Lessons from Enron: The Importance of

Proper Accounting Oversight

DATE
July 26, 2006
SPEAKER
Daniel L. Goelzer, Board Member
EVENT
Tokyo American Center
LOCATION
Tokyo, Japan
I am very pleased and honored to have the opportunity to visit Japan and to discuss the importance of proper
accounting oversight with you this afternoon. Both Japan and the United States depend for their prosperity on
free and transparent securities markets. The efficient operation of those markets rests on the financial
information that companies provide to the public. Investors willingness to commit their capital depends on
confidence that financial statements have not been manipulated.
Accountants are critical to maintaining that confidence. As a result of a series of financial reporting scandals in
the late 1990s, the U.S. public lost some of its trust in auditing and financial reporting. The Public Company
Accounting Oversight Board -- the PCAOB -- was created to help restore investor confidence.
I would like to outline the key characteristics of the PCAOB. I would also like to suggest some of the lessons
that we have learned and some of the challenges we still face. Many other countries, including Japan, have
also rethought how they oversee accountants. Of course, each country needs to adapt its oversight system to
its unique needs and traditions. However, I hope that our colleagues in other countries will find the U.S.
experience useful as they address the same issues.

Before I begin, I should note that the views I express are solely my own, and not necessarily those of the Public
Company Accounting Oversight Board, its other members, or the staff.

I. Erosion of Confidence and the Passage of the Sarbanes-Oxley Act

Four years ago this week, the U.S. Congress, by a nearly unanimous vote, enacted the Sarbanes-Oxley Act.
That law created the PCAOB. I want to start with a brief review of some of the factors that caused the
legislation.

It has always been recognized in the United States that auditors have important obligations to the investing
public. Many of the financial reporting failures that led to the Sarbanes-Oxley Act seemed to suggest that
auditors had forgotten their obligations to the public. Most auditors and most accounting firms performed their
work responsibly and professionally. But, during the early part of this decade, there were a series of highprofile financial reporting failures involving major companies and a large number of restatements of audited
financial reports. As a result, billions of dollars in market value disappeared. Investor losses caused a public
outcry. The bankruptcies of Enron and WorldCom, and the collapse of Arthur Andersen, one of the worlds
most prestigious auditing firms, have become symbols of that era.
In every case in of inaccurate public company financial reporting, the question inevitably arose, "Where were
the auditors and why didnt they uncover these problems?" Let me list three factors that, in my view,
contributed to the loss of trust in auditing:

First, audit firms placed increased emphasis on performing consulting services for audit clients.

In many cases, clients were paying their auditors more for consulting than for the financial statement audit.
As a result, the business risks to the firm of angering the client if there was a disagreement about an
accounting issue during the audit became extremely high.

Second, there was downward pressure on auditing fees.

Accounting firms faced considerable pressure to keep the audit fees low. Companies began to view the
audit opinion as merely another commodity to be purchased as cheaply as possible.

Third, firms placed increased reliance on cost efficient auditing.

The tactic of using the audit to gain access to additional, non-audit work, coupled with the difficulty in raising
audit fees, meant that the costs of auditing had to be controlled. That led to less emphasis on traditional
substantive testing. This approach can have disastrous consequences if the auditors judgments about
what to test and where the greatest risks are turn out to be incorrect.
As I mentioned a moment ago, the U.S. Congress responded to declining public confidence by passing the
Sarbanes-Oxley Act. The law made four fundamental changes in the relationship between auditors and public
companies.

First, it sharply restricted the auditors ability to render consulting services to audit clients.

Second, it made the companys audit committee, composed of independent directors, rather than
management, responsible for hiring the auditor.

Third, the Sarbanes-Oxley Act required both management and the auditor to report to the public on the
effectiveness of the companys internal control over financial reporting.

Finally, the new law ended the accounting professions long tradition of self-regulation. In its place, the
Sarbanes-Oxley Act created the Public Company Accounting Oversight Board.

II. Key Characteristics of the Public Company Accounting Oversight Board

I want to describe the Board by listing five of its key characteristics.
First, the Board has some features and responsibilities of a government regulatory agency, but it is not part of
the U.S. government.

Instead, the Board is a private, non-profit corporation. As a result, we have more flexibility in hiring
and decision-making processes than does a government agency.

But, the Board is under the close oversight of a U.S. federal agency, the Securities and Exchange
Commission. The SEC appoints the Board members and must approve the Boards annual budget,
auditing standards, and other rules before they can take effect.

Second, the PCAOB is independent of the accounting profession and the business community.

The Board is not a membership organization of accountants. In fact, the law provides that no more
than two of the five Board members may be accountants. It is also not a self-regulatory organization like
the stock exchanges. The funds needed to operate the Board come mainly from fees charged to public
companies, based on their market capitalization.

