EXECUTIVE SUMMARY
| THE SARBANES-OXLEY ACT OF
2002 is a major reform package
mandating the most far-reaching changes Congress
has imposed on the business world since FDR’s
New Deal.
THE ACT ESTABLISHES THE
PUBLIC COMPANY Accounting Oversight
Board (PCAOB) to regulate accounting
professionals that audit the financial
statements of public companies. The new
board’s operations are subject to direct and
substantial SEC oversight.
ONCE THE SEC DETERMINES
THE BOARD IS ORGANIZED and can
accept its responsibilities (which could occur
prior to April 26), public accounting firms
have 180 days to register with the board or
cease all participation in public company
audits.
TWO CRITICAL ISSUES THE
SEC AND THE NEW BOARD will need to
address relate to providing guidance regarding
who is required to register and the treatment
of persons associated with public accounting
firms, who might include individual
accountants or other entities that receive
compensation from the accounting firm or
participate as an agent of the accounting
firm.
PUBLIC ACCOUNTING FIRMS
WILL HAVE TO PAY CAREFUL attention
to the information on the application for
registration with the PCAOB, some of which
goes well beyond the scope of what is
currently required by state boards of
accountancy or the AICPA.
AN IMPORTANT FUNCTION OF
THE NEW BOARD includes conducting
inspections of registered firms. In addition,
it has a full range of sanctions at its
disposal, including suspension or revocation
of registration, censure and significant
fines.
THE SARBANES-OXLEY ACT
PROHIBITS ALL REGISTERED public
accounting firms from providing audit clients,
contemporaneously with the audit, certain
nonaudit services, including internal audit
outsourcing, financial-information-system
design and implementation services and expert
services.
THE ACT PROVIDES FOR
SIGNIFICANT CORPORATE governance
reforms regarding audit committees and their
relationship to the auditor, making the audit
committee responsible for the appointment,
compensation and oversight of the issuer’s
auditor. | PAUL H. PASHKOFF is an attorney and
associate at Fried, Frank, Harris, Shriver &
Jacobson, Washington, D.C. His e-mail address is
PashkPa@ffhsj.com
. RICHARD I. MILLER, JD, is general counsel
and secretary of the AICPA. His e-mail address
is RMiller@aicpa.org
. Mr. Miller is an employee of the Institute
and his views, as expressed in this article, do
not necessarily reflect the views of the AICPA.
Official positions are determined through
certain specific committee procedures, due
process and deliberation.
|
he Sarbanes-Oxley Act of 2002 is a major
reform package mandating the most far-reaching changes
Congress has imposed on the business world since FDR’s
New Deal. It seeks to thwart future scandals and
restore investor confidence by, among other things,
creating a public-company-accounting-oversight board,
revising auditor independence rules, revising
corporate governance standards and significantly
increasing the criminal penalties for violations of
securities laws. This article highlights the
provisions most important to accounting professionals
engaged in public company audits. Determining
its full scope and impact remains a work in progress
on many levels as the SEC undertakes the task of
implementing the act. AICPA President and CEO Barry C.
Melancon has affirmed the Institute’s commitment to
working toward the effective implementation of the act
and to rebuilding the faith of investors who depend on
accounting professionals for information critical to
the capital markets (see “ A
New Accounting Culture ”).
THE
PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
Sarbanes-Oxley establishes the
Public Company Accounting Oversight Board
(PCAOB) to regulate accounting professionals
who audit the financial statements of public
companies. The board’s operations are subject
to direct and substantial SEC oversight. It,
according to the act, is not a
government agency and will be made up of five
full-time “prominent individuals of integrity
and reputation.” Two members must be or must
have been CPAs. The SEC, in consultation with
the chairman of the Board of Governors of the
Federal Reserve System and the secretary of
the U.S. Department of the Treasury, is
responsible for identifying the initial board
members. The critical task of finding the
right individuals for this job is complicated
by the requirement that members of the PCAOB
refrain from engaging in any other
professional or business activity while
serving. The SEC must appoint the chairperson
and other initial members by October 28, 2002.
