COMMENTARY Balancing the Costs and Beneﬁts ofAuditing … Benefit II.pdfThe CIFiR represents an important public policy initiative to address concerns over how complex ﬁnancial

Balancing the Costs and Benefits of Auditingand Financial Reporting Regulation

Post-SOX, Part II: Perspectives from theNexus at the SEC

Zoe-Vonna Palmrose

INTRODUCTION

From August 2006 through July 2008, while on leave from the University of SouthernCalifornia, I served at the Securities and Exchange Commission !SEC" as Deputy ChiefAccountant for Professional Practice in the Office of the Chief Accountant !OCA". As I

explained in Part I of this article !see the June 2010 issue of Accounting Horizons", the Profes-sional Practice Group !PPG" was created in the aftermath of the Sarbanes-Oxley Act of 2002!SOX". PPG plays a significant role in leading and coordinating the Commission’s oversight of allthe Public Company Accounting Oversight Board !PCAOB" activities and the Commission’s workwith respect to auditor independence; it works alongside other offices and divisions within theAgency to provide perspective and input on a variety of audit-related issues; and it consults withaudit firms and registrants on audit matters.

This Commentary shares some experiences and offers insights on some of the initiatives withwhich I was involved during my time at the SEC. My primary intent in doing so is twofold: !1" toprovide perspective on some important public policy issues in accounting and auditing and !2" toassess what seems to be working well and what needs improvement in the regulation of thepractice of accounting and auditing. As such, I hope this Commentary will help inform yourresearch and teaching. In addition, I hope it will encourage some of you to take advantage ofopportunities for public service and input on public policy issues.

This Commentary appears in two parts. Part I focused on SOX Section 404 and the Commis-sion’s efforts to improve the implementation of it. This part, Part II, provides perspectives on anumber of other SEC activities and initiatives. These include the Commission’s oversight of the

Zoe-Vonna Palmrose is a Professor at the University of Southern California.

I very much appreciate the helpful comments of Joe Carcello, Dana Hermanson, the participants in the University of Texasat Austin Accounting Research Colloquium, and especially Bill Kinney.

Disclaimer: The views expressed in this Commentary are my own. They do not necessarily reflect the views of theSecurities and Exchange Commission, the Commissioners, or of any other members of the Commission’s staff.

Accounting Horizons American Accounting AssociationVol. 24, No. 3 DOI: 10.2308/acch.2010.24.3.4872010pp. 487–507

COMMENTARY

Submitted: October 2009Accepted: December 2009

Published Online: September 2010Corresponding author: Zoe-Vonna Palmrose

Email: [email protected]

PCAOB, the SEC Federal Advisory Committee on Improvements to Financial Reporting !CIFiR",International Financial Reporting Standards !IFRS", the U.S. Department of the Treasury AdvisoryCommittee on the Auditing Profession, and auditor independence. Part II also assesses auditregulation under SOX and concludes with a proposal for a new regulatory structure based on whathas been learned over the last seven years or so.

COMMISSION OVERSIGHT OF THE PCAOBPart I described PPG’s efforts to help the Commission improve the implementation of SOX

Section 404, but these efforts occurred in conjunction with PPG’s ongoing work in leading andcoordinating the Commission’s oversight of the PCAOB under SOX.1 PPG shares much of thiswork with other SEC offices and divisions. For example, SOX requires that the Commissionreview and approve the PCAOB’s annual budget. The Commission has established a process fordoing so. Staff from OCA and the Office of the Executive Director !OED" work with the PCAOBin accordance with the guidelines of this process. In addition, during my time at the SEC, theCommission considered it important for the PCAOB to integrate long-range strategic planning asan integral part of the PCAOB’s budget process. Thus, the work of PPG encompassed this area,too. In May 2007, the PCAOB approved its first strategic plan, which it subsequently revisedbased on input from the Commission. Revisions should continue to occur given the intent thateach year the PCAOB updates its plan as part of the budget process.

Under SOX, the Commission has the authority to conduct periodic, special, and other exami-nations of the records of the Board. PPG works with the SEC’s Office of Compliance, Inspections,and Examinations !OCIE" in conducting such inspections. Inspection of the PCAOB is largely partof the confidential work of the SEC, although the results of these inspections are shared with thePCAOB. However, as noted in Part I, the Commission did disclose the intent to conduct an SECinspection to address the PCAOB’s program for inspecting registered accounting firms. As part ofthis “inspection of inspections” and for a selected period, SEC staff focused on the PCAOB’scompliance with the relevant provisions of SOX and the PCAOB’s own rules and procedures, andconsidered the overall efficacy of the inspection process in carrying out the PCAOB’s mission!Palmrose 2007".

The Part I discussion of the efforts to improve the implementation of SOX Section 404 alsomentioned that the Commission is required to approve all PCAOB rules !e.g., for registration,inspections, and enforcement" and professional standards !for auditing, quality control, and inde-pendence" in order for them to become effective. So, ongoing work of the PPG encompasses theseactivities as they occur. PPG works on them, both prior and subsequent to PCAOB Board ap-proval, in conjunction with the Office of the General Counsel !OGC" and, depending on theirnature, other relevant SEC offices and divisions such as the Division of Corporation Finance!DCF", Investment Management !IM", Enforcement, and the Office of International Affairs !OIA".

With regards to auditing, independence, and quality control standards, a priority during mytime at the SEC was how PCAOB standards related to those of other international and U.S.standard setters. An overarching interest was the convergence of such standards !Palmrose 2007;Ellis 2008". The PPG staff continues to monitor and consider the activities of the InternationalAuditing and Assurance Standards Board !IAASB" and the Auditing Standards Board !ASB" forauditing standards, and their counterparts for standards on independence and ethics. This workalso facilitates PPG interactions with OCA’s International Group for SEC staff input to a TechnicalCommittee of the International Organization of Securities Commissions !IOSCO" as part of the

1 Croteau !2005" provides an in-depth discussion of PPG activities with respect to the Commission’s oversight of thePCAOB.

488 Palmrose

Accounting Horizons September 2010American Accounting Association

IOSCO process for commenting on the IAASB’s proposed International Auditing Standards!ISAs" and on proposed independence standards of the International Ethics Standards Board forAccountants !IESBA". Similarly, PPG works to support other audit and independence-relatedinitiatives of IOSCO, including those for IOSCO committees chaired by members of the Com-mission. For example, one such initiative related to audit quality and included a roundtable held inParis in June 2007.2

Another very important responsibility for the Commission is appointment of PCAOB Boardmembers. SOX Section 101!e" gives the Commission, in consultation with the Board of Governorsof the Federal Reserve System and the Secretary of the Treasury, responsibilities for appointmentof PCAOB Board members. The Commission has established a process for doing so. SOX speci-fies a five-member Board “appointed from among prominent individuals of integrity andreputation.”3 SOX restricts the Board to two members, and only two members, that shall be orhave been certified public accountants !CPAs" and a CPA chairperson may not have practiced forat least five years prior to Board appointment.

However, a selection factor—not widely known and not required by SOX—is that the ap-pointment of Board members has followed party lines: that is, two Democrats, two Republications,and the PCAOB chairman from the reigning Presidential party, similar to the appointment of SECCommissioners. While many are resigned to this “Washington, D.C.” twist, in my opinion, it addsanother unfortunate and unnecessary political element to an already complicated appointmentprocess—one that is misplaced in the regulation of public company audits, which should be anonpartisan activity.

SEC FEDERAL ADVISORY COMMITTEE ON IMPROVEMENTS TO FINANCIALREPORTING (CIFiR)

In addition to these PCAOB activities, several other important public policy initiatives relatedto accounting and auditing occurred during my time at the SEC. The two that I want to focus onboth involve long-standing initiatives that came to fruition, in the case of the CIFiR, or took newtwists, in the case of IFRS, during this period. Palmrose !2009" discusses both of these initiatives,but here I would like to provide a few other observations and insights.4

The CIFiR represents an important public policy initiative to address concerns over howcomplex financial reporting has become, discontent with the standard-setting process, and disen-chantment with the accounting standards that result from this process !e.g., Beresford 1999; SEC2005; FASB 2006". It is telling when an SEC Advisory Committee defines the central problem as:“Current accounting and financial reporting has become too difficult for users to understand, toodifficult for preparers to apply, and too difficult for constituents to audit, analyze, and regulate”!CIFiR 2008, 18–19". As an aside, this finding carries significant implications for the viability and

2 Further, in September 2009, an IOSCO Technical Committee published for public comment consultation reports onnon-professional ownership structures for audit firms, auditor communications, and transparency of firms that auditpublic companies.

3 SOX Section 101!e"!1" goes on to add that Board members shall “have demonstrated commitment to the interests ofinvestors and the public, and an understanding of the responsibilities for and nature of the financial disclosures requiredof issuers under the securities laws and the obligations of accountants with respect to the preparation and issuance ofaudit reports with respect to such disclosures.”

4 For additional !and differing" academic perspectives on the draft recommendations of the CIFiR and related research,see the analysis of the AAA National CIFiR Tracking Team !2008". And, on allowing the use of IFRS in filings with theSEC, see AAA Financial Accounting and Reporting Section of the Financial Reporting Policy Committee !2008"; AAAFinancial Accounting Standards Committee !2008"; and comment letters to the SEC on the proposed rule, Roadmap forthe Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards byU.S. Issuers !File No. S7–27–08", filed by, for example, the AAA Financial Accounting Standards Committee !April 14,2009", the AAA Financial Accounting and Reporting Section !April 17, 2009", and the FASB !Hail et al. 2009".