The third key characteristic of the PCAOB is its very broad inspection authority.

The accountant oversight system we replaced, called peer review, relied on firms to inspect each
other. Peer review did not look at audits that were the subject of litigation or investigation. In contrast, we
have a full-time staff of experienced auditors to conduct our inspections. We are able to attract very talented
people because Congress authorized us to offer pay and benefits that are competitive with the firms we
inspect.

Further, the Board uses a risk-based approach to selecting audits for review. This means that we look
at the engagements in which the firm faced difficult auditing and accounting issues. We also focus on
internal management that is, how the firm seeks to maintain audit quality and professionalism in its
practice. That can include such things as training, the firms internal inspection program, partner
compensation principles, and the tone and communications of its top management.

At the end of each inspection, the Board must issue a public report. However, the part of the report
that criticizes, or suggests improvements in, a firms quality controls is not public.

The next characteristic of the PCAOB I would like to highlight is our responsibility to set auditing standards.

In many countries, the job of inspecting and overseeing accounting firms and the job of setting auditing
standards are performed by two separate bodies. In contrast, the PCAOB does both. Therefore, we are
able to learn, through our inspections, how auditing standards are being applied in practice and to use that
knowledge in future standard-setting.

Finally, the PCAOB has the power to take strong enforcement action against firms that violate professional
standards.

Firms and individual accountants must take the PCAOB seriously because the Board can impose
severe penalties. Those penalties include monetary fines and suspension or expulsion from public
company auditing. But, we also have discretion as to when to bring an enforcement action and when to rely
on other means to improve audit quality.

Since opening for business in January, 2003, the Board has made considerable progress in putting these
characteristics to work. For example -

We now have over 450 employees, including approximately 200 inspectors. Many of these inspectors
are CPAs with recent public accounting experience.

Over 1,600 accounting firms are registered with the Board, including over 700 non-U.S. firms located
in 81 countries. Thirteen Japanese firms have registered. The Sarbanes-Oxley Act requires us to annually
inspect the nine accounting firms that audit more than 100 public companies. Other firms must be
inspected once every three years, if they are actually engaged in auditing public companies.

We have conducted nearly 400 inspections and issued over 300 inspection reports, representing
reviews of over 1,800 public company audits.

We have brought five enforcement actions.

We have issued four auditing standards, plus rules on auditor independence and rules governing
auditor tax services for audit clients.

III. Lessons and Oversight Challenges

The PCAOB is still new and evolving. However, some lessons are already clear. Also, some major challenges
still face us. I would like to outline five areas in which there are both lessons and challenges.

A. INDEPENDENT OVERSIGHT STRENGTHENS AUDITING

First, I think it is clear that independent oversight strengthens the auditing profession. The knowledge that the
auditors work on every engagement he or she performs may be reviewed in an inspection increases the care
and thought that goes into that work. It also encourages better documentation. Even more importantly, the fact
that the PCAOB may be reviewing how tough auditing and accounting issues were resolved empowers auditors
to resist management pressure to go along with questionable accounting calls or to ignore warning signs that
should be pursued.
But, along with this power to strengthen auditing comes a challenge. It is critical that we administer our
inspection program in a way that respects the role of judgment. Auditing is based heavily on the exercise of
professional judgment in response to the circumstances of the audit. The PCAOB needs to be tough on audit
failure, but to recognize legitimate areas of judgment. We do not want to encourage over-auditing or a
mechanical, checklist approach. Similarly, it is critical that our auditing standards not become overly detailed.

B. SUPERVISORY APPROACH -- INCENTIVES TO IMPROVE

Second, we have already learned that audit quality can usually best be improved by providing incentives, rather
than threatening punishment. The vast majority of auditors and accounting firms are deeply committed to
professionalism and integrity. Oversight should be a catalyst in helping firms to identify weaknesses and
strengthen their practices.
The Sarbanes-Oxley Act contains an example of this kind of incentive to improve. The Act prohibits the Board
from making public disclosure of inspection report criticisms of a firms quality controls, unless the firm fails to
correct the deficiencies within 12 months. This seems to be working well. After the issuance of the Boards
first set of inspection reports, the major U.S. firms discussed candidly with the Boards staff how they could
address the concerns we had identified. Each firm made a detailed written submission describing its efforts in
areas such as audit performance, evaluation and compensation of partners, independence, acceptance and
continuance of clients, and supervision of foreign affiliates.
The Board calls this philosophy the supervisory approach. Under that approach, as long as an auditing firm or
an individual auditor is acting in good faith and is willing to conduct audits in accordance with the PCAOBs
standards, we will generally seek to improve practice quality by making inspection recommendations, rather
than by taking disciplinary action.
The challenge here is to know when to exercise restraint and when to be aggressive. Some violations of the
auditing standards are too serious to rely solely on promises to improve in the future. We have brought
enforcement actions in cases where we did not think more limited steps would work. In those kinds of

situations, the Board must take the harsher enforcement approach. But deciding when to use inspections
reports to encourage improvement and when to use enforcement to punish violations requires careful
judgment.

