Introduction to Financial Services: Accounting and Auditing Regulatory Structure, U.S. and International

Introduction to Financial Services: Accounting and Auditing Regulatory Structure, U.S. and International

Updated January 5, 2023
Introduction to Financial Services: Accounting and Auditing
Regulatory Structure, U.S. and International
This In Focus provides an overview of how accounting and
auditing standards are created and regulated in the private
Material misstatement in financial reporting can be
sector, the federal government, and state and local
defined as misleading information on a financial
governments. Different accounting and auditing standards
statement that could potentially affect a reader’s
evolved in the private and public sectors to address the
investment decisions or conclusions about the financial
specific needs of their respective stakeholders. Two policy
status of a firm.
issues that might be of interest to Congress and investors
are also discussed.
Federal Government
Private Sector
The financial statements of the U.S. government and its
The private sector includes publicly traded and private
agencies provide taxpayers and Congress a comprehensive
companies as well as nonprofit organizations. The
view of how the government manages tax and other sources
accounting and auditing standards created for publicly
of revenue and how effective the federal government is at
traded firms are subject to Securities and Exchange
utilizing the resources. The Financial Report of the United
Commission (SEC) oversight.
States Government serves the same essential purpose as the
annual report issued by a publicly traded company—
Federal securities laws require public companies, both
providing a consolidated report of the U.S. government.
domestic and foreign, to share critical information about
The various agencies and departments within the U.S.
their performance on an ongoing basis with investors,
government issue their own reports.
regulators, and other stakeholders. The companies are
required to submit annual reports providing a
Accounting. The accounting standards established by the
comprehensive overview of their performance, including
Federal Accounting Standards Advisory Board (FASAB)
their audited financial statements.
are considered GAAP for federal financial reporting
entities. FASAB was created by the Government
Accounting. The SEC has relied on the private sector to
Accountability Office (GAO), the Department of the
establish and develop Generally Accepted Accounting
Treasury, and the Office of Management and Budget.
Principles (GAAP) in the United States throughout its
history. GAAP are a common set of principles and practices
Auditing. The financial statements of federal agencies and
that measure and report an organization’s economic
the U.S. government are audited by agency inspectors
activities. Currently, the SEC recognizes the Financial
general, GAO, or independent accounting firms. GAO
Accounting Standards Board (FASB) as the designated
issues the Generally Accepted Government Auditing
organization for establishing GAAP for the private sector.
Standards (GAGAS), also commonly known as the “Yellow
Book,” which provide a framework for conducting audits.
Auditing. Private- and public-sector stakeholders need
reasonable assurance that an entity’s financial statements
State and Local Governments
are free of material misstatement, whether caused by error
The Annual Comprehensive Financial Report (ACFR)
or fraud. In the private sector, independent assurance to
issued by a state or local jurisdiction serves the same
shareholders and other stakeholders is provided by a
purpose as the annual report issued by a publicly traded
qualified external party—an auditor. The auditor is engaged
company to its investors. States and territories have the
to give an unbiased professional opinion on whether the
flexibility to choose the accounting and auditing standards
financial statements and related disclosures are fairly stated
that suit their needs.
in all material respects for a given period of time in
accordance with GAAP. Generally Accepted Auditing
Accounting. The voluntary standard-setting body for state
Standards (GAAS) provide standards of practice on how an
and local governments’ accounting standards is the
audit should be conducted.
Governmental Accounting Standards Board (GASB).
Although the SEC requires publicly traded companies to
The Sarbanes-Oxley Act of 2002 (P.L. 107-204) created the
follow the accounting standards created by FASB, state and
Public Company Accounting Oversight Board (PCAOB) as
municipal governments are not required to follow
a self-regulatory organization to provide independent
accounting standards promulgated by GASB. States and
oversight of audits of public companies. The PCAOB also
municipalities can voluntarily adopt GASB accounting
oversees the brokers’ and dealers’ audits, including
standards without any changes, choose not to adopt a
compliance reports. The SEC has oversight authority over
specific standard, or modify a standard as needed.
the PCAOB and approves the board’s rules, standards, and
budget.
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Introduction to Financial Services: Accounting and Auditing Regulatory Structure, U.S. and International
Auditing. State and municipal government audits are
companies from U.S. exchanges after three years of
conducted by either an elected or appointed auditor. Elected
noncompliance. Without any changes to the existing law,
auditors conduct their work at all levels of government
these companies would be delisted from U.S. exchanges