Part II: Perspectives from the Nexus at the SEC 489


sustainability of public company audits because perceptions as to the value of audited financialstatements are inextricably linked to perceptions as to the value of financial statements prepared inaccordance with generally accepted accounting principles !GAAP". Undermining the latter con-tributes to turning GAAP financial reporting into a compliance exercise !Palmrose 2009", whichdoes not necessarily provide a robust !profitable" business model for firms that audit publiccompanies, particularly relative to the other business lines of such firms.

Anyway, the CIFiR deliberated for a year and its Final Report !CIFiR 2008" discusses theissues and makes numerous recommendations for increasing the usefulness of information in SECreports, enhancing the accounting standards-setting process, improving the substantive design ofnew accounting standards, delineating authoritative interpretive guidance, delivering financial in-formation !e.g., via XBRL", and clarifying guidance on financial restatements and accountingjudgments. However, nothing has yet occurred in the way of formal action by the Commission onthe CIFiR recommendations.

Admittedly, it is a bit misleading to imply that the SEC has done nothing because not allrecommendations require Commission action, and behind the scenes some have been implementedby the staff !White 2008". But the lack of any formal Commission action can undercut the staff’swork in this regard. For example, a number of CIFiR recommendations are directed toward others,in particular the Financial Accounting Standards Board !FASB" and also the PCAOB. Without anyformal action by the Commission, it is difficult for the heads and staffs of OCA and DCF toexercise leadership and push the FASB and PCAOB to implement the CIFiR recommendationsapplicable to them.

To illustrate, the CIFiR !2008" proposed that the SEC and PCAOB each adopt a frameworkfor reviewing the exercise of judgment. In the spirit of providing transparency into how regulatorsevaluate reasonableness, the CIFiR recommended that the SEC articulate the components of aframework for accounting judgments as a policy statement. And, the CIFiR recommended that thePCAOB should likewise issue a policy statement related to how it, including in its inspection andenforcement activities, would evaluate the reasonableness of judgments based on PCAOB auditingstandards, while acknowledging the PCAOB looks to the SEC’s statement of policy in evaluatingthe appropriateness of accounting judgments as part of an auditor’s compliance with PCAOBauditing standards. So, even though the chief accountants of OCA and DCF and their respectivestaffs can remind that this CIFiR recommendation reflects current advice !including advice on theSEC website to companies and auditors for consultations on accounting and auditing matters;therefore formal Commission action on a policy statement is not needed to affect such consulta-tions" the lack of any Commission action diminishes the strength of the signal that an Agency-wide policy statement would provide, both within and outside the SEC, and gives an excuse forinaction by the PCAOB.

The lack of any formal Commission action is attributed to the economic crisis, and also tohaving a “new” Commission and chairman who appear inclined to distance themselves from someinitiatives of others. However, in regards to the latter, it is important to emphasize that theoverarching concerns addressed by the CIFiR are at least a decade old. While the CIFiR wasappointed by and deliberated during the tenure of a particular chairman and Commission, theoverall initiative transcends any particular administration. Moreover, when it comes to the eco-nomic crisis, the role of GAAP is currently the subject of debate. Even before the crisis unfolded,the direction of accounting standard setting was being questioned !e.g., Brown and Palmrose 2005;Dichev 2008; Palmrose 2009; O’Brien 2010". Since the CIFiR addressed some of the very issueswith the standard-setting process and the standards themselves that arguably contributed to thecrisis, the CIFiR recommendations deserve to be considered as part of reform efforts in determin-ing the path forward.

490 Palmrose


INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS)One set of global high-quality accounting standards has been a long-standing goal of a

number of academics, practitioners, regulators, issuers, and others. So, the essential questionseems how best to accomplish this goal. Several decades ago as a University of Washingtongraduate student, I observed Professor Gerhard Mueller at the forefront of efforts to evangelizeglobal harmonization of accounting standards, which I recall as standard setters working under a“best efforts” approach to promulgate similar accounting standards. The last decade has broughtformal commitments by the FASB and International Accounting Standards Board !IASB" onconvergence of U.S. GAAP and IFRS, under a Memorandum of Understanding !MOU" in 2002!The Norwalk Agreement" and another MOU in 2006, which was updated in September 2008 andreaffirmed in November 2009. Now we are discussing whether the SEC should allow or requireoutright adoption of IFRS by U.S. companies, having previously allowed foreign filers to useIFRS !as promulgated by the IASB" without any reconciliation to U.S. GAAP.5

Much has been written about the advantages and disadvantages of uniform accounting stan-dards, in general, and the merits of IFRS, specifically. Academics are among those who have cutthrough all the hype and rhetoric !e.g., Ball 2006". Comment letters summarizing relevant aca-demic research have informed the SEC’s process for considering the use of IFRS by U.S. com-panies, as previously noted. The potential adoption of IFRS by U.S. companies is an immenselyimportant public policy issue that has and should continue to generate much research.

For me, the surprising aspect is the way such a significant and challenging public policy issuehas unfolded. While at the SEC, it seemed to me that key leadership moved almost overnight fromsupporting convergence to advocating adoption of IFRS for U.S. companies. In 2005, Don Nico-laisen as chief accountant made the case for convergence !Nicolaisen 2005".6 This speech came tobe known as the “IFRS Roadmap” because it laid out the actions that would need to occur and themilestones met for the SEC to drop the reconciliation requirement for foreign filers by 2009, orearlier. On the other hand, the notion of the SEC letting U.S. companies adopt IFRS seemed to“pop out” of a March 2007 IFRS roundtable focused on dropping the reconciliation, which wasquickly followed by an April 2007 announcement of next steps, a Concept Release in July 2007,and more roundtables in December 2007 and August 2008.

The proposed rule that eventuated for Commission vote on August 27, 2008, likewise calleda roadmap, provided for a “grand experiment.” Under a complicated rubric, the SEC proposed toallow a few U.S. companies to voluntarily adopt IFRS !perhaps only temporarily, so they alsoneeded to keep records in U.S. GAAP, too". Meanwhile, the SEC proposed to consider whether tomandate the use of IFRS down the road. Surprisingly, the proposal left unaddressed the greatmany challenges that would need to be faced and overcome in moving U.S. companies to IFRS.

For example, unanswered questions, both conceptual and practical, include those around themodel for setting accounting standards and the future role, if any, for the FASB or a similar U.S.standard setter; whether the SEC would designate IFRS as “generally accepted” under SOXSection 108 and, accordingly, whether the IASB would be funded under Section 109 by U.S.

5 The SEC’s November 15, 2007 press release announcing the Commission’s unanimous vote to drop the reconciliationrequirement for foreign private issuers, and thereby reduce the set of information available to investors, carried theironic title: “SEC Takes Action to Improve Consistency of Disclosure to U.S. Investors in Foreign Companies” !avail-able at: http://www.sec.gov/news/press/2007/2007-235.htm". Also of interest, during the open meeting several Commis-sioners, in expressing their support for the rule, publicly reminded that this support was conditioned on assurances thatthe FASB-IASB convergence efforts would stay on track.

6 By convergence, Nicolaisen did not expect U.S. GAAP and IFRS would necessarily produce totally identical financialstatements. Instead, he considered “it necessary that convergence result in close alignment of the accounting for thesame or essentially the same transactions, generally comparable results in trends and a continued cooperative will toreduce differences over time, as well as the transparent understanding of any significant differences” !Nicolaisen 2005".



http://www.sec.gov/news/press/2007/2007-235.htm

issuers and subject to budget approval by the SEC; the feasibility of two sets of GAAP coexistingamong U.S. companies, at least for some time, and the implications thereof for all U.S. capitalmarket participants; the nature of any emergent demand for IFRS from the investor community;the consequences for private companies, including those that might want to go public; and themany other cost-benefit considerations including regulatory, tax, contractual, legal, and educa-tional implications of permitting or mandating IFRS for public companies.

In September 2009, the SEC’s chief accountant, Jim Kroeker, announced that “the Commis-sion will make it a priority in the coming months to refocus on a proposed roadmap to move U.S.companies to international accounting standards,” !Chasan 2009" and, in February 2010, theCommission directed the staff to execute a work plan. The Commission and staff would be wiseto go back to square one. With so many loose ends and open questions, the 2008 proposal does notrepresent the SEC’s finest hour. The use of IFRS by some or all U.S. companies is clearly an issuethat should be decided by the Commission from an informed position and in a deliberate andunhurried manner. Finally, the costs versus benefits of such a decision must be carefully assessedand weighed. Part I of this Commentary focused on SOX Section 404 and discussed the Com-mission’s efforts to improve the cost-benefit balance of SOX Section 404. But, the costs ofimplementing SOX Section 404 may be trivial in comparison to the initial costs of U.S. companiesadopting IFRS !unconverged",7 and look what happened with SOX Section 404. Hopefully thelessons from the SOX Section 404 experience have been well learned.

