Response to corporate fraud in the United States and Europe: towards a consistent approach to...

Abstract

The recent spate of accounting scandals in the United States and in the European Union have shaken the faith in capital markets. Comprehensive measures have been undertaken on both sides of the Atlantic to restore the confidence of investors. In the United States, the Sarbanes-Oxley

Act created the Public Company Accounting Oversight Board (PCAOB), effectively ending over a century of self-regulation of the accounting profession. The Act also mandates that company management provide accurate and timely financial information to investors. Initially, the U.S. approach was strongly resented in Europe because of its impact on European companies and auditors. After a series of negotiations, the U.S. and EU authorities increased cooperation and decided to develop a compatible set of regulations.

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Introduction

In 2002, a series of sensational accounting scandals occurred in the United States. A number of leading companies admitted giving misleading impressions of their financial status by engaging in manipulation of their financial statements, and in outright fraud. In 2003, it was Europe's turn. Scandals at Parmalat and Royal Ahold have shaken the faith in capital markets to the core. As it turns out, neither the U.S. nor Europe has any shortage of accounting loopholes, or examples of managers taking advantage of these loopholes and auditors willing to assist them. Exhibit 1 summarizes the most prominent corporate scandals of recent years.

In response, the U.S. Congress acted swiftly and enacted the Sarbanes-Oxley Act (the "Act"), signed into law in 2002. The Act, considered to be the most important legislation affecting financial reporting since the Securities Acts of 1933 and 1934, effectively ended over a century of self-regulation of the accounting profession. The Act created the Public Company Accounting Oversight Board (PCAOB), to be organized as a non-profit corporation, with the Securities and Exchange Commission (SEC) given administration and oversight. The PCAOB's mission is to oversee the audits of public companies and related matters.

The Sarbanes-Oxley Act has wide sweeping implications for businesses and the accounting profession in the United States and abroad. The Act applies globally to supervisory boards, executives and auditors involved in both U.S. domestic and foreign public companies listed on U.S. stock exchanges. For these very reasons the Act was strongly criticized in Europe, especially because of the high cost of compliance. European companies seeking funds from the U.S. capital markets felt that PCAOB's new standard that requires an audit of internal control over financial reporting placed the full weight of the regulatory response to U.S. accounting scandals on them and their auditors. Many of the European companies listed on U.S. stock exchanges have considered delisting. At the heart of the controversy over the Sarbanes-Oxley Act, however, was the fact that the PCAOB was given a right to regulate European auditors, if they audited U.S. companies.

During 2003, EU finance ministers were threatening an uncompromising rejection of the U.S. legislation and called for a full exemption for EU audit firms from registration with the PCAOB. Today, the heated dispute is replaced by increased cooperation between the two sides and an agreement from the European Commission (the Commission) to replicate a large part of the Sarbanes-Oxley Act. Proposals set out in the new Directive on statutory audits in March 2004, if approved, would mirror many of the provisions of this Act and establish U.S.-style oversight boards in each of the EU member states, as well as an EU-wide committee in charge of the details of the new legislation [3].

The proposed new EU rules on statutory audits are part of an integrated approach to modernize company law and corporate governance in the European Union. The Commission concluded that a self-regulatory market approach is no longer sufficient to guarantee sound corporate governance. Instead, a common approach covering a few essential rules should be adopted and adequate coordination of national corporate governance codes should be ensured. Regulators of securities markets in the United States and the European Union were also encouraged to cooperate more closely. The objective of the enhanced dialogue between the U.S. and EU regulatory bodies is to more quickly address potential problems and converge the respective regulations.

All these developments are of great importance in order to restore investors' confidence in capital markets, integrate the capital markets, lower the cost of capital, as well as to create an infrastructure for the development and application of principles-based accounting standards in the United States and in Europe.

The objective of this paper is to discuss parallel developments in the United States and in the European Union aimed at the prevention of future corporate scandals. A discussion follows, including an outline of the major provisions of the Sarbanes-Oxley Act, a narrative of the major EC initiatives in the wake of corporate scandals and a description of the cooperation between the U.S. and the EU securities market regulators.

