Remarks before the 36th Annual SEC and Financial Reporting Institute Conference: “Advancing the Role of Credible Financial Reporting in the Capital Markets”

The Securities and Exchange Commission (“SEC” or “Commission”), as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees.  The views expressed herein are those of the author and do not necessarily reflect the views of the Commission, individual Commissioners, or of the author’s colleagues upon the staff of the Commission.

Introduction

Good morning and thank you Dean Holder for the kind introduction.  I want to also acknowledge and thank Professor Lori Smith for the invitation to speak here today at the conference sponsored in part by the University of Southern California and its Leventhal School of Accounting.

Before I begin, let me remind you that the views expressed today are my own and not necessarily those of the Commission, the individual Commissioners, or my colleagues on the Commission staff.

Let me also express a word of gratitude to the entire OCA team for their work in providing advice to the Commission regarding accounting and auditing matters arising in the administration of the federal securities laws.  I also want to acknowledge Ying Compton, Duc Dang, Susan Fennedy, Emily Fitts, Matt Hodder, Vassilios Karapanos, and Karen Liu for their valuable assistance in preparing me to make today’s remarks.

This morning my remarks will touch on several current issues we, the OCA staff, have been focused on recently, that I believe are integral to investors’ trust in financial reporting.  In addition, I will speak further to the critical roles that auditors and audit regulation play in maintaining the public’s trust in the audit profession while at the same time fostering innovation.

In the United States, private-sector businesses are the source of 124 million jobs.[1]  These businesses contribute to the tax basis of every city and state as well as the federal government.  They also contribute to our global economy, with approximately $2.2 trillion of American exports each year.[2] Among these businesses, public companies are a source of the financial security for a significant number of American households.  For example, about half of American households invest in stocks directly or through mutual funds or via employer sponsored retirement plans.[3]

The bedrock of our commercial system is reliable accounting and financial reporting.  In today’s economy, information and accountability have assumed a larger role.  Without adequate information, investors cannot properly judge the opportunities and risks of investment choices.  These choices depend on high quality accounting and auditing, which help inform how investors allocate capital, thereby sustaining our economy and our way of life.  The credibility of financial statements have a direct effect on a company’s cost of capital,[4] which is reflected in the price that investors are willing to pay for the company’s securities.  Accounting and auditing may not readily grab the general public’s attention, but they are nonetheless important to the livelihoods of all Americans.

A high quality financial reporting process starts with companies and their audit committees.  When companies produce high quality financial information with the oversight of an effective audit committee, it energizes our capital markets, which provide a marketplace for the purchase and sale of securities as well as a forum for the obtaining and granting of credit.

An audit performed by an independent accountant provides investors with confidence in a company’s financial statements as well as in the financial reporting process itself.  Maintaining the strength of financial reporting – and of our capital markets – depends on thorough and objective audits performed by auditors who are ethical, independent, skeptical, and who apply the diligence necessary to meet professional and regulatory standards.

Today’s investors expect and demand the auditor to perform rigorous independent audits in which auditors obtain reasonable assurance about whether the financial statements are free from material misstatement.  The continued relevance of - and trust in - the independent audit not only rests on the shoulders of the profession, but also on regulators. 

The PCAOB’s Important Role

First, I would like to focus on the important role of the PCAOB.  The PCAOB’s mission is to oversee the audits of public companies and brokers and dealers in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.  The PCAOB’s responsibilities are broad as it pertains to the audit profession – they include standard setting, registration and inspection of audit firms, and enforcement authority.  Accordingly, for the auditors of U.S. brokers and dealers and public companies that access the U.S. public markets, the PCAOB fills a critical oversight role in our capital markets. 

The PCAOB’s inspection program has played a critical role in improving the quality of independent audits over the past several years and remains at the core of the organization’s statutory mandate.  PCAOB inspections identify, report on, and foster remediation (where applicable) of deficiencies in auditors’ performance in recent audits in addition to potential defects in a firm’s system of quality control.  Insights gained from the PCAOB’s inspection process are communicated publicly in the form of Staff Inspection Briefs, Rule 4010 General Reports, as well as the public versions of the individual inspection reports. 

