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Sarbanes Oxley Compliance Professionals Association (SOXCPA)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Web: www.sarbanes-oxley-association.com

Dear Member, Today we will start from Thomas J. Curry, Comptroller of the Currency.

The Comptroller of the Currency Speaks to Community Bankers About Risk Management
Remarks by Thomas J. Curry, Comptroller of the Currency, Before the 8th Annual Community Bankers Symposium, Chicago, Illinois Good morning. It’s a pleasure to be here in Chicago, and to have this opportunity to talk about some of the issues affecting community banks. The past few years have been extraordinarily challenging for all financial institutions and for community banks and thrifts in particular. Margins are under pressure, the regulatory environment is evolving, and creditworthy borrowers are hard to find. Commercial real estate, a bread-and-butter product for many community institutions, is still suffering from high vacancy rates, as well as a significant level of problem assets.
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However, the environment is getting better for small banks and thrifts. I don’t want to minimize the difficulties, but we are seeing real improvements in asset quality, liquidity, underwriting, and capital, among other indicators. The number of problem banks is beginning to stabilize, and the volume of problem assets is falling. After the financial crisis and the recession that followed, these steady signs of improvement are welcome indeed. But as the industry moves to a better place, we ought to ask ourselves what it was that differentiated the more than 460 banks and thrifts that failed over the past few years from those that not only survived, but in many cases thrived. Clearly, the ones who made it had stronger capital, better liquidity management, better underwriting, and, in most cases, smaller asset concentrations. They are the ones who stuck to their knitting, served their communities, and didn’t try to reach too far for profits. They are the community banks that maintained their reputations, and were able to build upon their customers’ trust and confidence. But as important as each of those characteristics was, the strength of the community banks that prospered in difficult times came from more than just the sum of those parts. In fact, I would say it was something far more fundamental. They managed to prosper through hard times because they had effective risk management systems in place.
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In one sense, that’s almost self-evident. After all, banking is a business of managing risk, of understanding how decisions that are made today will affect the condition of the bank in the future, and planning accordingly. And importantly, the banks that were successful weren’t those with the fanciest systems. They were the institutions that focused on understanding the risks they were taking on and anticipating the future consequences of those risks. I’d like to spend the rest of my time today on the subject of risk management, and in particular on enterprise risk management. And yes, that’s a subject broad enough to capture almost everything you do in managing your institutions. But I’ll limit my comments to a few specific areas that I think are particularly important today, including capital planning, stress testing, and operational risk, which I’m sure will be more than enough for the time we have available. If you haven’t seen it yet, then I would encourage you to take a look at the OCC’s Semiannual Risk Perspective, which we published for the first time this spring. The report highlights three areas of risk that are front and center for the OCC, and each of them illustrates the importance of enterprise risk management. The first has to do with the aftereffects of the housing-driven boom-tobust credit cycle.

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The second involves the challenge of increasing revenues in a slowgrowth economy, and the third is focused on the potential for banks and thrifts to take excessive risks to improve profitability. None of this is really new: we’ve seen booms turn into busts before, and we’ve dealt with the consequences that followed. And of course, we’ve gone through cycles where revenue growth and earnings were hard to come by, and some banks and thrifts took on inappropriate risks to compensate. But there is something different about this cycle. It’s been far more challenging than any I’ve experienced in my working career, and it has been far more painful to work through it. And for all the improvements we’re seeing, creditworthy borrowers who want loans are still hard to find. This is a time where banks and thrifts of all sizes need to manage their operations carefully to ensure that they aren’t planting the seeds for the next crisis. Reaching out on the risk spectrum for earnings can be problematic. We have seen institutions cutting back on operating controls to enhance income, and this is a cause for concern. And I would say that’s where a strong enterprise risk management or a strong risk assessment system comes in. Enterprise risk management is an integrated approach to identifying, assessing, managing, and monitoring risk in a way that maximizes business success.

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It starts at the top, with the board and senior management making decisions about the institution’s business model and its appetite for risk, but it can’t be successful unless those policies are filtered into the bank’s culture. A strong risk culture is proactive, and it drives the way your bank sets strategy and makes decisions. It also translates into how your management team and employees anticipate and respond to risk throughout the bank. This means that individual risks aren’t considered only within the lines of business or by function, although the board and management can and should think about them in this way. It also means that risk and risk management are considered in their totality across the bank, as well as how different risks are related and interact with one another. So one aspect of enterprise risk management involves sharing information and breaking down the silos. For example, your loan staff should be talking with compliance staff when developing new products or services. This is especially important, and we’ve seen problems in the past when silos prevent these two groups from talking to each other. The fact is, everyone with a vested interest in new product decisions should be involved in the conversation, and that includes your supervisor. The regulatory agencies can be good resources to help you make sure you’ve identified all aspects of new product decisions that should be considered.
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Another key element of risk management involves taking advantage of the guidance issued by the OCC and other regulators and tailoring it to your own unique circumstances. Stress testing is an example. Our guidance describes a variety of methods that community banks can use to stress test their portfolios, and provides one example of a simple stress test framework. However, each institution is different, and every bank and thrift will need to decide for itself what method is most appropriate for its own specific circumstances. The key here—and the purpose of the guidance—was to encourage community banks to do some simple stress testing, and to help them understand how to do it. I want to underscore that we’re not requiring community banks to have the types of sophisticated models and processes that we expect from larger institutions, or that we think banks have to go hire consultants to meet our expectations. What we really want to see is that your banks do consider some form of stress testing or sensitivity analysis of your key loan portfolios on at least an annual basis. The goal is to help you analyze “what ifs”—what happens if a group of borrowers or an industry segment runs into problems—what will be the impact on your loan portfolios, your earnings and your capital. Community banks that have incorporated such concepts and analyses into their credit risk management and strategic and capital planning processes have demonstrated the ability to minimize the impact of negative market developments more effectively than those that did not use stress testing.
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Risk management is also a key element of a bank’s capital planning process, a point that we highlighted in guidance issued earlier in the year. In fact, the first step in capital planning is the identification and evaluation of all material risks. Again, every bank is different in the way it funds itsel f, its willingness to enter new lines of business, or its tolerance for asset concentrations, among other factors. Not every risk can be offset by the addition of capital —overly high CRE concentrations, for example—but once risks are identified, management and the board can begin to assess the institution’s capital needs. Of course, capital isn’t the only buffer available to banks and thrifts to provide a cushion against economic shocks. A well-managed allowance for loan and lease losses is also a vital risk management tool, and it’s one that I hope each of you is monitoring very closely. As the quality of some classes of assets has improved and charge-offs have moderated, there has been a tendency to reduce quarterly provisions, in many cases to levels that are inadequate to cover chargeoffs. It would be short-sighted to say that banks and thrifts can’t engage in some level of reserve releases, given the improvement we’ve seen in the fundamentals, and we at the OCC aren’t saying that. But I have warned on several occasions lately that we are monitoring this trend very closely, and we’re ready to take action if necessary. In this context, let me say that this is a trend each of you should be monitoring as well.
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One of the key lessons of the financial crisis has to do with the importance of capital and reserves. If you are letting your reserves decline rapidly, our examiners will want to see that you have a carefully-considered strategy for matching the allowance to risk in your loan portfolio. Finally, I said toward the outset that I wanted to discuss operational risk.

I doubt that any single area of risk management has occupied as much of my time since I became Comptroller in April as operating risk.
From the foreclosure processing mess to fair lending violations to credit card marketing issues, the risk of loss that results from the failures of people, processes, systems, and external events has become a significant safety and soundness issue. I’m sure that all of you noted that the problems I cited are all ones that involved large banks and thrifts, not community institutions. However, I want to caution each of you to be particularly vigilant about monitoring and managing operational risk, particularly in areas that involve the fair treatment of your customers. Op-risk failures are the surest way to undermine the reputation of your bank, and one of the greatest advantages community banks and thrifts have in today’s marketplace is their reputation. Your customers trust you and want to do business with you, and that is a vital resource that you should protect at all costs. The op-risk example highlights one key aspect of enterprise risk management, and that is the competitive advantage it confers on those who do it well.

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Sarbanes Oxley Compliance Professionals Association (SOXCPA) www.sarbanes-oxley-association.com

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Whether it is taking the steps necessary to safeguard your reputation or matching your long term capital needs against your risk profile, risk management should not be viewed as a defensive strategy, but as a proactive means of gaining a competitive advantage in the market. The reason I am so concerned about all of this is simple. Community banks and thrifts play a vital role in supporting local economies throughout the country, and America’s families and communities can’t be successful unless you are. So our goal in promoting sound risk management is to help ensure that the nation’s smaller banks and thrifts remain healthy, profitable, and strong enough to serve communities across the United States. Thank you.

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Sarbanes Oxley Compliance Professionals Association (SOXCPA) www.sarbanes-oxley-association.com

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SEC Chairman Mary Schapiro to Step Down Next Month
After nearly four years in office, SEC Chairman Mary L. Schapiro announced that she will step down on Dec. 14, 2012. Chairman Schapiro, who became chairman in the wake of the financial crisis in January 2009, strengthened, reformed, and revitalized the agency. She oversaw a more rigorous enforcement and examination program, and shaped new rules by which Wall Street must play. “It has been an incredibly rewarding experience to work with so many dedicated SEC staff who strive every day to protect investors and ensure our markets operate with integrity,” said Chairman Schapiro. “Over the past four years we have brought a record number of enforcement actions, engaged in one of the busiest rulemaking periods, and gained greater authority from Congress to better fulfill our mission.” Chairman Schapiro is one of the longest-serving SEC chairmen, having served longer than 24 of the previous 28. She was appointed by President Barack Obama on Jan. 20, 2009, and unanimously confirmed by the Senate. During her tenure, Chairman Schapiro worked to bolster the SEC’s enforcement and examination programs, among others.
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As a result of a series of reforms, the agency is more adept at pursuing tips and complaints provided by outsiders, better able to identify wrongdoers through vastly upgraded market intelligence capabilities, and more strategic, innovative and risk-focused in the way it inspects financial firms. In each of the past two years, the agency has brought more enforcement actions than ever before, including 735 enforcement actions in fiscal year 2011 and 734 actions in FY 2012. In addition, the SEC engaged in one of the busiest rulemaking periods in decades. Due to new rules now in place, investors can get clear information about the advisers they invest with, vote on the executive compensation packages at companies they invest in, benefit from additional safeguards that protect their assets held by investment advisers, and get access to more meaningful information about company boards and municipal securities. “I’ve been so amazed by how hard the men and women of the agency work each and every day and by the sacrifices they make to get the job done,” added Chairman Schapiro. “So often they stay late or come in on weekends to polish a legal brief, review a corporate filing, write new rules, or reconstruct trading events. And despite the complexity and the intense scrutiny, they always excel at what they do.” As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the agency has implemented a new whistleblower program, strengthened regulation of asset-backed securities, laid the foundation for an entirely new regulatory regime for the previously unregulated derivatives market, and required advisers to hedge funds and other private funds to register and be subject to SEC rules.
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During Chairman Schapiro’s tenure, the agency worked to improve the structure of the market by approving a series of measures that have helped to strengthen equity market structure and reduce the chance of another Flash Crash. Among other things, the Commission for the first time has required the exchanges to create a consolidated audit trail that will enable the agency to reconstruct trading across various trading venues. Chairman Schapiro previously served as a commissioner at the SEC from 1988 to 1994. She was appointed by President Ronald Reagan, reappointed by President George H.W. Bush in 1989, and named Acting Chairman by President Bill Clinton in 1993. She left the SEC when President Clinton appointed her as chairman of the Commodity Futures Trading Commission, where she served until 1996. She is the only person to have ever served as chairman of both the SEC and CFTC. As SEC chairman, Schapiro also serves on the Financial Stability Oversight Council, the FHFA Oversight Board, the Financial Stability Oversight Board, and the IFRS Foundation Monitoring Board.

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The SEC -- Revitalized, Reformed and Protecting Investors
As Chairman of the U.S. Securities and Exchange Commission, Mary L. Schapiro helped strengthen and revitalize the agency; oversaw a more rigorous enforcement program; and, shaped new rules by which Wall Street must play. During her tenure, the agency’s dedicated work force brought a record number of Enforcement actions, swiftly reacted to the May 6, 2010 Flash Crash, and achieved significant regulatory reform to protect investors.

