Speech by SEC Staff:
Remarks before the New York State Society of Certified Public Accountants
Jackson M. Day
Acting Chief Accountant
U.S. Securities and Exchange Commission
January 28, 2003
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the speaker, and do not necessarily represent the views of the Commission or of the speaker's colleagues upon the staff of the Commission.
Good afternoon. Thank you for the kind introduction and for the opportunity to speak with you today.
Before I move on I must remind you that my remarks are my own and do not necessarily represent the views of the Commission, Commissioners or other members of the Commission's staff.
It is great to be back in this wonderful city. In addition, I always consider it a great opportunity to speak to this group, a group that I believe, if my sources are right, is the largest and oldest state accounting organization in the United States.
I particularly appreciate the opportunity this year given the monumental changes that are occurring with respect to the accounting profession. Changes that are extremely positive and that I hope you will embrace and participate in.
In a speech I delivered a little over a month ago, I touched upon the need to focus on how we, as a profession, can change the future to restore its honor and credibility.
To restore the honor and credibility of the accounting profession, all participants must focus on one thing doing what is best for investors. As I have said before, if we keep that as our focus, investors will be better served by the profession; and consequently, the reputation of the accounting profession can be restored and further strengthened.
There are several initiatives underway that help address this issue of focusing on investors. In fact, the last two weeks were the busiest two weeks of rulemaking in the history of the Commission.
Just six months after President Bush signed the Sarbanes-Oxley Act into law, the Commission has adopted 9 final rules implementing both the legislative mandates of the Act and, in some cases, additional reforms that the Commission and Commission staff deemed necessary to advance the interests of investors.
Those rules relate to:
- CEO and CFO certifications
- Pro forma financial information
- Codes of ethics for senior executives
- Financial experts on audit committees
- Trading during pension fund blackout periods
- Disclosure of material off-balance sheet transactions
- Retention of audit records
- Independence standards for public company auditors, and
- Standards of conduct for attorneys.
I am not going to cover all of these rules in my remarks today. Most either have been posted to the SEC website or will be posted soon.
Rather, I am going to try to cover the three initiatives undertaken by the SEC that I believe are going to have the most significant effect on the accounting profession:
- The establishment of the Public Company Accounting Oversight Board,
- The adoption of new independence standards for public company auditors, and
- The efforts underway to improve the accounting standard-setting process and bring about international convergence of accounting standards.
If you are interested in hearing about the disclosure aspects of the Act, Carol Stacey, the Chief Accountant of the Division of Corporation Finance, will be addressing those after lunch.
But, before I get into specifics, let me make a couple of general observations about the Sarbanes-Oxley Act.
- First, the scope of the Act is broad.
As the list of rules that I just mentioned indicates, the Act requires significant reform in all aspects of our financial reporting and disclosure system. It is clear that life for both registrants and their auditors has been forever changed. But the accounting profession is not alone. Other members of our capital market system, including investment bankers, analysts, and even attorneys will now be more closely scrutinized.
- Second, its themes are simple and are intended to restore market credibility.
It is easy to get bogged down in the details of the Act; however, it is important not to lose your bearing. A few themes underlying the Act's provisions that are important to remember are:
I submit that these themes are not new, but rather are now reinvigorated by the provisions of the Sarbanes-Oxley Act.
- Each person must accept responsibility for his or her own behavior;
- Being an accomplice to or ignoring a bad deed may be the same as doing the bad deed;
- Those who carry out bad deeds shall be punished; and
- Appearance counts.
Public Company Accounting Oversight Board
Now, here are some of the details.
First, I would like to address issues related to the Public Company Accounting Oversight Board-which I will simply refer to in my remarks today as the Oversight Board.
The Oversight Board will be responsible for all aspects of supervision of auditors that serve public clients, subject to SEC oversight. All in all, the overarching goal of the Oversight Board is to improve the quality of the independent audit.
