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SEC Chief Accountant Discusses Sarbanes-Oxley Rulemaking

As the SEC embarks on its most extensive rulemaking effort in many years, Acting Chief Accountant Jackson M. Day outlined a number of issues involved in implementing provisions of the Sarbanes-Oxley Act. In remarks to the American Institute of Certified Public Accountants current issues conference in Washington, D.C., he said that the Sarbanes-Oxley Act requires significant reform in all aspects of the financial reporting and disclosure system and forever changes life for companies and their auditors.

In his view, a number of general themes underlie the act, one of which is that people must accept responsibility for their own behavior. Similarly, being an accomplice to, or ignoring, a bad deed may be the same as doing the bad deed. Finally, the Sarbanes-Oxley Act makes clear that "appearance counts."

More specifically, the SEC has proposed a model based on three basic principles to determine when non-audit services would impair an auditor's independence. Those principles are that auditors should not audit their own work, act as management or be advocates for their clients. Consistent with this model, auditors generally would no longer be able to serve as internal auditors, install information systems or provide actuarial services for their audit clients. The SEC would, however, allow audit firms to continue providing most traditional tax services since the Sarbanes-Oxley Act did not ban all tax services.

A company's audit committee would be required to approve all services, continued Mr. Day. Failure to obtain approval would cause the auditor's independence to be impaired even when providing potentially allowable audit and non-audit services, he noted.

Consistent with the Sarbanes-Oxley Act, the SEC proposal does not call for audit firm rotation. It does, however, call for more extensive partner rotation. Under the proposal, all partners providing significant audit services on a continuing basis will be required to rotate every five years and be subject to a five-year time out. The goal is to provide the "fresh look " afforded when auditors rotate, explained the SEC official, without losing the knowledge gained in prior audits. To achieve that goal, he continued, it will be important for firms to stagger the rotation of their partners on engagements with multiple partners.

Additionally, Mr. Day emphasized the importance of properly staffing all audit engagements to ensure that the engagement team is qualified and knowledgeable about the client and industry conditions. It is critical, emphasized the chief accountant, to strike the right balance between loss of continuity and the need to have a fresh set of eyes involved in the audit.

Another area of potential change relates to disclosures of fees paid to a company's audit firm. Different and more detailed disclosures would be required under the proposed disclosure of fees paid to auditors. The aim is to make the disclosures more transparent, line them up more directly with the Sarbanes-Oxley Act and the rules and to provide comparable information.

The Commission also proposes to prohibit members of an audit engagement team from being directly compensated for selling non-audit services to their audit clients. This proposal is designed to remove any incentives for behavior that might jeopardize an auditor's independence.

Finally, on the topic of internal controls, Sarbanes-Oxley mandates rulemaking to require the inclusion in annual filings of an internal control report that states the responsibilities of management for establishing and maintaining adequate internal controls, as well as an assessment by management of the effectiveness of the internal control structure and procedures for financial reporting. Furthermore, the act calls for an independent accounting firm to attest to management's report on internal controls.

In response to the act, the Commission has proposed rules calling for a company's annual report to include a report by management. This report should contain 1) a statement of management's responsibility for establishing and maintaining adequate internal controls and procedures for financial reporting, 2) an evaluation, as of the most recent year-end, of the effectiveness of a company's internal controls and procedures for financial reporting and 3) a statement that the independent accounting firm has attested to, and reported on, management's evaluation of the company's internal controls and procedures for financial reporting.

The act also states that the attestation and reporting of the independent auditor must be made in accordance with standards for attestation engagements issued or adopted by the new public company accounting oversight board. Once operational, declared Mr. Day, the impact of these requirements will be profound. Auditors will be required to understand, test and report on the internal control structure over financial reporting. While this requires additional work for the auditors, reasoned the SEC accountant, it also provides a tremendous opportunity for auditors to gain a greater understanding of their client's internal controls.

He believes this to be one of the most important provisions of the act as it relates to improving the quality of audits. The days of documenting that a system of internal controls is effective and then auditing around the internal controls are over, declared the senior official. Auditors will need to understand the systems and report on the deficiencies, he cautioned, and companies and their management will be held accountable for the deficiencies in the systems.