Highlights of PCAOB SAG Meeting - FOR FEI BLOG
PCAOB Needs to Start With Clean Sheet, Suggests Hanish; IFRS Isn’t Neurosurgery, Say Big 4; SEC Challenges PCAOB Restatements Study
October 18, 2007
On Oct. 18, 2007, the Public Company Accounting Oversight Board’s (PCAOB’s) Standing Advisory Group (SAG) met to discuss PCAOB’s standard-setting priorities for the upcoming year (outlined in Chief Auditor Tom Ray’s remarks.)
[PRIVATE COMPANIES NOTE: See the end of this Executive Summary for references to the trickle down effect of certain public company accounting and audit issues on private companies.]
The SAG also discussed audit implications of IFRS filings in the U.S. (whether by foreign private issuers without reconciliation, as currently proposed by the SEC, or by U.S. companies, as contemplated in SEC’s Concept Release). Additionally, SAG members discussed a PCAOB staff study of the impact of restatements on the market in the post Sarbanes-Oxley period. The final topic discussed, under ‘emerging issues,’ was a followup discussion from the SAG’s June meeting on developments relating to subprime mortgages, the related impact on the market, and related developments in auditing standards (specifically the Center for Audit Quality (CAQ’s) ‘white papers’ issued October 3).
In his introductory remarks, Ray noted the PCAOB had hired a new SAG coordinator, Judy Howard. He also noted Bella Rivshin of the Office of Chief Auditor would be working with Howard, and thanked Jennifer Rand for her previous work acting as SAG coordinator in addition to her other duties. Ray also introduced Brian Degano as the PCAOB’s newest Associate Chief Auditor, noting Degano previously was in the fraud and forensic areas at Deloitte, and spent a couple years working at the FASB. He noted at the close of the meeting it would be the last meeting for certain SAG members (without naming them) whose terms on the SAG had ended, and that the names of new SAG members and reappointed SAG members would be announced by the end of October.
Unfinished Priorities Remain on Standard-Setting Agenda; Suggestion to Take a “Clean Sheet” Approach, Bring Issuers and Auditors Together in Dialogue
SAG members were concerned that items on PCAOB's priorities list from prior years remain uncompleted. (This year’s priorities list is described in Chief Auditor Tom Ray’s remarks.) SAG members also asked if the PCAOB had sufficient resources to complete their projects. (PCAOB did not respond to this, they simply gathered SAG members’ input.)
Former SEC Chief Accountant Lynn Turner, now a Senior Advisor to Kroll, Inc., evaluated PCAOB’s progress on its standard-setting agenda as follows: “I’d have to give you a D at best on your performance over the past 5 years.” He added, “The [PCAOB] board started off on the right foot, but the profession has moved forward, and rather than being a leader, the board has become a clear-cut, undeniably, follower at this time.” Other SAG members agreed, and suggested the PCAOB try to leverage off work being done by the AICPA's Auditing Standards Board (ASB) and the International Auditing and Assurance Standards Board (IAASB), particularly where those groups were ahead of the PCAOB.
In a somewhat more temperate assessment, John Morrissey, former Deputy Chief Accountant at the SEC and now Managing Director and Controller of Fortress Investments Group, observed, “How quickly we forget the political and operational headwinds this board faced.” Noting the PCAOB’s issuance of its new internal control standard (AS5, replacing AS2), Morrissey added the PCAOB is to be commended for a job well done. “But, having said that, the honeymoon is over,” Morrissey noted, and urged the PCAOB to focus in particular on fair value guidance.
SAG member Arnie Hanish, Chief Accounting Officer at Eli Lilly and Company and Chair of Financial Executives International's (FEI's) Committee on Corporate Reporting (CCR), agreed, saying, “If I were to prioritize the priorities, I would hope given the FAS 157 (Fair Value Measurement) issues being debated right now at the FASB, I would put fair value - and link that in with use of specialists - at the top of the list, because of the need and urgency to get something out.” [NOTE: As previously reported here, FASB voted October 17 NOT to delay the effective date of FAS 157, Fair Value Measurement, although they will consider at a future meeting whether to delay the standard for certain transactions (e.g., nonfinancial assets and liabilities), or for certain constituents (e.g., private companies and/or small public companies). FEI's Committee on Corporate Reporting and Small Public Company Task Force had requested in this letter that FASB delay FAS 157 in its entirety for all companies while implementation issues, such as those being addressed by FASB's Valuation Resource Group (VRG) are being addressed.]