Executive Summary
Reforming and Revitalizing the SEC --During Chairman Schapiro’s tenure, the agency: - Streamlined its enforcement procedures to launch investigations more quickly - Developed its first national, centralized database for all tips and complaints and established an office to triage them - Created specialized enforcement units to harness expertise and experience - Eliminated a layer of management to put more expert attorneys back on the front lines - Modernized its technology and upgraded its case management system
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- Established a new whistleblower program already paying dividends - Established a new division to focus on risk and economic analysis - Created new corporate disclosure units - Bolstered its ranks by hiring more experts in risk management, quantitative analytics, trading, portfolio management, valuation skills -- and stepped up training - Enhanced collaboration by creating cross-agency working groups and making it a criteria for performance evaluations - Created the agency's first-ever Office of the Chief Operating Officer - Improved the agency’s financial reporting, eliminating material weaknesses

Achieved Record Results in Enforcement and Inspections
- Brought a record number of enforcement actions -- including 735 enforcement actions in FY 2011– and a near-record 734 actions in FY 2012 - Returned more than $6 billion since FY 2009 to harmed investors - Obtained more than $11 billion in ordered disgorgements and penalties since FY2009 - Brought an increased average of 50 Ponzi scheme cases each year between FY 2009 and 2012 – more than twice as many as compared to FY 2007 and 2008 - Filed actions against 129 individuals and institutions stemming from the financial crisis, including more than 50 CEOs, CFOs and other senior officers

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- Brought financial-crisis related actions against Fannie Mae and Freddie Mac, State Street, American Home Mortgage, New Century, IndyMac, Bancorp, Countrywide, Brookstreet, Citigroup, Wachovia Capital Markets, Goldman Sachs, Evergreen, J.P. Morgan Securities, Bank of America, Charles Schwab, Morgan Keegan, TD Ameritrade, and others - Brought a record number of enforcement actions against investment advisers - Increased the amount of enforcement actions involving municipal securities - Brought a record number of enforcement actions against investment advisers - Increased the amount of enforcement actions involving municipal securities - Introduced new tools, similar to those used by criminal authorities, to secure the cooperation of persons who are on the “inside” - Prosecuted the largest insider trading scheme ever discovered, winning a record $92.8 million fine in the civil case against the CEO of the Galleon Hedge Fund - Witnessed gains from a new Aberrational Performance Inquiry focused on hedge funds - Embraced a risk-based approach targeting examinations of registered firms, bringing a 50% increase in the rate at which exams result in referrals to the enforcement division - Imposed first-ever penalty against an exchange for rule violations

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- Launched an initiative to address concerns arising from reverse mergers and foreign issuers

Investor-Focused Rulemaking
- Experienced one of the busiest rulemaking periods in decades, including proposing or adopting more than ¾ of the rules required by the Dodd-Frank Act. - Enhanced safeguards for investors’ assets held by investment advisers - Proposed and began adopting an entirely new regulatory regime for the previously-unregulated derivatives market - Required companies to let shareholders weigh in on executive compensation and "golden parachute" compensation arrangements - Required advisers to hedge funds and other private funds to register and be subject to SEC rules – leading to the registration of about 4,000 of them -- and implemented a new reporting regime. - Required companies to disclose their use of conflict minerals and required resource extraction companies to disclose payments to governments - Adopted widely-hailed 2010 rules to enhance the resiliency of money market funds - Curtailed pay-to-play practices by advisers to government clients, like public pension plans - Provided investors with more meaningful and more-timely information regarding municipal securities – and issued a report recommending ways to improve the structure of the municipal securities market
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- Provided investors with more meaningful information about company boards and risk management - Required advisers to provide clients with brochures that plainly disclose such things as the advisers’ business practices, fees, conflicts of interests and disciplinary information - Adopted new rules designed to help revitalize the asset-backed securities market by encouraging better disclosure - Proposed rules to create a new and more equitable framework governing the way in which investors pay the costs for mutual funds to be marketed and sold - Proposed rules to help clarify the meaning of a date in a target date fund’s name and enhance the information in fund advertising and marketing materials in order to assist investors preparing for retirement

Addressed the Structure of the Market
- Approved measures that have helped to reduce the chance of another Flash Crash occurring - Approved single stock and market wide circuit breakers that have helped to limit the impact of technology errors in the market - Clarified up front for investors how and when erroneous trades would be broken - Required broker-dealers to put in place risk controls and effectively prohibited unfiltered access to the exchanges - Required, for the first time, the exchanges to establish a consolidated audit trail system that will enable regulators to track detailed order/trade information across the securities markets
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- Eliminated stub quotes - Set up a new system to collect information that will inform future rulemaking regarding high frequency trading

Reforming and Revitalizing the SEC
Streamlined enforcement procedures to launch investigations more quickly – This eliminated the need for attorneys to obtain clearance from the full Commission before initiating an investigation or commencing settlement negotiations. Developed the SEC’s first national, centralized database for all tips and complaints and set up an office to triage them – The system allows information to be effectively sorted, stored and compared regardless of how the information is received. A new Office of Market Intelligence reviews and analyzes the information to conduct market surveillance, to determine whether to open new investigations or route data to existing investigations, and to discover emerging trends that need to be watched. Created specialized enforcement units to harness experience -- The five new national specialized units allow the enforcement unit to build specialized expertise and institutional experience in areas including Structured and New Products, Market Abuse, Municipal Securities and Public Pensions, Asset Management, and FCPA. They allow the agency to better detect trends, links and patterns related to fraudulent conduct, and to more effectively investigate suspicious activity in these areas. Eliminated a layer of management to put more expert attorneys on the front lines of investigations -- This returned experienced attorneys to investigations and litigation.
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Modernized the agency’s technology and upgraded its case management system – Three systems have been increasing efficiency, including 1) A new eDiscovery system that is giving investigators faster access to information by vastly expanding their ability to parse evidence and drill down on key subjects; 2) An enhanced case management system that is providing a clearer view into the progress of every investigation and enforcement action, as well as aggregated statistics and performance metrics; and 3) A new system, TRENDS, that is helping the National Exam Program become more uniform in the way it does its exams and ensuring that staff enter exams fully prepared. Advocated and established a new whistleblower program that is paying dividends-- A new program, advocated by Chairman Schapiro, incentivized insiders to come forward with information regarding possible securities law violations. The new program has helped to reduce the length of investigations; paid out its first reward; and, generated more than 3,000 tips. Established a new division to focus on risk and economic analysis -- The Division of Risk, Strategy and Financial Innovation serves as the SEC’s “think tank,” improving the agency’s ability to track and respond to new products, trading practices and risks. Staffed with academics, economists and financial industry professionals, this division enhances the SEC’s cost/benefit analysis capabilities. Created new corporate disclosure units – The division that focuses on corporate disclosures set up new groups each to concentrate closely on the largest financial institutions, structured finance products, and capital markets trends. Hired new skill sets and stepped up training -- The agency has brought on board experts in risk management, trading, quantitative analytics,
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portfolio management and valuation skills to help it keep pace with those it regulates. And, it has more than doubled its training resources to ensure that veteran employees are up-to-date on the financial industry’s latest developments. Enhanced collaboration by creating cross-agency working groups and making it a part of performance evaluations -- Chairman Schapiro emphasized the need for collaboration to ensure rulemakings and studies benefit from the insight of the full spectrum of agency expertise. She also created a host of cross-functional teams to develop the tips and complaints database, establish requirements for the new consolidated audit trail, conduct the Muni Field hearings; address life settlements; and, study how to establish a fiduciary duty for both Investment Adviser and broker-dealers. She also incorporated collaboration criteria into performance evaluations. Created the agency's first-ever Office of the Chief Operating Officer – This position has enhanced agency efforts -- around information technology, financial reporting and records management -- to refocus resources and make the agency more efficient and effective. Improved the agency’s financial reporting, eliminating material deficiencies -- The SEC improved its internal controls, as the GAO reported that the agency had no material weaknesses for the second year in a row, and no significant deficiency in the area of information systems, a key area for strong financial reporting.

Overseeing a Successful Enforcement and Exam Program
Brought a record number of enforcement actions – In FY 2011, the agency brought 735 enforcement actions -- more than at any time in the agency’s history. And, in FY 2012, it brought a near-record 734 actions.
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Returned more than $6 billion to harmed investors -- Since FY 2009, the agency has identified and tracked down investors who were harmed by wrongdoing, and returned $6.75 billion to them. Obtained more than $11 billion in ordered disgorgements and penalties – The agency obtained $2.4 billion in FY 2009; $2.85 in FY 2010; $2.8 billion in FY 2011; and $3.1 billion in FY 2012. Brought an increased average of 50 Ponzi scheme cases --Between FY 2009 and 2012, the agency brought approximately 50 Ponzi cases each year, up from 22 per year between 2007 and 2008. Filed actions against 129 individuals and institutions stemming from the financial crisis -- The actions resulted in $2.6 billion in disgorgement, penalties and other financial relief. The institutions involved in the SEC’s credit crisis cases included Fannie Mae and Freddie Mac, J.P. Morgan Securities, Goldman Sachs, State Street, American Home Mortgage, New Century, IndyMac, Bancorp, Countrywide, Brookstreet, Citigroup, Wachovia Capital Markets, ICP Asset Management, Taylor, Bean & Whitaker, Evergreen, Bank of America, Charles Schwab, Evergreen, Morgan Keegan, and TD Ameritrade, and Stifel, Nicolaus & Co. Brought actions against more than 50 CEOs, CFOs and other senior officers in connection with the financial crisis – The agency has charged individuals in all but 8 of the financial-crisis related cases it has brought. A $67.5 million settlement with the former Countrywide Financial CEO resulted in the largest-ever penalty paid by a public company’s senior executive in an SEC settlement. Brought a record number of enforcement actions against investment advisers -- The SEC filed record numbers of enforcement actions against investment advisers and investment companies in FY 2011 and 2012.
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Increased the amount of enforcement actions involving municipal securities -- In FY 2012, the SEC filed more than double the number of enforcement actions related to municipal securities than it filed the previous year. Included in these actions were charges against the former mayor and city treasurer of Detroit in a pay-to-play scheme involving investments in the city’s pension funds, and Goldman Sachs for violations of various municipal securities rules resulting from undisclosed “in-kind” noncash contributions that one of its investment bankers made to a Massachusetts gubernatorial candidate. Encouraged greater cooperation with insiders -- The agency introduced new cooperation tools, similar to those used by criminal authorities, to secure the cooperation of persons who are on the ‘inside.’ This program is helping investigators to obtain information and the assistance of witnesses earlier in investigations, enabling the agency to build stronger cases more quickly. The SEC used this tool for the first time, among many, in 2010 when it charged a former executive of Carter’s Inc. with financial fraud – but not the company, which cooperated with the agency. Detected and prosecuted the largest insider trading scheme ever discovered – The agency won a record $92.8 million fine in the civil case against Raj Rajaratnam, Galleon Hedge Fund CEO. Rajaratnam’s parallel criminal conviction resulted in an 11-year prison sentence and $64 million in fines and forfeitures. In addition to Rajaratnam, the SEC has won civil judgments or negotiated favorable settlements with other traders, analysts, researchers and high-ranking executives. SEC support helped lead to pleas and criminal convictions for more than 50 other members of the conspiracy, including former Goldman Sachs
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board member and former Managing Director of McKinsey & Company, Rajat Gupta. The number of SEC insider trading actions filed since October 2009 have been the most in SEC history for any three-year period. Witnessed gains from a new Aberrational Performance Inquiry – This collaborative effort-with Risk Fin and the exam unit--uses quantitative analytics to search for hedge fund advisers whose claimed returns are unusual enough to raise a red flag. For instance, in 2011, as a result of a sweep, the agency charged four hedge fund advisers for inflating returns, overvaluing assets and other actions that materially misled and harmed investors. In 2012, the SEC charged three advisory firms and six individuals as part of this initiative to combat investment adviser fraud. Embraced a risk-based approach for targeting examinations -- By making its program more risk-based, the examination program has seen a 50% increase in its rate of referrals to the enforcement unit. The new program developed and improved algorithms that use publicly available data from registered entities to target those whose behavior is consistent with increased risk of unethical or illegal actions. Imposed first-ever penalty against an exchange – The penalty stemmed from rules violations that gave certain customers an improper head start on trading information. Launched an initiative to address concerns arising from reverse mergers and foreign issuers --Deregistered the securities of nearly 50 companies and filed more than half a dozen fraud actions against foreign issuers and executives since the initiative began.

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Engaging in One of the Busiest Rulemaking Periods
Experienced one of the busiest rule-writing periods in decades -- In both 2010 and 2011, the Commission proposed and/or adopted about 70 rul es, concept releases or interpretive releases each year. In addition, the Commission proposed or adopted about 80% of the rules required by the Dodd-Frank Act, including adopting 36 rules, proposing more than 39 other rules and conducting 15 studies required by the Act. Enhanced safeguards for investors’ assets -- In cases where registered investment advisers retain custody of a client’s assets, advisers are now required to hire an independent public accountant to conduct an annual "surprise exam" to verify those assets actually exist. In addition, the adviser must obtain a written report -- prepared by an accountant registered and inspected by the Public Company Accounting Oversight Board -- assessing the safeguards that protect the clients' assets. The agency has proposed similar rules for registered broker-dealers who retain custody. Proposed an entirely new regulatory regime for the previously unregulated derivatives market – The agency has laid the groundwork for an entirely new system that includes defining a series of terms related to security-based swaps; establishing a process for clearing transaction, trading on execution facilities and storing data in repositories; developing standards for operating and governing of clearing agencies; specifying steps that end-users must follow when engaging in transactions; and establishing registration requirements. Required companies to let shareholders weigh in on executive compensation -- The agency adopted rules allowing shareholder to approve executive compensation and "golden parachute" arrangements.
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It also joined with other regulatory agencies to propose rules requiring certain large financial institutions to disclose the structure of their incentive-based compensation practices, and prohibit such institutions from maintaining compensation arrangements that encourage inappropriate risks. In addition, the agency adopted rules requiring exchanges and national securities associations to prohibit the listing of any equity security of an issuer that does not comply with new compensation committee and compensation adviser requirements. Required advisers to hedge funds and other private funds to register and be subject to SEC rules – leading to the registration of about 4,000 of them -- The SEC adopted rules requiring advisers to hedge funds and other private funds to register with the SEC as part of the Dodd-Frank Act. As a result, the agency can now see the full landscape of hedge funds, rather than just a sliver based on those who registered voluntarily. In tandem with the CFTC, the Commission also adopted a new rule that would require hedge fund advisers and other private fund advisers to report systemic risk information to the Financial Stability Oversight Council. The SEC adopted a rule defining “family offices” that will be excluded from the definition of an investment adviser under the Investment Advisers Act. The SEC also adopted a rule defining advisers to “venture capital funds,” who are required to report basic information to the SEC and the public. Required companies to disclose their use of conflict minerals and required resource extraction companies to disclose payments to governments – The SEC adopted rules, under the Dodd-Frank Act, that require companies to disclose annually whether they use “conflict
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minerals” that originate from the Democratic Republic of the Congo or adjoining countries because of concerns that the exploitation and trade of these minerals by armed groups is helping to finance confl ict in the region and is contributing to a humanitarian crisis. The agency also adopted rules under the Dodd-Frank Act that require resource extraction companies to disclose payments to governments. Adopted widely-hailed rules to enhance the resiliency of money market funds -- The SEC adopted rules to make money market funds more resilient by strengthening credit quality, liquidity and maturity standards, as well as introducing stress testing requirements and mandating new reporting of money market fund holdings. In addition, the SEC made available to investors the detailed information about a fund's investments and the market-based price of its portfolio known as its "shadow NAV" (net asset value) or mark-to-market valuation. The Chairman also called upon the Financial Stability Oversight Council to act to make such funds less susceptible to destabilizing runs like occurred during the credit crisis. Curtailed pay-to-play practices by advisers to government clients, like public pension plans The agency prohibited the use of campaign contributions and related payments to influence the awarding of contracts for the management of public pension plan assets and similar government investment accounts. Provided investors with more meaningful and more-timely information regarding municipal securities – The Commission expanded existing rules prohibiting brokers, dealers, and municipal securities dealers from purchasing or selling municipal securities unless they reasonably believe that entities issuing the securities have agreed to disclose such things as annual financial statements and notices of certain material events, such as payment defaults and rating changes.
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The new rules expand coverage to variable rate demand obligations, improve disclosure of tax risk, strengthen disclosure of important events and establish more specific filing deadlines. The Commission also issued a report laying out a range of recommendations to improve the structure of the municipal market. Provided investors with more meaningful information about company boards --The Commission required companies to file detailed information about the structure of their boards; the qualifications of their directors and nominees; the fees and conflicts of compensation consultants; and the relationship between a company's overall compensation policies and its risk profile. Required advisers to provide clients with a brochure of key information – The Commission improved and updated a form so that clients of investment advisers can now get details most relevant to them, written in plain English, such as the advisers’ business practices, fees, conflicts of interests and disciplinary information. It also required brochure “supplements” to give resume-like information about the individuals at an investment advisory firm. Further, it ensured investors have easy access to the brochures, Form ADV, Part 2, which are filed electronically and posted on the SEC’s website. Adopted new rules designed to help revitalize the asset-backed securities market by encouraging better disclosure – The new rules require issuers of asset-backed securities: 1) To disclose the history of the requests they received and repurchases they made related to their outstanding asset-backed securities; and 2) To conduct a review of the assets underlying those securities. Proposed rules to create a new and more equitable framework governing the way in which investors pay the costs for mutual funds --The
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proposed rules would create a new and more equitable framework for the way in which investors pay the marketing and sales costs – so-called “12b-1 fees -- for mutual funds. In addition, the rules would limit the amount of asset-based sales charges that individual investors pay. Proposed rules to help clarify the meaning of a date in a target date fund’s name -The Commission proposed rules to help investors to better assess the anticipated investment glide path and risk profile of a target date fund by, for example, requiring graphic depictions of asset allocations in fund ads. The rules, which would require an asset allocation “tag line” adjacent to a target date fund’s name in an ad, also would enhance the information in ads and marketing materials to help investors prepare for retirement.

