New Rules in Accounting
Introduction
Over the last few years, several factors have caused concern over the reliability of corporate financial statements. The downturn in the economy put additional pressure on management to meet financial targets. The complexity of business structures and transactions and the difficult accounting standards have become too complex for the average financial statement user. The greed and dishonesty of some auditors and high-profile business failures have caused criticism and scrutiny of the relationships between accountants and their clients. The scandals surrounding the business failures have also diminished the public’s confidence in the accounting profession and company management.
Many organizations, including the Securities and Exchange Commission and the American Institute of Certified Public Accountants, have debated over the issues that led to the business failures. There have been countless suggestions of how to correct the problems that caused the failures. In an attempt to restore investor confidence in the capital markets, new rules for accountants and their clients have already been enacted. Numerous studies and proposals are also being considered to strengthen the reliability of audited financial statements.
The rules dramatically change the accounting profession by creating a new private regulatory structure, restricting the services auditors can provide, and imposing larger fines for violators of the rules. The rules will also require public companies to enhance their audit committees and obligate their top management to certify financial statements. The new rules are intended to protect investors by improving the accuracy and reliability of financial statements. The additional costs of compliance and risk will be passed on to companies through increased audit fees, insurance, and salaries, leaving less for investors. The rules intended to protect investors will unfortunately result in additional costs for investors.
The new rules contain a multitude of provisions that will have far-reaching effects on accounting firms and their corporate clients. It seems certain the new rules will force both accountants and management to focus on their responsibility to provide objective and accurate information. The consequences of the rules will be recognized as accounting firms and their corporate clients struggle with compliance requirements, relationships, and profitability.
The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 is significant legislation affecting the accounting profession and its clients. The intention of the act is to protect investors by improving the accuracy and reliability of corporate disclosures. The Act, passed by Congress in July 2002, is a major reform package that will create a public company accounting oversight board, revise auditor independence rules, revise corporate governance standards, and increase criminal penalties for violations of securities fraud.
Public Company Accounting Oversight Board
Title I of the Sarbanes-Oxley Act of 2002 establishes the Public Company Accounting Oversight Board (PCAOB) to regulate the accounting professionals who audit the financial statements of public companies. The PCAOB was established because the SEC felt accountants were not doing an adequate job policing their profession. Now, an independent board will monitor and discipline the profession with stricter requirements, higher costs, and harsher fines.
The PCAOB is comprised of five members. Two members must be or must have been CPAs. The remaining three members must not be or have been CPAs. Each member shall serve on the PCAOB on a full-time basis. No member can be paid a salary or profit from a public accounting firm. The SEC was required to appoint the chairperson and other initial members by October 28, 2002. It is clear the SEC was committed to finding strong leaders to fill the positions. The founding members of the PCAOB are as follows:
· Chair, William H Webster, former judge and head of the FBI and CIA
· Kayla J. Gillan, former general counsel of the California Public Employee’s Retirement system
· Daniel L Goelzer, CPA and attorney, former SEC general counsel
· Charles D Niemeier, CPA and attorney, current chief accountant of the SEC’s enforcement division
· Willis D. Gradison, Jr., a former Ohio congressman (AICPA)
The PCAOB must be organized and authorized by the SEC to function by April 26, 2003.
After the SEC determines the PCAOB is able to carry out its responsibilities, accounting firms will have 180 days to register with the new PCAOB, or cease all participation in audits of public companies. Applications will include the names of the companies the firm audited in the past year, those companies it expects to audit in the current year, and all fees received for services. It will include the firm’s most recent financial information. A statement of the firm’s quality control policies must be included. The application must contain a list of accountants who participate in audits, including any information relating to criminal, civil, or administrative actions against the firm, or any associated person of the firm. The PCAOB may request additional information in the application. Firms will be required to submit updated information at least annually. The PCAOB will collect a registration fee and an annual fee from the accounting firms. These fees will be enough to cover the administrative costs of processing and reviewing the applications and annual reports. An annual accounting support fee assessed on public companies will fund the balance of the costs of the PCAOB.
The PCAOB is responsible for establishing or adopting auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports. Previously, the Auditing Standards Board performed this responsibility. The new PCAOB is required to cooperate with professional groups of accountants and advisory groups when setting standards, but they can also amend, modify, repeal or reject standards suggested by these groups.
The PCAOB is responsible for conducting investigations and disciplinary proceedings and imposing sanctions against firms not in compliance with their standards. Annual quality reviews must be conducted for firms that audit more than 100 public companies. All other firms must have reviews at least every three years. The SEC and the PCAOB may order special inspections at any time. The PCAOB has the authority to investigate any act or practice that may violate the Act, the rules of the PCAOB, or the provisions of the securities laws relating to audit reports or professional standards. Disciplinary sanctions may include suspension or revocation of registration, censure, and fines. The Act contains several provisions relating to penalties and criminal violations of the Act and other federal securities laws. The maximum fine for persons willfully violating the Act was increased from $1 million to $5 million. The maximum prison sentence for violators was increased from ten years to twenty years. The Act also addresses increased penalties for failure to maintain audit work papers for five years; persons who knowingly alter, destroy, or falsify records in connection with a federal investigation; and mail or wire fraud violators.
