The Value of Integrity

Introduction

It is an honor and a privilege to be here today.

What I am going to tell you today are my own views and not necessarily those of other PCAOB Board members or staff.

I recently heard an economist speaking at a conference say that too much emphasis is being placed today on accounting and auditing, because from an economic perspective, accounting and auditing are not really worth much. He proposed that our markets would operate just as well without audit opinions. He proposed instead that companies should simply issue financial statements and the market place should be allowed to determine how much emphasis to place on them.

Unfortunately, this economist is not alone. Confidence in our profession has been shaken to the core by numerous high profile scandals. And, in this environment statements such as those made by the economist have the dangerous potential of ringing true.

I am here to tell you that nothing could be further from the truth. Today the accounting profession is alive and well and more valuable than ever. Anyone viewing accounting and auditing as having little value does not understand where the accounting profession currently is and where it is headed.

The Beginning of the Years of Plenty

Many of the scandals occurred years ago. The problems at Enron became public more than three years ago. And yet, we still feel their effects. Although a fair share of responsibility for these scandals does rest with the accounting profession, the problems in the system that led to these scandals go well beyond accounting.

Investigations of these scandals reveal that although the system to protect investors appeared to be working, too often the basic safety procedures embedded in the securities laws were circumvented by nominal compliance practices.

The most disturbing aspect of Enron and similar scandals was not what was done that was wrong, but what was done that was right. Enron did not ignore the rules and regulations, but instead it took them and used them to achieve results that were never intended. The smartest guys in the room created the illusion of a prosperous company by taking advantage of the holes in our system. Before its demise, Enron was actually considered to be a model citizen of good corporate governance practices.

The Sarbanes-Oxley Act took us back to the basic principles on which our security laws are based. But that call back to basics was not made just to the accounting profession.

Is it absurd to ask management to stand behind the operating results they report? That is really all that certifications are about.

Is it crazy to ask Boards to be knowledgeable and engaged?

Is it too much to ask that analysts be free from conflicts?

And, yes. Is it beyond reason to encourage auditors to look to the real users of the financial statements – investors - as their clients?

Although that call went out to many different groups, I am proud to say that the accounting profession has courageously looked at its involvement with these problems and has accepted the need to change. It has faced its shortcomings and is learning from them. And with that acceptance, the accounting profession has moved beyond the problems of the past and entered a new phase where accountants will no longer accept being minimum compliance experts. Instead, accountants are becoming the promoters of best practices, where accountants will no longer allow improper financial reporting just because there is nothing in the rules that says that it can’t be done, or just because the issue isn’t an SEC hot button or just because it involves a substantial client.

The economist that I heard speak was wrong about the accounting profession. He was wrong because he is still viewing the accounting profession from the perspective of the problems of the past. He has failed to recognize that the accounting profession has turned the corner and is moving beyond those problems.

Bobby Jones

Before Bobby Jones became a legendary golfer, he had many tough years as a golfer. His career has been divided into two parts – The Seven Lean Years followed by the Seven Years of Plenty. In fact, the Seven Lean Years were so tough that there were many times when he and others doubted that he would ever win a major tournament.

However, at the beginning of the Seven Years of Plenty, Bobby Jones faced a particularly difficult situation. One that would define him in the history books forever. Perhaps, one of the most significant aspects of the event is that it was not that he hit a speculator shot. In fact, the result was that his score was worse because of it.

During the 1925 U.S. Open, Bobby Jones inadvertently touched the ball causing it to roll slightly or at least that is what he believed. The thing is no one else saw him touch the ball or even saw the ball roll, including his playing partner and the tournament official who were both watching him. Neither believed that he touched the ball.

Bobby Jones could easily have simply let it pass, especially with the tournament official saying he did not see the ball move. Or he could have justified not pressing the issue, since even if he had touched the ball, it was clearly inadvertent and the ball moved so slightly that no one else even saw it. As the tournament official told Bobby Jones at the time, “Well Bobby it is up to you. Do you believe you touched the ball?” To which Bobby responded, “I know that I did.”

As a result, Bobby Jones imposed a one stroke penalty on himself, and he went on to lose the 1925 U.S. Open by that one stroke. When reporters tried to interview him about the self-imposed penalty, Bobby Jones forbid them from writing about it, stating that it would be inappropriate because there was nothing extraordinary about playing by the rules.

Just like Bobby Jones at the beginning of his Years of Plenty, the profession may have turned the corner and is headed in the right direction, but that does not mean that there are still no serious challenges and tests for the profession to address, including improving the current financial reporting model, and tackling fair value accounting and convergence of accounting and auditing standards, to name just a few.

I have great faith that the current and future leaders of the accounting profession will rise to address these issues – that is as long as they address these issues with integrity. As long as the profession holds integrity in as high regard as Bobby Jones did, the future of the accounting profession will remain bright no matter what obstacles lay ahead. That is because the true value of the accounting profession is the integrity.

Integrity

“Integrity” has been described as doing the right thing even though no one else is looking.

