February 14, 2014
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The Staff Guidance on Economic Analysis in PCAOB Standard Setting (February 14, 2014) ("Guidance") was prepared by PCAOB staff economists and the Office of General Counsel to provide guidance to PCAOB staff involved in rulemaking. The Chairman has directed the staff to follow the Guidance. The Guidance has not been approved by the Board and does not necessarily reflect the views of the Board, individual Board members or other PCAOB staff. The Guidance is not intended to, does not, and may not be relied upon to create any rights, substantive or procedural, enforceable at law by any party. |
The Board is charged with adopting, by rule, professional practice standards for auditors that serve the public interest and protect investors.[1] High-quality economic analysis helps the Board meet this statutory obligation. Economic analysis helps ensure that regulatory decisions, including whether to adopt new requirements and impose corresponding burdens, are informed by a rigorous review and analysis of the best information available. When changes to the Board's standards are being considered, economic analysis helps tailor the solution to the identified problems, and allows the Board, the Securities and Exchange Commission (SEC), and the public to compare the relative merits of different approaches.
This document was prepared by the PCAOB staff and provides general guidance about the purpose, scope, timing, and process for conducting economic analysis in PCAOB rulemaking.[2] The staff reached the views in this memorandum after considering, among other things, Office of Management and Budget's Circular A-4, guidance for economic analysis in SEC rulemaking prepared by SEC staff,[3] and the relevant legal framework. The analysis described informs, but cannot replace, the judgment the Board exercises when making policy decisions.
The guidance allows for the analysis to be adapted to the specific needs of any particular standard-setting project and, in part, formalizes practices the PCAOB has already begun to implement. Staff in the Office of the Chief Auditor, Office of Research and Analysis, and Office of the General Counsel should continue to work closely to determine the appropriate approach for each standard-setting project.
Section 103 of the Sarbanes-Oxley Act authorizes the Board to adopt professional practice standards "as required by this Act or the rules of the Commission, or as may be necessary or appropriate in the public interest or for the protection of investors." Once adopted by the Board, a new standard must be approved by the SEC in order for it to be effective.
In deciding whether to approve a Board standard, the SEC follows a statutory process that includes notice and consideration of comments from the public. The SEC approves the standard "if it finds that the rule is consistent with the requirements of [the Sarbanes-Oxley] Act and the securities laws, or is necessary or appropriate in the public interest or for the protection of investors."[4] In addition, pursuant to the Jumpstart Our Business Startups Act of 2012 (JOBS Act), in order for the standard to apply to audits of Emerging Growth Companies (EGCs), as that term is defined in Section 3 of the Securities Exchange Act, the Commission must determine "that the application of such additional requirements is necessary or appropriate in the public interest, after considering the protection of investors and whether the action will promote efficiency, competition, and capital formation."[5]
While the Act does not require the Board to follow particular rulemaking procedures, the Board, as a matter of policy, has chosen to use its own notice-and-comment process to develop the standards it submits to the SEC. Standard setting at the PCAOB includes, for example, at least one—and sometimes more than one—opportunity for public comment. These opportunities are afforded through concept releases, proposing releases, and, in some cases, re-proposals, all of which solicit input that the Board considers before it adopts a standard. While not required by law, these procedures serve important values and improve the final product that the Board sends to the SEC for approval.
Economic analysis is performed within this context. The Board undertakes economic analysis not to comply with any specific statutory mandate but to enhance its policymaking process and to inform its decision-making.
Economic analysis at the PCAOB should contain two related components. First, PCAOB releases should include economic analysis of the effects of a standard as it would apply generally. Second, PCAOB releases should discuss the likely economic effects of application of the standard to audits of EGCs. In most cases, the EGC analysis is informed by the economic principles discussed in the general analysis. The EGC analysis should be framed by the terms used in the JOBS Act. That is, the EGC analysis should consider whether application of the standard to audits of EGCs would protect investors and whether it would promote efficiency, competition, and capital formation.
Standard practice in the economic analysis of regulations involves addressing four main elements: (1) the need for the rule, (2) the baseline for measuring the rule impacts, (3) the alternatives considered, and (4) the economic impacts of the rule (and alternatives), including the benefits and costs.[6] These elements are discussed further below.
