Auditing Research on Current Issues: The Impact of SOX

1. Auditing Research on Current Issues: The Impact of SOX Auditing Section Doctoral Consortium New Orleans, Louisiana January 13, 2005 William R. Kinney, Jr. University of Texas at Austin

2. Outline • Background and assumptions • A model for corporate governance and auditing research • Research implications of SOX • Specific research questions and barriers • Conclusion and implications

3. 1. Background and assumptions • Research should reflect real world problems and complexity • Big change in real world - SOX • Need to identify new real world problems and • new theories, • new methods, and • new data to address them You are best qualified for the task

4. Information is valuable if the decision maker believes: • Measurement criteria are relevant • Measurement criteria are carefully applied • Measurement display is trustworthy

5. . . . but: Sarbanes-Oxley Act of 2002 challenges • Relevance of GAAP • Reliability of auditing standards • Trustworthiness of auditors, independent directors, standards setters, financial intermediaries, and contracts that bind them . . . this is a big new potato -- new states and new actions need new theories to explain/understand

6. Sarbanes-Oxley Act • Emphasizes compliance with rules over value • Management certification of “fair presentation” • Mandates some GAAP changes • Mandates internal control assertions/attestation • Funding changes for IB/FA, FASB, Auditing standards setting

7. Sarbanes-Oxley Act also • Mandates: • Independent (non-employee) audit committee • IAC hires and fires auditor (IAC is the “client”) • Non-audit service bans • “police beat” inspections of audit engagements • PCAOB as independent (and no cost/benefit test) : • Auditing standards setter (not just GAAS) • Independence standards setter • Registered audit firms’ inspector and enforcer

8. SEC (Supreme) FASB PCAOB Inspect/ Enforce GAAP Indep Stds. COSO (Int Ctrl) Audit Stds Financial Reporting Regulators in the U.S. Measurement criteria Application of criteria

9. FASB/ AICPA SEC Auditor Independent Directors Management Stockholders FS Customers Workers Suppliers Lenders Analysts/ intermediaries Competitors General public Congress 2. Accounting and Corporate Governance1978-2002

10. Management responsible for financial statements and has discretion to • choose transactions in which to engage • choose methods to account for transactions and events • choose how carefully to apply chosen methods (precision and bias of estimates and judgments) • choose to misapply methods (non-GAAP) …is motivated to manage reported earnings and has market power over all gatekeepers!

11. Auditor $ $ $ $ Management Stockholders $ $ $ Competitors $ $ General public Accounting and Corporate Governance Show me the money – pre-SOX! FASB/ AICPA SEC Independent Directors FS Customers Workers Suppliers Lenders Analysts/ intermediaries Congress

12. $ Auditor $ $ Management Stockholders $ $ $ Competitors $ $ General public Accounting and Corporate Governance Show me the money – post-SOX! FASB/ AICPA/ SEC PCAOB x $ x Independent Directors $ FS x Customers Workers Suppliers Lenders x Analysts/ intermediaries Congress

13. Huge stock-based compensation SAS No. 89, 1999 SAB No. 99, 2000 Sarbanes-Oxley Act of 2002 Pressure to “meet or beat EPS numbers” Manage/manipulate by pennies per share Auditors allow M < M* Accounting scandals, ethics, and regulations 1980s precursors 1990s developments 1999-2002 regs. Great stock market / 1993 OBRA sal. cap Reduced stock commissions Loose GAAP for stock-based comp. expense Information technology (MSNBC/ CNN) GAAS allows waiving M < M*

14. 3. Measurement Criteria Relevance • GAAP – • is it adequate for governance? • will mgt’s certification of “fairness” help? • COSO – does it adequately/usefully measure internal control process effectiveness? • Are “new” measurement criteria dead? • Can registered auditors’ “direct report” under PCAOB standards?

15. PCAOB Mission Statement • Oversee the auditors of public companies in order to (a) protect the interests of investors and (b) further the public interest in the preparation of informative, fair, and independent audit reports. (emphasis added) Question: does (b) allow PCAOB to require auditors to report on something other than management’s assertions with respect to GAAP and COSO?

16. Care in measurement: audit adequacy • Audits of • process vs. output (IC vs. financial statements) • estimates and risk assessments vs. hard numbers • relationships vs. physical assets • fairness vs. GAAP • Will the audit committee as the “client” and “can’t lie to your auditor” help? • “Auditing Standards” vs. GAAS (law vs. acceptance)? • The cost and value of PCAOB vs. self-regulation? • Effect of “police beat” audit inspections?

17. Trustworthiness of: • Use audit firm for – transactions design? systems design? internal audit outsourcing? tax advice? accounting “advice”??? • Conflicts of interest for: CEO, CFO, IA, IB/FA, corp. counsel, lenders, government officials • Audit Committee incentives for diligence? (independent vs. invested) • An auditor who is paid by clients? Are NAS restrictions the best way to ensure auditor independence?

18. 4. Research in Analytics • Need models for: • value of process vs. state reliability • role of subjective “fair presentation” • reporting and auditing “second moments” • economics of auditing as a regulated activity • auditing in context of corporate governance • rules-based vs. risk-based auditing standards • Barrier: extra parties and institutions hard to model

19. Research in Experiments • Questions: • Does SAB No. 99 work (Nelson et al. 2003)? • Will IAASB ED on accounting estimates work? • Does SAS No. 99 work? • Does ERM (COSO II) improve COSO? • Barrier: How to convince regulated audit firms that your experiments are valuable to them – what’s in it for them now?

20. Research in Archival Studies • What are the effects of • fee disclosures on profits and performance? • PCAOB as standards setter and regulator (similar to evaluating the FASB and SEC)? • SOX on innovation in auditing and standardized business measurement? • SOX provisions on attracting new CPAs? • Barrier - How to work with PCAOB and regulated audit firms as independent researchers – why should they help you?

21. 5. Summary and Conclusions • Wonderful opportunity for all – if you miss on this one you will not prosper • Should think broadly about what value auditing can add in a SOX-regulated information environment • Can we do it / Yes we can – if . . .