PUBLIC COMPANY AUDITS





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|PUBLIC COMPANY AUDITS |

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|What auditors/audit committees need to know and do to comply. |

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|Regulations Under the Sarbanes-Oxley Act |

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|BY RICHARD I. MILLER AND PAUL H. PASHKOFF |

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|EXECUTIVE SUMMARY |

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|[pic]THE SARBANES-OXLEY ACT OF 2002 is a major reform package mandating the most far-reaching changes Congress has imposed on|

|the business world since FDR’s New Deal. |

|[pic]THE ACT ESTABLISHES THE PUBLIC COMPANY Accounting Oversight Board (PCAOB) to regulate accounting professionals that |

|audit the financial statements of public companies. The new board’s operations are subject to direct and substantial SEC |

|oversight. |

|[pic]ONCE THE SEC DETERMINES THE BOARD IS ORGANIZED and can accept its responsibilities (which could occur prior to April |

|26), public accounting firms have 180 days to register with the board or cease all participation in public company audits. |

|[pic]TWO CRITICAL ISSUES THE SEC AND THE NEW BOARD will need to address relate to providing guidance regarding who is |

|required to register and the treatment of persons associated with public accounting firms, who might include individual |

|accountants or other entities that receive compensation from the accounting firm or participate as an agent of the accounting|

|firm. |

|[pic]PUBLIC ACCOUNTING FIRMS WILL HAVE TO PAY CAREFUL attention to the information on the application for registration with |

|the PCAOB, some of which goes well beyond the scope of what is currently required by state boards of accountancy or the |

|AICPA. |

|[pic]AN IMPORTANT FUNCTION OF THE NEW BOARD includes conducting inspections of registered firms. In addition, it has a full |

|range of sanctions at its disposal, including suspension or revocation of registration, censure and significant fines. |

|[pic]THE SARBANES-OXLEY ACT PROHIBITS ALL REGISTERED public accounting firms from providing audit clients, contemporaneously |

|with the audit, certain nonaudit services, including internal audit outsourcing, financial-information-system design and |

|implementation services and expert services. |

|[pic]THE ACT PROVIDES FOR SIGNIFICANT CORPORATE governance reforms regarding audit committees and their relationship to the |

|auditor, making the audit committee responsible for the appointment, compensation and oversight of the issuer’s auditor. |

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|PAUL H. PASHKOFF is an attorney and associate at Fried, Frank, Harris, Shriver & Jacobson, Washington, D.C. His e-mail |

|address is PashkPa@. RICHARD I. MILLER, JD, is general counsel and secretary of the AICPA. His e-mail address is |

|RMiller@. Mr. Miller is an employee of the Institute and his views, as expressed in this article, do not necessarily|

|reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process |

|and deliberation. |

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|[pic]he Sarbanes-Oxley Act of 2002 is a major reform package mandating the most far-reaching changes Congress has imposed on |

|the business world since FDR’s New Deal. It seeks to thwart future scandals and restore investor confidence by, among other |

|things, creating a public-company-accounting-oversight board, revising auditor independence rules, revising corporate |

|governance standards and significantly increasing the criminal penalties for violations of securities laws. This article |

|highlights the provisions most important to accounting professionals engaged in public company audits. |

|Determining its full scope and impact remains a work in progress on many levels as the SEC undertakes the task of |

|implementing the act. AICPA President and CEO Barry C. Melancon has affirmed the Institute’s commitment to working toward the|

|effective implementation of the act and to rebuilding the faith of investors who depend on accounting professionals for |

|information critical to the capital markets (see “A New Accounting Culture”). |

|THE PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD |

|Sarbanes-Oxley establishes the Public Company Accounting Oversight Board (PCAOB) to regulate accounting professionals who |

|audit the financial statements of public companies. The board’s operations are subject to direct and substantial SEC |

|oversight. It, according to the act, is not a government agency and will be made up of five full-time “prominent individuals |

|of integrity and reputation.” Two members must be or must have been CPAs. The SEC, in consultation with the chairman of the |

|Board of Governors of the Federal Reserve System and the secretary of the U.S. Department of the Treasury, is responsible for|

|identifying the initial board members. The critical task of finding the right individuals for this job is complicated by the |

