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SOME THOUGHTS ON AN AGENDA FOR THE PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD ELLIOTT J. WEISS INTRODUCTION The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) 1 was enacted in response to widespread concern
SOME THOUGHTS ON AN AGENDA FOR THE PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD ELLIOTT J. WEISS INTRODUCTION The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) 1 was enacted in response to widespread concern that there is a serious problem in financial reporting and disclosure and that Enron and like cases are aberrational only in size and severity. 2 The Act includes provisions regulating corporate boards of directors, 3 corporate audit committees, 4 transactions between corporations and their executives, 5 the obligations of attorneys who represent public corporations in securities Copyright 2003 by Elliott J. Weiss. Charles E. Ares Professor, James E. Rogers College of Law, University of Arizona. An earlier version of this paper was presented at an October 2002 conference at Villanova Law School on Enron and its aftermath. Participants at that conference, at a faculty workshop at the James E. Rogers College of Law, and at the ILEP conference, as well as colleagues on the accounting faculty of the University of Arizona and Larry Cunningham all provided helpful comments. This Article was largely completed in July 2003 and further revised in September To a very limited extent, it has been updated to reflect related legal developments. All errors are mine. 1. Pub. L. No , 116 Stat. 745 (codified in scattered sections of 11, 15, 18, 28, and 29 U.S.C.A. (West Supp. 2003)). 2. Donald Langevoort, Managing the Expectations Gap in Investor Protection: The SEC and the Post-Enron Reform Agenda, 48 VILL. L. REV. 1139, 1151 (2003). 3. The regulations imposed are both direct and indirect. See section 406 of Sarbanes- Oxley (15 U.S.C.A. 7264) (illustrating indirect regulation through required disclosure of the company s code of ethics for senior financial officers); see also sections 303 (15 U.S.C.A. 7242) (regulating conduct of directors relating to an audit of financial statements), 304 (15 U.S.C.A. 7243) (requiring forfeiture of bonuses or profits obtained due to misstated financial reports), and 306 (15 U.S.C.A. 7244) (prohibiting trading during pension fund blackout periods). 4. See section 301 (15 U.S.C.A. 78j 1(m)) (listing the standards and requirements applicable to public company audit committees). 5. See section 402 (15 U.S.C.A. 78(m)) (prohibiting corporate loans to executives). 492 DUKE LAW JOURNAL [Vol. 53:491 matters, 6 and the compensation and autonomy of securities analysts. 7 At the heart of the Act, though, are the provisions that authorize the creation of a new regulatory body, the Public Company Accounting Oversight Board (PCAOB or Board), require all accounting firms that audit the books of public corporations to register with the Board, and grant the Board broad authority to regulate those firms and their associated professionals. 8 Sarbanes-Oxley directs the PCAOB to take such actions as it deems necessary or appropriate to promote high professional standards among, and improve the quality of audit services offered by, registered public accounting firms and associated persons... in order to protect investors, or to further the public interest. 9 The Board s mission quite clearly is to develop regulations and implement regulatory procedures that will bolster and may even restore the public s confidence in the integrity of public accounting firms and the credibility of the financial reports they audit and certify. 10 Public confidence in the integrity of public companies financial reports has been shaken by numerous, highly publicized instances of financial fraud 11 at companies as prominent as 6. See section 307 (15 U.S.C.A. 7245) (charging the SEC with the task of establishing rules of professional responsibility for attorneys practicing before the Commission). 7. See section 501 (15 U.S.C.A. 78o 6) (requiring the Commission to set rules addressing conflicts of interest that can arise when security analysts recommend equity securities in research reports and public appearances ). 8. See sections 101 (15 U.S.C.A. 7211) (establishing the Board), 102 (15 U.S.C.A. 7212) (requiring registration with the Board), 103 (15 U.S.C.A. 7213) (granting the Board authority to set auditing, quality control, and independence standards). 9. Sarbanes-Oxley Act of (c)(5), 15 U.S.C.A. 7211(c)(5). 10. One study found that audit firms gave a clean bill of health to 93.9% of public companies that were subsequently involved in accounting problems. Martin D. Weiss, The Worsening Crisis of Confidence on Wall Street: The Role of Auditing Firms, at (July 5, 2002) (on file with the Duke Law Journal). 