This speech reviews the responsibilities of the Public Company Accounting Oversight Board and the steps it has taken to fulfill those responsibilities during the past two years. The Board’s responsibilities are registration of public accounting firms; inspection of accounting firms; setting of auditing and other professional standards; and enforcement. While the Board has moved aggressively to develop programs in all of these areas, many of the auditing issues the Board identifies will be dealt with through a combination of the inspection process and standard-setting. This philosophy reflects the Board’s “supervisory approach.” * The views expressed herein are solely those of the author and are not necessarily those of the Public Company Accounting Oversight Board or any of its other members or staff.
One element of professionalism on which inspections focus is how the firm maintains its independence. This includes gathering information on the relationship between independence and non-audit services, such as tax services and contingent fee arrangements. Board inspections also look at auditor/audit committee relationships. Among other things, the inspection staff asks about the audit committee’s philosophy regarding approval or disapproval of non-audit services, including tax services.
In the area of standard-setting, the Board is considering whether to propose a new professional standard that might require an auditor to discuss with the committee the overall quality of the financial statements. The Board is also considering proposing an auditing standard clarifying the auditor’s obligation to look for fraud.
The Board held a public roundtable on tax services and auditor independence last July. The discussion at the roundtable indicated that independence is a primary concern of the users of audited financial statements. It is likely that, in the relatively near future, the Board will propose for public comment new rules concerning auditor tax services for public company clients.
Audit committees that are considering whether to approve proposed auditor tax services should keep in mind the three “simple principles” set forth in the Senate Report on the Sarbanes-Oxley Act. To be independent of its audit client, an accountant:
- Should not audit its own work;
- Should not function as part of client management or as an employee; and
- Should not act as an advocate for the audit client.
These factors provide a good framework for audit committee discussion. The Board could perform a useful service by publishing information concerning how audit committees have dealt with tax services
The Work of the PCAOB and its Impact on Tax Services
Although it is difficult for me to believe, the Public Company Accounting Oversight Board has just celebrated its second anniversary. The founding Board members were appointed by the SEC on October 25, 2002 , and we opened the doors for business at our headquarters in Washington on January 6, 2003 .
During these past two years, the Board has gone from a start-up to an organization of nearly 250 people stationed in seven regional offices across the country. More significantly than opening offices and adding names to the payroll, we have put in place the foundation for accomplishing the Board’s mission of rebuilding public confidence in auditing and audited financial reporting. There is a Chinese proverb that says, “To do good work, you must first have good tools.” In keeping with this philosophy, we have spent the last two years developing the tools to do our work well.
I want to briefly review what the Board has done so far and some of the things we have left to do. Our basic job is, of course, to oversee the auditing profession. However, the Board’s work will also affect public companies. Given the focus of this conference, I would also like to highlight some of the ways in which we may impact auditor tax services.
Before I begin, I should note that the views I express are my own, and not necessarily those of the Board’s other members or staff.
I. What is the PCAOB?
I want to begin with a brief overview of the Board and its responsibilities.
The Board was created in the wake of a series of financial reporting failures that shook investor confidence to the core. Beginning with the scandal at Enron in late 2001, revelations of accounting frauds and accompanying astronomical investor losses seemed to appear in the headlines on a daily basis. The list included widely-known corporations such as Adelphia, Rite Aid, and Tyco, and reached a crescendo with WorldCom, which filed the largest bankruptcy in U.S. history.
In late July, 2002, Congress responded to the overwhelming public outrage these debacles had spawned by passing the Sarbanes-Oxley Act. Among the ways the Act sought to rebuild investor confidence was a new oversight regime for auditors of public companies under the aegis of the Public Company Accounting Oversight Board. The Board is a private, non-profit corporation whose mission is to oversee the audits of public companies, to protect the interests of investors, and to further the public interest in the preparation of informative, accurate, and independent audit reports. The creation of the Board signaled the end of self-regulation of the auditing profession and the beginning of independent oversight.
Congress gave the Board four primary responsibilities.
First, all accounting firms that issue or prepare audit opinions on the financial statements of U.S. companies must register with the Board. So far, 878 U.S.-based firms, and 500 foreign firms, have registered.
