Protecting Investors Through Change

Date: Dec. 12, 2018

Speaker: George Botic, Director, Division of Registration and Inspections

Event: AICPA Conference on SEC and PCAOB Developments

Location: Washington

Good afternoon. Thank you Jake Vossen for the kind introduction and for hosting our session this afternoon. Mark Adler and I are pleased to share our thoughts, but first we must say the views expressed are our own and should not be attributed to the PCAOB as a whole or any Board member or staff.

My family and I recently had the opportunity to spend a weekend in New York City at the start of the holiday season. Each time I visit New York, I am struck by the constant redevelopment and change. All of this activity is underpinned by our efficient equity and debt markets that are made possible, in part, by the important role of the audit to the financial ecosystem. I would like to focus my remarks around these two themes — change and the importance of the audit to the capital markets.

This week we have heard representatives from the Securities and Exchange Commission and the Financial Accounting Standards Board, as well as a number of representatives from the PCAOB, all of whom serve the public interest by protecting investors.

Auditors serve an important role in our capital markets. While advances in technology continue to transform the audit as well as the financial reporting process, the role of the auditor continues to be critical.

Rapid advances in technology only increase the need for individuals with diverse skill sets to become auditors. I believe these advancements will only continue to make the auditing profession an increasingly meaningful and challenging career. The auditor remains a necessary and vital pillar of well-functioning and efficient capital markets who promotes economic stability and resiliency — through protecting the interests of investors and standing as a sentinel for investors and the capital markets.

In 1894, Frederick Whinney told the Birmingham Chartered Accountants Students Society that the duty of an audit was to "ascertain whether figures were facts."^[1] While technology has evolved greatly since that time, the role of the auditor remains fundamentally the same.

This afternoon, continuing with the themes of change and the importance of the audit to the capital markets, I will anchor my remarks around — (1) the Activities at the PCAOB; (2) the State of Audit Quality; and (3) the Outlook for 2019.

Before I continue, we should pause and consider the mission of the PCAOB — this is consistent with how I start every divisional staff meeting:

The PCAOB mission is "to oversee the audits of public companies and SEC-registered brokers and dealers in order to protect investors and further the public interest in the preparation of informative, accurate, and independent audit reports."^[2]

Investor protection is our "Why." I believe it is imperative for all of us to remember the "Why." That is, to protect investors and the capital markets through consistently executing audits of high quality.

1. Activities at the PCAOB

Over the span of 15 years, we have developed many robust processes surrounding our registration and inspection activities. It is a good time to reevaluate and rethink how we do our work. As you heard from our Board members on Monday, we are going through a process of transformation — focused on people, process, and technology.

We have taken a clean-sheet approach — revisiting (1) the objective of an inspection; (2) the selection of audit engagements for review; and (3) the nature, timing, and extent of engagement and quality control inspection procedures.

From an inspections standpoint, the primary outcome will be a program that drives continuous improvement in audit quality — through a combination of activities that focus on efficient and effective prevention, detection, deterrence, and oversight of firms' remediation of audit deficiencies.^[3] The inspection program will be managed with an overall objective of being — continuously innovative; flexible through incorporating emerging technologies; and readily adaptable as risks, other environmental factors, and the needs of our stakeholders change.

We will implement certain changes as part of our 2019 inspection cycle, while other changes will take place incrementally over the next several years. To start this process, we reassigned approximately 30 inspectors to assist with approximately 15 transformation workstreams. In addition, we established a new position — Deputy Director, Inspection Innovation — to drive this change.

The first change will be how we assess a firm's overall system of quality control and its control environment. Consistent with our emphasis on up-front prevention of deficiencies, it is important that we expend additional effort understanding and analyzing a firm's quality control system and culture.

In order to facilitate this initiative, we have created a new leadership position — a Quality Control Leader — to lead our quality control approach across all of our inspections. The initial focus will be on the large annually inspected U.S. firms.