THE U.S. DEPARTMENT OF THE TREASURY’S ADVISORY COMMITTEE ON THEAUDITING PROFESSION

BackgroundThe Commission and its staff also provide input to and support for the initiatives of other

agencies. During my time at the SEC, one outside initiative for PPG was the U.S. Department ofthe Treasury’s Advisory Committee on the Auditing Profession !ACAP". ACAP was a cornerstoneof former Secretary Paulson’s Capital Markets Competitiveness initiative. While it may seem likea different era, in 2006 Paulson became the Secretary of the Treasury, and in the fall of that yearin a speech at the Economic Club of New York, Paulson explained that concern had shifted—frompreserving the integrity of our markets in the aftermath of the financial reporting scandals thatgave us SOX to maintaining the competitiveness of our capital markets.

This was the genesis of Paulson’s Capital Markets Competitiveness initiative to address thechallenges to “help America keep its competitive edge in the 21st century.” At the time, thisinitiative was intended to help define Paulson’s tenure at U.S. Department of the Treasury. Eventhough the economic crisis came to overshadow it, Paulson understood that accurate and trans-parent financial reporting is critical to our capital markets and the strength of the U.S. economy.8

Moreover, Paulson saw the auditing profession as essential for a well-functioning reporting systemand a vital component of U.S. capital market competitiveness.

In May 2007, Paulson announced that Arthur Levitt, former chairman of the SEC, and DonNicolaisen, former chief accountant of the SEC, had agreed to serve as co-chairs of ACAP. Thefull Committee consisted of a blue-ribbon group of 19 members, plus five observers from U.S. andforeign standard-setting organizations and regulatory agencies. The SEC was one observer, and Ihelped fill that role.

7 And hopefully, it has not gone unnoticed that one way to mitigate the transition costs is to have U.S. GAAP and IFRSsubstantially converged.

8 This understanding led to concerns over the proliferation of restatements and provided the impetus for the U.S. Depart-ment of the Treasury to commission a study on restatements for non-GAAP reporting over the last decade !Scholz2008", as another part of the Capital Markets Competitiveness initiative.

492 Palmrose


ACAP was charged with providing Paulson with advice and recommendations on the sustain-ability of a strong and vibrant public company auditing profession. The ACAP Final Report,issued October 6, 2008, contains a number of recommendations that were developed by threesubcommittees on Human Capital, Firm Structure and Finances, and Concentration andCompetition.9 Included in the Human Capital recommendations are some related to accountingeducation. For example, the Committee heard testimony on establishing a freestanding post-graduate professional educational structure for the accounting profession, which led to a recom-mendation encouraging the American Institute of Certified Public Accountants !AICPA" and AAAto jointly form a Commission to provide a timely study of the feasibility of doing so.

RecommendationsThe Final Report !ACAP 2008" contains a number of other recommendations that may inform

accounting and auditing teaching and research.10 Examples include recommendations related toaudit firm governance and transparency that ask regulators, in consultation with others, to studythe feasibility of appointing independent members with full voting power to audit firm boardsand/or advisory boards with meaningful governance responsibilities; to urge the PCAOB to re-quire certain public annual reporting by larger audit firms by the beginning of 2010; to request thePCAOB, in consultation with others, to determine the feasibility of developing key indicators ofaudit quality and effectiveness and require auditing firms to publicly disclose these indicators andthe PCAOB to monitor them; and to encourage the PCAOB to require audited !GAAP" financialstatements of larger auditing firms to be filed on a confidential basis with the PCAOB beginningin 2011.

The Final Report !ACAP 2008" also recommends that the PCAOB broadly monitor sources ofcatastrophic risk, which could threaten audit quality, and outlines a proposal for creating newstructures to help manage the preservation and rehabilitation of troubled larger public auditingfirms—although this proposal would require legislative action. Events during the last decade havesensitized regulators to the need for contingency planning in advance of a crisis. With plans andtools in place, regulators expect to be better positioned, not only to prevent a crisis from occurringin the event of the threat of failure of a large audit firm, but to deal with any such failure thatoccurs.11 And the substance of this recommendation reflects these notions.

However, there is no recommendation related to litigation, catastrophic or otherwise, eventhough many would consider liability as central to addressing audit firm viability and sustainabil-ity. There is none because the subcommittee could not agree on any type of recommendation.Indeed, they could not even agree on the need for a recommendation. Members could not agree onthe nature of the problem or even if there was a problem. They could not find any common groundfrom the evidence provided to them, including in testimony from lawyers, insurance industryrepresentatives, audit firm general counsels, and former regulators.

Several subcommittee members insisted that each of the six largest audit firms had to providedata on their firm’s litigation claims, settlements, and financial resources on a detailed-claim,case-by-case basis before they would consider any evidence. These members rejected the aggre-

9 For a detailed discussion of the ACAP recommendations and the views of some academics on these recommendations,see Carcello et al. !2009".

10 In addition, the materials requested by ACAP and collected by U.S. Department of the Treasury staff to facilitate thedeliberations of the Committee as well as copies of public testimony, all of which are maintained by the library at theU.S. Department of the Treasury, may be of interest for research and teaching.

11 An example of the efforts of global regulators, in this regard, is the IOSCO Technical Committee draft discussingcontingency planning in the context of a larger auditing firm failure and its impact on the provision of audit services!IOSCO 2008". Hope springs eternal that such planning is broad enough to be useful to address uncertainties !theunknown unknowns", not just risks !the known unknowns".



gate data provided by the firms as completely unsatisfactory. Without any disaggregated detailsfrom each firm, these members also declined to appreciate evidence on audit litigation provided byothers. The only path out of this stalemate that the subcommittee could find was to have eachgroup craft a summary of the issues—pro and con—around liability and the need for reform. TheFinal Report !ACAP 2008" contains these pro and con summaries.

Views of the Co-ChairsPerhaps the most provocative parts of the Final Report !ACAP 2008" are contained in the

statement of the co-chairs. Unlike most advisory committee reports where the chairs simply signa transmittal letter, the ACAP co-chairs provide their own views on the path forward for theauditing profession. The co-chairs call for Congress to take three actions: !1" create a federallychartered audit structure for audit firms and the exclusive mission of such firms would be auditingand auditing-related matters; !2" move to a national professional liability regime with federalstandards for public company auditing firms; and !3" establish a federal insurance agency toprovide coverage to investors in certain instances, funded by a portion of the audit fees charged topublic companies.

As to other conditions for these audit-only firms, the co-chairs suggest legislation shouldprovide for incorporation !with tax and financing advantages", requirements for capitalization,federal licensing, further clarity of PCAOB oversight, new governance structures with indepen-dent directors, limits on liability for audits of public companies, mandatory public reportingincluding audited financial statements, and improvements to the auditor’s report to investors.12

Clearly, the views of the co-chairs would change not just the margins of the regulatorylandscape, but the landscape itself. These views are provocative and worthy of public debate.Unfortunately, the way the process unfolded the three overarching legislative actions along withsome of the other legislative suggestions did not have an opportunity for public comment. Inparticular, the rationale for an audit-only firm with such a firm being the “quid pro quo” for auditliability reform may not be widely understood.

The idea of an audit-only firm surfaced in the aftermath of the Enron scandal and the per-ceived role of nonaudit services !NAS" in that scandal. It was a suggestion !from Paul Volcker" asa way for Arthur Andersen to restore the firm’s reputation before Andersen’s demise made thesuggestion irrelevant. Nonetheless, many perceive the NAS issue to have been addressed by, forexample, SOX proscriptions on certain NAS to audit clients, SEC proxy disclosure requirementsof fees paid to audit firms !for audit, audit-related, tax, and other NAS services", audit committeeoversight including pre-approval of audit firm services, and the PCAOB’s consideration of auditorindependence, including NAS, in the inspection process. So, the question arises: Why would theco-chairs again focus on NAS and why now?

Well, based on my observations, it seemed that the co-chairs were concerned about overallaudit firm revenues by type of service. In particular, they perceived a threat from the more recentgrowth in and level of NAS revenues compared to audit revenues, even though the firms’ NASrevenues appear to be driven by services provided to other than audit clients !ACAP 2008, V:17–20". Essentially, the co-chairs were concerned that auditing was at risk for becoming a“second-class citizen” within the larger audit firms !Wyatt 2004; Hermanson 2009".

12 In July 2009, the PCAOB issued a Concept Release on Requiring the Engagement Partner to Sign the Audit Report,which was among the ACAP recommendations and views of the co-chairs to enhance transparency and accountability.Comment letters from the large audit firms and the Center for Audit Quality provide in-depth analyses, absent from thediscussions in the ACAP Report !ACAP 2008" and Concept Release, that not only shed light on the complexities aroundthe issue, but reveal the importance of understanding the audit process and the U.S. institutional setting for consideringsuch a proposal.

494 Palmrose


Finally, you may be thinking the co-chairs’ views will have no effect. I would not be sosanguine. First, even though these views were not included in the draft ACAP Report and subjectto the public comment process, it is difficult for users of the ACAP Report !ACAP 2008" to ignorethese views and not give them at least some weight along with the recommendations of theCommittee itself. Moreover, considering that regulatory reform continues to be a focus in Wash-ington, D.C.; given that discussions with Paul Volcker, a member of ACAP, likely informed theco-chairs’ views, the advisory role of Volcker in the current administration, and the stature of theco-chairs and Volcker in the public policy setting; and depending on the outcome of the SupremeCourt decision on the constitutional challenge to the PCAOB, as subsequently discussed, thefuture course of regulation of the auditing profession is not at all assured. The views of theco-chairs will likely become part of any public policy discussions focused on the regulation ofauditing and the viability and sustainability of the audit profession. Importantly, from an academicperspective, since little exists in the way of evidence on or analysis of the nature and consequencesof the co-chairs’ proposals, they represent areas ripe for research.

