BA 427 – Assurance and Attestation Services

1. BA 427 – Assurance and Attestation Services Lecture 11 Evolution of the Regulatory and Self-regulatory Environment

2. Regulation and Self-Regulation The Public Audit Regulatory Oversight Corporate Governance & Reporting Internal Controls The Audit Committee Internal Auditing

3. Regulation and Self-Regulation • Regulation • Self-regulation “History is full of examples of how improper or ineffective self-regulation leads to government regulation.”

4. Regulation and Self-Regulation • Regulation • Self-regulation “History is full of examples of how improper or ineffective self-regulation leads to government regulation.” 1963 Leonard Spacek, second managing partner of Arthur Andersen

5. Regulation and Self-Regulation • Regulation • Federal Legislation • Federal Regulation • Regulation at the State level: Licensing • Self-regulation

6. Regulation and Self-Regulation • Regulation • Federal Legislation • Federal Regulation • Regulation at the State level: Licensing • Self-regulation

7. Time-line of Federal Legislation The stock market crash The Great Depression World War II The Cold War The Information Revolution 1929 1933 - 1934 1979 1991 2002 Foreign Corrupt Practices Act Sarbanes-Oxley The Securities Acts of 1933 and 1934 FDICIA

8. Regulation and Self-Regulation • Federal Legislation • Securities Acts of 1933 and 1934 • FCPA: Internal Accounting Controls • FDICIA: Internal Controls Reporting • Private Securities Litigation Reform Act:Auditors must notify the SEC of material illegal acts when the client fails to take timely and appropriate remedial action. • Sarbanes-Oxley Act of 2002

9. Regulation and Self-Regulation • Regulation • Federal Legislation • Federal Regulation • Regulation at the State level: Licensing • Self-regulation

10. Regulation and Self-Regulation • Regulation • Federal Legislation • Federal Regulation • Regulation at the State level: Licensing • Self-regulation

11. Regulation and Self-Regulation • Regulation • Federal Regulation • The Securities and Exchange Commission • GAO (Government Accountability Office, formerly the General Accounting Office) • Bank regulators

12. The Securities and Exchange Commission Congress created the SEC in 1934 for the purpose of enforcing the Securities Acts of 1933 and 1934, to promote stability in the markets, and to protect investors. The SEC consists of five commissioners, appointed by the President. No more than three commissioners can come from the same political party. The first SEC Chairman

13. The Securities and Exchange Commission In 1937, the SEC voted 3 to 2 not to set accounting standards, but rather, to let the accounting profession self-regulate. Future Supreme Court Justice William O. Douglas almost certainly voted with the minority. William O. Douglas SEC Chairman 1937-1939

14. Governance Structure in 1970 The AICPA U.S. Congress Securities & Exchange Commission Committee on Professional Ethics Committee on Auditing Procedures Accounting Principles Board

15. Governance Structure in 1975 Financial Accounting Foundation The AICPA U.S. Congress Financial Accounting Standards Board Securities & Exchange Commission Executive Committee of the Ethics Division Auditing Standards Board

16. The Metcalf Senate Report The Accounting Establishment: A Staff Study Senate Committee on Government Operations Senate Subcommittee on Reports, Accounting and Management Lee Metcalf, chairman Seven other members, including John Glenn and Lowell Weicker Report issued December, 1976 Lee Metcalf  (1911 - 1978) Democratic Senator From Montana (1961-1978)

17. The Metcalf Senate Report “I am disturbed by two of the study’s major findings. The first is the extraordinary manner in which the SEC has insisted upon delegating its public authority and responsibilities on accounting matters to private groups with obvious self-interests in the resolution of such matters.” Lee Metcalf  (1911 - 1978) Democratic Senator From Montana (1961-1978)

18. The Metcalf Senate Report “The second is the alarming lack of independence and lack of dedication to public protection shown by the large accounting firms … . … the subcommittee staff has prepared several recommendations which are designed to restore public confidence in the integrity and usefulness of corporate financial reports … .” Lee Metcalf  (1911 - 1978) Democratic Senator From Montana (1961-1978)

19. The World According to Metcalf Big 8 CPAs account for 15% of the AICPA membership, but dominate key AICPA committees Big 8 Public Accounting Firms Appoints the FAF Board of Trustees American Institute of CPAs Appoints members of the FASB Financial Accounting Foundation Sets standards that are recognized by the SEC FASB

20. The Metcalf Senate Report “Historically, Congress and the public have regarded accounting as an arcane subject better left to accountants themselves. Continual revelations of wrongdoing by publicly-owned corporations have caused a new awareness of the importance of accounting practices in permitting such abuses to occur.”

21. The Metcalf Senate Report “The ‘Big Eight’ are often called … ‘independent public accounting firms.’ This study finds little evidence that they serve the public or that they are independent …”

22. The Metcalf Senate Report “The controlling influence of the ‘Big Eight’ accounting firms in establishing accounting standards ultimately benefits the managements of their corporate clients by assuring that such standards will be generally acceptable to them.”

