Order Code RS21257
July 8, 2002
CRS Report for Congress
Received through the CRS Web
Auditing and Accounting Regulation:
Key SEC Powers
Gary Shorter
Specialist in Business and Government Relations
Government and Finance Division
Summary
Key auditing and accounting reform legislation, S. 2673 (Sarbanes), and H.R. 3763
(Oxley), and proposals for auditor oversight by the Securities and Exchange
Commission (SEC) have been launched to help restore public confidence in a system
of corporate financial accounting tainted by accounting fiascos at companies like Enron,
Tyco, and Worldcom. This report provides background on significant current SEC
regulatory powers in the area of accounting and auditing. It will be updated if there are
changes in SEC authority.
Introduction
Since late 2001, the United States has experienced a level of heightened concern
over accounting shortfalls and failures at publicly traded companies: Accounting fiascos
at companies like Enron, Tyco, and Worldcom have garnered considerable national
attention and either are or will likely be the subjects of federal and congressional probes.
Enron’s auditor, Arthur Andersen, one of only five national auditing firms, is in
significant legal and financial trouble and the recent pace of corporate earning
restatements appears to be unprecedented: There are reports indicating that more than 700
companies restated their earnings between 2000 and mid-year 2002.1 There is also a
widespread perception that at least part of the stock markets’ doldrums is attributable to
investor skepticism over the trustworthiness of corporate financial disclosures.
It is in this environment that Congress is deliberating on two key bills that seek to
restore greater confidence in the integrity of corporate financial disclosures. On April 24,
2002, the House passed H.R. 3763 (Oxley). On June 25th, the Senate Committee on
Banking, Housing, and Urban Affairs reported S. 2673 (Sarbanes). Though they differ
in a number of provisions, both bills would create a new independent panel to regulate
1 For example, see: The Huron Consulting Group, “A Study of Restatement Matters: For the Five
Years Ended December 31, 2001,” June 11, 2002, p. 8, and Jim McTague, “Fixable Flaws,”
Barron’s, Jan. 7, 2002, p. 16.
Congressional Research Service ˜
The Library of Congress
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auditors of publicly traded corporations, under the oversight of the Securities and
Exchange Commission (SEC), the federal regulatory agency that has the statutory
authority to regulate corporate accounting. On June 20, 2002, the SEC itself proposed a
rule that would create a new auditor oversight board through the use of the agency’s
existing authority to regulate the corporate accounting for publicly traded companies.2
In light of these congressional and regulatory developments, this report provides
background on significant SEC regulatory powers in the areas of corporate auditing and
accounting.
Auditing basically consists of examining an organization’s financial documents in
order to determine if the records and reports are valid and if the information is fairly
presented. An independent audit is normally conducted by a certified public accountant
(CPA) who then issues an opinion as to whether the statements accurately and fairly
represent the firm’s operations and financial position. Accountants are also increasingly
engaged in a widening array of other services with differing standards and procedures
relative to audits.3
Financial statement audits of private sector organizations are generally performed
by independent accountants (sometimes called external accountants). Independent
accountants are owners or employees of private sector firms that are separate from the
entities they audit. They are distinct from internal accountants, who work for the entities
being audited, and government accountants, who do most auditing of governmental
agencies. However, independent accountants may perform both internal and government
accounting.
The independent auditors for the public companies that register with the SEC are
charged with using generally accepted auditing standards (GAAS) in their assessment of
audited firms’ status. These are technical, qualitative standards regarding who is to
conduct audits, how audits are to be planned and carried out, and how audit results are to
be reported, which are used by the auditors to examine an issuer’s financial statements.
Auditors also use them to issue opinions on whether as a whole the financial statements
are presented fairly in accordance with generally accepted accounting principles (GAAP).
GAAP are guidelines and rules for use by accountants in preparing financial statements,
that have evolved over years, and are designed to help ensure that financial data are
presented fairly and are comparable from firm to firm and from industry to industry).4 In
expressing an opinion on financial statements, CPAs are required to stipulate whether or
not their statements have been prepared according to GAAP.
While they are different, GAAP and GAAS enjoy a complementary relationship:
The goal of an audit, which is governed by GAAS, is the expression of an opinion on
2 For a comparative look at the provisions in H.R. 3763, S. 2673, and the SEC rule proposal, see:
CRS Report RL31483,
Auditor Reform Proposals: A Side-by-Side Comparison, by Mark Jickling.
3 For more on this, see: CRS Report RS21120,
Auditing and Its Regulators: Proposals for
Reform after Enron, by Bob Lyke.
4 They range from relatively simple conventions like putting assets on the left-hand side of a
balance sheet to complex measurements like computing the liability for employee pensions.
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financial statements, statements normally prepared in accordance with GAAP. As a
consequence, auditors have a strong interest in accounting standards since they must attest
to an entity’s compliance with those GAAP-based standards.
