Evolving Regulations and Oversight in the Public Interest

An Interview with SEC Chief Accountant Donald T. Nicolaisen

By Robert H. Colson

SEC Chairman William H. Donaldson announced the appointment of Donald T. Nicolaisen, CPA, as the commission’s chief accountant in August 2003. Nicolaisen oversees the SEC’s accounting policy initiatives and leads its efforts with national and international standards setters on critical accounting and auditing issues. He also works closely with the Public Company Accounting Oversight Board (PCAOB) to ensure that auditors adhere to the highest business and ethical standards.

Nicolaisen was previously a senior partner at Pricewaterhouse- Coopers LLP, where he held a range of management and leadership positions after joining the firm’s predecessor, Price Waterhouse, in 1967. From 1988 to 1994, he led Price Waterhouse’s national office for accounting and SEC services. During that time, he was also a member of FASB’s Emerging Issues Task Force (EITF).

Nicolaisen met with CPA Journal Editor-in-Chief Robert Colson at the SEC’s Washington, D.C., office in late 2003.

The Role of the Chief Accountant

The CPA Journal: What is the dominant item on your agenda as the new chief accountant?
Donald T. Nicolaisen: Narrowing it down to one thing is difficult, but broadly, it’s helping investors be better informed and restoring investor confidence through reforms that improve the financial reporting process. This includes reform in the accounting and auditing profession, which the Sarbanes-Oxley Act has already catalyzed. The audit process must be improved, and investors deserve financial statements that are more transparent and easier to understand. This starts at the top of the organization and will involve, in many cases, a cultural change. In addition, there is an expectation gap between what the auditor is required to do and what the public expects the auditor to do. This gap needs to be addressed. Auditors must step up to the plate and better explain their role.

Fortunately, the OCA [Office of the Chief Accountant] staff comprises talented people, fully dedicated to quality financial reporting and investor protection. Together, I am confident that we will achieve our goals.

CPAJ: How would you characterize the problems you inherited on entering the chief accountancy?
Nicolaisen: Individual and corporate greed has strained the system and created excesses and abuses that have led to unethical and sometimes criminal behavior. In some cases, excessively detailed accounting rules have given those who choose to abuse the system a means to achieve better-looking numbers in financial statements by circumventing the fundamental principles behind the rules.

The SEC staff recently released a study on principles-based accounting standards. The report supports objectives-oriented standards, which will provide a better framework in which to exercise professional judgment and may help facilitate compliance with the intent of the standards. Such a change, where judgments are required and appropriately exercised, will go a long way toward improving the corporate reporting process.

CPAJ: How do you combat the “parsing the rules” mentality?
Nicolaisen: This is another example of how our culture has evolved. We have a society of laws and rules, and people—including business owners—who want to understand what rules apply to them and how to follow them, all of which is entirely fair. But problems arise when the rules are stretched and transactions with little or no underlying economic substance are entered into simply to achieve an accounting result. In these cases, people have crossed the line and have misled investors. Professional accountants, whether working as preparers or auditors, recognize that misleading investors is unacceptable, and they have the ability to contribute to quality financial reporting. Our challenge, and the accounting profession’s challenge, is not only to encourage compliance with the rules but also to inform investors about the underlying transactions and the resulting financial picture.

One area where parsing the rules has been especially troubling is the use of SPEs [special purpose entities]. I believe that FASB has identified the right approach in FIN 46 [Consolidation of Variable Interest Entities, effective October 9, 2003] to address the underlying economics of such entities. Now it’s up to the business community and accounting professionals to apply their professional judgment and implement these principles.

CPAJ: What is the role of the OCA in bringing about reform?
Nicolaisen: My role is to protect investors and maintain the integrity of our securities markets. OCA has a number of resources at its disposal to accomplish these goals. The bully pulpit is one such vehicle, and I intend to use it effectively. It’s essential that registrants and accountants understand that we’re serious about reform. I want to be very clear: We will enforce the laws and regulations, and people who violate the letter or spirit should expect to hear from us.

CPAJ: Has the pattern of registrants or accountants bringing problems to the OCA changed?
Nicolaisen: Historically, the chief accountant has had an open dialogue with registrants and accountants on how to account for difficult transactions, and I intend to continue that tradition. This approach has worked well for all parties. But we don’t see all the transactions we’d like to, although we often see the extremes, sometimes after the fact. In our experience, trade and industry groups have done an excellent job communicating their concerns to us.