Major Provisions of the Sarbanes-Oxley Act

Establishment of the Public Company Accounting Oversight Board (PCAOB). The Sarbanes-Oxley Act of 2002 created the PCAOB; explained its function, powers, and structures; and then left it to the newly created but powerful entity to establish rules to carry out the various aspects of its enormous responsibilities. Rules proposed by the PCAOB are subject in all instances to the SEC's approval.

The Act, which applies in general to publicly held companies and their audit firms, dramatically affects the accounting profession and impacts not just the largest accounting firms, but any CPA actively working as an auditor of, or for, a publicly traded company. The basic implications of the Act for accountants are summarized in Exhibit 2.

Financial Reporting and Auditing Process Additions. Issuers of publicly traded stock and their auditors must now follow new rules and procedures in connection with the financial reporting and auditing process. The new regulatory board has issued standards requiring auditors to have a thorough second partner review and approval of every public company audit report. Management must now assess and make representations about the effectiveness of the internal control structure and procedures of the issuer for financial reporting. Auditors' attestation reports must now be made in accordance with standards for attestation engagements issued or adopted by the PCAOB.

The PCAOB has recently issued a standard that requires every audit report to attest to the assessment made by management on the company's internal control structure, including a specific notation about any significant defects or material noncompliance found on the basis of such testing. The SEC, in its Release 33-8238 (issued June 5, 2003, and revised by Release 33-8392), adopted final rules to carry out the requirements of section 404, "Management Assessment of Internal Controls," which directs the SEC to adopt rules requiring each annual report required by section 13 (a) or 15 (d) of the Securities Exchange Act of 1934 to contain an internal control report. That report must state the responsibility of management for setting up and maintaining an adequate internal control structure and procedures for financial reporting; it must also contain an assessment, at the end of the most recent fiscal year, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.

New PCAOB Auditing Standards for Public Entities. Prior to Sarbanes-Oxley, the American Institute of Certified Public Accountants (AICPA) set standards on auditing, quality control, independence and ethics. The Public Oversight Board (POB), an independent private-sector body charged with overseeing and reporting on the peer review program of the SEC Practice Section (SECPS) of the AICPA Division of Firms, reviewed the quality of audits and the firms performing those audits. The SECPS established quality-control requirements for member firms and required each member firm (all firms that audited SEC registrants) to undergo peer review every three years. The SECPS was also responsible for reviewing allegations of audit failure to determine if there was any breakdown in a firm's quality-control system. Sarbanes-Oxley shifted all of these regulatory responsibilities regarding public entities from the AICPA to the PCAOB, effectively ending the profession's self-regulation.

To date, the PCAOB has finalized three auditing standards. All three standards have been approved by the SEC.

PCAOB Auditing Standard 1, References in Auditor's Reports to the Standards of the Public Company Accounting Oversight Board, directs auditors of publicly held companies to state that the audit was conducted in accordance with "the standards of the Public Company Accounting Oversight Board (United States.)" This requirement went into effect for audit reports issued on or after May 24, 2004.

PCAOB Auditing Standard 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements, addresses how to audit management's assessment of the effectiveness of internal control and requires that the audit of internal control be integrated with the financial statement audit.

PCAOB Auditing Standard 3, Audit Documentation, to address what documentation auditors need to generate and retain in an audit and review engagement. Standard 3 becomes effective for audits for fiscal years ending on or after the latter of November 15, 2004. For quarterly reviews, the standard is effective beginning with the first quarter after the first year-end audit.

Section 106(a) of the Sarbanes-Oxley Act provides that any non-U.S. public accounting firm that prepares or furnishes an audit report with respect to any U.S. public company is subject to the Act and rules of the Board and the SEC, in the same manner and to the same extent as a public accounting firm that is organized and operates under the laws of any state in the United States. Also, foreign private issuers registered with the SEC are included within the scope of the SEC's final rules implementing various sections of the Act.

