Framework for Enhancing the Quality of Financial Information Through Improvement of Oversight of the Auditing Process

Federal RegisterJul 5, 2002

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 229

[Release Nos. 33-8109; 34-46120; 35-27543; IA-2039; IC-25624; File No. S7-24-02]

RIN 3235-AI41

Framework for Enhancing the Quality of Financial Information Through Improvement of Oversight of the Auditing Process

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“SEC” or “Commission”) is proposing rules designed to restore investors” faith in the financial information that they rely on for their investment decisions. The proposed rules reform oversight and improve accountability of auditors of public companies, thereby enhancing the reliability and integrity of the auditing and financial reporting processes. Under the proposed rules, a registrant's financial statements will not comply with the requirements of the securities laws and Commission rules and regulations thereunder unless the registrant's independent accountant is a member of a Public Accountability Board (“PAB”), and the registrant engaging the accountant to audit or review financial statements or prepare attestation reports that are filed with the Commission is an adjunct member of the same PAB to which the accountant belongs.

To improve oversight of and investor confidence in the quality of financial reports filed with the Commission, the Commission will not recognize a PAB unless the PAB meets certain conditions and performs certain functions. A PAB must have a Board that is dominated by persons who are not members of the accounting profession and must be subject to the Commission's oversight. A PAB must be committed to improving the quality of financial statements relied on by investors and the professional conduct of accountants by, among other things, directing periodic reviews of accounting firms' quality controls over their accounting and auditing practices and, when appropriate, disciplining accountants. A PAB also would set, or rely on and oversee designated private sector bodies to set, audit, quality control, and ethics standards. Disclosure would be required in Commission filings if an executive officer, director, or director nominee of a registrant has been sanctioned as a member accountant by a PAB within the last five years and the sanction has not been reversed, suspended, or vacated.

DATES:

Comments should be received on or before September 3, 2002.

ADDRESSES:

Comments should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments also may be submitted electronically at the following electronic mail address:

rule-comments@sec.gov.

All comment letters should refer to File No. S7-24-02. This file number should be included in the subject line if electronic mail is used. Comment letters will be available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW., Washington, DC 20549. Electronically submitted comment letters will be posted on the Commission's Internet website (

http://www.sec.gov

We do not edit personal identifying information, such as names or electronic mail addresses, from electronic submissions. You should submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT:

Samuel L. Burke, Associate Chief Accountant, Bert W. Mehrer, Assistant Chief Accountant, or Robert E. Burns, Chief Counsel, Office of the Chief Accountant, at (202) 942-4400, U.S. Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-1103.

SUPPLEMENTARY INFORMATION:

We are proposing to amend rule 1-02

and rule 2-01

of Regulation S-X, add new rules 13-01 through 13-07 to Regulation S-X,

and amend item 401

of Regulation S-K.

17 CFR 210.1-02.

17 CFR 210.2-01.

17 CFR 210.13-01-13.07.

17 CFR 229.401.

I. Executive Summary

Congress, through the federal securities laws, imposed on public companies the obligation to disclose complete and accurate financial information. Cognizant of the lessons of history, however, Congress built into the securities laws a significant safeguard: requirements that a public company's financial information filed with the Commission be audited by certified or public accountants that are independent of that company.

The investing public and the Commission must rely on the competence, ethics, and independence of accountants who certify the financial statements of public companies. People invest their savings in the securities of public companies and thereby make capital allocation decisions in reliance on the financial statements of those companies. If investors lack confidence in the reliability of the information presented, the fundamental purposes of the federal securities laws—to protect investors and promote efficient markets—are thwarted.

Effective oversight of the accounting profession is critical to quality financial information and trust in and reliance on that information. By having effective oversight, investors are assured that skilled, disinterested professionals operating under high ethical standards and strict quality control procedures are auditing financial statements. Strong oversight helps to strengthen audit practice and to detect and deter weaknesses that could detract from an accountant's ability to fulfill the goal of having financial statements audited by competent, independent accountants. Further, when oversight is compromised, the quality of financial information can be affected, and investors' trust in the quality of financial information is compromised as well.

The current system of oversight has not produced a credible result. Flaws in the system have contributed to the confluence of several factors that have undermined investor confidence in financial information and market efficiency.

Those factors include:

See, e.g.,

Matt Krantz and Greg Farrell,

Fuzzy accounting raises flags,

USA Today, June 22, 2001, at 1B (quoting an individual investor, “I almost don't believe any numbers I read anymore”); Rebecca Byrne,

Audit Business Nearing Crisis of Faith,

TheStreet.com, Dec. 10, 2001.

• The dramatic and sometimes sudden reversals of public companies' financial conditions, with corresponding significant financial losses by investors and pensioners;

• Revelations of accounting irregularities at public companies, including large and seemingly well-regarded companies;

• The number of restatements of financial information by public companies;

• Increasing pressures on company management and auditors in today's economic environment;

• Continuing concerns about the oversight of the accounting profession, including issues regarding the independence and effectiveness of the current peer review and disciplinary processes; and

• The ineffectiveness of the Public Oversight Board (“POB”) that had overseen the peer review system of public accountants.

These factors highlight longstanding deficiencies in the regulatory system used to oversee the quality of the audits and reviews of financial statements that are filed with the Commission and relied on by investors and the Commission. These factors, among others, have contributed to a consequent decline in investor confidence, and provide the impetus for the Commission's proposals.

We are proposing a new system of independent private sector regulation designed to improve oversight of the auditing process and strengthen investor confidence in financial information. The accounting profession would not and could not control or dominate the proposed system. Rather, instead of a body that functions under the aegis of the American Institute of Certified Public Accountants (“AICPA”), which represents the accounting profession, we propose to create a framework for a new independent, private sector body (or bodies) that we have termed a “Public Accountability Board” (“PAB”).

Under our proposals, more than one PAB could be formed. For purposes of this release, however, we will refer to PABs in the singular.

Among other things, a PAB would discipline accounting firms and individual accountants for unethical or incompetent conduct or other violations of professional standards. A PAB would also direct periodic reviews of accounting firms' quality controls for their accounting and auditing practices. A PAB would supplement, not supplant, our enforcement efforts. We would continue vigorously to investigate and pursue instances of accounting misconduct. The new system would expand the opportunities to detect and remedy ethical lapses or deficiencies in competence, or violations of professional standards, thereby complementing our enforcement efforts.

Based on public input we have received to date, and our own experience, we have identified certain key elements of a new framework to improve oversight of the accounting profession. We believe that these elements will promote investor confidence in the financial reporting process.

The following elements, as well as others discussed in more detail below, are the foundation of our proposals:

See, e.g.,

Transcripts from the public Roundtables that the Commission sponsored on

Assuring Adequate Oversight of Auditing Function

held on March 4, and 6 and April 4, 2002, in New York, Washington, DC and Chicago, respectively (“SEC Roundtables”). Transcripts of the SEC Roundtables are available through the Commission's web site: www.sec.gov. Participants included: On March 4, Robert Mundheim (moderator), William Allen, Warren Buffet, James Copeland, David Shedlarz, Melvyn Weiss; on March 6, Judge Stanley Sporkin (Ret.) (moderator), Robert Glauber, Neil Lerner, Professor Jonathan Macey, Ted White; on April 4, J. Carter Beese, Jr. (moderator), Ken Bertsch, Davis Costello, Professor Dan Fischel, Barbara Franklin, and Edward Nusbaum. The Commission also held an Investor Summit (“Investor Summit”) at which it received valuable input. The webcast of the Investor Summit is available at www.connective.com/events/secsummits/.

• Private Sector System of Regulatory Oversight. The accounting profession would be subject to a private sector system of regulatory oversight directed by representatives of investors and issuers, not self-regulation by the profession.

• Requirements as to Financial Statements. To assure that the benefits of the oversight process extend to investors in all public companies:

• An SEC registrant's financial statements would not comply with Commission requirements unless the registrant's accountants who audited or reviewed those statements were members of a PAB; and

• An SEC registrant's financial statements would not comply with Commission requirements unless the registrant were a member of, and thereby bound to cooperate in any review or proceeding commenced by, the same PAB as its accountants.

As we discuss in detail below, a PAB will require a registrant's cooperation only to the extent necessary to further a PAB's reviews or proceedings regarding the registrant's accountant. A PAB will not conduct “roving” investigation of registrants and will not sanction registrants.

•

Independent Board.

To ensure independence from the accounting profession that it would oversee, a PAB would be a diverse board, dominated by persons who are not associated with the accounting profession.

•

Independent and Dependable Funding Source.

To assure continuity and independence, a PAB would have a dependable, uninterrupted funding source and not be voluntarily or solely funded by members of the accounting profession. A PAB's operations would be funded through the assessment of fees on accounting firms who are members of the PAB and on the audit clients of those firms—a funding mechanism that is not controlled by the accounting profession.

•

SEC Oversight.

Because a PAB would serve an important public function, a private entity could not serve as a PAB unless it was recognized by the Commission after Commission review of, among other things, the entity's proposed structure, its charter, by-laws, budget, and proposed board members. Conditions of a PAB's recognition by the Commission would include a PAB's irrevocable consent to the continuous oversight function by the Commission.

•

Cooperation with a PAB.

To remain in “good standing,” accounting firms, individual accountants, companies, and companies' management would cooperate with PAB quality control reviews, supplemental reviews, and disciplinary proceedings.

•

PAB Quality Control Reviews.

A PAB would perform quality control reviews of audit procedures and practices. To maintain high standards of auditing, ethics, and quality control among its members, a PAB would perform periodic quality control reviews of its member accounting firms. In conducting reviews, a PAB would ensure that accounting firms have quality control policies and procedures regarding, among other things: (i) independence, integrity, and objectivity; (ii) personnel management; (iii) acceptance and continuation of clients; (iv) audit performance; (v) audit methodology; and (vi) consultation and resolution of differences of professional opinion. A PAB would perform annual reviews of large accounting firms.

•

PAB Disciplinary Powers.

A PAB would conduct public disciplinary proceedings and would have the ability to discipline accountants for unethical or incompetent conduct or other violations of professional standards. A PAB would be able to impose a wide range of disciplinary or remedial sanctions, including:

• Fines;

• Censures;

• Required remediation;

• Removal of an individual or termination of a firm from an audit engagement;

• Limitations on certain activities; and

• Suspension or disbarment from membership in a PAB.

•

Audit Standard Setting.

A PAB should have responsibility for assuring high standards of ethics, auditing, and quality controls for its members. A PAB should either set such standards or oversee any private sector bodies designated to set standards.

II. The Pressing Need To Improve Oversight of, and Restore Confidence in, the Auditing and Financial Reporting Processes

A. The Federal Securities Laws Contemplate, and Their Effective Application Depends Upon, the Existence of Mechanisms for Adequate Oversight of the Auditing Component of the Financial Disclosure Process

It is no mystery what problem Congress intended to remedy—and believed it was remedying—by seeking to insure that issuers provide investors with “complete information relative to the financial condition of the issuer.”

As the Senate Report on the Securities Exchange Act of 1934 (“Exchange Act”) described:

S. Rep. No. 73-792, 1934 WL 1289 at *10 (Apr. 17, 1934) (Senate Report on Securities Exchange Act of 1934).

The committee has repeatedly heard testimony illustrating the evasions, suppressions, distortions, exaggerations, and outright misrepresentations practiced by corporations with intent to cloak their operations and to present to the investing public a false or misleading appearance as to financial condition. The chairman of the committee on stock list of the New York Stock Exchange testified that * * * [in one case] practically all the assets of the company consisted of notes receivable, good will, and licenses arbitrarily valued at grossly exaggerated figures. The testimony also established that within a period of a few days the assets of the company were written up 100 percent in value. In another case brought to the attention of the committee, the assets of a company were marked up from $4,000,000 to $24,000,000. A memorandum prepared by a corporate official was introduced in evidence which discussed the alternatives of preparing the corporation's annual report in either the ‘standard' or the ‘understandable’; form, the decision being in favor of the former. Many other instances of ‘window dressing' were observed, where inexcusable methods were employed to inflate assets, obscure liabilities, and conceal deficits.

Id.

at 11.

We begin from the premise that, through the securities laws' requirements related to financial disclosure, Congress intended to address these issues directly and forcefully. Congress did so by prescribing certain general statutory requirements and delegating to the Commission the regulatory flexibility to implement those requirements and to adopt regulations in furtherance of the statutes' purposes.

Those statutory prescriptions include requirements that public companies' financial information filed with us be certified by independent public or certified public accountants.

Without an unqualified audit opinion from an accounting firm,

a Commission registrant or issuer in an initial public offering has not satisfied and cannot satisfy the statutory and regulatory requirements for audited financial statements, its filings are deficient under the securities laws, and it cannot sell securities to the public or file its annual reports in conformity with Commission rules. Furthermore, without an accounting firm's review of a registrant's quarterly financial statements,

a registrant cannot not file its quarterly reports in conformity with Commission rules.

Accounting firms also must prepare attestation reports related to the internal controls of certain broker dealers,

investment companies,

transfer agents,

and others.

For example, Items 25 and 26 of Schedule A to the Securities Act of 1933 (“Securities Act”), 15 U.S.C. 77aa(25) and (26), and Section 17(e) of the Securities Exchange Act of 1934 (“Exchange Act”), 15 U.S.C. 78q(e), expressly require that financial statements be audited by independent public or certified accountants. Sections 12(b)(1)(J) and (K) and 13(a)(2) of the Exchange Act, 15 U.S.C. 78

(b) and 78m(a)(2), Sections 5(b)(2)(H) and (I), 10(a)(1)(G), and 14 of the Public Utility Holding Company Act of 1935 (“PUHCA”), 15 U.S.C. 79e(b), 79j(a)(1)(G), and 79n, Sections 8(b)(5) and 30(e) and (g) of the Investment Company Act of 1940 (“ICA”), 15 U.S.C. 80a-8(b)(5) and 80a-29, and Section 203(c)(1)(D) of the Investment Advisers Act of 1940 (“Advisers Act”), 15 U.S.C. 80b-3(c)(1)(D), authorize the Commission to require the filing of financial statements that have been audited by independent public accountants.

“An unqualified opinion states that the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity in conformity with generally accepted accounting principles.” AICPA, Statements on Auditing Standards (“SAS”) No. 58, Codification of Statements on Auditing Standards (“AU”) § 508.10.

The proposed rules would define “review” in this context to mean a review of financial statements in accordance with generally accepted auditing standards (“GAAS”), as may be modified or supplemented by the Commission. A review includes procedures that are less in scope than an audit, and consists generally of inquiries and analytical procedures, rather than research and verification procedures.

See,

SAS No. 71, AU § 722 (as revised by SAS No. 90).

Rule 10-01(d) of Regulation S-X, 17 CFR 210.10-01(d), which states in part, “Prior to filing, interim financial statements included in quarterly reports on Form 10-Q (17 CFR 249.308(a)) must be reviewed by an independent public accountant using professional standards and procedures for conducing such reviews, as established by generally accepted auditing standards, as may be modified or supplemented by the Commission.”