Hanish also suggested the PCAOB start with a ''clean sheet of paper' to consider: “What would we have in the way of approaches to auditing, and more flexibility based on company size, to eliminate certain procedures many of us believe are passé at this point.” His suggestion was echoed by other SAG members. Hanish noted examples the PCAOB could consider addressing included voluminous, boilerplate language used by auditors for their communications with audit committees, saying, “I question whether or not it is serving the purpose for what it was intended, maybe take a fresh look, how effective they are.” Similarly, he noted the “representation letters” that auditors require clients to sign “have gotten out of control from length, breadth, and depth, and have become untenable.”
Additionally, Hanish urged the PCAOB to continue its dialogue with working groups of auditors, issuers and others. However, he suggested there was more to be gained if the PCAOB would bring those groups together for a shared dialogue, vs. keeping them separate. “My perspective is,” said Hanish, “the way things have been set up the last four to five years, because of the mandate you have to police the audit profession, you’ve been reluctant to put the groups together, the auditors and preparers, to find a common ground.” He added, “I would encourage more cohesiveness in that area, I think you’d get a better product.” For additional details on this portion of the meeting, see the separate summary of Part 1 of the SAG meeting.
Audit Firms Gearing Up for IFRS; FASB’s Linsmeier Agrees the One Global Standard Will be IFRS: Some SAG Members Wonder if SEC’s Move May be Premature
SAG members representing Big 4 audit firms indicated that for all intents and purposes, they looked at IFRS adoption as the one ‘global standard’ at some point as being a done deal. They said they are already training on it, and it is not a question of whether, but when it will be the standard in the U.S.
The Big 4 representatives on the SAG generally thought moving to IFRS would require mainly a change in mind-set and behavior on the part of auditors, since IFRS is a relatively -but not exclusively - more principles-based regime, and will involve more judgments vs. following detailed rules.
Bob Kueppers of Deloitte described how in many respects it will be a change in culture to adapt to IFRS, which are conventionally viewed as more principles-based than U.S. standards. As an example, he said, “As awkward as it is today where clients say, tell me where it says I can’t do that, we’ll be in a much less definitive space when we say well, I just disagree with you, my judgment vs. yours, and if you disagree to point where you won’t sign the [audit] opinion, you’ve got a bit of a standoff.”
He observed, “I think there’s general support for more principles based standards, but many are ill-prepared to live in that world - not that its bad, it’s just different,” adding, “I think as an auditor, that’s going to significantly change the way you interface and work to the best you can with your client.”
A Question of Goal-Posts
Vin Colman of PwC said the movement to IFRS “is a reality we’re all going to have to deal with – it’s just a question of when.” Colman also noted he is a member of the Financial Accounting Standards Advisory Council (FASAC), which recently discussed this topic, using the analogy of goal posts: “There are places where you have to be between the goal posts… and there are things where it is acceptable whether you are to the right or left.” Colman said there needs to be transparency around this, to meet investors’ expectations.
David Becker, former General Counsel at the SEC, said, “There is an auditing concern embedded in this - whatever the difference between principles and rules means, and I am not sure it has a great deal of meaning.” Using the goal post analogy, Becker questioned:
- are they narrower?
- do they move?
- are they visible?
“The question is,” posited Becker, “whose judgment is conclusive - and whose judgment is expressed?” He said, “Without confidence that within some range their judgment will be conclusive,” he said, “issuers and auditors are going to press for more guidance, or they will take principles based guidance as if it were rules based, so when you talk about ‘fair presentation’ - you can’t really uncouple that from questions of whose view, and whose view is conclusive.”