C. INTERNAL CONTROL AUDITING

The third area of lessons and challenges is internal control auditing. This topic is one that may be of special
interest, in light of the internal control reporting requirements that J-SOX would create in Japan.
I mentioned earlier that one of the things that Congress did to restore investor confidence was to require
management and auditor reporting on the effectiveness of company internal control over financial reporting. To
make that new responsibility work, Congress required the PCAOB to issue an auditing standard on this new
aspect of the auditors responsibilities. One of the lessons we have learned is how difficult it is to balance costs
and the benefits in this area.
The good news is that internal control seems to be improving. In 2005, nearly one in 12 public companies filed
restatements and almost 16 percent of the companies subject to internal control reporting concluded that their
controls were not effective. In 2006, through May 15, that percentage had fallen to about 8 percent. A recent
study suggests that the securities markets place a premium on effective controls. It finds increases in capital
costs of about one percent for companies that report material weaknesses and comparable decreases in those
costs when reported weaknesses are corrected.
However, internal control reporting has come at a high cost. One study has found that, in the first year of
reporting, the average total cost of compliance was $8.5 million for large companies with market caps over
$700 million and $1.2 million for small. While costs fell substantially in the second year, they are still significant
and may be unsustainable for smaller companies. We do not want internal control reporting costs to drive
small companies out of the securities markets.
Making sure that the benefits of internal control auditing can be achieved on a cost-effective basis is one of the
greatest challenges the PCAOB faces.
We intend to take several steps.

The Board has announced that it will amend its internal control auditing standard. We want to make
sure that the auditors work focuses on the controls that prevent or detect the highest risks of material
misstatements in financial reports. We also want the financial statement audit and the internal control audit
to be integrated -- that is, performed as a single process. We are also looking for other ways to make sure
that internal control audits are as efficient as possible.

The Board has also announced that the 2006 inspections of large firms will focus on how firms are
conducting internal control audits. We know the inspection program is a powerful tool. We want to make
sure that we are using it to encourage auditors to do this new job effectively and efficiently.

We recognize that small audit firms may need training to help with the process. The Board plans to
develop guidance for auditors of small companies.

D. THE AUDITOR-AUDIT COMMITTEE RELATIONSHIP

The fourth lesson we have learned is that external accounting oversight cannot be fully effective if the company
itself is not committed to fair and accurate financial disclosure. In that regard, the relationship between the
companys auditor and its independent audit committee is key.
The PCAOB does not oversee public company audit committees. However, the Board wants to strengthen the
auditor-audit committee relationship. We periodically hold educational forums for small company audit
committee members, and we interview audit committee heads as part of our inspections in order to understand
how the committee and the auditor are working together. The inspection program also looks at the information
that auditors provide to audit committees.

E. AUDITING AS A GLOBAL PROFESSION

The final lesson I would like to mention is one that was, of course, clear from the beginning. Auditing is a global
profession. Therefore, it is critical for the Board to work with other auditor oversight bodies. The Board
recognizes that the oversight of the roughly 700 non-U.S. firms that audit SEC registered companies raise
complex issues, including potential conflicts between our laws and those of other the countries.
To address those issues, the Board will rely, to an appropriate degree, on the work of non-U.S. accounting
oversight systems. Exactly how we inspect firms in other countries will be determined in consultation with the
home country regulator on a case-by-case basis. Right now, we are working with our counterparts in many
countries around the world. Here in Japan, we have established an excellent working relationship with the
CPAAOB.
Dealing with a world in which businesses and their auditors operate across borders will be a continuing
challenge. It will require us to be sensitive to how we approach our responsibilities when borders are crossed
and to the sovereignty of other countries. However, I am very optimistic about the benefits we can derive from
working with other auditor oversight bodies.

IV. Conclusion

I want to conclude by suggesting that, ultimately, all of us accountants, public company officials, or regulators
face the same challenge: to foster and maintain public confidence in financial reporting.
Those responsible for investor protection and auditor oversight in other countries may have different
approaches than does the U.S., and those who practice in other countries may face different problems than do
U.S. auditors. However, for all of us building the publics trust and confidence is the goal. Our markets and our
economies are critically dependent on reliable financial information. Therefore, the auditors role is too
important not to get right.