17 CFR 240.17a-5(g), (h), and (j).

Form N-SAR, item 77B; 17 CFR 274.101.

17 CFR 240.17Ad-13.

See, e.g.,

Exchange Act Release No. 16900 (June 17, 1980), 45 FR 41920 (June 23, 1980) regarding clearing agencies and Exchange Act Release No. 24216 (Mar. 13, 1987), 52 FR 8998 (Mar. 20, 1987) regarding depository trust companies.

Under the statutory scheme, accountants are the only professionals that Commission registrants and issuers

must

engage before making a public offering of or having a public market for their securities. That alone is a significant indication of legislative intent concerning the critical role of the auditing process, but Congress did not stop by describing the required professionals merely as “accountants.” Rather, the securities laws qualify that term so that accountants auditing the financial statements of public companies are both subject to oversight intended to facilitate a high level of competence—reflected in the statutory requirement to be “certified public” or “public”—and disinterested in any outcome of the audit process other than getting reliable information to the public—reflected in the statutory requirement to be “independent.”

The securities laws supplement those safeguards by giving the Commission significant flexibility to make rules and regulations bearing on public companies' financial disclosures, including the methods and forms employed in making those disclosures.

The Supreme Court has recognized and underscored the significant and unique role in which the securities laws cast accountants that audit public companies. In declining to extend to accounting firms certain confidentiality protections available to attorneys representing a client and preparing for trial, the Court emphasized that:

[a]n independent certified public accountant performs a different role. 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 * * * [and] owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public.

United States

Arthur Young & Co.

, 465 U.S. 805, 817-18 (1984). The Court further noted that, pursuant to the securities laws, “The SEC requires the filing of audited financial statements in order to obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the Nation's industries.”

Id.

at 819 n.15.

The Commission relies on certified financial statements, and consequently on the competence, ethics, and independence of accountants, to protect its processes and carry out its mandate.

While our staff reads and

comments on a great many filings, it does not, cannot, and should not perform the extensive audit or review procedures that auditors must perform under GAAS. In addition, the volume of financial information filed with us far exceeds what the Commission staff can meaningfully review. We, therefore, must rely heavily on the accounting profession, as Congress intended, to ensure and enhance the integrity of the large volume of financial information that forms the cornerstone of our full disclosure system.

In this regard, the Commission adopted Rule 102(e) of our Rules of Practice to protect the integrity of Commission processes. 17 CFR 201.102(e).

See, e.g., Touche Ross & Co.

SEC,

609 F.2d 570, 582 (2d Cir. 1979) (upholding the predecessor to Rule 102(e) as “reasonably related” to the purposes of the securities laws, in part because the rule “provides the Commission with the means to ensure that those professionals, on whom the Commission relies heavily in the performance of its statutory duties, perform their tasks diligently and with a reasonable degree of competence”).

To protect its own processes, and by extension the investing public, the Commission vigorously pursues violations of professional standards. We have initiated Rule 102(e) proceedings when auditors failed to adhere to professional standards. For example, we sanctioned auditors under Rule 102(e) for not appropriately responding to warning signals pointing to client fraud (

see, e.g., In the Matter of Nanette Miller,

Accounting and Auditing Enforcement Release No. (“AAER”) 1241 (Mar. 29, 2000);

In the Matter of Laubscher and Griffin,

AAER 1082 (Sept. 29, 1998)), and when they have failed to obtain the specialized knowledge necessary to perform an audit (

see, e.g., In the Matter of Ruzicka,

AAER 1155 (Aug. 24, 1999).

The courts have recognized this regulatory regime.

Touche Ross,

609 F.2d at 581.

In sum, investors and the Commission rely on accountants to assure disclosure of accurate and reliable financial information. As a result, “[b]reaches of professional responsibility jeopardize the achievement of the objectives of the securities laws and can inflict great damage on public investors.”

Effective oversight of the accounting profession therefore is critical to protecting the public interest and preventing this “great damage” to investors.

Id.

We are concerned that we are today facing some of the same problems that Congress sought to address in the 1930s when the federal securities laws were enacted. Certainly there is evidence of a public perception that these problems are recurring with disconcerting, and unacceptable, frequency.

It falls to the Commission to try to identify the causes of the problem, and, to the extent possible, craft solutions consistent with its statutory mandate.

See, e.g.,

Nanette Byrnes,

Accounting Failures Aren't New—Just More Frequent,

Bus. Wk., Jan. 28, 2002, at 46.

We have carefully considered the causes. For the reasons described below, we believe that the oversight mechanism for insuring that public companies have their financial statements audited by skilled, disinterested professionals operating under high ethical standards and strict quality control procedures is not working as intended. We are concerned that the deficiencies in that mechanism frustrate the financial disclosure purpose of the securities laws, undermine investor confidence in financial disclosures, and contribute to inefficient capital allocation in the markets.

B. Current Oversight Mechanisms Do Not Meet Their Objectives

Several factors lead us to consider whether the accounting profession's self-regulatory oversight mechanisms, on which the markets and we have previously been willing to rely, do not meet the necessary objectives. For the reasons described below, we conclude that the self-regulatory mechanisms are not producing credible results, and that this failure may be linked to features that cannot realistically be expected to change through further self-regulation or minor changes to the current oversight mechanism.

The factors that concern us include the recent increases in the number of public companies restating their financials, revelations of serious financial difficulties at a variety of companies, a closed-door professional disciplinary process, and serious questions related to the current system of firm-on-firm “peer reviews” as a check on accountants' quality control processes.

The need for significant structural reforms in the oversight process to protect the public has been suggested by several people.

During the initial stages of the Commission's consideration of these issues, the profession's vehicle for oversight of the peer review system was the POB, until it voted to disband, and as of April 30, 2002, ceased official operations. The AICPA's SEC Practice Section (for firms that audit financial statements filed with the Commission) (“SECPS”) has indicated that, notwithstanding the POB's decision to terminate operations, the SECPS will continue its peer review and QCIC programs until such time as a new regulatory model replaces them. The SECPS also has indicated that it will continue to fund the oversight operations of the POB staff (now called the Transition Oversight Staff, or TOS) during this transition period. Letter from Robert J. Kueppers, Chair, to Robert K. Herdman, Chief Accountant (Feb. 15, 2002).

See also

SEC Press Release No. 2002-40 (Mar. 19, 2002) regarding the TOS's continuing review of certain accounting firms' quality control systems for assuring compliance with auditor independence requirements.

See generally

Section II.C. below.

As noted, one indication of the need for an enhanced regulatory structure is the increase in the number of restatements in recent years. According to a recent study, in the last three years more than 700 companies have restated earnings.

While there are many reasons for these restatements, we are concerned that they contribute to investor confusion and weaken investor confidence in the financial reporting process.

One recent study identified 234 restatements in 1999, 258 restatements in 2000, and 305 restatements in 2001. Huron Consulting Group,

A Study of Restatement Matters: For the Five Years Ended December 31, 2001,

at 8 (June 11, 2002).

See also

Jim McTague,

Fixable Flaws,

Barron's, Jan. 7, 2002, at 16.

Through the 1990s, such restatements, as well as allegations of accounting irregularities at companies such as Miniscribe and Phar-Mor, and more recently at companies such as Rite-Aid, Cendant, MicroStrategy, Sunbeam, McKesson HBOC, Waste Management, and Xerox have caused increasing concern. The bankruptcy of Enron Corporation last year, which was the largest bankruptcy in history and resulted in substantial financial losses to investors and pensioners, has dramatically heightened the public attention given to those concerns, posing a critical threat to investor confidence in financial information generally.

During the 19909s, federal banking regulators reviewed the performance of accounting firms in relation to the savings and loan crisis of the late 1980s and early 1990s. Accounting firms' settlements of actions pending before the Office of Thrift Supervision included, among other things, increased training requirements for individuals working on audits of financial institutions, work paper retention requirements, additional consultation procedures within the firms, and the payment of significant restitution to the Federal Deposit Insurance Corporation and Resolution Trust Corporation.

See In the Matter of Ernst & Young,

OTS Order No. AP 92-127 (Nov. 23, 1992);

In the Matter of Deloitte & Touche,

OTS Order No. AP 94-13 (Mar. 14, 1994);

In the Matter of KPMG Peat Marwick,

OTS Order No. AP 94-37 (Aug. 9, 1994);

In the Matter of Grant Thornton, L.L.P.,

OTS Order No. AP 96-30 (Oct. 3, 1996).

To the extent that restatements and accounting irregularities suggest a failure of those in the accounting profession to perform consistently with sufficient skill and competence,

we are concerned that inherent limitations in the existing oversight mechanism prevent that mechanism from doing all that is required to curb such lapses. For example, the existing self-regulatory mechanism has not through its system of peer review uncovered significant deficiencies in competence, and it does not, and probably cannot, include the power to suspend incompetent individuals altogether from providing audit, review, or attest services to public companies.

See

Janet Whitman,

For Competence, Accounting Gets “D” in New Poll,

Wall St. J., Apr. 10, 2002, at A7;

Accounting Faces Crisis of Competence, Not Integrity; “Andersen-itis” Isn't What Ails the Industry,

Newstream.com, Apr. 10, 2002 (surveyed companies indicated accountants lack competence in certain technical areas).

While some aspects of the existing system are plainly beneficial, including, for example some portions of the Quality Control Inquiry Committee (“QCIC”) process,

the profession's

ability to discipline or remedy incompetent or unethical conduct has been a persistent concern.

The profession's disciplinary program continues to suffer from several inherent weaknesses, including:

Under the membership requirements of the SECPS, after receiving service of a complaint in any litigation against the firm or its personnel, or the commencement of any publicly announced regulatory investigation, that alleges deficiencies in the conduct of an audit of the financial statements of a Commission registrant, the firm must not only review the engagement to evaluate the performance of senior personnel with respect to the specific issues contained in the complaint but also report the matter to the QCIC. SECPS,

Requirements of Members,

at k; SECPS,

Appendix M—Procedures in Connection with an Alleged Audit Failure,

SECPS § 1000.46. The QCIC will review the matter and, if appropriate, refer it to the AICPA Professional Ethics Division, which will evaluate whether the matter warrants investigation.

See, e.g.,

David S. Hilzenrath,

Auditors Face Scant Discipline,

Wash. Post, Dec. 6, 2001, at A01;

See, e.g.,

John C. Burton,

The Evolutionary Revolution in Public Accounting,

52 Brook. L. Rev. 1041, 1046-47 (1987) (Mr. Burton, former Chief Accountant to the SEC, commenting on the POB, has stated that “[w]hile the structure created was highly promising and the development of a regular process of peer review is very desirable, my own judgment is that the results have fallen short of expectations. In the first place, the emphasis on process and remedial actions has been too limiting. Peer reviews need to go beyond process to look at application of procedures and to develop a significant disciplinary process”).

•

Peer reviews may not consistently be as thorough as necessary.

Peer review is the process by which other accountants assess and test compliance with quality control systems for the accounting and auditing practices of SEC Practice Section (“SECPS”) members. The objectives of peer review are to determine whether the reviewed firm: (i) designed its system to meet Quality Control Standards established by the AICPA; (ii) complied with its quality control system to provide reasonable assurance of complying with professional standards; and (iii) complied with SECPS membership requirements. Upon the completion of a review the peer reviewer prepares a report and a letter of comments, which may recommend improvements to the firm's system of compliance. On occasion, firms have received “clean” peer review reports despite well-publicized problems within a firm. For example, a report published by an independent consultant noted one firm had numerous violations of the auditor independence rules,

yet the next peer review report on the firm mentioned neither the need for improvements in the firm's quality controls in this area nor the efforts the reviewed firm had underway to make those improvements. Our staff has provided the POB with comments on peer reviews with the goal of improving the process and achieving more understandable communications to the public of peer reviewers' findings.

For many years, we had stated in our Annual Report that the peer review and QCIC processes resulted in accounting firms “focusing on and achieving the important goal of maintaining and improving effective quality control systems.”

Because of our growing concerns, however, we intentionally did not include that statement in our 1999, 2000, and 2001 Annual Reports.

See

SEC Press Release No. 2000-4 (Jan. 6, 2000).

See, e.g.,

SEC,

Annual Report 2001,

at 90; SEC,

Annual Report 1999,

at 91. The SEC staff oversees the peer review and QCIC processes by periodically selecting at random a sample of peer reviews and evaluating working papers and POB oversight files related to those reviews. Our staff also reviews QCIC closed case summaries and related POB oversight files.

See, e.g.,

SEC,

Annual Report 1998,

at 74.

•

The disciplinary process is voluntary.

The disciplinary program is conducted within the auspices of the AICPA, which is a voluntary private sector organization dominated by accounting firms.

•

There is no independent and dependable funding source.

During discussions about the POB's reviews of the firms' systems of quality controls over auditor independence, the SECPS took the unprecedented step of threatening to halt the funding for the POB's reviews.

•

The disciplinary process relies solely on information gathered from accountants.

The process is generally limited to reviewing information obtained from the accountants and does not include obtaining information from third parties, such as management of the audit client. As Norman R. Walker, former chairman of an AICPA disciplinary panel has said, “Basically we're confined to looking at the [public] record and the information that the [member] is able to provide and willing to provide.”

David S. Hilzenrath,

Auditors Face Scant Discipline, supra

note 31.

•

Sanctions are weak.

The most stringent sanction in an AICPA proceeding is expulsion from the AICPA, which does not directly affect an accountant's ability to practice before the Commission or elsewhere.

AICPA, Official Releases: Organizational Structure and Functions of the SEC Practice Section of the AICPA Division for CPA Firms,

J. Acct., Nov. 1977, at 113, 115.

•

The disciplinary proceedings are not public.

AICPA disciplinary proceedings are conducted behind closed doors and, while improvements have been made in the public reporting of sanctions, limited information is available regarding the results of its proceedings.

C. The Need for Reform Is Widely Recognized

Investor confidence in the quality of financial information is critical, and it is directly linked to investor confidence in the quality of audits.

As a participant in the Commission's Roundtables stated:

See Relationships Between Registrants and Independent Accountants,

Accounting Series Release No. 296 (Aug. 20, 1981), 46 FR 43181 (Aug. 27, 1981), which states in part:

[T]he capital formation process depends in large part on the confidence of investors in financial reporting. An investor's willingness to commit his capital to an impersonal market is dependent on the availability of accurate, material and timely information regarding the corporations in which he has invested or proposes to invest. The quality of information disseminated in the securities markets and the continuing conviction of individual investors that such information is reliable are thus key to the formation and effective allocation of capital. Accordingly, the audit function must be meaningfully performed and the accountant's independence not compromised.

[T]he public should have real confidence that their interest is being looked after in the mechanism for regulating the profession, and disciplining the members of the profession, setting professional standards. All of those. They want to know that the way that this is done is going to look after their interests, and not just the interests of the body of the individuals who practice in that profession.

