Recent PCAOB Highlights

Date: July 20, 2017

Speaker: Steven B. Harris, Board Member

Event: PCAOB Forum on Auditing in the Small Business Environment

Location: New York

Welcome to the PCAOB Small Business Forum. This is our 12th year in New York City and it is good to see so many of you once again. In addition to the audience in attendance at the Grand Hyatt today, this year over 400 people from 35 states and territories and 10 countries are participating through the live stream.

These forums provide an excellent opportunity for us to inform you of the Board's activities with respect to the oversight of audits and auditors of public companies, and also for us to hear your comments and concerns and answer your questions.

Before I continue, I must inform you that the views I express today are my own and do not necessarily reflect the views of the PCAOB.

As you can see from your schedules, we have a full agenda that will cover significant components of the Board's oversight of auditors of public companies. We have PCAOB staff with us from the Division of Registration and Inspections, the Office of Chief Auditor, and the Division of Enforcement and Investigations. They will provide information about the PCAOB inspection process, discuss compliance with PCAOB standards, take you through a number of case studies, and highlight recent PCAOB standard-setting activities and enforcement actions. Once again, we are very pleased to have a representative from the Securities and Exchange Commission here with us today, this time to provide an overview of the revenue and lease accounting standards. Please do not hesitate to ask questions during the presentations throughout the day.

Auditor Independence

As I noted last year at this forum, under our federal securities laws, auditors enjoy a unique franchise because every company that raises money through our capital markets or has a security listed on a national securities exchange must hire an independent public accountant to audit its financial statements. The Supreme Court, in United States v. Arthur Young, described the audit as a "public watchdog" function that "demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust."^[1]

Thus, independent auditors of public companies serve a critical public function. Investors, creditors, and others rely on the competence and independence of the auditors who audit the financial statements of public companies. Indeed, our markets have been able to attract capital because of the confidence and trust investors place in the financial information that companies report. In other words, auditors serve as the lynchpins of our free market capital system. And I want to acknowledge up front my appreciation to you for the invaluable service you provide to our capital markets and to the investing public.

In recognition of its public responsibilities, the auditing profession has long held itself to certain ethical and independence standards. Foremost among these is the mandate that the auditor must be independent of his or her audit client. As described by the SEC–

The independence requirement serves two related, but distinct, public policy goals. One goal is to foster high quality audits by minimizing the possibility that any external factors will influence an auditor's judgments…. The other related goal is to promote investor confidence in the financial statements of public companies.^[2]

Our inspections staff, however, continues to identify deficiencies related to non-compliance with PCAOB and SEC rules and regulations related to auditor independence, which is why I continue to focus on this issue year after year. The majority of these independence deficiencies have been identified in triennially- inspected firms. Some examples include instances in which auditors:

• Provided to their audit clients impermissible non-audit services, including bookkeeping services and management functions; and,
• Did not obtain pre-approval from the audit committee prior to performing non-audit services.^[3]

Our inspectors also are noting that auditors are not sufficiently communicating to audit committees items required under PCAOB rules and standards. Some examples include:

• Insufficient communication to the audit committee about the scope of tax consulting services performed and the potential effects of all tax services on the independence of the firm; and,
• Neglecting to make the required communications to the audit committee concerning independence.^[4]

Continued deficiencies related to auditor independence indicate that certain firms do not have quality control systems that provide sufficient assurance that the firms' personnel understand the independence requirements. For example, in some instances, auditors appear to have inappropriately concluded that certain financial or employment relationships with audit clients did not impair independence. Auditors should continue to assess their personal and professional activities to ensure compliance with the applicable independence rules and standards.

Investor representatives I have spoken with believe that the quality of the audit is improved by the nature and quality of the interaction between the audit committee and the auditor. I encourage you to pay special attention to your communications with the audit committees of the issuers you audit and communicate with them, as required, any independence concerns you may have.

An ongoing robust dialogue between the audit committee and auditor creates a healthy environment which assists both parties as they carry out their responsibilities to investors.