Bobby Jones was only in the early part of the Years of Plenty when this event occurred, and he had not yet established himself as a great golfer. Bobby Jones was a fierce competitor, so probably no one wanted to win that tournament more than he did. Nonetheless to Bobby Jones, winning the US Open would have been meaningless if he had done so without integrity.

After that fateful 1925 US Open, Bobby Jones went on to win 11 out of the next 15 majors and became the first and only man ever to win four majors in one year. What makes his winning record all the more extraordinary is that to Bobby Jones integrity was always far more important than winning itself.

One of the biggest problems with maintaining integrity is that it cannot be regulated. And yet, it is the only true protection there is against future scandals. Every 10 years or so, since the creation of the securities laws in the 1930s, we have had some kind of serious problem with financial reporting, substantially because the motivations that led to the stock market crash of 1929 are still with us and in some ways are even more pronounced today. Integrity is about the long-term, but we have a society that is focused on the immediate. Our system must move away from emphasizing and rewarding the achievement of short-term goals, short-term earnings goals in particular, especially when the achievement of such goals is at the expense of long-term value or true economic benefit altogether. In a system where the short-term is more important than the long-term, appearances become more important than reality.

As long as these incentives remain, the accounting profession will be fighting an uphill battle. That is why the accounting profession cannot do this on its own.

PCAOB

An integral part of this new era for the profession is the Public Company Accounting Oversight Board. We at the PCAOB believe in the accounting profession. There are those that call us the watchdogs of the profession, and there is an aspect of what we do that is exactly that. Our success will not depend on our ability to be watchdogs, but instead it will depend on our ability to connect with accountants.

I believe that the basic essence of virtually everyone in this profession is good. In fact, I don’t know of anyone that went to college to become an accountant to help companies commit fraud.

Investigations of the most significant scandals revealed that too often it was not that the auditors failed to find the problems, it is what they did when they found them. This is a different kind of problem that goes beyond setting standards and enforcing them. We must understand the pressures and limitations under which accountants work and free them to do what comes naturally. No longer should accountants be forced to choose between doing the right thing and being able to send their children to college.

Inspections

It was with this concept in mind that we focused our inspections on issues that previously were considered to be outside the scope of peer review. We focused on the business context in which audits are performed. Without ignoring issues related to compliance with standards, we looked at the tone at the top of the firms, whether the messages from the top carried throughout the organization, how partner compensation is structured and whether or not the compensation structure rewards good auditing.

You will hear today from George Diacont, the Director of Registration and Inspections, as well as members of his staff as they discuss in more depth what they have been doing and where they are going.

Registration

There was a great deal of speculation when we were first created that many of the accounting firms that previously audited public companies would choose not to register with us. And, perhaps there were a few that did not; however, today approximately 1400 firms are registered with us.

Small Firms

Although the majority of US issuers are audited by the largest 8 accounting firms, over 1,100 of the firms registered with us have 5 or fewer public company clients. Because of that, we are focused not just on the largest firms. We appreciate that small accounting firms make an important contribution to the markets and that these firms have issues that are unique to them. We are not the Public Company Accounting Oversight Board for large firms alone, but for all accounting firms that play a substantial role in auditing U.S. public companies.

In this regard, we are in the process of holding a series of meetings throughout the country entitled “Forum on Auditing in the Small Business Environment” in an effort to reach out to smaller firms that audit public companies as well as the directors of small- and medium-sized companies. This effort is headed by Board member Kayla Gillan.
International Firms

Over 500 of these firms are located outside the United States. To address these non-US firms, Chairman McDonough has worked diligently with our staff to establish a system whereby we can join forces and rely on PCAOB-like organizations in other countries. The more independent and robust the home country system is, the more we will be able to rely on it.

We reached out early in 2003 to the regulators and other interested groups in countries around the world in holding a roundtable discussion here in Washington where we heard their thoughts and concerns firsthand. We also had numerous meetings with the European Commission and its staff which had a positive influence on the EC issuing the Eighth Company Law Directive earlier this year that directs member states to create organizations like our own.

Standard Setting

You will also hear from Doug Carmichael, our Chief Auditor and Director of Professional Standards, and from members of his staff. Although many of the recent large audit failures may not have resulted principally from weaknesses in the audit standards or even the failure to apply them, there remains ample room for improvement in the area of standard setting, such as in the area of fraud detection and independence.

We are quite fortunate to have Doug Carmichael to head this effort for us, especially in this critical initial period.

Enforcement

I would like to tell you that our enforcement team has nothing to do. But, unfortunately they are quite busy. So, last, but certainly not least, you will hear from Claudius Modesti, our Director of Enforcement and Investigations and certain members of his staff.

Financial Analysis and Risk Assessment

From the creation of this organization, we understood that we had been given a special responsibility to restore public confidence and that Congress had given us special tools to achieve that goal. The PCAOB has access to information that no other one organization has ever had access to before. Through the eyes of the auditors we have the ability to see trends and anomalies in financial reporting of companies of all industries and sizes throughout the U.S. public company financial reporting system.