AUDITOR INDEPENDENCEThe Role of the SEC

I previously noted that one of the activities of PPG is leading and coordinating the SEC’swork with respect to auditor independence—a formal responsibility of the Commission. ArthurLevitt once commented that his preconceived notions were forever changed by being at the SEC.For me, this comment particularly applies to auditor independence. For example, I arrived sup-porting such notions as !1" the SEC should transfer its independence functions and activities to thePCAOB and !2" the SEC’s independence rules were too complex and needed to be rationalized.13

Both of these preconceived notions I came to reconsider while at the SEC.The PCAOB has the authority under SOX to promulgate independence and ethics standards

for audits of public companies. However, the Board has decided to proceed cautiously in this areaand has promulgated few such standards. I quickly appreciated the wisdom of this decision. Thevast majority of the independence requirements that apply to audits of public companies reside inthe SEC’s rules. This is important and I would now argue should remain so. The subtlety here isthat the audit independence rules apply to issuer filings; they do not just apply to auditors. ThePCAOB has no authority over issuers.

Essentially, it is the issuer’s financial statements that an auditor examines; issuers have thelegal responsibility to file the financial information with the Commission as a condition for ac-cessing the public securities markets; and it is issuer filings that are legally deficient if auditorswho are not independent certify their financial statements !Husich 2006". Only the SEC can decidewhether issuer filings comply with SEC rules and regulations. While such decisions can be in-formed by consultation with the PCAOB in the more limited circumstances where PCAOB auditorindependence rules are involved, the decisions reside with the SEC. Thus, the SEC, rather than thePCAOB, is in the best position to assess the costs and benefits of rules for auditor independence.

The Current State of AffairsMuch is heard about the convergence of accounting standards and now more about the

convergence of auditing standards, but little is heard about convergence of auditor independencestandards. Yet, the lack of convergence for independence standards creates similar compliance

13 Before I arrived, PPG staff began discussing a more principles-based approach to independence standards !Bailey 2005".



challenges for market participants, including audit firms and their clients, globally.14 Differentmodels of auditor independence have evolved. Audit committees of public companies who areexpected under SOX to exercise oversight in this area can find it challenging to figure out the rulesthat apply.15

Let me give a few illustrations of the complexities. In 2003, the PCAOB adopted some, butnot all, of the AICPA’s Code of Professional Conduct as its Interim Standards. Many do notrealize, for example, that the PCAOB did not adopt Rule 203, so there is no GAAP override inPCAOB Interim Standards !Ball 2009; Palmrose 2009".16 Also, the PCAOB did not adopt RuleNo. 301 on the auditor’s responsibilities for maintaining confidentiality of client information. ThePCAOB decided it was not necessary to do so to meet its SOX mandate under 103!a"!1". None-theless, in approving Auditing Standard !AS" No. 6 !Evaluating Consistency of Financial State-ments", the Commission !SEC 2008" encouraged the PCAOB to adopt its own rule to alleviateconfusion and concerns that the lack of a rule on confidentiality might be construed as minimizingthe auditor’s responsibilities for maintaining confidentiality of client information. Finally, it is easyto forget that the PCAOB’s Interim Standards are frozen to those as of 2003. Subsequent changesby the AICPA have not been adopted by the PCAOB, so divergence is occurring between the twosets of standards with the passage of time, including in bright-line thresholds.

Recommendations of ACAPI considered the U.S. Department of the Treasury’s ACAP a wonderful opportunity to set the

stage for efforts to rationalize the auditor independence rules. PPG tried to facilitate the work ofthe subcommittee on Concentration and Competition, including by educating subcommittee mem-bers on the current independence landscape. In addition, through public testimony and commentletters, the Advisory Committee received suggestions for changes. One such suggestion related tothe rules applicable to the investment company complex.17 Although this is not an issue onacademic radar screens, it certainly is an important practice issue. Application and compliancewith the existing rules !especially in the context of auditor change and company mergers andacquisitions in the investment and financial services industries" get to be very complicated foraudit firms and clients even with support from the firms’ robust real-time IT systems with globalreach. Another, albeit different, suggestion likewise recognized the changes over the last decadethat have occurred in audit firm quality control systems related to independence and asked for theSEC to institute a de minimus standard applicable to audit firms themselves, not just individualauditors.

The ACAP subcommittee on Concentration and Competition, chaired by Damon Silvers,deliberated on these and other suggestions. And, to his credit, the subcommittee chair did not let

14 Discussions by members of ACAP noted that complexities in accounting, auditing, and independence rules may dis-courage smaller audit firms from, and disadvantage them in, competing for public company audits.

15 To assist audit committees and others, PPG staff prepared a brochure !see SEC OCA Audit Committee Brochure,available at: http://www.sec.gov/info/accountants/audit042707.pdf", which is useful as classroom material, too. Also,Karapanos !2007" summarizes SEC sources addressing auditor independence.

16 Rule 203 of the AICPA Code of Professional Conduct allows the auditor, under unusual circumstances, to render anunqualified opinion on financial statements that depart from GAAP, if it can be demonstrated that such a departure isnecessary to make such financials not misleading. In other words, if complying with GAAP does not capture theunderlying economics of the relevant transactions and events, management could depart from GAAP to do so, andauditors could still issue clean opinions.

17 Under the SEC’s final rule !posted on November 21, 2000", Revision of the Commission’s Auditor IndependenceRequirements !Releases 33–7919 et al.", the definition of an investment company complex is sweeping and not straight-forward. In addition to an investment company and its investment adviser or sponsor, an investment company complexcan include, among others, any entity controlled by or controlling an investment adviser or sponsor or any entity undercommon control with an investment adviser or sponsor.

496 Palmrose


http://www.sec.gov/info/accountants/audit042707.pdf

his personal views—that the auditor independence rules should not be changed—dominate thesedeliberations. In the final analysis, ACAP recognizes the importance of auditor independence andthe importance of audit firms maintaining and promoting it at all levels within an audit firm,including among partners. The Final Report !ACAP 2008" does acknowledge the complicatednature of the existing rules and recommends that the SEC and others compile the rules so that theyare readily accessible and can be compared. I understand PPG is working on a project to do so.

However, the important point here is that the recommendation emphasizes that compilationshould not require rule-making. This recommendation and the discussion in the text of the FinalReport !ACAP 2008" make it very clear that investor representatives do not support any change inthe existing rules. I have come to appreciate that investor representatives view any changes in orrationalization of the rules as retrenchment, and this hurdle would need to be overcome beforethey would support change. Quite frankly, a compilation comparing rules may be helpful in thisregard. For example, it may highlight discontinuities between the SEC and PCAOB rules vis-à-visthose of the AICPA that beg for reasoned explanations and justifications.

Convergence of Independence StandardsLikewise, a compilation may facilitate discussions on the convergence of independence stan-

dards, although the ACAP deliberations likewise revealed a lack of consensus on whether conver-gence of independence standards should even occur. A major impediment is that the internationalstandards promulgated by the IESBA use a threats and safeguards approach, which some investoradvocates in the U.S. adamantly oppose. Even so, compilation of the independence rules mayreveal elements of a conceptual framework in the SEC’s independence rules and commonalitiesnot inconsistent with extant standards promulgated under a threats and safeguards approach.However, it is worth noting that if unanimity existed on the concept, the process for convergingwould still be an arduous one. In the U.S., for example, convergence would require not just theSEC, PCAOB, and AICPA to coordinate and revise their respective auditor independence rules,but potential legislation to boot because SOX and state laws include provisions related to auditorindependence.

Whether investors are well served by the existing global patchwork quilt of independencerules and regulations largely developed before audit firms had installed robust quality controlsystems for independence !now subject to PCAOB inspection" remains an open question. Forexample, the auditor independence rules !along with litigation risks" represent an impediment toimplementing the U.S. Department of the Treasury ACAP recommendation on including indepen-dent members with full voting power on audit firm governance boards. Nonetheless, from a publicpolicy perspective, the reality remains that any proposals to change the auditor independence rulesin the U.S. would have to cogently and convincingly argue why such changes maintain investorprotection goals and are otherwise in the best interests of investors.

ASSESSING AUDIT REGULATION UNDER SOXThe PCAOB

ACAP represented the first national initiative to assess the state of auditing since SOX estab-lished the PCAOB to regulate audits of public companies. The deliberations and recommendationsof ACAP should have been a wake-up call for the PCAOB. Some members of ACAP weresurprised at how narrowly the PCAOB parses its stated mission, which focuses on audit qualityand reducing the risks of auditing failures in the U.S. public securities market. Certainly, therealways is a need for vigilance to avoid mission creep. Even so, many substantive issues areinextricably linked with audit quality, and ACAP found the PCAOB sometimes wanting in thisregard. To make this point, ACAP explicitly tied some recommendations to audit quality. Forexample, to overcome Board perceptions that monitoring catastrophic risk was not within the



scope of the PCAOB’s mission, the ACAP recommendation reads: “As part of its current oversightover registered auditing firms, the PCAOB should monitor potential sources of catastrophic riskwhich would threaten audit quality” !ACAP 2008, VIII: 10".

