SEC Proposes New Independent Oversight of the Auditing Process
July 2002
On June 26, 2002, in response to calls to reform the accounting industry in the wake of Enron and other accounting scandals, the U.S. Securities and Exchange Commission (SEC) issued proposed rules intended to improve oversight of the auditing process. Through this proposed oversight framework, the SEC seeks to increase the quality of the financial information on which the investing public relies. Under the proposed rules, new, private, not-for-profit entities called Public Accountability Boards (PABs) would be formed that would be recognized by the SEC after review. These PABs would direct periodic reviews of accounting firms, discipline accountants and accounting firms and set or oversee the setting of accounting standards. In addition, the proposal would require public companies to issue financial statements that are audited or reviewed, as applicable, by an independent public accountant that is a member in good standing of a PAB. Each public company must be an adjunct member in good standing of the PAB of which its accountant is a member.
Independent Nature of Public Accountability Boards
The SEC envisions multiple PABs under its proposed rules. These PABs would be independent of the accounting profession with limited industry representation. No board member of a PAB could be an employee of an accountant’s professional organization at any time during the prior two years. In addition, no more than one-third of the board members, up to a maximum of three, could be a member of the accounting profession within the prior 10 years. Board members who had previously been accounting professionals would not be able to vote on disciplinary matters. Each PAB would be funded by mandatory fees on its member accounting firms as well as its adjunct member public companies. These fees would also be applied toward funding the Financial Accounting Standards Board (FASB), the accounting standards body endorsed by the SEC as the primary source for generally accepted accounting principles.
Duties of Public Accountability Boards
PABs would have three primary responsibilities: directing periodic reviews of accounting firms, disciplining accountants and accounting firms and setting, or overseeing the setting of, accounting standards. Instead of the current framework where one accounting firm will peer review another every three years, under the SEC’s proposal, PABs would conduct annual reviews of their large accounting firm members (firms having 70 or more SEC-reporting clients). This review would focus on a firm’s quality controls over its accounting and auditing practices and would include a review of policies and practices regarding the following:
- independence, integrity and objectivity
- personnel management
- acceptance and continuation of clients
- audit performance
- audit methodology
- consultation and resolution of differences of professional opinion
PAB reviews would be paid for by the accounting firm being reviewed. Smaller accounting firms with less than 70 SEC-reporting clients would be reviewed at least once every three years. This review of smaller accounting firms could be conducted by non-PAB staff if there was a proper level of PAB oversight.
PABs would be empowered to discipline accountants and accounting firms for unethical or incompetent conduct or other violations of professional conduct and would conduct disciplinary proceedings regarding such violations. A PAB could impose a range of disciplinary or remedial sanctions, including the following:
- fines
- censures
- required remediation
- removal of an individual or termination of a firm from an audit engagement
limitations on certain activities - suspension or disbarment from membership in the PAB
Given the broad disciplinary powers a PAB would have, including the ability to limit or suspend an accountant’s practice before the SEC, a disciplined accountant or accounting firm would have the ability to seek review of a PAB disciplinary decision by the SEC.
Finally, a PAB would set, or designate a private sector body to set, audit, quality control and ethics standards for its members when the PAB sees a need for new or revised standards. If the PAB were to designate a private sector body to set standards, it would oversee the designated body and engage in and comment on the decision-making process.
New Obligations to Be Imposed on Reporting Companies
The scope of the SEC’s proposal is not limited to the accounting industry. Under the proposal, SEC-reporting companies will be required to file financial statements that have been audited or reviewed, as applicable, by an accounting firm that is a member of a PAB during all times of the engagement period. Reporting companies must also be adjunct members of the same PAB as their accounting firm and pay mandatory fees to the PAB as adjunct members. The SEC’s proposal does not suggest what the amount of the mandatory fees should be, but it encourages the adoption of a fee schedule based on different classes of adjunct members. In addition, upon request, a reporting company must supply documents and testimony relevant to a PAB’s quality control review, supplemental review or disciplinary proceeding of the reporting company’s accounting firm. In responding to a PAB’s document or testimony request, a reporting company would be required to use its best efforts to cause its agents and non-management employees to supply any documents or testimony required by the PAB. A reporting company could raise good faith legal objections to a request by its PAB.
The SEC’s proposals would also require disclosure under Item 401(f) of Regulation S-K of any sanctions imposed against directors, director nominees or executive officers within the previous five years by a PAB, which have not been reversed, suspended or vacated, for violations of professional standards, PAB rules or membership requirements in such director, nominee or executive officer’s capacity as a PAB member accountant.
PABs, although primarily focused on accounting firms, would wield some disciplinary powers over SEC reporting companies. A reporting company could be found by its PAB, after public notice and required PAB procedure, to be delinquent in paying assessed fees or responding to the PAB’s request for documents or testimony relevant to the review of the reporting company’s accounting firm. A reporting company found to be delinquent in paying required fees or responding to a PAB document or testimony request would be deemed an adjunct member not in good standing. As such, a reporting company would be unable to file financial statements with the SEC and thus maintain its status as a public company, unless it were reinstated in good standing with its PAB. If a reporting company were determined not to be in good standing, this status would be recognized by other PABs, if any, and would prevent the reporting company from simply joining a new PAB as an adjunct member in good standing. Given the serious consequences of such an action, the SEC has indicated in its proposal that it would condition the recognition of a PAB, in part, on the PAB having fair procedures for requesting documents and testimony and for resolving any disputes concerning those requests.
Possible Implications for Reporting Companies
Implications of the SEC’s proposal for companies subject to SEC reporting requirements may include the following:
- Under the SEC’s proposal, reporting companies will be obligated to provide documents and testimony or face the potential penalty of being deemed "not in good standing." Because of this possibility, reporting companies have the incentive to provide documents and testimony damaging to their accountants in order to protect their good standing status. This may raise tensions between reporting companies and their auditors.
- PABs would have a duty to notify the SEC if they become aware of information indicating that a violation of securities laws has, or is likely to have, occurred. Thus, reporting companies will likely keep tighter controls over their accounting and finance functions and their work papers and documents related to the audit and review work done by their accountants. Such documents could be requested and subject to review during the annual review of their accounting firms PABs with any likely securities law violations brought to the SEC’s attention.
- As currently proposed, an accounting firm must be in good standing with its PAB for the entire engagement period to be recognized as certified public accountants by the SEC with respect to an audit client. Financial statements audited or reviewed by an accounting firm that was not in good standing during the engagement period would not be accepted by the SEC and would force a SEC-reporting company to switch auditors, unless the firm was reinstated by its PAB. A determination that it is not in good standing would cause severe, and potentially fatal, harm to an accounting firm and result in great difficulties for its clients.
- The reporting companies will face increase cost associated with the auditing process. Not only will fees be assessed by a company’s PAB, costs and executive time and resources would be incurred when a company was required to comply with a PAB request.
Comments on the SEC’s proposed framework are due within 60 days after publication. If enacted, the SEC anticipates that it would promptly review any submissions by entities seeking to be a PAB and, if possible, would issue an order recognizing a PAB by January 2003.
