparation of accurate financial statements, adherence to rules about the use of company assets and the safeguarding of company assets.

In June 2004, the PCAOB’s Auditing Standard No. 2 went into effect – it provides for an integrated audit of both internal control over financial reporting and the financial statements themselves. Due to the importance of this requirement, the PCAOB monitored its implementation carefully. Monitoring included, among other things, two public roundtables hosted by the SEC and PCAOB, dedicated sessions of the Board’s Standing Advisory Group, detailed study of firms’ implementation as part of PCAOB inspections, the issuance of a Board policy statement, a Board report on its inspections observations, and several rounds of staff guidance.

The Current Proposal to Replace Auditing Standard No. 2

In response to concerns identified, the PCAOB acted in December through the release of a proposed standard to replace AS2 and related proposals. The proposal package seeks to achieve a better alignment of the costs of these audits with their benefits. We believe that the proposal responds to many of the concerns that emerged during the early implementation of the current PCAOB standard.

The Comment period for the proposal ended on February 26th. Overall, the PCAOB received approximately 170 comments letters from investor groups, corporations, auditors and other stakeholders. In general, the letters indicate a strong support for the direction of the PCAOB proposals with a number of suggestions of how the PCAOB could improve the standard even more. We are carefully considering these recommendations and will move forward with a vote on a final standard over the coming months.

I believe the proposals that we are considering now will help bring about a better alignment between the costs and benefits of the internal control audit. Of course, for the full benefit of the new standard to be realized, we will need to allow for implementation of the standard by the auditors in the field. With regard to implementation and transition, I am hearing from the larger auditing firms that they are preparing to train their engagement teams based on the proposed new standard. While we can expect that the proposal will evolve to a degree before it is made final (in response to the comments received on the standard), I expect that this early training may result in a smoother transition period once the standard is made final.

The PCAOB will continue to work closely on Section 404 with the SEC. Among other things, we will seek to align, where appropriate, provisions in our standard with those in the SEC’s management guidance. Ultimately, our expectation is that the result will be a balanced audit standard that enables auditors to appropriately tailor the scope of their audit in response to the risk profile of their client. The next stage will be important, as the Board hopes to vote on a new standard in the coming months.

The Impact of the PCAOB

It has now been over four years since the corporate scandals rocked investor confidence and led to the passage of the Sarbanes-Oxley Act. We are now starting to be able to evaluate the extent to which investors are more confident in the reliability of financial reporting by U.S. public companies. Overall, there is a renewed confidence in financial reporting, and the PCAOB’s work has contributed to a reduction in the risk of financial reporting failures. These developments are favorable for the U.S. securities markets.

Evidence of these trends, for example, can be taken from the information on the quality of internal control over financial reporting and disclosures that is now 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 control over financial reporting and independent audits.

The problems identified by accelerated filers in the first two years of reporting tell us a great deal about the progress made already. An 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 9.5 percent for the second year.[1]
  • Although the number of adverse ICFR opinions that reference either restatements or material year-end adjustments continues to be high as a percentage of total adverse ICFR opinions, there has been a shift from those referencing restatements of previously issued financial statements to those referencing material year-end adjustments. This may imply that errors are being identified earlier than in the past.
  • This improving trend is also reflected in the data on financial restatements for 404 filers. For example, from 2005 to 2006, restatements for large accelerated filers declined from 242 to 196. This is in contrast to the restatement trend for non-accelerated filers that are not yet subject to Section 404. For non-accelerated filers, restatements are increasing. That is, they grew from 921 to 1,318 in the same period.[2]

Other Issues Facing the Audit Profession

As the supervisor of audit firms, the PCAOB is closely engaged with the firms on the key issues facing the profession. Audit firms today are operating in a very different environment from five years ago. In addition to being subject now to oversight by the PCAOB (a body independent of the profession), two other key developments are worth noting. First, due to enhanced importance of independence requirements, the firms have transformed their business models, which many have observed as fundamentally changing the client-firm relationship. Second – with regard to the Big 4 – they are part of a more concentrated group of large firms.