Since the PCAOB has adopted a supervisory !prudential" approach to audit oversight, the factthat it was not already monitoring catastrophic risk came as a surprise to some ACAP members. Inthe regulation of financial institutions, the background of the last two PCAOB chairmen, a super-visory or prudential approach focuses on safety and soundness to protect depositors and reduce thelevel of risk exposure of bank creditors. Translating these notions to an audit setting makes thesupervisory approach seem connected to audit firm catastrophic risk.

This demonstrates a problem with the meaning and import of the supervisory approach, whichis not always well articulated by the PCAOB or understood by its constituents. This is particularlyconcerning because the supervisory approach is the only vision for audit regulation expressed bythe PCAOB. What the PCAOB means by a supervisory approach is “to address many auditingproblems through a combination of inspections and standards-setting” rather than enforcement!PCAOB 2008, 3".18 This has wisdom as a first principle. But then it leads to important questionsof execution.

Discussions of the problematic elements of the PCAOB’s regulation of public company auditsinclude Kinney !2005", Palmrose !2006", and Glover et al. !2009". Indeed, Glover et al. !2009"conclude that the two pillars of the PCAOB’s supervisory approach—standards and inspections—are fatally flawed.19 Stepping back, three over-arching and interrelated problems appear to under-mine the post-SOX regulation of public company audits: !1" expertise !sacrificing expertise on thealtar of objectivity"; !2" legalistic approach and process !reflecting the PCAOB’s legislative foun-dation, the influence of Board and staff members with legal backgrounds and SEC experience, andthe important role of the PCAOB’s General Counsel Office"; and !3" lack of transparency.

To illustrate these problems in the context of standard setting, it is noteworthy that, unlike theFASB, the IASB, the IAASB, and the ASB, the PCAOB has not chosen to develop auditingstandards in sunshine. The PCAOB uses a legalistic approach to standard setting, apparentlymodeled after SEC rule-making.20 Outsiders can only observe the open meeting at which theBoard votes to issue a proposed or final standard. No transparency exists with the PCAOB’sdeliberative process for crafting standards. 21 The PCAOB’s due process for auditing standardsoccurs through a formal comment period on a proposed standard. Such formal comment processesare likewise used by the other standard-setting bodies, although their comment processes havebeen informed by outsiders being able to observe and comment on the deliberations of thestandard-setting body along the way.

A non-expert board, generally unschooled in the intricacies of auditing, likely contributes tothe PCAOB’s standard-setting approach. But even if Board members themselves are not subject

18 As an aside, I have also heard the PCAOB’s prudential or supervisory approach may encompass the notion that theBoard and staff do not tell accounting firms how to run their businesses. This is not without elements of wisdom, too.On the other hand, it likewise reinforces that the viability and sustainability of public company auditing is not a focusfor the PCAOB.

19 The flaws outlined by Glover et al. !2009" in audit standard setting include the Board’s decision to write PCAOB auditstandards and continued resistance to convergence with or adoption of the ISAs, a non-expert Board along with staffexpertise issues, lack of productivity, poor quality standards and unclear and delayed guidance, and succumbing topolitical pressures and motivations. Flaws in the inspection process likewise include problems with staffing, maintainingcurrent relevant expertise, and succumbing to political pressures and motivations, plus lack of process and accountabil-ity, and ineffective and untimely feedback of inspection results to firms and outsiders.

20 However, unlike the SEC, the PCAOB is not subject to the Administrative Procedures Act and the Government inSunshine Act, which provide some transparency on process.

21 In 2009, the PCAOB began using Concept Releases to solicit public comment in advance of crafting a standard,although one Board member expressed reservations about lengthening the standard-setting process this way.

498 Palmrose


matter experts, there are ways to give more transparency into the standard-setting process. Forexample, dedicated sessions for discussing issues, including sessions for staff education of theBoard, could be public. With such sessions, the views and deliberations of the Board could bebetter understood by all market participants, including auditors who have to implement the stan-dards and educators who have to teach them.

Still, a non-expert Board is only part of the expertise problem. The PCAOB expects a !small"staff of employees to write standards. Unfortunately, it is unrealistic to expect that a permanentstaff !of any size" can have or maintain the requisite expertise to formulate standards for allaspects of public company audits. Formulating standards requires a breadth and depth of current,relevant audit knowledge and experience—it takes a village. Yet, the Board appears to rely on staffwithout using task forces or other mechanisms. One mechanism both the SEC and FASB use tobring current, relevant expertise to their activities is professional accounting fellow programs. TheACAP Final Report !ACAP 2008, VIII: 8" discusses testimony that encouraged the PCAOB tocreate a professional practice fellowship program. To date, the PCAOB has declined to introduceany professional fellow or internship programs.

Thus, all things considered, the PCAOB process for developing and drafting auditing stan-dards excludes meaningful input from outsiders with current, relevant expertise. This means thatproposed standards are not necessarily informed by the most knowledgeable experts on any par-ticular topic. Such experts include but are not limited to auditors currently engaged in practice.22

The PCAOB has a Standing Advisory Group !SAG", which is cited as its external source ofadvice on standards. SAG consists of thirty or so members as representatives of various stake-holders in public company audits. But only a few—currently, less than a quarter—are associatedwith audit firms. Moreover, SAG meetings are limited in frequency and duration. The PCAOBconvenes SAG about twice a year for generally one- or two-day public meetings. While over theyears SAG agendas have touched on a variety of topics, regardless of topic, SAG discussions tendto be quite general with wide-ranging views expressed and no consensus reached.

Given these factors, SAG provides little in the way of meaningful guidance on the develop-ment and crafting of particular standards. Further, SAG meetings do not provide a forum for opendialog and discussion with the PCAOB Board and staff. The protocol for SAG meetings has beenthat the attending Board members and staff maintain a “listening mode,” based on Board instruc-tions not to express views or comments. While the October 2009 SAG meeting reflected a liftingof this ban to allow staff responses to at least some questions raised by SAG members, SAGmeetings have yet to provide substantive insight on PCAOB Board or staff thinking on thespecifics of a proposed standard or its development. Because of all these factors, SAG does notfunction as a mechanism for bringing the necessary in-depth expertise !and transparency" to thestandard-setting process in any robust way.

As another source of advice, the Board recently formed an Investor Advisory Group !IAG". InSeptember 2009, the PCAOB announced the appointment of 19 members to the inaugural group.The IAG charter describes the purpose of IAG as to provide views, high-level advice, and insightsto the Board on broad policy issues and other matters that affect investors and relate to the workof the Board. Apparently advising the Board on ACAP recommendations is one example of such

22 Perhaps in partial recognition of and response to these problems, in 2008, the PCAOB added an Audit Risk WorkingGroup, which involves PCAOB staff meeting regularly with the lead technical partners of the largest accounting firmsand the Center for Audit Quality. According to the PCAOB’s 2008 Annual Report, the objectives of this group are tofurther the PCAOB’s efforts to identify, monitor, and assess events affecting audit risk, and gain an improved under-standing of risk assessment methodologies employed by the firms. While this represents a step in the right direction, ifand how this group informs the standard-setting process remains unknown, as there exists no transparency on theactivities of this group.



advice. Unstated are the rationale and support for having such advice come from an advisorygroup that consists only of investor representatives and not others who likewise have a demon-strated history of commitment to investor protection, including practicing accountants, audit com-mittees, and issuers.23 In addition to failing to include other experts, IAG is not committed totransparency. Its charter provides for open meetings at the discretion of the chair of IAG, who isa PCAOB Board member.

Overall, these problems with the PCAOB’s process undermine the wisdom of the Board’sinitial decision to write its own audit standards and its subsequent disinclination to commit toglobal convergence of auditing standards. Many view the PCAOB as, at best, third in the worldwhen it comes to standard setting—falling behind the IAASB and the ASB, who have also agreedto converge their standards.24 While the PCAOB considers the IAASB’s standards in developingits proposed standards and has begun to compare its proposed requirements to the ISAs, thePCAOB misses the larger point here and fails to appreciate that this effort falls far short.

Essentially, the PCAOB has failed to make the general case that public company audits in theU.S. are sufficiently unique to require their own auditing standards that differ from the IASB’s inboth form and content.25 Moreover, in each specific case, the PCAOB has failed to explain, in anycompelling or convincing way, why its proposed standard needs to differ and is somehow better!on aspects from conceptual to terminology, including the audit requirements themselves". Avariety of voices, including the United States Government Accountability Office !GAO",26 arecalling for the PCAOB to adopt as a base the standards of the IAASB, and organizations such asthe World Federation of Exchanges have endorsed the ISAs !Ellis 2008". Further, the PCAOB failsto sufficiently appreciate the ensuing discontinuities in both the U.S. and global markets from their“go it alone” approach. As just one example, in the U.S., two sets of audit standards that increas-ingly diverge create issues for companies considering initial public offerings.

Turning to the second pillar of the PCAOB’s supervisory approach, inspections, it is impor-tant to recognize the magnitude of the challenge the PCAOB faced in getting an inspectionprogram up and running to meet the requirements of SOX. The PCAOB has largely done so foraudits of public companies by U.S. registered accounting firms. However, this is not the case forinspections of non-U.S. auditors where significant issues continue. The PCAOB recently voted topostpone for up to three years the first inspection of many such firms !Lumb 2009".