Second, the law requires the Board to inspect registered accounting firms. Following an inspection, the Board must issue an inspection report, and the firm must correct any weaknesses in its quality control system.
Third, the Board is empowered to establish auditing, quality control, and ethics standards for public company audits.
Finally, the Board may conduct investigations and bring disciplinary proceedings when it believes that an accounting firm or its employees have violated the law or professional standards. The Board can impose fines, require remedial action, or suspend or bar a firm or individuals from participating in public company audits.
While the Board has moved aggressively to develop programs in all of these areas, many of the auditing problems the Board identifies will be dealt with through a combination of the inspection process and standard-setting. Given this philosophy, which we call the “supervisory approach”, I want to focus today on our inspection and standard-setting efforts.
Inspections are the Board’s main tool for assuring that auditors are doing their job properly and that the public can have confidence in audited financial reporting.
In crafting the inspection program, we have focused on some areas of professionalism and firm culture that were not part of the auditing profession’s peer review program. Some of the things that our inspectors look at include --
- the “tone at the top” that firm management seeks to infuse in the organization,
- how (and for what) partners are compensated and promoted,
- relationships with foreign affiliates and how the firm seeks to assure uniform audit quality and worldwide compliance with applicable U.S. standards,
- how the firm internally inspects its own practice,
- client acceptance and retention policies, and
- how the firm assures that it maintains its independence and the impact on its practice of non-audit services.
Regarding this latter point, one of the things we are doing is gathering information on the relationship between independence and tax services. We will be looking at engagement letters relating to non-audit services, tax services, contingent fee arrangements and other types of services to see whether such arrangements hint at any independence issues. In addition, we are looking at tax accrual workpapers to learn whether any tax services are being provided.
In addition to professionalism and firm culture, Board inspectors look at the way a firm performed specific audit engagements. While we can examine all of a small firm’s public company audits, for the largest firms that would be impossible. This year, for the largest firms, we are reviewing up to five percent of public company engagements. We hope to increase that percentage significantly in the future. Audits are selected based on our assessment of risk and difficulty. The Board is devoting considerable resources to developing and refining this risk-based approach because we believe it will result in early detection of trends that could, if undetected, lead to serious auditing problems. Similarly, in reviewing the way an audit was performed, the Board’s staff focuses on areas it views as higher risk.
The engagement reviews involve examining audit work-papers and interviewing the auditors who did the work. However, in addition to focusing on audit procedures, a Board inspection looks at how the auditor made its calls on the application of accounting principles in a client’s financial statements. Inevitably, the review of an audit engagement is also a review of the client’s financial statements. Given our staff’s access to audit work papers, Board inspections focus in greater depth on GAAP issues in the financial statements than can the SEC in routine filing reviews. Following our first round of inspections of the Big Four last year, our inspection process resulted in at least 20 public companies filing restatements due to GAAP issues in the financials.
As part of reviewing an audit engagement, the Board also looks at the auditor/audit committee relationship. In 2003, the inspection teams interviewed about 50 audit committee chairs. These interviews aim to learn what the committee expects of the auditor and how it evaluates the auditor’s performance. In addition, the inspectors are interested in hearing about auditor communications with the committee, especially regarding such things as critical accounting judgments, audit risk areas, sensitive management estimates, and audit adjustments. The inspection staff also asks about the audit committee’s philosophy regarding approval or disapproval of non-audit services, including tax services, and about any information the firm may have provided the committee concerning the independence impact of such proposed services.
At the conclusion of an inspection, the Board issues a report. The reports have a public and a non-public portion. The public portion describes in detail the Board’s inspection procedures and includes a general discussion of the results. The Sarbanes-Oxley Act prohibits the Board from disclosing criticisms of a firm’s quality controls, unless the firm fails to correct deficiencies within 12 months. Therefore, the nonpublic portion of the report addresses these kinds of quality control issues.
On August 26, the Board issued its first inspection reports describing the results of the 2003 limited inspections of the Big Four. While the reports indicate that there is room for improvement in the audit quality and professionalism of the Big Four firms, the Board has stated that the reports are not a broad condemnation of the Big Four Firm’s audit practices. On the contrary, all four are clearly capable of high quality audit work.