Concentration is in itself an important issue, and it is a global one. For large, multinational issuers, due to a number of considerations, there is a limited choice when it comes to selecting an auditor, and the potential for conflicts of interest has increased. At the same time, I am encouraged by the growth taking place in firms following the "Big 4." Their continuing improvement in size and expertise is good for our markets and should allow the markets – in particular for small, medium …and even some larger issuers – to have additional choices, which I believe is important for the resilience of the audit profession.

What is the role of a supervisor with regard to this sort of concentration? In the first instance, I believe the role of the PCAOB in this area is to continue our work to identify and discuss emerging risk within the firms. For the small and mid-size firms, the PCAOB also should carefully consider whether there is anything that we’re doing that is unnecessarily holding back a firm from its growth potential. Talent, capital, and the legal structure of firms have been observed by some as being barriers to growth. With these barriers in mind and the risks which accompany growth, many other firms are seeking growth but not necessarily the growth to become a "Big 4." Instead, some firms are making the choice to specialize. There is value for the market place in that development too.

On the international level, there is a shared interest in the subject of concentration and contingency planning. We will continue to discuss the topic with our peers in other countries. In my view, the focus should be on sharing lessons learned from previous experiences, and to assure that we are aware of emerging issues beyond our borders.

Though operating in a concentrated pool of large firms, the profession at large appears to be healthy, and the U.S. audit profession’s capability is well-regarded internationally. However, talent is a key asset for the profession, and the ability to attract and retain talent is a constant challenge. The stability of the business model is also a reflection on health – while the model has evolved over time, it has returned to focus more on its audit services. The overall health of the audit profession is also tied, in a way, to the PCAOB’s mandate. As supervisors of the auditors of public companies, the PCAOB’s role in supporting the integrity of information used in the capital markets is to reduce the risks of financial reporting and audit failures in the public securities market.

If we are doing our jobs as supervisors of the audit profession correctly, the PCAOB should provide greater stability, accountability and confidence to financial reporting and thereby the markets. If we are doing our jobs as supervisors of the audit profession correctly, our work also should ultimately provide greater stability to the audit profession.


The PCAOB works hard to achieve its objectives, and part of this hard work involves looking carefully at programs and requirements, and their impact. The Board will continue to assess its oversight program and will make appropriate adjustments to assure that it achieves the objectives of the Act in the most effective and efficient manner possible. I am encouraged that the PCAOB model resonates in countries that are seeking to strengthen the integrity of their own capital markets, and we are pleased that other nations are implementing similar models of auditor oversight. As this trend grows, it will help securities markets globally provide investors similar levels of confidence in financial reporting.

Through our supervisory approach, the PCAOB has the ability to promote improvements, particularly in the area of quality controls. Because the PCAOB inspects periodically and has a supervisory -- not enforcement -- focus, we can identify problems that firms can correct and we can promote the remediation of control deficiencies. To that end, I am encouraged by the substantial and meaningful changes that some firms have made to enhance audit quality, including improvements relating to internal inspection, partner evaluation, promotion and compensation, and the supervision of foreign affiliates. The Board described many of these changes in a release issued in March 2006, and I think any reader of that release would have to be encouraged that the PCAOB’s supervisory approach is helping to focus firms on meaningful improvement.

With regard to the broader policy debate at hand for U.S. financial policy makers, it is healthy and appropriate to debate over the appropriate level and nature of financial supervision and regulation in the United States and other factors that may affect the decision to list on U.S. financial markets. I agree that unnecessary regulatory costs should be identified and eliminated; however, we should not let that mission detract us from developing and implementing the high quality standards and investor protections that have been the trademark of the U.S. markets for decades. For the PCAOB, it is our job to identify efficiencies so that the implementation of our requirements can achieve intended results without unintended costs.

Thank you again for the opportunity to share my thoughts with you today.

[1] Data were compiled from Audit Analytics for reports on internal control filed as of December 31, 2006.

[2] Data on financial restatements were compiled from Audit Analytics, for restatements filed as of December 31, 2006.

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