Good Morning,
I am very honored to be here this morning to address this
distinguished group of individuals who have devoted their careers to
the development and improvement of the profession that I joined over
thirty years ago, when I graduated from college in Minnesota and
joined McGladrey and Pullen as a young accountant.
A great deal has happened since then. While accounting has always
been a dynamic and evolving profession, its greatest changes have
occurred in the last decade, since the collapse of Enron, the
bankruptcy of WorldCom and the subsequent passage of the
Sarbanes-Oxley Act of 2002. Before "SOX," as so many affectionately
call this landmark legislation, the auditing profession in the
United States was subject to self-regulation, and, in response to
major corporate bankruptcies and concerns about the quality of
public company audits in 1970's, the American Institute of Certified
Public Accountants ("AICPA") established a variety of measures to
enhance oversight over the practice of auditing, including the
Auditing Standards Board, the SEC Practice Section, and the Quality
Control Inquiry Committee. Nevertheless, the 1980's featured the
Savings & Loan crisis and a number of other high profile
corporate bankruptcies, followed by a series of cases involving
earnings management in the 1990's.
Things came to a head in 2001 and 2002 with the discovery of
financial reporting and auditing improprieties at some of the
largest public companies in the United States: Enron, Global
Crossing, Adelphia, Tyco, Qwest Communications, Xerox. This resulted
in a national crisis of confidence in the integrity and reliability
of public company financial reporting and a focus on the need for
enhancements in internal controls over financial reporting and
corporate governance. Early in the summer of 2002 both houses of
Congress were considering legislation that would, among other
things, increase regulation of public companies and their auditors.
Then, on July 15, 2002, WorldCom announced an overstatement in its
cash flow of over $3.8 billion, resulting in the single largest
bankruptcy ever filed in the United States. Less than two weeks
later, Congress passed the Sarbanes-Oxley Act almost unanimously,
resulting in the most significant legislation relating to the
federal securities laws since 1934.
Before I go further I must tell you that the views I express
today are my personal views and do not necessarily reflect the views
of the Board, any other Board member, or the staff of the PCAOB.
Consistent with the Sarbanes-Oxley Act, the PCAOB commenced
operations in 2003, building programs to meets its four statutory
obligations: registration, inspections, enforcement and standard
setting. Initially conducting only limited inspections of the four
largest firms, the Board quickly ramped up its operations and
inspected 99 audit firms in 2004 and 281 in 2005 (including 15 firms
located outside the United States). Currently, over 2300 firms,
including foreign firms from 85 jurisdictions, are registered with
the PCAOB. To date, the Board has conducted over 1800 inspections,
including inspections in 37 jurisdictions outside the United States.
Likewise, the Board has actively pursued its standard setting and
enforcement obligations. The Board has issued publicly 45
disciplinary orders — many with multiple parties sanctioned — while
other cases remain pending in various stages investigation or
litigation and must be kept confidential by the Board. Enforcement
actions have been brought for auditors' failure to comply with
applicable auditing standards and certain provisions of the
securities laws, independence violations, and failure to cooperate
with Board processes such as inspections, investigations, and the
requirements to file annual reports and pay annual fees. Sanctions
imposed by the Board have ranged from censures and suspensions to
practice bars and revocations of firm registrations, both temporary
and permanent. Several enforcement matters also resulted in orders
for firms or individual auditors to pay monetary penalties.
Since its inception, the Board also has issued 15 auditing
standards — including, for example, on audit documentation, internal
controls, audit planning, engagement quality review, and risk
assessment — and has substantially amended a number of interim
standards — including, for example, AU 325, AU 411, AU 508, AU 350
and AU 329. More recently, the Board issued concept releases or
proposals to trigger wide-ranging discussions about potential
changes to certain fundamental aspects of auditing, including the
auditor's report, audit transparency, and auditor independence,
objectivity, and skepticism.