I encourage registrants and auditors to discuss questions with OCA early in the process, before an issue has escalated into a crisis. It’s important to understand that we don’t say “no” to every proposed accounting treatment brought to our attention. Nonetheless, I would caution that if the company’s auditor is challenging the accounting, then we’re also likely to see problems with it. In short, we’re encouraging a more open dialogue that begins earlier in the process.

CPAJ: How do you view the change in the corporate accounting culture from an objective, scorekeeping function to a profit center?
Nicolaisen: Restoring investor confidence will require a top-to-bottom cultural change for some entities. Unfortunately, the profit-center culture exists in some companies where executives place undue pressure on the accounting function to find ways to add to the bottom line through accounting entries rather than expecting the accounting function to serve as the neutral reporter. Of course, many CEOs run their businesses in the right way—by supporting appropriate research and development programs, ensuring quality manufacturing and distribution, and trying to earn an honest return for their shareholders—and treat the accounting function as an objective scorekeeper of their successes and failures. The CEO and CFO certifications that Sarbanes-Oxley now requires represent a big step forward, because officers now have to affirmatively certify that the financial statements provide an accurate picture of results. The act of signing one’s name on such a certificate drives home the fact that the CFO or CEO is personally vested in the financial reporting process.

CPAJ: What are your thoughts about the differences between the responsibility of officers and directors for financial statements and that of independent auditors?
Nicolaisen: Quality financial reporting starts with officers and directors. When public company CEOs, CFOs, audit committees, and boards set a tone at the top that respects and supports the integrity of the financial reporting process, the likelihood of quality communications with investors increases significantly. That tone at the top, starting with the CEO managing the business, accepting his or her stewardship of others’ investments, and the CFO reporting on the business as a steward of others’ resources, is vital to the entire process. Section 404 [of the Sarbanes-Oxley Act] and other certifications will not work unless directors and officers accept their responsibility and accountability to investors. CEOs or CFOs who fail in these roles may find themselves facing SEC enforcement actions. The independent auditor’s role is to understand and challenge the accounting and reporting of the company, serving as an objective evaluator of both compliance and fair presentation.

CPAJ: Does the chief accountant have different responsibilities for preparers and auditors?
Nicolaisen: I have high expectation of both, and, although their roles differ, both groups have a duty to investors and can significantly contribute to quality financial reporting. OCA is at the hub of lots of activity within the SEC, much of which includes the preparer community. We also advance the Commission’s interests with the Public Company Accounting Oversight Board [PCAOB], FASB, IASB, and others in the international arena. FASB sets GAAP for preparers, and the PCAOB standards serve the auditor community.

The PCAOB is a brand-new organization, for which the SEC has oversight responsibility, as it does for FASB. As a practical matter, the SEC coordinates its oversight of both organizations through OCA. The PCAOB, under Chairman Bill McDonough’s leadership, has it exactly right: It will hold firms and individuals to the highest level of professional and ethical standards. Enhancing the audit process and ensuring that firms are independent in fact and appearance is extremely important.

The SEC is a strong advocate of the PCAOB inspection process, which compares what firms say to what they do. We also have experience with how registrants interpret and use accounting principles, and we share that experience with FASB as it strives to improve the principles underlying financial reporting. Also, we work closely with the SEC’s Division of Corporation Finance [Corpfin] in certain areas as it reviews registrants’ filings and issues comment letters, as well as with the Enforcement Division on actions concerning both accounting (preparer) and auditing issues.

Ethics and Independence

CPAJ: CPAs’ ethics require them to follow FASB standards in financial reporting. Should non-CPA CFOs and controllers adopt similar ethics?
Nicolaisen: Yes. While Sarbanes-Oxley requires CFOs to adopt ethical standards, it does not require any specific standard or SEC approval of such a standard. It will be interesting to see if CFOs, whether or not they are CPAs, voluntarily adopt such rigorous standards. I think it would be a very good thing for associations that represent financial officers to address this in their codes of ethics, and I would not anticipate different standards for CPAs and non-CPAs.