While there is certainly an element of learning that comes with inspection experience that should inform auditors’ future performance, the PCAOB cannot rely on inspections alone to fulfill its mission.  Another important tool the PCAOB uses in fulfilling its mission is its enforcement program, which identifies issues that should be addressed through formal disciplinary proceedings.  Additionally, the PCAOB fulfills its mission through the establishment and maintenance of rigorous high-quality auditing standards that keep pace with the evolution in financial reporting. 

The PCAOB’s standard-setting agenda contains projects that, if adopted and ultimately approved by the Commission, are intended to respond to the changing needs of investors and, more importantly, changing risks to audit quality.  Recently implemented changes to the standard-setting process now include an annual environmental scan by the PCAOB to identify current or emerging audit issues.  This analysis, along with additional observations throughout the year, enable the PCAOB staff to inform the Board whether the current or emerging audit issues identified potentially warrant additional consideration by the PCAOB to determine if regulatory action is necessary.[5]  

The PCAOB continues to develop proposals for maintaining the strength and comprehensiveness of its auditing standards as well, having recently published for public input and comment proposed standards on Auditing Accounting Estimates, Including Fair Value Measurements and The Auditor’s Use of the Work of Specialists.[6]

The PCAOB has also completed nearly seven years of outreach and public comment in publishing a final auditor reporting standard, The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion (the “ARM release”).[7]  This standard must be approved by the Commission before it can become effective.  As a general matter, in connection with an approval process, the Commission would publish a notice of the proposed standard for public comment in the Federal Register.[8]  After consideration of the comments, the Commission would then determine whether to approve the standard. 

If approved by the Commission, the audit reports for public companies would retain a pass/fail opinion, while adding communication of critical audit matters, disclosure of audit firm tenure, and other revisions to clarify the auditor’s role and responsibilities and make the auditor’s report easier to read.[9]  As a result, the PCAOB’s standard, if approved, will require more differentiation among audit reports.  

The PCAOB’s ARM release is particularly relevant because investors are the primary beneficiaries of an audit and the auditor’s report is the primary means by which the auditor communicates to them.  Indeed, there have been numerous recommendations over the years to update the auditor’s report, including:

• In 1978, the Commission on Auditors’ Responsibilities (Cohen Commission) observed: “For the largest corporations in the country, an audit may involve scores of auditors and tens of thousands of hours of work for which the client may pay millions of dollars. Nevertheless, the auditor’s standard report compresses that considerable expenditure of skilled effort into a relatively few words and paragraphs.”[10] 
• In 1987, the National Commission on Fraudulent Financial Reporting (Treadway Commission) recommended that the standard auditor’s report more clearly identify the auditor’s responsibilities, the degree to which users can rely on the audit, and the limitations on the audit process.[11]
• In 2008, the U.S. Department of the Treasury’s Advisory Committee on the Auditing Profession (Paulson Committee) urged the PCAOB “to undertake a standard-setting initiative to consider improvements to the auditor’s standard reporting model” and further urged the PCAOB and the SEC to “clarify in the auditor’s report the auditor’s role in detecting fraud under current auditing standards and further that the PCAOB periodically review and update these standards.”[12]

Your comments are very important to the standard-setting process generally and are encouraged. 

Audit Committee Consideration of Audit Tenure

Even as stakeholders are considering the various important elements of the PCAOB’s ARM release, it is useful to note that, today, some audit committees consider (and disclose to investors) the year in which the auditor began serving as the company's auditor within their audit committee reports as part of their oversight of the external audit. In other cases, research and information service companies collect and make the data available.  

Regardless of where, or whether, prior years of service of an audit firm is disclosed, the years of experience may be one of the many factors considered by audit committees in their selection and oversight of the external auditor.  In doing so, for example, an audit committee might consider an audit firm's prior service experience in contributing to the firm's understanding of the company's business and audit risks.  And, also, an audit committee may want to incorporate prior auditor service into its oversight of the auditor's expertise, incentives and, ultimately, appropriate performance in the conduct of the audit. 

