Statement by SEC Staff:
Remarks Before the 2005 AICPA National Conference on Current SEC and PCAOB Developments
Brian T. Croteau
Associate Chief Accountant, Office of the Chief Accountant
U.S. Securities and Exchange Commission
December 5, 2005
As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
Good afternoon. As you know the PCAOB is a private-sector, non-profit corporation that was established by an act of Congress - Title I of the Sarbanes-Oxley Act of 2002 (the "Act") - to oversee the auditors of public companies. The SEC has oversight responsibilities related to the PCAOB that are required by the Act. 1 This afternoon, I'd like to provide insight into how the SEC and the PCAOB interact on a day-to-day basis, and how through those interactions the Commission effectively discharges its oversight responsibilities. The Office of the Chief Accountant (OCA) has a significant role in leading and coordinating the Commission's oversight work; however, the responsibilities extend across many of the offices and divisions within the Commission.2
General Oversight Responsibility
The Act authorizes the Commission to conduct periodic, special, or other examinations of the records of the Board.3 Also, the PCAOB's Office of Internal Oversight and Performance Assurance (IOPA) perform internal examinations of PCAOB programs and operations. The Commission is provided access upon request to the full reports from these examinations, and summaries of these reports are available on the PCAOB's website.
Earlier this year, when approving the Board's 2005 budget, the Commission set an expectation that the Commission staff would commence its first inspection of the PCAOB before the Commission considers the 2006 budget.4 Staff members from the SEC's Office of Compliance, Inspections, and Examinations along with staff from the Office of the Chief Accountant are coordinating this first inspection of the PCAOB covering a portion of their operations. The staff will consider the scope and results of this examination as part of its recommendation to the Commission regarding the PCAOB's 2006 budget.
Budget and Accounting Support Fee
The PCAOB is required to approve an annual budget for its upcoming fiscal year by November 30th of each year.5 You may be aware that last month the PCAOB approved its budget reflecting total outlays of approximately $131 million for 2006 (compared to total budgeted outlays of $137 million in 2005). The budget, which can be found on the PCAOB's website, is subject to Commission review and approval. The Commissioners, OCA staff, and staff from the Office of the Executive Director are all involved in this process, which culminates in a Commission vote on whether to approve the budget. Additional information provided by the PCAOB that explains the budget will be made public as part of the Commission's approval process.
In the Commission order approving the 2005 budget, the Commission also requested that the PCAOB provide a long-range strategic plan and a self-assessment of the Board's internal controls for its operations and budget in advance of the Commission voting on the 2006 budget. These items are being considered as the Commission staff prepares to make a recommendation to the Commission regarding the Board's 2006 budget.
The PCAOB is also required to submit an annual report to the Commission containing audited financial statements. Once received, the Commission provides the annual report to both the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services.
Rules and Professional Standards
Moving on to the Board's rules and professional standards, the Commission is required to approve all PCAOB rules and professional standards in order for them to become effective. Once approved by the Commission, PCAOB rules also become enforceable by the Commission.
The SEC is designated as an official observer, with speaking rights, on the Board's Standing Advisory Group. In addition, Commission staff meets regularly with the Board's staff to discuss emerging practice matters and to provide input on standard-setting activities. The goal is for SEC staff to provide input and insights, recognizing that it is the PCAOB's rule to draft and interpret. OCA and PCAOB staff positions generally become reasonably close before the PCAOB staff takes a proposal to their Board. Of course, the Board and staff can always make changes, but if the process works properly, rare will be the occasion where the Chief Accountant does not recommend that the SEC adopt a PCAOB rule. Once rules or standards are adopted by the Board, they are filed with the Commission.6 The Commission generally publishes the proposed rule or standard for public comment in the Federal Register. After consideration of the comments, the Commission votes on whether to approve the rule or standard. If approved, the rule or standard becomes effective in accordance with its terms. Finally, the text of the Commission order is printed in the Federal Register. The Commission must vote for or against a rule or standard in the form it is submitted by the PCAOB. The law does provide a process by which the SEC can, by order, amend, delete, or add to the rules or standards of the Board;7 however, the Commission has not issued any orders of this nature to-date.
While I have the opportunity, I'd like to say to this audience, in particular, that your comments both to the PCAOB and to the SEC are very important to the rulemaking process and are encouraged. I'll also note that you should not be surprised to see the SEC pose specific questions for comment when the SEC exposes a PCAOB rule or standard. These questions are not intended to limit the scope of your comments, but rather to ensure that the Commission receives feedback on key issues in order to consider whether to approve the rule or standard as it is proposed by the PCAOB.
The PCAOB announced its standard-setting agenda for 2006 during its October Standing Advisory Group meeting. The list includes topics that will have significant impact on how audits are planned and performed and contribute towards shaping the future of auditing - which is a vital component to maintaining investor confidence in financial reporting.