Improving the Structure of the Market
Approved a series of measures that have helped to reduce the chance of another Flash Crash occurring – Months before the Flash Crash, Chairman Schapiro launched a comprehensive review of the structure of the markets and, following May 6, summoned the exchange heads to Washington to hammer out a series of measures to address the issues raised by that day’s volatile trading. Approved a variety of circuit breakers to help limit the impact of technology errors in the market -- The Commission approved a proposal establishing a “limit up-limit down” mechanism that prevents trades in individual exchange-listed stocks from occurring outside of a specified price band. It also approved market-wide circuit breakers that when triggered, halt trading in all exchange-listed securities throughout the U.S. markets.
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Clarified up front for investors how and when erroneous trades would be broken -- The new rules approved by the Commission outline when an erroneous trade would be broken, so that market participants are less likely to flee when computer glitches occur. Required broker-dealers to put in place risk controls and effectively prohibited unfiltered access to the exchanges -- The Commission approved new rules that require broker-dealers to implement controls and supervisory procedures to manage the financial and regulatory risks of market access, particularly the technology systems that enter orders in to the marketplace. The rules also assured broker-dealers would implement risk controls to reduce the chance of computer glitches. Approve a first-ever consolidated audit trail system -- The Commission approved a new rule requiring the exchanges and FINRA to submit a comprehensive plan for developing, implementing, and maintaining a consolidated audit trail. The audit trail will collect and accurately identify every order, cancellation, modification, and trade execution for all exchange-listed equities and equity options across all U.S. markets. The new measure will increase the data available to regulators investigating illegal activities and it will significantly improve the ability to reconstruct broad-based market events in an accurate and timely manner. Eliminated stub quotes --The Commission approved new rules proposed by the exchanges and FINRA to strengthen the minimum quoting standards for market makers and effectively prohibit “stub quotes” in the U.S. equity markets. Set up a new system to collect market and trading data -- The new system will inform future rulemaking regarding high frequency trading
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ADDITIONAL INVESTOR PROTECTION MEASURES
- Issued a record number of investor alerts and bulletins - Established an investor advisory committee - Created a new investor.gov website and upgraded sec.gov

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PCAOB Publishes Staff Audit Practice Alert on Maintaining and Applying Professional Skepticism in Audits

The Public Company Accounting Oversight Board published a Staff Audit Practice Alert to remind auditors of their requirement to exercise professional skepticism throughout their audits. "Investors depend on independent audits to provide a meaningful check on the financial statements prepared by company management," said PCAOB Chairman James R. Doty. "Without professional skepticism, the audit cannot serve that essential function." The PCAOB continues to observe instances in which circumstances suggest that auditors did not appropriately apply professional skepticism in their audits.

Staff Audit Practice Alert No. 10: Maintaining and Applying Professional Skepticism in Audits focuses on the importance of professional
skepticism, the appropriate application of professional skepticism in audits, and certain important considerations for audit firms' quality control systems. PCAOB standards define professional skepticism as an attitude that includes a questioning mind and a critical assessment of audit evidence, and it is essential to the performance of effective audits under Board standards. "This Alert discusses factors that impair an auditor's skepticism, and steps that firms and auditors can take to enhance their application of
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professional skepticism," said Martin F. Baumann, PCAOB Chief Auditor and Director of Professional Standards. "PCAOB standards require every individual auditor to exercise professional skepticism throughout their audits." The timing of the release of Staff Audit Practice Alert No. 10 is intended to assist audit firms' emphasis in upcoming calendar year-end audits on the importance of the appropriate use of professional skepticism. Due to the fundamental importance of the appropriate application of professional skepticism in performing an audit in accordance with PCAOB standards, the Board is also continuing to explore whether additional actions might meaningfully enhance auditors' professional skepticism. The PCAOB publishes Staff Audit Practice Alerts to highlight new, emerging, or otherwise noteworthy circumstances that may affect how auditors conduct audits under the existing requirements of PCAOB standards and relevant laws. Auditors should determine whether and how to respond to these circumstances based on the specific facts presented. The statements contained in Staff Audit Practice Alerts do not establish rules of the Board and do not reflect any Board determination or judgment about the conduct of any particular firm, auditor, or any other person.

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STAFF AUDIT PRACTICE ALERT NO. 10 MAINTAINING AND APPLYING PROFESSIONAL SKEPTICISM IN AUDITS
Staff Audit Practice Alerts highlight new, emerging, or otherwise noteworthy circumstances that may affect how auditors conduct audits under the existing requirements of the standards and rules of the PCAOB and relevant laws. Auditors should determine whether and how to respond to these circumstances based on the specific facts presented. The statements contained in Staff Audit Practice Alerts do not establish rules of the Board and do not reflect any Board determination or judgment about the conduct of any particular firm, auditor, or any other person.

Executive Summary
Professional skepticism is essential to the performance of effective audits under Public Company Accounting Oversight Board ("PCAOB" or "Board") standards. Those standards require that professional skepticism be applied throughout the audit by each individual auditor on the engagement team. PCAOB standards define professional skepticism as an attitude that

includes a questioning mind and a critical assessment of audit evidence. The standards also state that professional skepticism should be exercised throughout the audit process.
While professional skepticism is important in all aspects of the audit, it is particularly important in those areas of the audit that involve
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significant management judgments or transactions outside the normal course of business. Professional skepticism also is important as it relates to the auditor's consideration of fraud in an audit. When auditors do not appropriately apply professional skepticism, they may not obtain sufficient appropriate evidence to support their opinions or may not identify or address situations in which the financial statements are materially misstated. Observations from the PCAOB's oversight activities continue to raise concerns about whether auditors consistently and diligently apply professional skepticism. Certain circumstances can impede the appropriate application of professional skepticism and allow unconscious biases to prevail, including incentives and pressures resulting from certain conditions inherent in the audit environment, scheduling and workload demands, or an inappropriate level of confidence or trust in management. Audit firms and individual auditors should be alert for these impediments and take appropriate measures to assure that professional skepticism is applied appropriately throughout all audits performed under PCAOB standards. Firms' quality control systems can help engagement teams improve the application of professional skepticism in a number of ways, including setting a proper tone at the top that emphasizes the need for professional skepticism; implementing and maintaining appraisal, promotion, and compensation processes that enhance rather than discourage the application of professional skepticism; assigning personnel with the necessary competencies to engagement teams; establishing policies and procedures to assure appropriate audit documentation, especially in areas involving significant judgments; and appropriately monitoring the quality control system and taking necessary corrective actions to address deficiencies, such as, instances in which engagement teams do not apply professional skepticism.
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The engagement partner is responsible for, among other things, setting an appropriate tone that emphasizes the need to maintain a questioning mind throughout the audit and to exercise professional skepticism in gathering and evaluating evidence, so that, for example, engagement team members have the confidence to challenge management representations. It is also important for the engagement partner and other senior engagement team members to be actively involved in planning, directing, and reviewing the work of other engagement team members so that matters requiring audit attention, such as unusual matters or inconsistencies in audit evidence, are identified and addressed appropriately. It is the responsibility of each individual auditor to appropriately apply professional skepticism throughout the audit, including in identifying and assessing the risks of material misstatement, performing tests of controls and substantive procedures to respond to the risks, and evaluating the results of the audit. This involves, among other things, considering what can go wrong with the financial statements, performing audit procedures to obtain sufficient appropriate audit evidence rather than merely obtaining the most readily available evidence to corroborate management's assertions, and critically evaluating all audit evidence regardless of whether it corroborates or contradicts management's assertions. The Office of the Chief Auditor is issuing this practice alert to remind auditors of the requirement to appropriately apply professional skepticism throughout their audits. The timing of this release is intended to facilitate firms' emphasis in upcoming calendar year-end audits, as well as in future audits, on the importance of the appropriate use of professional skepticism. Due to the fundamental importance of the appropriate application of professional skepticism in performing an audit in accordance with
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PCAOB standards, the PCAOB also is continuing to explore whether additional actions might meaningfully enhance auditors' professional skepticism.

Professional Skepticism and Due Professional Care
Professional skepticism, an attitude that includes a questioning mind and a critical assessment of audit evidence, is essential to the performance of effective audits under PCAOB standards. The audit is intended to provide investors with an opinion on whether the financial statements prepared by company management are presented fairly, in all material respects, in conformity with the applicable financial reporting framework. If the audit is conducted without professional skepticism, the value of the audit is impaired. The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. This responsibility includes obtaining sufficient appropriate evidence to determine whether the financial statements are materially misstated rather than merely looking for evidence that supports management's assertions. PCAOB standards require the auditor to exercise due professional care in planning and performing the audit and in preparing the audit report. Due professional care requires the auditor to exercise professional skepticism. PCAOB standards define professional skepticism as an attitude that

includes a questioning mind and a critical assessment of audit evidence.
PCAOB standards require the auditor to exercise professional skepticism throughout the audit.
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While professional skepticism is important in all aspects of the audit, it is particularly important in those areas of the audit that involve significant management judgments or transactions outside the normal course of business, such as nonrecurring reserves, financing transactions, and related party transactions that might be motivated solely, or in large measure, by an expected or desired accounting outcome. Effective auditing involves diligent pursuit of sufficient appropriate audit evidence, particularly if contrary evidence exists, and critical assessment of all the evidence obtained. Professional skepticism is also important as it relates to the auditor's consideration of fraud in the audit. Company management has a unique ability to perpetrate fraud because it frequently is in a position to directly or indirectly manipulate accounting records and present fraudulent financial information. Company personnel who intentionally misstate the financial statements often seek to conceal the misstatement by attempting to deceive the auditor. Because of this incentive, applying professional skepticism is integral to planning and performing audit procedures to address fraud risks. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a bel ief that management is honest. Examples of the application of professional skepticism in response to the assessed fraud risks are (a) Modifying the planned audit procedures to obtain more reliable evidence regarding relevant assertions and (b) Obtaining sufficient appropriate evidence to corroborate management's explanations or representations concerning important matters, such as through third-party confirmation, use of a specialist
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engaged or employed by the auditor, or examination of documentation from independent sources. PCAOB inspectors continue to observe instances in which the circumstances suggest that auditors did not appropriately apply professional skepticism in their audits. As examples, audit deficiencies like the following raise concerns that a lack of professional skepticism was at least a contributing factor: • For certain hard-to-value Level 2 financial instruments, the engagement team did not obtain an understanding of the specific methods and/or assumptions underlying the fair value estimates that were obtained from pricing services or other third parties and used in the engagement team’s testing related to these financial instruments. Further, the firm used the price closest to the issuer’s recorded price in testing the fair value measurements, without evaluating the significance of differences between the other prices obtained and the issuer’s prices. • The issuer discontinued production of a significant product line during the prior year and introduced a new product line to replace it. There were no sales of the discontinued product line during the last nine months of the year under audit. The engagement team did not test, beyond inquiry, the significant assumptions management used to calculate its separate inventory reserve for this product line. • The engagement team did not evaluate the effects on the financial statements of management's determination not to test a significant portion of its property and equipment for impairment, despite indicators that the carrying amount may not have been recoverable. These indicators in this situation included operating losses for the relevant segment for the last three years, substantial charges for the impairment of goodwill and other intangible assets during the year, a
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projected loss for the segment for the upcoming year, and reduced and delayed customer orders. • After the date of the issuer's balance sheet, but before the release of the firm's opinion, the issuer reported that it anticipated that comparable store sales for the first quarter of the year would be significantly lower than those for the first quarter of the year under audit. The engagement team had performed sensitivity analyses as part of its assessment on the issuer's evaluation of its compliance with its debt covenants, the issuer's ability to continue as a going concern, and the possibility of the impairment of the issuer's long-lived assets. The engagement team did not consider the implications of the anticipated decline in sales on its sensitivity analyses and its conclusions with respect to compliance with debt covenants, the issuer's ability to continue as a going concern, and impairment of long-lived assets. The PCAOB's enforcement activities also have identified instances in which auditors did not appropriately apply professional skepticism. For example, in one recent disciplinary order, the Board found, among other things, that certain of a firm's audit partners accepted a company's reliance on an exception to generally accepted accounting principles ("GAAP") requirements for reserving for expected future product returns even though doing so conflicted with the plain language of the exception and the firm's internal accounting literature. The partners were aware of, but did not appropriately consider, contradictory audit evidence indicating that the returns were not eligible for the exception. This illustration of a lack of professional skepticism reappeared in the firm's response when the issue was questioned by the firm's internal audit quality reviewers. Although certain of the partners involved determined that the company's reliance on the exception to GAAP did not support the company's
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accounting, they, along with other firm personnel, formulated another equally deficient rationale that supported the company's existing accounting result.