KPMG’s Sam Ranzilla said, “There’s a fairly compelling case to move to one set of global standards.” More specifically, he added, “If you are for a single set of global accounting standards,” he added, I’m afraid to deliver the news there is only one option left, and that’s IFRS. “
Ranzilla’s assessment echoed recent comments of FASB Chairman Bob Herz at FEI’s Global Financial Reporting Conference on September 28. Although Herz had been supporting a move to one set of global accounting standards for some time, his remarks at the FEI conference were believed to mark the first time he stated he believed that one set of standards would eventually be IFRS.
FASB board member Tom Linsmeier, speaking in his personal capacity at the SAG meeting (attending the October 18 SAG meeting as FASB’s observer), said he agreed IFRS would become the global standard, even in the U.S., and the complications in having two separate boards (FASB and the IASB), and separate staffs work together, let alone under numerous regulators, could not remain a permanent arrangement.
Although the Big Four firms seemed comfortable with the move to IFRS, other SAG members representing investors, academic institutions, and smaller audit firms voiced a great deal of concern as to whether the U.S. system (auditors, preparers, investors, regulators, and universities) was prepared to move to IFRS and international audit standards, based on a lack of understanding, training and experience in those standards. They suggested the SEC’s consideration of removing the reconciliation requirement for foreign private issuers who currently have to reconcile the financial statements in their SEC filings from IFRS to U.S. GAAP, and any potential move to permit or require U.S. companies to file in IFRS, may be premature, and some believe it would also reduce existing leverage to further converge IFRS with U.S. GAAP.
An interesting exchange took place between SEC Deputy Chief Accountant Julie Erhardt and SAG member Joe Carcello, who serves as Director of Research at the University of Tennessee’s Corporate Governance Center. Erhardt said she wanted to make clear the SEC was not proposing to ‘require’ something, or ‘eliminate’ something in its IFRS proposal, but rather to offer “a third choice to the menu” - which currently permits foreign private issuers (FPI’s) to file in IFRS with reconciliation to U.S. GAAP, or to file directly in U.S. GAAP. The proposed third choice would be to allow FPIs to file in IFRS ‘as published by the IASB’ without reconciliation to U.S. GAAP.
Carcello took issue with Erhardt’s characterization, saying “regulators exist to narrow choices,” adding he also took issue with a related point in a speech by SEC Division of Corporation Finance Director John White to the Practicing Law Institute (PLI) May 2nd, in which White said, “market forces may well be the driver leading companies to select one system over another.”
Carcello argued, “Market forces may be [there] if owners/shareholders could meaningfully impact the decision, but shareholder access looks bleak. Without meaningful shareholder access, too many boards defer to management.” Thus, Carcello said, “A true market doesn’t exist, rather we have a rigged market, where choices may be to maximize management flexibility [implying, to maximize earrings].”
Gaylen Hansen, Director of Accounting and Auditing Quality Assurance, Ehrhardt Keefe Steiner & Hottman PC and a member of the Colorado State Board of Accountancy and the board of directors of the National Association of State Boards of Accountancy (NASBA), outlined some key points from his comment letter sent to the SEC on its IFRS proposal, including concerns about IASB oversight, funding and independence. Referencing the fact that the EU has issued ‘carve-outs’ saying EU companies did not have to follow certain provisions of the IASB’s derivatives standards, and that other countries sometimes adopt their own versions of IFRS, Hansen said: “It’s an illusion to say there is a single [set of] IFRS.”
“What I’ve tried to articulate,” said Hansen, “is there’s another side of this issue at some level that really needs to be examined; I feel we’ve committed ourselves to this whole proposition of going down this path, I wanted to voice my opinion.”
The University of Tennessee’s Carcello applauded Hansen, urging him to send copies of his to people running for U.S. President, particularly because Hansen noted in his comment letter, “[F]or the U.S., adopting IFRS would be tantamount to handing foreign parliaments a significant political role in our standard-setting process.”