PCAOB releases must clearly describe the need for standard setting and explain how the proposed standard would meet that need. This statement of need should generally include evidence of the problem and a logical conceptual argument describing how the standard is expected to address the problem.
Usually, the Board's professional practice standards address information-based market failures (i.e., asymmetric, imperfect, or incomplete information) that cannot be effectively corrected without regulatory intervention.[7] Other sources of market failures that might be addressed by rulemaking—though less frequently by PCAOB rulemaking—include market power and externalities.[8] While most standard setting at the PCAOB is intended to address a market failure, regulation can also be justified on other grounds.[9] For the PCAOB, these might include, among other things, improving administrative processes, interpreting a statute the Board administers, or satisfying a legislative mandate.[10]
Properly evaluating the potential economic effects of a new regulatory requirement requires evaluating the world with and without the requirement. This requires establishing a baseline against which impacts can be considered, including the economic attributes of the market being regulated (i.e., the market for public company and/or broker-dealer audit services).[11] The baseline serves as a primary point of comparison for an analysis of the proposed standard.[12]
The discussion of the baseline should include the current regulatory requirements that will be affected by a new regulatory requirement, as well as information available regarding the wider range of audit performance and market behavior that are actually found in practice. The release should describe the key assumptions used in establishing the baseline, along with any uncertainties.[13] Benefits and costs should always be evaluated against the same baseline.[14]
The discussion and analysis of alternative approaches to solving the stated problem being addressed should answer three questions. First, it should explain why standard setting is preferable to another approach, such as providing interpretive guidance or enhancing inspection or enforcement efforts. Second, it should describe why the chosen standard-setting approach is preferable to other reasonable standard-setting approaches. Finally, it should explain the key policy choices made by the Board in determining the details of the standard.
The project team should bear in mind that "[t]he number and choice of alternatives selected for detailed analysis is a matter of judgment" and that "[t]here must be some balance between thoroughness and the practical limits on your analytical capacity."[15] In many cases, the team will informally consider more alternatives than is necessary to discuss in detail in the release.
The alternatives to any given approach will, of course, depend on the facts and circumstances. It may be appropriate, for example, to consider alternatives such as different degrees of stringency, different compliance dates, or different requirements for different sized firms. When developing and evaluating alternatives, the project team should consider whether a standard should apply to audits of EGCs, as well as whether audits of EGCs should be subject to an alternative requirement.
To analyze the economic impacts of the standard and its alternatives, the project team should identify and describe the most likely economic benefits and costs. Economic impacts should be described in terms of incremental changes relative to the baseline. A proposal to amend an already-required audit procedure, for example, should focus on the incremental impacts of the amendment, not on the cumulative impact of the existing and enhanced procedure.
The benefits of a standard generally correspond to the need for standard setting, and should therefore be framed as such. The benefits of a standard that reduces asymmetric information, for example, generally include increases in allocative efficiency in capital markets. Benefits may also include a reduction in monitoring costs and risk premiums more generally that could lead to enhanced capital formation. Benefits of PCAOB standard setting often also include reducing the likelihood of a low-probability but high-impact event, such as a high-profile audit failure, that could increase the cost of capital for issuers generally. There may also be other categories of benefits, including some that are ancillary to the primary purpose for standard setting.
The economic analysis should consider direct and indirect costs. Direct costs are those incurred by the regulated entity to comply with the new standard. The comment process can be especially valuable in identifying the nature and scope of such costs, particularly when commenters describe the factors used to generate any estimates. Indirect costs can be incurred by the regulated entity or by other affected entities. Examples of indirect costs include costs associated with any anti-competitive effects or misallocation of resources. Indirect costs may be more difficult to identify and evaluate than direct costs, but it is important that the economic analysis explore them since they may be substantial and more significant economically than the direct costs.