III. Auditing Standards
Let me turn next to auditing standard-setting. In addition to our inspection activities, we have been developing our standard-setting program as another powerful tool for improving audit credibility and rebuilding public confidence.
A. Standard-Setting So Far
During the past two years, we have taken some important steps in the area of standard-setting. First, the Board adopted interim auditing standards. In effect, the Board adopted generally accepted auditing standards as they existed in April, 2003, as temporary Board standards. The Board announced that it would review all of these interim standards and would determine, standard by standard, whether they should be modified, repealed, or made permanent. This will, of course, be a long-term project.
Second, we have made sure that we have access to the kind of experience and expertise necessary to do this complex job. We have recruited a staff of highly qualified accountants from academia, professional practice, and government. In addition, the Board appointed an advisory group to ensure that we have access to all of the perspectives that are affected by new auditing standards. This body, which we call the Standing Advisory Group or SAG, is comprised of 30 members, including practicing auditors, financial statement preparers, and investors. It meets publicly with the Board several times a year.
Third, the Board has adopted new auditing standards addressing three fundamental issues.
PCAOB Auditing Standard No. 1 changes the wording of the auditor’s opinion. Instead of the familiar statement in the opinion that the audit was conducted in accordance with generally accepted auditing standards, future audit opinions filed with the SEC now must say that the review was conducted in accordance with the standards of the PCAOB.
PCAOB Auditing Standard No. 2 addresses the auditor’s review of internal control over financial reporting. Section 404 of the Sarbanes-Oxley Act requires management reporting on the effectiveness of internal controls and requires auditor reporting on management’s conclusions. Auditing Standard No. 2 fulfills the Board’s obligation to develop a standard to govern how auditors perform that Congressionally-mandated new task.
Section 404 reporting will have a profound and far-reaching impact. Previously, auditors only reviewed internal control as part of planning the financial statement audit and in order to determine the extent to which they could rely on controls. Now, their review will be from a much different perspective -- to gather evidence to support an opinion on whether the system of internal control is effective in providing reasonable assurance that financial reporting is accurate and in accordance with GAAP. In effect, the auditor will be performing two audits at once -- one of internal control effectiveness and one of the financial statements.
The projected costs and benefits of this new responsibility are controversial. I believe that, once we get through the initial round of reviews and control enhancements -- which may take several years -- the benefits in terms of more reliable financial reporting, as measured by fewer restatements and SEC enforcement actions, will be clear. But, we are committed to monitoring costs, especially the impacts on small issuers, and to making mid-course corrections if necessary.
PCAOB Auditing Standard No. 3 deals with audit documentation. It requires the audit work papers to contain enough information so that an experienced auditor, having no previous connection with the engagement, can understand the work performed, who performed it and when, and the basis for the conclusions reached. Adequate audit documentation is an important support for our inspection program.
B. The Board’s Standard-Setting Agenda
Much of the Board’s standard-setting activity may be, from the perspective of clients, rather technical. However, some of the areas we are considering for upcoming standard-setting projects would have far-reaching effects.
For example, the Board may codify in a new professional standard all of the auditor’s obligations to communicate information to the audit committee. SOX expanded these responsibilities, and it seems useful to have a single standard that deals with auditor/audit committee communications. However, in addition to merely collecting and updating the existing requirements, a new standard might require an auditor to discuss with the committee the overall quality of the financial statements. That type of presentation would provide a more in-depth understanding of the results of the financial reporting process and of the choices and judgments that went into the company’s reporting.
The Board is also considering clarifying the auditor’s obligation to look for fraud. Existing standards in this area have been strengthened during the past several years. However, they can still be read to limit the auditor’s duty to address the possibility of management fraud. In contrast, investors have told us that, from the perspective of financial statement users, assurance that management has not intentionally manipulated the financial statements should be a primary purpose of the audit.
IV. Independence and Tax Services
Most of you in the room today are probably involved, not in auditing, but in tax compliance. From that perspective, most of the Board’s activities may be of only passing importance to your day-to-day work. However, one facet of the Board’s mandate may be of great interest: The Board has the authority to set standards in the areas of ethics and independence and could exercise that authority to affect the tax services that an auditor may render to its clients. While I am not in a position today to tell you what the Board will do in this area, I want to offer some comments that may help you understand how we are approaching the issue.