Thus, the Board has evolved over time, from a start-up
institution focused on establishing a comprehensive, consistent
oversight system to a maturing regulatory organization with the
experience and resources to adapt to changing times and new
challenges. And many challenges there are indeed! The accounting
profession as a whole is facing difficult questions as a result of
the increasing complexity of business transactions and cutting edge
financial instruments which are appearing more frequently not only
in the financial statements of financial institutions but many other
types of companies as well. Management and their accountants
increasingly must tackle fair value measurements and management
estimates, consistent with new accounting standards and EITF
guidance in connection with derivatives, securitizations,
consolidations, debt/equity issues, revenue recognition, leases and
other issues. At the same time, in the wake of the financial crisis,
the work of accountants is subject to increased scrutiny by
regulators and investors, particularly in the areas of disclosures
and internal controls over financial reporting.
Auditors also must master these accounting challenges, while
simultaneously overcoming the difficulties associated with auditing
numbers increasingly subject to measurement uncertainty. Fair value
estimates of financial instruments established through the use of
third party pricing services are proving particularly difficult to
audit. First, auditors have to consider whether management itself
did enough work to understand how the pricing services arrived at
their results, including the techniques used, the judgments made,
and the controls that are in effect. Likewise, under PCAOB
standards, the auditors cannot simply rely on the values established
by management's third party pricing services. Rather, they must "get
behind" the numbers by doing some testing and critically evaluating
the methodologies and assumptions of management. Because this is
such a challenging area, the PCAOB convened a Pricing Sources Task
Force last year to assist the Board's Office of the Chief Auditor to
gain insight into issues related to auditing the fair value of
financial instruments. This group of investors, financial statement
preparers, auditors and representatives of pricing services and
brokers met three times in 2011 to discuss the valuation of
financial instruments that are not actively traded and the use of
third-party pricing sources to value such instruments. The Office of
the Chief Auditor is evaluating the input received from the Task
Force and may develop some additional guidance for auditors.
In addition to such technical challenges, auditors face pressures
related to tight deadlines, as well as fee pressures, demands for
client service, and business development expectations, all of which
may undermine incentives to conduct comprehensive, high quality
audits. At the same time, auditors face criticism from those who
believe that they did not do enough, in the years or months leading
up to the recent financial crisis, to sound an alarm about the risks
and uncertainties associated with certain companies. PCAOB
inspections also present a challenge to auditors, but one that I
hope and believe can provide an effective counter- balance to fee
and client service pressures by focusing auditors on the
requirements of PCAOB standards and reminding them of their ultimate
responsibility to protect the interests of investors.
I firmly believe that PCAOB inspections, standard setting and
enforcement activities have had a substantial, positive impact on
audit quality since the PCAOB's establishment, but we are not
without our critics. The audit profession, among others, has
expressed concerns, often in the form of letters in response to our
draft inspection reports, but also in meetings with the Board, in
connection with Board advisory groups, and in other forums. One
frequent comment from audit firms is that PCAOB inspections are too
tough, and that the PCAOB inspections staff does not respect the
professional judgment exercised by auditors. Some auditors believe
that the positions taken in inspections set an unreasonably high bar
and constitute de facto standard setting by the inspection
teams. Others charge that the PCAOB takes too long to do pretty much
everything, including issuing inspection reports and setting new
standards. One result of our activities, according to some, is that
the best and brightest auditors become frustrated and leave the
profession, having concluded that the negatives — such as their
interactions with the Board, increased scrutiny and criticism by
investors, and intensifying fee and other pressures — outweigh the
positives of continuing to audit public companies.