The European Commission's Initiatives in Wake of Corporate Scandals

In the aftermath of the multibillion-euro scandals involving European companies, the European Commission outlined several areas of EU policy that had to be examined. The Commission has been focusing on statutory audit and other corporate governance measures. It also undertook steps to curtail insider dealing and improve financial reporting by publicly traded companies. Recently, the Commission has announced a broad strategy to fight fraud.

1. Proposed Directive on Statutory Audit

Corporate accounting regulation within the European Union requires that the annual accounts or consolidated accounts of companies, banks and other financial institutions, as well as insurance undertakings, are audited by one or more persons entitled to carry out such audits. The Eighth Council Directive of April 10, 1984 (84/253/EEC) regulates the approval of persons responsible for carrying out the statutory audits in the Member States. It does not, however, indicate how a statutory audit should be conducted and does not specify the required degree of public oversight or external quality assurance, which is needed to ensure a high audit quality. These matters were left to the discretion of the appropriate authorities in the Member States.

The reorientation of the EU policy on statutory audit started in 1996 with a Green Paper on "The Role, Position and Liability of the Statutory Auditor in the EU." (2) Respondents to the Green Paper expressed dissatisfaction with the lack of a harmonized approach to statutory auditing within the EU and suggested a need for action at EU level beyond that authorized by the Eighth Council Directive. The policy conclusions which the Commission drew from these responses were included in the 1998 Communication, "The Statutory Audit in the European Union: The Way Forward." It proposed the creation of an EU Committee on Auditing which would develop further action in close cooperation between the accounting profession and Member States. Based on the Committee's work, the Commission issued two Recommendations:

* "Quality Assurance for the Statutory Auditor in the EU" in November 2000; and

* "Statutory Auditors' Independence in the EU" in May 2002.

Preparatory work on the use of International Standards on Auditing (ISA) has also been carried out.

Recent accounting scandals only underlined the urgency of the new policy. The European Commission, while appreciating the quick response by the U.S. legislators in the form of the Sarbanes-Oxley Act of 2002, criticized the Act for creating a series of problems due to its outreach effects on European companies and auditors. At the heart of the controversy were claims that Sarbanes-Oxley Act sought to influence matters well beyond U.S. jurisdiction by giving the PCAOB the right to inspect European auditors if, for example, they audit a U.S. subsidiary [3]. The Commission and European auditing groups have repeatedly applied for exemption for EU audit firms from this aspect of the Sarbanes-Oxley Act under Article 106, because of the high standards of national oversight and regulation in the EU.

The Commission engaged in an intense regulatory dialogue with a view to negotiate acceptable solutions with the U.S. authorities. In response, the PCAOB hosted a series of roundtable meetings to solicit views on whether the registration requirements should be modified for foreign public accounting firms, and how the Board should discharge its oversight responsibilities with respect to registered foreign public accounting firms.

On April 14, 2003, the European Commissioner for the Internal Market and Financial Services, Frits Bolkestein, wrote to U.S. authorities to set out the case for exemption of EU audit firms from registering in the United States. He called for a moratorium of the registration of EU audit firms so that effective transatlantic and international solutions can be agreed upon to restore confidence in financial markets without imposing disproportionate burdens on EU businesses and audit firms. Despite these efforts, the PCAOB decided on April 23, 2003, that it would oblige EU auditing firms working in the United States to register and submit to its oversight procedures.

In May 2003, the Commission published its own response to accounting scandals and market failures in the form of a Communication on statutory audit entitled "Reinforcing the Statutory Audit in the EU," where it set priorities to improve audit quality within the EU. The Communication, calling for similar regulation of the accounting profession as being imposed in the United States under the Sarbanes-Oxley Act, contained a 10-point plan divided into short- and medium-term priorities. The short-term priorities, set for the 2003-2004 period, include modernization of the Eighth Council Directive; creation of an Audit Regulatory Committee of Member State representatives equipped with the power to adopt detailed binding audit regulations; strengthening of public oversight of auditors at the Member State and EU levels; and a requirement to implement ISA for all statutory audits of EU companies from 2005 onward. Medium-term priorities, set within the 2004-2006 time frame, include, among others, improvement of the system of disciplinary sanctions; increased disclosure requirements for audit firms and their networks; strengthening of audit committees and internal control; and reinforcement of auditor independence and codes of ethics.