11. See Deborah Solomon, Fraud Detector: SEC Sets a New Rule, WALL ST. J., May 28, 2003, at C1 (noting that the SEC s recent rulemaking efforts are designed to prevent frauds, such as those at Enron and HealthSouth, which undercut investor confidence); David Wessel, Capital: Jitters over War with Iraq May Not be the Only Factor Weighing on the Economy, WALL ST. J., Feb. 20, 2003, at A2 (stating that financial scandals hurt not only public confidence in business but also attitudes of investors, bankers, corporate directors, and executives toward each other); Robert J. Shiller, Celebrity CEOs Share the Blame for Street Scandals, WALL ST. J., June 27, 2002, at A20 (noting that scandals like Rite-Aid and WorldCom have the potential to upset investor confidence by changing fundamental beliefs about management s ability to promote long-term earnings growth over short-term share price increases). 2003] PUBLIC COMPANY ACCOUNTING 493 Enron, 12 Rite-Aid, 13 WorldCom, 14 and HealthSouth, 15 and by the failure of auditors to detect that those companies had been cooking their books for many years. 16 There is no doubt that one prominent item on the PCAOB s substantive agenda will be figuring out how to encourage or require auditors to detect such frauds. This Article, however, does not focus on the ways in which the PCAOB should deal with fraud-related issues. Rather, it is directed at two more pervasive problems that also have sapped the public s confidence in the integrity of corporations financial reports: Earnings management, by which I mean the tendency of many corporate managers to make the numerous accounting judgments that generally accepted accounting principles (GAAP) 17 permit or require not in good faith, but with a view to reporting some desired level of corporate income (or some other desired figure in their company s financial statements) See Markets, L.A. TIMES, Dec. 2, 2003 at C4 (noting that Sarbanes-Oxley was passed after the Enron and WorldCom scandals eroded confidence in Wall Street ); see also Andrew Parker, Firms Await Audit Crackdown Regulator to Unveil Tough Rules on Fees and Additional Work for Clients, FINANCIAL TIMES, Nov. 22, 2003, at 1 ( US business scandals such as Enron and WorldCom undermined confidence in companies accounts partly because of allegations of poor work by auditors. ). 13. See Scott Kilman, Rite Aid Ex-Officials Charged in Accounting Fraud Probe, WALL ST. J., June 24, 2002, at A2 (describing the scheme that resulted in what was then the largest U.S. corporate earnings restatement to date (approximately $258 million)). 14. See Jared Sandberg & Deborah Solomon, WorldCom Board to Begin Search for New CEO, WALL ST. J., Sept. 11, 2002, at A3 (describing the market downturn that resulted from the discovery of WorldCom s $3.8 billion financial overstatement, later to total more than $7 billion). 15. See Carrick Mollenkamp & Chad Terhune, HealthSouth Puts False Accounting at $2.5 Billion, WALL ST. J., July 8, 2003, at A3 (reporting the results of the auditor s cumulative investigation $2.5 billion in fraudulent or improper accounting designed to manipulate earnings and meet Wall Street expectations). 16. See Jerry Useem, In Corporate America It s Cleanup Time, FORTUNE, Sept. 16, 2002, at 62 (noting that companies who meet analyst estimates exactly or beat them by a penny face a presumption that they have been cooking their books); Carol J. Loomis, Lies, Damned Lies, and Managed Earnings, FORTUNE, Aug. 2, 1999 at 74 (equating the term cooking the books with criminal accounting fraud). 17. GAAP are the principles that govern how financial information is to be presented in financial statements. They are set forth in Statements of Financial Accounting Standards (SFAS) promulgated by the Financial Standards Accounting Board (FASB), as well as by similar standards promulgated by predecessors to the FASB that have not been superceded by SFAS, and by authoritative statements in the accounting literature that address issues not addressed by such standards. DONALD E. KEISO & JERRY J. WEIGANDT, INTERMEDIATE ACCOUNTING, 6, (9th ed. 1998). 18. Patricia M. Dechow & Douglas J. Skinner, Earnings Management: Reconciling the Views of Accounting Academics, Practitioners, and Regulators, 14 ACCT. HORIZONS 235, 238 494 DUKE LAW JOURNAL [Vol. 53:491 The failure of public companies and their accountants to make clear to the public the extent to which critical entries in those companies financial statements are based on highly subjective judgments, the accuracy of which cannot be measured objectively. Inevitably, with the passage of time, some of those judgments prove inaccurate. Even if those judgments were made in good faith, investors who do not appreciate the amount of subjectivity involved in preparing financial statements may suspect that the disparity between what was reported and economic reality is a product of earnings management, if not of outright fraud. Professor Don Langevoort argues that the best way to address these problems is for the Securities and Exchange Commission (SEC) again to overhaul its approach to Management s Discussion and Analysis (the MD&A). 