The board is responsible for, among other
things, |
Timing Is
Everything The
Sarbanes-Oxley Act says the Public
Company Accounting Oversight Board
must be organized and SEC-authorized
to function on or before April 26,
2003. As soon as the SEC sees that
the new board has the capacity to
carry out its responsibilities
(which could occur prior to April
26), public accounting firms have
180 days to register with the board
or cease all participation in public
company audits. Accounting firms
should not attempt to wait until
the 179th day to register because
the board has 45 days to act on an
application and is permitted to
request additional information
from an applicant. It would be
prudent for accounting firms to
allow a sufficient time cushion
for the registration process and
submit applications no later than
the 135th day after the SEC’s
determination. | |
Registering public accounting firms.
Establishing or adopting—by
rules—auditing, quality control, ethics, independence
and other standards relating to the preparation of
audit reports.
Conducting inspections (the successor to
peer review for public companies) of registered
accounting firms.
Conducting investigations and
disciplinary proceedings.
Imposing appropriate sanctions to enforce
compliance with the rules and laws. It is
important to note the responsibility for establishing
auditing, attestation and quality control standards—a
function currently performed by the Auditing Standards
Board (ASB)—now rests with the Public Company
Accounting Oversight Board. While the new board is
required to “cooperate on an ongoing basis” with
designated professional groups of accountants and
advisory groups engaged in standard setting, it will
have authority to amend, modify, repeal or reject any
standards suggested by these groups. Accordingly, the
board may, but is not required to, continue to allow
the ASB to establish these standards. (The AICPA
expects to demonstrate to the PCAOB that the Auditing
Standards Board is the appropriate body to continue to
set auditing standards.)
REGISTRATION WITH THE BOARD The
Sarbanes-Oxley Act says the Public Company Accounting
Oversight Board must take such action necessary to
enable the SEC to determine by April 26, 2003 that it
is organized and has the capacity to carry out its
responsibilities under the legislation. After this
determination is made (which could occur prior to
April 26), public accounting firms have 180 days to
register with the new board or cease all participation
in public company audits. Most of the act’s
provisions affecting practitioners are effective upon
registration with the PCAOB. As a practical matter,
however, accounting firms should not attempt to wait
until the 179th day to register because the new board
has 45 days to act on an application and is permitted
to request additional information from an applicant.
It would be prudent for accounting firms to allow a
sufficient time cushion for the registration process
and submit applications no later than the 135th day
after the SEC’s determination. Each firm should
carefully review its application and request
confidential treatment, as permitted under the act,
with respect to any proprietary or personal
information. Another critical issue the SEC
and the board will need to address relates to
providing guidance regarding who is required to
register. The act says accounting firms that “prepare
or issue” or “participate” in the preparation or
issuance of any audit report for any “issuer” must be
registered. Exactly what is meant by “participate in
the preparation…of any audit report,” for example, is
not entirely clear. Nor is the act’s definition of
“issuer,” which includes any issuer, as that term is
defined by the Securities Exchange Act of 1934, whose
securities are registered under Section 12 of the
Exchange Act, that is required to file reports under
Section 15(d) of the Exchange Act or that files a
registration statement that has not yet become
effective and that has not been withdrawn. Informal
conversations with SEC representatives, as well as the
Department of Labor, resulted in inconsistent
interpretations regarding, for example, whether an
employee benefit plan filing a Form 11-K would fall
within the legislation’s definition of an issuer.
THE ASSOCIATED-PERSONS QUESTION
Another question left unanswered by the
act is the treatment of persons associated with public
accounting firms, who might include individual
accountants or other entities that, “in connection
with the preparation or issuance of any audit report,”
receive compensation from the accounting firm or
participate as an agent of the accounting firm. But
what constitutes compensation in connection with an
audit report will not be known until regulations are
issued. The act does not require associated persons to
register with the board or abide by the legislation’s
independence requirements. The act does, however,
grant the SEC and the PCAOB authority to extend these
requirements to associated persons. Whether or not
this authority is exercised will have far-reaching
consequences with respect to a variety of services
provided to issuers by persons associated with public
accounting firms, both domestically and
internationally.