In October 2003, significant consultations and negotiations between the PCAOB and the Commission were launched. The two regulatory bodies undertook a two-way cooperative approach based on effective equivalence of regulation and oversight, to avoid duplication of oversight and minimize any conflict of law. Following the consultations, on March 16, 2004, the Commission put forward a proposal of a Union-wide law on corporate auditing in the form of a new "Directive on Statutory Audit of Annual Accounts and Consolidated Accounts" [2].

The proposed Directive, based on the May 2003 Communication on statutory audit, introduces a requirement for external quality assurance by ensuring robust public oversight over the accounting profession. The proposal aims at improving cooperation between oversight bodies within the EU, and with oversight bodies of non-EU countries. It also clarifies the duties of statutory auditors, their independence and ethics. The new directive would replace and extend the Eighth Directive on auditing of 1984.

The proposed Directive follows the 10 priorities listed in the May 2003 Communication on a statutory audit, but the initial thinking has been adapted to take into account the specific implications of the most recent accounting scandals. Particularly, the Parmalat and Ahold cases have shown the need for publicly held entities to have a body which monitors the financial reporting and auditing process. Therefore, the proposed Directive requires listed companies, including banks and insurance companies, to set up an audit committee. It was originally envisaged to introduce audit committees through a non-binding recommendation. Furthermore, the proposal now indicates precisely which areas of the company an audit committee must monitor, such as the company's internal control, internal audit and risk management systems. Only non-audit practitioners can participate in the governance of public oversight of listed companies. The proposal also establishes a clear chain of responsibility in situations where groups of companies are audited by several different firms in a large number of locations worldwide, as it was in the case of Parmalat. The new Directive would specifically require that the auditor of the consolidated accounts take full responsibility for the audit of those consolidated accounts. This responsibility requires the group auditor to review and document the work of other auditors. Exhibit 3 summarizes the main proposals included in the Directive.

As the PCAOB did in the United States, the proposed Directive, if adopted, effectively ends self-regulation of the accounting profession in the European Union. It will require the Member States to set up independent supervisory bodies to regulate accountants and reinforce regulatory cooperation within the EU. It introduces common criteria for public oversight systems at the Member State level where non-practitioners would have to predominate. A model of cooperation among regulatory authorities of Member States has been created. The model includes mutual recognition by Member States of each other's regulatory requirements in the case of audits covering more than one jurisdiction.

It also establishes procedures for the exchange of information between oversight bodies of Member States in investigations. In addition, the proposal provides a framework for cooperative arrangements between the authorities of the EU Member States and authorities in other countries, such as the U.S. PCAOB.

Article 45 of the proposed Directive on statutory audit contains provisions for non-EU auditors, including U.S. audit firms. Specifically, all non-EU auditors that provide an audit report concerning the following matters must be registered in the European Union:

* the annual or consolidated accounts of a company established outside the Community whose securities are admitted to trading on a regulated market of the Member State,

* the consolidated accounts of a foreign group, which has a subsidiary within the EU that is itself exempted from consolidation on the basis of the Seventh Council Directive on consolidated accounts.

Because presently there is no single EU oversight body, this effectively means that non-EU auditors must register with competent authorities of each Member State where they operate. According to the proposal, Member States shall subject registered audit firms from non-EU countries to their system of oversight, their quality assurance system and their system of investigations and sanctions. Audit reports issued by audit firms from non-EU countries that are not registered in the Member States will not have legal effect in that Member State.

But the proposed Directive also states that such registration would no longer be necessary when the oversight system that exists in the third country is considered equivalent to the EU model. This leaves open the possibility that agreement could eventually be reached between the United States and the EU that removes the requirement of dual-registration.

