Speech by SEC Commissioner:
Remarks before the American Institute of Certified Public Accountants
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
December 5, 2005
Thank you for that kind introduction. It is a privilege to have the opportunity to address you during this conference and to share the SEC keynote slot with Chairman Cox … or at least virtually with his video likeness. You have set an ambitious agenda for yourselves over the next several days, so thank you for asking me to be here and for making time for me. Let me start by saying that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
We are in a period of inevitable change at the Securities and Exchange Commission. We have a new chairman and Annette Nazareth has left the staff to join the Commission. I am enjoying working with both of my new colleagues and am optimistic about the direction that the Chairman has set for the Commission. Our new chairman has ushered in a new spirit of reconstruction, cohesion, co-operation, and modernization. As you just heard, he is focused on the issues, actively engaged, forward-looking, and innovative. He has very appropriately focused thus far on long-neglected issues of infrastructure, budgeting, and internal control. I am happy to say that his attention during his first couple of months produced at last clean financial reports for the agency, and we are well on the way toward being in compliance with Sarbanes-Oxley.
I am also confident that no longer will the SEC ignore the will of Congress that we weigh the costs and benefits of our actions. In the past, at times we engaged in cost/benefit analyses in only a perfunctory way. You might say that sometimes it was almost as an afterthought to justify regulatory actions that were already formulated and decided, rather than using economic analysis as a way to guide and design a regulatory approach. I am much more confident that the SEC will actually act responsibly with respect to the economic consequences of our actions.
The federal courts have done a good job recently of reminding us of our obligation in that regard. Government must be sensitive toward balancing the costs as well as the benefits of its actions. One-size-fits-all regulatory mandates, although generally well-intentioned, can take decision making out of the hands of those closest to the situation. Across-the-board mandates deprive investors of the decision-making power that is rightfully theirs and may impose costs on investors, while not producing a proportionate return.
I have a sneaking suspicion that you let Chairman Cox and me speak first to get all of us lawyers out of the room early so that you could relax and enjoy the conference. The urge to talk without the lawyers is somewhat understandable in light of the role that lawyers have had in shaping the work that you do. Many of the challenges faced by the accounting profession are the product of exploding litigation risks and costs. People feel compelled to take steps to insulate themselves from legal liability. They become hesitant - and scared - to act without precise guidance, and thus seek evermore explicit rules from standard setters and regulators. Take one look at FAS 133, for example, and ask why it stretches to hundreds of pages.
The possibility of a future challenge by someone exercising 20-20 hindsight makes people reluctant to use their professional judgment. We have seen how some class action lawyers have become adept at turning questions of professional judgment into the basis for lucrative lawsuits and self-promotion. True, there are also tragic situations of investors sucked into heinous frauds. But, often the professionals have been duped, too. Are they culpable? Were they reckless? Should they have known better? What is their appropriate liability? Mix in conflicting interests as potential signs of impure motives, and the situation looks bad in retrospect. The consequences can be devastating to the individuals and firms involved, not to mention investors, employees, and many others.
President Bush, first as governor of Texas and now as president, has been sensitive to the issue of growing litigation costs and has taken active steps to try to address it. Congress has also acted, and I expect that it will continue to work on this problem. But a problem that was decades in the making is susceptible to no easy solutions.
As these solutions are being worked out at the political level, those of us in the trenches need to do what we can to alleviate, or at least not worsen, the problem. We do not have much room for error. Based on concerns that I have heard overseas, American litigiousness and the specter of what some are viewing increasingly as a "lottery system of justice" threaten to make this country a less attractive place to invest and to do business. That would be a tragic result for American workers, investors, and consumers.
Accountants and auditors are frequent targets of this culture of litigation. There is a clear expectation gap among the public regarding an audit: its scope, its goals, and its deliverables are not necessarily well understood. Many expect you to prevent mistakes or to pay for them when they happen. You tend to be one of the remaining "deep pockets" (or so it may seem) when others have collapsed in a financial fraud. The accountant is, in the eyes of some, an omniscient super-detective who ought to be able to uncover every corporate fraud. We all know that the reality is rather different, particularly since collusive fraud is so difficult to detect. Thieves, embezzlers, and cheats have been able to outwit systems, controls, and watchdogs long before the recent spate of corporate scandals.
On the positive side, however, these expectations have caused greater attention and resources to be devoted to financial reporting and auditing. You face the question of whether you can stem the tide of litigation by managing people's expectations about your role, augmenting the efficacy of the audit against financial fraud, and trying to explain the role of the audit as based on reasonableness and professional judgment. We on the public policy side must help in this regard, because no less a question is involved than the value proposition of the modern audit.
