Remarks at the AICPA 2013 Conference on Current SEC and PCAOB Developments
Chief Accountant, Office of the Chief Accountant
U.S. Securities and Exchange Commission
Dec. 9, 2013
Good morning. Thank you Melanie for the kind introduction and thanks once again for inviting me to share my views at the annual AICPA National Conference on Current SEC and PCAOB Developments. I am sure that Russ Golden will be disappointed to see that FASB still isn’t in the Conference title. Maybe next year’s chairman of the conference will take that up as a cause.
As I was working on the speech over Thanksgiving weekend, I promised my wife this would be a barnburner. She could not resist the temptation to mock me. On many levels, this was probably well deserved. I know that most of you (hopefully all of you) are here to hear things that will help you do your job better. I will highlight some policy areas that you might want to focus on over the coming year. Some of the messages may seem familiar as they echo points made in previous speeches. At the risk of appearing that I lack creativity, there are some issues that remain important enough that I want to make sure they stay in the front of everyone’s mind.
I need to start, as always, by reminding you that for me and for all of the SEC staff speaking at this conference, the views expressed are each speaker’s own and not necessarily those of the Commission, the individual Commissioners, or other colleagues on the Commission staff.
FASB Outreach to Investors
I would like to start by talking about the process the FASB uses to perform outreach on their standard setting process. I think it is easy for some to criticize the FASB and the process they go through to set standards. But standard setting is never easy.
One change I have observed over the last couple of years is the increased focus on outreach - in particular going directly to investors who are making investment decisions. It is not only the staff who are making these efforts, but also the Board members who are taking the time to understand not only what information would be useful, but also how it is used by investors. At times, this process has led to fairly significant changes in the direction of projects, and I think we would all agree it was for the better. The one area that I think could benefit the most from improvements to outreach is in the agenda decision-making process. At the outset, if the Board was better informed of the problem that needs to be solved through outreach, it could improve both the efficacy and efficiency of the entire standard setting process. In this regard, I am encouraged by the recent addition of staff at the FASB dedicated to agenda research, and I am encouraged by the steps they have taken to focus on the agenda setting process.
Simplification of Accounting Standards
This leads me to another area where the FASB has discussed its efforts to improve current GAAP, and that is the simplification of accounting standards. This is an area I have heard Russ [Golden] mention on a couple of occasions, and I expect this to be the subject of future efforts of the FASB. I think the concept of simplification applies to both revisiting current standards and future standard setting projects. There are certainly areas of current GAAP that could be simplified without a loss of the quality of information provided to investors. I agree it would be worthwhile for the FASB to begin to identify these areas and work towards simplifying existing standards. A frustration I hear from some investors is that the accounting standards are too complex to understand, and this complexity does not facilitate an understanding of the information being presented in financial statements.
One of the issues to consider may be in the approach to major projects. When addressing major projects, it feels like too often we consider alternatives taken from whole cloth, rather than focusing on targeted improvements. This approach at times has lead to complex models, which require a significant amount of implementation efforts. This complexity may lead to investors having less useful information if they cannot readily comprehend the information provided. This does not mean we should not explore new models when it is appropriate, but we need to focus on what problem we are trying to solve and to avoid replacing one set of challenges with another. I am reminded of a passage out of the Wheat Report from 1972 that recommended the establishment of the FASB:
The need for a fundamental conceptual foundation has been much debated in accounting circles for many years. We believe this debate may have produced more heat than light. Financial accounting and reporting are not grounded in natural laws as are the physical sciences, but must rest on a set of conventions or standards designed to achieve what are perceived to be the desired objectives of financial accounting and reporting. We understand the primary work of the Accounting Objectives Study Group to be the development of such objectives and some guidelines for their achievement.
I have found this passage to be informative because it highlights what I have always believed, which is that accounting standards do not equate to gravity. I am encouraged that simplification is going to be an area of focus by the FASB and believe this ultimately will help investors.