The discussion of benefits and costs should provide insight on how the approach taken achieves the stated policy objectives as well as significant tradeoffs between alternatives considered. Benefits and costs should be quantified to the extent feasible. OMB has explained that "[w]here all benefits and costs can be quantified and expressed in monetary units, benefit-cost analysis provides decision makers with a clear indication of the most efficient alternative, that is, the alternative that generates the largest net benefits to society (ignoring distributional effects)."[16] Many have noted the difficulty, however, of reliably estimating the costs and benefits of financial regulation.[17]
It may not be feasible to quantify many costs and benefits of PCAOB standards. When costs and benefits cannot be quantified reliably or meaningfully, a well-developed qualitative discussion, along with an explanation of why quantification is not feasible, still allows the Board and those affected by its standards to be more clear about the potential impacts of a policy decision, and results in an improved policy-making process.[18]
The economic analysis should be framed neutrally, be internally consistent, and evaluate costs and benefits even-handedly and candidly, without unsupported, self-serving statements or opportunistic or selective use of evidence or studies. Limitations in any empirical data or academic studies cited in the release should be acknowledged, and data or studies that support a contrary view, if any, should be referenced. Where data or studies conflict, the Board's reasons for crediting some but not others should be explained.
Economic analysis can and should inform each stage of the Board's standard-setting process. As a general matter, economic analysis can bring the greatest benefit if begun early in the process, since it can play a crucial role in defining critical policy questions and in developing and evaluating different approaches to addressing identified problems. Accordingly, economists should be fully integrated into, and be members of, project teams, and assume primary responsibility for the economic analysis. The following discussion describes how economic analysis should evolve throughout the rulemaking process.[19]
PCAOB standard setting generally begins with relatively informal discussions about how to address a particular problem that has been identified.[20] Involving the Board's economists in these discussions, at the earliest stage of a standard-setting project, serves several important purposes.
First, economists should assist in developing a clear understanding of the need for regulatory action, including by evaluating any research or data that suggests Board action is necessary. Economists can then assist in considering the objectives of Board action, and the role that different regulatory approaches can play. Because standard setting usually imposes at least some regulatory burden, it is important to carefully consider alternatives that may be less burdensome. It is expected that in this early assessment process, other actions (e.g., inspections, enforcement, guidance, an Audit Practice Alert) will be evaluated and compared to standard-setting approaches.
Second, when changing professional practice standards is warranted, economic analysis can assist in identifying, evaluating, and comparing the advantages and disadvantages of different standard-setting approaches. The Board could, for example, seek to correct a problem by proposing specific, new audit performance requirements. Depending on the circumstances, the Board might also consider other types of standards or rules that could address the problem (e.g., rules that are intended to mitigate conflicts of interest, increase the likelihood of the audit being performed with due care and professional skepticism, or allow those who contract for and those who benefit from audit services to make more-informed decisions).[21] Within these broad categories of types of standards or rules will be more specific alternatives.
At this stage, the project team should develop, at a high level, the key elements of an economic analysis. This should include a statement of the problem being addressed, including a concise discussion of the economic rationale for standard setting; a discussion of the policy objective and goals to be achieved, along with key anticipated decisions for the Board; an explanation of why the team believes standard setting is the appropriate means for achieving those goals compared to other approaches; a discussion of the staff's recommended approach to standard setting and potential alternatives; and a high-level description of the likely economic impacts.
In a proposing release, the economic analysis should provide sufficient context and framing so that questions posed to the public will elicit useful feedback that can contribute to the economic analysis for the adopting release. The release should also provide the public with an opportunity to review and comment on any research and empirical evidence used to design the proposed standard and/or evaluate its likely economic consequences,[22] and request any additional data that commenters might be in a position to provide. Finally, the proposing release should solicit specific comment on the potential economic effects on EGCs, and ask commenters to express their views on whether the application of the standard to audits of EGCs would protect investors and promote efficiency, competition, and capital formation.
Economic aspects of the proposing release should be drafted by the Board's economists or in close collaboration with them. The Office of Research and Analysis's concurrence in the economic analysis in the proposing release should be obtained for the final draft that is formally circulated to the Board for action.
In an adopting release, the economic analysis should further refine and clarify the economic discussion of the proposed standard. The adopting release should contain a complete economic analysis of the final standard, including appropriate information and, when appropriate, a recommendation to the SEC regarding the applicability of the new standard to audits of EGCs. The economic analysis should also address relevant comments received on the proposed standard. Economic aspects of the adopting release should be drafted by the Board's economists or in close collaboration with them. The Office of Research and Analysis's concurrence in the economic analysis in the adopting release should be obtained for the final draft that is formally circulated to the Board for action.