EC Roundtables,

supra

note 8, at 37 (Mar. 6, 2002) (statement of Neil Lerner, Head of Risk Management (U.K.), KPMG).

Because of the above-described concerns, calls for improved oversight of the accounting profession have become more urgent.

Congress, the Commission, and many others have questioned whether weaknesses inherent in the profession's self-regulatory process limit its ability to improve sufficiently the performance of audits of public companies. More generally, strong public sentiment has emerged calling for more effective oversight. The connection between that oversight and investor confidence has never been as pronounced as it is today.

The need for reform has been highlighted by President George W. Bush. On March 7, President Bush announced a ten-point plan to improve corporate disclosure, make corporate officers accountable, and develop a stronger and more independent audit system. In discussing the latter point, President Bush stated:

An independent regulatory board should ensure that the accounting profession is held to the highest ethical standards. Under this proposal, an independent regulatory board would be established, under the supervision of the SEC, to develop standards of professional conduct and competence. This board would have the ability to monitor, investigate, and where needed, enforce its

ethics principles by punishing individual offenders.

Specifics on the President's Ten-Point Plan (Mar. 7, 2002) are available at

http://www.whitehouse.gov/news/releases/2002/03/20020307.html.

In addition, the Commission recently held the SEC Roundtables to discuss a variety of issues relating to the financial reporting process, including auditor oversight and held an Investor Summit.

Participants in our Roundtables represented a variety of constituencies. Participants provided us with the benefit of extensive and diverse insights into the issues confronting the profession's self-regulatory programs and how those programs should be improved.

For example, Mr. Ken Bertsch, Director, Corporate Governance, at Teachers Insurance and Annuity Association College Retirement Equities Fund (“TIAA-CREF”), noted his organization's lack of confidence in the current peer review process. Others, such as Mr. David Shedlarz, Chief Financial Officer, Pfizer Inc., offered constructive outlines of the attributes and duties for a new regulatory body. While our proposals are not identical to any one participant's suggested approach, the discussions at the Roundtables were very valuable in helping us to identify issues, consider alternatives, and frame the positions contained in our proposed rules.

See supra

note 8 regarding the SEC Roundtables and Investor Summit.

Id.

Beyond our Roundtables, others have voiced concerns with the current self-regulatory system and called for reform. For example, the Consumer Federation of America has called for a complete overhaul of the profession's self-regulatory system.

The Financial Executives International (“FEI”) also has recommended the creation of a new oversight body for the accounting profession.

The FEI has indicated that a majority of the new oversight body's board should be executives with knowledge in accounting and finance, but should not be drawn from the audit profession. FEI further has stated that the new body's principal tasks should be oversight of audits and discipline.

Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Hearing Before the Senate Comm. on Banking, Housing, and Urban Affairs,

at 6 (Mar. 20, 2002) (statement of Senator Howard M. Metzenbaum (Ret.), Chairman, Consumer Federation of America).

FEI,

FEI Observations and Recommendations: Improving Financial Management, Financial Reporting and Corporate Governance

(Mar. 2002).

Id.

at 3.

Many other observers and members of the accounting profession have lost confidence in the efficacy of the SECPS programs overseen by the POB and have encouraged the development of a stronger body that plays a more active role in the oversight of quality control reviews and professional discipline. Former SEC Chairman Arthur Levitt also has called for a new oversight body. In his testimony before the Senate Committee on Governmental Affairs, he supported a “truly independent” non-governmental oversight body that has the power to conduct timely investigations and to discipline accountants. He also stated that the new body should operate in public—not behind closed doors—and, to preserve its integrity, the accounting profession should not fund the body.

The Fall of Enron: How Could It Have Happened?: Hearing Before the Senate Comm. on Governmental Affairs

(Jan. 24, 2002) (statement of Arthur Levitt, Chairman, Securities and Exchange Commission, 1993-2000).

In addition, Harold Williams, who was the Chairman of the Commission at the time the SECPS and POB were created, stated in recent testimony before the Senate Committee on Banking, Housing, and Urban Affairs:

Self-regulation, aggressively overseen, can be much more effective in enforcing the spirit of the rules than can a policing agency of government. However, it is evident that the existing structure is not adequate to the task and needs to be redesigned and strengthened * * *.

The Public Oversight Board was created by the profession during my chairmanship as an effort at self-regulation. We expressed concern at the time whether the peer review process administered by the profession would be adequate. But, as believers in the principle of self-regulation, we concluded that the Board should have the opportunity to prove itself. In my opinion, the events over the intervening years have demonstrated that it does not meet the needs and is not adequate * * *. A system needs to be established which is independent of the accounting profession, transparent and able to serve both effective quality control and disciplinary functions.

Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Oversight Hearing Before the Senate Comm. on Banking, Housing, and Urban Affairs

(Feb. 12, 2002) (statement of The Honorable Harold M. Williams, Chairman, Securities and Exchange Commission, 1977-81).

At the same hearing, former SEC Chairman David Ruder called for a new private sector regulatory system to oversee the accounting profession. In describing the deficiencies in the current system, he said:

[A]lthough the POB's powers have been strengthened, it does not have sufficient budget to allow it to function effectively. It does not have the power to force accounting firms to provide the documents necessary to complete investigations * * *. It is forced to rely upon the accounting profession itself to engage in enforcement activities. Most important, its connection to the AICPA creates an appearance of control by that body.

Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Oversight Hearing Before the Senate Comm. on Banking, Housing, and Urban Affairs,

at 8 (Feb. 12, 2002) (statement of David S. Ruder, Chairman, Securities and Exchange Commission, 1987-89)

Former SEC Chief Accountants and other leaders of the accounting profession also have stated publicly that a new regulatory body is needed.

Mr. James Turley, Chairman of Ernst & Young LLP, recently stated in an op-ed article in The Wall Street Journal:

Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Oversight of the Accounting Profession, Audit Quality and Independence, and Formulation of Accounting Principles: Hearing Before the Senate Comm. on banking, Housing, and Urban Affairs

(Feb. 26, 2002) (statement of Michael H. Sutton, Chief Accountant, Securities and Exchange Commission, 1995-98) which states: “Regulatory processes that will build confidence in the auditing profession will be truly independent; they will be open; they will actively engage, inform, and involve the public; they will be adequately resourced and empowered to accomplish their mission; and they will be amendable to change as events dictate. I believe that the critical ingredients of an effective regulatory process that can restore and maintain pubic trust include:

• Timely and thorough investigations of circumstances that may involve fraudulent financial reporting.

• Objective and fair assessments of the role and performance of the auditor.

• Timely and meaningful discipline of auditors and firms that violate acceptable norms of conduct.

• Regular oversight and periodic examinations of the policies and performance of independent auditors.

• Timely and responsive changes in professional standards and guidance when a need for improvements is identified.”

[W]e should create a new regulatory body for the profession. It should have its own funding, offices and staff. It should have direct power over the profession's disciplinary and audit quality control programs, replacing the current “peer review” process in which firms review each other. To ensure maximum public credibility, this oversight should come from a body other than the American Institute of Certified Public Accountants, because many believe it has not maintained its historic focus on professional responsibility.

James S. Turley,

How Accounting Can Get Back Its Good Name,

Wall St. J., Feb. 4, 2002, at A16.

Similarly, PricewaterhouseCoopers LLP, in letters to certain audit clients that are Commission registrants, stated, “[T]here is no question that the current regulatory structure is in need of reform.”

It stated that changes that are especially critical include having oversight come from outside the accounting profession and involve more participative reviews by staff that is independent of the accounting firms. It

also stated that the regulatory structure “needs teeth” and, “if an independent oversight body finds quality procedures lacking, it must have the right to revoke an individual's or firm's right to practice.”

Letters from Samuel A. DiPiazza, Jr., Chief Executive Officer, PricewaterhouseCoopers LLP to selected audit clients (Jan. to Feb. 2002).

Id.

Congress has introduced several bills that would create bodies similar to, but in some respects different than, a PAB. Numerous committees in both the Senate and House have held hearings to explore reform of the accounting regulatory structure. A common theme in these hearings was the need for improvements in the manner in which accountants are regulated, and, in particular, the need for effective private-sector regulation of the accounting profession.

See H.R. 3763, the Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002: Hearing Before the House Comm. on Financial Services

(Apr. 9, 2002) (statement of Richard C. Breeden, Former Chairman, U.S. Securities and Exchange Commission 1989-93) (“[T]here is only one governmental ‘regulator’ for the accounting industry, and that regulator is now and should remain the SEC. The SEC has the history, the culture and the institutional strength to be able to stand up to any wrongdoer. However, private sector groups working under the SEC's aegis can extend the reach of supervision in a healthy fashion.”);

Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Hearing Before the Senate Comm. on Banking, Housing, and Urban Affairs

(Feb. 14, 2002) (statement of Paul A. Volcker, Chairman of the Trustees of the International Accounting Standards Board and Former Chairman, Board of Governors of the Federal Reserve System) (“[E]xperience strongly suggests that governmental oversight, with investigation and enforcement powers, is necessary to assure discipline * * *. [T]his committee will want to explore means for providing more “backbone” for industry oversight, either through legislation or by encouraging exercise of SEC regulatory authority. Better means of identifying professional misconduct, with the possibility of meaningful fines and withdrawal of professional licenses, appears essential.”);

Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Hearing Before the Senate Comm. on Banking, Housing, and Urban Affairs

(Mar. 5, 2002) (statement of Joel Seligman, Dean and Ethan A.H. Shepley University Professor, Washington University School of Law) (“I believe at this time a new auditing self-regulatory organization is necessary. It should replace not just the POB, but a byzantine structure of accounting disciplinary bodies which generally have lacked adequate and assured financial support; clear and undivided responsibility for discipline; and an effective system of SEC oversight.”);

Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Hearing Before the Senate Comm. on Banking, Housing, and Urban Affairs

(Mar. 6, 2002) (statement of Shaun O'Malley, Chair of the 2000 Public Oversight Board Panel on Audit Effectiveness, and Former Chair, Price Waterhouse LLP) (“I am in favor of the creation of an organization to oversee the accounting profession, whether it is created by regulation or by legislation.”).

We intend to continue to work with Congress on these and other bills, and will monitor the progress of pending legislation. We will implement any legislation that is enacted. The Commission must proceed with its proposal under its existing statutory mandate, however, to strengthen investor confidence in the oversight of the auditing process and assure investors of comprehensive reform in the event that no legislation is passed.

D. The History of Audit Oversight Mechanisms Suggests the Need for a Different Type of Oversight Mechanism

Over the years the accounting profession has been subject to various forms of oversight with varying degrees of success. As a foundation for understanding the elements of the new oversight mechanism that we propose, we believe that it is useful to examine the history of the present system.

The current self-regulatory mechanism was developed as a result of concerns expressed during congressional hearings in the mid to late 1970s. These hearings investigated unexpected failures by major corporations and questioned why auditors failed to detect, and financial statements failed to reflect, illegal payments made by United States companies to foreign officials. During these hearings, the accounting profession's competence to detect and deter such problems was a significant issue. The question was asked, “Where was the independent auditor?'

And bills were introduced that would have created a new regulatory structure for the profession.

Staff of Subcomm. on Reports, Accounting, and Management of the Senate Comm. on Government Operations, 95th Cong.,

Report on the Accounting Establishment: A Staff Study,

7 (Subcomm. Print Mar. 31, 1977).

See, e.g.,

H.R. 13175, 95th Cong. (1978).

The hearings in the House of Representatives focused on how several federal agencies used the regulatory powers granted by Congress.

After considering the work of accounting firms that audit registrants' financial statements, the Subcommittee on Oversight and Investigations of the House Committee on Interstate and Foreign Commerce found that the “SEC's reliance on the private accounting profession alone to assure that corporate records are examined by independent auditors has been insufficient to protect public investors and to accomplish the objectives of the Federal securities laws.”

See

Staff of Subcomm. on Oversight and Investigations of the House Comm. on Interstate and Foreign Commerce, 94th Cong.,

Report on Federal Regulation and Regulatory Reform,

1 (Subcomm. Print Oct. 1976). (also known as the “Moss Report”).

Id.

at 38.

The Senate hearings began with a staff study prepared for the Subcommittee on Reports, Accounting, and Management that was critical of the accounting profession. The staff study stated, “Reforms are needed to restore public confidence in the accuracy and reliability of financial and other information reported by publicly-owned companies.”

During the several months that followed, the Subcommittee gathered extensive information from accounting firms, the Commission, and others. At the conclusion of the hearings, the Senate Subcommittee Report stated, “Self-initiated action by the private sector in cooperation with the SEC is the method of reform preferred by subcommittee members.”

Staff of Subcomm. on Reports, Accounting, and Management of the Senate Comm. on Government Operations, 95th Cong.,

Report on the Accounting Establishment: A Staff Study,

20 (Subcomm. Print Mar. 31, 1977).

Staff of Subcomm. on Reports, Accounting, and Management of the Senate Comm. on Governmental Affairs, 95th Cong.,

Report on Improving the Accountability of Publicly Owned Corporations and Their Auditors 4

(Subcomm. Print Nov. 4, 1977).

The Commission's involvement in issues related to the AICPA's self-regulatory processes, which included the establishment in 1977 of the POB, increased during and after these congressional hearings. The Commission undertook to oversee, and annually report to Congress on, the profession's response to Congressional concerns.

The 1977 self-regulatory system is described in more detail in Appendix A.

Accounting and Auditing Practices and Procedures: Hearing Before the Subcomm. on Reports, Accounting and Management of the Senate Comm. on Governmental Affairs

(June 13, 1977) (statement of Harold M. Williams, Chairman, U.S. Securities and Exchange Commission).

As concerns about the quality of financial reports has increased in recent years, the POB, the Commission and others began to call for an update to the governance mechanisms of the POB, which were adopted soon after it was formed in 1977. While intended to be autonomous (the POB could set its own budget, establish its own operating procedures, and appoint its own members, chairperson, and staff), the POB relied for its funding on voluntary dues paid by AICPA firms that audited public companies and belonged to the AICPA section composed of such firms—SECPS. In addition, the POB lacked the ability to organize and implement its own quality control reviews. And, the POB was not given any authority to sanction auditors for deficiencies or incompetence noted during quality control reviews.

Discussions among the Commission staff, POB, SECPS, AICPA, accounting firms, and others, culminated in the adoption of a new POB charter in February 2001. The principal features of the new charter included:

• Oversight of the SECPS and, for the first time, oversight of the Auditing Standards Board and the now-defunct Independence Standards Board;

• Expanded responsibility for improving communications among various bodies involved in the profession's regulatory processes;

• Expanded responsibilities to undertake special reviews and projects; and

• Increased funding from the SECPS.

POB,

Annual Report 2000,

at 5. The POB charter is available at

http://www.publicoversightboard.org/charter.htm.