In addition to your independent public watchdog responsibilities, it is essential that you avoid conflicts of interest, safeguard yourselves from management bias, and exercise professional skepticism throughout the conduct of your audits. Our first panel discussion this morning will deal with exercising professional skepticism.

Before I turn to my next topic — standard setting — I would like to remind you of a very important aspect of our inspection program that directly affects the quality of your audits: the process of remediating deficiencies identified through our inspection program. This is a matter of utmost importance to the Board. I encourage each firm to communicate with the remediation contact, provided to you in the cover letter to your final inspection report, in order to immediately begin a dialogue on your approach to the remediation process. This will go a long way toward accomplishing a successful remediation.

Alan Skinner will be providing an overview of the inspections process after lunch today and will be available throughout the day to respond to questions you may have with respect to our inspection program, including the remediation process.

In addition, Sylvia Alicea from the SEC will, as I noted earlier, provide an overview of the revenue and lease accounting standards. As you are aware, your issuer audit clients are in the process of implementing these new standards. I encourage you to get ahead of your clients' implementation and thoroughly understand the ramifications of these standards on your audit engagements.

Standard-Setting Activities

Now, I would like to take a few moments to discuss our standard-setting activities.

On June 1, the Board adopted a new auditor reporting standard. By adopting this standard, the Board took a step toward harmonizing U.S. standards with those of numerous other jurisdictions that have already expanded their auditor's reports in the aftermath of the financial crisis. By expanding the information contained in the report, auditors will be directly communicating far more meaningfully with investors than they have in the past. While retaining the existing pass/fail opinion, this new standard features additional improvements to the auditor's report that investors and other stakeholders should find useful.

Among the most important provisions of this new standard is a requirement that auditors must communicate in the audit report any critical audit matters arising from the current period's audit or state that the auditor determined that there are no critical audit matters. A critical audit matter is defined as a matter that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment.

In addition, under the new standard, the report must now include:

1. A statement regarding the requirement for the auditor to be independent;
2. Amended language that adds the phrase "whether due to error or fraud," when describing the auditor's responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements;
3. The year in which the auditor began serving consecutively as the company's auditor.

On June 1, the Board also issued two proposals for public comment – a new auditing standard related to accounting estimates, including fair value measurements,^[5] and revisions to standards related to the auditor's use of the work of specialists.^[6] Accounting estimates and fair value measurements are more prevalent and significant in today's financial statements than ever before. These estimates often have a major impact on a company's reported financial position and results of operations. Because they usually involve subjective assumptions and measurement uncertainty, they are susceptible to management bias. Thus, these accounts usually comprise the areas of high risk in an audit.

Accounting estimates also often involve complex processes and methods. As a result, companies typically turn to specialists for assistance in developing accounting estimates or performing assessments of assets. In turn, the auditor's use of specialists during an audit also has increased.

Both proposals protect investors' interests by strengthening the procedures auditors perform when testing accounting estimates, evaluating the work of a company's specialist, and supervising the work of an auditor's specialist. I encourage you to comment on these proposed standards. The comment period for both proposals closes on August 30.

Finally, I would like to mention that in 2017 auditors began to disclose the names of engagement partners on Form AP. This is information that investors have sought for a number of years. Since its effective date on January 31, 2017, more than 10,000 Form APs have been filed by more than 420 firms, including over 3,000 unique engagement partners.^[7]

The information in Form AP is available on our website, which provides investors, audit committees, and other interested parties with an opportunity to evaluate and compare the performance of individual engagement partners as well as other participants in the audit.

Lisa Calandriello will have more to say about these subjects during the afternoon.

Enforcement

Turning to our enforcement activities, the Board continues to see a number of enforcement actions reflecting serious departures from PCAOB standards and other applicable laws. Often those actions have resulted in engagement partners being barred or suspended from association with a PCAOB registered firm or revocation of the firm's registration with the PCAOB.