23. The Metcalf Senate Report “The FASB represents only the interests of its private sponsoring groups.”

24. The Metcalf Senate Report According to Business Week: The report on the accounting profession just released … is incompetently researched and grossly biased. Metcalf and his staff have tried to solve a complex problem by pounding it with a sledgehammer, and the result is pure junk. Lee Metcalf  (1911 - 1978) Democratic Senator From Montana (1961-1978)

25. Regulation and Self-Regulation • Self-Regulation • Financial reporting • Financial Accounting Standards Board • Auditing • AICPA • Auditing Standards Board • Executive Committee of the Professional Ethics Division • Public Oversight Board (now defunct)

26. Governance Structure in 1980 Financial Accounting Foundation The AICPA Public Oversight Board U.S. Congress Financial Accounting Standards Board Securities & Exchange Commission Executive Committee of the Ethics Division Auditing Standards Board SEC Practice Section

27. The Public Oversight Board • Created in 1977, in response to concerns expressed by the SEC and members of Congress. • An independent, private-sector body • Created to oversee and report on the self-regulatory programs of the SEC Practice Section (SECPS) of the AICPA. • Funded by dues paid by SECPS members. • The POB appointed its own members and staff, and set its own budget.

28. The Public Oversight Board • In 1979, the POB issued its report Scope of Services by CPA Firms. • As input for the report, the POB held two days of hearings, received 152 comment letters, and conducted an extensive literature review.

29. The Kirk Panel • In 1994, the POB releases the report of the Advisory Panel on Auditor Independence: Strengthening the Professionalism of the Independent Auditor(the Kirk Panel). • The Panel was commissioned by the POB following a speech by SEC Chief Accountant Walter Schuetze, in which he criticized the accounting profession for not standing up to clients on financial reporting matters.

30. The Kirk Panel • The Panel concluded that: • existing rules on auditor independence and conflicts of interest were adequate. • a rule mandating the rotation of audit firms was impractical and unnecessary.

31. The Kirk Panel • The Panel recommended: • Company boards of directors need to be more independent, stronger, and more accountable. • Auditors should communicate with the audit committee regarding the quality of financial reporting (appropriateness, not just acceptability).

32. The Kirk Panel • auditors should look to the audit committee and the board as their client, not company management. • audit firms should ensure that the audit function is not marginalized by consulting services. • audit firm national technical offices should be independent of practice partners.

33. Independence Standards Board • June 1997: The SEC, AICPA and Big 6 firms agree to the formation of a new self-regulatory body: the ISB. • ISB’s mission: to establish independence standards for public company auditors. • ISB organizational structure is similar to the POB: eight-member board, four from the accounting profession. • October 1997: The ISB begins operations.

34. Governance Structure in 1998 Financial Accounting Foundation Independence Standards Board The AICPA Public Oversight Board U.S. Congress Financial Accounting Standards Board Securities & Exchange Commission Executive Committee of the Ethics Division Auditing Standards Board SEC Practice Section

35. Independence Standards Board • February 2000: The ISB issues a Discussion Memorandum for public comment on a conceptual framework for auditor independence. • November 2000: The ISB issues an exposure draft. A final draft is issued in 2001.

36. Stock Ownership Rules • Winter of 1997: SEC receives anonymous letter alleging that C&L audit staff owned stock in companies that C&L audits. • C&L merges with Price Waterhouse. • SEC requires PwC to conduct an internal investigation; uncovers 8,000 violations that involve 50% of the firm’s partners, including some senior partners. • The SEC urges the other firms to conduct investigations of their compliance with these rules. • The POB agrees to conduct the investigations.

37. Self-Regulation Unravels • May 2000: The AICPA refuses to fund the POB stock ownership probes. • In response to the AICPA’s action, SEC Chairman Arthur Levitt stated that “Self Regulation by the Accounting Profession is a Bad Joke.”

38. Self-Regulation Unravels • July 2001: The ISB votes to dissolve. • Fall 2001: Enron’s stock price collapses • Jan. 17, 2002: SEC Chairman Harvey Pitt proposes a new private-sector regulatory structure. • Jan. 18: Don Kirk resigns from the POB. • Jan. 20: The POB votes to dissolve. • Mar. 19: POB Chairman testifies to Congress. • May 1: The POB disbands. • June 2002: Arthur Andersen Convicted of obstruction of justice.

39. POB Chairman Bowsher’s Testimony in the Congressional Enron Hearings The Public Oversight Board strongly believes that a new regulatory structure for the accounting profession is essential. However, we believe that to be effective, it must be totally independent of the accounting profession and it must be based on the foundation of congressional action creating a statutory self-regulatory organization.

40. Events of 2001 and 2002 Financial Accounting Foundation Independence Standards Board The AICPA Public Oversight Board U.S. Congress Financial Accounting Standards Board Securities & Exchange Commission Executive Committee of the Ethics Division Auditing Standards Board SEC Practice Section The PCAOB

41. Governance Structure Today Financial Accounting Foundation The AICPA U.S. Congress Financial Accounting Standards Board Securities & Exchange Commission Executive Committee of the Ethics Division Auditing Standards Board SEC Practice Section The PCAOB