Impediments to the Application of Professional Skepticism
Although PCAOB standards require auditors to appropriately apply professional skepticism throughout the audit, observations from the PCAOB's oversight activities indicate that, as a practical matter, auditors are often challenged in meeting this fundamental audit requirement. In maintaining an attitude that includes a questioning mind and a critical assessment of audit evidence, it is important for auditors to be alert to unconscious human biases and other circumstances that can cause auditors to gather, evaluate, rationalize, and recall information in a way that is consistent with client preferences rather than the interests of external users. Certain conditions inherent in the audit environment can create incentives and pressures that can serve to impede the appropriate application of professional skepticism and allow unconscious bias to prevail. For example, incentives and pressures to build or maintain a long-term audit engagement, avoid significant conflicts with management, provide an unqualified audit opinion prior to the issuer's filing deadline, achieve high client satisfaction ratings, keep audit costs low, or cross-sell other services can all serve to inhibit professional skepticism. In addition, over time, auditors may sometimes develop an inappropriate level of trust or confidence in management, which may l ead auditors to accede to inappropriate accounting. In some situations, auditors may feel pressure to avoid potential negative interactions with, or consequences to, individuals they know (that is, management) instead of representing the interests of the investors they are charged to protect.
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Other circumstances also can impede the appropriate application of professional skepticism. For example, scheduling and workload demands can put pressure on partners and other engagement team members to complete their assignments too quickly, which might lead auditors to seek audit evidence that is easier to obtain rather than evidence that is more relevant and reliable, to obtain less evidence than is necessary, or to give undue weight to confirming evidence without adequately considering contrary evidence. Although powerful incentives and pressures exist that can impede professional skepticism, the importance of professional skepticism to an effective audit cannot be overstated, particularly given the increasing judgment and complexity in financial reporting and issues posed by the current economic environment. Auditors and audit firms must remember that their overriding duty is to put the interests of investors first. Appropriate application of professional skepticism is key to fulfilling the auditor's duty to investors. In the words of the U.S. Supreme Court: By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.
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However, inadequate performance of audit procedures may be caused by factors other than the lack of skepticism, or in combination with a lack of skepticism. As discussed further below, firms should take appropriate steps to understand the various factors that influence audit quality, including those circumstances and pressures that can impede the application of professional skepticism.

Promoting Professional Skepticism via an Appropriate System of Quality Control
PCAOB standards require firms to establish a system of quality control to provide the firm with reasonable assurance that its personnel comply with applicable professional standards and the firm's standards of quality. This includes designing and implementing policies and procedures that lead engagement teams to appropriately apply professional skepticism in their audits. Firms' quality control systems can help engagement teams improve the application of professional skepticism in a number of ways, including the following: • "Tone-at-the-Top" Messaging. The PCAOB's inspection findings have identified instances in which the firm's culture allows or tolerates audit approaches that do not consistently emphasize the need for professional skepticism. Consistent communication from firm leadership that professional skepticism is integral to performing a high quality audit, backed up by a culture that supports it, could improve the quality of work performed by audit partners and staff.

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On the other hand, messages from firm leadership that are excessively focused on revenue or profit growth over achieving audit quality, can undermine the application of professional skepticism. • Performance Appraisal, Promotion, and Compensation Processes. An audit firm's performance appraisal, promotion, and compensation processes can enhance or detract from the application of professional skepticism in its audit practice, depending on how they are designed and executed. For example, if a firm's promotion process emphasizes selling non-audit services or places an undue focus on reducing audit costs, or retaining and acquiring audit clients over achieving high audit quality, the firm's personnel may perceive those goals as being more important to their own compensation, job security, and advancement within the firm than the appropriate application of professional skepticism. • Professional Competence and Assigning Personnel to Engagement Teams. A firm's quality control system depends heavily on the proficiency of its personnel, which includes their ability to exercise professional skepticism. To perform the audit with professional skepticism, it is important that personnel assigned to engagement teams have the necessary knowledge, skill, and ability required in the circumstances, which includes appropriate technical training and experience. Professional skepticism is interrelated with an auditor's training and experience, as auditors need an appropriate level of competence in order to appropriately apply professional skepticism throughout the audit. In addition, it is important for the firm's culture to continually reinforce the appropriate application of professional skepticism throughout the audit.
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• Documentation. It is important for a firm's quality control system to establish policies and procedures that cover documenting the results of each engagement. Although documentation should support the basis for the auditor's conclusions concerning every relevant financial statement assertion, areas that require greater judgment generally need more extensive documentation of the procedures performed, evidence obtained, and rationale for the conclusions reached. In addition to the documentation necessary to support the auditor's final conclusions, audit documentation must include information the auditor has identified relating to significant findings or issues that is inconsistent with or contradicts the auditor's final conclusions. • Monitoring. Under PCAOB standards, a firm's quality control policies and procedures should include an element of monitoring to ensure that quality control policies and procedures are suitably designed and being effectively applied. If the firm identifies deficiencies, the firm should evaluate the reasons for the deficiencies and determine the necessary corrective actions or improvements to the quality control system. Accordingly, if a firm identifies deficiencies that include failures to appropriately apply professional skepticism as a contributing factor, the firm should take appropriate corrective actions.

Importance of Supervision to the Application of Professional Skepticism
The supervisory activities performed by the engagement partner and other senior engagement team members are important to the application of professional skepticism.
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The engagement partner is responsible for the proper supervision of the work of engagement team members. Accordingly, the engagement partner is responsible for setting an appropriate tone that emphasizes the need to maintain a questioning mind throughout the audit and to exercise professional skepticism in gathering and evaluating evidence, so that, for example, engagement team members have the confidence to challenge management representations. It is also important for the engagement partner and other senior engagement team members to be actively involved in planning, directing, and reviewing the work of other engagement team members so that matters requiring audit attention are identified and addressed appropriately. In directing the work of others, senior engagement team members, including the engagement partner, may have knowledge and experience that may assist less experienced engagement team members in applying professional skepticism. For example, senior engagement team members might help more junior auditors identify matters that are unusual or inconsistent with other evidence. In addition, senior members of the engagement team might be better able to challenge the assertions of senior levels of management, when necessary.

Appropriate Application of Professional Skepticism
Although a firm's quality control systems and the actions of the engagement partner and other senior engagement team members can contribute to an environment that supports professional skepticism, it is ultimately the responsibility of each individual auditor to appropriately apply professional skepticism throughout the audit, including the following areas among others:
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• Identifying and assessing risks of material misstatement; • Performing tests of controls and substantive procedures; and • Evaluating audit results to form the opinion to be expressed in the auditor's report.

Identifying and Assessing Risks of Material Misstatement
By its nature, risk assessment involves looking at internal and external factors to determine what can go wrong with the financial statements, whether due to error or fraud. When properly applied, the risk assessment approach set forth in PCAOB standards should focus auditors' attention on those areas of the financial statements that are higher risk and thus most susceptible to misstatement. This includes considering events and conditions that create incentives or pressures on management or create opportunities for management to manipulate the financial statements. The evidence obtained from the required risk assessment procedures should provide a reasonable basis for the auditor's risk assessments, which, in turn, should drive the auditor's tests of accounts and disclosures in the financial statements. The risk assessment procedures required by PCAOB standards also should provide the auditor with a thorough understanding of the company and its environment as a basis for identifying unusual transactions or matters that warrant further investigation. They also provide a basis for the auditor to evaluate and challenge management's assertions. It is important to note that the auditor's understanding should be based on actual information obtained from the risk assessment procedures.
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It is not sufficient for auditors merely to rely on their perceived knowledge of the industry or information obtained from prior audits or other engagements for the company.

Performing Tests of Controls and Substantive Procedures
Appropriately applying professional skepticism is critical to obtaining sufficient appropriate audit evidence to determine whether the financial statements are free of material misstatement and, in an integrated audit, whether internal controls over financial reporting are operating effectively. Application of professional skepticism is not merely obtaining the most readily available evidence to corroborate management's assertion. The need for auditors to appropriately apply professional skepticism is echoed throughout PCAOB standards. For example, PCAOB standards caution that representations from management are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for an opinion regarding the financial statements under audit. Also, the standards warn that inquiry alone does not provide sufficient appropriate evidence to support a conclusion about a relevant assertion. In addition, PCAOB standards require auditors to design and perform audit procedures in a manner that addresses the assessed risks of material misstatement and to obtain more persuasive evidence the higher the assessment of risk. The auditor is required to apply professional skepticism, which includes a critical assessment of the audit evidence. Substantive procedures generally provide persuasive evidence when they are designed and performed to obtain evidence that is relevant and reliable.
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When discussing the characteristics of reliable audit evidence, PCAOB standards observe that generally, among other things, evidence obtained from a knowledgeable source independent of the company is more reliable than evidence obtained only from internal company sources and evidence obtained directly by the auditor is more reliable than evidence obtained indirectly. Taken together, this means that in higher risk areas, the auditor's appropriate application of professional skepticism should result in procedures that are focused on obtaining evidence that is more relevant and reliable, such as evidence obtained directly and evidence obtained from independent, knowledgeable sources. Further, if audit evidence obtained from one source is inconsistent with that obtained from another, the auditor should perform the audit procedures necessary to resolve the matter and should determine the effect, if any, on other aspects of the audit. The following are examples of audit procedures in PCAOB standards that reflect the need for professional skepticism: • Resolving inconsistencies in or doubts about the reliability of confirmations; • Examining journal entries and other adjustments for evidence of possible material misstatement due to fraud; • Reviewing accounting estimates for biases that could result in material misstatement due to fraud; • Evaluating the business rationale for significant unusual transactions; and • Evaluating whether there is substantial doubt about an entity's ability to continue as a going concern.

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Evaluating Audit Results to Form the Opinion to be Expressed in the Audit Report
When professional skepticism is applied appropriately, the auditor does not presume that the financial statements are presented fairly in conformity with the applicable financial reporting framework. Instead, the auditor employs an attitude that includes a questioning mind in making critical assessments of the evidence obtained to determine whether the financial statements are materially misstated. PCAOB standards indicate that the auditor should take into account all relevant audit evidence, regardless of whether the evidence corroborates or contradicts the assertions in the financial statements. Examples of areas in the evaluation that reflect the need for the auditor to apply professional skepticism, include, but are not limited to, the following: • Evaluating uncorrected misstatements. This includes evaluating whether the uncorrected misstatements identified during the audit result in material misstatement of the financial statements, individually or in combination, considering both qualitative and quantitative factors. • Evaluating management bias. This includes evaluating potential bias in accounting estimates, bias in the selection and application of accounting principles, the selective correction of misstatements identified during the audit, and identification by management of additional adjusting entries that offset misstatements accumulated by the auditor. When evaluating bias, it is important for auditors to consider the incentives and pressures on management to manipulate the financial statements.
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• Evaluating the presentation of the financial statements. This includes evaluating whether the financial statements contain the information essential for a fair presentation of the financial statements in conformity with the applicable financial reporting framework. When evaluating misstatements, bias, or presentation and disclosures, it is important for auditors to appropriately apply professional skepticism and avoid dismissing matters as immaterial without adequate consideration.

Conclusion
The Office of the Chief Auditor is issuing this practice alert to remind auditors of the requirement to appropriately apply professional skepticism throughout their audits, which includes an attitude of a questioning mind and a critical assessment of audit evidence. The timing of this release is intended to facilitate firms' emphasis in upcoming calendar year-end audits, as well as in future audits, on the importance of the appropriate use of professional skepticism. Due to the fundamental importance of the appropriate application of professional skepticism in performing an audit in accordance with PCAOB standards, the PCAOB also is continuing to explore whether additional actions might meaningfully enhance auditors' professional skepticism.

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James R. Doty, Chairman

Keynote Address

EVENT: LOCATION:

AICPA National Conference on Current SEC and PCAOB Developments Washington, DC

Thank you for inviting me to speak today. It is a pleasure to participate in the 40th occasion for this conference. It is my second year here, and I am honored to be back. I was also honored to participate in the AICPA's 125th Anniversary in May. I congratulate you again on what you have put forth for the public interest in those years, and I have high expectations for the years to come. Let me begin by saying that the views I express are my own and should not be attributed to the PCAOB as a whole or any other members or staff. You have an excellent conference program, offering valuable insights on current technical questions and quandaries as well as an opportunity to discuss important policy issues. I am especially pleased that the conference devotes more attention to auditing each year.