Additional procedures and analyses will ultimately facilitate a deeper understanding of a firm's key controls and predictors of audit quality. We will also consider how a firm's culture underpins a strong system of quality control that drives audit quality and responds to risks, including client acceptance and retention processes.

Next, we will deploy a team of inspectors focused on performing more targeted inspection procedures across a number of firms. This targeted team of approximately 10 inspectors will allow us to be more agile and focus on topics that may include emerging audit risks, certain industries, or certain audit areas. We plan to share the results of these targeted reviews as part of our outreach initiatives.

We intend to increase the level of engagement with audit committee chairs of U.S. companies selected as part of our domestic based inspections. We plan to use this opportunity — to engage in a dialogue — to provide audit committee chairs with insight into our inspection process, as well as to hear their views.

Finally, our inspection activities provide a unique opportunity to observe audit practices that work well and practices that do not work well. Commencing in 2019, we intend to establish a program that seeks to identify practices employed by firms that promote or enhance the quality of audits. We plan to share these practices as part of our outreach initiatives.

The last two areas where I expect changes in 2019 relate to how we report inspection results and review and process firm remediation submissions. To be as effective as possible, our inspection reports must be timely, relevant, transparent, and written in plain English. We are looking at the content of our reports. I anticipate that you will see changes in the large firm inspection reports in 2019 related to inspections performed during 2018. For remediation, we are looking at our process and ways to improve the timeliness of Board determinations.

Looking forward, we will continue to strengthen our capabilities through data analysis and greater use of technology.

In addition to focusing on the inspection process and technology, our people are our most important asset and key to our transformation. Our inspectors are motivated and dedicated, with deep technical skills and diverse backgrounds across many industries and geographies.

In the world of audit oversight, nothing is more meaningful or important than being called "an inspector" and that is true whether it is at the PCAOB or at one of our non-U.S. counterparts. Simply put, our inspectors make a difference, and we are listening to their ideas and suggestions.

2. State of Audit Quality

As we plan for the future, I have taken time to contemplate the current state of audit quality — how far we have come yet realizing there is more to be done.

We are at an inflection point in order to continue to make improvements in audit quality. It is time for self-reflection, for us as well as for audit firms. Sustainable audit quality is supported by a system of quality control that has the proper balance of both preventive and detective controls.

Firms should consider which metrics may be predictive of audit quality. For example, we understand that certain audit quality indicators (AQIs), such as having a greater portion of audit fieldwork performed before year end, may be predictive of higher audit quality and hence, positive inspection outcomes. Other AQIs may provide insight into how firms — deploy their professionals; plan their audits; utilize specialists; and manage and monitor the nature, timing, and extent of audit work.

I encourage firms to be innovative as they identify, consider, and respond to these underlying drivers or predictors of sustainable audit quality. As part of our information gathering activities in 2019, we intend to understand these AQIs and how firm leadership utilizes them — at the engagement, local, regional, and national level — to drive quality throughout the audit process.

We cannot talk about audit quality without considering those areas where we observe frequent inspection findings. I will cover a few of these areas and the nature of the audit deficiencies observed during our 2018 inspections.

Revenue and Accounts Receivable

We frequently inspect the audit work covering revenue and related accounts — and in light of the new accounting standard, I expect this to continue in 2019. Revenue is one of the areas where we have frequent findings.

In many cases, these deficiencies can be attributed to an insufficiently performed risk assessment. A well-performed risk assessment is fundamental to every audit, particularly in the area of revenue where there may be several complex revenue streams. In fact, a well-designed and executed risk assessment contributes to positive audit quality.

When performing a risk assessment, a firm should understand the issuer's business and industry in order to properly identify the risks of material misstatements. Often, inspectors observe that auditors have not taken the time to identify the risks of material misstatements and therefore, fail to design and perform appropriate audit procedures to mitigate those risks.

Accounting Estimates

Another area where we frequently identify deficiencies is in the testing of accounting estimates, such as assets and liabilities acquired in business combinations and allowance for loan losses. The risk of material misstatement of these estimates normally varies with — the complexity and subjectivity associated with the process; the number and significance of assumptions that are made; the availability and reliability of relevant data; and the degree of uncertainty associated with the assumptions.