Cynthia Richson, President of Richson Consulting Group, said, “I would encourage the PCAOB to use this as opportunity to assert its leadership role,” adding, “If the SEC permits U.S. companies to elect IFRS, that will change the entire landscape.” On the need for education, she noted most of the experts on the SAG indicated they aren’t aware of what the major differences are between U.S. GAAP and IFRS.
“It strikes me as a little remarkable to be considering a standard that requires people to do things for which they are presently untrained,” said David Becker, an attorney with Cleary Gottlieb, and formerly General Counsel at the SEC. He added, “I’m not an auditing expert, but it sounds to me, if I said, we want to give people the option of filing their disclosure documents in French, and we’d say, we need a whole bunch of people who speak French to evaluate them, and there aren’t a whole lot of people that speak French in the audit firms, what’s the cart and what’s the horse?” He added, “It’s rather foolish to give issuers the choice of doing things that perhaps they’re not in a position to evaluate.”
“What strikes me as critical,” said Becker, “is that the PCAOB have a view whether the profession is in a position to discharge its responsibilities, and be able to communicate that view to the SEC.” Without that, he said, “I’m worried there is a whiff of utopianism around this,” making the analogy, “it would be great if we could have everyone speaking Esperanto, but we may not have enough people that speak Esperanto.”
IFRS Isn’t Neurosurgery or Rocket Science, It’s Accounting, Say Big 4
KPMG’s Ranzilla acknowledged, “I appreciate there’s a fear of the unknown,” but said listening to SAG members comments, it sounded like they were talking about ‘taking a bunch of accountants and turning them into neurosurgeons.” He added, “It’s accounting, it’s not all that difficult.”
Turner jumped on this, saying, “I could get over there and kiss Sam [Ranzilla] about how simple [he said] it is, and I look forward to your comment letter to them [SEC] saying it’s very simple and not rocket science.”
It turned out two SAG members have degrees in physics - Rebecca McEnally of CFA Institute, and Dick Dietrich, Chair of the Department of Accounting and MIS at the Ohio State University - and they both agreed IFRS is more challenging than rocket science.
Carcello noted it wasn’t such a smooth transition for European countries, given SEC staff comments on SEC filings telling foreign private issuers they were not in compliance with IFRS as published by the IASB, as noted in the CFA Institutes’ comment letter on the SEC’s proposal.
“The fact that even some multinational companies were not in compliance raises concerns,” said Carcello. He noted, “Maybe the transition from statutory [GAAP] to IFRS wasn’t as seamless as you think,” adding, “If I ever need brain surgery, I hope these folks aren’t holding the scalpel.”
Ranzilla responded, “I think the answer to this question, maybe a bit in defense of earlier comments, … is not that what we do is simple,” but that it is about “taking people who are accountants, with education and experience, and converting them over to understand and apply IFRS.” He said “it is much more about change management, and the ability to apply standards that have more principles.”
PwC’s Colman agreed it’s not neurosurgery. “There are underlying principles … they’re both anglo-basis accounting.” Although there is still some ‘breakage’ between the two sets of rules, he reiterated moving to IFRS “is going to happen …it’s just a matter of time.” The audit firms “have got to deal with this today,” he emphasized, “and we’re changing our philosophy of what we’re doing, we have no choice.”
To meet these demands, Colman noted there is a need for people coming into the profession and in the profession to have more valuation and finance skills, since business transactions are different today, and investors expect auditors to understand the business. Referring to FASB’s new standards for fair value measurement, FAS 157, and its Fair Value Option standard, FAS 159, Colman said, “The 157s, 159s, are forcing a different skill set, whether we like it or not.” He added, “The CPA exam does need to change quicker, if that is the practicality of the impetus for change, we need to do that.”
