The Legacy of Sarbanes-Oxley and Its Implications for Dodd-Frank

DATE: March 2, 2012 
SPEAKER(S): Steven B. Harris, Board Member 
EVENT: Conference on Investor and Consumer Protection in the New Financial Marketplace 
LOCATION: Washington, DC 

Thank you for that introduction, Professor Cunningham.

I am honored to be among such accomplished panelists. I am particularly pleased to be here with Harvey Goldschmid, who, as SEC Commissioner in 2002, helped write the rules for much of what we will be discussing today.

The topic of our discussion — the "Legacy of the Sarbanes-Oxley Act" — is certainly timely. This July will be the 10th anniversary of the enactment of that Act, which, among other things, created the Public Company Accounting Oversight Board.

This is a good place for me to tell you that the views I express today are my own and do not necessarily reflect those of the other Board Members or the staff of the PCAOB.

That disclaimer is particularly important because, 10 years ago, I was the Staff Director and Chief Counsel for the Chairman of the Senate Banking Committee, Senator Paul Sarbanes.

History Leading up to the Passage of the Sarbanes-Oxley Act

At that time, the Committee was dealing with the fallout from the collapse of Enron and WorldCom.

Ten years ago last month, the Senate Banking Committee held its first of a series of oversight hearings on "Accounting and Investor Protection Issues Raised by Enron and Other Public Companies."

Little did we know how many "Other Public Companies" would victimize investors that year with careless accounting, insider dealing and questionable perks for executives.

Billions in earnings and assets were restated due to accounting errors and irregularities. These failures translated into staggering lost savings for investors and lost jobs and pensions for many American families — making it clear to Congress that auditor self-regulation had failed.

Let me put this timeframe into context: We were barely six months past the September 11th terrorist attacks and the anthrax mailings that targeted our colleagues in Congress. The United States was at war with the Taliban in Afghanistan, and the administration was preparing for war in Iraq.

And yet the corporate wrongdoing created such public outrage and an outcry for justice that it rose above the noise of war.

As Michael Young points out in his book on financial fraud, "When scandal over the application of accounting principles displaces the topic of war in the national headlines, something has definitely gone awry in the world of financial reporting."[1]

At the time, investors had lost $67 billion in the case of Enron and $161 billion in the case of WorldCom.

People also tend to forget that, in the days before the bill was signed into law, on July 30, 2002, the Dow had dropped almost 1,700 points, losing 18% of its value in just three weeks, from a July 5th high at that time of 9,380 to 7,702 on July 23rd.

In response, the Democratic-controlled Senate and the Republican-led House did something we haven't seen recently: work together to overhaul corporate governance, financial reporting and accounting practices through the Sarbanes-Oxley Act.

The Act strengthens auditors' independence from their audit clients; clarifies the reporting responsibilities of public companies and their management and audit committees; enhances the quality of financial disclosures; limits analysts' conflicts of interest; and stiffens penalties for corporate fraud and white-collar crimes.

The Act also helps to remind auditors that their duty under the law is to serve, first and foremost, the interests of investors — not management. Finally, the Act ended the regime of self-policing in the accounting profession by establishing the Public Company Accounting Oversight Board. The Board's mandate is simple: we are "to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports."

Responsibilities and Accomplishments of the PCAOB

The Act directed the PCAOB to register public company auditors, set the rules for those auditors, "audit," or inspect, the auditors, and, when necessary, discipline the auditors. The Dodd-Frank Act also gave the PCAOB authority over the auditors of brokers and dealers. The Board is in the process of implementing that authority.

From my perspective, as someone who was involved in crafting the Sarbanes-Oxley Act, the PCAOB has achieved an impressive record of accomplishments in response to this directive.

Accounting firms that want to audit public companies or brokers and dealers must be registered with the Board. Today, almost 2,400 accounting firms are registered with the Board, and almost 40 percent of those are located outside the United States.

