Auditor Oversight: Proposals for New Regulator

Auditor Oversight: Proposals for New Regulator

Order Code RS21173
Updated April 18, 2002
CRS Report for Congress
Received through the CRS Web
Auditor Oversight:
Proposals for a New Regulator
Mark Jickling
Specialist in Public Finance
Government and Finance Division
Summary
The collapse of Enron Corp. in late 2001 put the obscure topics of corporate
accounting and auditing under intense scrutiny. Through the first half of 2001, Enron’s
public financial statements showed steady profits and fast-growing revenues. In fact, the
company was using dubious accounting maneuvers to conceal both serious business and
investment losses and the size of its debt burden. That these questionable accounting
methods were not exposed and rejected by Enron’s outside auditor has led to calls for
reform in the regulation of corporate financial reporting. Uncertainty in the stock market
has risen, as investors fear the discovery of “other Enrons.” Reforms proposed by
Congress and the executive branch focus on oversight of the independent auditor, whose
responsibility (in the broadest sense) is to certify that a corporation’s accounting
statements reflect its true financial condition. This report provides basic background
information on current regulation of auditors and summarizes alternatives now under
consideration. See CRS Report RS21135 for an overview of Enron-related financial
issues. The report will be updated to reflect new legislative and regulatory
developments.
Federal securities law requires corporations that sell stock or bonds to the public to
disclose detailed information about their financial condition. The most comprehensive
disclosure documents are the registration statements that must be filed with the Securities
and Exchange Commission (SEC) before a public sale of securities can take place, and the
annual reports required of all companies whose securities are traded in public markets.
Two major requirements that apply to these disclosures are that (1) the financial
statements they contain must be prepared in accordance with generally accepted
accounting principles and (2) they must be certified by independent (or outside) auditors.
The independent auditor’s role is to serve as a watchdog, or gatekeeper, and to
provide the markets with assurances about the reliability of corporate financial statements.
To many observers, the failure of firms like Enron and Global Crossing, and the suspicion
that overly “creative” accounting methods may be in wide use, indicate that the watchdog
function of the independent auditor needs strengthening. The regulation of auditors has
become the major locus for post-Enron accounting reform proposals.
Congressional Research Service ˜ The Library of Congress

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Current Regulation of Auditors1
The securities laws give the SEC broad authority to regulate all aspects of accounting
by publicly traded companies, including the performance of independent audits.
Historically, however, the SEC has not attempted to regulate directly, but has relied on
private-sector bodies to set accounting and auditing standards, and to enforce those
standards. The SEC does review corporate disclosure filings, issue staff bulletins that
interpret accounting rules, and impose sanctions on accountants, but it recognizes that
direct supervision of all corporate accounting is beyond its capacity.2
The most comprehensive supervision of auditors of public companies is exercised by
the American Institute of Certified Public Accountants (AICPA) and its SEC Practice
Section (SECPS). These private accounting bodies, while they do have a regulatory and
disciplinary role, do not have the same formal relationship to the SEC as the National
Association of Securities Dealers (NASD) and the stock exchanges. These latter
institutions are explicitly recognized in the securities statutes as “self-regulatory
organizations” (SROs), which must register with the SEC and are charged with specific
responsibilities and duties to maintain fair and orderly markets and protect public investors.
The SEC must approve major changes in NASD or exchange rules, and may impose new
rules upon them if it sees fit. No federal agency exercises this degree of control over
private accounting organizations.
The degree to which the acts or omissions of Enron’s outside auditor contributed to
its collapse is likely to be the subject of complex civil and/or criminal litigation. However,
concerns about independent audits go well beyond Arthur Andersen’s difficulties. The
broad question is whether auditors are an effective barrier to financial reporting that is
opaque, misleading, or, at worst, fraudulent. Are auditors more likely to challenge (or
refuse to certify) financial statements that mask their clients’ financial problems, or to
accommodate corporate management? Do auditing firms (in their dual capacity as
consultants and financial engineers) often help devise structures and transactions that may
meet the letter of the law but allow manipulation of reported profits?3 In the wake of
Enron, the answers to these questions are not clear, and this uncertainty is driving calls for
reform.
1 For more on auditor regulation, see CRS Report RS21120, Auditing and Its Regulators:
Proposals for Reform After Enron, by Bob Lyke.
2 To put the limitations in perspective, consider that Enron paid $25 million for audit services in
2000, while the SEC’s budget that fiscal year was $368 million. Thus, auditing Enron alone would
have consumed nearly 7% of the SEC’s resources – and over 17,000 companies file financial
statements with the SEC.
3 Arthur Andersen billed Enron more than $1 million for advice on the Raptor “special purpose
entity” transactions, which hid (for a time) over $1 billion in losses.