While recognizing the accomplishment of implementing an inspection program for U.S. reg-istered audit firms, significant issues still exist as to the effectiveness of this implementation. Aspreviously noted, Kinney !2005", Palmrose !2006", and Glover et al. !2009" discuss concerns withthe efficacy of the PCAOB’s inspection program and the usefulness of its inspection reports.27

Further, disquieting evidence has surfaced that reinforces these concerns. For example, thePCAOB inspected the auditor of Satyam Computer Services !Subramaniam et al. 2009". Since thePCAOB’s risk-based inspection approach that focuses on more risky engagements and the morerisky areas of those engagements failed to detect the fraud, an assessment of what went wrong

23 Another unfortunate aspect of investor representatives being designated as a “special interest” group is that auditcommittees likewise represent the interests of investors, issuers are often investors, too, and auditors focus on investorsas users of the audited financial statements.

24 In addition, the large audit firms use the IAASB’s ISAs as a basis for their global audit methodologies.25 The requirement for ICFR reporting on integrated audits of public companies does not make the case. For example, the

ASB promulgated an equivalent standard to AS No. 5 in An Examination of an Entity’s Internal Control Over FinancialReporting that is Integrated with an Audit of Its Financial Statements !AT Section 501", which is effective when thesubject matter or assertion is as of, or for a period ending on or after, December 15, 2008.

26 For example, see the GAO’s letter to the PCAOB dated February 18, 2009 commenting on PCAOB Release No.2008–06, Proposed Auditing Standards Related to the Auditor’s Assessment of and Response to Risk.

27 The PCAOB individual firm inspection reports, 4010 reports of aggregate inspection findings, and staff alerts could allbe made more valuable if the PCAOB focused on the intended audience for these items and how they would use them.

500 Palmrose


with this approach—in concept and/or execution—seems in order. As another example, thePCAOB inspected a small U.S. audit firm under a tri-annual inspection cycle whose public clientsgrew from three in 2005 to 280 in 2008.28 The PCAOB issued two inspection reports !in 2005 and2008", which disclosed some engagement deficiencies, and provided no indication of a failure toremediate any quality control defects. It was not until SEC and PCAOB enforcement actions inAugust 2009 that investors were finally alerted to the audit firm’s pervasive quality control defects,substantially substandard audits, and false audit reports !SEC 2009".29

Finally, from an investor protection perspective, the economic crisis has revealed gaps in theSOX framework that require registration and inspection of firms that audit public companies. SOXactually requires firms that audit issuers to register with the PCAOB, and these auditors are subjectto PCAOB standards, inspections, and enforcement. Issuers, as defined by SOX, include compa-nies that are registered under Section 12 or file reports under 15!d" of the Securities Exchange Actof 1934, or file registration statements under the Securities Act of 1933. However, there are anumber of other entities such as broker-dealers and investment advisers that, while registered withthe SEC, do not meet these conditions. Therefore, audits of these entities currently do not fallunder the purview of the PCAOB. With the revelation of the Madoff fraud, the SEC let expire anexemption for nonpublic broker-dealers to file financial statements that have been audited by aPCAOB-registered public accounting firm. So, beginning in 2009, audit firms for such entitiesmust register with the PCAOB. Nonetheless, without legislative action, these audit firms are notsubject to PCAOB inspection !as they do not audit issuers".30 Whether financial statement userscan sort through these distinctions remains an open question.SEC Oversight

When assessing audit regulation under SOX it is also important to consider the SEC. SOXrequires the SEC to exercise oversight of the PCAOB, and I previously described a number ofaspects of this oversight. SEC oversight is essential for maintaining the constitutionality of thePCAOB !Meade et al. 2009". It also helps assure that the PCAOB is fulfilling its statutoryresponsibilities, encourages continued improvement in the effectiveness and efficiency of thePCAOB’s activities, and serves as a check and balance on these regulatory activities. But the SECexercises oversight—it does not “run” the PCAOB.

The Commission’s key levers are the appointment !and removal" of Board members, approvalof the PCAOB budget !and the budget order", approval of PCAOB rules and standards,31 inspec-tion of the PCAOB, and appellate authority for registered accounting firms for certain PCAOBdecisions. In exercising these levers, certainly informal relationships develop between Boardmembers and Commissioners for informational and educational purposes, just like they do be-tween the staffs at the two agencies. In addition, expectations about the Commission’s and indi-vidual Commissioner’s views likely influence the nature of PCAOB activities and Boarddecisions—both generally and in the context of any specific matter.

28 A March 2009 report by Audit Analytics listed the firm as the seventh largest public company audit firm in the U.S.29 While it is important to appreciate the necessity of maintaining confidentiality during an enforcement proceedings as

required by SOX, the nature of the audit deficiencies in this case, including the use of high school graduates with notraining or proficiency in accounting and auditing to perform audits, raises questions about the efficacy of the inspectionprocess and why the Board would even issue an inspection report under the circumstances. Further, the 2008 inspectionreport disclosed that the firm had 162 issuer audit clients, which appears to represent a red flag for a tri-annuallyinspected audit firm.

30 Legislation passed by the House of Representatives in December 2009—H.R. 4173, The Wall Street Reform andConsumer Protection Act of 2009—includes provisions to amend Title I to expand the PCAOB’s oversight responsi-bilities to include audits of the financial statements and selected practices and procedures of broker-dealers.

31 It is my understanding that the SEC has approved all PCAOB rules and standards that it has posted in the FederalRegister and put out for public comment. However, in doing so, it has made follow-on recommendations !e.g., asdiscussed with AICPA Ethics Rule 301".



However, oversight by the Commission and its staff does not cure the problematic elements ofthe PCAOB as the post-SOX regulator of public company audits. Moreover, meeting the oversightrequirements in SOX introduces additional SEC processes, complexities, and uncertainties intoregulation of public company audits. And, because the Commission must approve all PCAOBrules and standards, the SEC’s due processes lengthen the time before rules and standards forpublic company audits are finalized and their implementation required.

Finally, it is important to remember that the Commission has many responsibilities, only oneof which is oversight of the PCAOB. Commissioners’ plates are very full. While Part I describedsome of the SEC’s activities in rationalizing the implementation of SOX Section 404, the elevatedlevel of Commission involvement as the PCAOB replaced AS No. 2 with AS No. 5 represents aunique chapter in SEC oversight of the PCAOB. Further, there are other variabilities and vagariesin the SEC oversight process. For example, priorities can differ among the Commission, thePCAOB, PCAOB regulated audit firms, and other market participants. Plus, both priorities andviews at the SEC can change, in particular, with changes in the chairman, other Commissioners,and key staff. Finally, the SEC participates in IOSCO, and the Commission and staff priorities andviews, can be influenced by this global perspective.

A NEW REGULATORY STRUCTURE: A PROPOSALAfter seven or so years under SOX, much has been learned about the usefulness and limita-

tions of the PCAOB as regulator of public company auditing. I have previously analyzed issuesrelated to the regulation of public company audits post-SOX !Palmrose 2006", and my thinking onthese matters certainly evolved through my experience at the SEC. To reflect this evolution, Iconclude this Commentary by suggesting a new public company audit regulatory structure.

While the economic crisis has focused a good deal of attention on regulatory reform, at thistime there is no indication that any reforms will include an overhaul of the existing structure foraudit regulation,32 and, in all fairness, ACAP did not call for this to occur. Even so, the legalchallenge to the constitutionality of the PCAOB presents an interesting possibility that auditregulation post-SOX may yet need to be reconsidered. The case, Free Enterprise Fund andBeckstead & Watts v. PCAOB !Doc. No. 08–861" is currently before the U.S. Supreme Court ona grant of certiorari after a split panel ruling of the D.C. Circuit Court of Appeals found that thePCAOB’s creation is constitutional. The plaintiffs allege that in creating the PCAOB, SOX vio-lates two basic tenants of the Constitution: the separation of powers and the Appointments Clauseregarding the President’s appointment and removal powers !Hamilton 2009; Nagy 2009; King2010". A decision from the Supreme Court is expected in the spring of 2010.33

Setting aside the merits of these allegations, which are best argued by legal scholars, onepossible scenario is that the plaintiffs prevail, the Supreme Court declares the PCAOB unconsti-tutional, and Title I of SOX becomes void.34 Rather than simply making a “constitutional fix,” thisscenario makes it seem timely and important to consider what has been learned and what shouldbe done differently in regulating public company audits.

32 However, in September 2009 as part of regulatory reform, the House passed bipartisan legislation !H.R. 2664" requiringthe chairs of the SEC, FASB, and PCAOB to testify annually before Congress on accounting and auditing issues.

33 Some speculate that if this constitutionality challenge fails that others will follow. Apparently, another dimension fortesting the constitutionality of the PCAOB is on the funding requirements in SOX Section 109, which can be challengedas taxation without the appropriate Congressional process of authorization and oversight.

34 While SOX contains no explicit severability clause, I have heard some legal theorists argue that an implied severabilityclause exists and the remaining portions of SOX would still be in effect even if the Supreme Court decides in favor ofthe plaintiffs. However, from a political standpoint, any Congressional action to remedy constitutional issues with TitleI could likewise open up other sections of SOX for reconsideration.