In that regard, we have two groups at the PCAOB that work on risk assessment. There is a risk assessment group within Inspections headed by Phil Wedemeyer, Deputy Director of Inspections. And, there also a separate office for risk assessment called the Office of Financial Analysis and Risk Assessment, which is headed by Richard Clark, a forensic accountant and intelligence officer by background. They are supported by a team of other forensic accountants, analysts and economists. These two groups will work together to gather and analyze information for the purpose of identifying key areas of risk, hopefully before these areas can manifest into financial reporting problems.

You will hear from Phil Wedemeyer about certain aspects of his program. And although, you will not hear from anyone from the Office of Financial Analysis and Risk Assessment, you should not take that to mean that it is any less important. Because it was our last office to be formed, it was too late to give its own time slot for this conference.

Section 404

I would be remiss if I did not include at least some discussion of 404. No other requirement of Sarbanes-Oxley has had a bigger impact.

Companies and their auditors are working feverishly to meet the deadlines that are rapidly approaching for many companies. No one yet knows exactly what the costs will be to comply with Section 404, although the costs of complying with 404 during the initial implementation period are expected to exceed the costs in subsequent years.

Like almost all other Sarbanes-Oxley requirements, the requirement itself is based on something that is hardly new. Congress determined that the costs of a public company having adequate internal controls were less than the costs of a company not having them. But Congress made that determination, not in 2002 but in 1977, when it enacted laws requiring that all public companies have an adequate system of internal controls.

Internal control is a fundamental building block for good financial reporting. In adopting PCAOB Auditing Standard No. 2, the Board was especially mindful of the impact that compliance with 404 could have on small- and medium-sized companies and provided flexibility in its application depending on the size and complexity of the company involved.

Our staff has issued three sets of FAQ’s to address key areas of concern and to help alleviate the burden of a first year implementation. And, we just issued an executive order that, in conjunction with an action taken by the SEC, provides additional relief for accelerated filers that have a market capitalization of less than $700 million. The order provides these companies with an additional 45 days to file management’s first report on internal control over financial reporting and the related reports from their auditors, as long as these companies meet certain conditions.

Although we do not yet know all of the benefits that will result from compliance with 404, we do know of immediate benefits that companies and their auditors are already experiencing, namely that auditors are gaining a better understanding of the companies that they audit much better than ever before and even public companies are getting to know things about themselves that they were previously unaware of.

It has taken us years to get to where we are today, and we should not expect that all companies will receive a clean opinion from their auditors related to 404 in the first year. We must look at this as a two to three year process. The report on internal controls is a disclosure obligation by management and an adverse opinion or even a disclaimed opinion does not mean that the company cannot receive a clean audit opinion on its financial statements at the same time.

And, we must all keep in mind that regardless of the number of adverse or disclaimed opinions that are issued this year, the risk related to potential financial reporting problems will be far less this year when compared to such risks even just a year ago, due to the work being done by companies in their effort to comply with 404.

Conclusion

There is an extremely positive attitude at the PCAOB. One that is quite contagious. You may sense that attitude today as you listen to the members of our staff. That is not because we don’t see problems, we see plenty of them, but because our staff recognize that they are part of something that is not only having an immediate impact, but that has the potential to effect positive change for many years to come.

The accounting profession has turned the corner and is headed in the right direction, but we must learn from past problems in order to keep from falling into the same traps as before. After each set of scandals, there is a period of self-reflection and seemingly good behavior. That is until the next time. This time we need to work to make sure there is no next time, certainly not one where the accounting profession is implicated in improper behavior.

I leave you with some advice given by George Catlett, a well respected former Arthur Andersen partner and leader of the accounting profession. Although he spoke these words in November of 1972, they unfortunately remain remarkably applicable today, and the advice remains difficult to improve upon. I believe the time is right for us to take these words to heart.

The words of George Catlett:

"The 'lawsuit explosion' that has occurred in recent years has been an unfortunate experience for those accountants involved and a worrisome development for everyone. The result of all of this has been to put the accounting profession in a defensive frame of mind. More of these cases have involved questions of auditing and disclosure than accounting principles. While the lawsuits are troublesome and costly, the end result may be of some benefit to the profession, because this may be the only way that the responsibilities of accountants (as well as of managements, directors, lawyers and underwriters) can be properly determined so that everyone knows what is expected of him.”

“Public accounting is a profession and not a business. This distinction is more than mere words.… If we are to have a profession, we must conduct ourselves like one and measure our conclusions against what is best for the public.”

"Not only the accounting profession as a whole, but also the members of the profession individually can represent a powerful force for the right kind of progress if a truly professional attitude is adopted. The excitement of these challenges that face us should serve to increase our desire to achieve the satisfaction of a professional job well done."

- Catlett, George, In Pursuit of Professional Goals, pp. 197-98.

Thank you.