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US Securities and Exchange Commission

SEC Chair Gensler Signals Tougher Approach to Regulating Auditors

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

During a speech commemorating the 20th anniversary of the Sarbanes-Oxley Act of 2002, SEC Chair Gary Gensler signaled a tougher approach to regulating auditors. Among other issues, Gensler said that the PCAOB has been historically slow to write robust standards that accountants must follow while auditing public companies’ financial statements. And that is set to change. He said he is encouraged that the current leadership of the PCAOB has an active agenda to update the standards.

When the board was set up about two decades ago, it adopted—on a temporary basis—standards written by the accounting profession, the AICPA. But many of the association’s standards are still the PCAOB’s interim standards today.

“The profession was writing its own rules. That’s an inherent conflict,” Gensler said on July 27, 2022, during the Evolution of Corporate Reporting event hosted by the Center for Audit Quality (CAQ), an affiliate of the AICPA which represents accounting firms that audit public companies.

“Additionally, auditing firms were tasked with ‘inspecting’ each other,” Gensler said. “Naturally, such inspections had conflicts, failing to identify serious shortcomings in auditor independence and audit quality.”

Gensler replaced four of five board members, and in May this year, the PCAOB refreshed its agenda. Among other things, the board said it plans to update almost all of the remaining interim standards. (See New PCAOB Leaders Set Ambitious Standard-Setting Priorities in the May 6, 2022, edition of Accounting & Compliance Alert.)

His views reflect criticisms that the previous board leadership, especially when William Duhnke was chairman, had very few standard-setting activities and was too lenient to the auditing profession. Duhnke was then-SEC Chairman Jay Clayton’s choice to run the PCAOB. Clayton was President Trump’s appointee while Gensler is President Biden’s appointee. The two have different philosophies towards regulation: the former was business-friendly; the latter has been more concerned about investor protection with strong rules.

“I look forward to these critical auditing standard updates. While they have their work cut out for them, I believe that Chair Erica Williams and the Board can live up to Congress’s original vision with respect to standard-setting,” Gensler said. “I hope we can make some progress before Sarbanes-Oxley can legally drink.”

The PCAOB was established after the House passed Sarbanes-Oxley almost unanimously, and the Senate in July 2022 voted 99-0 to make it a law in response to large accounting frauds. When Enron collapsed in December 2001, it was the largest bankruptcy in U.S. history. The company had cooked its books, and its auditors Arthur Andersen let it happen. Then six months later, the SEC brought charges against WorldCom. Other accounting scandals followed at Adelphia and Tyco.

The SEC oversees the PCAOB, which not only sets auditing standards but also have inspection and enforcement authority over accounting firms registered with the board.

“Under the current leadership, the PCAOB has a chance to reinvigorate its enforcement program,” Gensler said. “The work to improve auditing standards, coupled with rigorous enforcement of auditor’s professional and ethical requirements, is essential for investor protection.”

He added that the accounting and auditing cases are an important enforcement focus for the SEC as well, citing a recent action against Ernst & Young LLP for cheating by its auditors “on Certified Public Accountant ethics exams, no less.”

Revisiting Independence Rules?

In his speech, he also touched upon auditor independence and accounting firms’ consulting businesses. Enron revealed that there was weak auditor independence. Many audit firms had consulting contracts with the companies they were auditing because consulting is lucrative business.

Sarbanes-Oxley tasked the SEC to write stronger independence rules. While a number of accounting firms spun off their consulting businesses in the days shortly before and after Sarbanes-Oxley, over the past 20 years, many of these firms went on to rebuild them.

Gensler cited that PCAOB inspections have continued to find problems with independence and a lack of professional skepticism.

“I have asked the PCAOB to consider adding updates for auditor independence standards to their agenda,” he said. “We may need to take a fresh look at the SEC’s auditor independence rules as well.”

While Gensler did not mention a rulemaking during Clayton-era that gave auditors more flexibility in determining their independence, many investor advocates were critical of changes made to Rule 2-01Qualifications of Accountants, in Regulation S-X by the SEC. The PCAOB followed-up with its corresponding changes. (See PCAOB Revises Auditor Independence Rules to Align with SEC’s Rule Changes in the November 20, 2020, edition of ACA.)

It is unclear whether this particular rulemaking will be revisited, but Gensler during a question and answer session said that he wants to take a look at independence requirements holistically.

“I have asked staff and I certainly asked the PCAOB,” Gensler responded. “There’s auditor independence standards at the PCAOB, and then there’s the rule at the Securities and Exchange Commission, and they work together. I have asked both to consider what would be appropriate here, particularly if the PCAOB, in addition to what they laid out earlier this spring, think they would be appropriate to address and update auditor independence standards.”

“In the meantime, I encourage firms to review and enhance their independence protocols with respect to their auditing and consulting practices,” Gensler suggested in his prepared remarks .

China

At the end of his speech, which covered a wide range of provisions in Sarbanes-Oxley, he emphasized that the law requires foreign companies who trade on U.S. markets to comply with American securities laws, targeting China’s long-standing unwillingness to allow PCAOB inspectors to completely inspect Chinese auditors.

“Sen. Sarbanes thought about it — he was always thoughtful — but was unambiguous. Investors should be protected — and should have trust in the numbers — regardless of whether an issuer is foreign or domestic,” said Gensler who was at the time a senior adviser to the senator.

To address the China problem, Congress passed a law. If the PCAOB is unable to inspect or investigate completely, then the auditors’ clients’ shares will be prohibited from trading.

“Going forward, will our markets include Chinese issuers? That still is up to our counterparts in China. It depends on whether they are willing to comply with the requirements of U.S. law to be able to remain in the U.S. markets,” Gensler said.

“While important, any framework [cooperative agreement] is merely a step in the process. In light of the time required to conduct these inspections — as well as to fulfill quarantine requirements — a Statement of Protocol would need to be signed very soon if the inspections have any chance to be completed by the end of this year,” Gensler explained. This could be particularly important as Congress is considering accelerating the … timeline from three years to two years.”

 

This article originally appeared in the July 28, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.

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