502 Palmrose


The remainder of this section sketches a proposal for a new regulatory structure for the auditsof public entities !an “Audit SecRO”"—organizationally separate from, but overseen by, the SECas a variation on a self-regulatory organization.35 According to Wikipedia, a self-regulatory orga-nization !SRO" is an organization that exercises some degree of regulatory authority over anindustry or profession. The proposed Audit SecRO would apply to audits of public entities subjectto SEC jurisdiction—whether through the securities laws, Investment Act, or any other regulationsand that the SEC requires to provide audited GAAP financial statements or other audited financialinformation !e.g., internal control reporting", such as issuers, broker-dealers, investment funds, andinvestment advisers.

To be very clear, an Audit SecRO would not be a return to self-regulation pre-SOX. Rather,it represents an attempt to best serve the interests of investors and other users of audited financialstatements by appropriately balancing expertise and objectivity in the regulation of public com-pany audits, recognizing lessons learned post-SOX under the PCAOB !both what works well andwhat does not", and avoiding any Constitutional issues and political vagaries in construction andimplementation of audit regulation.

Form a Regulatory Organization for Audits of Public Entities (an Audit SecRO)For audits of public entities, the SEC should oversee the formation of an Audit SecRO.36 All

firms that audit entities subject to SEC jurisdiction would have to be registered with the SecROand subject to its requirements. There would be no “free-riding.” That is, unlike with the PCAOB,other audit firms could not register, while avoiding the PCAOB’s requirements. !According to thePCAOB’s 2008 Annual Report and preceding the newly required registration of nonpublic broker-dealer audit firms, of the 1,874 firms registered with the PCAOB, 1,131 did not issue any auditreports for public companies in 2008. Thus, for example, they are not subject to inspection by thePCAOB." Inaugural registration would consist of audit firms that had been inspected by thePCAOB and were current with any required remediation. In another change from the current stateof affairs, other audit firms not yet inspected !such as those planning to audit public companies orbroker-dealer auditors" would be subject to some credentialing process, in particular thresholdreviews by the Audit SecRO on the adequacy of the firms’ quality controls, in order to have theirregistration approved.

Governance of the Audit SecRO would be by a Board of Directors !which would functionsimilar to the Boards of public companies with appropriate balancing of expertise and objectivityconcerns". The operations of the SecRO would be managed by full-time executive officers withexpertise in their assigned functions. The SEC would maintain oversight and enforcement author-ity over the Audit SecRO, similar to what it has over other SROs such as the Financial IndustryRegulatory Authority !FInRA", the Municipal Securities Rulemaking Board !MSRB", and clearingagencies that help facilitate trade settlement.

The Audit SecRO would be responsible for setting audit and quality control standards !theSEC would retain independence standards". However, the SecRO could delegate these activities toan SEC approved outside body !which hopefully could be designed for recognition by all relevantregulators and bodies as the U.S. audit standard setter similar to the ASB pre-SOX". The Audit

35 Thus, for example, I am not proposing that PCAOB Board members be subject to a Presidential appointment and Senateconfirmation process. And, I am not proposing other alternatives such as restructuring the PCAOB as a traditionalindependent regulatory agency or a unit within the SEC with members and staff who are SEC employees !Nagy 2009".Among the advantages of this proposal for a separate organization under SEC oversight are that market-based salariescould be used to attract an expert staff.

36 This is consistent with the authority reflected in the SEC’s Proposed Rule: Framework for Enhancing the Quality ofFinancial Information Through Improvement of the Information of Oversight of the Auditing Process !Release No.33–8109" for a Public Accountability Board !June 26, 2002".



SecRO would likewise have inspection responsibilities. But it could exercise these responsibilitiesthrough the use of a limited full-time !expert" staff by focusing on firms’ quality control systems!including their internal inspection programs" and overseeing a modified peer review program toprovide an inspection system that appropriately balanced expertise and objectivity.

Establish an SEC Office of Chief AuditorAs noted, the Audit SecRO would be subject to SEC oversight. To exercise day-to-day

oversight of the SecRO, the Commission should establish an Office of the Chief Auditor andtransfer the activities of PPG to this new office. This office would function for the Audit SecROsimilar to what the SEC’s Division of Trading and Markets does in assisting the Commission in itsoversight of SROs such as FInRA. The Chief Auditor Office would review—and in some casesapprove under authority delegated from the Commission—proposed new rules and proposedchanges in existing rules filed by the Audit SecRO. For example, if audit and quality controlstandards had been through a due process !under a rule approved by the Commission" and ap-proved by the Office of the Chief Auditor under its delegated authority, they could be effective onfiling without an additional public comment process. The office would also assist in all otheraspects of SEC oversight of the SecRO, including examining its operations.

Task the Audit SecRO with Establishing an Audit-NTSB37 to Investigate Alleged AuditFailures

The SEC would maintain enforcement authority, and the Audit SecRO could make referrals inthis regard. The Audit SecRO would also review the adequacy of audit firm responses to allega-tions of audit deficiencies in accordance with their quality control system requirements !e.g., seePanel on Audit Effectiveness 2000, 152–153". Beyond these activities, another potential role toconsider for the SecRO would be for it to establish a mechanism for investigating alleged auditfailures !or at least those of significant public interest, including significant instances of fraudulentfinancial reporting, in the context of litigation and regulatory actions"—like an “audit-NTSB.”Rather than discipline, the objective of this audit-NTSB would be to provide feedback to improveaudit firm processes, SecRO supervision and activities such as standard setting and inspections,and SEC oversight and to help maintain confidence in the regulatory system.

An audit-NTSB would restore some aspects of the role played by the Public Oversight Board!POB" Quality Control Inquiry Committee !Panel on Audit Effectiveness 2000, 193–197; POB2002, 26–31", which appear to have been lost under the PCAOB. It incorporates aspects of theauditing master proposal by Palmrose !2006". And, it responds to portions of the ACAP recom-mendation for the PCAOB to establish a fraud center. Essentially, the purpose of the audit-NTSBwould be to assess the merits, if any, of the allegations and relative role of the various contributingfactors—whether auditor performance, audit firm quality control systems and methodologies, stan-dards, inspections, GAAP, or client characteristics and circumstances. Naturally, such a proposalraises confidentiality concerns that would need to be considered !e.g., see Palmrose 2006", espe-cially given what many see as the risk to audit firm viability and sustainability from litigation inthe current environment !ACAP 2008".

Fund the Audit SecRO with an Audit Fee SurchargeFinally, the Audit SecRO could be funded using the SOX methodology, but with entities

subject to SEC jurisdiction being assessed an audit fee surcharge !paid directly to the SecRO" andsubject to advance approval by the SEC. Additional funding could be provided by audit firm

37 NTSB stands for National Transportation Safety Board. The NTSB conducts in-depth investigations of airplane crashes.

504 Palmrose


registration and annual reporting fees. Since SOX Section 109 not only provides for funding of thePCAOB but the FASB under the SEC’s designation of it in accordance with Section 108, the SECwould need to decide if some funding for an accounting standard setter should likewise continueunder the SecRO umbrella.

CONCLUDING REMARKSThis Commentary overviewed and provided perspectives on some SEC activities related to a

variety of auditing and financial reporting public policy issues and initiatives. Drawing on my SECexperiences and an assessment of the regulation of public company audits post-SOX, the Com-mentary concluded with a proposal for a new audit regulator—an Audit SecRO—under the as-sumption that a constitutional challenge to the PCAOB as enacted by SOX may make it essentialto do so.

In conclusion, it was my pleasure to serve as deputy of an expert and highly dedicated staff inthe Professional Practice Group in OCA. This small and hard-working group accomplished a greatdeal during the two years that I served at the SEC. In reflecting on my time at the SEC, I havelikewise come to appreciate the role of perceptions, chance, and circumstances over which wehave no control. Humility is important because legacies can be defined not so much by what onedoes, but by what one does not do. Still, skeptics aside and subsequent events to the contrary, Icontinue to value the wisdom expressed in a speech by chairman Cox: “As regulators, we have tobe aggressive in our role as market referees and protectors of investors’ interests. And, at the sametime, we have to be humble in recognizing that regulation is not the fuel that drives our markets—though it undoubtedly is the oil that greases the gears” !Cox 2007". It is essential to recognize theimportance of regulatory balance for economic vitality.

REFERENCESAAA Financial Accounting and Reporting Section of the Financial Reporting Policy Committee. 2008.

Response to the SEC release “Acceptance from Foreign Private Issuers of Financial Statements Pre-pared in Accordance with International Financial Reporting Standards without Reconciliation to U.S.GAAP File No. S7-13-07.” Accounting Horizons 22 !2": 223–240.

AAA Financial Accounting Standards Committee. 2008. A perspective on the SEC’s proposal to acceptfinancial statements prepared in accordance with International Financial Reporting Standards !IFRS"without reconciliation to U.S. GAAP. Accounting Horizons 22 !2": 241–248.

AAA National CIFiR Tracking Team. 2008. Response to the progress report of the SEC Advisory Committeeon Improvements to Financial Reporting !Release No. 33–8896; File No. 265–24". Accounting Hori-zons 22 !4": 471–494.

Advisory Committee on the Auditing Profession !ACAP". 2008. Final Report (October 6). Washington, D.C.:U.S. Department of the Treasury.