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I. High Quality, Independent Auditing is Critical to Our Economic Success.
As I have learned in this job, getting the accounting right is indeed not the same thing as getting the auditing right. My sense from accountants I talk to is that auditing is receiving welldeserved attention in its own right. Our economic success depends on the confidence of the users of capital and the providers of capital alike. Corporate managers hire internal accountants — many of you here today — to ensure they have accurate and detailed information on which to base management decisions. Managers ignore opportunities to glean trends and insights from this data at their peril. Mistakes in this information can send a company into a business line or market that squanders resources. We now know that the true cost of financial misstatement is much greater than stock market fallout, concomitant lawsuits and insurance claims. Researchers from Rutgers and NYU reported in 2009 on the costs of misstatements by companies known to have been managing earnings between 1997 and 2000. In their words, "the essential point that emerges" is that if management wants to maintain appearances, then hiring and investment must be consistent with reported profits. Therefore, they found, during the years of earnings management the companies increased hiring by 25 percent.
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Competitors increased hiring, on average, by only seven percent. As soon as the companies came clean, the unneeded employees were fired. The researchers estimated that the restating companies fired between 250,000 and 600,000 workers between 2000 and 2002, slashing payrolls by more than 25 percent, while other companies cut them by just 1.5 percent. Investors and employees of misreporting companies are not the only ones hurt. Columbia Business School Professor Gil Sadka did his PhD dissertation at the University of Chicago on the effects of fraudulent reporting on competitor companies. He found that false reporting leads both companies who misreport and their competitors to overinvest in new technology and engage in misguided price wars. He did a case study on WorldCom to test the point. WorldCom's major competitors were Sprint and AT&T, which together made up 60 percent of the telecommunications market. The price war prompted by WorldCom during the period of fraud drove industry pricing down in key product lines. The artificially low prices took a toll on margins at WorldCom's competitors. Both Sprint and AT&T experienced a decline in their operating margins during the period. This is the kind of information we can, of course, only know with hindsight.
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What it teaches us is that the unanticipated cost of misreporting can be both general in impact and great. Fudging the financials misleads investors and other companies alike into inefficient allocation of capital. Economists warn that this, in turn, leads workers to train up, and sometimes move families, for jobs in industries that don't need them. Years later, when they lose those jobs, their potential productivity is yet again wasted in unemployment. These are social costs of financial misreporting in economic terms. When they occur, they imply a market failure: efficient market allocations have been diverted by bad numbers. That's where the auditing profession comes in. High quality auditing is critical to our economic success because it allows us to allocate capital efficiently. Indeed, it has done so since our country was formed. If it weren't for auditing, our country would likely not have moved forward from frontier land speculation and canal projects to an industrial economy that would employ sophisticated financing through global capital markets. Accounting standard-setters have rightly spent much of the last ten years exploring ways to close loopholes wedged open by companies that issued fraudulent financial reports at the turn of this century. But it would be a mistake to conclude that, until standard-setters close loopholes, our system permits or tolerates fraudulent exploitation of them. Both Bernie Ebbers of WorldCom and the Rigas father-and-son team that headed Adelphia learned that lesson the hard way when the
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Second Circuit Court of Appeals, in separate cases, affirmed their convictions, rejecting their arguments that Generally Accepted Accounting Principles allowed the fraudulent reporting treatments. In both cases, the Second Circuit Court of Appeals affirmed the convictions. In Ebbers's case, the Court held — If the government proves that a defendant was responsible for financial reports that intentionally and materially misled investors, the [securities fraud] statute is satisfied. The government is not required in addition to prevail in a battle of expert witnesses over the application of individual GAAP rules. In Judge Wesley's opinion in the Rigas case, "Even if Defendants complied with GAAP, a jury could have found, as the jury did here, that Defendants intentionally misled investors." Securities lawyers know that the cases since Enron broke no new ground. They were founded on the long-standing principle articulated in the 1969 case, United States v. Simon. There, three auditors were convicted for their role in the Continental Vending fraud. On appeal, the court rejected the auditors' argument that they could not be found guilty if the company's disclosures complied with accounting standards. In a thoughtful opinion by Judge Henry Friendly, one of the most respected jurists in U.S. history, the Second Circuit Court of Appeals affirmed the trial court's decision that proof of compliance with GAAP was "not necessarily conclusive that [the auditors] acted in good faith, and that the facts as certified were not materially false or misleading."
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Many accounting firms devote inestimable time and attention to the study of the fine points of the applicable accounting regimes. But with this history, it is high time that we focus on auditing as its own discipline, to be studied, nurtured and trained. All auditors should be versed in the case studies on fraud. It is simply not the case that frauds do not repeat; although there may be new twists, familiar elements reappear. The economic literature also provides important insights and is worth more than mere browsing. Just last month, David Larcker of Stanford University and other researchers revealed thought-provoking new evidence of the linkage between certain kinds of equity incentives and misreporting. The work of academics and other thought leaders has refocused on the importance of the audit profession. Their new look at the archives of the last decade may lead you to new insights of your own. It could make you a better auditor, and better equip you to recognize and confront a bad situation.

II. Audit Firm Culture Must Support Auditors' Work.
I acknowledge that auditors are in a tough spot. With rare exception, they are an ethical breed. One does not go into, or stay in, auditing just for the tangible benefits. As in all professions, fair compensation is critical to the vitality of the profession.
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I never met an auditor who wasn't proud of finding a fraud, avoiding the company's demise, and sparing investors' ruin. Yet firms are, by design, profit enterprises. The public is the intended beneficiary of the audit. But the public doesn't pay the auditor's bills. Auditees do, and, in the United States, the audit fees that those engagements pay are a decreasing portion of audit firms' revenues. Large audit firms' revenues from consulting are growing rapidly, at some firms more than 15 percent a year. Audit fees have stagnated at, basically, the inflation rate. Thus audit practices have shrunk in comparison to audit firms' other client service lines — not all of which are schooled in, or depend upon, the fundamental exercise of skepticism. This threatens to weaken the strength of the audit practice in the firm overall. After nearly ten years of inspecting the audits of issuers, the PCAOB has identified hundreds of engagements that did not meet PCAOB standards in significant respects. These are serious audit deficiencies in procedures and actions that mean, essentially, that the audit opinions involved were not adequately supported. Moreover, inspection findings have increased at many firms over the last several years. This is a hard message. It is to be expected that the inspection findings are a disappointment
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to a profession proud of its reputation for technical excellence. Some firms have seen even more findings this year. Yet I say with confidence that I have seen dramatic improvements in audit quality in response to the findings. When a firm accepts the findings, and undertakes a rigorous root cause analysis, it can design actions to reduce and eliminate recurrence. The audit firm takes a significant step on the road to excellence when it acknowledges that the number and vector of our findings indicate root cause, systemic issues, and not merely episodic failures in execution. That involves self-monitoring and testing — not just waiting to see if the PCAOB finds the problem in other audits. Inspectors have seen it done. This requires, when a firm is grappling with evidence of a lack of skepticism in certain past audits, the firm demands — through its words, actions and subsequent testing — pervasive and explicit evidence of skepticism in the work papers. It means the firm issues meaningful, believable and consistent messages internally that quality is not one of many goals, but the firm's number one priority. It means these communications go to — and are honored by — all professionals, because the firm engages all professionals in the remediation efforts. I hope you are seeing these actions and improvements in your firm. Not all firms have gone to these lengths. But this is what quality means.
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III. The PCAOB's Initiatives are Aimed at Enhancing the Relevance, Credibility and Transparency of Audits.
The PCAOB too is deeply engaged in examining ways to enhance the relevance, credibility and transparency of the audit to better serve investors. In November 2011, the PCAOB adopted a major new strategic plan to focus its programs and initiatives on ways to do so. It built on the work of the founding board but brought that work forward to address current challenges and expectations for the organization. The Board reaffirmed that strategic plan last week, in connection with adopting the PCAOB's 2013 Budget. The new plan reflects modest updates and adjustments as well. In particular, it includes a new strategy to underscore the continuing development of the PCAOB's Global Network Firm Inspection Program, as well as a new strategy related to standard-setting for audits of emerging growth companies, in light of recent legislative developments. Since last November, we have brought on a new director for our Office of Research and Analysis, Greg Jonas. We have also adopted a new IT governance framework. Therefore, the plan also includes an updated strategy related to managing knowledge and leveraging IT, reflecting enhancements to our IT governance and our vision for research and analysis under Greg's leadership. In my message accompanying the plan, I set forth certain near-term priorities.
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They afford some insight into initiatives that our inspections, research and standards-setting programs have undertaken to improve audit quality in the interest of the investing public.

A. Inspection Initiatives Will Focus on Deepening Inspection Analysis and Improving Reporting.
Our inspections initiatives will focus on further deepening our inspection analysis and improving our reporting — both for inspections and remediation. This past year our inspections program, under the leadership of Helen Munter, has been very active — issuing around 200 reports and completing approximately 265 inspections thus far. While inspection findings for the 2012 inspection cycle are still preliminary, the deficiencies continue to be high relative to prior years and Helen will speak about that on Wednesday. Helen's group has devoted considerable attention to further develop the infrastructure necessary to reduce the time it takes to produce reports. That effort will continue into 2013 and is one of the near-term priorities of the Board. Our reports do take time to produce. While we aim to issue reports within 12 months of the inspections fieldwork, and many now beat that target, some reports take longer. The period from the end of the fieldwork to the time a report is produced is an important time period. We issue comments on potential findings, give firms time to respond and then evaluate their responses to develop the draft report. Once drafted, reports go through several reviews to ensure
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consistency of approach across firms and findings. Inspectors take care to ensure that findings are appropriate, and that if they criticize conduct, they criticize it consistently wherever they find it. Importantly, inspectors give time throughout the process for dialogue with firm personnel and leadership. We continue, however, to improve our processes to reduce the time it takes to issue our domestic large firm inspection reports and to improve the content of our other reports. A note about form: An essential ingredient of the inspection process is candor with firms about the points on which we see a need for improvement. That emphasis may often result in inspection reports that appear to be laden with criticism of a firm's policies, practices, and audit performance, and less concerned with a recitation of a firm's strengths. Grounded in the vision of the Sarbanes-Oxley Act, the inspection reports are not intended to serve as balanced report cards, rating tools, or potential marketing aids for any firm. The reports are intended principally to focus our inspection-related dialogue with a firm on those areas where improvement is either required for compliance with relevant standards and rules, or is likely to enhance the quality of the firm's audit practice. That purpose should not be lost. But in light of these goals, the inspections division will also consider ways to deepen our own analysis of inspection findings, over time and across firms, so that we see more and miss less when we encounter what may be only the tip of a problem.
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I anticipate more summary reports on insights from inspections, on more topics. We will prepare these reports always with an eye on, among other things, getting useful information to audit committees. This will build on the release the Board issued in August on how audit committees can learn more from the results and implications of the PCAOB's inspection findings. Armed with more and better information, audit committees should be in a better position to champion audit quality. PCAOB outreach to audit committees is naturally an important component. An observation here, about outreach to and interaction with audit committees — one of our near-term priorities: Our outreach and interaction should help audit committees promote audit quality. Audit committees have a role in fostering not just integrity in management's reporting, but the vitality and viability of the independent audit. In my experience, when an audit committee meets with internal audit or compliance staff, the first question they ask is, "do you have enough resources?" Do the audit committees you interact with ask the same of the external auditor? They should, and the good ones do. The audit is the linchpin of the investing public's confidence in the company; it is not something to be procured from the lowest cost supplier.

B. The PCAOB's Office of Research and Analysis Will Initiate a Project to Identify Audit Quality Measures.
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I've mentioned our new Director of Research and Analysis. We've served Greg a full plate. His office works closely with the inspections division on inspection planning. As in past years, the office is responsible for delivering detailed risk analysis to the inspection division in the Fall, to assist with planning for the next year. This is in addition to the year-round work the office does to spot audit and accounting risks, run them down as far as they can based on public information and their own analysis, and work with others internally to determine the best resource to address the risk. In 2013, the Office of Research and Analysis will also initiate a project to identify audit quality measures, with a longer-term goal of tracking such measures over time and across firms and networks of firms, and back-testing them for their predictive value. The fruits of this data analysis could also enable us not only to better inform our own processes, but to provide meaningful analysis to auditors, audit committees, and the investing public. We are at the earliest stages of this endeavor, but I have high hopes.

C. Evaluating the PCAOB's Standard-Setting Framework.
The PCAOB's standards-setting staff are also hard at work finding ways to make our standards-setting process as effective as possible, including through greater use of economic analysis. All but fifteen of the audit standards were adopted by the profession itself. The PCAOB adopted those standards as its own in 2003 and called them the "interim standards." We don't rewrite standards just for the sake of change.
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Since its earliest days, the PCAOB has endeavored to develop instructive standards that comprise the real intellectual content of what auditors do. The standards ought to be a living set of principles that a learned profession can believe in and resort to for support. At the same time, they must be sufficiently clear and concrete to be enforceable fairly, for enforcing them is an important element of what we do — a subject that our enforcement director, Claudius Modesti, will talk about later. To these ends, under Chief Auditor Marty Baumann's leadership, the PCAOB's standards-setting staff have devoted renewed attention to developing a new framework by which to organize and integrate the interim standards with the PCAOB's new standards. I don't envision that this exercise should result in an immutable set of standards for all time. Each generation will have to evaluate new needs for change, for example as the interim related parties standard is today receiving renewed attention in light of new information about the relationship between executive compensation and audit risk. To my mind, the standards — even the reorganization of them — ought to reflect a contemporary review of the challenges that auditors face, which we alone among standards-setters can see through our inspections. We should also take good ideas from wherever else they come. For example, under Arnold Schilder's leadership, the International Auditing and Assurance Standards Board is moving forward with its paper on using the auditor's reporting model to communicate useful information from the audit to investors. PCAOB staff and board members have had numerous discussions
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with Arnold and his team, and our own project on the Auditor's Reporting Model has benefitted greatly from our interaction. But there should be no presumption for simply adopting, off-theshelf, other standards-setters' work in order to trade out an interim standard expeditiously. Above all, emphasis should be placed on identifying and reacting appropriately to risk, and on establishing counterweights to circumstances that could detract from the ultimate goal of obtaining a high level of assurance that the financial statements are free of material misstatement. This is why I believe it is so important to reexamine how we protect the auditor's independence, including by considering term limits. Economic analysis can help us in this review of the PCAOB's standards-setting framework. Economic analysis prompts us to ask critical questions: What is the problem? What are our alternatives, both to rulemaking and by rulemaking? What is the most cost-effective solution for society? Indeed, economic analysis may tell us that if we can drive audit quality improvements through certain kinds of structural changes — such as by enhancing independence, introducing more transparency, or infusing the audit report with more insight, turning the auditor's focus more squarely toward communication with the investing public — we may be able to avoid the incremental cost of requiring additional audit procedures. Economic analysis may also help us help the profession overcome market obstacles and realign incentives to promote sustainable excellence. I want to see the audit profession compete on quality more than
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price. I imagine you wish for that as well, but wishing isn't doing. Standards that give audit committees and the public tools to distinguish on the basis of quality may help you get there. *** Historians remind us that each generation is, in a sense, the custodian of and fiduciary for the best ideas the past has given us. The enduring lesson of the past is that men and women do change their worlds. Through this annual conference, the profession comes together each year to discuss and debate the work you do to serve the public. This conference is not about business development, or client service. It's about serving the public interest. I commend you for showing such initiative, year in and year out, to find new and better ways to do so. You have been a gracious audience and I thank you very much for your attention.