|requirement that members of the PCAOB refrain from engaging in any other professional or business activity while serving. The|

|SEC must appoint the chairperson and other initial members by October 28, 2002. The board is responsible for, among other |

|things, |

|Timing Is Everything |

|The Sarbanes-Oxley Act says the Public Company Accounting Oversight Board must be organized and SEC-authorized to function on|

|or before April 26, 2003. As soon as the SEC sees that the new board has the capacity to carry out its responsibilities |

|(which could occur prior to April 26), public accounting firms have 180 days to register with the board or cease all |

|participation in public company audits. |

|Accounting firms should not attempt to wait until the 179th day to register because the board has 45 days to act on an |

|application and is permitted to request additional information from an applicant. It would be prudent for accounting firms to|

|allow a sufficient time cushion for the registration process and submit applications no later than the 135th day after the |

|SEC’s determination. |

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|[pic]Registering public accounting firms. |

|[pic]Establishing or adopting—by rules—auditing, quality control, ethics, independence and other standards relating to the |

|preparation of audit reports. |

|[pic]Conducting inspections (the successor to peer review for public companies) of registered accounting firms. |

|[pic]Conducting investigations and disciplinary proceedings. |

|[pic]Imposing appropriate sanctions to enforce compliance with the rules and laws. |

|It is important to note the responsibility for establishing auditing, attestation and quality control standards—a function |

|currently performed by the Auditing Standards Board (ASB)—now rests with the Public Company Accounting Oversight Board. While|

|the new board is required to “cooperate on an ongoing basis” with designated professional groups of accountants and advisory |

|groups engaged in standard setting, it will have authority to amend, modify, repeal or reject any standards suggested by |

|these groups. Accordingly, the board may, but is not required to, continue to allow the ASB to establish these standards. |

|(The AICPA expects to demonstrate to the PCAOB that the Auditing Standards Board is the appropriate body to continue to set |

|auditing standards.) |

|REGISTRATION WITH THE BOARD |

|The Sarbanes-Oxley Act says the Public Company Accounting Oversight Board must take such action necessary to enable the SEC |

|to determine by April 26, 2003 that it is organized and has the capacity to carry out its responsibilities under the |

|legislation. After this determination is made (which could occur prior to April 26), public accounting firms have 180 days to|

|register with the new board or cease all participation in public company audits. |

|Most of the act’s provisions affecting practitioners are effective upon registration with the PCAOB. As a practical matter, |

|however, accounting firms should not attempt to wait until the 179th day to register because the new board has 45 days to act|

|on an application and is permitted to request additional information from an applicant. It would be prudent for accounting |

|firms to allow a sufficient time cushion for the registration process and submit applications no later than the 135th day |

|after the SEC’s determination. Each firm should carefully review its application and request confidential treatment, as |

|permitted under the act, with respect to any proprietary or personal information. |

|Another critical issue the SEC and the board will need to address relates to providing guidance regarding who is required to |

|register. The act says accounting firms that “prepare or issue” or “participate” in the preparation or issuance of any audit |

|report for any “issuer” must be registered. Exactly what is meant by “participate in the preparation…of any audit report,” |

|for example, is not entirely clear. Nor is the act’s definition of “issuer,” which includes any issuer, as that term is |

|defined by the Securities Exchange Act of 1934, whose securities are registered under Section 12 of the Exchange Act, that is|

|required to file reports under Section 15(d) of the Exchange Act or that files a registration statement that has not yet |

|become effective and that has not been withdrawn. Informal conversations with SEC representatives, as well as the Department |

|of Labor, resulted in inconsistent interpretations regarding, for example, whether an employee benefit plan filing a Form |

|11-K would fall within the legislation’s definition of an issuer. |

|THE ASSOCIATED-PERSONS QUESTION |

|Another question left unanswered by the act is the treatment of persons associated with public accounting firms, who might |

|include individual accountants or other entities that, “in connection with the preparation or issuance of any audit report,” |

|receive compensation from the accounting firm or participate as an agent of the accounting firm. But what constitutes |

|compensation in connection with an audit report will not be known until regulations are issued. The act does not require |

|associated persons to register with the board or abide by the legislation’s independence requirements. The act does, however,|