CPAJ: You talked about “tone at the top” at public companies. What’s the appropriate tone at the top for accounting firms?
Nicolaisen: OCA encourages firms to approach client acceptance and retention with selectivity, retaining those companies as audit clients that are consistent with their ethical expectations. Senior management at the firms sets the standards and values of their respective organizations. For example, compensation plans are a tangible measure of a firm’s values. If a firm doesn’t support audit partners making tough calls and replaces them with partners who are more accommodating, that practice will damage this profession and the firm along with it.

The director of the Enforcement Division, Steve Cutler, has made it clear that the SEC considers individual as well as firm accountability. Having the PCAOB inspection as part of the process will help immensely in understanding the tone at the top. The PCAOB’s inspectors are asking auditors about the level of support they receive from their firm when they make tough decisions. In cases where appropriate support has been lacking, you can expect PCAOB action with the full support of the SEC.

CPAJ: How do you deal with registrants who come to you with accounting questions? For gray-area questions, would you tell them specifically what to do? Alternatively, would you explain your view of what they should consider but leave the decision to them?
Nicolaisen: Our starting point is to consider what’s best for the investor, and how to make the economics of the transaction as transparent as possible to investors. I’d want to understand the economics of the transaction and whether the proposed accounting is consistent with the economics. Normally, after considering the views of the preparer, its audit committee, and the preparer’s auditor, my staff would express its views regarding the appropriate treatment.

Of course, when someone brings in a question that doesn’t fall in a gray area, the process is shorter because I don’t hesitate to say “yes” or “no” as appropriate. For example, transactions that lack economic substance and that appear to have been entered into only to achieve an accounting result would lead to a simple “no” response.

CPAJ: The code of professional conduct positions CPAs as objective neutrals, without primary allegiance to a specific interest, such as management, investors, or creditors. Yet the public expects that CPAs represent third-party users when performing services where such users are inherent to the engagement. Should CPAs formally address this in the code of conduct?
Nicolaisen: Without parsing words, it seems to me that every set of audited financial statements has a third-party user, either immediately or eventually. Having a code of conduct that made it clear that CPAs are the users’ watchdog would have certain legal implications, but, nevertheless, it would be a good thing. Preparers and management have a tremendous information advantage over users. OCA’s stance on Management’s Discussion and Analysis of Financial Condition and Results of Operations [MD&A] is clear: We want management to share with investors their views about the business. The auditor can help management in identifying appropriate disclosures.

In any event, our markets work on the underlying assumption that the auditor’s primary responsibility is to the investor. Increasing awareness of this perspective would also make the CPA profession more attractive to young people. I understand that there is a resurgence of interest on campuses in accounting precisely because young people are attracted by the importance of auditors’ work in our capital markets and by the ethical dimension inherent in being an accountant.

CPAJ: How can we increase ethics awareness among CPAs?
Nicolaisen: My experience has been that you really learn something well when it’s part of your work responsibilities and especially when you teach it to someone else. Teaching ethics within the firm, or mentoring young people in ethics, is one way for senior-level professionals to retain ethical considerations in the forefront. Evaluating individuals on their participation in such a mentoring program would also increase its importance. Firms should reward partners and staff for taking tough stands and doing the right thing. Prompt disciplinary action can help as well.

CPAJ: What are your reactions to the concerns that new audit requirements, such as the forensic tone of SAS 99 [Consideration of Fraud in a Financial Statement Audit], could work against the free flow of information between client and auditor?
Nicolaisen: SAS 99 could alter the tone of the relationship between some auditors and their clients, but it would be for the better if the result is that the auditor is more objective, more neutral, and more discerning about internal control and the risks of financial statement fraud. In too many cases, auditors failed to respond critically to inappropriate actions of their clients. The auditor’s primary job is to remain independent in fact and appearance and not to get “cozy” with the client. In turn, I would expect that clients, whether private or public, want auditors to be as tough as possible on the basics because toughness gives their financial statements that much more credibility. The job of the auditor is to be honest, sometimes brutally honest, with company management. An auditor shouldn’t be capricious or belligerent; a thoughtful, independent, critical, and professional auditor, however, is very valuable. If you’re going to be an auditor of a public company, you have to place auditing and its culture first in all things and forgo the role of advocate.

Finally, the auditor should bring issues to management and the audit committee early in the process. An auditor fails in some sense when management is surprised—often at the last minute—by breaches of internal control or low-quality financial statements.