Martin Baumann, Chief Auditor Remarks
AICPA Conference on Current SEC and PCAOB Developments Washington, DC Good afternoon. I'm delighted once again to be a part of this AICPA conference. I congratulate the AICPA for this annually successful conference that
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benefits thousands of professionals and congratulate all of you for attending. The Office of the Chief Auditor is responsible for advising the Board on the establishment of auditing and related professional standards to strengthen the reliability of audits. As Chief Auditor I'm fortunate to lead an extraordinary group of professionals at the PCAOB who are dedicated to audit quality — and to the development of standards and related guidance to continually improve audit quality. This afternoon I want to touch on, first, our most recently adopted standard — AS 16, Communications with Audit Committees- and then briefly comment on two standard-setting projects — the Auditor's Reporting Model and Going Concern. Then I want to focus my remarks on a most critical aspect of auditing — Professional Skepticism. AS 16 was adopted by the PCAOB in August. Subject to SEC approval, it is intended to be effective for audits beginning on or after December 15, 2012. Through appropriate and timely communications with audit committees, this standard can significantly improve audit quality. It also benefits the audit committee in fulfilling the role it was charged with under the Sarbanes-Oxley Act. Among other things, the standard improves auditor communications regarding the audit strategy, significant risks, information about other firms and specialists participating in the audit, the company's most complex accounting estimates, significant unusual transactions, complaints about accounting matters, and the auditor's evaluation of the company's ability to continue as a going concern. AS 16 went through an extensive exposure process and generally
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received strong support for its improvements in audit quality. Some firms are planning to adopt its communications principals early, in this year's audits. The Auditor's Reporting Model has been referenced a number of times in this conference, including the many commissions or committees that have recommended the need for the audit report to change, the extensive outreach we have made in considering changes to the Auditor's Report, as well as related global initiatives by the IAASB and the European Commission. We have received significant and valuable input to help in our deliberations. We are being extremely thoughtful and careful in our approach — making changes to the auditor's report has significant support, but making such changes needs the deliberative approach we are taking. Our plan at this stage, as noted in our current standard-setting agenda, is to issue a proposal for public comment in the first-half of 2013. We expect many comment letters on such an important proposal but we also plan further Roundtables and discussions with our Advisory groups. Economic Analysis is also an important ingredient in considering any new audit report — so we will be soliciting views there as well. So a lot has been done, but much more is yet to be done as we address this most important matter of revising the Standard Auditor's Report. We have a very busy standard-setting agenda, but I want to mention just one more item — that is, revising the standard on the auditor's consideration of a company's ability to continue as a going concern.
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The financial crisis evidenced a need for improvements in this standard, but just as importantly evidenced the need for improved reporting by Issuers. The FASB has recently approved a project to require periodic evaluations by management and disclosures under certain circumstances about doubts regarding the company's ability to continue as a going concern. They plan an Exposure Draft in early 2013 and we will plan to propose our revised auditing standard shortly thereafter. This is the holistic approach to this problem that investors, preparers and auditors have asked for. Now, let me turn away from current standard-setting and comment on a very important existing audit requirement — Professional Skepticism. In August, 2011, the PCAOB issued a Concept Release entitled "Auditor Independence and Audit Firm Rotation". Auditors have long recognized that Independence is critical to an audit and critical to the viability of auditing itself. The Concept Release noted, however, that the Board continues to find instances in which auditors did not approach some aspect of the audit with the required Independence, Objectivity and Professional Skepticism. Sometimes it's interesting to go back to basics - so let me do that. On independence, the second general standard on auditing (written before most of you were born) says that - "In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor." Let me highlight some words again — "IN ALL MATTERS"
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pertaining to the audit, "INDEPENDENCE IN MENTAL ATTITUDE" is required of the auditor. There are a plethora of independence rules, as you know — generally they focus on financial interests and services that are deemed to impair independence. But remember at its core — Independence is a matter of maintaining an independent mental attitude in all matters pertaining to the audit. The third general standard of auditing requires that "Due professional care" is to be exercised throughout the audit and in preparing the audit report. And that standard goes on to say that "Due Professional Care requires the auditor to exercise professional skepticism." I want to pause for a moment to make sure I'm engaging not only the auditors here, but also so many of you who are the preparers of the financial statements — the controllers, those in accounting policy or operations or other Corporate executives. This message is also important for you. When your auditor questions your assertions, he or she is not being difficult. They're just doing their job. They're acting like an auditor is required to. And when I talk about the risks of management fraud today, please don't think I'm being difficult. That's just the job of an audit standard-setter. Under PCAOB standards, the auditor neither assumes management
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is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest. "Professional Skepticism!" Just two words. But so fundamental to the performance of an audit. Observations about the lack of professional skepticism in some audits was at the heart of the Concept Release to which I referred earlier. And the PCAOB is not alone in identifying concerns regarding professional skepticism in audits. Regulators in many other countries such as Australia, Canada, Germany, The Netherlands, Singapore, Switzerland and the United Kingdom have each cited concerns in public reports about the lack of professional skepticism in audits they have inspected. So, I want to focus the remainder of my remarks on this topic so essential to the ongoing relevance and quality of audits. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. It is essential to the performance of effective audits. Professional skepticism is required in every aspect of every audit by every auditor working on the audit. Audits are performed to provide investors with assurance on the fair presentation of the financial statements prepared by management. If the audit is conducted without professional skepticism, the value of the audit to investors and others is seriously impaired. While professional skepticism is important in all aspects of the audit, it is particularly important in those areas of the audit that involve
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significant management judgments , including judgments in areas with great measurement uncertainty, or transactions outside the normal course of business, such as nonrecurring transactions, financing activities, and related party transactions that might be motivated solely, or in large measure, by an expected or desired accounting outcome. Effective auditing involves diligent pursuit of sufficient appropriate audit evidence, particularly if contrary evidence exists. Professional skepticism is also critical as it relates to the auditor's consideration of fraud in the audit. Company management has a unique ability to perpetrate fraud because it frequently is in a position to directly or indirectly manipulate accounting records and present fraudulent financial information. Company personnel who intentionally misstate the financial statements often seek to conceal the misstatement by attempting to deceive the auditor. Because of this incentive, applying professional skepticism is integral to planning and performing audit procedures to address fraud risks. PCAOB inspectors continue to observe instances in which the circumstances suggest that auditors did not appropriately apply professional skepticism in their audits. As examples, audit deficiencies like the following, observed in our inspections, raise concerns that a lack of professional skepticism was at least a contributing factor: - For certain hard-to-value Level 2 financial instruments, the engagement team failed to obtain an understanding of the specific methods and assumptions underlying the prices that were obtained from pricing services and other third
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parties and used in the engagement team's testing related to these financial instruments. Further, the firm used the price closest to the issuer's recorded price in testing the fair value measurements, without evaluating the significance of differences between the other prices obtained and the issuer's prices. - The issuer discontinued production of a significant product line during the prior year and introduced a new product line to replace it. There were no sales of the discontinued product line during the last nine months of the year under audit. The engagement team did not test, beyond inquiry of management, the significant assumptions management used to calculate its separate inventory reserve for this product line. - The engagement team did not evaluate the effects on the financial statements of management's determination not to test a significant portion of its property and equipment for impairment, despite indicators that the carrying amount may not have been recoverable. These indicators in this situation included operating losses for the relevant segment for the last three years, substantial charges for the impairment of goodwill and other intangible assets during the year, a projected loss for the segment for the upcoming year, and reduced and delayed customer orders. The PCAOB's enforcement activities also have identified instances in which auditors did not appropriately apply professional skepticism. For example, in one recent disciplinary order, the Board found that certain of a firm's audit partners accepted a company's reliance on an
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exception to GAAP for reserving for expected future product returns even though doing so conflicted with the plain language of the exception and the firm's internal accounting literature. The partners were aware of, but did not appropriately consider, contradictory audit evidence indicating that the returns were not eligible for the exception. Although auditing standards require auditors to appropriately apply professional skepticism throughout the audit, observations from our oversight activities indicate that, as a practical matter, auditors are often challenged in meeting this fundamental audit requirement. In maintaining an attitude that includes a questioning mind and a critical assessment of audit evidence, it is important for auditors to be alert to unconscious human biases and other circumstances that can cause auditors to gather, evaluate, rationalize, and recal l information in a way that is consistent with client preferences rather than the interests of investors. Certain conditions inherent in the audit environment can create incentives and pressures that can serve to impede the appropriate application of professional skepticism and allow unconscious bias to prevail. For example, incentives and pressures to build or maintain a longterm audit engagement, avoid significant conflicts with management, provide an unqualified audit opinion prior to the issuer's filing deadline, achieve high client satisfaction ratings, keep audit costs low, or cross-sell other services can all serve to inhibit professional skepticism. I think audit staff too often hear from their leaders about the importance of delivering high quality "client service." That expression, "client service", can have confusing overtones to the
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audit team — like, keeping the client happy. How about deleting "client service" from the language and have leaders say instead — "audit teams, be focused on delivering the highest audit quality possible." Focus on extraordinary "audit quality", not extraordinary "client service." Another factor possibly impeding skepticism is that, over time, auditors may sometimes develop an inappropriate level of trust or confidence in management, which may lead auditors to accede to inappropriate accounting. In some situations, auditors may feel pressure to avoid potential negative interactions with individuals they know (that is, management) instead of representing the interests of the unseen investors they are charged to protect. By the way, that's a good lead-in to some other phrases I think we should re-consider. They are "Relationship Partner" and "maintaining strong client relationships." The term "relationship" can also have confusing overtones to an audit team , like "kinship" or "closeness". Does that feeling support skepticism? As far as I know, Federal Bank Regulators, State Insurance Departments, and Securities Regulators all perform their examinations, getting everything they need to complete their work, without a focus on "relationships". I'd substitute "professional courtesy" for "client relationships." Let's create the right tone from the top. Other circumstances also can impede the appropriate application of
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professional skepticism. For example, scheduling and workload demands can put pressure on partners and other engagement team members to complete their assignments too quickly, which might lead auditors to seek audit evidence that is easier to obtain rather than evidence that is more relevant and reliable, to obtain less evidence than is necessary, or to give undue weight to confirming evidence without adequately considering contrary evidence. Although powerful incentives and pressures exist that can impede professional skepticism, the importance of professional skepticism to an effective audit cannot be overstated, particularly given the increasing judgment and complexity in financial reporting, and issues posed by the current economic environment. Auditors and audit firms must remember that their overriding duty is to put the interests of investors first. Appropriate application of professional skepticism is key to fulfilling the auditor's duty to investors. In the words of the U.S. Supreme Court: "By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This 'public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust". Firms' quality control systems can help engagement teams improve
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the application of professional skepticism in a number of ways. They include setting a proper tone at the top that emphasizes the need for professional skepticism; implementing and maintaining appraisal, promotion, and compensation processes that enhance rather than discourage the application of professional skepticism; assigning personnel with the necessary competencies to engagement teams; and appropriately monitoring the quality control system to take necessary corrective actions to address audit engagements lacking professional skepticism. When professional skepticism is applied appropriately, the auditor does not presume that the financial statements are presented fairly. Instead, the auditor employs an attitude that includes a questioning mind in making critical assessments of the evidence obtained to determine whether the financial statements are materially misstated. PCAOB standards indicate that the auditor should take into account all relevant audit evidence, regardless of whether the evidence corroborates or contradicts the assertions in the financial statements. Examples of areas in the auditor's evaluation that reflect the need for the auditor to apply professional skepticism, include, among many others, the following: Evaluating uncorrected misstatements. This includes evaluating whether the uncorrected misstatements identified during the audit result in material misstatement of the financial statements, individually or in combination, considering both qualitative and quantitative factors. Evaluating management bias. This includes evaluating potential bias in accounting estimates, bias in the selection and application of
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accounting principles, the selective correction of misstatements identified during the audit, and identification by management of additional adjusting entries that offset misstatements accumulated by the auditor. When evaluating bias, it is important for auditors to consider the incentives and pressures on management regarding financial results. Evaluating the presentation of the financial statements. This includes evaluating whether the financial statements contain the information essential for a fair presentation of the financial statements in conformity with the applicable financial reporting framework. Do the financial statements really tell the complete story? When evaluating misstatements, bias, or presentation and disclosures, it is important for auditors to appropriately apply professional skepticism and avoid dismissing matters as immaterial without adequate consideration. In summary, it was my intent here to remind auditors of the importance of appropriately applying professional skepticism throughout their audits. In upcoming year-end audits, and in all audits, it is essential that every auditor be professionally skeptical in all aspects of their audit work, to maintain a questioning mind and make a critical assessment of audit evidence. I must respectfully disagree with the notion mentioned by a speaker yesterday that professional skepticism calls for a "trust but verify" approach. I hope my comments have made clear that it is the responsibility of
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each individual auditor to have a questioning mind throughout the audit. That means to be mindful of the risks of fraud or material misstatements, to obtain sufficient appropriate audit evidence rather than merely available evidence that corroborates assertions, and critically evaluate all evidence — especially when it contradicts those assertions. The Office of the Chief Auditor has issued an Audit Practice Alert today on "Maintaining and Applying Professional Skepticism in Audits." I consider it essential reading for all auditors. I believe it will also be useful for audit committee members and others in understanding the responsibilities of auditors to maintain an attitude of professional skepticism throughout the audit. Due to the fundamental importance of the appropriate application of professional skepticism in performing an audit, the PCAOB is also continuing to explore whether additional actions might meaningfully enhance auditors' professional skepticism. Thank you so much for your attention as I addressed this critically important subject, and other standard-setting matters.