The European Parliament and the Council have been considering the proposal in detail with the aim of adoption by mid-2005. The Member States will then have a period of 18 months to implement it into national law. But many Member States are already taking legislative and regulatory actions in line with those in the proposed Directive.

Despite intensive lobbying from European firms and negotiations between the EU and U.S. regulators, the requirement for foreign firms auditing U.S. publicly held companies to register with the PCAOB remains in the U.S. legislation. On June 9, 2004, the PCAOB adopted rules related to the oversight of non-U.S. registered public accounting firms. These firms had to register with the PCAOB by July 19, 2004. The SEC approved the rules on August 30, 2004.

In the spirit of mutual recognition, invoked during the long EC-PCAOB negotiations, the rules allow the PCAOB to implement the provisions of the Act, with respect to non-U.S. firms, by relying on a non-U.S. oversight system [4]. The process for examining foreign firms, however, would vary from country to country. The Board would use a "sliding scale" approach that would weight the rigor and sophistication of national oversight systems [5]. Specifically, under the Board's rules, a firm would first provide the Board with a one-time statement asking the Board to rely on a non-U.S. inspection. At an appropriate time before each inspection of a non-U.S. firm that has submitted such a statement, the Board would determine the appropriate degree of reliance based on information about the non-U.S. system obtained primarily from the non-U.S. regulator. The Board would also take into consideration its discussions with the appropriate entity or entities within the oversight system concerning the specific inspection program of a non-U.S. firm at hand. The more independent and rigorous a national system of oversight is found to be, the higher the Board's reliance on that system.

2. Other Corporate Governance and Anti-fraud Initiatives

The proposed EU rules on statutory audit, discussed above, should be seen in a wider context of an integrated approach to modernization of company law and enhancement of corporate governance in the European Union. The main objectives of the modernization are to strengthen shareholders' rights; protect shareholders and third parties; and promote the efficiency and competitiveness of businesses. The Commission's proposals cover corporate governance; capital maintenance and alteration; and corporate restructuring and mobility, among others.

In terms of corporate governance, the Commission concluded that the European Union should adopt a common approach covering a few essential rules and should ensure adequate coordination of national corporate governance codes. The Commission proposed introduction of an Annual Corporate Governance Statement required from all listed companies, development of a legislative framework designed to help shareholders to exercise various rights and creation of a European Corporate Governance Forum to help encourage coordination and convergence of national codes and of the way they are enforced and monitored.

The Commission also introduced, in 2003, a new Directive on insider dealing and market manipulation. The Directive involves several important changes, including forcing companies and their advisers, such as law firms and accountants, to keep detailed lists of people with access to price sensitive information relating to stock exchange announcements or mergers. Relationships between analysts and investment banking and individual trading accounts would also come under scrutiny.

The current level and frequency of the mandatory financial information that publicly traded companies must provide to the markets throughout the financial year was also upgraded. Under the new Transparency Directive, all issuers of securities must publish an audited annual financial report, based on IFRS, and a management report, within four months of the end of each financial year. They also are required to publish a half-year condensed financial report based on an update of the last annual management report.

On September 30, 2004, a new broad-based strategy to fight corporate malpractice was unveiled by Frits Bolkenstein, the EU Commissioner for Internal Market. The new strategy is based on four defenses against corporate misconduct: (1) internal control in the company, (2) independent auditing, (3) supervision and oversight and (4) law enforcement. It calls for more transparency and information exchanges in the company tax area; more coherent EU policies concerning offshore financial centers; new policies to tackle obstruction of justice, corporate liability and asset-sharing; and restoration of confiscated proceeds.

The U.S.-EU Collaboration in Regulating Securities Markets

The regulators of securities markets in the United States and the European Union are also trying to develop closer working relationships. Under the current regulatory framework, global securities markets are regulated by national securities regulators. In the European Union, the Committee of European Securities Regulators (CESR) was established as a coordinating forum for national regulators. This action created a partner for the U.S. Securities and Exchange Commission (SEC) in their regulatory efforts.