Independence and the PCAOB

CPAJ: What is the most important consideration when considering auditor independence?
Nicolaisen: In my mind, the appearance of independence is critical. Whenever there is a potential for a conflict of interest caused by the appearance of a lack of independence, Sarbanes-Oxley provides a mechanism for the audit committee to determine whether the service should be performed or whether the auditor has compromised his or her independence. Because the appearance of independence is so important, auditors should disclose and discuss with the audit committee not only services that management wants them to perform, but also other relationships that might arise during the ordinary course of business, such as leases of office space or purchases of products or services.

Independence is a difficult area, and one that will receive lots of attention from this office and the PCAOB. Because specific facts vary, Sarbanes-Oxley calls for full disclosure to the audit committee and requires the audit committee to reach a conclusion.

CPAJ: What is your response to the SEC’s final rules on auditors and tax services? Is the identification of permitted services clear enough to keep auditors from becoming advocates in this arena?
Nicolaisen: Sarbanes-Oxley permits independent auditors to provide tax services to their audit clients if such services are preapproved by the audit committee. Auditors do need tax expertise, and they need to understand the tax process in order to adequately audit a company’s tax liabilities and uncertainties. But there are some services for which the audit committee should be especially probing. A recent Senate staff report analyzed several cases where the auditor sold highly structured, highly complex, and highly aggressive tax products to companies for significant fees. Other audit committees have identified similar “products” being “sold” to executives of the independent auditor’s client. I believe that these types of services are not consistent with either Congressional intent embodied in the act or with the appearance of independence on the part of the auditor.

For example, I think it’s appropriate for auditors that are also involved in tax-return preparation to explain to their clients how they will treat certain transactions for tax purposes, and to suggest legitimate tax strategies, such as that the client should consider accelerated depreciation rather than straight-line. But that kind of advice is very different from the design of complicated, sophisticated tax shelters that involve attorneys, investment bankers, and auditors, often at fees significantly above hourly scales. Auditors, in my view, should not participate in those types of activities.

CPAJ: How does the OCA participate in the SEC’s oversight of PCAOB rule making?
Nicolaisen: The PCAOB discusses with OCA where it’s headed with a standard before their board votes to release it, and communication between the PCAOB and OCA is appropriate. OCA’s experience base provides us and the PCAOB with a useful perspective on how to achieve the PCAOB’s goals. Our expectation is that OCA and the PCAOB staffs’ positions will be reasonably close before the PCAOB staff takes a proposal to their board. Of course, their board and staff can always make changes, but if the process works properly, there won’t be any occasions when the chief accountant is unable to recommend that the SEC adopt a PCAOB rule.

To date our relationship has worked very well. Under the leadership of Bill McDonough, the PCAOB has done a tremendous amount of work on a tight timeframe, including hiring staff, registering U.S. public accounting firms, promulgating a number of important standards, and engaging in a limited inspection of the large firms.

CPAJ: Would you explain the process, using the PCAOB’s section 404 attestation proposal as an example?
Nicolaisen: OCA has read the public comment letters on the proposed rule and discussed the concerns raised and views expressed with SEC and PCAOB staff. We consider these comments very carefully, and I encourage interested parties to participate in this process. In the end, I believe the PCAOB will produce a standard that appropriately considers all input and addresses this difficult issue. The objective of reporting on internal controls has been discussed as long as I’ve been a member of this profession, so I’m excited to finally see it become a reality, and I’m confident that the investor will benefit from this requirement.

CPAJ: Describe your take on the differences of opinion regarding the extent of substantive testing as part of the auditor’s attestation on internal control.
Nicolaisen: The current debate and discussion on the extent of auditor involvement in internal control attestations has been healthy and useful. The PCAOB did an excellent job issuing a proposal that would generate the appropriate level of discussion regarding their views. Many comment letters expressed concern with cost, and many suggestions were offered as to how the independent auditor might obtain satisfaction in a cost-effective manner. I agree with the view of the PCAOB that the auditor has to understand and test the effectiveness of controls, and I believe the final PCAOB standard will strike an appropriate balance.