The Oversight Board's statutory responsibilities include:
- Registering CPAs and public accounting firms that prepare audit reports for public companies-which is required within 180 days of the Commission's determination that the Oversight Board is operational;
- Establishing auditing, quality control, ethics, and independence standards for auditors and audit firms; and
- Conducting inspections, investigations, and disciplinary proceedings of public accounting firms and their associated persons that work on public companies; and otherwise
- Enforcing compliance with the rules of the Oversight Board and professional standards.
The Sarbanes-Oxley Act provides detailed guidance describing Congressional intent on how the Oversight Board should carry out these responsibilities.
The Act also provides the Oversight Board with the flexibility to make additional changes, if appropriate, subject to Commission oversight.
So who is going to pay for this Board? The answer is most of you-and you will be paying for the FASB too. Under the Act, registrants will involuntarily fund both the Oversight Board and the FASB.
And, in the case of the Oversight Board, the accountants and the accounting firms that serve public companies will involuntarily chip in too.
Before moving on I would like to mention that the Commission and its staff will continue to oversee the FASB. That is, the FASB will not be under the umbrella of the Oversight Board, although registrants ultimately may receive a single bill for the funding of the two operations.
Another milestone in the effort will be the official recognition of the Oversight Board by the Commission, which the Act stipulates is to occur by the end of April.
In order for that to happen, the Act stipulates that the Oversight Board must be able to operate and carry out its responsibilities.
And, the Oversight Board is doing just that. They are up and running in their new office in Washington. They have been hiring staff, addressing fiscal needs and otherwise getting organized. And most important to investors, they are working on an operating plan.
The Oversight Board has been meeting with various individuals and organizations involved in the current process. They are rolling up their sleeves and diving into the details.
One thing they are doing is carefully studying the current self-regulatory system-assessing both its strengths and weaknesses. They are studying the past activities and effectiveness of all aspects of the current self-regulatory system including the functions of the:
- AICPA SEC Practice Section including the peer review, discipline, and quality control functions;
- Auditing Standards Board; and the
- Transition Oversight Staff.
I am not sure that people will ever agree on why the profession's self-regulatory system failed. But it is clear that it had many structural deficiencies that have been addressed in the development of the Oversight Board.
For example, the Act either explicitly or implicitly addresses issues such as independent funding, the ability to gather information during investigations, and accountability of the oversight function.
With that as backdrop I would like to outline some of the questions and issues the Oversight Board is facing in the next few weeks.
In many conversations about the Oversight Board, the first issue to talk about is its inspection program. Implementation of a quality inspection program may be the Oversight Board's biggest and maybe most important challenge.
Here are a few of those questions and issues:
- Who will be reviewed and how often?
The Act provides that the largest firms must be inspected each year and other firms every third year.
However, the unanswered questions include how many partners will be reviewed each time the firm is reviewed, what functions will be reviewed, and whether risk will be a determinate in answering those questions.
The Oversight Board also must think about the effects of its timing given the seasonality of the auditing business.
- Who will perform the inspections?
The Oversight Board must determine if it will perform all inspections or contract some of them out, and what effect the required internal inspections should have on their work.
They also must address the issue of resources and how to get the expertise necessary to address issues such as computer auditing, independence, client acceptance and continuance, technical accounting consultations, and auditing fair value estimates. And layered on top, is the need for industry expertise.
And that is just the start of the list. Here are a few more issues:
- What reporting and remedial actions to take when inspections indicate deficient auditing;
- The interplay between the inspection process and new Commission rules, such as those on independence, which require certain procedures at certain firms;
- The interplay between the inspection process and state regulatory requirements, which often require firm-on-firm peer reviews;
- The effects of the inspection process on foreign accounting firms and affiliates of US accounting firms; and
- Transition from peer reviews to the Oversight Board's inspections.
With regard to standard setting, the first question is whether the Board will set its own standards or adopt standards recommended by an advisory group. Regardless of that decision, the Commission must approve any new rules that are issued.
