Speech by SEC Staff:
Remarks Before the 2004 AICPA National Conference on Current SEC and PCAOB Developments
Andrew D. Bailey, Jr.
Deputy Chief Accountant
Office of the Chief Accountant
U.S. Securities and Exchange Commission
December 6, 2004
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.
It's a real privilege for me to be here today and to have the opportunity to speak to you as we head into the final stages of the annual auditing and reporting season. This conference is an excellent opportunity to share information and bring ourselves up-to-date on the critical issues we face as we strive to create quality audited financial statements.
Before I continue, let me make the usual SEC disclaimer. The remarks I make today are my own and do not necessarily represent the views of the Commission or its staff.
I have been the Deputy Chief Accountant, Auditing for just short of a year. I was previously a member of the SEC staff as the academic fellow a short three years ago. That gap in time really reinforced for me the loss of investor confidence and resulting change in the business and regulatory environment that occurred in those three years.
I spent most of my career as an accounting academic. The first draft of this speech was a rather academic description of the nature of “quality audited financial statements” – an important matter, but I probably took too academic an approach in view of the practical issues we face today – so you can all breathe a sigh of relief. I cannot ignore the issue of high quality audited financial statements, but I will take this opportunity to speak about my experiences of the past year, including some of the critical audit issues, and the areas my group will focus on in the upcoming months.
High Quality Audited Financial Statements
High quality audited financial statements serve the public interest and help protect investors by providing them with relevant, reliable and understandable financial information, broadly defined to cover not only the core financial statements, but also related schedules and disclosures. The auditor plays a significant role in meeting the goal of high quality audited financial statements, but the auditor is only the last key gatekeeper before you find yourself dealing with the SEC.
High quality audited financial statements require that all participants do their jobs. The FASB, in its accounting standard setting role, must provide users and auditors with objectives based standards that are capable of consistent implementation and audit. Management and the Audit Committee must, in turn, be committed to not merely the letter of the accounting standards, but to their intent. Principles based accounting standards will not work unless management and the audit committee apply the principles, not just comply with the rule. The auditor’s contribution is limited by the accounting standards and the preparers’ actions. The precision of the audited numbers is bounded by the precision of the underlying accounting standards and in situations where fraud occurs and is concealed by multiple parties; it can be hard to catch no matter what actions the auditor takes.
The PCAOB must also provide objectives based auditing standards that are effective, when properly applied, in reducing the incidence of materially misstated financial statements. The standards must not only be effective, they must also balance costs and benefits. An audit cannot be so costly as to be a burden to markets beyond its benefit. Where a significant and pervasive change in practice occurs such as the PCAOB integrated audit, I think it is appropriate to evaluate the cost/benefit relationships and consider ways to improve the tradeoffs...
Finally, auditors must commit to the audit as their primary function and with the mindset that they serve first the financial markets and the public interest. Because the audit is largely an invisible service, quality is measured primarily on inputs. Unfortunately, output measures tend to appear only when there is a putative audit failure. Today, the PCAOB has at its disposal two new tools, inspections and investigations that will give us a more transparent view as to auditor performance and audit quality.
Nevertheless, despite anything else that may be done, public belief in the quality of auditors and audits will likely remain a matter of public perception as to auditors’ competence and independence.
This brings me to my next topic, auditor independence.
One of the major focuses of the past year has been in the area of auditor independence. The Commission’s strengthening of its auditor independence rules in 2003 went fully into effect in May of this year. I am pleased to report that it appears that auditors and audit committees are taking these rules seriously. In an effort to meet both the letter and the spirit of the rules, audit committees and their auditors are engaging in substantive and detailed discussions about the types of services that the independent auditor should provide. Audit committee actions may be responsible for the fact that the most recent proxy statements show that the level of non-audit services, including taxes, provided by the audit firms to their audit clients have continued to decline as measured by the relation to the total fees. I don’t want you to misconstrue what I am saying. I am not advocating a ban on value-added, non-audit services. However, I strongly support continued, substantive discussions at the audit committee level about whether nonaudit services that are provided are consistent with the need for auditor independence and the quality of the audit. While auditors do have to observe the independence rules, this should not become a check the box exercise. Keep in mind that it is the auditors’ competence and independence that matters.
Don Nicolaisen’s recent action with respect to contingent fees is perhaps the single most visible and significant action in the area of independence since the 2003 rules were finalized. It is also another area in which the Audit Committee is again highlighted as a significant part of the independence process. Don’s letter on the matter made very clear OCA’s view as to the prohibitions on contingent fees and the importance of substantive Audit Committee communications.
While there have been a number of positive developments in the area of independence, unfortunately, there is still a lot of room for improvement. One of the most troublesome areas is in what have been termed “inadvertent” independence violations. The choice of descriptor is itself revealing. By labeling violations of the rules as “inadvertent”, it appears to deflect the responsibility to some remote location where the violation occurred. At the remote location there was, presumably, an intentional or (“advertent” to coin a word) act, but by labeling it “inadvertent” the firms seem to suggest that it was “not our fault.” But, of course, it was someone’s fault.
Without independence in fact and appearance, auditors cannot satisfy their responsibility to the public. We expect all auditors, individually and as firms, to develop an ethic of independence and the necessary organizational processes that will insure that that ethic is understood by everyone, supported and adhered to by all those associated within the firm.