[1] Section 103 of the Sarbanes-Oxley Act; see also Section 101(a) of the Sarbanes-Oxley Act (establishing the Board "to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports").
[2] The guidance focuses on standard setting, which accounts for most of the Board's rulemaking activity. The principles also apply, however, to rulemaking projects that would impose a substantive requirement through a Board rule rather than a professional practice standard.
[3] Memorandum from Division of Risk, Strategy, and Financial Innovation (now, Division of Economic and Risk Analysis) and Office of the General Counsel to Staff of the Rulewriting Divisions and Offices re: Current Guidance on Economic Analysis in SEC Rulemakings (Mar. 16, 2012) (SEC Staff Guidance).
[4] Section 107(b)(3) of the Sarbanes-Oxley Act.
[5] Section 103(a)(3)(C) of the Sarbanes-Oxley Act. As discussed below, the Board's practice is to consider these factors in the first instance, as they relate to audits of EGCs, when requesting the Commission's approval of new standards.
[6] See, e.g., Office of Management & Budget, Circular A-4 (2003); SEC Staff Guidance; Financial Industry Regulatory Authority, Framework Regarding FINRA's Approach to Economic Impact Assessment for Proposed Rulemaking (2013). Typically, as noted above, PCAOB economic analyses also specifically consider the effects on efficiency, competition, and capital formation of the application of proposed standards to audits of EGCs.
[7] Broadly understood, the audit serves to enhance the reliability of certain information companies disclose, thus addressing the asymmetry of information that exists between a public company's management and its investors.
[8] See, e.g., OMB Circular A-4 at 4 (describing "externality, market power, and inadequate or asymmetric information" as market failures that might be addressed through regulation). "An externality occurs when one party's actions impose uncompensated benefits or costs on another party." Id. "Firms exercise market power when they reduce output below what would be offered in a competitive industry in order to obtain higher prices." Id.
[9] See, e.g., OMB Circular A-4 at 4-5; SEC Staff Guidance at 5.
[10] See SEC Staff Guidance at 5-6. The SEC Staff Guidance also notes that "providing exemptive relief from statutory prohibitions where the Commission concludes that doing so is in the public interest" is a justification for rulemaking.
[11] See, e.g., SEC Staff Guidance at 7.
[12] See id. at 6.
[13] For example, the PCAOB obtains data about firms' methodologies and practices through its inspections and other oversight activities. Sufficient information about variations in current practices, however, may not be available.
[14] See OMB Circular A-4 at 15.
[15] Id.; see SEC Staff Guidance at 9.
[16] OMB Circular A-4 at 2.
[17] See, e.g., SEC Staff Guidance at 10; GAO, Dodd-Frank Act Regulations: Implementation Could Benefit from Additional Analyses and Coordination at 19 (2011) (noting that "the difficulty of reliably estimating the costs of regulations to the financial services industry and the nation has long been recognized, and the benefits of regulation generally are regarded as even more difficult to measure"). Estimates that are unreliable or unsupported may be misleading and should, of course, be avoided.
[18] See, e.g., NERA Economic Consulting, The FSA's Methodology for Cost-Benefit Analysis at 14 (2004) (stating that "[a] great deal of the potential value of CBA lies in the process of thinking through what the impact of the policy is likely to be. The question of how to quantify and value the impacts comes later.").
[19] The Board's recently-established Center for Economic Analysis is also working, along with other PCAOB staff, to develop a post-implementation review program to evaluate the impact of new auditing and professional practice standards.
[20] In many cases, the problem is first identified through the Board's oversight programs, but discussions with the Board's Advisory Groups, the SEC, and other regulators and standard setters have also led to standard-setting projects.
[21] See Sections 102, 103, 201 of the Sarbanes-Oxley Act; see also Executive Order 13563, 76 Fed. Reg. 3821 (Jan. 21, 2011) (including disclosure requirements in list of "regulatory approaches that reduce burdens and maintain flexibility and freedom of choice for the public"); OMB Circular A-4 at 8 (explaining that agencies should consider, among other alternatives, market-oriented approaches rather than direct controls).
[22] The Board uses available research and data not only in economic analysis but more broadly in standard setting and in Board releases.