19 I disagree. The SEC has been pushing that particular string with little success for many years now, 20 which leads me to question whether any new approach the SEC is likely to adopt will be much more successful in eliciting meaningful, forward (2000). Professors Dechow and Skinner point out that it is difficult to measure earnings management because it turns on managers subjective intent, which cannot be observed directly. Id. 19. Langevoort, supra note 2, at The SEC requires every public company to include an MD&A in its annual reports on Form 10-K and its quarterly reports on Form 10-Q. Regulation S-K, 17 C.F.R (2003) (commonly known as Regulation S-K, Instruction 3, Item 303). According to the SEC, the purpose of the MD&A is to provide (i) a narrative explanation of the company s financial statements that enable investors to see the company through the eyes of management; (ii) a context within which the company s financial statements should be analyzed; and (iii) information about the quality of, and potential variability of, the company s earnings and cash flow, so that investors can better assess the company s likely future performance. Analysis of Financial Condition and Operations, Securities Act Release No. 6711, 52 Fed. Reg. 13,715, 13,717 (Apr. 24, 1987). 20. For those unfamiliar with this expression, it refers to the fact that a string can be pulled but cannot be pushed. Recent evidence of the SEC s lack of success is provided by a report from the Division of Corporation Finance, which reviewed the annual reports for 2001 filed by all Fortune 500 companies and noted significant deficiencies in 350 of them. U.S. Sec. & Exch. Comm n, Summary by the Division of Corporation Finance of Significant Issues Addressed in the Review of the Periodic Reports of Fortune 500 Companies, at divisions/corpfin/fortune500rep.htm (last modified Feb. 27, 2003) (on file with the Duke Law Journal). The Division noted that although the SEC had indicated in FR-60 that companies should provide more information in their MD&A about their critical accounting policies, a substantial number of companies did not provide any critical accounting policy disclosure[;]... the critical accounting policy disclosures of many companies did not adequately respond to the guidance provided in FR-60 [and] many companies failed to provide the sensitivity analysis the Commission encouraged in FR-60. Id. (emphasis added.). In K reporting, the SEC identified little quantified sensitivity analysis. Linda C. Quinn & Ottilie L. Jarmel, MD&A 2003: Linchpin of SEC Post-Enron Disclosure Reform, 1395 PLI/Corp 487, 495 (Nov. 2003). 2003] PUBLIC COMPANY ACCOUNTING 495 looking disclosures from corporate managers than have the SEC s past, failed efforts. A major conceptual problem with the SEC s approach, in my view, is that the Commission has persisted in treating historical financial information as if it is fixed in nature, rather than inherently uncertain. Thus, in its guidance concerning preparation of the MD&A, the SEC advises issuers to focus on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or future financial conditions. 21 The SEC ignores or treats as nonexistent the possibility that as a consequence of material [future] events and uncertainties, reported financial results will prove not to reflect accurately past operating results or past financial conditions. Yet, as every sophisticated user of financial reports knows, this almost always is a distinct possibility. 22 The SEC has a tradition of viewing historical information as fixed and certain so long as it is not tainted by fraud. 23 The PCAOB is not bound by this tradition and thus is well positioned both to limit earnings management and to help investors better appreciate the uncertainties inherent in all financial statements, including those prepared in good faith. If the Board does so, investors will have greater confidence in the integrity of public companies financial 21. Regulation S-K, 17 C.F.R To illustrate, when a company that sells on credit establishes an allowance for doubtful accounts receivable, it must make assumptions about whether those customers who now owe it money are more likely, less likely, or as likely to pay their bills as the customers to whom the company has sold its products in prior periods, as well as whether a significant shift in overall economic conditions or conditions within a particular industry or locale are likely to lead to substantial changes in its customers bill-paying habits. Even assumptions made in good faith may prove to be wrong. If they are, the company s real economic results and financial position may vary considerably from the results and financial position it reported in its filing with the SEC. 23. See Paul H. Dawes et al., The Sarbanes-Oxley Act of 2002 and SEC Rulemaking, 1378 PLI/Corp 245, 256 (2003) (noting that Sarbanes-Oxley s encouragement of qualitative information disclosures could result in a reappraisal of the Commission s traditional emphasis on historical information as the basis on which investment decisions are made, but whether this will be more effective against fraud remains to be seen ); Jeanne Calderon & Rachel Kowal, Safe Harbors: Historical and Current Approaches to Future Forecasting, 22 J. CORP. L. 661, 662 (1997) (describing the Commission s preference for historical ( hard ) information in company disclosures); Carl W. Schneider, Nits, Grits and Soft Information in SEC Filings, 121 U. PA. L. REV. 254, 258 (1972) ( The Commission tries to confine [SEC filings] to hard information to assure a continued high degree of reliability... [which also] makes it easier to establish accountability for inadequate disclosures. ). 