Sometimes, of course, accountants do not live up to even reasonable expectations. There is no denying that accountants are playing an increasingly visible and vital role. This carries with it great responsibility. In some cases, accountants have been responsible for - or complicit in - improper behavior, and some auditors have been insufficiently vigilant. Our docket at the SEC attests to this. The Sarbanes-Oxley Act created the PCAOB because of deep failings in the U.S. accounting profession's ability to regulate itself. During and prior to the Enron-era, the accounting profession fell down on the job and I think got what it deserved in the Act. The SEC will not shy away from taking enforcement action against accountants when their behavior warrants it.
That said, we regulators can also stifle professional judgment by punishing you after the fact for exercising it. Accounting issues are often not black and white. We can recognize this and act accordingly without undermining GAAP. Bob Herz of the FASB recently was quoted as saying, "Principles-based accounting is hard when you don't have principles-based enforcement or principles-based litigation around the system."1 One accountant's approach can differ from another's without either approach violating our rules. It is inappropriate for regulators to take enforcement action over reasonable differences of opinion about the application of GAAP. Even if a sanction is "light," the mere existence of an enforcement action is significant. We must acknowledge the heavy personal toll an enforcement investigation takes on the subjects of the action, especially during its pendency when careers are suspended and perhaps unfairly damaged if no enforcement action ultimately is found to be appropriate. The enforcement action can also spawn groundless private lawsuits and, indirectly, act as a damper on the willingness of accounting professionals to use their judgment.
I have spoken often of the need for transparency in our regulatory processes. This means that we should not foster a regulatory environment that relies on informal guidance as a basis for enforcement action. The realm of accounting standards is a welter of all sorts of levels of principles, rules, and other guidance put out over decades by an alphabet soup of institutions. We at the SEC should not add to that muddle. Earlier this year, an SEC enforcement case faulted a registrant for failing to change its method of accounting in response to the issuance of frequently asked questions by the SEC staff. The commissioners were also told that the registrant's approach contravened a statement made by the SEC staff at an AICPA Committee meeting.
You will hear from many of the fine accountants on our staff during this conference. The SEC is fortunate to have such a wealth of talent. But the preferred approaches of SEC staff accountants, even when expressed in a widely attended meeting such as this one, should not be viewed as binding law unless those views have been formalized through Commission action. The disclaimer that I made at the beginning of this talk - required by our own ethics standards - applies to all SEC employees: they speak only for themselves, and not for the Commission. There are only five officers of the United States at the Commission, and it is our vote that binds the institution, because we are the ones that are appointed by the president and accountable to the taxpayer.
Enforcement actions should not be built around staff pronouncements. If the SEC believes that everyone should follow a particular approach, the approach should be set forth in a rule or standard that has been subjected to due process of notice and comment. This is not just my personal view; it happens to be the law of the land. Congress adopted the Administrative Procedure Act to provide sunshine and due process. The FASB and PCAOB have also adopted this practice of notice and comment.
Similarly, at times the SEC staff has departed from this essential element of transparency. Some so-called "Staff Accounting Bulletins" are more like accounting rules than interpretations of existing accounting standards. I have no argument as to our staff's attempting to explain or apply an SEC rule or accounting standard to a current situation. Our staff performs similar tasks in other areas, including issuing so-called "no-action letters" - letters based on specific fact situations regarding which they state formally that they would not recommend enforcement proceedings. This practice has developed as an essential aid to lawyers and other professionals in giving advice to their clients. Technically, it does not bind the Commission, but the Commission would be hard-pressed to take action.
But sometimes staff pronouncements can fundamentally change existing market practices. For example, SAB 101 (subsequently updated as SAB 104) addressed in depth various aspects of revenue recognition. Subsequent to its release, the "effectiveness" of that SAB was delayed several times as additional Q&As were added based on comments from stakeholders. The final guidance provided for registrants to reflect the adoption of SAB 101 as a change in accounting principle, similar to the adoption of a new FASB standard. With all of the attributes of rulemaking from the perspective of affecting the marketplace, it is difficult to argue that such pronouncements are not rules and should not be subject to the requirements of the Administrative Procedure Act.
The opportunity to provide consultation to the public is a good way of ensuring that the parties that will be affected by the rules have a chance to raise issues and concerns. Some of these may arise out of unique facts and circumstances that the staff and the Commission would not otherwise have considered. It would be unfair to expect our staff, even after talking informally to some representatives in the industry, to recognize all of the potential issues that companies and their auditors might face.