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Proposals for Reforms in Auditor Regulation
Auditor regulation is the preferred target of the many bills introduced post-Enron that
seek to improve corporate financial reporting. The legislative proposals take three distinct
approaches. First, several bills propose to increase auditors’ exposure to civil suits in
cases of securities fraud. Second, other bills seek to reduce conflicts of interest by putting
limits on the kinds of non-audit services that outside auditors can provide to their audit
clients.4 Finally, and the focus of this report, are five bills – and proposals from President
Bush and SEC Chairman Harvey Pitt5 – that would create a new regulator to shift auditor
oversight away from private groups towards direct government oversight.
The proposals for a new auditor oversight body differ in detail. (A side-by-side
comparison of the major features of each proposal appears in table 1 below.) Implicitly,
however, they share a common assumption that the present system of oversight by private
industry groups is inadequate and that a more direct government regulatory role is needed.
Several elements common to all the proposals would remove the control and funding of
auditor oversight from the accounting industry. These include the following:
! A majority of the new regulator’s governing board would consist of non-
accountants.
! The oversight body would either be part of the SEC, or would be under
direct SEC oversight.
! The new regulator would enforce standards of ethics, competence, and/or
independence, and would be responsible for maintaining quality control
in auditing. (An exception is the organization proposed by H.R. 3795,
which would conduct audits itself.)
! The audit regulator’s funding would not depend on voluntary
contributions by accountants and accounting firms.
Any of the proposals, if put into place through legislation or SEC rule making, would
bring to the accounting industry a combination of the kind of self-regulation (with SEC
oversight) that currently applies to stock brokers and exchanges, and direct SEC
regulation of the kind that applies to mutual funds and other aspects of the securities
industry. As Table 1 shows, the mix of self- and direct regulation varies from proposal to
proposal, but any of them would represent a marked change in how independent auditors
– the accounting watchdogs – are themselves watched.
4 An indexed list of Enron-related legislation appears on the CRS website.
5 The President’s proposal (which covers other aspects of accounting as well) was set out in a
speech on March 7, 2002. See [www.whitehouse.gov/news/releases/2002/03/20020307-3.html]
Chairman Pitt’s proposal was set out on January 17, 2002, in a speech, “Regulation of the
Accounting Profession.” See [www.sec.gov/news/speech/spch535.htm].