Even under the new charter, however, the POB lacked the express authority to direct the review of a firm's quality control system or to discipline a firm, or persons in a firm, for noncompliance with professional standards or the SECPS membership requirements. The new charter also provided that the SECPS would continue to be the sole source for the POB's funding, and required the SECPS to approve funding for the POB's special or unanticipated projects and for any amount above the $5.2 million annual limit set forth in the charter.

The new POB charter also fell short of instituting all of the recommendations of the Panel on Audit Effectiveness. For example, the Panel had recommended that the POB should approve all appointments to the Auditing Standards Board and SECPS Executive Committee, that the POB oversee the AICPA's evaluations, compensatory hiring and promotion decisions with respect to the staff of the AICPA committees it was to oversee, and the establishment of “no strings attached” funding for the POB. The Panel on Audit Effectiveness,

Report and Recommendations

140 (Aug. 31, 2002).

E. A New System of Private Sector Oversight Will Address Current Problems and Increase Investor Confidence

The private sector framework we are proposing would provide reasonable assurance to investors and to the Commission that accounting firms' audit, review, and attest procedures, which are required by the securities laws and Commission regulations, fulfill their statutory and regulatory purposes, and thereby will increase assurances that financial reporting, also required by the securities laws and Commission regulations, meet applicable legal and regulatory requirements. While no system of private sector or government regulation can ensure one hundred percent compliance with professional standards, we believe that this system would enhance investors' confidence that accounting firms are performing their public responsibilities and that, therefore, the financial information published by registrants and issuers is reliable.

After full consideration of the weaknesses of the present system and how it can be improved, we have based our proposed rules on the position that a PAB should reflect eight core principles:

1. A

PAB should be separate from, and independent of, the AICPA

—Despite the POB's oversight, significant failures in the auditing process continue to exist. In addition, there is a perceived conflict between the AICPA's dual roles of serving the best interests of its membership and serving investors. To restore confidence in the system, we believe that it is necessary for a new PAB to be established, operated, and overseen completely outside of the profession.

Requirements as to financial statements

—To assure that the benefits of the oversight process extend to investors in all public companies, the financial statements of an SEC-registered company would not comply with Commission requirements unless the company's accountants were members of a PAB and the company was a member of, and thereby bound to cooperate in any review or proceeding commenced by, the same PAB as its accountants. In the Commission's view this is necessary to assure cooperation and access necessary to carry out its reviews, quality control, and disciplinary activities over the accounting profession.

A PAB should operate under the SEC's oversight

—The SEC's relationship with the POB was based on the desire of the profession and the POB to provide assurance to Congress and to the public that the peer review process and related programs were working well. The SEC had limited ability to affect the work of the POB or the peer review program. Under the new framework, the Commission would recognize a PAB after reviewing, and being satisfied with, among other things, the entity's charter, by-laws, proposed budget, and proposed board members. The SEC would have the ability to review, alter, modify, or abrogate any PAB rule and to review any PAB disciplinary action.

Public members should dominate a PAB

—To be credible, it must be clear that the PAB is an independent organization and places the public interest and the interest of investors above all else. A PAB would be a diverse board, dominated by persons who are not associated with the accounting profession and who are in the position to make all significant decisions on quality control and disciplinary issues.

A PAB should have an independent and dependable funding source

—A PAB must have an independent and dependable funding source. The POB was funded by the AICPA, which called into question its ability to act totally separate from the profession. To assure continuity and independence, a PAB should be neither controlled nor principally funded by members of the accounting profession. A PAB's operations should be funded on a non-voluntary basis through the assessment of fees on accounting firms who are members of the PAB and on those firms' audit clients, the reliability of whose financial reporting would be presumptively benefited by the activities of the PAB.

See, e.g.,

SEC Roundtables,

supra

note , at 38 (Mar. 6, 2002) (statement of Ted White, Corporate Governance Director, California Public Employees' Retirement System) (“I would suggest some of the key tenets be * * * a board that consisted of independent members with solely independent funding”).

For larger firms, annual PAB-directed reviews of firms' quality controls for accounting, auditing, and auditor independence should replace triennial firm-on-firm peer reviews

—While individuals within accounting firms generally regard firm-on-firm peer reviews as serious events that can affect their careers, investors and critics of the program often consider such reviews among the limited number of large firms to be a “one hand washes the other” approach to regulation.

In addition, the triennial reviews are too infrequent for large firms.

See, e.g.,

Editorial, Watching the Watchers, Wash. Post, May 21, 2002, at A16; SEC Roundtables,

supra

note , at 55-56 (Mar. 4, 2002) (statement of William Allen, New York University Law School) (suggesting that the public perception of the current peer review process is an “I scratched your back, you scratch my back organization”).

See

Letter from Robert J. Kueppers, Chair, SECPS Executive Committee, to Managing Partners of SECPS Member Firms, (Mar. 21, 2002), which announces new requirements for member firms with more than 500 SEC clients to undergo annual review procedures during each of the years between triennial peer reviews.

A PAB should have the ability to discipline firms and individuals and be able to impose a wide range of sanctions, including the ability to require an accountant to no longer audit a particular public company

—A primary criticism of the current system is that it does not include effective disciplinary proceedings. The strongest sanction issued by the AICPA is expulsion from that organization, which does not remove the individual or firm

from practice before the Commission. We believe that we should continue to pursue violations of the securities laws and disciplinary actions under Rule 102(e). We also believe, however, for a PAB's quality control system to have “teeth” the PAB should have the ability to discipline its member accountants for incompetent, unethical, or other deficient conduct discovered during a quality control review or that otherwise comes to its attention, and that it must be able to sanction accounting firms for deficient quality control systems. The public must be assured that a PAB would be expected to and able to take appropriate and meaningful action to address incompetent or unethical conduct and violations of professional standards.

A PAB should issue public reports of its activities

—Although the POB issued an annual report, the SECPS has not issued a separate public report since 1997. To promote the understanding of its processes and to inform the public of the results of its programs and proceedings, a PAB should issue reports to the public at least annually and, to the extent possible, on a real time basis, that describe the PAB's quality control and disciplinary activities, contain the PAB's audited financial statements, explain the fees it has imposed on its members, and other information.

The Commission invites comments on these factors, including suggestions for alternative or additional factors that should lay the foundation for our rules. In addition, the Commission invites and encourages persons who would consider forming a PAB to begin a dialogue with the Commission as soon as possible. The Commission will make itself available for meaningful dialogue to further and facilitate the timely establishment of a PAB.

III. Discussion of Proposed Rules

We are proposing to amend and add rules to Regulation S-X. To assure that the benefits of the oversight process extend to investors in all public companies:

• An SEC registrant's financial statements would not comply with Commission requirements unless the accountants who have audited or reviewed those statements are members of a PAB. Attest reports would not comply with Commission requirements unless prepared by outside accountants who are members of a PAB; and

• An SEC registrant's financial statements and attestation reports contained in or accompanying an SEC registrant's reports or registration statements would not comply with Commission requirements unless the registrant is a member of the same PAB as its accountants, and thereby is bound to cooperate in that PAB's reviews or proceedings regarding the registrant's accountant.

For the Commission to recognize a PAB, a PAB would have to meet certain conditions and perform certain functions. We also are proposing to require disclosure if an executive officer, director, or person nominated to become a director of a public company has been sanctioned as a member accountant by a PAB within the last five years.

A. Regulation S-X Definitions

Rule 1-02 contains the general definitions for terms used throughout Regulation S-X.

Although the terms “review” and “attest” are common to accountants, they have never been defined within Regulation S-X. Because those terms are used in the rules we are proposing in this release, and in other rules within Regulation S-X,

we are proposing to define them in rule 1-02(d). Each proposed definition codifies the current common understanding of the term by referring to GAAS and to Statements on Standards for Attestation Agreements,

as may be modified by the Commission.

17 CFR 210.1-02.

See e.g.

, Rule 10-01(d) of Regulation S-X, 17 CFR 210.10-01(d), which requires that quarterly financial statements in Forms 10-Q be reviewed by an independent accountant prior to a registrant filing its Form 10-Q with the Commission.

See generally

SAS No.71, AU § 722 (as revised by SAS No. 90).

See also

Attestation Standards: Revision and Recodification, Statement on Standards for Attestation Engagements No. 10 (Jan. 2001).

We solicit comments on the above definitions. Do the definitions of “review” and “attest” capture the understanding of the words common to accountants? Should the definitions differ from those in GAAS? If so, why and in what way? Are there reasons why we should not define “review” or “attest” in the rule? Should we narrow or broaden the definitions? If so, how?

B. Requirements for Financial Statements and Attestation Reports

Qualifications of Accountants

Existing Commission regulations state that accountants are not qualified to practice before the Commission unless they are licensed under the laws of the place of their residence or principal office, and are independent from their audit clients.

As a practical matter, however, it has long been recognized that, in addition to these two qualifications, auditing a public company requires special expertise.

The foundation for that expertise has been developed over many generations of accountants practicing before us and is embodied in professional standards for auditing, attestations, quality controls, ethics, and other areas. These standards guide accountants in their daily work of examining the accuracy and completeness of financial information disclosed by management to investors. It is imperative, therefore, that auditors reach reasoned decisions that are well grounded in these professional standards.

17 CFR 210.2-01.

See generally

SECPS membership requirements.

See also

SAS No. 1, § AU 210.

Further, as we stated when we revised our auditor independence rules in 2000, auditor independence is instrumental to the financial reporting process and to investor confidence in financial statements.

Investors will commit their savings to an impersonal securities market only if they know that unbiased auditors take a critical look at managements' decisions and processes used to prepare the financial statements and that those auditors will place the concerns and interests of investors above not only the company's interests but above the accountant's self-interest as well.

Revision of the Commission's Auditor Independence Requirements

, Securities Act Release No. 33-7919 (Nov. 21, 2000), 65 FR 76008 (Dec. 5, 2000).

Relationships Between Registrants and Independent Accountants

, Accounting Series Release No. 296 (Aug. 20, 1981), 46 FR 43181 (Aug. 27, 1981).

Strong oversight of the profession helps to (and one goal of a PAB is to) strengthen firms' audit practices and to detect and deter weaknesses that might detract from an accountant's ability to fulfill professional standards of ethics and competence and requirements of auditor independence. In performing quality control reviews and through the disciplinary process, a PAB would play an important role in identifying and addressing competency, ethics, independence, and other professional practice issues.

The securities laws require, or authorize the Commission to require, that registration statements and reports include financial statements that have been audited by an independent public or certified public accountant.

See supra

note 12.

In recognition of the critical importance in having auditors well-versed in professional standards operating under effective quality control systems, proposed rule 2-01(a)(2) would state that the Commission would not recognize any accountant to be a “certified public accountant” or “public accountant,” or as “independent” with respect to an audit client if, during the

professional engagement period, that accountant is not a member in good standing of a PAB (

see

below for discussion of the definition of “member accountant in good standing”). A PAB's oversight of accountants, particularly as to independence issues, will in some cases require a PAB to consider information that can be supplied only by the audit client. We therefore believe that the purposes of the statutory requirements will be advanced significantly if an audit client is a member of the same PAB as its accountant, and thereby agrees to supply information in connection with that PAB's reviews and proceedings regarding the accountant. Accordingly, the proposed rule contemplates that an audit client be an adjunct member of the same PAB of which its accountant is a member.

Registrants' Reports and Registration Statements

Under the same reasoning as discussed above, proposed rule 13-01(a) requires reports and registration statements filed with the Commission that contain financial statements

be audited or reviewed by an accountant that: (1) Is a member in good standing of a PAB of which the registrant

filing the report or statement is an adjunct member in good standing, and (2) satisfies all other requirements prescribed by the federal securities laws and the rules and regulations thereunder concerning an accountant that audits, reviews, or prepares such report or registration statement.

See, e.g.

, Section 13(b)(1) of the Exchange Act, 15 U.S.C. 78m(b)(1), which states, “The Commission may prescribe, in regard to reports made pursuant to this title, the form or forms in which the required information shall be set forth * * *. Regulation S-X, 17 CFR 210, prescribes the form and content of financial statements filed with the Commission.

“Registrant” is defined in rule 1-02(t) of Regulation S-X, 17 CFR 210.1-02(t), to mean “the issuer of the securities for which an application, a registration statement, or a report is filed.” As discussed above, for purposes of proposed amendments to § 210.2-01, adjunct membership requirements would also extend to “audit clients.” Accordingly, throughout the discussion in this release, any reference to “registrant” should also be understood to encompass “audit client” where the context requires.

We request comment on proposed rules 2-01(a)(2) and 13-01(a), including the approach and structure of those rules for the filing with the Commission of financial statements and attestation reports. Are the definitions appropriate? Will they further the goals of enhanced oversight of the financial reporting process and enhanced quality of financial information? We request comment on the aspect of the proposed rule regarding registrant membership. Should registrants be adjunct members? Could our objectives be accomplished other than by having registrants be adjunct members—for example, by simply requiring registrants to participate in funding a PAB and to cooperate with a PAB's reviews and proceedings? Why or why not? We solicit comment on alternative frameworks to accomplish our goals. For example, if registrants can demonstrate that their accountants have an alternative system or process that meets the objectives of our rules (

e.g.

, through third-party reviews or other organizations), should the registrants be exempted from the operation of the rules, in particular Rules 2-01(a)(2) and 13-01? Should such systems or processes be required to operate with our approval and under our oversight? In addition, we solicit comment on what role, if any, exchanges and the National Association of Securities Dealers (“NASD”) should play with respect to a PAB.

Investment advisers, certain broker-dealers, transfer agents and certain other entities that file audited financial statements with us are not considered to be “registrants” under Regulation S-X because they are not issuers of securities and, therefore, would not fall within Article 13. Nonetheless, because the auditor independence rules discuss “audit clients” and not registrants, auditors of such entities' financial statements, and the entities, would be subject to the proposed rules. Is this appropriate? Should entities that are not registrants be outside the scope of the proposed rules? Should accountants that audit only entities that are not issuers of securities be outside the scope of the rules?

The proposals utilize the definition of “audit client” that is contained in Rule 2-01(f)(6) of Regulation S-X. That definition includes affiliates of the audit client. We request comment on the application of that definition to the rules proposed in this release. Should the definition of “audit client” include affiliates for purposes of the proposed rules? Why or why not? Are there special concerns in the investment company, investment adviser, or broker-dealer context that are raised because of the inclusion of affiliates?

C. Definitions for Article 13

In addition to providing definitions for use throughout Regulation S-X, the proposed rules would provide certain definitions of terms that would have a specific meaning for the purposes of Article 13 and a PAB.

Accountant

. Proposed rule 13-02(a) would define “accountant” for the purposes of Article 13. This definition has two important characteristics. First, it encompasses both accounting firms and individual accountants. Second, it limits the term “accountants” to those public or certified public accountants and firms engaged in auditing or reviewing financial statements, or preparing attest reports, that are filed with the Commission. The definition is similar to the definition of “accountant” in our auditor independence rules.