Inspection of Registered Public Accounting Firms
I'll turn now to inspections. Section 104 of the Act requires that the Board conduct a continuing program of inspections of registered public accounting firms. We are frequently asked questions such as: what is the SEC's involvement in the inspection process; when is it appropriate to contact the SEC about a PCAOB inspection; and how are we informed by the results of these inspections? I'll address all of these questions now.
As a general policy, we do not have knowledge about specific inspections that are in progress. Primarily we are a recipient of both the public and non-public portions of the resulting inspection reports. In addition to firm-specific inspection reports, PCAOB Rule 4004 provides a process for the Board to report to the Commission matters of non-compliance with relevant rules and regulations related to a registered accounting firm, or any other person, that come to its attention through an inspection. Further, if concerns come to the Commission staff's attention about auditor performance that the staff believes may be either individually significant or indicative of systemic issues, the staff may share this information with the PCAOB for consideration in planning their inspections.
So, when is it appropriate for registered accounting firms, or issuers, to contact the SEC with respect to a PCAOB inspection? Registered accounting firms may choose to seek Commission review8 if they have provided a response to the Board to a draft inspection report and they disagree with the assessment that is ultimately contained in any final inspection report. Registered accounting firms may also seek Commission review if they disagree with the determination of the Board that quality control criticisms or defects identified in an inspection report (part II of the reports) have not been addressed to the satisfaction of the Board within one year. Registered firms have 30 days from the event giving rise to the disagreement to seek Commission review. Any quality control criticisms will not be made public for 30 days from the date a firm requests Commission review. At the end of 30 days, unless the Commission takes action to instruct the Board otherwise, the matter generally would be made public in accordance with the normal rules and procedures of the PCAOB.
What about PCAOB communications with issuers? Although the PCAOB does not formally contact issuers, management may become aware that their audit is the subject of a PCAOB inspection. For example, the PCAOB may contact an audit committee chair to ask if he or she is agreeable to voluntarily being interviewed to aid them in their assessment of an auditor's performance. Other possible examples include situations where an auditor elects to discuss the details of an inspection with a client, or is required by professional standards to have such discussions because the auditor becomes aware of a need to either withdraw a previously issued report or perform more work to substantiate a previously issued report. In assessing auditor performance and compliance with auditing standards, the PCAOB naturally considers the auditor's assessment of the issuer's application of GAAP. If the PCAOB raises questions to an accounting firm about the application of GAAP, the accounting firm and/or the issuer may conclude that consultation with the OCA is appropriate. Issuers should not contact the PCAOB to discuss accounting matters. Please also note that the PCAOB acknowledges in its inspection reports that any description in a report of "perceived departures from GAAP should not be understood to be an indication that the Commission has considered or made any determination regarding these GAAP issues unless otherwise expressly stated by the Commission."
A recent article on WebCPA titled "Groundhog Day for the Big 4" 9 raised the questions, "Were the deficiencies this year so different from the ones identified by the Board in last year's reports? And one year later, why were they not corrected?" In reading the article, I couldn't help but react to a potential misperception that could be emerging among readers of the inspection reports. It is important to keep in mind that inspections are focused on identifying deficiencies in audit quality. With that objective in mind, the PCAOB employs a risk-based approach to seek out areas where problems are most likely to occur. As a result, it should not be a surprise when the use of this approach yields listings of problems each and every year and if, on the surface, these problems perhaps look somewhat similar to prior year's reports. After all, each year, we expect that the PCAOB will adjust the risk metrics to account for areas that have improved by taking them off the high risk list. To simply look at the findings without putting them in context, might cause individuals to reach erroneous conclusions. I spent a little time thinking about other complex environments sometimes involving difficult judgments, made on a real-time basis, where people rely upon systems of quality controls. Immediately the aviation industry came to mind. I noted that according to the FAA's Administrator's Fact Book10, in 2004, there were 145 near midair collisions, 2,628 pilot deviations, 1,216 operational errors, 263 vehicle pedestrian deviations, 882 surface incidents, and 310 runway incursions. Also, to me these statistics looked somewhat similar to those reported in the prior year. Should I draw a conclusion based on these reported incidents that air travel is not reasonably safe? I think most people would agree that these reported statistics, on their own, do not provide sufficient information to draw conclusions about overall quality or improvements that may be occurring. Changes in the environment such as adding or changing rules will likely impact the number of incidents as adjustments are being made to the approach. Focus has also been placed on the number of restatements relating to the correction of errors arising from the inspection process, and I think most would agree that the frequency of restatements to correct errors, regardless of whether identified through the inspection process or otherwise, is unacceptably high. But, I don't think it's practical to expect we're ever going to reach zero restatements. Is it my point that we shouldn't continuously seek to reduce the number of restatements or that a focus isn't needed on the cause of restatements? Of course not.