Ranzilla agreed with Colman’s assessment, that there’s no question the world is moving to one set of global standards, and what those standards will be. Therefore, Ranzilla advised, “The real key is to develop a reasonable plan that takes into acct the needs of preparers and auditors to move to IFRS. The educational system in this case is the tail wagging the dog. What we’re doing as firms with respect to training: we’ve trained thousands of our people in US on IFRS, because, we had to credential them to already apply ‘neurosurgery’ in the form of IFRS. Is it a small undertaking to get our people up to speed on IFRS - no. At times it is mind numbing in terms of volume of training you’ll have to do. The basic question is: are you for a single set of globally accepted standards, and you can say, I’ll wait around for more convergence to occur, or I can fully embrace the option that’s left [IFRS], and put together a plan for this country to meet what’s in the rest of the world.”
The above remarks were similar to FASB Chairman Bob Herz’ assessment shared at FEI’s Global Financial Reporting Conference in September, in which Herz said it was time for the U.S. to declare its intentions around adopting IFRS, and to develop a plan, laying out milestones and a timetable, to work toward that goal. For further details on this part of the SAG meeting, see the separate summary of Part 2 of the SAG meeting.
SEC Challenges PCAOB Staff Study on Restatements in Post-Sarbox Era, And Asks Why PCAOB Would Present a Study Showing ‘Insignificant’ Impact of Misstatements, Restatements
Staff from the PCAOB’s Office of Research and Analysis, including Director Marty Baumann, and Economists Steven J. Byers, PhD and Jana Hranaiova, PhD, presented the results of Byers/Hranoiova’s study of the impact of restatements on study of the impact of restatements on the market in the post-Sarbanes-Oxley era.
The study compared the stock market reaction to restatements pre- vs. post Sarbanes-Oxley, and found a significant reduction in market reaction, particularly negative market reaction, to restatements in the post-Sarbanes Oxley period.
The study also found the effect of a large portion of restatements on the market, in both the pre-Sox and post-Sox periods, to be ‘insignificant.’
SEC Deputy Chief Accountant Zoe Vonna Palmrose, an observer at the SAG meeting, harshly criticized the study, saying the study had failed to consider or ‘control’ for certain factors. SAG members described these factors as: materiality and nature of the restatement, whether other information (such as positive information) had been included with the restatement (e.g., if the restatement was first announced in a 10-K or 10-Q, sometimes called a ‘stealth restatement,’ vs. announced earlier in a Form 8-K; changes in SEC’s 8-K rules which accelerated the deadline for filing Form 8-K, and the potential impact of different methodology of data collection or ‘protocols’ using data gathered by one academic published in 2002, with more recent data gathered separately by the PCAOB staff.
Palmrose, a PhD herself, having taught at the University of Southern California’s (USC) Marshall School of Business, and having served as a member of the Panel on Audit Effectiveness in 2000 (the “O’Malley Panel”, named for its Chair Sean O’Malley), minced no words when she said,
“I find it really curious the PCAOB would come out with a paper that says restatements don’t matter,” stated Palmrose. She added, “I worry why the PCAOB is coming out with a paper that really undermines what it is they’re trying to do in terms of discourage misstatements and restatements by implying they don’t matter,” and asked, “can they [the PCAOB researchers] really tolerate this kind of peer review process that has to be willing to significantly change findings, and is that the best use of resources.” The study met with criticism by other SAG members as well. For further details on this portion of the meeting, see the separate summary of Part 3 of the SAG meeting.
Impact of Subprime Issues Continues to be an Emerging Issues: Recent Guidance from CAQ
At the end of the SAG meeting, as traditionally done at all SAG meetings, the SAG discussed ‘emerging issues.” The only item discussed was a continuation of SAG’s discussion of audit issues relating to the downward trend in the subprime markets and its wider impact on liquidity and the credit markets.
PCAOB staff said they have been meeting with the accounting firms, SEC staff, banking agency staff, and senior staff at the Center for Audit Quality (CAQ - affiliated with the AICPA) on these issues. They noted CAQ released guidance in the form of white papers earlier in October, on issues relating to fair valuing thinly traded securities, to the treatment of off balance sheet entities called “Special Investment Vehicles” (SIVs) under FIN 46R “Consolidation of Variable Interest Entities” and to loan commitments.