Rule 2-01(f)(1) of Regulation S-X, 17 CFR 210.2-01(f)(1), which states, “Accountant * * * means a certified public accountant or public accountant performing services in connection with an engagement for which independence is required. References to the accountant include any accounting firm with which the certified public accountant or public accountant is affiliated.”

Is this definition appropriate? Is it appropriate for the definition to include both accounting firms and individual accountants? Would the goals of the proposed rules be better or more appropriately accomplished if only one or the other was required to be a PAB member? Does this definition raise practical problems for firms that have partners who specialize in tax or other non-audit services, but also may be consulted briefly during an audit? For example, a firm might wish to have a tax partner consult for a very brief time with an audit engagement partner about a company's tax accrual. Would requiring such partners to be members of a PAB pose an unnecessary burden on the partners or accounting firms? If there would be an unnecessary burden, what would that burden be and is there any empirical data that would quantify such a burden?

Adjunct member in good standing

. Under proposed rule 13-02(b), an entity is an “adjunct member in good standing,” when the entity is an adjunct member of a PAB and is not delinquent (as defined in proposed rule 13-02(c)) in paying fees assessed by the PAB, or in appropriately responding to a PAB's request for documents and testimony relevant to a PAB quality control review, supplemental review, or disciplinary proceeding concerning the adjunct member's accountant. With respect to documents and testimony, the adjunct member's “good standing” would turn on whether it has produced documents that a PAB has requested from the adjunct member or its management, provided testimony that a PAB has requested from the adjunct member or its management, and used best efforts to cause its agents and non-management employees to supply any documents and testimony requested

from it by the PAB.

In defining “good standing,” the proposed rule provides only for “best efforts” by an adjunct member with respect to non-management employees and agents. While such employees may often have documents and knowledge relevant to a PAB review or disciplinary proceeding, we are concerned about making the good standing of every public company turn on its ability to preclude any single employee from refusing to cooperate with a PAB review or proceeding. Rather, an adjunct member will remain in good standing as long as it uses its best efforts to cause those employees and other agents to comply with PAB requests for testimony, and so long as the adjunct member and its management provide all requested documents and testimony and the adjunct member is timely in paying fees assessed by the PAB.

As discussed with respect to the definition of “delinquent,” below, we expect that a PAB will adopt reasonable practices and procedures for dealing fairly with good faith assertions of legal objections to document and testimony requests.

We invite comments on alternative approaches. Are there other, preferable, ways to define or condition an audit client's good standing that are sufficient to achieve the goals of PAB funding and PAB access to information relevant to its mission? Should the good standing of an adjunct member be contingent on willingness of management to testify? How should former management be treated? How, if at all, should “management” be defined for these purposes? Should more than management be covered by the requirement? For example, our auditor independence rules use the defined term “accounting role or financial reporting oversight role.”

Should the proposed rule include all or any of the individuals covered by that definition? Should the rule cover directors? With respect to non-management employees and agents, is it appropriate for the rule to require only that the adjunct member make best efforts to secure from them any documents or testimony requested by the PAB, or should the adjunct member's good standing depend upon the adjunct member actually causing the employee or agent to supply the documents and testimony? Is there an appropriate intermediate approach to addressing that issue? Alternatively, should the standard be “reasonable efforts” instead of “best efforts.”

Rule 2-01(f)(3) of Regulation S-X, 17 CFR 210.2-01(f)(3).

Delinquent

. Under proposed rule 13-02(c), a member or adjunct member of a PAB is “delinquent” when a PAB has provided public notice (consistent with proposed section 13-04(d)(11)) that the member or adjunct member has failed to pay the fees assessed by the PAB, or has failed to produce required documents or provide required testimony after any good faith legal objection to the request for documents or testimony has, in accordance with the PAB's rules, been resolved in the PAB's favor. An adjunct member may also be determined to be delinquent if it fails to use best efforts to cause its non-management employees and agents to supply requested documents or testimony.

A PAB's ability to obtain fees, documents, and testimony from members and adjunct members would be critical to the PAB's ability to carry out the purposes of the proposed rules. Accordingly, becoming delinquent in paying or responding to a PAB request, in accordance with a PAB's rules, automatically terminates the good standing of a member or adjunct member.

Under proposed rule 13-04(d)(11), discussed below, a PAB must devise a rule for advance public notice of the danger of a delinquency, sufficient to give audit clients an opportunity to prepare for such a delinquency and the consequent potential loss of good standing by their accounting firm.

In addition, proposed rules 13-04(d)(7) and 13-04(d)(11) condition a PAB's Commission recognition on the PAB having fair procedures for requesting documents and testimony and for resolving any disputes concerning those requests or concerning fees. We would expect a PAB to take seriously the need for full and fair procedures before making a delinquency determination as to a member or adjunct member asserting a good faith legal basis for objecting to any request for documents or testimony.

We would expect that, with respect to good faith assertions of privilege, a PAB would adopt a reasonable approach comparable to that of other private organizations or similarly situated private parties.

Cf. D.L. Cromwell Investments, Inc.

NASD Regulation, Inc.

, 279 F.3d 155, 161-63 (2d Cir. 2002) (interview demand issued by private membership organization to a member lacked sufficient nexus to government inquiry to trigger Fifth Amendment protection, since organization was not state actor and interview demand was not result of collusion with government) (citing

Desiderio

National Association of Securities Dealers, Inc.

, 191 F.3d 198, 206 (2d Cir. 1999),

cert. denied

, 531 U.S. 1069 (2001) (rejecting constitutional challenges to NASD action because “NASD is a private actor, not a state actor”) and

United States

Solomon

, 509 F.2d 863, 867-71 (2d Cir. 1975) (rejecting Fifth Amendment challenge to New York Stock Exchange inquiry of member because New York Stock Exchange is not government actor)). We would specifically expect, however, that a PAB would not honor any assertion of an accountant-client privilege. An accountant client privilege is not recognized under federal law.

See United States

Arthur Young & Co.

, 465 U.S. 805 (1984);

Couch

United States

, 409 U.S. 322 (1973). Further, the recognition of such privilege by a PAB would significantly impair its ability to further the goals and purposes of federal securities laws reflected in the proposed rules.

We request comment on the proposed definition of delinquent. Are the proposed notice provisions appropriate? Are there other additional circumstances when a member or adjunct member of a PAB should be considered delinquent? What are they? Should the rule explicitly identify specific privileges or categories of privileges that a PAB may not invade? If so, what are they?

Foreign Accountant.

We have proposed in rule 13-02(d) to define “foreign accountant” to mean an accountant:

(1) Having a place of residence and principal office outside the United States and its territories, and (2) not licensed in the United States or its territories. If an accountant resides, practices, or is licensed in the United States, that accountant would be subject to the proposed rules. In this regard, if a foreign-licensed accountant resides in the United States as a result of a temporary assignment to work at a U.S. firm, he or she might be subject to the proposed rules. We intend for the PAB, however, to consider such issues and the many variations of working relationships that may arise in the operation of the firms' international organizations and, if considered necessary or appropriate, to interpret this provision, adopt related rules, or request amendments to the Commission's definition.

As noted previously, under proposed rule 13-02, the term “accountant” includes both individuals and firms, but is limited to those auditing or reviewing financial statements or preparing attestation reports filed with the Commission.

Is the proposed definition of “foreign accountant” appropriate? Is the requirement that both the residence and principal place of business be outside the United States and its territories unduly restrictive, or not restrictive enough? Are there other factors that should be included in the definition? Is the intent to permit a PAB to consider this issue appropriate? Does the proposed definition provide sufficient flexibility for a PAB to consider these issues?

Member accountant in good standing.

Proposed rule 13-02(e) describes the requirements that an accountant must satisfy to be a member accountant in good standing with a PAB. First, the accountant must be a member of the PAB, a status that would be obtained through enrollment procedures devised by a PAB pursuant to proposed rule 13-04(d)(1). In addition, status as a member

accountant in good standing involves two further elements that must be satisfied. The first element is satisfied if the accountant has not been barred, suspended, or otherwise sanctioned by a PAB. Alternatively, if the accountant has been barred, suspended or otherwise sanctioned, the first element is satisfied if the accountant has been reinstated by the PAB after having been barred or suspended, or if the accountant has not been cited by the PAB in a public notice as being noncompliant with the terms and conditions of any other sanction imposed by the PAB. The second element is rooted in the need to ensure funding of, and cooperation with, a PAB, and so is similar to the requirements to be an adjunct member in good standing, described above. Specifically, an accountant satisfies the second element if the accountant is not delinquent in paying fees or supplying required documents and testimony. The documents and testimony that must be supplied at a PAB's request in order for the accountant to remain in good standing are the accountant's documents and testimony and the documents and testimony of any of the accountant's employees, or other agents.

Should the rule prescribe different limits on the documents and testimony that an accountant must provide to maintain good standing? Are there other factors that the rule should take into account for purposes of determining “good standing?”

As discussed above with respect to the definition of “delinquent,” we expect that a PAB will adopt reasonable practices and procedures for dealing fairly with good faith assertions of legal objections to document and testimony requests.

Public Accountability Board.

Proposed rule 13-02(f) would define the term “Public Accountability Board” or “PAB” to mean an entity that is organized in accordance with, and for the purposes described in, proposed Article 13, and that is recognized by the Commission.

Professional Engagement Period.

Both proposed rule 2-01(a)(2) and proposed rule 13-01 operate by reference to the “professional engagement period.” Under the operation of those rules, if either the accountant or the audit client is not a member in good standing with a PAB for any portion of the professional engagement period, the financial statements and attestation reports included in or accompanying that audit client's filings with the Commission will not be acceptable. We consider it important that any failure of good standing during the professional engagement period have significant consequences since auditors must be independent during the professional engagement period, and we do not want to permit any gamesmanship with respect to cooperating with the PAB.

The term “professional engagement period” is defined in proposed rule 13-02(g) to begin when an accountant either signs an engagement contract to review or audit financial statements or to prepare an attestation report, or begins audit, review, or attest procedures, whichever is earlier. The period ends when the registrant or accountant notifies the Commission that the registrant is no longer the accountant's audit client.

This definition parallels the definition of the same term in the auditor independence rules.

Such notice may occur under item 4 of Form 8-K, 17 CFR 249.308.

17 CFR 210.2-01(f)(5)(ii)(A) and (B).

Does the proposed definition capture the appropriate period? Is there a different beginning point that would be more appropriate? Would a different end point be appropriate?

Professional Standards.

Proposed rule 13-02(h) defines “professional standards” to include accounting,

auditing,

and attestation standards,

the Commission's auditor independence regulations,

the standards of the Independence Standards Board, and any other standards related to the audit, review, or preparation of financial statements filed with the Commission. These standards would include those set, or designated as authoritative, by a PAB, including auditing, quality control, or ethics standards. Does this definition capture all of the standards and regulations that are needed and appropriate?

The Financial Accounting Board (“FASB”) and other sources establish generally accepted accounting principles (“GAAP”) used to prepare financial statements filed with the Commission. For the “hierarchy of GAAP,”

see

SAS No. 69, AU § 411.

The AICPA's Auditing Standards Board (“ASB”) issues SAS. Under Rule 202 of the AICPA's Rules of Professional Conduct, AICPA members must adhere to these standards or be prepared to justify any departures from them. The ASB's Audit Issues Task Force is assigned the responsibility to provide timely guidance on the application of the ASB's pronouncements.

The AICPA's ASB issues Statements on Standards for Attestation Engagements, or SSAEs.

17 CFR 210.2-01.

SEC clients.

Proposed rule 13-03(i) defines the term “SEC clients.” We have defined this term, which is distinct from “registrant,” for the very limited purpose of identifying the dividing line (by reference to the number of “SEC clients”) between those accounting firms that will be subject to an annual quality control review and those (with fewer SEC clients) that will be subject to a triennial quality control review. For consistency, we have incorporated into the proposed rule the definition of “SEC clients” that is found in the AICPA's bylaws and resolutions,

but we have provided a PAB with the ability to amend the definition to add entities that the PAB believes should be considered to be SEC clients for the purpose of this rule. Under the AICPA definition, SEC clients include issuers in initial public offerings and registrants filing periodic reports under the Exchange Act (except broker-dealers filing only because of section 15(a) of that Act

) or the Investment Company Act. With respect to SEC clients, should companies whose reporting obligations arise solely under Section 15(d) of the Exchange Act be included within the definition of SEC clients?

AICPA Bylaw section 230R, Implementing Resolutions Under Section 2.3.5 for Definition of “SEC Client” (As adopted by Council Jan. 8, 1990), which states:

That for purposes of section 2.3, an SEC Client is

• An issuer making an initial filing, including amendments, under the Securities Act of 1933.

• A registrant that files periodic reports (for example, forms N-SAR and 10-K) with the SEC under the Securities Exchange Act of 1934 (except brokers or dealers registered only because of Section 15(a) of that Act) or the Investment Company Act of 1940.

15 U.S.C. 78o(a).

We also generally request comment on all of the definitions in the proposed rule, including the proposed scope of those definitions, and whether there are additional definitions that should be added or proposed definitions that should not be included in any final rules?

D. Commission Recognition of Public Accountability Boards

A PAB must be an organization that places the interests of investors above all else. To assure the ability and desire of an entity to represent investors and promote high quality financial reporting, the Commission would study carefully each organization before determining whether to recognize it as a PAB under the proposed rules. In this regard, proposed rule 13-03(a) would require that each entity desiring to become a PAB make a submission to the Commission containing the representations and materials necessary for the Commission to determine the entity's ability to carry out the functions and to accomplish the purposes that are described in Article 13. As noted in proposed rule 13-03(b), the Commission may ask the entity to supplement its submission with additional information.

Proposed rule 13-03(b) also indicates that the Commission would, consistent

with the public interest and for the protection of investors, decide whether to recognize an entity as a PAB based on the entity's commitment and capacity to carry out the functions and accomplish the purposes of the proposed rules. The Commission would make its determination by issuance of a Commission order.

We request comment on the procedures for Commission recognition of a PAB. In particular, is the standard for recognition of a PAB appropriate? Should we base our determination on factors other than or in addition to the entity's commitment and capacity to carry out the functions and to accomplish the purposes of the proposed rules? What other factors should the Commission consider?

Proposed rule 13-03(c) sets forth the information to be submitted to the Commission by an entity seeking recognition as a PAB. Under proposed rule 13-03(c)(1), the entity's submission must include its organizational structure, proposed budget, and proposed board members and terms of board membership. This information must be sufficient for the Commission to determine that the entity will satisfy the requirements set out in proposed section 13-04(b), and discussed below. Under proposed rule 13-03(c)(2), the proposed PAB must submit its charter and bylaws. Specific criteria that the charter and bylaws must satisfy are set out in proposed section 13-04(c) and discussed below. We solicit comment on the materials that a PAB should submit to the Commission when seeking recognition as a PAB. Are these materials appropriate for the Commission to require? Are there other materials regarding the organization of an entity seeking recognition as a PAB that the Commission should require or review to inform its determination of whether to recognize a PAB? For example, should we require an entity seeking to be recognized to submit its rules, membership requirements, and descriptions of its systems and procedures for our review before we make a determination about recognition?