The Oversight Board must develop a transition plan consistent with the Act. And, it must address the expectation gap that exists between what investors expect of auditors and what auditors are required to do to comply with generally accepted auditing standards.
While the Act provides the Oversight Board with substantial disciplinary powers related to misconduct of accountants, it is intended that the disciplinary powers of the Oversight Board will complement, not replace, the SEC Enforcement Division's efforts in this regard.
Of course, some details will need to be figured out - interaction with the Commission and what remedial actions to take to promote higher quality audits.
And there is more:
- The Oversight Board is responsible for registration of accounting firms and auditors, as well as billing.
- It will have to think about outreach activities - with whom and when it will meet and to what extent members and its staff will participate in the speech circuit;
- The Oversight Board must determine how to deal with the Commission, Congress and the press; and
- It must address all of the operational issues related to a start-up operation.
I look forward to working with the Oversight Board as they work through all of these challenges.
Independence Standards for Public Company Auditors
The Oversight Board is just one important step towards restoring investor confidence in auditors and in the capital markets more generally. The new rules regarding independence standards for public company auditors that the Commission adopted last week are yet another important step.
Many have asserted that the accounting profession no longer acts in a manner that puts investors first. Whether that assertion is true really does not matter anymore. The perception is so strong in the minds of many that it is affecting business activities, investment decisions and the markets.
Perceptions affect beliefs, and what a person believes affects his or her actions. New rules have been adopted that are aimed at addressing an auditor's independence for the registrant it audits in both fact and appearance to restore investors' confidence in the "independent audit".
Last Wednesday, the Commission approved measures that will:
- revise the rules related to the non-audit services that, if provided to an audit client, would impair an accounting firm's independence;
- require that certain partners on the audit engagement team rotate after no more than five or seven consecutive years, depending on the partner's involvement in the audit, except that certain small accounting firms may be exempt from this requirement;
- establish rules that an accounting firm would not be independent if certain members of management of that issuer had been members of the accounting firm's audit engagement team within the one-year period preceding the commencement of audit procedures;
- establish rules that an accountant would not be independent from an audit client if any "audit partner" received compensation based on the partner procuring engagements with that client for services other than audit, review and attest services;
- require the auditor to report certain matters to the issuer's audit committee, including "critical" accounting policies used by the issuer;
- require the issuer's audit committee to pre-approve all audit and non-audit services provided to the issuer by the auditor; and
- require disclosures to investors of information related to audit and non-audit services provided by, and fees paid to, the auditor.
Rather than walk you through all of the details of the rules, I would like to make just a few general observations.
First, the rules will describe a model, based on three basic principles, to determine when non-audit services would impair the auditor's independence. Those principles are that an auditor should not audit his or her own work, act as management, or be an advocate for his or her audit clients. It's pretty hard to argue with those basic principles.
Consistent with that model, the rules will list nine non-audit services that, if provided by the accounting firm, would impair the firm's independence. Other non-audit services can be provided to audit clients if they are pre-approved by the audit committee.
As the final rules are not posted yet, I direct you to the Commission's press release issued on January 22nd for the specifics on the prohibited non-audit services.
Audit Partner Rotation
The provisions of the proposed rules related to mandatory audit partner rotation also received a considerable amount of attention by those who commented on the proposal.
The final rules will define a new term-audit partner-for purposes of the requirements for partner rotation. An audit partner will be defined as a partner who is a member of the audit engagement team who has responsibility for decision-making on significant auditing, accounting and reporting matters that affect the financial statements or who maintains regular contact with management and the audit committee.
The term audit partner will include the lead and concurring partners as well as partners who serve the client at the issuer level, other than a partner who consults with others on the audit engagement team regarding technical or industry-specific issues. It also includes the lead partner on subsidiaries of the issuer whose assets or revenues constitute 20% or more of the consolidated assets or revenues of the issuer.