In the last nine years, the Board has conducted more than 1,700 inspections of those firms. We have published 24 new auditing standards and practice alerts, which primarily address the riskier areas of financial reporting.

And, because we continue to find failures by auditors that violate our rules and standards, our enforcement staff has also been active. Just last month, for example, Ernst & Young agreed to settle a PCAOB disciplinary action and pay a civil penalty of $2 million for audit failures.

The PCAOB's accomplishments go beyond these statistics, however. For example, we approach inspections by first identifying where audit problems are likely to exist and then targeting those potential problem areas when we select audits for review.

Using this approach, the PCAOB has issued thousands of comments to the audit firms, highlighting numerous audit performance issues.

As a result, over the past decade, many accounting firms have revised their audit methodologies in response to identified weaknesses; tailored training programs to focus on how to audit a complex transaction, not just how to account for it; and introduced robust internal inspection programs.

In short, I think it is fair to say that because of the passage of the Sarbanes-Oxley Act and the work of the PCAOB, audit firms are refocusing from serving management and providing non-audit services. They are more focused on their first and foremost responsibility — to perform high quality audits for the protection of investors.

One other noteworthy measure of the PCAOB's success is that since the passage of the Act in 2002, more than 40 countries and jurisdictions around the world have adopted similar regulatory regimes to oversee the accounting profession. While some of those systems differ in structure and approach, the goal is universal — to improve audit quality.

Outstanding Issues

Even though I believe the Sarbanes-Oxley Act has led to better audit quality, there is always more that needs to be done. The number of concerns raised by our inspection staff is on the increase, and we are seeing a troubling rise in the volume of significant audit deficiencies. That may be due to added complexity in financial reporting, or it may be that we are improving our inspections approach. Either way, our findings confirm that, among other things, improvements are still needed in auditor independence, objectivity and professional skepticism, as well as in the supervision and review practices at the firms.

With these findings in mind, the Board issued a concept release last year to solicit public comments on ways that auditor independence, objectivity and professional skepticism can be enhanced, including through a potential requirement that each public company change auditors after a set period of time — for example, maybe 10 years. Many of the companies that found themselves in trouble during the financial crisis had the same auditor for decades and our inspection findings continue to show a lack of independence and skepticism. We also expect to propose new supervision rules in the near future.

In addition, we continue to hear through our Investor Advisory Group that investors want more from auditors. For example, with the lack of any warnings from the auditors in the lead up to the financial crisis, investors have raised questions about the relevancy of the auditor's report and the need to re-evaluate the role of auditors in the capital markets. In response, the Board issued a concept release last year to explore possible revisions to the auditor's report to include more information.

I could go on with a list of the work that remains to be done, but in the interest of time, let me briefly highlight some of the issues that the PCAOB still needs to address. They include:

A number of these issues are currently being considered by the European Union and abroad.


In conclusion, I will defer to the other panelists on how the legacy of the Sarbanes-Oxley Act and the work of the PCAOB may affect the legacy of the Dodd Frank Act.

If there is a common theme for the two pieces of legislation, it may be that lax regulation of accounting and financial reporting in part led to the Sarbanes-Oxley Act, just as lax regulation of excessive or impulsive risk taking by banks and others led in part to the Dodd-Frank Act.

Both of these failures in our financial system have had devastating repercussions for the American people. With those regulatory failures, and the resulting strain placed on American investors, taxpayers and workers in mind, let me close with this thought.

While there is a clear need for continued independent regulation of public company accounting and auditing, I believe we must remember that too many regulations, or overly complex regulations and standards, may not be in the best interest of investors. My goal as a regulator of the auditing profession is to oversee a targeted, effective, cost-efficient, regulatory process that ensures that our financial markets adhere to the highest standards of transparency and efficiency, and remain the most widely admired in the world.

Thank you for your attention. I look forward to the discussion and will be pleased to take any questions.

[1] Young, Michael R, Accounting Irregularities and Financial Fraud, Third Edition, 2006, page 1.