In seeking recognition as a PAB, under proposed rule 13-03(c)(3), an entity would represent that it would pursue certain goals, such as to work to improve the quality of member firms' audits and reviews; work to improve member firms' quality controls and compliance with auditor independence and ethics requirements; enhance investor confidence in the audit process; and foster cooperation and coordination among private sector standard-setting bodies.

Proposed rule 13-03(c)(4) requires an entity seeking Commission recognition as a PAB to represent that it would establish rules, membership requirements, systems and procedures designed to further the goals described in proposed rule 13-03(c)(3) and sufficient to accomplish, at a minimum, the further objectives described in proposed section 13-04(d), and discussed below. With regard to proposed rules 13-03(c)(3) and (4), are these appropriate representations for the Commission to require? More generally, are there additional representations or information that an entity should be required to provide to aid the Commission's determination of whether to recognize the entity as a PAB?

Finally, proposed rule 13-03(c)(5) would require an entity seeking recognition as a PAB to represent that it would study and monitor quality control developments in other countries and report periodically to the Commission on whether the exemption for foreign accountants in proposed rule 13-07, discussed below, should be withdrawn. A PAB may recommend that the exemption be maintained, withdrawn in whole or part, or modified to place conditions on the receipt of the exemption. Although not stated in our proposed rules, a PAB also may choose to participate in efforts to develop and improve international or foreign national auditing, quality control or ethics standards. With regard to proposed rule 13-03(c)(5), is this an appropriate and useful study for a PAB to conduct? What should be the time frame of the study? Are there other areas that we should require a PAB to study and report on to the Commission?

E. Conditions of Commission Recognition of Public Accountability Boards

Proposed section 13-04 sets conditions to ongoing Commission recognition of a PAB. An entity seeking recognition as a PAB under proposed section 13-03 must meet certain of these requirements, specifically those contained in subsections (b) and (c), at the time of its initial request for recognition. For continued recognition by the Commission, the criteria in this section must be met on an ongoing basis. For the reasons described below, we believe that these conditions are necessary to ensure that a PAB acts in the public interest, consistently with the rules.

Organizational Structure, Board Membership, and Budget

To improve investor confidence in the integrity of the oversight process, a PAB must be, and must be perceived by investors to be, dominated by representatives of investors and issuers, or “public members,” as opposed to representatives of the accounting profession. Proposed rule 13-04(b) sets forth several requirements for the structure, membership, and budget of a PAB designed to ensure that public board members dominate all aspects of a PAB's activities. First, proposed rule 13-04(b)(1) would require that a PAB have a fixed number of board members, none of whom are, or have been at any time in the previous two years, an employee of an accountants' professional organization.

Additionally, no more than one-third of the members, and in no event more than three of the members, may be, or have been at any time in the ten year period preceding his or her PAB term: (1) An accountant; (2) a partner, principal, shareholder, or managerial employee of an accounting firm; or (3) a retired partner, principal, shareholder, or managerial employee of an accounting firm.

One of our core principles for a PAB is that it be outside the auspices of the AICPA or similar association or organization that has a purpose of serving the interests of “accountants,” as defined in Article 13. If an employee of such an organization served on a PAB, he or she would be obligated to serve both accountants and investors. While the interests of accountants and investors often are the same, they also may differ at times. To avoid real conflicts and the appearance of conflicts of interest, we have proposed that no employee of such an association or organization be a PAB board member and that there be a two-year period between working for such an organization and serving on a PAB. Because members of state boards of accountancy, which are state governmental agencies assigned the mission of protecting the public, would not face such conflicts, being a member or employee of a state board would not disqualify an individual from serving on a PAB.

The proposed rule does not set the number of PAB board members, but rather leaves this to a PAB's discretion. In this regard, however, because of the variety of functions to be performed by the PAB, we suggest that a PAB consisting of nine members likely could meet the objectives of the rule.

We believe that having a small minority of accountants on a PAB would be appropriate because of the functions we anticipate a PAB would perform. Under the previous self-regulatory system, the POB had five members who had not been, or had not recently been, members of the accounting profession. That regulatory system also contained, however, the SECPS Executive Committee, the Peer Review Committee, and the QCIC, which were comprised entirely of active or retired accountants. We envision a PAB taking over the work of not only the prior POB but also much, if not all,

of the work of these committees. Because the PAB would be more involved than the POB had been in evaluating each review report, determining the appropriateness of attendant recommendations for improvements in quality controls, directing reviews of larger firms, and performing similar functions, we believe that some minimal professional representation on the PAB is appropriate. We have taken the added precaution, in proposed rule 13-04(g)(5), however, of stating that only public board members, and not any accountant or retired accountant board members, may participate in any vote on whether to institute a disciplinary proceeding, or any vote on the findings or sanctions to be imposed in any such proceeding.

Under the proposed rule, the remainder of the PAB board members would be public members. A PAB may have as many public members as it believes are appropriate and necessary to fulfill its duties under Article 13. Public members should represent the interests of individual investors, institutional investors, and issuers. We anticipate that the public members may include, among others, former public officials, lawyers, bankers, institutional investors, securities industry executives, academics, economists, and business executives.

Each public member should have a background that permits him or her to make a contribution to the operations of the PAB. Having been, at some point in his or her career, an accountant who audited or reviewed financial statements that were filed with the Commission, or a partner or employee of an accounting firm that performed those functions, would not necessarily preclude a person from being a public member. To assure that such a member is, and is perceived as a public member, the proposed rule would require that he or she not have practiced as an accountant or been a partner or employee of an accounting firm for at least the ten-year period immediately before joining the PAB. We believe that an individual with such a prolonged separation from practice and from accounting firms, and with the intervening experiences gained in other professional endeavors, should not be presume to be a representative of the accounting profession.

We request comment on the composition of the board. Should the proposed rule set the number of board members? If so, what number is appropriate to accomplish the goals of the rules? We also request comment on the board membership requirements. Should we revise the criteria or ratios set forth above? Is the two-year parameter regarding employees of an accountant's professional organization appropriate? Would revising the criteria result in a board dominated by public members? Is the rule setting the ten-year parameter appropriate to ensure that the board has appropriate representation to fulfill the goals of the proposals? Are there other qualifications or restrictions on board members that ought to be addressed by Commission rule?

Does the rule appropriately define accountant members and public members or is some other definition more appropriate? We have indicated a person may be a “public” member of a PAB if he or she has not been an accountant within the last ten years. Is ten years too long? If a different period is appropriate, what period should it be?

We solicit comment on allowing a small number of accountants to be on a PAB. Should we require, rather than permit, that a certain percentage of board members be accountants? Whether mandatory or permissive, is the one-third standard appropriate, too high, or too low? Why? Is it appropriate to limit the number of accountants to three, no matter how large the board? Should there be no accountants permitted to be on a PAB, or is their expertise necessary for a PAB to carry out its mission?

Under proposed rule 13-04(b)(2) members would serve staggered terms in order to ensure continuity of operations. The proposed rule does not set the duration of terms or impose term limits on members. While the proposed rule leaves these matters to the PAB's discretion, we believe that three-year terms with some term limit, perhaps nine years, is appropriate. Such a term limit would allow new members with fresh ideas to make a contribution. We solicit comment on board terms. Should terms be staggered? Why or why not? Should the rule specify term limits and length of terms? If so, what would be an appropriate term and limit. For example, would a three-year term and nine-year limit further the goals of the rules?

Serving on a PAB would be a serious and time-consuming task. We have proposed in rule 13-03(b)(3) that a PAB's Chairman and Vice Chairman would be selected from among the public members and that at least one of these individuals would serve on a full-time basis. We envision that the remaining PAB members would devote approximately 20 to 25 percent of their professional time to PAB activities. A PAB's rules could provide for additional full-time members.

We solicit comment on the proposal to require that the Chairman and the Vice-Chairman be public board members and that at least one of them serve on a full-time basis. Is this requirement appropriate? Is it appropriate to limit the chairmanship and vice-chairmanship to the public members? Is it necessary or appropriate to accomplishing the purposes of a PAB that the Chairman or the Vice-Chairman be required to serve full time? Should more than one board member be required to serve full time, and if so, does it matter which board member(s)? Should we require the PAB to monitor and report to us on the time spent by PAB board members on PAB matters? Should requirements short of full-time service be placed on the percentage of time some or all the remaining board members devote to a PAB?

Another essential attribute for any entity applying to be a PAB, as reflected in proposed rule 13-03(b)(4), would be adequate staff and facilities, and the ability to hire consultants or advisers, necessary to carry out the purposes of Article 13. We anticipate that the professional staff of a PAB would include accountants with extensive experience in auditing and in the structure and operation of firms' quality control systems. These individuals must be able to assess the quality of audits and detect flaws in complicated quality control systems. They must be able to structure plans for reviewing firms' quality controls, put those plans into action, and conduct or supervise reviews that yield tangible improvements in the audit process. We also envision a PAB having a sufficient legal staff to facilitate effective disciplinary proceedings and provide sound advice on legal, procedural, and regulatory matters.

We solicit comment on the proper make-up of a PAB's staff. Should the proposed rules provide additional requirements regarding a PAB's staff or the means, capacity, and plans to hire that staff? Should a PAB be required to report to the Commission with respect to staff resource issues? If so, how often, and what should the reports entail? We have designed the composition of the board to provide assurance that a PAB would administer competently the proposed rules and that the public members would dominate the activities of a PAB. We request comment on all aspects of our proposed structure for the composition of a PAB, and on whether a PAB, as proposed, would be able to carry out its mandate effectively.

During our Roundtable discussions, Neil Lerner, a partner in the United Kingdom (“U.K.”) KPMG accounting

firm, discussed the professional oversight system recently adopted in that country.

The UK system uses a series of boards, each having a majority of non-accountant members, to oversee the setting of professional standards and to discipline inappropriate professional conduct. We solicit comment on this and similar comprehensive regulatory approaches and the extent to which such systems may be the basis for the regulatory system used in the United States.

SEC Roundtables,

supra

note 8, at 40-41 (Mar. 6, 2002) (statement of Neil Lerner, Head of Risk Management (U.K.), KPMG).

Charter and Bylaws

Proposed rule 13-04(c) sets certain requirements for a PAB's charter and bylaws. First, to limit the potential for excessive or unnecessary fees, proposed rule 13-04(c)(1) requires the charter and bylaws to provide that the entity will be a not-for-profit entity. Second, to assure that recusals, vacancies, or other factors do not result in a shift of voting power among the PAB members that would defeat public board member control of a PAB, proposed rule 13-04(c)(2) states that the entity's charter or bylaws must include quorum provisions ensuring that the public members can control the outcome of each vote by PAB members. Third, under proposed section 13-04(c)(3), in order to obtain Commission recognition, a PAB's charter and bylaws must provide that it will be subject to, and act in accordance with, Commission oversight as described in proposed section 13-04(i). Finally, proposed rule 13-04(c)(4) provides that a PAB's charter and bylaws must provide for immediate effectiveness of any changes that the Commission makes to the PAB's rules. As discussed below, proposed rule 13-04(i)(1) allows the Commission, by rule, to abrogate, add to, and delete from the rules of a PAB. In order for any such Commission rulemaking to operate efficiently, the PAB's charter or bylaws must make these changes effective with or without further action by the PAB.

We request comment on our proposals concerning a PAB's charter and bylaws. Should a PAB be required to be a not-for-profit entity? Could a for-profit entity achieve the purposes and goals of proposed Article 13 as well as, or better than, a not-for-profit entity? Are the other proposed requirements for a PAB's charter and bylaws necessary or appropriate to achieve the purposes and goals of proposed Article 13? Are there more appropriate and effective means for addressing these issues other than through a PAB's charter and bylaws? Are there other items that we should require a PAB to have in its charter and bylaws?

Rules, Membership Requirements, Systems, and Procedures

Proposed rule 13-04(d) describes certain rules, membership requirements, systems, and procedures that a PAB must have in place to be recognized by the Commission. A PAB would need to have these requirements in place, at a minimum, in order to achieve the goals set forth in proposed section 13-03(c). These rules, requirements, systems, and procedures would accomplish the following:

Enrollment Procedures.

Proposed rule 13-04(d)(1) would require a PAB to provide for membership enrollment procedures that: (1) minimize the administrative burden on individual accountants by maximizing the extent to which an accounting firm could satisfy the requirements on behalf of its individual accountants, and (2) require members and adjunct members to agree to be bound by a PAB's rules and membership requirements. The proposed rule allows a PAB latitude to determine the best approach to enrolling accountant-members, consistent with our requirement to minimize any burden on individual accountants. We expect that a PAB could adopt enrollment procedures that allow an accounting firm to enroll automatically all of its individual accountants by providing a PAB with a list of their names. This would eliminate any administrative burden on individual accountants. The proposed rule also reflects our intention that all members and adjunct members be made aware of their obligation to comply with a PAB's rules and membership requirements.

We solicit comment on our proposals concerning PAB enrollment procedures. Should our rules allow a PAB more or less flexibility in this area? Are there ways to reduce further administrative burden that could be specified in our rules? Should an entity that is an audit client of a PAB member accountant be required to file an application or other information with a PAB?

Quality Control Systems.

Proposed rules 13-04(d)(2)-(4) concern a PAB's quality control system requirements for its members. Under proposed rule 13-04(d)(2), a PAB's rules would require member-accountants to maintain a system of quality controls for their accounting and auditing practices designed to meet requirements set or designated by a PAB. At a minimum, a PAB would set or designate quality control requirements that would encompass those described in proposed section 13-04(e), discussed below. Under proposed rule 13-04(d)(3), a PAB would require its member-accountants to comply with their quality control systems in a way that provides reasonable assurance of conforming with professional standards. A PAB would also, under proposed rule 13-04(d)(4), develop and administer a continuing quality control review program for its members concerning accounting and auditing practices, and adherence to Commission and professional auditor independence requirements. The requirements for the quality control review program are set out in proposed rule 13-04(f), discussed below.

We solicit comments on the proposed rules concerning a PAB's requirements for members concerning quality control systems. Should a PAB have any other rules in place concerning its members' quality control systems?

Retention of Documentation Related to Audits and Reviews.

It will be critical for a PAB to be able to review documents relating to audits performed and accordingly, it will be important for a PAB to have clear and effective requirements regarding record retention. Under proposed rule 13-04(d)(5), Commission recognition of a PAB would be conditioned on a PAB having in place rules, membership requirements, systems, or procedures that would direct each member firm to retain documentation related to the firm's audit and review engagements for a set period of time after completion of the engagement, and in accordance with such other policies as a PAB may establish. The records to be kept would include those required by the professional auditing literature,

and records that otherwise document the procedures performed and the resolution of material issues during the engagement. Record retention policies and the period of time for the records to be kept would be determined by a PAB under its rulemaking process.