The idea for greater collaboration came after CESR Chairman Docters van Leeuwen visited Washington at the end of 2003, and SEC Chairman William H. Donaldson followed with his meeting of the CESR officials in Brussels in January 2004. At the CESR's plenary meeting on June 4, 2004 in Amsterdam, the SEC and CESR announced their intention to publish terms of reference for enhanced cooperation and collaboration. In a joint announcement, SEC Commissioner Roel C. Campos and CESR Chairman Docters van Leeuwen indicated two primary objectives of the enhanced dialogue between the two regulatory bodies [1]:

1. to identify emerging risks in U.S. and European securities markets and more quickly address potential regulatory problems;

2. to share information about potential regulation in an effort to find commonalities and possibly draft compatible regulations.

In practice, the work will involve officials from both regulatory agencies, including chairmen of the organizations as well as other employees, speaking several times per year. For the rest of the 2004 and early 2005, Campos and van Leeuwen outlined several areas for discussion, such as:

* the SEC's review of U.S. national market structure,

* the CESR's work on implementation of a new European Investment Services Directive,

* future mutual fund regulation, specifically as it relates to stale price arbitrage,

* late trading and corporate governance, and

* implementation of IFRS.

The cooperation between SEC and CESR will complement other multilateral efforts to regulate securities markets, including work carried out in the International Organization of Securities Commissions (IOSCO), the Council of Securities Regulators of the Americas, the Financial Action Task Force and the U.S.-EU Financial Markets Regulatory Dialogue.

Conclusion

The scandals at Enron, WorldCom, Ahold and Parmalat were largely caused by questionable accounting practices, bad management and weak internal controls. These failures have effectively put an end to the principle of self-regulation of the accounting profession in the United States and in the European Union. Although the EU countries and the U.S. have different historical, cultural, economic, financial and legal traditions, the ongoing discussions between the EU authorities and the U.S. PCAOB have shown that there is a great deal of agreement on new regulations for governing the accounting profession. The European Commission and the PCAOB have demonstrated that they can cooperate effectively to produce a compatible set of regulations.

The cooperation between the U.S. and EU regulators also extends to the securities markets. The U.S.-EU Financial Markets Regulatory Dialogue and the working relationship between the SEC and the CESR mark a new era of coordinated efforts to fight corporate abuses. The goal is to restore investor confidence in the world's financial markets by strengthening corporate governance and improving transparency. This should result in a lower cost of capital for public companies around the world. A common comprehensive and effective regulatory framework is also necessary for world-wide convergence of accounting standards.

EXHIBIT 1. RECENT MAJOR CORPORATE SCANDALS IN NORTH AMERICA AND EUROPE

                                        Auditor of    Questionable
Country of                              Consolidated  Accounting
Incorporation  Company      Industry    Accounts      Practices

USA            Enron        Energy &    Arthur        Widespread use of
                            utilities   Andersen      off-balance sheet
                                                      financing in the
                                                      reporting of
                                                      partnership
                                                      transactions.
                                                      Enron was forced
                                                      to restate its
                                                      profits from 1997
                                                      through 2000--
                                                      lowering its book
                                                      value by $1.25
                                                      billion.
USA            WorldCom     Telecommu-  Arthur        Reduction of
                            nications   Andersen      operating expenses
                            Services                  by: (1) improperly
                                                      releasing certain
                                                      reserves held
                                                      Services against
                                                      operating
                                                      expenses, and (2)
                                                      recharacterizing
                                                      certain expenses
                                                      as capital assets.
                                                      Material
                                                      overstatement of
                                                      the reported
                                                      income by
                                                      approximately $9
                                                      billion.
Bermuda        Global       Telecommu-  Arthur        Inflation of pro
               Crossing,    nications   Andersen      forma values for
               Ltd.         Services                  cash revenue and
                                                      adjusted EBITDA by
                                                      including amounts
                                                      for which cash was
                                                      not received or
                                                      where there had
                                                      been non-monetary
                                                      exchanges of
                                                      capital capacity.
Italy          Parmalat     Dairy       Deloitte &    3.95 billion in
               Finanziara,              Touche        cash and
               SpA                      (Grant        securities
                                        Thornton--    supposedly
                                        individual    contained in a
                                        accounts)     Cayman-based bank
                                                      account did not
                                                      exist.
The            Royal Ahold  Retail      Deloitte &    Fraudulent
Netherlands    N.V.         Trade/Food  Touche        inflation of
                            Service                   promotional
                                                      allowances at U.S.
                                                      Foodservice,
                                                      Ahold's wholly
                                                      service-owned
                                                      subsidiary, the
                                                      improper
                                                      consolidation of
                                                      joint ventures
                                                      through fraudulent
                                                      sideletters; and
                                                      other accounting
                                                      errors and
                                                      irregularities
                                                      which amounted to
                                                      $880 million.