Internal Control over Financial Reporting
Switching gears a bit, another critical area where I have dedicated significant amounts of my time over the past year is Section 404 of the Sarbanes-Oxley Act and management’s assessment of internal control over financial reporting. The past year has been an exciting time, as well as a time of significant change, with the requirements of Section 404 becoming effective for the first time for a large number of companies. Additionally, the PCAOB completed their 404 companion audit standard (AS2) on integrated audits, as well as a number of other standards, that will provide guidance to the auditors preparing to opine on the effectiveness of internal control over financial reporting.
At this point, companies should have substantially completed their assessments and both the company and their auditors should be heading down the “home stretch”. It is true that the recent SEC Exemptive Order did provide limited relief for a class of smaller accelerated filers. However, as the time approaches for all registrants to report the results of their assessment of internal control over financial reporting, I want to remind registrants that they need to provide complete, robust, and transparent disclosures – don’t try to “disguise” or “pretty up” your material weaknesses – provide a full explanation of the weakness in question and any remedial action that have occurred or will occur so that investors can determine for themselves the severity of the weakness. Some investor groups have already indicated they will not view all material weaknesses as the same. A complete story will help the investor make the appropriate distinctions.
Both the SEC and the PCAOB have received a significant number of questions from registrants and auditors as companies are completing their first annual assessment. Please keep the letters, emails, and calls coming. We have tried to be responsive to many of these questions, and have each issued answers to frequently asked questions to address some of the most common concerns. We understand that this is the first year for all of us on what is, probably, the most significant change in auditing in fifty years. I am convinced that effective and efficient implementation of 404 and AS 2 will result in higher quality audited financial statements and a more informed investor, but we do not expect perfection - in the first year.
Finally, it is true that Section 404 of SOX and the PCAOB’s Auditing Standard 2 are the most significant changes in auditing in the last fifty-years, but management and auditors should not lose sight of the importance of the financial statements in their efforts to complete the assessment and audit of internal controls. Do not forget to do the audit.
Frequently Asked Questions
While I am on the topic of frequently asked questions, I would like to address another issue I have noticed during my past year at the SEC. My staff and I receive many questions on various topics, but most frequently on independence matters and Section 404 implementation issues. We welcome these questions, and the vast majority of them are thoughtful questions on complex issues. These questions give our staff insight as to the areas where companies are struggling and help us focus our attention on the hot topics and important issues. Additionally, where appropriate, we use the questions received to create our “Frequently Asked Questions” documents in order to get the word out to everyone.
However, I am troubled by the questions we receive where it is quite clear that the questioner – whether it be a registrant, an auditor, a lawyer or some other party – is simply trying to find a way around the rules. We expect registrants and auditors to comply with the spirit of the rules, rather than trying to structure around the exact words. .
We continually hear about the desire, on the part of all parties involved, for more principles based standards, in auditing as well as accounting standards. Principles based standards only work if everyone is committed to complying with the objectives of the standards, rather than using the language of the standards themselves to structure around the requirement. This change in mindset requires a cultural shift, and a significant one at that, before objectives based standards can be truly operational.
I am also involved with some of the international issues that might interest you. The first is to stress our strong commitment to not only to convergence of accounting standards, but alsoto making progress on auditing standards convergence as well. OCA is a strong supporter of an objectives based approach to both accounting and auditing standards. We also encourage convergence of those standards toward high quality international standards. The recent restructuring of IFAC governance contributes to this goal. The restructuring resulted in a Public Interest Oversight Board (PIOB) with a distinctly international and public interest focus and a restructured standard setting body, the IAASB. While the IAASB is not fully separated from the profession, as is the PCAOB, we believe these changes are a major step in the right direction and in protecting the publics’ interests in the area of auditing standards setting.
Second, it may be worth noting that, where it involves an SEC registrant, it is our view that the worldwide affiliates quality and independence platforms should deliver uniform worldwide quality. IFAC and the Forum of Firms are working toward that end. Though significant progress is being made, the large, worldwide public accounting firms have, in my opinion, not yet managed to put together organizations that completely support their claims to uniform worldwide quality and independence standards. This is not a viable long-term position. Consider that the SEC and PCAOB seldom make distinctions based solely on national boundaries. AS 2 applies worldwide. The SEC independence standards apply worldwide.
Cost and Benefits of the Public Trust
As Don mentioned earlier, we are aware that 404, AS 2 and the Independence Rules add to costs for both registrants and auditors. It is, of course, easier, particularly today, to measure and feel the costs and pains of implementation. It is much harder, particularly in the short-term, but even in the long-term, to measure and feel the benefits of successful implementation and maintenance of good internal controls and high levels of independence. We are all incurring the costs of lost public trust, a trust that cost nothing to lose, but requires significant expenditures of time, talent and money to reclaim.
Nevertheless, the SEC considers the costs and benefits of all of its rules. We take the matters of effectiveness, efficiency and cost seriously. In order to protect investor interests we must have effective systems of internal financial reporting and disclosure control. At the same time, the investor can reasonably expect that that these systems will be only as costly as is necessary. After the first round of public reporting the OCA will consider ways in which it can obtain public input as to the costs and benefits of 404.
So far, I have thoroughly enjoyed my year here at the SEC. Everyone I deal with at the Commission and those who come to visit us for various reasons have provided me with a new educational experience. It has been a great experience – similar to a second Ph. D. program given how much I have learned. These are exciting times, given the sweeping changes taking place and impacting registrants and the auditing profession. Progress has been made to help restore investor confidence, and while additional progress is still needed, I truly believe we are on our way and will get there.
I cannot leave the podium without acknowledging my colleagues in this endeavor. I will not name them all, but without this truly exceptional group of dedicated people doing all the real work and trying to keep me out of trouble as well, I would not survive very long in this position.
Now, let me introduce our next speaker, Scott Taub.