As in the case of internal control, it is important to start with what Congress said. The Sarbanes-Oxley Act prohibits an accountant from providing nine categories of services for the public companies it audits. These include appraisal or valuation services; fairness opinions; management functions; internal audit; legal and expert services unrelated to the audit; and any other service that the Board determines should be prohibited.
Services that are not on the prohibited list -- and that expressly includes tax services -- may be performed, if approved in advance by the client’s audit committee. The Act does not define “tax services.” In that regard, the SEC issued a release last January which said that “accountants may continue to provide tax services such as tax compliance, tax planning, and tax advice to clients, subject to the normal audit committee pre-approval,” but that audit committees should “scrutinize carefully” the retention of the auditor in a tax-motivated transaction initially recommended by the auditor.
The Board held a public roundtable on the issue of tax services and auditor independence last July. At that meeting, we heard from auditors and tax professionals, institutional investors, public company officials with financial reporting and tax compliance responsibilities, and regulators, including the IRS. The discussion was wide-ranging and candid. Some of the provocative issues raised included --\
- Should auditors be precluded from performing the traditional services of preparing returns for clients and from giving “plain vanilla” advice on the tax treatment of corporate transactions? Do these services improve audit quality and tax compliance? If so, how should that factor be balanced against investor perceptions concerning the adverse impact on independence?
- Should auditors be precluded from marketing novel, tax-driven, financial products to their audit clients? If so, how should the line be drawn between these products and more conventional tax planning advice?
- How do fee arrangements in the tax services area affect independence?
- What is the independence impact of tax services that the auditor performs for officers and employees of an audit client? Should all tax services for senior executives with financial reporting responsibilities be prohibited? What about assistance to rank-and-file employees who are stationed outside of the U.S. and must grapple with foreign tax regimes?
- Should any of these questions be answered differently for large companies than for small? What would be the impact of new auditor tax service limitations on public companies that lack in house tax expertise?
As the discussion at the roundtable indicated, independence remains a primary concern of the users of audited financial statements -- the investing public, including large institutional investors. For that reason, the Board regards this area as a priority. It is likely that, in the relatively near future, we will propose new rules concerning auditor tax services for public company clients.
Regardless of how the Board answers some of the thorny questions that were raised at the roundtable, tax services are likely to remain an area with which audit committees will have to grapple. Short of an absolute ban on any services having anything to do with taxes, audit committees will still be in the position of having to weigh the costs against the benefits in deciding whether to authorize tax services proposed by their auditors.
In doing so, it may be useful for audit committees to keep in mind, the legislative history of the prohibited services in the Sarbanes-Oxley Act. The Senate Report says that the list is based on three “simple principles.” To be independent of its audit client, an accountant:
- Should not audit its own work;
- Should not function as part of client management or as a client employee; and
- Should not act as an advocate for the audit client.
The SEC staff has said that the application of these principles to tax services is “tempered somewhat” by tradition and the tax regulatory regime. Nonetheless, it seems to me that audit committees should still keep these fundamental concepts in mind. While opinions may vary concerning how these factors apply to a particular proposal, they provide a good framework for the discussion.
And, while regulating audit committees is not part of the Board’s mandate, we may eventually be able to be helpful to committees in this area. The Board has broad authority to publish confidential information collected in its inspection process so long as we do it in a way that does not identify particular companies or accounting firms. I believe we could perform a useful service by using that authority to create a data base concerning how committees have dealt with tax services proposals, including what questions they have asked, what information they have received from the auditor, and what decisions they have reached.
In conclusion, I believe that the PCAOB has accomplished much during the past two years toward the goal of creating the tools that will permit it to fulfill the auditor oversight mandate of the Sarbanes-Oxley Act. As I said earlier, the Board’s basic job is to instill confidence in auditing and financial reporting. That is an important task. Without the investing public’s confidence, our securities markets -- the engine of our national prosperity -- would cease to operate. I hope that each of you will take an interest in our work and feel that you have a stake in our success.
Thank you. I would be happy to answer any questions.
* / The views expressed herein are solely those of the author and are not necessarily those of the Public Company Accounting Oversight Board or any of its other members or staff.