EXHIBIT 2. IMPLICATIONS OF THE SARBANES-OXLEY ACT FOR THE ACCOUNTING PROFESSION

Section 101. Establishment and Duties of the Board

* Public Company Accounting Oversight Board. The Public Company Accounting Oversight Board (the Board) has been appointed and overseen by the SEC. The Board, made up of five full-time members, oversees and investigates the audits and auditors of public companies, and sanctions both firms and individuals for violations of laws, regulations and rules.

* Board Composition. Two of the five Board members must be or have been CPAs. The remaining three must not be and cannot have been CPAs. The Chair may be held by one of the CPA members, but he or she must not have practiced accounting during the five years preceding his/her appointment.

Section 109. Funding

* The Board is funded by public companies through mandatory fees. Accounting firms that audit public companies must register with the Board ("registered firm"), and pay registration and annual fees.

Section 108. Accounting Standards

* The Board issues standards or adopts standards set by other groups or organizations, for audit firm quality controls for the audits of public companies. These standards include: auditing and related attestation, quality control, ethics, independence and "other standards necessary to protect the public interest." The Board has the authority to set and enforce audit and quality control standards for public company audits.

Section 105. Investigations and Disciplinary Proceedings

* The Board is empowered to regularly inspect registered accounting firms' operations and investigates potential violations of securities laws, standards, competency and conduct. Sanctions may be imposed for non-cooperation, violations, or failure to supervise a partner or employee in a registered accounting firm. These include revocation or suspension of an accounting firm's registration, prohibition from auditing public companies and imposition of civil penalties. During investigations, the Board can require testimony or document production from the registered accounting firm or request information from relevant persons outside the firm. Investigations can be referred to the SEC, or with the SEC's approval, to the Department of Justice, state attorneys general or state boards of accountancy under certain circumstances.

Section 3. Commission Rules and Enforcement

* A violation of Rules of the Board is treated as a violation of the Securities Exchange Act of 1934, giving rise to the same penalties that may be imposed for violations of that Act.

Section 103. Auditing, Quality Control and Independence Standards and Rules

* Registered public accounting firms are required to prepare and maintain, for at least seven years, audit documentation in sufficient detail to support the conclusions reached in the auditor's report.

The relationship between accounting firms and their public audit clients is outlined below:

* Auditors Report to Audit Committee. Auditors must now report to and be overseen by a company's audit committee, not management.

* Audit Committees Must Approve All Services. An audit committee must preapprove all services (both audit and non-audit services not specifically prohibited) provided by its auditor.

* Auditor Must Report Additional Information to Audit Committee. This information includes: critical accounting policies and practices to be used, alternative treatments of financial information within GAAP that have been discussed with management, accounting disagreements between the auditor and management, and other relevant communications between the auditor and management.

* Offering Specified Non-Audit Services Prohibited. The Act statutorily prohibits auditors from offering certain non-audit services to audit clients. These services include: bookkeeping, information systems design and implementation, appraisals or valuation services, actuarial services, internal audits, management and human resources services, broker/dealer and investment banking services, legal or expert services related to audit services and other services the board determines by rule to be impermissible. Other non-audit services not banned are allowed if preapproved by the audit committee.

* Audit Partner Rotation. The lead audit partner and audit review partner must be rotated every five years on public company engagements.