See generally,

SAS No. 96, AU § 339 (as revised 2002).

We request comment on the requirement for a PAB to direct its member firms to retain certain documents. Are the categories of records the proposed rules would require a PAB to direct its members to retain appropriate? Should we be more specific in our rules with respect to either which documents must be retained or for how long? If so, please be specific about the types of documents and the length of time.

Supplemental Reviews, Disciplinary Proceedings, and Dispute Resolution Procedures.

Under proposed rule 13-

04(d)(6), Commission recognition of a PAB would be conditioned on a PAB having rules and procedures for conducting supplemental reviews and disciplinary proceedings in accordance with the criteria set out in proposed rule 13-04(g), discussed below. Under proposed rule 13-04(d)(7), a PAB would need to provide procedures for requesting documents and testimony relevant to any PAB review or proceeding as described in proposed rules 13-04(f) and 13-04(g). We expect that a PAB will adopt rules and procedures in this area that are fair to all concerned while appropriately reflecting the need for strong enforcement mechanisms.

We solicit comments on our proposals regarding PAB procedures for disciplining and sanctioning member accountants, and resolving disputes with members and adjunct members. Should our rules provide more or less flexibility for a PAB in this area? Should we specify procedures for a PAB to resolve disputes with its members and adjunct members about fees, documents or testimony? Should we specify procedures, in addition to those described in proposed rule 13-04(g) below, for disciplining and sanctioning member accountants? If so, what specific procedures would be appropriate?

Conflicts of Interest.

Under proposed rule 13-04(d)(8), a PAB would adopt appropriate policies to address any conflicts or potential conflicts of interest that may arise involving the PAB's board members, employees, contractors, and professional representatives. Even the appearance of a conflict of interest can damage investor confidence. Accordingly, we expect a PAB to devote careful attention to this area, and adopt policies that reassure investors that the PAB is acting in the public interest.

We solicit comments on our proposal concerning a PAB's conflict of interest policies. What conflicts of interest are likely to arise? Will a PAB be able to adopt policies to address these conflicts? Do we need to be concerned about an appearance of conflict? If so, should we revise the proposed rules to address better eliminating perceived conflicts of interest? Should we require a PAB to adopt specific rules in this area or should we allow a PAB to develop its own rules? What specific rules, if any, should we require?

Funding for a PAB.

As noted above, a mandatory and continuous source of funds is critical to the independence and viability of a PAB. A PAB should not be dependent solely on the accounting profession for its funds or it may be viewed as beholden to, and influenced by, the profession. Accordingly, under proposed rule 13-04(d)(9)(i), a PAB would impose fees on both member accounting firms and on registrants who are adjunct members, to fund the operations and administration of the PAB. A PAB would be encouraged to adopt schedules that provide for different classes of firms and registrants to pay different fees, such that the fees would not impose unfair or disproportionate burdens on any one firm or registrant. We also would expect that the fee structure would not result in the PAB being overly reliant on any class of firms or registrants for its revenues. The PAB would determine the most appropriate method for collecting the fees.

Each accounting firm, however, should bear the cost of its own quality control reviews. Proposed rule 13-04(d)(10), therefore, would provide for each firm to pay fees to the PAB, separate and apart from the fees determined according to the schedules discussed in the preceding paragraphs, that are sufficient for the PAB to recover its costs and expenses related to each quality control review of that firm pursuant to proposed rule 13-04(f). The review of a large firm's quality controls may cost in excess of a million dollars. It would be inappropriate, in our view, to have smaller or competing firms shoulder part of those costs.

We request comment on our proposals concerning funding for a PAB. Are there alternative funding mechanisms that would better achieve the goals and purposes for which a PAB would be established? The proposed rules permit a PAB to impose fees on its members and adjunct members, but the proposed rules do not describe in detail how such fees should be set or collected. Should we be more specific, or should such matters be left to the discretion of the PAB?

The proposed rules would require a PAB to impose fees on each member firm to reimburse it for the costs associated with the quality control review of the firm. Under our proposals, firms with 70 or fewer SEC Clients might undergo quality control reviews performed by other accounting firms. The PAB would impose fees on the reviewed firm related to the PAB's evaluation and oversight of the review. The reviewed firm, however, might pay the reviewer directly. Is the fee provision appropriate? Should each firm bear the approximate cost of its own quality control reviews, or should these costs be spread evenly among firms? Are there advantages or disadvantages to a system in which each firm bears the costs of its own reviews? Are there particular approaches to billing and payment arrangements that would work best? Should our rules more specifically prescribe those arrangements? Should adjunct members contribute to the funding of these reviews?

Funding for the FASB.

Proposed rule 13-04(d)(9)(ii) indicates that a PAB would collect fees sufficient not only to fund its own operations but also to fund the operation and administration of an accounting standards-setting body endorsed by the Commission as the primary source for generally accepted accounting principles. Today that body is the FASB.

The FASB currently receives most of its funding from two sources—sales of its publications and the receipt of voluntary donations.

Because accounting firms and corporations purchase a significant portion of FASB's publications and make the majority of the voluntary donations to the FASB, these two groups have significant influence over the funds available to the FASB. By reducing donations, or by reducing the volume of their purchases, they have the potential to impact the funds available to the FASB.

Financial Accounting Foundation,

High-Quality Financial Reporting: 2001 Annual Report

, at 29, which indicates FASB received net contributions of $5,113,000 and subscription and publication sales of $14,818,000; its direct costs of sales was $1,586,000.

During debates of controversial accounting proposals, perceptions may arise that a corporation or accounting firm, or groups of corporations or firms, could use donations and sales volume to influence the FASB's decisions on substantive accounting issues.

To remove such possibilities, and to increase the stature, neutrality, and perceived independence of the FASB, we have proposed that the FASB, through fees paid to a PAB, have a mandatory and continuous source of funds.

See, e.g.,

Stephen Barr,

FASB Under Siege,

CFO Magazine, Sept. 1994, at 34, 46; Dean Foust,

It's Time to Free the FASB Seven,

Bus. Wk., May 3, 1993, at 144.

Accordingly, we anticipate that a PAB would receive a proposed budget from the FASB and the PAB would include the amount required to fund the FASB in determining the fees to be collected from accounting firm members and registrant-adjunct members. After collection, a PAB would pass those funds to the FASB.

We anticipate that the Financial Accounting Foundation (“FAF”), which is a private sector body

comprised of representatives of the business, professional, and academic communities that selects FASB members and handles financial matters for the FASB,

would continue to play a significant oversight role in determining the FASB's budget.

In the event that more than one entity obtains Commission recognition as a PAB, as we anticipate that the FASB would receive funding through each PAB according to a formula that takes fair account of any significant difference in the size of the various PAB's membership.

The FAF is comprised of 16 Trustees representing a broad range of professional backgrounds. The FAF currently has responsibilities for FASB and the Government Accounting Standards Board (“GASB”), and for their Advisory Councils, including oversight of the standard-setting process, selection of FASB and GASB members, and arrangmenets for financing.

Further discussion of the history of the Commission's endorsement and oversight of FASB can be found in Appendix B.

We request comment on our proposal concerning funding for the FASB. Should fees collected by a PAB be used to fund the FASB? How would an appropriate amount of fees for such a purpose be determined? Is it sufficient to rely on the FAF to assist in the preparation of the FASB's budget or should the FASB be required to submit an annual budget to the PAB? Our proposal anticipates full funding for the FASB, with the FASB appropriately reducing or eliminating the cost of its publications. Should the FASB, however, continue to generate revenues from the sale of its publications, and replace only the donations it receives with fees collected by a PAB? Would a PAB collect fees to fund the FASB in a different manner than the fees used to fund the PAB's operations and, if so, how should the fees to fund the FASB be collected? Should registrants and accounting firms be required to join the FAF so that the FAF may directly impose fees to fund the FASB?

In addition to raising funds for the FASB, the FAF raises funds for the GASB, which sets financial accounting and reporting standards for state and local governmental entities. Financial reports prepared under GASB may be the basis for investment, credit, and regulatory decisions. Because GASB has not been in existence as long as FASB, more of its funding is derived from private contributions. Costs associated with GASB are discussed in the Cost-Benefit Section of this Release. Should a PAB collect fees to fund GASB as well as FASB?

Fair Dispute Resolution Procedures and Notices of Delinquencies.

Under proposed rule 13-04(d)(11), Commission recognition of a PAB would be conditioned on the PAB having fair procedures for disciplining and sanctioning accountants and for resolving disputes with member accountants and adjunct members concerning fees, document requests and requests for testimony. As discussed above in connection with the definition of “delinquent,” we would expect a PAB to take very seriously the need for fair procedures to resolve any good faith disputes.

The proposed rule also specifies the need for a PAB to have procedures for providing appropriate notice to member accountants, adjunct members, the Commission, and the public, of any action that could result, or has resulted, in suspension or bar of a member accountant, or any other loss of good standing by a member accountant or an adjunct member. The PAB's rules and procedures should be designed to balance a member or adjunct member's legitimate interest in keeping certain disputes nonpublic (such as may occur during a nonpublic PAB supplemental review) with the need to provide the public, including an accountant's audit clients, with sufficient notice of an accountant's potential loss of good standing before actually revoking good standing. In addition, it is pursuant to this proposed rule that a PAB must have procedures for providing actual notice that a member accountant or adjunct member has been determined to be delinquent.

We request comments on our proposals regarding these notices. Should the proposed rules be more specific about when these notices would be required, or about the content of the notices? If so, when should the notices be required? For example, would it be appropriate to require a 90-day notice period before a PAB makes a public determination that a member or adjunct member is delinquent? What should the notices say?

Professional Standards.

For a PAB to be effective, it must be able to address not only personnel and systems failures in accounting firms, it must be able to address poor quality or vague standards that lead to deficient audits. When a PAB sees a need for new or revised standards, it must have a means to assure those standards are adopted and that other standard-setters, to the extent appropriate, conform their standards to facilitate the correction of the problem. Accordingly, a PAB, under proposed rule 13-04(d)(12), would either set, or designate private sector bodies to set, audit, quality control, and ethics standards. If it chooses to designate private sector bodies to set such standards, then a PAB would oversee the designated bodies by attending meetings, commenting on proposed standards, meeting as needed with each body, and, requesting that items be added to the private sector standard-setters' agendas and notifying the Commission when any such request is made.

Under proposed rule 13-04(d)(13), a PAB would also request that matters be added to the agendas of private sector bodies that set accounting or independence standards, and similarly notify the Commission of each such request. Under proposed rule 13-04(d)(14), a PAB also would sponsor meetings with and among private sector standard-setting bodies to coordinate their activities and to promote the sharing of information and effective communications.

These meetings would include not only the bodies involved in setting audit, quality control, and ethics standards, but also accounting standard-setting bodies, the Commission staff, and any other persons that the PAB considers appropriate.

See, e.g.,

The Panel on Audit Effectiveness,

Report and Recommendations,

at 141 (Aug. 31, 2000), which emphasizes the need for effective communications among standard-setting bodies and the bodies involved in disciplining accountants and conducting reviews of accounting firms' quality control systems.

We request comments on our proposals regarding professional standards. What is the proper role of a PAB in standard setting? Should a PAB have the ability to set standards? Should it have the ability to designate which bodies would be considered authoritative? We request comment on the proposed role of a PAB in contributing to the agenda of private sector bodies that set accounting or independence standards and in coordinating among standard-setting bodies. Are these appropriate and useful roles for a PAB to play in satisfying the goals and purposes sought through proposed Article 13? Are there more specific or additional roles that a PAB ought to play in this regard? Should the Commission approve the bodies designated by a PAB before those bodies are considered authoritative?

Open and Deliberative Process.

A PAB's process for amending governing documents, rules, membership requirements, and procedures would include an open and deliberative rulemaking process with open meetings and publication for public comment of draft rules, requirements and procedures. Allowing for public input would enhance public confidence in a PAB's process, and improve the quality of a PAB's governing documents, rules, membership requirements, and procedures. Accordingly, we have addressed the need for such processes in proposed rule 13-04(d)(15).

We request comment on the importance of an open and deliberative rulemaking process for a PAB. What

goals does it serve in the context of a PAB? Should our rules specify the types of procedures that a PAB should employ in rulemaking, or is this better left to a PAB to decide? What matters should a PAB be required to address only through an open process? Are there circumstances we should provide for under which issues concerning the amendment of governing documents, rules, membership requirements, and procedures should be handled other than through such open processes?

Full Faith and Credit.

Under proposed rule 13-04(d)(16), a PAB would give “full faith and credit” to the sanctions and good standing requirements of another PAB. This would be necessary, if more than one PAB is formed, to prevent an accountant from attempting to avoid a sanction by one PAB by resigning and joining a different PAB. This provision also notes that a registrant may not avoid a finding that it is in violation of a PAB's good standing requirements (due to not paying fees assessed by the PAB or not providing requested testimony or documents) simply by firing its current accountant and engaging another accountant that is a member of a different PAB. In such circumstances, the new PAB would consider the registrant to be not in good standing until the registrant remedied the nonpayment of fees or delinquency in providing testimony or documents.

We request comment on the proposed requirement to extend full faith and credit to another PAB. How would this requirement work in practice? Will a requirement to extend full faith and credit prevent attempts to avoid sanction by resigning from one PAB and joining a different PAB? Should our rules be more specific?

Training.

A key to maintaining professional competence is continued training throughout an accountant's career. Business and financial transactions, as well as audit practices, change with ever-increasing speed. Accountants need to be able to keep abreast of these developments and adapt their skills. Under proposed rule 13-04(d)(17), therefore, we condition the Commission's recognition of a PAB on the PAB providing training for, or imposing appropriate training requirements on, its member accountants in matters relating to accounting, auditing, attestation, assurance, ethics, independence, and quality controls. A training requirement should increase investor confidence that audits are being performed effectively and competently.

We request comment on the proposed requirement that a PAB provide or require training. Should we specify the particulars of a required training program? What would be the components of such a program? Should our proposed rules require a specific amount of training per year? How much training should be required?

Other Duties or Requirements.

Under proposed rule 13-04(d)(18), a PAB's rules, membership requirements, systems, and procedures would specify that the PAB would perform such other duties or functions as the Commission determines are necessary or appropriate in the public interest or for the protection of investors and to carry out the purposes of proposed Article 13. This provision would allow the Commission to oversee effectively a PAB's activities to make sure that the PAB is operating in accordance with the proposed rules, and would allow for the possibility of marshalling a PAB's resources for special projects that fall within its realm of responsibility. For example, in the past ten years, we asked the former POB to study accounting firms' quality control systems related to auditor independence, recent changes in audit techniques and practices, and various issues related to professionalism and independence.