from states to cities and towns. Appointed auditors are often
beginning in 2024.
appointed by the legislature or the chief executive of the
respective municipal organization with the legislature’s
In addition to other Chinese companies that have delisted
consent. State and municipal auditors might follow GAGAS
from U.S. exchanges for various reasons in recent times,
or other audit standards that meet their specific needs.
five State-Owned Enterprises (SOEs) announced in August
2022 that they would voluntarily delist. Another SOE
Policy Issues
delisted in July 2022. Combined, these six SOEs represent
Two policy issues might be of particular interest to
$341 billion in market capitalization.
Congress and investors. The first is the limits encountered
by PCAOB to inspect the work of foreign accounting
ESG Disclosures
(audit) firms that audit the foreign firms listed on the U.S.
Companies, investors, and various stakeholders—including
exchanges. The second is the emerging sustainability
academics and advocacy groups—continually debate
accounting standards for businesses, which encompass
exactly what should be disclosed by public firms. Recently,
environmental, social, and governance (ESG) issues.
issues related to sustainability accounting standards and
increasing shareholder expectations for corporations to
PCAOB Inspection Limits
address material ESG issues are at the forefront of those
Foreign firms accessing U.S. capital markets use foreign
debates. For example, demand for “ESG funds”—funds that
auditors from their home countries to audit their financial
invest in companies deemed to be especially responsible on
records. The SEC and the PCAOB have entered into
ESG issues—continues to increase. Reportedly, ESG funds’
various bilateral or multilateral agreements with more than
assets have surpassed $2.7 trillion globally. Meanwhile, the
50 foreign regulators over the past several years.
SEC continues to scrutinize “greenwashing”—labeling
Nevertheless, the SEC and the PCAOB still face limitations
funds or bonds as ESG investments while the criteria used
with regulators in the People’s Republic of China.
to make the classification are questionable or not disclosed.
For example, the Chinese government restricts the PCAOB
The Sustainability Accounting Standards Board (SASB), a
from inspecting the audit work and practices of PCAOB-
U.S.-based nonprofit, created a set of standards to help
registered accounting firms in China, including Hong Kong.
corporations address increased shareholder interest in ESG
The PCAOB and Chinese financial authorities agreed on a
issues. Over the past few years, there has been some
new Statement of Protocol in 2022. The PCAOB is
consolidation among ESG standards—SASB standards are
expected to reassess the effectiveness of the new protocol.
now part of International Sustainability Standards Board
Meanwhile, according to the U.S.-China Economic and
(ISSB) standards. However, corporate filers with the SEC
Security Review Commission, U.S. exchanges list 262
are not required to follow SASB or ISSB standards.
Chinese companies with $775 billion in total market
Publicly traded firms are subject to certain other ESG-
capitalization as of September 2022.
related disclosure requirements (e.g., GAAP disclosure
requirements). These disclosure requirements might not be
The Statement of Protocol includes commitment from
as relevant for ESG investors’ decisions as compared with
Chinese authorities on four issues:
those created by SASB or other standards developers.
1. Engagement Selection: PCAOB has
One ongoing debate is whether companies should be
discretion to select audit firms and clients
required to make certain ESG disclosures. Proponents of
that it examines.
ESG disclosures suggest that investments in material issues
2. No Redaction: PCAOB can see all audit
(e.g., climate change) can increase shareholder value by
work papers without any redactions. For
differentiating among competitors within each industry.
restricted data, including personally
Critics argue that existing regulations address many of the
identifiable information, there are specific
ESG issues or allow issuers to disclose voluntarily
processes for viewing.
information that is material. Additional disclosures and
reporting requirements, they say, could be an unnecessary
3. Testimony: PCAOB can interview and
regulatory burden.
obtain testimony from audit firm
personnel in China and Hong Kong.
CRS Resources
4. Onward Sharing: Information, including
CRS Report R44894, Accounting and Auditing Regulatory
restricted data, can be shared with the
Structure: U.S. and International
SEC for all purposes, including
administrative and civil enforcements.
CRS In Focus IF11716, Introduction to Financial Services:
Congress passed the Holding Foreign Companies
Environmental, Social, and Governance (ESG) Issues
Accountable Act (HFCAA, P.L. 116-222) to address audit
CRS In Focus IF12212, U.S.-China Auditing Agreement
limitations faced by the PCAOB. HFCAA requires foreign
and Issues for Congress
companies listed in U.S. stock exchanges to be subject to
the same accounting and audit oversight as listed domestic
Raj Gnanarajah, Analyst in Financial Economics
companies. The law requires the SEC to identify each
foreign firm not in compliance and suspend trading of those
IF10701
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Introduction to Financial Services: Accounting and Auditing Regulatory Structure, U.S. and International

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https://crsreports.congress.gov | IF10701 · VERSION 10 · UPDATED