FOREIGN FIRMS Foreign firms
that prepare or furnish audit reports with respect to
any issuer are required to register under the act.
Further, the Public Company Accounting Oversight Board
has discretion to extend the act’s registration
requirements to foreign firms that play a “substantial
role” in the preparation of audit reports for any
issuer. The act also has implications for any
U.S.-registered firm that relies on the opinion of a
foreign accounting firm in issuing part of any audit
report. In such cases, the U.S. firm is deemed to have
(1) consented to supplying the audit workpapers of the
foreign firm in response to a request by the board or
SEC and (2) secured the agreement of the foreign firm
to such production as a condition of its reliance on
the opinion. This provision remains very controversial
because of the opposition of many countries to its
broad extraterritorial reach. Further, the deemed
consent to production of their documents may be
inconsistent with, and in some cases prohibited by,
the laws of foreign jurisdictions. Both the PCAOB and
the SEC have authority to exempt foreign accounting
firms from these requirements, and will undoubtedly be
called upon to grapple with this issue in the near
future.
APPLICATION REQUIREMENTS Public
accounting firms will have to pay careful attention to
the information on the application for registration
with the PCAOB. The following information is required
under the new act, some of which goes well beyond the
scope of what is currently required by state boards of
accountancy or the AICPA:
Names of all audit clients who are
issuers.
Annual fees received from each issuer,
broken down by audit and nonaudit services.
Financial information as requested by the
PCAOB.
A statement of quality control policies
for the firm’s auditing and accounting practices.
A list of all accountants participating
in any audit report of any issuer, including license
or certification numbers.
Information relating to criminal, civil
or administrative actions or disciplinary proceedings
pending against the firm or any associated person of
the firm.
Copies of any periodic or annual
disclosures regarding disagreements between the issuer
and the firm during the preceding calendar year.
Any additional information specified by
the new board. The application must include a
consent by the firm to cooperate with the new board
with respect to any request for documents or testimony
(and an agreement by the firm to obtain similar
consents from each person providing any audit services
to issuers). Registered firms will be required to
update the information contained in the application at
least annually.
PERIODIC INSPECTIONS One of the
central functions of the Public Company Accounting
Oversight Board is to conduct inspections of
registered firms. They will occur annually for firms
that audit more than 100 issuers and at least once
every three years for all other firms (the new board
has the discretion to adjust these schedules). The
inspection concept is fundamentally different from the
current peer review. First, it is not firm on firm.
Second, it is not strictly remedial. Thus, if the
inspectors find any violations of the act, the PCAOB’s
rules, federal securities laws, applicable
professional standards or the firm’s own quality
control policies, these findings may serve as the
basis for disciplinary action by the board. In
addition, the inspections may include matters subject
to ongoing litigation. Interestingly, although
the current system of regulation has been criticized
for operating outside the public eye, any criticisms
or deficiencies relating to a firm’s quality control
system will not be made public unless the firm fails
to satisfactorily address the issues within 12 months
from the date of the inspection report. (There is some
question as to whether the new board’s inspection
process will satisfy the peer review requirements of
certain state accountancy boards.)
DISCIPLINARY POWERS The PCAOB’s
other major responsibility is its disciplinary
function. The new board has a full range of sanctions
at its disposal, including suspension or revocation of
registration, censure and significant fines. It has
authority to investigate any act or practice that may
violate the act, the new board’s rules, the provisions
of the federal securities laws relating to audit
reports or applicable professional standards. These
proceedings will generally be confidential, unless for
good cause the board orders a public hearing. Although
any disciplinary sanctions, accompanied by a
supporting statement from the board, would be made
public after the process was concluded, the act
includes confidentiality provisions protecting most
documents prepared or received by the board in
connection with an investigation. These materials can,
however, be shared with other regulators.