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Table 1: Proposals for a New Auditor Oversight Body
SEC
President Bush’s
H.R. 3763
H.R. 3795
Chairman’s
Proposal
(Rep. Oxley)
(Rep. Kucinich)
Proposal
New
Private sector
Independent
Public Regulatory
Federal Bureau of
Regulator
regulatory body
Regulatory Board
Organization (PRO)
Audits (FBA)
Membership/
Dominated by
Not specified, but
Accounting
Part of the SEC;
Governance
public
would be under
professionals, and
officers to be
membership
SEC supervision
public members
presidential
(who shall
appointees, with
constitute at least
Senate
2/3 of the
confirmation
governing board)
Scope of
Disciplinary
Ability to monitor,
Only PRO-certified
Would conduct
Jurisdiction
power in cases of
investigate, and
accountants can
annual audits of all
violations of
enforce its ethics
perform
corporations that
ethical and/or
principles (see
independent audits;
report to the SEC
competence
below) by
PRO can impose
standards;
punishing
sanctions on
permanent peer
individual offenders
violators of
review/quality
standards of
control staff
competence, ethics,
or independence
Accounting
No provisions
Would develop
No provisions.
SEC, not FBA,
Standards
standards of ethics
would assume
and competence;
control of generally
CEO to certify
accepted auditing
financial statements
standards
Auditor
No
SEC to strengthen
PRO would review
10-year prohibition
Indepen-
provisions/SEC
independence rules
potential conflicts
on FBA employees
dence
would retain
of interest and
taking jobs with
existing authority
impose sanctions
issuers or
where SEC rules
accounting firms
were violated or
that provide audit-
independence was
related services
impaired.
Source of
Unspecified (but
Unspecified
Self-funded, but not
Fees sufficient to
Funding
private)
solely by the
cover operations
accounting
would be collected
profession
by the SEC from
securities issuers
Source of
Existing SEC
Existing SEC
New legislation
New legislation
Authority
authority
authority

CRS-5
Table 1 (continued): Proposals for a New Auditor Oversight Body
H.R. 3818
H.R. 3970
S. 2004
(Rep. LaFalce)
(Rep. Dingell)
(Sens. Dodd & Corzine)
New Regulator
Public Accounting
Independent National
Independent Public
Regulatory Board
Board of Accountancy
Accounting Board
Membership/
7 board members selected
5 members appointed by
5 board members (no more
Governance
by SEC and Comptroller
SEC – no more than 2 to
than 2 to be CPAs) ,
General; 2 members would
be accountants (who
appointed by SEC, the
be accountants
could not be in current
Fed, and the Treasury
practice)
Scope of
All public accountants who
All accountants who
Under SEC oversight, the
Jurisdiction
perform audits must
prepare SEC-required
board would annually
register with the board,
documents must register
inspect accounting firms
which will establish
and make periodic
that perform audits, review
standards for auditors,
disclosures; board would
selected audits, and issue a
conduct quality reviews
inspect auditing and
public report on its
and direct inspection of
accounting practices of
findings. Public
audits, and inspect
registered firms; board to
accountants who perform
registered public
make and enforce quality
audits must register with
accounting firms
control and audit
the board
standards
Accounting
Board will establish quality
SEC would conduct an
Board would establish
Standards
control and professional
annual review of FASB
auditing and quality
and ethical standards for
(with GAO evaluation of
control standards; SEC
auditors
review process); CEO
would designate a new
and CFO must certify
accounting standard
financial statements
setting board, to be funded
by securities issuers
Auditor
Board would establish
Broad prohibition of non-
Provision of certain non-
Independence
standards for auditor
audit services by
audit services prohibited;
independence. Prohibition
auditors; board to enforce
others permitted if
on provision of many non-
SEC independence rules;
approved by the issuer’s
audit services to audit
auditor rotation required
audit committee
clients
every 7 years
Source of
To be funded by fees on
Registration fees and
Registration fees and
Funding
securities issuers whose
annual dues paid by
annual dues collected from
financial statements must
registered accounting
registered accounting firms
be audited
firms
Source of
Amendments to Securities
New legislation
New legislation
Authority
Exchange Act of 1934

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Latest Developments
On April 16, 2002, the House Financial Services Committee passed H.R. 3763, by a vote of 14-
12. In addition to creating the Public Regulatory Organization described in Table 1, the bill would
require real time disclosure of certain information, including insider transactions, and prohibit
corporate insiders from trading while the company pension fund was “locked down.” The bill directs
the SEC to issue rules to improve the transparency of financial reports, including treatment of off-
balance sheet entities and related-party transactions. GAO and the SEC are directed to study and
report on several issues, including stock analysts, bond raters, corporate attorneys, the role of
investment banks in manipulative accounting, corporate governance, and SEC review of financial
statements and enforcement actions.