Advisory Committee on Improvements to Financial Reporting !CIFiR". 2008. Final Report of the AdvisoryCommittee on Improvements to Financial Reporting to the United States Securities and ExchangeCommission (August 1). Washington, D.C.: SEC

Bailey, E. W. 2005. Speech by SEC staff: Remarks before the 2005 AICPA National Conference on CurrentSEC and PCAOB Developments. Available at: http://www.sec.gov/news/speech/spch120505ewb.htm.

Ball, R. 2006. International financial reporting standards !IFRS": Pros and cons for investors. Accounting andBusiness Research !Special Issue: International Accounting Policy Forum 2006": 5–27.

——– 2009. Market and political/regulatory perspectives on the recent accounting scandals. Journal ofAccounting Research 47 !2": 277–323.

Beresford, D. R. 1999. It’s time to simplify accounting standards. Journal of Accountancy !March": 65–67.Brown, M. W. and Z-V. Palmrose. 2005. Thog’s Guide to Quantum Economics: 50,000 Years of Accounting

Basics for the Future. Duvall, WA: MAC Productions.Carcello, J. V., J. C. Bedard, and D. R. Hermanson. 2009. Responses of the American Accounting Associa-



http://dx.doi.org/10.2308/acch.2008.22.2.223




http://www.sec.gov/news/speech/spch120505ewb.htm

http://dx.doi.org/10.1111/j.1475-679X.2009.00325.x

http://dx.doi.org/10.1111/j.1475-679X.2009.00325.x

tion’s tracking team to the recommendations of the Advisory Committee on the Auditing Profession.Accounting Horizons 23 !1": 69–84.

Chasan, E. 2009. SEC to refocus on IFRS roadmap-official. Reuters.com !September 17".Cox, C. 2007. Speech by SEC Chairman: Keynote address to the 2007 US-EU Corporate Governance

Conference !October 9". Available at: http://www.sec.gov/news/speech/2007/spch100907cc.htm.Croteau, B. T. 2005. Statement by SEC staff: Remarks before the 2005 AICPA National Conference on

Current SEC and PCAOB Developments. Available at: http://www.sec.gov/news/speech/spch120505bc.htm.

Dichev, I. D. 2008. On the balance sheet-based model of financial reporting. Accounting Horizons 22 !4":453–470.

Ellis, J. 2008. Speech by SEC staff: Remarks before the 2008 AICPA National Conference on Current SECand PCAOB Developments !December 8". Available at: http://www.sec.gov/news/speech/2008/spch120808je.htm.

Financial Accounting Standards Board !FASB". 2006. FASB Response to SEC Study on Arrangements withOff-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers.!February 16". Norwalk, CT: FASB.

Glover, S. M., D. F. Prawitt, and M. H. Taylor. 2009. Audit standard setting and inspection for U.S. publiccompanies: A critical assessment and recommendations for fundamental change. Accounting Horizons23 !2": 221–237.

Hail, L., C. Leuz, and P. Wysocki. 2009. Global accounting convergence and the potential adoption of IFRSby the United States: An analysis of economic and policy factors. Working paper, The Wharton School.

Hamilton, J. 2009. Challenge to PCAOB’s constitutionality focuses on separation of powers and appoint-ments clause. The PCAOB Reporter 7 !16": 1, 4, 8.

Hermanson, D. R. 2009. How consulting services could kill private-sector auditing. The CPA Journal 79!January": 8–9.

Husich, M. W. 2006. Speech by SEC staff: Remarks before the 2006 AICPA National Conference on CurrentSEC and PCAOB Developments. Available at: http://www.sec.gov/news/speech/2006/spch121106mwh.htm.

International Organization of Securities Commissions !IOSCO". 2008. Contingency Planning for Events andConditions Affecting Availability of Audit Services !May 27". Available at: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD269.pdf.

Karapanos, V.. 2007. Speech by SEC staff: Remarks before the 2007 AICPA National Conference on Currentand PCAOB Developments. Available at: http://www.sec.gov/news/speech/2007/spch121007vk.htm.

King, R. 2010. The PCAOB meets the Constitution: The Supreme Court to decide on PCAOB’s conformitywith the separation of powers doctrine and appointments clause. Accounting Horizons 24.

Kinney, W. R., Jr. 2005. Twenty-five years of audit deregulation and re-regulation: What does it mean for2005 and beyond. Auditing: A Journal of Practice & Theory 24 !Supplement": 89–109.

Lumb, J. 2009. PCAOB adopts rule on timing of certain non-U.S. inspections. The PCAOB Reporter 7 !13":1, 6.

Meade, C. J., R. Pildes, and C. M. A. Carroll. 2009. Brief for amici curiae former chairmen of the Securitiesand Exchange Commission in support of respondents in the Supreme Court of the United States, FreeEnterprise Fund and Beckstead and Watts, LLP v. Public Company Accounting Oversight Board andUnited States of America !October".

Nagy, D. 2009. Is the PCAOB a “heavily controlled component” of the SEC? An essential question in theconstitutional controversy !November". Indiana University Maurer School of Law Research Paper No.142. Bloomington, IN: Indiana University.

Nicolaisen, D. T. 2005. Statement by SEC Staff: A securities regulator looks at convergence !April". Avail-able at: http://www.sec.gov/news/speech/spch040605dtn.htm.

O’Brien, P. C. 2010. Changing the concepts to justify the standards. Accounting Perspectives.Palmrose, Z.-V. 2006. Maintaining the value and viability of auditors as gatekeepers under SOX: An auditing

master proposal. In Financial Gatekeepers: Can They Protect Investors, edited by Fuchita, U., and R.Litan, 103–135. Baltimore, MD: The Brookings Institute.

506 Palmrose



http://www.sec.gov/news/speech/2007/spch100907cc.htm

http://www.sec.gov/news/speech/spch120505bc.htm

http://www.sec.gov/news/speech/spch120505bc.htm


http://www.sec.gov/news/speech/2008/spch120808je.htm

http://www.sec.gov/news/speech/2008/spch120808je.htm


http://www.sec.gov/news/speech/2006/spch121106mwh.htm

http://www.sec.gov/news/speech/2006/spch121106mwh.htm

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD269.pdf

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD269.pdf

http://www.sec.gov/news/speech/2007/spch121007vk.htm


http://www.sec.gov/news/speech/spch040605dtn.htm

——– 2007. Speech by SEC staff: Considering audit regulation under SOX !December 10". Available at:http://www.sec.gov/news/speech/2007/spch121007zvp.htm.

——– 2009. Science, politics, and accounting: A view from the Potomac. The Accounting Review 84 !2":281–297.

Panel on Audit Effectiveness. 2000. Report and Recommendations (August 31). Stamford, CT: Public Over-sight Board.

Public Company Accounting Oversight Board !PCAOB". 2008. Public Company Accounting OversightBoard Strategic Plan 2008–2013 (March 31). Washington, D.C.: PCAOB.

Public Oversight Board !POB". 2002. Final Annual Report 2001. Stamford, CT: POB.Scholz, S. 2008. The Changing Nature and Consequences of Public Company Financial Restatements 1997–

2006 (April). Washington, D.C.: U.S. Department of the Treasury. Available at http://www.treas.gov/press/releases/reports/FinancialRestatements_1997_2006.pdf.

Securities and Exchange Commission !SEC". 2005. Report and Recommendations Pursuant to Section 401(c)of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, SpecialPurpose Entities, and Transparency of Filings by Issuers !June 15". Available at: http://www.sec.gov/news/studies/soxoffbalancerpt.pdf.

——–. 2008. Public Company Accounting Oversight Board: Order Approving Proposed Rule on AuditingStandard No. 6, Evaluating Consistency of Financial Statements, and Conforming Amendments. Re-lease No. 34–58555 !September 16". Washington, D.C.: SEC.

——–. 2009. SEC charges Las Vegas-based accountant for issuing false audit reports !August 27". Availableat: http://www.sec.gov/news/press/2009/2009-188.htm. Washington, D.C.: SEC.

Subramaniam, S., I. Katz, and B. Holland. 2009. India’s Enron puts auditors back under scrutiny. Bloomberg-.com !January 13".

White, J. W. 2008. Speech by SEC staff: Don’t throw out the baby with the bathwater: Keynote address at theABA Section of Business Law Fall Meeting !November 21". Available at: http://www.sec.gov/news/speech/2008/spch112108jww.htm.

Wyatt, A. R. 2004. Accounting professionalism—They just don’t get it! Accounting Horizons 18 !March":45–53.



http://www.sec.gov/news/speech/2007/spch121007zvp.htm

http://dx.doi.org/10.2308/accr.2009.84.2.281

http://www.treas.gov/press/releases/reports/FinancialRestatements_1997_2006.pdf

http://www.treas.gov/press/releases/reports/FinancialRestatements_1997_2006.pdf

http://www.sec.gov/news/studies/soxoffbalancerpt.pdf

http://www.sec.gov/news/studies/soxoffbalancerpt.pdf

http://www.sec.gov/news/press/2009/2009-188.htm

http://www.sec.gov/news/speech/2008/spch112108jww.htm

http://www.sec.gov/news/speech/2008/spch112108jww.htm


COMMENTARY Balancing the Costs and Beneﬁts ofAuditing … Benefit II.pdfThe CIFiR represents an important public policy initiative to address concerns over how complex ﬁnancial

Documents