Consumer Federation of America

1. The bill would create a new regulator to oversee the audits of public companies.

To be effective, a new regulator for auditors of public companies must have the following five characteristics: independent governance, adequate and independent funding, broad standard-setting authority, extensive investigatory powers, and strong enforcement authority, including the authority to impose meaningful sanctions. The Sarbanes bill meets four of these standards but fails to guarantee that the governing board would not be controlled by the accounting industry.

Its five-member board would serve on a full-time basis and receive no compensation from an accounting firm while on the board except fixed payments under a standard retirement plan. However, members must include up to two present or past CPAs. There are no meaningful independence standards for the remaining three “public” members. It is all but inevitable that the accounting industry would dominate this board in time. (See “Key Improvements that Must be Made to Senate Accounting Reform Legislation.”)

Funding would be provided by fees imposed on issuers. This should provide a guaranteed source of adequate funding that is not subject to the type of threat the industry has used to cow the Public Oversight Board.

The bill would give the new body responsibility to set audit, quality control, ethics, and independence standards. A regulator that can only enforce standards set by the industry it regulates is doomed to ineffectiveness. Having this standard-setting authority would allow the regulator not just to clean up problems after they occur, but to prevent them by imposing and enforcing high standards for how audits are conducted.

In addition to charging the new regulatory board with responsibility to inspect audit firms on a regular cycle, the bill would give the board the necessary powers to investigate suspected wrong-doing. This includes the power to compel testimony and documents, authority that is backed up by the potential suspension of registration for failure to cooperate.

Where violations of laws, rules, or standards are found, the board would have authority to impose a wide range of sanctions. These include censure, retraining, limitations on activities, significant civil money penalties, and suspension or revocation of registration, which carries with it the right to audit public companies. As a result, the board would have needed flexibility to respond at an appropriate level to different types or degrees of wrong-doing. The threat of meaningful sanctions would serve as an effective deterrent to abusive practices.

2. Although it stops well short of the comprehensive reform that is needed, the bill would modestly enhance the independence of the audit. Restoring real independence to the audit will require a multi-faceted approach that lessens the financial sway audit clients hold over their auditors and closes the revolving door that all too often exists between auditors and their audit clients. To that end, we support requiring periodic rotation of auditor firms, prohibiting all non-audit services that cannot be shown to improve the quality of the audit without creating significant conflicts of interest, and imposing a cooling off period before partners or employees of the audit firm could be employed with the audit client without forcing a change of auditors.

The bill would ban accounting firms from providing nine non-audit services to audit clients, many of which are already prohibited under weak SEC rules. Unfortunately, the bill does not define the extent of these banned services, which leaves this key role in the hands of the SEC. There is nothing in the bill to prevent the SEC from declaring that it codifies weak existing definitions for those services that are covered by current rules. Given the SEC Chairman's stated opposition to broader restrictions on non-audit services, and his role in negotiating the existing watered down rules, it will be imperative that the Senate include definitions of the banned services in this legislation. (See “Key Improvements that Must be Made to Senate Accounting Reform Legislation.”)

The bill supplements its limited and vague ban on non-audit services with a provision that would make board audit committees responsible for decisions about hiring the auditor to perform non-audit services. Moreover, the Audit Committee must pre-approve all non-audit services that are not banned by law, unless the services are less than 5 percent of the total revenues paid the auditor. This should help to reduce the conflict that arises when management controls these decisions, and auditors with significant consulting services at stake fear that challenging management aggressively on the audit puts not just the audit itself but also that consulting business at risk.

The recently added provision giving the new regulatory authority to grant exemptions on a case-by-case basis should not pose a serious threat to the audit independence standards, as long as the board's independence is protected.

3. The bill would enhance the audit committee's responsibility for overseeing the audit and its ability to do so effectively.

Audit committees are supposed to oversee the audit to ensure its integrity. Too often, however, they abdicate those responsibilities, relying instead on the assurances of management. The bill would force audit committees to take responsibility for overseeing the audit and would give them the tools they need to do so.

The bill would make audit committees directly responsible for the appointment, compensation, and oversight of the auditor. This includes responsibility for resolving disputes between management and the auditor over financial reporting.

The bill also would improve the information audit committees have available to them in fulfilling their responsibilities. The auditor would be required to provide a report to the audit committee that describes: the critical accounting policies and practices to be used; all alternative treatments under generally accepted accounting principles that have been discussed with management, any disagreements between the auditor and management, and any other written communications between the auditor and management.

The bill would authorize audit committees to engage counsel or other outside advisors to assist them in fulfilling their responsibilities and would require companies to comply promptly with requests for funding for this purpose.

The bill supplements these protections with new provisions to help ensure the independence of the audit committee. It would do so by imposing limits on the financial ties that audit committee members could have to the issuer.

4. The bill would reduce incentives for management to make misleading disclosures and provide greater accountability when they do.

Company management often faces enormous pressure to keep the company's stock price on a steady upward trajectory. Their personal financial well-being is also often at stake. The Sarbanes bill would help to counteract those forces by imposing greater accountability on management for ensuring the integrity of the audit and by imposing heavier sanctions when they fail to do so.

! Chief executive officers and chief financial officers would be required to certify that the audit report fairly and accurately presents the financial condition and operations of the issuer.

! The bill would make it a crime for an officer, director, or person acting under their direction to fraudulently influence, coerce, manipulate, or mislead the auditor for the purposes of rendering the audit report materially misleading.

! CEOs and CFOs would be required to reimburse the issuer for any bonus or other incentive-based compensation received during the 12-month period before an accounting restatement that is required because of misconduct that resulted in material noncompliance with financial reporting requirements under the securities laws.

! In actions involving violations of the securities laws, the bill would authorize the SEC to seek, and courts to grant, any equitable relief, including disgorgement of any or all benefits received from any source in connection with the conduct giving rise to the action, including salary, commissions, fees, bonuses, options, profits from securities transactions, and losses avoided through securities transactions.

5. The bill would substantially increase SEC funding. The Enron collapse has helped draw attention to a long-festering problem -- the gross underfunding of the Securities and Exchange Commission. The call for greater scrutiny of corporate financial disclosures and the growing enforcement caseload that have followed have put new strains on that budget. The Sarbanes bill would authorize a dramatic increase in funding from $437.9 million in FY 2002 to $776 million in FY 2003. Of that, $98 million would fund the hiring of at least 200 professionals, $102.7 million would be made available to fund a pay increase for SEC staff, and $108.4 million would go toward information technology, security enhancements, and the costs of recovery from the September 11 attack.