GASB Standards and Municipal Issuers
This next topic is certainly a different topic for me and that is GASB standards. In June 2012, the GASB issued two companion standards on pension accounting. My comments today are mainly focused on the reporting by issuers of municipal securities on the financial impacts of their pensions. For those of you that are not aware, our authority is a little different over issuers of municipal securities than over other types of issuers. Both the 1933 Act and the 1934 Act have broad exemptions for municipal securities from all of the provisions except the antifraud provisions. In the absence of a statutory scheme for regulation of municipal securities, the Commission’s investor protection efforts have been accomplished primarily through regulation of broker-dealers who trade in municipal securities, Commission interpretations, enforcement of the antifraud provisions, and Commission oversight of the Municipal Securities Rulemaking Board. In addition, the Commission recently adopted rules implementing the Commission’s authority over municipal financial advisors provided by the Dodd-Frank Act.
Municipal securities have certainly received a lot of attention over the last few years at the Commission. The Commission has brought several important enforcement cases on fraudulent reporting by state and local governments, including several key cases focused on pension obligations. In 2010, the Commission for the first time charged a state – the State of New Jersey – with violations of the federal securities laws related to its failure to disclose to investors the underfunding of its two largest pension plans. The offering documents created the impression that both plans were adequately funded.
Similarly, in March 2013, the Commission settled charges with the State of Illinois related to its disclosure of pension obligations. Although the offering documents included a discussion of the state’s unfunded pension obligations, the documents failed to include information that would have been material to municipal investors, including that the state’s funding plan continued to increase the unfunded liability, underfunded the state’s pension obligations, and deferred pension funding. The offering documents also failed to disclose the increased risk faced by the State of Illinois as a result of its pension obligations.
As a result of the GASB efforts, the new standards should result in a more faithful representation of the full impact of the obligations provided by state and local governments. For those that invest in fixed income securities in the muni market, this will provide valuable information so that investors are able to make informed investment decisions. In particular, it will provide information about the assumptions the state and local governments are using to report their obligations to retired workers. Those investing in fixed income securities in the muni market and the auditors in the audience should pay particular attention to these assumptions and make sure they are reasonable and supportable.
The SEC’s Office of Municipal Securities and the Division of Enforcement seek to improve the state of the municipal securities market and help investors. As recent enforcement cases indicate, this continues to be an area of focus for the staff who are committed to ensuring that investors understand the risks facing municipalities, including risks related to pension liabilities.
Two years ago, in a speech I gave at this conference, I highlighted the need for the valuation profession to make strides in improving themselves as a profession. As we learned in the financial crisis, valuation is becoming increasingly more integral to financial reporting. Financial instruments are becoming increasingly more complex, and prudential regulators are becoming increasingly more focused on valuation of financial instruments in connection with regulatory capital requirements.
That speech generated a fair amount of discussion among valuation professionals. I think the discussion highlighted a number of challenges and opportunities for the profession to consider. While this discussion revealed that a number of organizations should play a role in improving valuation standards, it is important that the organizations involved have the necessary expertise to help the profession make improvements to the current landscape.
The valuation profession is highly fragmented, and the maturity of the profession varies across asset classes. For example, credentials and the accompanying enforcement framework exist for certain aspects of valuing real estate, businesses, and intangibles; however, similar attributes are not prevalent for valuation of financial instruments. In less mature areas of the profession, though, there are some standardized methodologies for valuing certain assets.
In my discussion among valuation professionals, I feel that there is a general commitment by stakeholders to make the necessary improvements in the valuation profession. But it is too early to declare victory. While there has been a lot of healthy dialogue, the next step is still needed to make firm commitments to assess the valuation profession. I hope that collectively we can improve the structure of the valuation profession so that investors have the confidence in the information they need to make sound investing decisions.
Audit Committees and Audit Fees
As a result of the Sarbanes Oxley Act, audit committees of listed companies are charged with selecting and overseeing the auditor. This is an important responsibility that the audit committee has to fulfill in order to protect the interests of investors. Inherent in vesting the audit committee with this responsibility is the tacit acknowledgement that the audit committee is best-positioned to determine whether the auditor is providing a high quality audit.