The rules will specify that the lead and concurring partner must rotate after five years and be subject to a five-year "time out" period after rotation. Additionally, certain other significant audit partners will be subject to a seven-year rotation requirement with a two-year time out period.
Cooling Off Period
In addition to rotation requirements, the rules will require a cooling off period before a member of the audit engagement team may accept employment in certain, designated positions with a public company.
The rules, therefore, will provide that an accounting firm is not independent if a member of management involved in overseeing financial reporting matters within the one year period preceding the commencement of the audit of the current year's financial statements was:
- the lead partner,
- the concurring partner, or
- any other member of the audit engagement team who provided more than ten hours of audit, review or attest services for the public company.
Consideration of Smaller Firms
Let me make one more point as it relates to the new independence rules. We recognize that some of the rule's provisions could impose a burden on certain smaller accounting firms.
Accordingly, the rules will provide that firms with fewer than five audit clients and fewer than ten partners may be exempt from the partner rotation and compensation provisions, provided each of these engagements is subject to a special review by the Public Company Accounting Oversight Board at least every three years.
In the interest of time that is all I am going to say with respect to auditor independence. Again, I direct you to the January 22nd press release on our website for more details. Additionally, I expect the final rules to be published on our website soon.
Shifting gears a little, I would like to cover a topic that I have been discussing in almost every one of my speeches for the past year the topic of accounting standard setting.
When the Enron story first broke, one of the first to be blamed was the standard setters, in particular, the FASB. Certainly there are a few accounting problem spots that have needed resolution for a considerable period of time such as consolidations, revenue recognition and certain financial instrument issues. Undoubtedly, the FASB needs to focus on resolving these problems and other problems like them in a timely manner, subject to appropriate due process.
However, as more accounting scandals surfaced, auditors and management became the prime targets for blame. More and more people focused on the fact that these people were not following GAAP.
In some cases, we were not dealing with complex structures. Rather, the questions were relatively simple, for example, whether costs should be capitalized or expensed. I often wonder what would have happened and how the current climate might be different if they had just followed GAAP.
During the past year, the standard setters have been moving along and have been pretty productive. For example, the FASB has provided new guidance on guarantees, restructurings, impairments, and consolidation of variable interest entities (including SPEs). We also understand from the FASB that new guidance on distinguishing liabilities and equity is right around the corner.
And problems, such as those related to the accounting for energy contracts, have been addressed. A major project on revenue recognition was added to the Board's agenda and deliberations on that project have begun.
And while all of this has been occurring on the domestic front, international convergence efforts have been gaining momentum. In fact, the FASB has announced its intentions to work with the International Accounting Standards Board (IASB) to achieve greater convergence of accounting standards world-wide. All of these advancements are very encouraging and important to the continual development of the world capital markets.
Important to the success of convergence is an infrastructure that enables consistent, comparable and appropriate application in multiple jurisdictions around the world. This may be the most difficult part given the diversity of backgrounds and regulatory structures of each of the jurisdictions. The use of interpretative bodies, such as the Emerging Issues Task Force in the U.S. and the International Financial Reporting Interpretations Committee in the international arena, is a critical part of this infrastructure. While not every question can, or should, be answered, there also cannot be fifteen answers to a pervasive question. That would undermine the credibility of the global accounting system.
In the interest of investors, I assure you, we will be closely monitoring all of the convergence efforts as they move forward.
With everything that is going on today in the world of accounting standard-setting, I could go on for days. But rather than do that, I would like to leave you with one thought stay in tune with what is happening both at the FASB and at the IASB.
I have just touched on a few of the initiatives that have been set in motion. There are numerous others that I could discuss with you, but unfortunately we would need more time - much more time. I encourage you, to the extent you have not already done so, to become familiar with these and other initiatives aimed at restoring confidence in this great profession and in the capital markets more generally. And to do even more than that to become a part of the positive change that is very much underway.