496 DUKE LAW JOURNAL [Vol. 53:491 statements and should be better able to appreciate the risks involved in buying and selling the securities those companies have issued. Although the PCAOB lacks the authority to prescribe or amend GAAP, this should not impair its ability to achieve these goals if the Board makes creative use of its authority (i) to establish and amend Generally Accepted Auditing Standards (GAAS), 24 (ii) to inspect the operations of public accounting firms, and (iii) to discipline those firms and their associated personnel where they do not follow the auditing standards the Board has prescribed. More specifically, the PCAOB should be able to decrease earnings management and increase investors understanding of public companies financial statements by embarking on a three-part program that includes the following: 25 Independence: The PCAOB should seek to ensure that public accountants approach audit assignments at public companies as independent professionals committed to ensuring that the financial statements they audit and certify reflect economic reality as closely as reasonably possible. Accuracy: The PCAOB should amend GAAS to require auditors to be more sensitive to the possibility of earnings management and, where circumstances suggest earnings management is likely, to scrutinize closely all important judgments and assumptions that GAAP permit or require managers to make. 24. GAAS are the principles that govern the procedures an accountant should use to verify the accuracy of the information in a financial statement it is auditing. Prior to the creation of the PCAOB, GAAS were promulgated by the American Institute of Certified Public Accountants (AICPA), the professional organization to which most certified public accountants belong. GAAS issued by the AICPA can be found in the Codification of Statements on Auditing Standards (AICPA 2002). 25. The Board, of course, also must address a number of major organizational and administrative issues, especially during the early years of its existence. These include staffing a major new regulatory organization from the ground up and developing policies and procedures to govern that organization s operations. The Board also must issue regulations to implement a number of specific legislative mandates. For example, section 103(a)(1) of Sarbanes-Oxley requires the Board to establish auditing and related attestation standards, quality control standards, and ethics standards to be used by registered public accounting firms in the preparation and issuance of audit reports. The Board is also granted the power to establish rules to implement the auditor independence requirements in Title II of the Act. PCAOB Rel. No , Compliance with Auditing and Related Professional Practice Standards: Advisory Groups, PCAOB Rulemaking Docket Matter No. 004 (June 30, 2003). As evidenced by the Board s website, which lists all of its regulatory initiatives, that process seems to be well under way. See (last visited Jan. 26, 2003). 2003] PUBLIC COMPANY ACCOUNTING 497 Transparency: The PCAOB should also endeavor to ensure that investors better understand the inherent subjectivity of public companies financial statements by requiring auditors to explain why they believe a public company s financial statements present fairly, in conformity with GAAP, the results of its operations and its financial position. 26 As explained below, to achieve these objectives the PCAOB will need to think outside the box and promulgate auditing and ethical standards that address the very issues the accounting profession traditionally has chosen not to address. 27 In addition, the Board will need to use its authority to review the performance of registered public auditing firms and to discipline firms and auditors in order to promote a high level of compliance with whatever new standards it chooses to promulgate. I. INDEPENDENCE One major concern that led to the passage of Sarbanes-Oxley was that, as accounting firms began to derive an increasing portion of their revenues from nonaudit services, they faced increasing conflicts of interest. Title II of Sarbanes-Oxley 28 addresses the issue of auditor independence, which, according to the relevant Senate report, is at the center of this legislation. 29 Title II includes a 26. This is the key language in the opinions public accountants now issue w
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