Asked whether FASB was going to rethink FIN 46R in light of issues raised with SIVs, FASB observer Tom Linsmeier said FASB was currently looking at whether companies were in compliance with FIN 46R. Former SEC Chief Accountant Lynn Turner said he had met with an analyst who told him required disclosures under FIN 46R were missing from certain filings of sponsors of SIVs, and Turner suggested to SEC observer Palmrose that the SEC look into this. Further details on this portion of the meeting can be found in the separate summary of Part 4 of the SAG meeting.
NOTE FOR PRIVATE COMPANIES
Since half of FEI’s members are from private companies, (info. on our Committee on Private Companies which conducts advocacy, educational and networking programs on behalf of our private company members, is available here) we wanted to provide information in this FEI summary on references to private companies made during the October 18 SAG meeting. Although the PCAOB regulates audit firms registered with the PCAOB to conduct public company audits, and sets standards and conducts inspections of audit firms related thereto, private companies can experience a trickle down effect to the extent that audit firms choose to adopt certain procedures firm-wide in the conduct of all audits which emanate from PCAOB requirements (e.g., documentation or other requirements). Some of the AICPA’s recent standard-setting efforts applicable to private company audits have also attempted to conform to some degree with PCAOB standards. Additionally, private companies may opt to adopt certain practices similar to those required of public companies, or may be asked by third parties (e.g., lenders or independent board members) to adopt certain of those policies. Broad issues like a movement to one global accounting standard (e.g. IFRS) and questions about global auditing standards can have a significant impact on private companies as well.
There were a number of references to the trickle down effect on private companies mainly in the third part of the October 18 SAG meeting, during the discussion of audit implications of IFRS. There was also a general reference in the first part of the SAG meeting (the discussion of PCAOB’s upcoming standard-setting priorities) indicating that some companies are viewing PCAOB standards as the ‘low cost alternative’ to some of the AICPA’s recent standards. Following are points mentioned that related to private companies:
- Ernie Baugh, National Director of Professional Standards for Mayer, Hoffman, McCann P.C., said, “I’m getting questions from Private Companies in using PCAOB standards as the low cost alternative.” [NOTE: This may have been a reference to the AICPA’s eight new auditing standards - Statement of Auditing Standards (SAS’s) No. 104-111. Further information about the eight new SAS’s, called the Risk Assessment Standards, can be found on AICPA’s website here and here.] Separately, Baugh also suggested the PCAOB embark on a codification project, similar to that of the Financial Accounting Standards Board (FASB), to bring together standards and practices for public companies into a ‘reasonable, researchable data base.”
- Gaylen Hansen, Director of Accounting and Auditing Quality Assurance, Ehrhardt Keefe Steiner & Hottman PC and a member of the Colorado State Board of Accountancy and the board of directors of the National Association of State Boards of Accountancy (NASBA) noted, “Our firm is a local practice, with 400 people, we’re doing IFRS work right now.” He added for a firm that size, they were probably unusual in that regard, noting it goes to the issue of being competitive. Besides the impact on public companies, Hansen warned, there could be “A trickle down effect on private companies, government entities, [and other nonpublic entities],” for which “there could be a substantial impact, especially if FASB is totally absorbed into the IASB.” If that were to happen, he asked, “how does that impact that major part of economy [nonpublic companies],” adding “there is a huge concern out there [as to] who would set their [e.g., private companies’] standards going forward, whether it be auditing, ethics, or accounting.”
- Joe Carcello, Director of Research at the University of Tennessee’s Corporate Governance Center, said, “Some colleges may decide they just want to train [accountants] for private companies.” He added, “most colleges and universities are not profit making enterprises, they may just go for a different market.” Carcello cautioned, “there seems to be a shortage of auditors now, think about the unintended consequences” relating to IFRS education or lack thereof.
Updated Oct. 21, 2007 by Edith Orenstein, Director, Technical Policy Analysis, Financial Executives International (FEI), based on listening to the webcast of the PCAOB SAG meeting. This summary does not represent FEI opinion unless specifically stated above.