This is not to say that this is an easy job. In fact, as I meet with audit committee members, I hear a similar refrain that their job is becoming increasingly challenging. In particular, I believe that there is a general acknowledgement that assessing audit quality can be challenging. The PCAOB has a project on its agenda to try to identify audit quality indicators. The PCAOB’s project has the potential to bring insight and more focus to matters that impact audit quality. If successful, these audit quality indicators could be an excellent tool for audit committee members to use to evaluate audit quality. I think we should all be encouraged by the PCAOB’s efforts so far. However, no amount of data can replace the judgment of seasoned individuals.
So why am I spending time talking about audit quality and the role of audit committee members? Because it is my sincere hope that audit committee members focus on audit quality when considering whether to hire or retain an auditor and do not always choose the low cost provider. Anecdotally, when I hear about auditor changes, I very often hear it in the context of fee reductions. I worry that audit committees may be focusing too much on the amount of the fee and not focusing enough on the expected audit quality. This is not to say that audit committee members should not focus on making good business decisions. But I believe focusing on audit quality is completely consistent with making good business decisions.
The message here is that the “bottom line” should not drive the decision to retain and or hire an auditor. The decision should focus on which auditor is going to protect the interests of shareholders best. Moreover, if the audit committee is solely fee hunting and if there was a subsequent audit failure, beyond the obvious problems for the auditor and the company, this may raise questions about the diligence of the members of the audit committee in fulfilling their responsibilities.
Last year at this conference, I discussed how, as a profession, accountants have a duty to act with integrity, objectivity, and high ethical standards. This has long been a hallmark of our profession. I observed last year that revenue and profit pressures at an accounting firm can give rise to conflicting incentives, but the accountant's obligation to the public trust cannot change. My remarks may not have been surprising to you then, and they were consistent with those of those of my predecessor, Jim Kroeker, who said at this conference in 2010: “I trust that the profession will not need to re-learn lessons of the past on the serious, adverse effects of under-investing in the quality or failing to strictly maintain the independence of their audit process.”
Since then, we have seen some firms make significant investments in technological and other improvements to their audit practices. In addition, after the PCAOB released multiple quality control criticisms related to the 2007 and 2008 inspections of some of the large firms for not making satisfactory progress to remediate its quality control findings, in some cases those same firms have now reported that the PCAOB determined that its quality control criticisms of the firms for 2009 and 2010 were satisfactorily addressed.
So while there is some good news, I continue to observe that accounting firms actively are growing their consultancy practices. Last year, I talked about some of this being anecdotal and noted that, in my mind, more important was how the accounting firm views its non-audit services practice, and how this view affects whether this results in the accounting firm devoting the appropriate resources to its audit and attest practice.
I also said that I was concerned that expanding into businesses that have little relevance to the accountant's primary competencies probably does little to promote audit quality, and it has the potential to distract a firm's leadership and other personnel from providing appropriate attention to their audit practice. Such expansion runs the risk of damaging the accountant's reputation.
While I am not singling out any one firm, I reviewed a few firm press releases related to firm acquisitions by large public accounting firms during the past year. I compared the firm statements regarding growth in areas outside their core competencies with the statement by the major firms when they sold their consulting practices a decade ago. It seems that while in early 2000 audit firms were disposing of their consulting practices because of regulatory constraints and restraints, more than ten years later, the same firms now believe that similar consulting practices can achieve greater growth under firm ownership notwithstanding the significant regulatory changes over the last decade.
The Sarbanes-Oxley Act prohibited certain non-audit services for audit clients, and the creation of the PCAOB resulted in additional auditor independence rules and oversight. I’d like to remind everybody that, in addition to the specific rules, and I quote “independent auditors have an important public trust.” That was the Commission speaking from its 2000 release adopting revisions to the auditor independence rules. The Commission also in that release discussed a “… growing concern on the part of the Commission and users of the financial statements about the effects on independence when auditors provide both audit and non-audit services to their audit clients ….” In my view, it continues to be the case that “… investor confidence in auditor independence rests in large measure on investor perception.”