|grant the SEC and the PCAOB authority to extend these requirements to associated persons. Whether or not this authority is |

|exercised will have far-reaching consequences with respect to a variety of services provided to issuers by persons associated|

|with public accounting firms, both domestically and internationally. |

|FOREIGN FIRMS |

|Foreign firms that prepare or furnish audit reports with respect to any issuer are required to register under the act. |

|Further, the Public Company Accounting Oversight Board has discretion to extend the act’s registration requirements to |

|foreign firms that play a “substantial role” in the preparation of audit reports for any issuer. The act also has |

|implications for any U.S.-registered firm that relies on the opinion of a foreign accounting firm in issuing part of any |

|audit report. In such cases, the U.S. firm is deemed to have (1) consented to supplying the audit workpapers of the foreign |

|firm in response to a request by the board or SEC and (2) secured the agreement of the foreign firm to such production as a |

|condition of its reliance on the opinion. This provision remains very controversial because of the opposition of many |

|countries to its broad extraterritorial reach. Further, the deemed consent to production of their documents may be |

|inconsistent with, and in some cases prohibited by, the laws of foreign jurisdictions. Both the PCAOB and the SEC have |

|authority to exempt foreign accounting firms from these requirements, and will undoubtedly be called upon to grapple with |

|this issue in the near future. |

|APPLICATION REQUIREMENTS |

|Public accounting firms will have to pay careful attention to the information on the application for registration with the |

|PCAOB. The following information is required under the new act, some of which goes well beyond the scope of what is currently|

|required by state boards of accountancy or the AICPA: |

|[pic]Names of all audit clients who are issuers. |

|[pic]Annual fees received from each issuer, broken down by audit and nonaudit services. |

|[pic]Financial information as requested by the PCAOB. |

|[pic]A statement of quality control policies for the firm’s auditing and accounting practices. |

|[pic]A list of all accountants participating in any audit report of any issuer, including license or certification numbers. |

|[pic]Information relating to criminal, civil or administrative actions or disciplinary proceedings pending against the firm |

|or any associated person of the firm. |

|[pic]Copies of any periodic or annual disclosures regarding disagreements between the issuer and the firm during the |

|preceding calendar year. |

|[pic]Any additional information specified by the new board. |

|The application must include a consent by the firm to cooperate with the new board with respect to any request for documents |

|or testimony (and an agreement by the firm to obtain similar consents from each person providing any audit services to |

|issuers). Registered firms will be required to update the information contained in the application at least annually. |

|PERIODIC INSPECTIONS |

|One of the central functions of the Public Company Accounting Oversight Board is to conduct inspections of registered firms. |

|They will occur annually for firms that audit more than 100 issuers and at least once every three years for all other firms |

|(the new board has the discretion to adjust these schedules). The inspection concept is fundamentally different from the |

|current peer review. First, it is not firm on firm. Second, it is not strictly remedial. Thus, if the inspectors find any |

|violations of the act, the PCAOB’s rules, federal securities laws, applicable professional standards or the firm’s own |

|quality control policies, these findings may serve as the basis for disciplinary action by the board. In addition, the |

|inspections may include matters subject to ongoing litigation. |

|Interestingly, although the current system of regulation has been criticized for operating outside the public eye, any |

|criticisms or deficiencies relating to a firm’s quality control system will not be made public unless the firm fails to |

|satisfactorily address the issues within 12 months from the date of the inspection report. (There is some question as to |

|whether the new board’s inspection process will satisfy the peer review requirements of certain state accountancy boards.) |

|DISCIPLINARY POWERS |

|The PCAOB’s other major responsibility is its disciplinary function. The new board has a full range of sanctions at its |

|disposal, including suspension or revocation of registration, censure and significant fines. It has authority to investigate |

|any act or practice that may violate the act, the new board’s rules, the provisions of the federal securities laws relating |

|to audit reports or applicable professional standards. These proceedings will generally be confidential, unless for good |

|cause the board orders a public hearing. Although any disciplinary sanctions, accompanied by a supporting statement from the |

|board, would be made public after the process was concluded, the act includes confidentiality provisions protecting most |

|documents prepared or received by the board in connection with an investigation. These materials can, however, be shared with|