Even if adopted through a notice and comment process, overly prescriptive standards can rob you of the ability to apply your professional judgment. The specter of litigation is one of the factors that drives the demand for ever-more-precise guidance. A thick rulebook is no substitute for the exercise of judgment and the application of standards to particular sets of facts.
I mentioned earlier FAS 133. I also would argue that the PCAOB's Audit Standard 2 may be another example of an overly prescriptive standard. At a minimum, it is widely acknowledged that under AS2, corporate management and auditing firms have been much too conservative in exercising their judgment. People seem to be driven by the impulse to document virtually every process in an effort to appear to be thorough and to avoid being second-guessed by regulators and litigators. The PCAOB itself acknowledged this in the report issued last week on the implementation of AS2. The PCAOB found that there were problems with its implementation, including a tendency to employ a bottom-up approach, which resulted in the expenditure of "more time and effort than was necessary to complete the audit."2
People will not dare to rationalize their approach to the internal control process until both the SEC and the PCAOB have given them comfort that we will not continually second-guess their professional judgment. The SEC and the PCAOB, which both issued guidance in the Spring, generally agree that there was overkill by auditors (and management) in the first year. I have heard stories of companies and their auditors determining that they have 20,000; 60,000; or even 200,000 key internal controls! Earlier this year, the CFO of a large European company told me that the company determined that it had 500 key controls, but its outside auditor found 20,000 key internal controls. Even in a large company, can this many controls be "key"? How can the costs and burdens to audit and document tens or hundreds of thousands of controls provide commensurate benefits?
Our rule adopting the internal control provision provides that the control process must provide "reasonable assurance" regarding its control structures. Records should be maintained in "reasonable detail" and a company's policies and procedures should provide "reasonable assurance" that transactions are recorded accurately in accordance with GAAP. Let me be clear -- reasonable means reasonable -- it does not mean absolute or certain or perfect.
With respect to auditor attestations under Section 404, company management and its outside auditor should be working hand-in-hand to get this right. I fear, however, that in the current environment, especially with the way in which the independence rules at first were interpreted by some with respect to 404 audits, many executives feel as if they aren't working hand-in-hand but are actually in hand-TO-hand combat with their auditors as they go through the 404 process! You can work to rein in the costs associated with section 404, so that it serves its important goals without drowning corporations in costs.
You can also help by managing the expectations around Section 404. It is not at all clear, as some have argued, that documentation of internal controls would have been able to prevent the type of collusive fraud by management that we saw in the recent corporate failures. Internal controls, which have been required since the 1970s, are a tool to assist financial reporting; they are not a stand-alone goal and they are not an insurance policy against fraud.
Finally, I would like to briefly address the continued importance of a strong working relationship between the SEC and the PCAOB. It is clear that Congress considered the SEC's oversight to be critical, and I am committed to ensuring that we do not shirk this oversight role. The PCAOB must be monitored because it is a quasi-governmental organization that has de facto taxing authority. Unlike the members of the PCAOB, SEC commissioners are directly accountable to the American taxpayer; we are stewards of taxpayers' money and they pay our salaries. It is important that we establish solid procedures for carrying out this oversight in these early years of the PCAOB's life. Our doing so should not be viewed as an indictment of the work of the PCAOB, but rather as a commitment to carrying out our own Sarbanes-Oxley responsibilities.
One of the critical areas of oversight is the PCAOB's budget, which we are required to review and approve. This responsibility is more appropriately exercised at a public meeting than behind closed doors. For this reason, last March, we had a public meeting to consider the budget. We will have the opportunity to take another hard look at the budget now that PCAOB has approved its budget for 2006.
Like the Chairman, I also thank Bill McDonough for his hard work during the past two and a half years. He has gotten the PCAOB off to a solid start. I am looking forward to working with Bill Gradision, whom we appointed acting chairman last week. I expect that Bill will ensure that the PCAOB will work closely with our staff to facilitate SEC oversight. As with auditors and their clients, our relationship should be a cooperative one, but also one in which the SEC asks sufficiently tough questions of the PCAOB.
Your profession is exceedingly important in the modern capital markets. It has recently rediscovered its roots, so to speak, through embarrassment, adversity, and wholesale change. Just as the modern profession got its start through British investors sending Scottish accountants to America as an independent check on how the Yanks were spending their money, so too today's investors look to you for your independent check on how their investment is doing. You are a vital component of investor confidence in our capital markets. We need a strong, independent profession. Just as you are trained to tell your clients what you think, do not be afraid to tell us regulators what the real situation is - even if we are the problem! We do not need ostriches or opossums as accountants - we need eagles and lions.
Thank you for your attention. My door is always open, so please feel free to stop by to share your thoughts on these issues and any others that are on your mind. Enjoy the rest of your conference.