The Board is very cognizant of these concerns and has gone to
great lengths to ensure that its inspectors are experienced,
well-trained professionals who understand and respect the practice
and the business of auditing. Consistency and fairness are our
mantras. Our inspection process has evolved over time, and our
internal processes have been improved to facilitate a consistent
approach to inspections across firms. Much of the time that passes
after inspection field work ends and before the report is issued is
spent on quality control. Our inspectors compare notes about the
interpretation of standards; they involve the Office of the Chief
Auditor when in doubt, and we have a number of individuals in the
Inspections Division dedicated exclusively to reviewing inspection
reports for consistency, clarity and fairness. This process is
necessarily time-consuming, but we are taking steps to streamline
certain processes and to eliminate delays where possible.
In that context, let me talk a little more about our inspection
process, both in terms of how we operate and what we are finding.
PCAOB inspections are not intended to establish or provide reports
presenting a balanced view of the strengths and weaknesses of each
inspected firm. We do not provide grades to firms (as much as doing
so might be popular with this particular audience). Consistent with
the requirement in the Sarbanes-Oxley Act that PCAOB inspections
"assess the degree of compliance of each . . . firm . . . with th[e]
Act, the rules of the Board, the rules of the Commission, or
professional standards,"[1] our inspectors specifically look
for audit deficiencies and inspect those engagements where they are
most likely to find them.
Inspections are therefore risk-based, both in terms of the
engagements and audit areas that are selected for review. Our
inspectors work closely with our Office of Research and Analysis to
determine what industries or specific issuers present higher levels
of audit risk. Within each audit engagement selected, inspectors
choose the most challenging and high risk audit areas, in order to
test the firm's ability appropriately to address those challenges
and risks. Some have criticized this approach, suggesting that we
should review audits more randomly. But in order to have the
greatest impact on audit quality, in order to help auditors learn
from our inspections, and in order to achieve our goal of protecting
investors, we need to allocate our limited resources to finding
those audits that do not measure up to our standards, rather than
spending our time reviewing those that do.
So what have we found? Common inspection findings reported by the
Board in late 2010, based on inspections conducted in 2007 through
2009 during the height of the financial crisis, included instances
where auditors appear not to have complied with PCAOB auditing
standards in certain audit areas, including, for example, fair value
measurements, impairment of goodwill, indefinite-lived intangible
assets, and other long-lived assets, allowance for loan losses,
off-balance-sheet structures, revenue recognition, inventory and
income taxes. Our results in 2010 showed an alarming increase in
inspection findings, particularly, as I noted earlier, in the area
of fair value.
In the context of fair value, PCAOB inspectors have observed
that:
- Auditors did not obtain a sufficient understanding of the
valuation methods or assumptions used by external valuation
services utilized by management;
- Auditors did not test, or test sufficiently, the operating
effectiveness of internal controls over various aspects of
issuers' valuation processes to support the degree of reliance
placed by the firms on those controls;
- Auditors did not evaluate significant differences between
independent estimates used or developed by firms and the fair
values recorded by management in the financial statements; and
- Auditors did not test, or test sufficiently, significant,
difficult-to-value securities, for example, by limiting procedures
to inquiries of issuer personnel or extending to year-end
conclusions regarding the valuation of investment securities that
were reached at an interim date without taking into account
volatile market conditions.
PCAOB inspection findings related to valuations and fair value
issues in general are not limited to financial instruments, however.
Inspectors have also found deficiencies in connection with the
valuation of non-financial measurements, for example in the areas of
business combinations and goodwill impairment, and with other
management estimates, such as allowance for loan losses and
valuation of inventory and income tax valuation allowances.
In the context of multi-national audits, the Board also has
reported that some U.S.-based firms issuing audit reports based on
work performed by firms outside the United States were not properly
applying PCAOB standards. As a result of these findings, the Board
in July 2010 issued a Staff Audit Practice Alert to remind
registered firms of their obligations when using the work of other
firms or using assistants engaged from outside the firm. The alert
describes the circumstances under which the firm issuing the audit
report may use the work and reports of another auditor. The alert
also explains that auditors who engage assistants from outside the
firm are governed by the same standards regarding planning the audit
and supervising assistants that apply when audit work is performed
by assistants who are partners of, or employed by, the auditor's
firm.