FUNDING Accounting firms will
pay a registration fee and an annual fee to cover the
costs of processing and reviewing applications and
annual reports. The bulk of the Public Company
Accounting Oversight Board’s funding will be provided
through an annual accounting support fee assessed on
issuers; these funds will support the board’s
inspection program, relieving firms of a financial
burden they now bear. The fee will be levied in
proportion to each issuer’s equity market
capitalization—larger issuers will pay larger fees.
These fees also will be used to fund the FASB, which
will continue to set accounting standards.
DOCUMENT RETENTION There are
three separate, and potentially inconsistent, document
retention requirements in the act. First, the board is
required to adopt rules mandating a seven-year
retention period for audit workpapers and “other
information related to any audit report, in sufficient
detail to support the conclusions reached in such a
report.” Second, the board may require retention of
additional documents for inspection purposes. Third,
the criminal provisions of the act include a five-year
retention period for all audit and review workpapers,
and the SEC is directed to establish rules relating to
the retention of such workpapers by January 26, 2003.
These document retention issues may be further
complicated by state-level retention requirements. For
example, California recently passed a law requiring
accountants to maintain certain audit documentation
for seven years and accounting firms to write document
retention and destruction policies. As the penalties
for noncompliance can be severe, it is increasingly
important for accounting firms to pay careful
attention to the various record retention requirements
that may be applicable in the jurisdictions in which
they practice.
AUDITOR INDEPENDENCE
Sarbanes-Oxley prohibits all registered
public accounting firms from providing audit clients,
contemporaneously with the audit, certain nonaudit
services including internal audit outsourcing,
financial-information-system design and implementation
services and expert services. These scope-of-service
restrictions go beyond existing SEC independence
regulations. In addition, all other services,
including tax services, are permissible only if
preapproved by the issuer’s audit committee and all
such preapprovals must be disclosed in the issuer’s
periodic reports to the SEC. The act also
requires auditor (not audit firm) rotation. The lead
audit partner and/or the concurring review partner
must rotate off the engagement if he or she has
performed audit services for the issuer in each of the
five previous fiscal years. There is no distinction
regarding the capacity in which the audit or
concurring partner provided such audit services.
Accordingly, services provided as a manager or in some
other capacity appear to count toward the five-year
period. In addition, the provision applies as soon as
the firm is registered, so, absent guidance to the
contrary, the audit and concurring partner must count
back five years starting with the date in which PCAOB
registration occurs. This provision is particularly
important because of its potential impact on small
accounting firms. The SEC is considering whether or
not to accommodate small firms in this area; currently
there is no small-firm exemption from this provision.
AUDIT COMMITTEES The act
provides for significant corporate governance reforms
regarding audit committees and their relationship to
the auditor, making the audit committee responsible
for the appointment, compensation and oversight of the
issuer’s auditor. This should fundamentally change the
auditor/client relationship. Further, the auditor
reports directly to the audit committee, not to
management, reinforcing the position that the
auditor’s duties run to the shareholders, rather than
management. Each member of the audit committee must be
independent, and the audit committee must have the
authority to hire independent counsel and other
advisers. In addition, each issuer must provide
appropriate funding, as determined by the audit
committee, for compensating the auditor and any
advisers retained by the audit committee. The audit
committee also must establish procedures for handling
complaints regarding accounting or auditing matters
and for the confidential submission by employees of
concerns regarding questionable accounting or auditing
matters. In light of these new increasingly important
audit committee responsibilities, the audit committee
must forge an effective working relationship between
itself and the auditor. The full scope of the
act is too expansive to address in this article other
provisions such as CEO and CFO certification of
financial reports, enhanced financial disclosures,
including off-balance-sheet transactions and special
purpose entities, pro forma financial information
reconciling to GAAP financial statements and auditor
reports on management assessments of internal
controls. The act mandates the completion of several
studies, which may result in additional legislation or
rule making. There is no doubt the profession
is on the cusp of a new era of accounting regulation.
Accordingly, it must appropriately focus on the
effective implementation of the Sarbanes-Oxley Act, as
well as the challenge of meeting its primary
objective: restoring investor confidence. |