The SEC, the Federal Securities Laws and Corporate
Registration and Financial Disclosure Requirements
In 1933, Congress enacted the Securities Act of 1933 (Securities Act)5, which created
the SEC and required publicly owned companies to file registration statements with the
SEC. Audited financial statements were also required as a part of this process. In 1934,
Congress enacted the Securities Exchange Act of 1934 (Exchange Act),6 which required
companies with registered securities to file periodic reports with the SEC, including
audited financial statements. The law also authorized the SEC to determine the manner
in which such financial statements were to be disclosed. For example, sections of the
Securities Act7 and the Exchange Act8 require that the financial statements of registered
companies be audited by independent public or certified accountants. Sections of the
Exchange Act,9 and the Investment Company Act (ICA),10 give the SEC authority to
prescribe accounting principles to be used in the preparation of required financial
statements.
Establishing “Independence”
The SEC observes that the federal securities laws require, or permit the agency to
require, that financial information filed with us be certified or audited by “independent”
public accountants, and note that this “franchise” has helped to transform independent
auditors into the “gatekeepers” of the nation’s public securities markets. From a public
policy perspective, the SEC has said that there are two related goals of ensuring the
independence of public accountants:1 ) the need to foster high quality audits by
minimizing the possibility that any external factors will influence an auditor’s judgments;
and 2) the need to promote investor confidence in the financial statements of public
companies.
5 15 U.S.C. §§ 77a-77aa. (This and most of the legal citations that follow derive from: The
Securities and Exchange Commission, “Final Rule: Revision of the Commission’s Auditor
Independence Requirements, “ 2001, footnote 34.)
6 15 U.S.C. §§ 78a-78kk.
7 See: Items 25 and 26 of Schedule A to Securities Act, 15 U.S.C. §§ 77aa(25) and (26).
8 See: See: Section 17(e) of the Exchange Act, 15 U.S.C. §§ 78q.
9 See: 15 U.S.C. §§78q.
10 See: 15 U.S.C. §§ 80a-30. The ICA regulates the organization of companies, including
mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose
own securities are offered to the investing public. It requires these entities to disclose their
financial condition and investment policies to investors when stock is initially sold and on an
regular basis thereafter.
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Sections of the Exchange Act11, the Public Utility Holding Company Act of 1935
(PUHCA)12, the ICA,13 and the Investment Advisers Act of 194014 (Advisers Act) give the
SEC the authority to require the filing of financial statements that have been audited by
independent accountants.
Under authority granted to it by the statutes described above, the SEC has done
extensive rulemaking under Regulation S-X, a broad body of SEC-promulgated rules,
which provide the standards that registrant companies and their auditors must comply
with
when they prepare the financial sections of their SEC filings under the Securities Act and
the Exchange Act.15 Under Regulation S-X, the agency has required that certain financial
statements be audited by independent accountants. The Federal securities laws also give
the SEC the authority to define the term “independent” accountant. And various sections
of the Securities Act,16 the Exchange Act,17 PUHCA,18 and the ICA,19 give the SEC the
authority to define the accounting, technical, and trade terms used in the federal securities
laws that have helped to mold the parameters of the definition of an independent
accountant.
The Private Securities Litigation Reform Act of 1995 (PSLR), P.L. 104-67, 20 added
a new section to the Exchange Act that involved financial statements filed under the
Exchange Act’s registration and reporting provisions. Among other things, the PSLR
requires an independent accountant to adopt, in accordance with generally accepted
accounting procedures as modified or supplemented by SEC rules: (a) procedures
designed to provide reasonable assurance of detecting illegal acts that would have a direct
and material effect on the financial statements; (b) procedures designed to identify related
party transactions; and (c) to undertake an evaluation of the issuer’s ability to continue as
a going concern during the ensuing year.
11 See: Sections 12(b)(1)(J) and (K) and 13(a)(2) of the Exchange Act, 15 U.S.C. §§§§ 78l and
78m.
12 See: PUHCA, Sections 5(b)(H) and (I), 10(a)(1)(G), and 14, 15 U.S.C. §§ 79e(b), 79j,
and 79n. Under PUHCA, interstate holding companies engaged, through subsidiaries, in the
electric utility business or in the retail distribution of natural or manufactured gas are subject to
regulation under this Act.
13 See: Sections 8(b)(5) and 30(e) and (g) of the ICA, 15 U.S.C. §§§§ 80a-8 and 80a-29.
14 See: Section 203(c)(1)(D) of the Advisers Act, 15 U.S.C. §§ 80b-3(c)(1). The Advisers Act
regulates investment advisers and generally requires that firms or sole practitioners compensated
for advising others about securities investments with at least $25 million under management
must register with the SEC.
