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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis. All posts prior to September, 2007 are in the public domain, but after September 4, 2007, only subscribers to The Analyst's Accounting Observer will see all posts going forward. Only selected, occasional posts will be released to the public domain from September 4 forward.

Cox Testimony: A Hint Of Exams To Come
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Posted by: Jack Ciesielski 9/25/2006 6:39 AM
SEC Chairman Christopher Cox testified last Tuesday on the impact of the Sarbanes-Oxley Act before the U.S. House Committee on Financial Services. The testimony got little mention in the press, and what mention it did receive focused on Cox's remarks about the costs of Section 404 examinations. (This article, for instance.)

True enough. His testimony did include a recap of the SEC's efforts to effectively neuter Section 404 for small companies (those with a market cap under $75 million), including their most recent proposal to extend the date by which a firm's auditor must attest on internal controls to the first annual report filed for a fiscal year ending on or after December 15, 2008.

It's hard to accept the reasoning in that action, and it's hard to believe that the implementation of the evaluation of internal controls has been so problematic in small companies. They certainly can't be as complex as their grown-up brethren; the issue is probably that they simply don't have adequate controls and auditors must extend their testing further in expressing an opinion on the financial statements as a whole.

Back to the Cox testimony. What's been under-reported: Cox offered an understated rebuttal to those carping critics citing the recent large IPO listings in foreign markets as evidence that SOX 404 requirements have made American capital markets "non-competitive". (Never mind that investment banking fees can be twice as high in the U.S. compared to Europe.) He commented that some of the same countries enticing firms to list on their home exchanges as a way of avoiding SOX are, in fact, adopting some of its provisions. Some examples:

"Governments in the major markets around the world have established independent auditor oversight bodies like the PCAOB. For example, the European Union recently adopted a directive requiring all EU member states to create an auditor oversight body..."

"Other major capital markets have also recognized the conflicts of interest that some non-audit services create, and the need to place restrictions on these services to improve audit quality. The European Union, the United Kingdom, France, Hong Kong, China, Japan, Australia, Canada, and Mexico have all passed reforms requiring mandatory audit partner rotation, although they vary regarding the details about how this rotation works."

"The United Kingdom, Hong Kong, Australia, Canada, and Mexico have all introduced reforms since 2002 requiring that all members of the audit committee be independent of management."

"A number of countries have even adopted requirements similar to the first half of the controversial Section 404 of the Sarbanes-Oxley Act, which requires management to do its own assessment of internal controls. Several countries, including the United Kingdom, Australia, and Hong Kong, have adopted a comply-or-explain approach to a management assessment. Japan, France, and Canada all now have legislation or regulations requiring a management assessment of internal controls."

Cox also defended the effect that the Act has had on the "tone at the top," saying that the Act's requirements for CEO and CFO certification of the financial statements has stopped corporate buck-passing. He testified that the Act has improved the audit process and improved audit committees.

He also testified that while "[w]e have also become convinced that there are no irreparable problems with Section 404 implementation," the SEC would work with the Public Company Accounting Oversight Board to mitigate the implementation issues that have caused small companies to gag at the prospect of implementing internal control reviews. Cox addressed the next SEC inspections of the PCAOB, hinting that they'll focus on whether the PCAOB is looking for auditor effectiveness in carrying out their inspections of public accounting firm audits of public companies. The SEC's concern is that audits are being done without wasted time and effort:

"We anticipate that the SEC staff's next inspection of the PCAOB will focus on the PCAOB's own inspection program for registered audit firms. In particular, the staff will likely focus on the PCAOB's inspections of audits under PCAOB Auditing Standard No. 2.

This authority to inspect the PCAOB is an important aspect of the Commission's general oversight under Section 107(a) of the Sarbanes-Oxley Act. By focusing our next inspection of the PCAOB on its largest program area — inspections of registered public accounting firms under Sarbanes-Oxley 404 and Auditing Standard 2 — we hope to achieve greater compliance with the Commission's and the PCAOB's own guidance that these audits be risk-based and cost-effective."

In short, carrying out the task of auditing public companies in accordance with the standards set by the PCAOB won't be good enough - they have to be efficiently done as well. Considering that the vast initial job of documenting control systems and getting them in order is now out of the way - at least, for firms above the $75 million market cap threshold - it's reasonable to expect that auditors are moving along the learning curve. We'll see when the PCAOB completes its inspections.
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