* Employment Implications. An accounting firm cannot provide audit services to a public company if one of that company's top officials (CEO, Controller, CFO, Chief Accounting Officer, etc.) was employed by the firm and worked on the company's audit during the previous year.

EXHIBIT 3. MEASURES BEING PROPOSED IN THE DIRECTIVE ON STATUTORY AUDIT

Measures to apply to all statutory auditors and audit firms:

* Requirement to use International Standards on Auditing (ISA) for all EU statutory audits--once those standards have been endorsed under an EU procedure; Member States can only impose additional requirements in certain defined circumstances;

* Possible adoption of a common audit report throughout the EU for financial statements that have been prepared on the basis of International Financial Reporting Standards (IFRS);

* Update of the educational curriculum for auditors, which must now also include knowledge of IFRS and ISA;

* Liberalization of the ownership and the management of audit firms by opening up the ownership and the management to statutory auditors of all Member States;

* Introduction of an electronic registration system for auditors and audit firms in all Member States, with a catalogue of registration information that has to be permanently updated;

* Requirement that statutory auditors and audit firms be subject to a code of professional ethics at least as rigorous as the code adopted by the Ethics Committee of IFAC;

* Establishment of legal underpinning of principles of auditor independence, including the duty of the statutory auditor or audit firm to document factors which may affect auditors' independence and safeguards against these sorts of risks;

* Obligation for Member States to set rules for audit fees that ensure audit quality and prevent "low-balling;"

* Disclosure by companies, in the notes to their financial statements, of the audit fee and other fees for non-audit services delivered by the auditor;

* Introduction of a requirement for Member States to organize an audit quality assurance system that has to comply with clearly defined principles;

* Obligation for Member States to introduce effective investigative and disciplinary systems;

* Adoption of common rules concerning the appointment and the resignation of statutory auditors and audit firms, and introduction of a requirement for companies to document their communication with the statutory auditor or audit firm.

Measures to apply to statutory auditors and audit firms of publicly held companies:

* Introduction of an annual transparency report for audit firms that includes information on the governance of the audit firm, its international network, its quality assurance systems and the fees collected for audit and non-audit services; these reports would be publicly available;

* Auditor rotation with the following options left to the Member States:

** rotation of the lead audit partner on an engagement every five years; or

** rotation of the entire audit firm every seven years;

* Shortening of the period when an audit quality review must be carried out from five to three years;

* Appointment of the statutory auditor or audit firm on the basis of a selection by the audit committee which must be set up in all publicly held companies;

* Obligation for the statutory auditor or audit firm to report to the audit committee on key matters arising from the statutory audit, particularly on material weaknesses of the internal control system;

* Disclosure to and discussion with the audit committee of any threats to the auditor's independence and confirmation in writing to the audit committee of his/her independence.

Endnotes

1. Unlike their U.S. counterparts, foreign companies listed in the United States have until July 15, 2005 to comply with the Act.

2. Green papers--discussion papers published by the Commission on a specific policy area. Primarily they are documents addressed to interested parties--organizations and individuals--who are invited to participate in a process of consultation and debate. In some cases they provide an impetus for subsequent legislation.

References

1. Clair, C. "European, U.S. Regulators Outline Collaboration Plans," HedgeWorld USA Inc., June 8, 2004.

2. Commission of the European Communities, Proposal for a Directive of the European Parliament and of the Council on Statutory Audit of Annual Accounts and Consolidated Accounts and Amending Council Directives 78/660/EEC and 83/349/EEC, Brussels: COM (2004).

3. Dombey, D. "When William McDonough ...," Financial Times, April 23, 2004, 9.

4. PCAOB, Auditing Standard No. 3, "Audit Documentation," Washington, DC, June 9, 2004.

5. Taub, S. "PCAOB Approves Rules for Foreign Auditors," Economist.com, June 10, 2004.

Sylwia Gornik-Tomaszewski, The Peter J. Tobin College of Business, St. John's University

Irene N. McCarthy, The Peter J. Tobin College of Business, St. John's University