Public expectations from auditors have grown over the years and continue to grow every time there are public perceptions that, had the auditors been more objective, perhaps investors would be better informed. The public considers audit firms to be “gatekeepers” and not consultants. You earn the public’s trust by improving audit quality and by strengthening a firm’s audit function.
As I said last year, I'm hopeful that my comments today will help encourage reflection when firms are faced with decisions about growth that undoubtedly will shape the public's long-term views of their firm and potentially of the entire profession.
Internal Control over Financial Reporting
As I’ve said before, I believe there can be no question that investors have benefited from improvements in the reliability of financial reporting due to the increased focus on internal control over financial reporting (ICFR) since the passage of the Sarbanes-Oxley Act. We heard repeatedly during the implementation of the ICFR reporting requirements that there were varying degrees of deferred maintenance of internal accounting controls since the requirements to maintain such controls were initially established in the 1970s. Last year, I had a very simple message that I’d like to repeat again this year. Let's not lose ground. Let's stay focused on the importance of ICFR. We learned from the past that maintaining and evaluating ICFR must be an iterative and ongoing process with the appropriate involvement and support of management throughout a company.
Later this morning, Brian Croteau, OCA’s Deputy Chief Accountant for our Professional Practice Group, will discuss some observations related to ICFR. He’ll also touch on quarterly evaluations of disclosure controls and procedures. Tomorrow, staff from our Division of Corporation Finance will also be addressing these topics, including some considerations related to COSO’s recent update to its framework. Finally, you’ll also hear from the PCAOB about recent inspection findings related to audits of internal control over financial reporting. I encourage you to give thought to the points you’ll hear throughout this conference and more broadly to thinking about your own organizations or your audit clients and thinking about what you can do to ensure we don’t find ourselves losing the ground we’ve gained over the last decade.
Thank you for your time today, and enjoy the rest of the conference.
 Establishing Financial Accounting Standards – Report on the Study on Establishment of Accounting Principles (Mar. 29, 1972), available at www.sechistorical.org/collection/papers/1970/1972_0329_WheatStandards.pdf.
 See Statement No. 67 of the Government Accounting Standards Board, Financial Reporting for Pension Plans- an Amendment of GASB Statement No. 25, (June 2012); Statement No. 68 of the Government Accounting Standards Board, Accounting and Financial Reporting for Pensions – and Amendment of GASB No. 27 (June 2012).
 Securities Act Release No. 9135, In the Matter of State of New Jersey (order) (Aug. 18, 2010), available at http://www.sec.gov/litigation/admin/2010/33-9135.pdf.
 Securities Act Release No. 9389, In the Matter of State of Illinois (order) (Mar. 11, 2013) available at http://www.sec.gov/litigation/admin/2013/33-9389.pdf.
 Paul A. Beswick, Deputy Chief Accountant, Office of the Chief Accountant, Securities and Exchange Commission, Prepared Remarks for the 2011 AICPA National Conference on SEC and PCAOB Developments (Dec. 5, 2011), available at http://www.sec.gov/news/speech/2011/spch120511pab.htm.
 James L. Kroeker, Chief Accountant, Office of the Chief Accountant, Securities and Exchange Commission, Remarks Before the 2010 AICPA Conference on Current SEC and PCAOB Developments (Dec. 6, 2010), available at http://www.sec.gov/news/speech/2010/spch120610jlk.htm.
 Paul A. Beswick, Acting Chief Accountant, Office of the Chief Accountant, Securities and Exchange Commission, Remarks Before the 2012 AICPA Conference on Current SEC and PCAOB Developments (Dec. 3, 2012), available at http://www.sec.gov/News/Speech/Detail/Speech/1365171491922.
 Securities Act Release No. 33-7919, Revision of the Commission’s Auditor Independence Requirements, (Nov. 21, 2000) [65 FR 76008 (Dec. 5, 2000)], available at, http://www.sec.gov/rules/final/33-7919.htm.