|other regulators. |

|FUNDING |

|Accounting firms will pay a registration fee and an annual fee to cover the costs of processing and reviewing applications |

|and annual reports. The bulk of the Public Company Accounting Oversight Board’s funding will be provided through an annual |

|accounting support fee assessed on issuers; these funds will support the board’s inspection program, relieving firms of a |

|financial burden they now bear. The fee will be levied in proportion to each issuer’s equity market capitalization—larger |

|issuers will pay larger fees. These fees also will be used to fund the FASB, which will continue to set accounting standards.|

|DOCUMENT RETENTION |

|There are three separate, and potentially inconsistent, document retention requirements in the act. First, the board is |

|required to adopt rules mandating a seven-year retention period for audit workpapers and “other information related to any |

|audit report, in sufficient detail to support the conclusions reached in such a report.” Second, the board may require |

|retention of additional documents for inspection purposes. Third, the criminal provisions of the act include a five-year |

|retention period for all audit and review workpapers, and the SEC is directed to establish rules relating to the retention of|

|such workpapers by January 26, 2003. These document retention issues may be further complicated by state-level retention |

|requirements. For example, California recently passed a law requiring accountants to maintain certain audit documentation for|

|seven years and accounting firms to write document retention and destruction policies. As the penalties for noncompliance can|

|be severe, it is increasingly important for accounting firms to pay careful attention to the various record retention |

|requirements that may be applicable in the jurisdictions in which they practice. |

|AUDITOR INDEPENDENCE |

|Sarbanes-Oxley prohibits all registered public accounting firms from providing audit clients, contemporaneously with the |

|audit, certain nonaudit services including internal audit outsourcing, financial-information-system design and implementation|

|services and expert services. These scope-of-service restrictions go beyond existing SEC independence regulations. In |

|addition, all other services, including tax services, are permissible only if preapproved by the issuer’s audit committee and|

|all such preapprovals must be disclosed in the issuer’s periodic reports to the SEC. |

|The act also requires auditor (not audit firm) rotation. The lead audit partner and/or the concurring review partner must |

|rotate off the engagement if he or she has performed audit services for the issuer in each of the five previous fiscal years.|

|There is no distinction regarding the capacity in which the audit or concurring partner provided such audit services. |

|Accordingly, services provided as a manager or in some other capacity appear to count toward the five-year period. In |

|addition, the provision applies as soon as the firm is registered, so, absent guidance to the contrary, the audit and |

|concurring partner must count back five years starting with the date in which PCAOB registration occurs. This provision is |

|particularly important because of its potential impact on small accounting firms. The SEC is considering whether or not to |

|accommodate small firms in this area; currently there is no small-firm exemption from this provision. |

|AUDIT COMMITTEES |

|The act provides for significant corporate governance reforms regarding audit committees and their relationship to the |

|auditor, making the audit committee responsible for the appointment, compensation and oversight of the issuer’s auditor. This|

|should fundamentally change the auditor/client relationship. Further, the auditor reports directly to the audit committee, |

|not to management, reinforcing the position that the auditor’s duties run to the shareholders, rather than management. Each |

|member of the audit committee must be independent, and the audit committee must have the authority to hire independent |

|counsel and other advisers. In addition, each issuer must provide appropriate funding, as determined by the audit committee, |

|for compensating the auditor and any advisers retained by the audit committee. The audit committee also must establish |

|procedures for handling complaints regarding accounting or auditing matters and for the confidential submission by employees |

|of concerns regarding questionable accounting or auditing matters. In light of these new increasingly important audit |

|committee responsibilities, the audit committee must forge an effective working relationship between itself and the auditor. |

|The full scope of the act is too expansive to address in this article other provisions such as CEO and CFO certification of |

|financial reports, enhanced financial disclosures, including off-balance-sheet transactions and special purpose entities, pro|

|forma financial information reconciling to GAAP financial statements and auditor reports on management assessments of |

|internal controls. The act mandates the completion of several studies, which may result in additional legislation or rule |

|making. |

|There is no doubt the profession is on the cusp of a new era of accounting regulation. Accordingly, it must appropriately |

|focus on the effective implementation of the Sarbanes-Oxley Act, as well as the challenge of meeting its primary objective: |

|restoring investor confidence. [pic] |

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