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Report to Congress on Assigned Credit Ratings
As Required by Section 939F of the Dodd-Frank Wall Street Reform and Consumer Protection Act

Interesting Parts
This is a study by the Staff of the Division of Trading and Markets of the U.S. Securities and Exchange Commission. The Commission has expressed no view regarding the analysis, findings or conclusions contained herein. December 2012 On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) into law. Title IX, Subtitle C of the Dodd-Frank Act (“Title IX, Subtitle C”), “Improvements to the Regulation of Credit Rating Agencies,” among other things, established new self-executing requirements applicable to nationally recognized statistical rating organizations (“NRSROs”), required certain studies, and required that the Commission adopt rules applicable to NRSROs in a number of areas. Under section 939F of Title IX, Subtitle C (“section 939F”), the U.S. Securities and Exchange Commission (“Commission”) must submit to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives, not later than 24 months after the date of enactment of the Dodd-Frank Act, a report containing:
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(1) the findings of a study on matters related to assigning credit ratings for structured finance products; and (2) any recommendations for regulatory or statutory changes that the Commission determines should be made to implement the findings of the study. In particular, section 939F provides that the Commission shall carry out a study of the following: (1) The credit rating process for structured finance products and the conflicts of interest associated with the issuer-pay and the subscriber-pay models; (2) The feasibility of establishing a system in which a public or private utility or a self regulatory organization (“SRO”) assigns NRSROs to determine the credit ratings for structured finance products, including: (a) An assessment of potential mechanisms for determining fees for NRSROs for rating structured finance products; (b) Appropriate methods for paying fees to NRSROs to rate structured finance products; (c) The extent to which the creation of such a system would be viewed as the creation of moral hazard by the Federal Government; and (d) Any constitutional or other issues concerning the establishment of such a system; (3) The range of metrics that could be used to determine the accuracy of credit ratings for structured finance products; and (4) Alternative means for compensating NRSROs that would create incentives for accurate credit ratings for structured finance products.
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Section 939F also provides that, after submission of the report to Congress containing the findings of the study, the Commission shall, by rule, as the Commission determines is necessary or appropriate in the public interest or for the protection of investors, establish a system for the assignment of NRSROs to determine the initial credit ratings of structured finance products, in a manner that prevents the issuer, sponsor, or underwriter of the structured finance product from selecting the NRSRO that will determine the initial credit ratings and monitor such credit ratings. In issuing any rule pursuant to section 939F, the Commission is directed to give thorough consideration to the provisions of section 15E(w) of the Exchange Act, as that provision would have been added by section 939D of H.R. 4173 (111th Congress), as passed by the Senate on May 20, 2010 (the “Section 15E(w) Provisions”), and shall implement the system described in section 939D of H.R. 4173 (the “Section 15E(w) System”) unless the Commission determines that an alternative system would better serve the public interest and the protection of investors. The Commission requested public comment to assist the staff in carrying out this study. The Commission received thirty-two comment letters in response to its solicitation for comment. Six of the comment letters were submitted by NRSROs. The remaining twenty-six comment letters were submitted by other interested parties, including organizations representing investors, trade organizations, non-profit organizations, brokerage and financial services firms, academics and individuals. The staff reviewed each comment letter. The comment letters helped to inform the staff and raise complex issues for consideration.
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The staff also gathered information about the credit rating process for structured finance products, conflicts of interest in the issuerpay and subscriber-pay systems and alternative models for compensating NRSROs through: (1) a review of certain studies, articles, and testimony; (2) meetings with proponents of alternative models; and (3) meetings with NRSROs. The staff’s study focused on the Section 15E(w) System and potential alternatives to that system, including an existing rule (Rule 17g-5) under the Exchange Act that is designed to mitigate the issuer-pay conflict with respect to structured finance products. This report – which was prepared by Commission staff and approved for release by the Commission – is being submitted to Congress pursuant to section 939F. The views expressed in this report are those of the Commission staff and do not necessarily reflect the views of the Commission or the individual Commissioners. The report identifies potential benefits and concerns with respect to the Section 15E(w) System and potential alternatives to that system. The report also identifies potential regulatory or statutory changes the Commission could consider if the Commission determined to implement the Section 15E(w) System or one or more of the potential alternatives.

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The Credit Rating Process
The credit rating process for structured finance products used by NRSROs generally is similar, at least with respect to the more common types of products such as RMBS. The following summarizes the general process for rating a non-synthetic structured finance product. The issuer of the securities to be rated is a bankruptcy remote entity (typically a trust or a limited liability company) that is created solely to hold a pool of assets that generates cash flows, which are used to pay principal and interest on securities issued by the issuing entity. The securities typically are issued in “tranches” that are assigned priorities in terms of receiving interest and principal payments from the cash flows generated by the asset pool and incurring losses resulting from the failure of the assets in the pool to perform (e.g., because of defaults). The tranche that is the last to incur losses has the highest level of “credit enhancement.” This tranche receives the highest credit rating and, generally, the arranger of the transaction seeks to obtain a credit rating that is in the highest category of credit rating the NRSRO issues (e.g., “AAA”). Usually, the arranger seeks to design a capital structure for the issuer that will result in securities at given tranches receiving specific credit ratings that are demanded by the potential investors in the securities (e.g., the arranger will seek to design a capital structure that results in a “AAA” rating for securities in the most senior tranche). The investors may require specific credit ratings to obtain benefits or relief under statutes and regulations using the term NRSRO.
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They also may require specific credit ratings to meet investment guidelines or contractual requirements. The arranger initiates the rating process by sending the NRSRO data on the assets to be held by the issuing entity (e.g., mortgages, student loans, credit card receivables or, in the case of CDOs and CLOs, the underlying RBMS or ABS), the proposed capital structure of the trust, and the proposed level of credit enhancement for each tranche of security to be issued by the issuing entity. The NRSRO assigns a lead analyst, who is responsible for analyzing the information and, ultimately, for formulating a ratings recommendation that will be submitted to a rating committee. The lead analyst uses quantitative expected loss models and qualitative analysis to develop predictions as to how the assets in the pool held by the issuing entity likely will perform under market stresses of varying severity. These predictions include assumptions regarding the amount of principal likely to be recovered in the event of default when the asset is secured by collateral. The analyst typically reviews different characteristics of each asset in the pool. For example, in the case of an RMBS (which holds a pool of residential mortgages), the analyst reviews the value of the property relative to the amount of the loan, the amount of equity the borrower has in the property, the geographic location of the property, the credit score of the borrower, the income and net worth of the borrower, and the amount of documentation provided by the borrower to verify the borrower’s financial condition. The analyst also may consider other factors, such as the quality of the loan servicer or the actual performance of similar pools of assets.
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The purpose of this loss analysis is to determine how much credit enhancement a given tranche would need for a security in that tranche to receive a particular category of credit rating (e.g., a “AAA” rating). The analyst next evaluates the proposed capital structure of the issuer. Generally, the arranger proposes a capital structure with credit enhancement levels to obtain desired credit ratings for securities in each tranche. The analyst reviews the proposed credit enhancement levels against the predictions as to how the assets in the pool will perform to determine whether the amount of credit enhancement at each tranche is sufficient to support the desired credit rating. If the analyst concludes that the capital structure of the issuer will not support the desired rating for a security in a particular tranche, the analyst typically conveys this preliminary conclusion to the arranger. The arranger requests this preliminary view from the analyst because – as noted above – the potential investors who will purchase the securities generally demand specific credit ratings. Consequently, if the securities will not receive the credit rating sought by the potential investors, the arranger may not be able to sell them. In the case where the analyst’s preliminary view differs from the expectation of the arranger, the arranger can accept the lower credit ratings or take steps to obtain the desired credit ratings. These steps can include changing the composition of the asset pool so that it yields better expected loss measures or adjusting the capital structure of the issuer to increase the level of credit enhancement at a given tranche.

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The next step in the process is to perform a cash flow analysis on the interest and principal expected to be received by the issuing entity from the asset pool to determine whether these cash flows will be sufficient to pay the interest and principal due on each security, as well as to cover the administrative expenses of the issuing entity. The analyst uses a quantitative model often developed by the NRSRO that analyzes the amount of principal and interest payments from the assets over the terms of the securities under various stress scenarios. The outputs of this model are compared against the required payments on the securities specified in the transaction’s legal documents. In addition to the expected loss and cash flow analysis, the analyst reviews the legal documentation of the issuing entity to evaluate whether it is bankruptcy remote (i.e., isolated from the effects of any potential bankruptcy or insolvency of the arranger). The analyst also reviews operational and administrative risk associated with the issuing entity, using the results of periodic examinations of the principal parties involved in the issuance of the security, including the asset originators, the servicer of the assets, and the trustee. In assessing the servicer, for example, an NRSRO might review its past performance with respect to loan collections, billing, recordkeeping, and the treatment of delinquent loans. Following these steps, the analyst develops a rating recommendation for the securities in each tranche. The recommendation is presented to a rating committee, which may be comprised of a lead analyst, a senior analyst, and a chairperson, among others. An analyst is not allowed to participate on a committee if he or she has a conflict of interest.
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Potential conflicts of interest may be monitored throughout the rating process. Conflicts of interest also are controlled by internal procedures, such as requiring credit ratings to be determined by a committee rather than individual analysts, requiring rating committees to act by majority vote, and physically or substantively segregating rating committees from business functions. Generally, the rating committee votes on the rating for the securities in each tranche and usually notifies the issuer privately of the rating decision. An issuer may be able to appeal a rating decision, although the appeal is not always granted, and, if granted, may not necessarily result in any change in the rating decision. In those cases where appeals are granted, the issuer may be entitled to a decision by a second rating committee, but the standards for changing a rating are generally very stringent (e.g., missing or materially misinterpreting critical information). Final rating decisions are published and subsequently monitored and maintained through surveillance processes. Generally, the analyst who monitors the rating after it is issued is different than the analyst who performed the initial rating. The surveillance process generally includes a periodic review of the performance of the assets in the pool, including delinquency and loss trends. If it is determined that the asset pool is performing differently than predicted, the surveillance analyst may recommend taking a rating action by presenting the recommendation to a rating committee.
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An NRSRO that operates under an issuer-pay model typically is paid only if the credit rating is issued, though sometimes it receives a partial fee for the analytic work undertaken if the credit rating is not issued. The issuer will pay an initial rating fee to the NRSRO when the transaction is sold. A surveillance fee for maintaining the rating also may be paid at closing or over the life of the securities.

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Chairman Ben S. Bernanke
At the New York Economic Club, New York

The Economic Recovery and Economic Policy
Good afternoon. I am pleased to join the New York Economic Club for lunch today. I know that many of you and your friends and neighbors are still recovering from the effects of Hurricane Sandy, and I want to let you know that our thoughts are with everyone who has suffered during the storm and its aftermath. My remarks today will focus on the reasons for the disappointingly slow pace of economic recovery in the United States and the policy actions that have been taken by the Federal Open Market Committee (FOMC) to support the economy. In addition, I will discuss some important economic challenges our country faces as we close out 2012 and move into 2013--in particular, the challenge of putting federal government finances on a sustainable path in the longer run while avoiding actions that would endanger the economic recovery in the near term.

The Recovery from the Financial Crisis and Recession
The economy has continued to recover from the financial crisis and recession, but the pace of recovery has been slower than FOMC participants and many others had hoped or anticipated when I spoke here about three years ago. Indeed, since the recession trough in mid-2009, growth in real gross domestic product (GDP) has averaged only a little more than 2 percent per year.
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Similarly, the job market has improved over the past three years, but at a slow pace. The unemployment rate, which peaked at 10 percent in the fall of 2009, has since come down 2 percentage points to just below 8 percent. This decline is obviously welcome, but it has taken a long time to achieve that progress, and the unemployment rate is still well above both its level prior to the onset of the recession and the level that my colleagues and I think can be sustained once a full recovery has been achieved. Moreover, many other features of the jobs market, including the historically high level of long-term unemployment, the large number of people working part time because they have not been able to find full time jobs, and the decline in labor force participation, reinforce the conclusion that we have some way to go before the labor market can be deemed healthy again. Meanwhile, inflation has generally remained subdued. As is often the case, inflation has been pushed up and down in recent years by fluctuations in the price of crude oil and other globally traded commodities, including the increase in farm prices brought on by this summer's drought. But with longer-term inflation expectations remaining stable, the ebbs and flows in commodity prices have had only transitory effects on inflation. Indeed, since the recovery began about three years ago, consumer price inflation, as measured by the personal consumption expenditures (PCE) price index, has averaged almost exactly 2 percent, which is the FOMC's longer-run objective for inflation.

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Because ongoing slack in labor and product markets should continue to restrain wage and price increases, and with the public's inflation expectations continuing to be well anchored, inflation over the next few years is likely to remain close to or a little below the Committee's objective. As background for our monetary policy decision making, we at the Federal Reserve have spent a good deal of effort attempting to understand the reasons why the economic recovery has not been stronger. Studies of previous financial crises provide one helpful place to start. This literature has found that severe financial crises--particularly those associated with housing booms and busts--have often been associated with many years of subsequent weak performance. While this result allows for many interpretations, one possibility is that financial crises, or the deep recessions that typically accompany them, may reduce an economy's potential growth rate, at least for a time. The accumulating evidence does appear consistent with the financial crisis and the associated recession having reduced the potential growth rate of our economy somewhat during the past few years. In particular, slower growth of potential output would help explain why the unemployment rate has declined in the face of the relatively modest output gains we have seen during the recovery. Output normally has to increase at about its longer-term trend just to create enough jobs to absorb new entrants to the labor market, and faster-than-trend growth is usually needed to reduce unemployment. So the fact that unemployment has declined in recent years despite economic growth at about 2 percent suggests that the growth rate of potential output must have recently been lower than the roughly 2-1/2 percent rate that appeared to be in place before the crisis.
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There are a number of ways in which the financial crisis could have slowed the rate of growth of the economy's potential. For example, the extraordinarily severe job losses that followed the crisis, especially in housing-related industries, may have exacerbated for a time the extent of mismatch between the jobs available and the skills and locations of the unemployed. Meanwhile, the very high level of long-term unemployment has probably led to some loss of skills and labor force attachment among those workers. These factors may have pushed up to some degree the so-called natural rate of unemployment--the rate of unemployment that can be sustained under normal conditions--and reduced labor force participation as well. The pace of productivity gains--another key determinant of growth in potential output--may also have been restrained by the crisis, as business investment declined sharply during the recession; and increases in risk aversion and uncertainty, together with tight credit conditions, may have impeded the commercial application of new technologies and slowed the pace of business formation. Importantly, however, although the nation's potential output may have grown more slowly than expected in recent years, this slowing seems at best a partial explanation of the disappointing pace of the economic recovery. In particular, even though the natural rate of unemployment may have increased somewhat, a variety of evidence suggests that any such increase has been modest, and that substantial slack remains in the labor market. For example, the slow pace of employment growth has been widespread across industries and regions of the country. That pattern suggests a broad-based shortfall in demand rather than a substantial increase in mismatch between available jobs and workers,
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because greater mismatch would imply that the demand for workers would be strong in some regions and industries, not weak almost across the board. Likewise, if a mismatch of jobs and workers is the predominant problem, we would expect to see wage pressures developing in those regions and industries where labor demand is strong; in fact, wage gains have been quite subdued in most industries and parts of the country. Indeed, as I indicated earlier, the consensus among my colleagues on the FOMC is that the unemployment rate is still well above its longerrun sustainable level, perhaps by 2 to 2-1/2 percentage points or so. A critical question, then, is why significant slack in the job market remains three years after the recovery began. A likely explanation, which I will discuss further, is that the economy has been faced with a variety of headwinds that have hindered what otherwise might have been a stronger cyclical rebound. If so, we may take some encouragement from the likelihood that there are potentially two sources of faster GDP growth in the future. First, the effects of the crisis on potential output should fade as the economy continues to heal. And second, if the headwinds begin to dissipate, as I expect, growth should pick up further as many who are currently unemployed or out of the labor force find work.

Headwinds Affecting the Recovery
What are the headwinds that have slowed the return of our economy to full employment? Some have come from the housing sector.