15 For example, see: Article 3 of Regulation S-X, 17 CFR 210.3-01 et seq.
16 See: Section 19(a) of the Securities Act, 15 U.S.C. §§ 77s(a).
17 See: Section 3(b) of the Exchange Act, 15 U.S.C. §§ 78c(b).
18 See: Section 20(a) of PUHCA, 15 U.S.C. §§ 79t(a).
19 See: Section 38(a) of the ICA, 15 U.S.C. §§ 80a-37(a).
20 Securities Exchange Act § 10A(a) P. L. No. 104-67,15 U.S.C. §§ 77a et seq.
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In February 2001, the SEC controversial amendments of Rule 2-01 of Regulation S-
X21 on auditor independence went into effect. The amendments applied to any auditor
whose client files audited financial statements with the SEC, and to any accountant who
provides audit services to a broker/dealer. Among other things, the SEC was concerned
with scenarios in which an auditor has multiple business relationships with an audit client
and would not be considered capable of providing an independent audit opinion on the
client’s financial statements. The amendments restricted independent auditors to no more
than 40% of the internal audit services of a public company client. And they made public
companies’ audit committees responsible for determining whether nonaudit services
(other than those that are banned) impair audit independence. The amendments also
required public companies to disclose in their annual proxy materials the dollar amounts
spent for audit, information technology (IT) consulting, and other nonaudit services.22
Delegation of the Formulation of Accounting
Standards
The federal securities laws give the SEC statutory authority to require financial
reporting, to dictate the form in which financial information is presented in registration
statements and periodic reports, the methods to be followed in the preparation of
accounts, and the definition of accounting terms. But, occasionally, the SEC issues rules
and interpretive releases on the form and content of financial statements through
Regulation S-X and its Codification of Financial Reporting Policies. And the agency’s
staff issue Staff Accounting Bulletins, which are interpretive guidance and practices that
the agency used in implementing its financial reporting disclosure requirements.
However, early in its history, the agency largely opted to rely on accounting standards
established in the private sector as long as such standards had substantial authoritative
support. Since 1973, the Financial Accounting Standards Board (FASB) has been the
designated organization in the private sector that establishes standards for financial
accounting and reporting. An independent, private-sector organization, FASB receives no
federal funding of any kind and has no legislative charter or grant of enforcement power.
The SEC officially recognizes GAAP standards established by FASB as authoritative. It
has specifically stated that the standards promulgated by the FASB and its predecessors
have had “substantial authoritative support” and that principles that are inconsistent with
such standards do not have “substantial authoritative support.”23
Disciplinary Actions
Historically the SEC has largely delegated responsibility to the American Institute
of Certified Public Accountants (AICPA, the major national association of certified
public accountants) to oversee accountants, including those who audit public companies.
However, under its Administrative Rule 102(e) it may disqualify from its practice
21 17 CFR 210.2-01.
22 The Securities and Exchange Commission, “Final Rule: Revision of the Commission’s Auditor
Independence Requirements, “ November, 2001.
23 See: Accounting Series Release No. 150, Fed. Sec. L. Rep. (CCH)¶ 72, 172.
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accountants who are unqualified, lack character or integrity, engage in unethical or
improper professional conduct, or willfully violate (or aid and abet others to violate)
federal securities laws. After conviction on obstruction of justice charges, Enron’s
outside auditor, Arthur Andersen, told the SEC that it would cease practicing before it
by August 31, 2002 unless the agency set an earlier date.24
Under the Penny Stock Reform Act of 1990’s (The Remedies Act, PL. 101-492)
amendments to the Exchange Act, the SEC received authority to seek civil penalties in
federal district court Securities Enforcement Remedies and Penny Stock Reform Act.
Congress buttressed the SEC’s enforcement powers, authorizing administrative civil
penalties and “cease and desist” orders.25 Auditors may be subject to such SEC civil
actions and orders to cease and desist. Under provisions of the Private Securities
Litigation Reform Act of 1995 (PSLR), P.L. 104-67,26 the Exchange Act was amended
so that auditors are required to report to an issuer/client of any illegal act discovered by
the auditor. If the company fails to take the necessary corrective action, the auditor may
be forced to resign or report the misconduct to the SEC. If an auditor fails to discharge
such “whistle blower” duties, it may be subject to SEC administrative sanctions.27
24 CRS Report RS21120,
Auditing and Its Regulators: Proposals for Reform after Enron, by
Bob Lyke.
25 The Remedies Act is codified as 15 U.S.C. § 780. Its cease and desist provisions are
codified as Section 8A(a) of the Securities Act, 15 U.S.C. §77h-1(a)], 15 U.S.C.
§77h-1(a). A cease and desist order is an administrative remedy directing a person to stop
illegal activity and to refrain from engaging in such activity in the future
.
26 Securities Exchange Act § 10A(a) P. L. No. 104-67,15 U.S.C. §§ 77a et seq.
27 See: 15 U.S.C. §§ 78j-l; 15 U.S.C. §§ 78j-l(b)(1)-(3); and 78j-1(d).