Common deficiencies include instances where the auditor did not evaluate the reasonableness of certain significant assumptions that management used in developing its estimates, including evidence that may appear to contradict those assumptions or conclusions.

Internal Control Over Financial Reporting

I would be remiss if I did not say a few words about testing internal controls. We continue to observe deficiencies around ICFR, most frequently in testing controls that include a review element and in selecting controls that address the assessed risks.

Although the number of deficiencies in testing controls that include a review element has decreased over the past few years, these deficiencies continue to be the most frequent findings observed when inspecting ICFR. Many of these findings relate to testing the controls — over assumptions used in determining the reasonableness of revenue recognition; and estimates related to business combinations, financial instruments, and allowance for loan losses.

In summary, we have discussed these areas of recurring deficiencies over the past few years. Remediation methods that have worked in the past to address deficiencies may not address current and future deficiencies. I encourage firms to look deeply and broadly to understand the reasons why findings continue to recur and to consider their post-issuance review procedures when deficiencies are identified.

Root Cause Analysis

Improvements in audit quality have generally been observed where a firm has established an effective root cause analysis program. The occurrence of a negative or positive quality event should trigger a corresponding root cause analysis. A thoughtful root cause analysis will assist the firm in designing a remediation response. A robust root cause analysis is another example of a good practice.

Form AP

2018 was the second year that firms were required to file Form AP, which requires auditors to disclose the name of the engagement partner, and the first year that auditors had the requirement to file a Form AP, which discloses other accounting firms participating in the audit. Our preliminary inspection results indicate that certain firms are either not submitting a complete Form AP or not filing timely.

Form AP information can be used by our stakeholders to consider an engagement partner's industry experience and to identify the level of participation from other accounting firms. This information is particularly helpful to understand the structure of audits of multinational companies.

3. 2019 Outlook

As 2018 comes to a close, we are actively planning for the 2019 inspections. Last Thursday, we posted to our website our 2019 Inspections Outlook^[4] communication. While this communication is primarily intended for auditors, I encourage all stakeholders to review it. I would like to touch on a few of the topics:

Key Inspection Focus Areas

As I mentioned earlier, we intend to increase our focus on the design and operating effectiveness of firms' system of quality control as well as recurring inspection deficiencies.

Technology Risks

In the area of technology, our inspectors will continue to perform procedures to understand how firms consider risks associated with a company's cybersecurity incidents and digital assets (e.g., cryptocurrencies and uses of distributed ledger technology).

Inspectors will also continue to monitor the use and development of firm software audit tools, including considering whether engagement teams are effectively using these tools and applying due care, including professional skepticism.

Changes to the Auditor's Report

Preliminary results indicate a high rate of compliance with the first phase of the new Auditor's Reporting Model requirements. We are monitoring the implementation activities of critical audit matters (CAMs) through communications with firms to understand their methodologies and experiences with pilot testing and dry runs.

We are coordinating and collaborating within the PCAOB to understand any logistical or interpretive issues faced by firms and other stakeholders in execution. Inspectors will begin to assess compliance with the requirements to report CAMs for certain large accelerated filers in late 2019.

Communications with our Stakeholders

Last, I want to mention that we will be engaging more with all of our stakeholders as we move forward by increasing the frequency and timeliness of our communications. We are actively reinventing how we communicate and share information with all of you. We want our communications to inform not only firms and auditors but all stakeholders, such as investors, preparers, and audit committee members.

Embracing Change

I would like to conclude where I began — focused on change and the importance of the audit to the capital markets.

John F. Kennedy once said, "Change is the law of life. And those who look only to the past or present are certain to miss the future."^[5]

As we enter 2019, my colleagues in the Division of Registration and Inspections and I are embracing change and remain steadfast in focusing on the importance of investor protection.

Thank you for your attention.