Understanding the significance of inspection report findings and making relevant comparisons of the reports between firms, or between years, requires significant judgment. Knowledge is likely needed of the relevant facts and circumstances beyond what is contained in a single report, or even series of reports for a single firm. Measuring the impact on improvement in audit quality by reading the reports themselves will likely prove, at minimum, difficult for those other than the registered accounting firm itself. Investors, regulators, registered accounting firms, and issuers all look forward to the results of continued improvements in audit quality. I think there is plenty of runway ahead for all parties to contribute to these improvements. I believe that risk-based inspections are one of the early-warning systems that will lead to improvement in audit quality and reduce the frequency of audit failures leading to misstatements.
I am hopeful that summaries or generalized reports that the PCAOB issues in accordance with PCAOB Rule 4010 will be helpful by focusing broader audiences on areas in need of improvement and identifying recurring themes and more general quality assessments. These reports include information, without attribution to individual firms, some of which is contained in otherwise non-public portions of inspection reports. The first of these reports, which I personally believe to be quite constructive, was issued last week. It relates to the effectiveness and the efficiency of the work done in implementing PCAOB Auditing Standard No. 2, An Audit of Internal Controls over Financial Reporting Performed in Conjunction with a Financial Statement Audit.
Last, I'd like to address areas in which OCA plays a more limited role.
Appointment of Board Members
I want to at least acknowledge the Commission's responsibilities, in consultation with the Board of Governors of the Federal Reserve System and the Secretary of the Treasury, for the appointment of Board Members. Section 101(e) of the Act discusses the appointment, composition, powers, limitations, and other important aspects of Board membership. The five-member Board must include exactly two members who are, or have been, CPAs. In addition, the chairman may not have been a practicing CPA for at least five years prior to his or her appointment. In general, terms of service are five years, and no Board member is allowed to serve more than two terms – regardless of whether such terms are consecutive. As you know, one Board member's term recently expired and Chairman McDonough's resignation became effective last week. As Chairman Cox has recently stated, the Commission is currently working through a process for the appointment of Board members. Meanwhile, on Friday, Board Member Bill Gradison was named Acting Chairman.
Investigations and Review of Disciplinary Actions by the Board and Other Matters
Section 105 of the Act covers the Board's investigation and disciplinary proceeding activities. These activities are coordinated closely between the PCAOB and the Commission - particularly the Commission's Division of Enforcement. Finally, Section 101(c)(5) of the Act makes it the Board's responsibility to perform other duties or functions as the Board, or the Commission, determines necessary or appropriate to promote high professional standards and improve the quality of audit services provided by registered public accounting firms. This general charge provides the PCAOB and the SEC significant latitude in setting its strategic goals for the future.
In fairly broad terms, this covers our oversight of and interaction with the PCAOB. In summary, I believe we are working well together. While part two of this speech could easily have been a discussion of many of the PCAOB's accomplishments, I'll leave that topic for PCAOB representatives and indicate that I am personally impressed with their efforts, and congratulate them on their accomplishments to-date.
Thank you for your attention. For those of you that are flying home later this week, safe travels.
|1 || See section 107(a) of the Act.
|2 || The Divisions of Corporation Finance, Enforcement, and Investment Management along with the Offices of the Chairman, Commissioners, Compliance Inspections & Examinations, the Executive Director, General Counsel, and the Secretary all have roles in the Commission's interaction with, and oversight of, the activities of the PCAOB.
|3 || See section 107(a) of the Act and the provisions of section 17(a)(1) of the Securities Exchange Act of 1934.
|4 || Exchange Act Release No. 51313, Order Approving Public Company Accounting Oversight Board Revised Budget And Annual Accounting Support Fee For Calendar Year 2005 (March 3, 2005).
|5 || Section 109 of the Act requires that the Board shall establish a budget for each fiscal year, which shall be reviewed and approved by their Board not less than one month prior to the commencement of the fiscal year to which the budget pertains. It is then subject to Commission approval in accordance with the Act.
|6 || Pursuant to Exchange Act Rule 19b-4 rules are filed on Form 19b-4 with the Commission.
|7 || See section 107(b)(5) of the Act and section 19(c) of the Securities Exchange Act of 1934 describe the required process.
|8 || See section 104(h) of the Act.
|9 || Bill Carlino, Editor-in-Chief of WebCPA, “Groundhog Day for the Big 4” (November 4, 2005).
|10 || See U.S. Department of Transportation, Federal Aviation Administration: Administrator's Fact Book, August 2005.