Complying with the new requirements of the SEC and other agencies will increase the costs of doing business in public accounting. The accounting firms that audit public companies will be required to pay initial registration fees, annual registration fees, and annual accounting support fees to support the PCAOB. Registering and processing the annual updates will cause internal administrative costs to rise. Public accounting firms will also see increased costs in inspections by the PCAOB and costs involved in defending any disciplinary hearings or sanctions. The SEC has the reputation of being burdened with too many cases not investigated or closed timely, due to its lack of resources, staff turnover, and low employee moral. The SEC’s poor reputation is likely to change in the near future. Nyberg claims, “During the next year, the SEC is expected to devise 24 sets of new rules, launch and complete six major studies, shepherd the formation of the new public accounting oversight board, hire 200 new employees, and review one out of three filings. To smooth the way, Congress promised $776 million, which amounts to a 77 percent year-over-year budget increase”. SEC Chairman, Harvey L. Pitt said, “Discipline and quality monitoring must be responsive not to the profession, but to the SEC”. Armed with increased funds, better strategies, and the ability to assess increased fines and penalties, the SEC is in a stronger position to monitor and regulate public companies and their accountants. It is possible many accounting firms will need an internal staff just to ensure compliance. Smaller firms, unable to bear the increase cost of compliance, will cease doing business with public companies or they will merge into larger companies. Accounting firms that continue to provide audit services to public companies will include the additional fees and costs of compliance in their audit fees, causing them to rise. The increased costs absorbed by the company will decrease earnings and dividends paid to the shareholders. The increased cost of filing audited annual and quarterly reports could also discourage small, privately owned companies from entering the public markets and cause some public companies to take their business private.
Auditor Independence
Title II of the Sarbanes-Oxley Act of 2002 addresses auditor independence. The Act states it is unlawful for a registered firm, which is issuing an audit opinion, to perform non-audit services including: bookkeeping, financial systems design and implementation, appraisals or valuations, actuarial services, internal audit outsourcing services, management functions or human resources, investment services, legal and expert services, and any other services determined by the PCAOB. Other services, including tax services, are permissible only if pre-approved by the public company’s audit committee and disclosed in their periodic reports to the SEC. The act also requires the lead audit partner and the concurring review partner rotate off the engagement if he or she had performed audit services for the company in each of the five previous years. In another effort to protect the independence of an audit, the Act makes it unlawful for accounting firms to provide audit services if the client’s CEO, CFO, controller, or chief accounting officer was employed by the auditing firm and participated in the audit of the company during one year prior to the start of the audit.
The Act ends the long debate about the appropriateness of auditors performing non-auditing services, but the rules are likely to cause the costs of conducting audits to rise. Synergies that exist when a firm provides non-auditing services to clients will now be lost because they are now considered an impairment of independence. Accountants that have a comprehensive knowledge of a company, because they perform duel services such as financial information systems design and audits, will no longer be able to capitalize on their efficiencies. Ericson states, “The Investor Responsibility Research Center surveyed more than 1,200 firms in the S&P 500, mid-cap and small cap markets during fiscal year 2000. These companies reported paying a total of $5.7 billion to their auditors, of which 72 percent related to non-audit services, on a weighted average basis”. In the past, accounting firms could present a potential client with proposed audit fee at a discount rate because they anticipated recovering those costs in other more lucrative non-audit services. Many of the larger accounting firms have or will spin-off portions of their consulting businesses. The age of using audits as a loss leader is over. Accountants will be forced to submit the actual costs of the audit in their proposals. It is almost certain audit fees will increase if there are no anticipated profits from other services.
Accounting firms are now required to rotate the lead auditor and reviewing partner off the engagement every five years. This regulation appears to be the result of rigid opposition of a proposal to mandate audit firm rotation. Since the Act doesn’t specify the capacity in which the auditor provided services, services provided as a manager or other capacity would count toward the five-year period. The rotation requirement is especially harmful to smaller regional firms since they don’t have enough SEC audit partners to rotate each five years. The rotation requirement could force some smaller accounting firms to consolidate. Proponents of the rotation requirement argue, if auditors know their work is for a limited period and will eventually be scrutinized by a successor, they would be less likely to sacrifice accounting rules for the sake of a friendly relationship. Advocates of the regulation argue it will cause increased audit fees due to loss of accumulated audit knowledge of the client. While both sides of the argument are credible, the requirement may improve the perceived independence of auditors.
