Sunday, October 17, 2010

PCAOB Advisory Group Examines Failure to Supervise and Professional Judgment Issues

At a recent meeting of the PCAOB's Standing Advisory Group (SAG), a panel discussed potential challenges to auditing. One of the most pressing issues today is the move towards global principles-based accounting and auditing standards promulgated respectively by the IASB and the IAASB. Samuel Ranzilla, KPMG National Managing Partner, cautioned that a combination of principles-based accounting standards and prescriptive rules-based auditing standards would be a dangerous cocktail. PCAOB Member Bill Gradison said that we are entering a new world of principles-based accounting standards in which the Board has no control over how fast and deep accounting standards will become principles-based. In light of accounting standards using more judgments, Member Gradison said that it would be useful to re-examine the basic assumptions underlying the auditing standards.

Former PCAOB Chief Auditor Douglas Carmichael said that, as we move to principles-based accounting standards, it is important that the Board coordinate with other regulators and standard-setters. Auditing standards generally start where accounting standards stop, he noted, so advance coordination would be useful.

Duke Law Professor James Cox said that audit committees could be useful in getting a better view of financial statements prepared under principles-based standards. As auditor communication with audit committees is enhanced, he said, judgments by outside auditors could be part of that communication to audit committees or even to regulators.

Barbara Roper of the Consumer Federation of America said that a professional judgment framework under which investors are told to respect and not second guess auditor judgments makes investor advocates nervous. The notion behind auditor skepticism isto question these judgments, she noted, adding that a safe harbor for professional judgments should not be implied.

The SAG panel went on to discuss the PCAOB concept release on issues relating to the responsibilities of an accounting firm and its supervisory personnel with respect to supervision (PCAOB Release No. 2010-005). Section 105(c)(6) of the Sarbanes-Oxley authorizes the Board to impose sanctions on accounting firms and their supervisory personnel for failing reasonably to supervise associated persons who have violated certain laws, rules, or standards. The comment period on the release ends on Nov. 3, 2010.

There was consensus in SAG that failure to supervise should be baked into quality control. John Archambault, Grant Thornton senior partner, said that the issue of failure to supervise flows into quality control standards. The main thrust of failure to supervise rules is that audit firm personnel need to know who has what responsibilities. Mary Hartman Morris, Calpers Investment Officer for Global Equity, said that failure to supervise is one more step toward audit quality and is tied to key quality performance indicators. Steven Rafferty of BKD added that if Board inspections are finding that the failure to supervise is a failure of people to do their jobs then it is part of the quality control system.

Former SEC Chief Accountant Lynn Turner said that the Board should think of failure to supervise in broad terms, including tone at the top. He cautioned that a narrow definition of supervision would not work and could even insulate people. The former Chief Accountant also believes that a few really good enforcement actions would be more effective than rulemaking in this area. Enforcement actions involving a failure to supervise will do more to wake people up and improve performance than rules. Barbara Roper agreed on the efficacy of enforcement actions in this area. She also noted that failure to supervise issues will become more important as the use of professional judgments becomes more prevalent.

But PCAOB Member Steven Harris noted that Board inspection staff are finding problems in the failure to supervise area that go beyond simple enforcement. He added that the Board’s initiative on failure to supervise is extremely important because of the sheer volume of inspection reports that mention this issue year after year with no remediation.

Professor Cox urged the PCAOB to look at a 1992 SEC action in the failure to supervise area, In the Matter of Gutfreund, Release No. 34-31554, 1992 CCH Decisions ¶85,067. He said that the Gutfreund decision is a leading decision on what indicia and level of involvement make a person a supervisor. In Gutfreund, three senior managers of a brokerage firm, including the chief executive officer, settled proceedings relating to their failure to supervise a former managing director of the firm with a view to preventing securities law violations in connection with the submission of false bids in auctions of U.S. Treasury securities. The SEC held that the chief legal officer of the brokerage firm, who was informed by senior management of the serious misconduct of a senior firm official and was involved as part of management's collective response to the problem, was a "supervisor" for purposes of Sections 15(b)(4)(E) and 15(b)(6) of the Exchange Act. Professor Cox said that the decision teaches that the level of involvement is an important factor in deciding if one is a statutory supervisor.

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