We solicit comment on this provision.

These projects are noted in Appendix A.

More generally, we solicit comment on these rules and requirements. Should we include other requirements necessary for the proper functioning of a PAB as we describe it? Are any of the proposed requirements too onerous? Why?

Quality Control Requirements

Proposed rule 13-04(e) conditions Commission recognition of a PAB on the PAB ensuring that its member accountants maintain a quality control system designed to meet the requirements of quality controls set or designated as authoritative by the PAB. These controls should encompass at least the current AICPA quality control elements: independence, integrity, and objectivity; personnel management; acceptance and continuance of clients and engagements; engagement performance; and monitoring.

In addition, the proposed rule conditions Commission recognition on a PAB requiring its members to maintain certain specific quality controls, many of which are current SECPS membership requirements.

100

A PAB may supplement or otherwise modify the quality control elements and specific requirements with other elements and requirements it deems appropriate.

AICPA,

System of Quality Control for a CPA Firm's Accounting and Auditing PRactice,

¶ 7, Quality Control (“QC”) § s20.07.

100

See generally,

SECPS,

Requirements of Members,

items, e, f, h, i, k, m, n, o, and p. The membership requirements are available online at

htt://www.aicpa.org/members/div/secps/require.htm.

“Independence, integrity, and objectivity” policies address the firm's relationships with its clients. “Personnel management” refers to the criteria for the hiring, development, continuing education, advancement, and assignment of personnel. The element related to the “acceptance and continuance of clients and engagements” is designed to provide reasonable assurance that the likelihood of associating with a client's management that lacks integrity is minimized. “Engagement performance” policies are intended to provide reasonable assurance that the firm complies with applicable professional standards and regulatory requirements. And “monitoring” involves an ongoing evaluation of the relevance of the firm's policies, the appropriateness of the firm's guidance materials and practice aids, the effectiveness of professional development activities, and compliance with the firm's policies and procedures.

101

We believe that these elements continue to be essential to high quality accounting and auditing practice and should continue to be required.

101

See supra

note 99, QC §§ 20.07-20.20 (description of each quality control eleemnt).

We request comment on conditioning Commission recognition on a PAB requiring that its member accountants maintain a quality control system. We stated that the controls should encompass at least the current AICPA elements and certain SECPS membership requirements. Are these elements appropriate to address the concerns discussed in the release? Are there other elements that we should require a PAB to include as part of its quality control system?

The specific quality controls that should continue to guide accounting firms' accounting and auditing practices include:

• Rotating the partner in charge of an audit engagement at least once every seven years;

102

SECPS,

Requirements of Members,

at item e.

• Having a second-partner (one other than the partner in charge of the audit engagement) independently review the audit report and the financial statements,

103

unless the PAB authorizes alternative procedures where

this requirement cannot be met because of the size of the firm;

103

Id.

at item f.

• Ensuring policies and procedures are in place to comply with auditor independence requirements and to refrain from providing to audit clients consulting services that are inconsistent with § 210.2-01 and conducting public opinion polls and merger and acquisition assistance for a finder's fee;

104

Id.

at item h and o.

• Reporting to the audit client and the SEC when the firm resigns, declines to stand for reelection, or is dismissed;

105

Id.

at item m.

• Seeking to have foreign associated firms adopt policies and procedures consistent with the objectives of the proposed rules, and notifying the Commission when any such firms have done so;

106

and

106

Id.

at item n. As discussed elsewhere in this release, foreign accountants would be exempt from the coverage of the proposed rules. The provisions in this section is intended only to continue current practices, under the SECPS membership requirements, of encouraging foreign firms to improve their quality control systms.

• Ensuring the firm has policies and procedures for reporting litigation or government investigations or proceedings to the PAB,

107

with a copy of the report to the Commission's Office of the Chief Accountant.

107

Id.

at items k and p.

We request comment on each of these items. Is a requirement to rotate a partner every seven years, for example, the appropriate time frame? Should a PAB be permitted to make any exceptions to these requirements in some cases? If so, under what circumstances?

In addition to the current SECPS membership requirements, other practices currently enhance investors' confidence and contribute to improved audit quality. Under proposed rule 13-04(e), Commission recognition of a PAB depends on the PAB requiring its members' quality control systems to encompass these practices as well. For example, proposed rule 13-04(e)(4) essentially restates the requirement in Independence Standard No. 1 regarding communications on auditor independence issues between an accountant and the audit committee of its audit client.

108

Independence Standards Board,

Independence Discussions with Audit Committes,

Independence Standard No. 1 (Jan. 1999), which requires the auditor to disclose to the audit committee, in wiritng, relationships that the auditor believes may reasonably be thought to bear on auditor independence, confirm in the letter its independence, and discuss its independence with the audit committee.

Another example of a beneficial practice is maintaining a central office function that has expertise in accounting and financial reporting matters, and having policies and procedures in place for: (1) Engagement partners and others to consult with that office, and (2) the resolution of differences of opinions between that office and engagement partners. Proposed rule 13-04(e)(8) would condition Commission recognition of a PAB on the PAB ensuring that member firms maintain such a central office function, but a PAB could authorize alternative procedures for firms that could not meet this requirement because of their size. We solicit comment on the central office function requirement. Would this requirement place a burden on those firms that do not already maintain a central office function? Would conditioning recognition on the maintenance of a central office function pose any competitive concerns?

Finally, proposed rule 13-04(e)(9) would condition Commission recognition of a PAB on the PAB ensuring that its members incorporate many of the procedures discussed by the Independence Standards Board in Independence Standard No. 3,

Employment with Audit Clients.

109

This standard requires an accounting firm, when an audit client employs a former firm professional, to take steps to eliminate the risk that the firm's former partner or employee could, by reason of his or her knowledge of or relationships with the firm, adversely influence the quality or effectiveness of the audit.

110

109

See

Independence Standards Board,

Employment with Audit Clients,

Independence Standards No. 3 (July 2000).

110

Id.

We request comment on the quality control elements and specific requirements we have included in the proposed rule. Should we require these items, or should we defer to a PAB's discretion to devise quality control elements and requirements or to designate another entity's as authoritative? If they should be retained, should any be omitted or should additional procedures be added? Which ones? For example, should all partners who participate in a portion of the audit of a registrant's financial statements be rotated periodically? Are there other circumstances when we should require reporting to the audit client, a PAB, and/or the SEC? What are they? Should the Commission provide greater or lesser direction regarding the content of requirements set or adopted by a PAB?

Quality Control Review Program

In section 13-04(f), we propose to build on the most successful parts of the SECPS's peer review process and membership requirements to create a stronger, more diligent and independent system. Proposed rule 13-04(f) conditions Commission recognition of a PAB on the PAB having a continuing program for the review and inspection of member accountants' compliance with the PAB's rules and membership requirements and professional standards.

The frequency of the reviews of a firm's quality control system under proposed rule 13-04(f)(1) would vary based on the number of the firm's SEC clients. For each member firm with more than 70 SEC clients, or such other number of SEC clients as the PAB may determine, the proposed rule would require a PAB to conduct an annual review of the firm's quality control system. For all other member firms, a review would be conducted at least once every three years.

According to a recent computer run of SECPS members, ten accounting firms have more than 70 SEC clients.

111

We have chosen 70 SEC clients for the dividing line to ensure that those accountants who audit the vast majority of registrants will be subject to very frequent scrutiny by a PAB. We recognize that the number of firms with more or less than 70 SEC clients, and the need to review more or fewer firms on an annual basis, may change over time. Proposed rule 13-04(f)(1), therefore, would provide a PAB with the discretion to change the number of SEC clients that would trigger an annual, as opposed to a triennial, review.

111

The same data, derived from a list obtained from the SECPS, indicates that ten firms have between 30 and 75 SEC clients and approximately 800 firms have fewer than 30 SEC clients.

Should a PAB conduct reviews more or less often than annually for the larger firms? Will triennial reviews for small firms meet the goals of the proposed rules? Should a PAB have the discretion to alter these frequency requirements based on experience over time with the review process? If so, in what way, if any, should that discretion be guided by Commission rules?

We also request comment on whether 70 SEC clients is the appropriate trigger for an annual review or whether a larger or smaller number of SEC clients would be more appropriate. Additionally, we request comment on the proposal to provide a PAB with discretion to alter the 70 SEC client trigger/standard. Should a PAB have that discretion? If it does not, how should developments over time and a PAB's experience with the review process be factored into or accounted for in adjusting the trigger, as

may be appropriate? If a PAB is granted discretion to change the trigger, are there factors the Commission should identify to guide the exercise of that discretion?

Proposed rule 13-04(f)(2) would permit a PAB to direct its member firms to make and keep records that are necessary for the conduct of the reviews. Proposed rule 13-04(f)(3) would make clear our expectation that a PAB would establish the policies and procedures for conducting reviews, establish reporting requirements, and maintain public files. Under proposed rule 13-04(f)(4), a PAB would monitor each review to ensure that it is conducted in a fair and impartial manner and that appropriate procedures are recommended and implemented to correct any noted deficiencies in a timely and effective manner.

We request comment on all aspects of our proposals regarding quality control reviews, including on the elements of a strong quality control review program. How can a PAB best assess compliance of its members with rules of a PAB and with professional standards? How can a PAB best assess compliance of individual accountants associated with a firm?

If a PAB program would be compared to the peer review program that currently is conducted under the auspices of the AICPA, we would expect that the PAB and its staff would perform the functions related to peer reviews that currently are performed by the Peer Review Committee,

112

the SECPS Executive Committee,

113

and until recently the POB and the POB staff,

114

to the extent those functions are deemed necessary by a PAB.

112

The Peer Review Committee administers the peer review program, establishes standards for conducting peer reviews, establishes standards for reports on peer reviews and publication of such reports, requests the SECPS Executive Committee to appoint a hearing panel when it believes that sanctions should be imposed on a member firm for failure to comply with membership requirements, keeps records of peer reviews, and establishes and maintains a public file for each member firm, which includes the firm's three most recent annual reports, the latest peer review report, the reviewer's letter of comments, and the firm's response.

See

AICPA,

Governing Bodies

at:

http://www.aicpa.org/members/div/secps/bodies/index.htm.

113

The SECPS Executive Committee, among other things, establishes requirements for membership in the SECPS and determines sanctions to be imposed on member firms for failure to comply with the SECPS's membership requirements, ordinarily through the appointment of hearing and appeals panels.

Id.

114

The POB and the POB staff, among other things, monitored and evaluated the effectiveness of the Peer Review Committee and the SECPS Executive Committee and determined whether the Peer Review Committee was ascertaining that firms were taking appropriate action as a result of findings during peer reviews.

Id.

Under proposed rules 13-04(f)(5) a PAB would direct and make all key decisions related to each review of a firm that has over 70 SEC clients, or such other number of SEC clients as the PAB may determine. For firms with 70 or fewer SEC clients, a PAB may permit the reviews to be conducted by non-PAB staff, but only if the PAB: (1) Approves the review program; (2) establishes policies and procedures for the reviews as well as for reporting the results of the reviews; (3) maintains public files related to the reviews; (4) monitors the program to insure that reviews are conducted in a thorough and impartial manner; and (5) evaluates each review to gain assurance that appropriate procedures are being recommended and implemented to correct any noted deficiencies in a timely and effective manner.

We request comment on whether a PAB should be permitted to use approved review programs. The five items listed should help to make sure that such programs operate effectively. Are there any other requirements that should be added to this list before a PAB may permit reviews under a review program? If review under a program is permitted, should a PAB, as part of its oversight of such a program, have control or veto power over the reviewer?

Under proposed rule 13-04(f)(5)(i), in performing a PAB-directed review, the PAB may engage accountants from one or more non-associated firms to work on the review. As noted above, however, all key decisions must be made by the PAB. We are proposing to allow the PAB to engage such accountants to assist in doing the “leg work” of the reviews, so that a PAB may decide whether to hire a larger permanent staff or to contract for additional support on reviews as needed. Any accountants engaged to assist the PAB in conducting the reviews would perform only assigned functions and be supervised by the PAB or its staff.

Should a PAB be permitted to engage accountants to work on a review? If so, what is the scope of functions that accountants engaged to assist a PAB in conducting reviews should be permitted to perform? Should there be other limitations or requirements on the accountants that may be engaged to assist a PAB in conducting a review? Would it be practical, and would a PAB be able to obtain the necessary expertise, if it had to conduct all or a significant portion of reviews exclusively with its own staff? Should a PAB direct the reviews, and make all key decisions for all reviews? In a PAB-directed review, should a PAB be permitted to engage, on a contract basis, employees of firms that are not affiliated with the firm being reviewed to do the “leg work” on the review? We have proposed that firms with 70 or fewer SEC clients may have quality control reviews conducted under a review program approved by a PAB. Should firm-on-firm reviews be allowed? If firm-on-firm peer reviews are allowed, should a PAB, as part of its oversight of such a program, have veto power over a firm's selection of its reviewer? Should these reviews be conducted by teams of persons from one accounting firm or should the teams include members from several firms? What are the advantages and disadvantages of either team composition? Should firms employ staff members dedicated, at least on a part-time basis, to PAB quality control reviews?

Proposed rule 13-04(f)(6) provides that a PAB or approved reviewer would examine various offices and personnel within the firm. It also would require a PAB or reviewer to determine whether the firm's quality control system is appropriate, whether adequate documentation and communication of quality control policies and procedures exists within the firm, and whether those policies and procedures provide reasonable assurance of compliance with the Commission's rules, the PAB's rules and membership requirements, and professional standards. Under proposed rule 13-04(f)(7), a PAB or reviewer would prepare a report of its findings and comments during each review. Each report and any response provided by the reviewed firm would be available to the public.

We solicit comments on the appropriate scope of a review and the type of report and access to the report that should be established by the rules.

Supplemental Reviews and Disciplinary Proceedings

In proposed rule 13-04(g) we have created the framework for a disciplinary process that for the first time would add teeth to the quality control review process. Under this proposal, the PAB could suspend or bar an individual or firm from being a member of a PAB or impose other remedial or disciplinary sanctions, as it believes appropriate. Such a proceeding might be based on an individual accountant's incompetent or unethical conduct, other acts or omissions that constitute a failure to comply with professional standards, or for violations of the PAB's rules or membership requirements. A proceeding against a firm might be based on the issuance of an adverse

review report, which indicates that the firm's quality controls, or compliance with those controls, are deficient and fail to provide reasonable assurance that the firm is complying with professional standards during its audit, review, or attest engagements. A PAB could also institute disciplinary proceedings against a firm or an individual for conduct that comes to the attention of a PAB other than through the quality control review.

Proposed rule 13-04(g)(1) conditions Commission recognition of a PAB on the PAB having rules, membership requirements, systems, and procedures, incorporating the criteria described in this section, pursuant to which it could institute public disciplinary proceedings to determine whether an accountant has violated PAB rules or membership requirements, or professional stand

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