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Previous recoveries have often been associated with a vigorous rebound in housing, as rising incomes and confidence and, often, a decline in mortgage interest rates led to sharp increases in the demand for homes. But the housing bubble and its aftermath have made this episode quite different. In the first half of the past decade, both housing prices and construction rose to what proved to be unsustainable levels, leading to a subsequent collapse: House prices declined almost one-third nationally from 2006 until early this year, construction of single-family homes fell two-thirds, and the number of construction jobs decreased by nearly one-third. And, of course, the associated surge in delinquencies on mortgages helped trigger the broader financial crisis. Recently, the housing market has shown some clear signs of improvement, as home sales, prices, and construction have all moved up since early this year. These developments are encouraging, and it seems likely that, on net, residential investment will be a source of economic growth and new jobs over the next couple of years. However, while historically low mortgage interest rates and the drop in home prices have made housing exceptionally affordable, a number of factors continue to prevent the sort of powerful housing recovery that has typically occurred in the past. Notably, lenders have maintained tight terms and conditions on mortgage loans, even for potential borrowers with relatively good credit. Lenders cite a number of factors affecting their decisions to extend credit, including ongoing uncertainties about the course of the economy, the housing market, and the regulatory environment.
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Unfortunately, while some tightening of the terms of mortgage credit was certainly an appropriate response to the earlier excesses, the pendulum appears to have swung too far, restraining the pace of recovery in the housing sector. Other factors slowing the recovery in housing include the fact that many people remain unable to buy homes despite low mortgage rates; for example, about 20 percent of existing mortgage borrowers owe more on their mortgages than their houses are worth, making it more difficult for them to refinance or sell their homes. Also, a substantial overhang of vacant homes, either for sale or in the foreclosure pipeline, continues to hold down house prices and reduce the need for new construction. While these headwinds on both the supply and demand sides of the housing market have clearly started to abate, the recovery in the housing sector is likely to remain moderate by historical standards. A second set of headwinds stems from the financial conditions facing potential borrowers in credit and capital markets. After the financial system seized up in late 2008 and early 2009, global economic activity contracted sharply, and credit and capital markets suffered significant damage. Although dramatic actions by governments and central banks around the world helped these markets to stabilize and begin recovering, tight credit and a high degree of risk aversion have restrained economic growth in the United States and in other countries as well. Measures of the condition of U.S. financial markets and institutions suggest gradual but significant progress has been achieved since the crisis.

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For example, credit spreads on corporate bonds and syndicated loans have narrowed considerably, and equity prices have recovered most of their losses. In addition, indicators of market stress and illiquidity--such as spreads in short-term funding markets--have generally returned to levels near those seen before the crisis. One gauge of the overall improvement in financial markets is the National Financial Conditions Index maintained by the Federal Reserve Bank of Chicago. The index shows that financial conditions, viewed as a whole, are now about as accommodative as they were in the spring of 2007. In spite of this broad improvement, the harm inflicted by the financial crisis has yet to be fully repaired in important segments of the financial sector. One example is the continued weakness in some categories of bank lending. Banks' capital positions and overall asset quality have improved substantially over the past several years, and, over time, these balance sheet improvements will position banks to extend considerably more credit to bank-dependent borrowers. Indeed, some types of bank credit, such as commercial and industrial loans, have expanded notably in recent quarters. Nonetheless, banks have been conservative in extending loans to many consumers and some businesses, likely even beyond the restrictions on the supply of mortgage lending that I noted earlier. This caution in lending by banks reflects, among other factors, their continued desire to guard against the risks of further economic weakness.
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A prominent risk at present--and a major source of financial headwinds over the past couple of years--is the fiscal and financial situation in Europe. This situation, of course, was not anticipated when the U.S. recovery began in 2009. The elevated levels of stress in European economies and uncertainty about how the problems there will be resolved are adding to the risks that U.S. financial institutions, businesses, and households must consider when making lending and investment decisions. Negative sentiment regarding Europe appears to have weighed on U.S. equity prices and prevented U.S. credit spreads from narrowing even further. Weaker economic conditions in Europe and other parts of the world have also weighed on U.S. exports and corporate earnings. Policymakers in Europe have taken some important steps recently, and in doing so have contributed to some welcome easing of financial conditions. In particular, the European Central Bank's new Outright Monetary Transactions program, under which it could purchase the sovereign debt of vulnerable euro-area countries who agree to meet prescribed conditions, has helped ease market concerns about those countries. European governments have also taken steps to strengthen their financial firewalls and to move toward greater fiscal and banking union. Further improvement in global financial conditions will depend in part on the extent to which European policymakers follow through on these initiatives. A third headwind to the recovery--and one that may intensify in force in coming quarters--is U.S. fiscal policy.
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Although fiscal policy at the federal level was quite expansionary during the recession and early in the recovery, as the recovery proceeded, the support provided for the economy by federal fiscal actions was increasingly offset by the adverse effects of tight budget conditions for state and local governments. In response to a large and sustained decline in their tax revenues, state and local governments have cut about 600,000 jobs on net since the third quarter of 2008 while reducing real expenditures for infrastructure projects by 20 percent. More recently, the situation has to some extent reversed: The drag on economic growth from state and local fiscal policy has diminished as revenues have improved, easing the pressures for further spending cuts or tax increases. In contrast, the phasing-out of earlier stimulus programs and policy actions to reduce the federal budget deficit have led federal fiscal policy to begin restraining GDP growth. Indeed, under almost any plausible scenario, next year the drag from federal fiscal policy on GDP growth will outweigh the positive effects on growth from fiscal expansion at the state and local level. However, the overall effect of federal fiscal policy on the economy, both in the near term and in the longer run, remains quite uncertain and depends on how policymakers meet two daunting fiscal challenges--one by the start of the new year and the other no later than the spring.

Upcoming Fiscal Challenges
What are these looming challenges? First, the Congress and the Administration will need to protect the economy from the full brunt of the severe fiscal tightening at the
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beginning of next year that is built into current law--the so-called fiscal cliff. The realization of all of the automatic tax increases and spending cuts that make up the fiscal cliff, absent offsetting changes, would pose a substantial threat to the recovery--indeed, by the reckoning of the Congressional Budget Office (CBO) and that of many outside observers, a fiscal shock of that size would send the economy toppling back into recession. Second, early in the new year it will be necessary to approve an increase in the federal debt limit to avoid any possibility of a catastrophic default on the nation's Treasury securities and other obligations. As you will recall, the threat of default in the summer of 2011 fueled economic uncertainty and badly damaged confidence, even though an agreement ultimately was reached. A failure to reach a timely agreement this time around could impose even heavier economic and financial costs. As fiscal policymakers face these critical decisions, they should keep two objectives in mind. First, as I think is widely appreciated by now, the federal budget is on an unsustainable path. The budget deficit, which peaked at about 10 percent of GDP in 2009 and now stands at about 7 percent of GDP, is expected to narrow further in the coming years as the economy continues to recover. However, the CBO projects that, under a plausible set of policy assumptions, the budget deficit would still be greater than 4 percent of GDP in 2018, assuming the economy has returned to its potential by then.
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Moreover, under the CBO projection, the deficit and the ratio of federal debt to GDP would subsequently return to an upward trend. Of course, we should all understand that long-term projections of everincreasing deficits will never actually come to pass, because the willingness of lenders to continue to fund the government can only be sustained by responsible fiscal plans and actions. A credible framework to set federal fiscal policy on a stable path--for example, one on which the ratio of federal debt to GDP eventually stabilizes or declines--is thus urgently needed to ensure longer-term economic growth and stability. Even as fiscal policymakers address the urgent issue of longer-run fiscal sustainability, they should not ignore a second key objective: to avoid unnecessarily adding to the headwinds that are already holding back the economic recovery. Fortunately, the two objectives are fully compatible and mutually reinforcing. Preventing a sudden and severe contraction in fiscal policy early next year will support the transition of the economy back to full employment; a stronger economy will in turn reduce the deficit and contribute to achieving long-term fiscal sustainability. At the same time, a credible plan to put the federal budget on a path that will be sustainable in the long run could help keep longer-term interest rates low and boost household and business confidence, thereby supporting economic growth today. Coming together to find fiscal solutions will not be easy, but the stakes are high. Uncertainty about how the fiscal cliff, the raising of the debt limit, and the longer-term budget situation will be addressed appears already to be
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affecting private spending and investment decisions and may be contributing to an increased sense of caution in financial markets, with adverse effects on the economy. Continuing to push off difficult policy choices will only prolong and intensify these uncertainties. Moreover, while the details of whatever agreement is reached to resolve the fiscal cliff are important, the economic confidence of both market participants and the general public likely will also be influenced by the extent to which our political system proves able to deliver a reasonable solution with a minimum of uncertainty and delay. Finding long-term solutions that can win sufficient political support to be enacted may take some time, but meaningful progress toward this end can be achieved now if policymakers are willing to think creatively and work together constructively.

Monetary Policy
Let me now turn briefly to monetary policy. Monetary policy can do little to reverse the effects that the financial crisis may have had on the economy's productive potential. However, it has been able to provide an important offset to the headwinds that have slowed the cyclical recovery. As you know, the Federal Reserve took strong easing measures during the financial crisis and recession, cutting its target for the federal funds rate--the traditional tool of monetary policy--to nearly zero by the end of 2008. Since that time, we have provided additional accommodation through two nontraditional policy tools aimed at putting downward pressure on longer-term interest rates: asset purchases that reduce the supply of
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longer-term securities outstanding in the market, and communication about the future path of monetary policy. Most recently, after the September FOMC meeting, we announced that the Federal Reserve would purchase additional agency mortgage-backed securities (MBS) and continue with the program to extend the maturity of our Treasury holdings. These additional asset purchases should put downward pressure on longer-term interest rates and make broader financial conditions more accommodative. Moreover, our purchases of MBS, by bringing down mortgage rates, provide support directly to housing and thereby help mitigate some of the headwinds facing that sector. In announcing this decision, we also indicated that we would continue purchasing MBS, undertake additional purchases of longer-term securities, and employ our other policy tools until we judge that the outlook for the labor market has improved substantially in a context of price stability. Although it is still too early to assess the full effects of our most recent policy actions, yields on corporate bonds and agency MBS have fallen significantly, on balance, since the FOMC's announcement. More generally, research suggests that our previous asset purchases have eased overall financial conditions and provided meaningful support to the economic recovery in recent years. In addition to announcing new purchases of MBS, at our September meeting we extended our guidance for how long we expect that exceptionally low levels for the federal funds rate will likely be warranted at least through the middle of 2015.

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By pushing the expected period of low rates further into the future, we are not saying that we expect the economy to remain weak until mid2015; rather, we expect--as we indicated in our September statement-that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In other words, we will want to be sure that the recovery is established before we begin to normalize policy. We hope that such assurances will reduce uncertainty and increase confidence among households and businesses, thereby providing additional support for economic growth and job creation.

Conclusion
In sum, the U.S. economy continues to be hampered by the lingering effects of the financial crisis on its productive potential and by a number of headwinds that have hindered the normal cyclical adjustment of the economy. The Federal Reserve is doing its part by providing accommodative monetary policy to promote a stronger economic recovery in a context of price stability. As I have said before, however, while monetary policy can help support the economic recovery, it is by no means a panacea for our economic ills. Currently, uncertainties about the situation in Europe and especially about the prospects for federal fiscal policy seem to be weighing on the spending decisions of households and businesses as well as on financial conditions. Such uncertainties will only be increased by discord and delay.

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In contrast, cooperation and creativity to deliver fiscal clarity--in particular, a plan for resolving the nation's longer-term budgetary issues without harming the recovery--could help make the new year a very good one for the American economy.

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Sarbanes Oxley Speakers Bureau
Visit our Sarbanes Oxley Speakers Bureau. The Sarbanes Oxley Compliance Professionals Association (SOXCPA) has established the Speakers Bureau for firms and organizations that want to access the Sarbanes Oxley expertise of Certified Sarbanes Oxley Experts (CSOEs), Certified JSOX Experts (CJSOXEs) and Certified EU Sarbanes Oxley Experts (CEUSOEs) - experts of the 8th Company Law Directive of the European Union. The SOXCPA will be the liaison between our certified professionals and these organizations, at no cost. We strongly believe that this can be a great opportunity for both, our certified professionals and the organizers. We will give the details of an event to one or more Sarbanes Oxley experts, who will contact directly the organization requesting services. The Sarbanes Oxley experts will negotiate services and fees. To learn more: www.sarbanes-oxleyassociation.com/Sarbanes_Oxley_Speakers_Bureau.html

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Certified Sarbanes-Oxley Expert (CSOE) Distance Learning and Online Certification Program.
The all-inclusive cost is $147 What is included in the price:

A. The official presentations we use in our instructor-led classes (2247 slides)
The 1271 slides cover what is needed for the exam and 976 slides cover the Dodd Frank Act that is not part of the exam). Updated: February 17, 2011. The presentations include the Auditing Standards 8 to 15 that apply to Sarbanes Oxley audits, from the PCAOB. Course Synopsis: www.sarbanes-oxley-association.com/CSOE_Course_Synopsis.htm

B. Up to 3 Online Exams
There is only one exam you need to pass, in order to become a Certified Sarbanes-Oxley Expert (CSOE). If you fail, you must study again the official presentations, but you do not need to spend money to try again. To learn more you may visit: www.sarbanes-oxleyassociation.com/Questions_About_The_Certification_And_The_Exams _1.pdf www.sarbanes-oxley-association.com/CSOE_Certification_Steps_1.pdf

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C. Personalized Certificate printed in full color
Processing, printing, packing and posting to your office or home

D. The Dodd Frank Act and the Sarbanes Oxley amendments (976 slides)
The US Dodd-Frank Wall Street Reform and Consumer Protection Act is the most significant piece of legislation concerning the financial services industry in about 80 years. What does it mean for risk and compliance management professionals? It means new challenges, new jobs, new careers, and new opportunities. The bill establishes new risk management and corporate governance principles, sets up an early warning system to protect the economy from future threats, and brings more transparency and accountability. It also amends important sections of the Sarbanes Oxley Act. For example, it significantly expands whistleblower protections under the Sarbanes Oxley Act and creates additional anti-retaliation requirements. THE DODD FRANK ACT PRESENTATION IS NOT PART OF THE EXAM - THERE ARE NO QUESTIONS BASED ON THESE 976 SLIDES We will follow the steps: www.sarbanes-oxleyassociation.com/Distance_Learning_and_Certification.htm

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Sarbanes Oxley Compliance Professionals Association (SOXCPA) www.sarbanes-oxley-association.com

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