So what does all of this mean for you — the educators of future
accountants and auditors and the leaders in research relating to
this important profession?
Unlike their predecessors five or more years ago, recent and
future graduates of accounting programs received their training in
the post-Sarbanes-Oxley world. They benefit from the renewed focus
by accountants and auditors on investor protection, auditor
independence, and internal controls. I was pleased to see in the
AAA's Statement of Responsibilities the commitment to "[d]eveloping
in students an appreciation for the importance of ethics and
professionalism as well as technical expertise." Your agenda for
this meeting also provides several opportunities for discussion of
research relating to auditor ethics, independence, and professional
skepticism, and I applaud you for your continued focus on these
important topics. As I mentioned earlier, however, the pressures
faced by auditors once they begin to practice in the real world may
chip away at some of the important investor protection priorities
instilled by all of you. It is up to the firms that the students
ultimately join to continue to emphasize the importance of these
important principles, and I challenge them to do so through training
and leadership by example.
Beyond adhering to these overarching principles of auditor
conduct, however, one question we should ask is whether auditors are
otherwise equipped for the business world of the 21st Century, and
whether there are things we can do collectively to make sure that
they are. It is difficult, if not impossible, for accounting
programs to teach in real time the accounting developments emerging
on a daily basis in the business world. There are certain trends,
however, that may merit increased attention, due to the changing
business models and accounting practices we have observed in recent
years.
I have already discussed some of the complexity in business
models and transactions that pose unprecedented challenges to
accountants and auditors today. Fair value accounting and the
auditing of fair value measurements and management estimates play an
increasingly important role in today's economy, yet even experienced
auditors struggle with these issues every single day. Many
universities and colleges have begun to include fair value
accounting modules in their curriculum, but I urge you to consider
whether more can be done. Provide real world examples to your
students, and address both the accounting requirements and
appropriate audit approaches. Cost accounting is an indispensable
building block in any accounting education, but fair value
accounting is an indispensable skill in today's business world.
Other developments that auditors increasingly encounter include
complex intellectual property arrangements, rapid business cycles
where companies move quickly from start-up to IPO to merger and
acquisition or sell-out, and, of course, the expansion in the use of
International Financial Reporting Standards. I know many of you
incorporate these and other emerging themes into your teaching and
research activities, and I applaud you for your efforts.
We at the PCAOB also are trying to do our part to support future
auditors. The Sarbanes-Oxley Act provides that all monetary
penalties collected by the PCAOB must be used to fund merit
scholarships for students in accredited accounting degree programs.
In 2011, the Board implemented this requirement and announced the
inauguration of its scholarship program, awarding 52 scholarships of
$10,000 each to students around the country who demonstrated high
ethical standards and an interest and aptitude in accounting and
auditing. PCAOB Board members and staff also frequently visit
colleges and universities around the country to talk to accounting
students about the auditing profession and the Board's work, and we
periodically welcome groups of students visiting Washington, D.C. to
our headquarters for discussions with PCAOB staff and Board members.
Finally, your academic research activities complement the work of
the Board to improve audit quality and enhance investor protection.
The Board and Board staff review and consider the conclusions of
relevant academic studies in formulating Board policies. We have
benefited from academic studies looking at the efficacy and
relevance of our regulatory activities. Some of you also may be
current or former participants in the joint PCAOB-AAA research
synthesis projects, while others may have participated in the AAA
Auditing Standards Committee's work to provide comments to the Board
in connection with our standard setting process. Several of your
members also have served on our advisory groups or have participated
in our public round tables or the PCAOB's annual Academic
Conference. Finally, some of you have visited us at the PCAOB to
discuss your research or to work with our staff on a variety of
projects, and we welcome such opportunities to hear directly from
you. So I would like to end by thanking you for inviting me to speak
to you here today and for your continued and tireless engagement in
our shared objective of improving audit quality and enhancing
investor protection.