CPAJ: What does the SEC plan to do when companies self-assess as having a material weakness in internal control, and the auditor concurs?
Nicolaisen: We’ve been discussing that issue quite a bit. I believe that the commission will accept internal control assessments with material weaknesses as long as the audit opinion on the financial statements is unqualified. We don’t want a situation where rendering a negative opinion on internal control would by itself preclude a company from participating in our markets. The principal objective is to inform investors. The marketplace will decide what it means if there is a material weakness in internal control but the auditor’s opinion on the financial statements is unqualified.

CPAJ: How would an auditor evaluate the audit committee on internal control?
Nicolaisen: I think for the auditor to grade an audit committee, using A, B, or C, would be a bad idea and would place the auditor in an awkward position. But in implementing Sarbanes-Oxley and in considering the important role of the audit committee, it’s hard to envision how an evaluation of internal control would be complete without considering the audit committee’s activities, objectivity, and performance. There are many strong audit committees, and I am confident that they will continue to improve over time, in part because they will feel increasing pressure to represent shareholders’ interests, which include the need for complete and accurate reporting.

Looking Forward

CPAJ: What’s your take on the future of the accounting profession?
Nicolaisen: In light of the recent financial scandals, no one could claim that the auditor is irrelevant, and the investing public and Congress have made it clear that they value good financial reporting and high-quality audits. To me, that translates into an expectation that accounting and auditing should have a bright future. Many changes under way will affect CPAs and the profession, and that is especially true at the audit firm level.

The audit firms’ near-term adjustments to the challenges of finding the right people and developing the right expertise to perform financial statement audits and internal control attestations as envisioned by Sarbanes-Oxley will determine whether accounting will be an exciting, growth profession. From what I see now, the road may be a little bumpy, but I am confident that the accounting and auditing profession will emerge stronger, more independent, and that it will offer a more rewarding career to young people who are considering entering the profession.

CPAJ: What’s the role of the AICPA in the world after Sarbanes-Oxley?
Nicolaisen: The AICPA’s role has changed, but it is a strong organization with tremendous talent and resources. I would caution, however, that whatever role it chooses to take in the future should not be confusing to the public—the AICPA is no longer a regulator or a standard setter for public company audits, and self-regulation of those who audit public companies is a thing of the past. However, regulation and standards setting for public company audits aside, the AICPA has a tremendously important role to play in training, education, supporting its members and the rest of the profession, and representing the face of the profession to its many constituencies. Its role with respect to private companies is significant.

I would love to see the AICPA do even more in the educational area, such as creating and distributing material like its recent Audit Committee Toolkit. Such publications are extremely valuable, serve the public good, and create positive impressions of the CPA profession. The AICPA also has an important role to play in supporting other institutions in the accounting profession, such as the PCAOB and FASB. Working together, the future of the accounting profession is bright.

CPAJ: Is the AICPA’s restructuring of the Auditing Standards Board, to set audit standards for the private sector, helpful?
Nicolaisen: It’s too early to tell, but I would hope that differences in auditing standards would be minimal. From my perspective, substantially different auditing and accounting standards for public and private companies could be confusing and potentially counterproductive. The PCAOB process is deliberate, open, and independent; as a result, I would expect that the marketplace and investors will gain confidence in their standards and that they will be the standards most familiar to the investing public. While the AICPA does set standards for private companies, every bifurcation of audit standards has the potential to confuse the public and investors about what CPAs do. Accordingly, I would encourage cooperation between the AICPA and PCAOB.

CPAJ: Is it time for more consistent regulation of CPAs at the state level?
Nicolaisen: I suspect that what state a CPA’s license is in makes very little difference to the investing public. Investors are looking for the assurance of a CPA’s report on an audit of financial statements. The difference in licensing requirements across the states does add complications, and the Uniform Accountancy Act [UAA] hasn’t worked well enough to encourage licensing authorities to pursue that route.

On one hand, it’s in the best interest of the investing public to have uniform, national qualifications for CPA licensure; on the other hand, the states clearly have an interest in licensing professionals who practice within their borders. Although, at the state level, passage of a uniform law hasn’t worked, we’re at a unique juncture in the history of the CPA profession. Thus, it may be possible that an arrangement could be made that would preserve the states’ legitimate interest in licensure while serving the national interest as it relates to CPAs’ importance to the investing public. This is a good issue for the NYSSCPA and other state societies to consider.

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Robert H. Colson, PhD, CPA, is Editor-in-Chief of The CPA Journal.