Our Division of Enforcement and Investigations has been particularly focused on any conduct involving the potential improper alteration of documents. I believe this form of auditor misconduct is highly problematic because it undermines the regulatory process. Over the last year, the Board has issued enforcement actions against firms and individuals that attempted to cover up audit violations, including through improper alteration of documents and provision of false testimony to investigators. In one particular case, the misconduct at the firm went all the way to the top.^[8]

In these situations, audit engagement teams did poor quality audits and then sought to disguise their misdeeds by improperly altering the work papers. In most cases, the alteration is worse than the potential violation.

Despite several years of interim inspections on broker-dealer audits, the Board continues to take enforcement actions against audit firms that improperly prepare the financial statements of a broker-dealer audit client — a violation of SEC independence rules.^[9] As a result, DEI will continue to focus on potential independence violations among auditors of issuers and broker-dealers.

The Board also has pursued enforcement actions that involve issues associated with the engagement quality review in both issuer and broker-dealer audits.^[10] As you are aware, the EQR is a fundamental and critical audit requirement. These enforcement actions concern not just the failure to have an EQR, but also instances related to objectivity, integrity, independence, and cooling-off periods. We will continue to focus on all aspects of the engagement quality review.

The PCAOB also investigates and takes appropriate actions against non-U.S. audit firms and auditors that are registered with the PCAOB and have failed to comply with relevant PCAOB rules and other relevant U.S. laws and regulations. For example, the PCAOB has recently taken enforcement actions against auditors and audit firms in Brazil,^[11] Mexico,[12] Hong Kong,[13] and Indonesia.^[14] Kim Kolar will provide an enforcement update later in the day.

International

In closing, I would like to briefly discuss our activities in foreign countries. As a reminder, the PCAOB, under the Sarbanes-Oxley Act, has jurisdiction over and must inspect and take appropriate enforcement action against all audit firms and auditors that perform audits on companies whose securities trade on U.S. financial markets. For this reason, the PCAOB is the only audit regulator in the world that regularly inspects audit firms and auditors outside its home jurisdiction.

To date, the PCAOB has conducted inspections in 48 non-U.S. jurisdictions but is still unable to inspect in China, Hong Kong (with respect to audits related to mainland China), and a few European jurisdictions due to ongoing sovereignty and conflict of law issues. The PCAOB continues to work with its counterpart regulators in these non-U.S. jurisdictions to resolve these issues. In order to facilitate its international inspection program, the PCAOB negotiates bilateral cooperation agreements with the home regulator where appropriate, especially in jurisdictions where such bilateral agreements are needed for the PCAOB to conduct inspections. To date, the PCAOB has signed 22 bilateral cooperation agreements, including 13 with European countries, and seeks to sign several more later this year.

The PCAOB is also a member of, and plays an active role in, the International Forum of Independent Audit Regulators, whose 52 members meet regularly to discuss, and work cooperatively on, ways to improve audit quality around the world.

Earlier this year, IFIAR released its annual Inspections Findings Survey, which includes collected data on findings from inspections of individual audit engagements.^[15] IFIAR noted that the audit areas with the highest frequency of findings from inspected audits of public interest entities (a category that includes what we would call public companies) were accounting estimates, including fair value measurements, internal control testing, and audit sampling.^[16]

Our inspection staff issued a staff inspection brief in April 2016 which noted similar findings: our results indicate that the most frequent audit deficiencies identified were in audits of internal control, fair value measurements and disclosures, and management estimates, including revenue.^[17]

The PCAOB, as well as audit regulators from around the world, remain concerned about the continued high number of audit deficiencies and want to see ongoing improvement.

To conclude, I want to again express my appreciation to you for the invaluable service you provide to our capital markets and to the investing public.

With that, we will begin our program with our panel on exercising professional skepticism. Greg Scates will moderate. He is joined by Alan Skinner from Inspections, Kim Kolar from Enforcement, and Lisa Calandriello from Standards.