These are only several considerations, recognizing that years of service is often a matter to be evaluated in the context of company- and firm-specific facts and circumstances.  In doing so, it is useful to keep in mind that the PCAOB's standard on ARM notes that existing research on any relationship between an auditor's tenure and either audit quality or auditor independence has varied conclusions.[13] 

International Collaboration

Turning to international collaboration, foreign regulators and standard setters have updated and expanded audit reports as well.[14]  Indeed, in today’s interconnected world economy, investors depend on high-quality auditing and auditing standards around the world.  U.S. investors routinely invest in companies based outside the United States and listed in non-U.S. jurisdictions to diversify their portfolios.  Recent data indicates:

• U.S. investors have invested $9 trillion in foreign equity and long-term debt (out of which $4 trillion is in U.S. mutual funds that hold debt and equity securities issued by companies based outside the United States).[15]  To put this number into perspective, the corresponding U.S. investors’ ownership of domestic equity and long-term debt is $61.4 trillion.[16]
• Just for the week ending on May 17, 2017 alone, U.S. investors added $9.9 billion to U.S.-based mutual and exchange-traded funds that invest in stocks abroad, the 24th straight week of inflows and the largest since July 2015.[17]

In well-functioning capital markets, strong institutions are in place to govern corporate financial reporting and to provide investor protection.  In the U.S., for example, our legal systems, corporate governance, and the auditing profession are all important mechanisms that help facilitate compliance with U.S. accounting and auditing standards so that financial reporting in the U.S. provides useful information to investors.

In countries where enforcement of accounting and auditing standards through legal systems and corporate governance is not well developed, the strength of an independent audit may be especially important to the protection of shareholders, including U.S. investors.[18]  

Independent auditors play a key role, acting in the public interest and contributing to the credibility of financial statements on which they report.  The degree of credibility afforded by an audit depends on, among other factors, the technical quality of the standards that serve as the basis of the audit. 

Accordingly, oversight[19] and governance of international audit and related standards (audit and assurance, ethical and educational standards) is important so that standards and guidance for auditors support the delivery of high-quality audits. This in turn builds public trust and confidence in financial statements and financial reporting more broadly.

Adoption of “New-GAAP” Accounting Standards

On the accounting standards front, investors, businesses, and others requested that the FASB and IASB enhance the accounting and reporting of revenue for contracts with customers, leases, and financial instruments, including credit losses, which I collectively refer to as “New-GAAP” standards.  Over the next three years, businesses will be required to incorporate these new standards into their financial reporting, as they become effective.

Revenue

First, I will discuss a few matters specific to the new accounting standard related to revenue recognition.

Many of you regularly monitor public SEC staff remarks regarding financial reporting.  Accordingly, I will not repeat the themes highlighted in previous public remarks, some of which were expressed in separate speeches by Sylvia Alicea[20] and me[21]as recently as last month.  However, given that we are now in June and are getting closer to the effective date for the new revenue recognition standards, I want to reinforce three items.

The first item I want to emphasize is the positive impact to implementation of an audit committee understanding management’s implementation plans and understanding the status of progress, including any required updates to internal control over financial reporting.[22]  The audit committee plays a very important role overseeing a company’s financial reporting, including implementation of new accounting standards. 

Auditors have an important role here too.  Auditors, among other things, communicate with the audit committee about concerns identified by the auditor regarding management's anticipated application of a new accounting pronouncement that, while it is not yet effective, might have a significant effect on future financial reporting.[23]

Second, I have previously emphasized the importance of disclosures in the new revenue recognition standard.  The new revenue disclosures may require the disclosure of different data and information than previously provided, potentially necessitating updates to existing processes and controls.[24]  I encourage companies to ensure they are dedicating the appropriate resources to planning for preparation of those disclosures. 

Third, it bears mentioning that some companies have early adopted the standard (as permitted) and are now applying the new revenue standard.  In those cases, investors are benefitting from the enhancements to revenue recognition.  For those companies that anticipate applying the standard as required in 2018, robust transition disclosures as described in Staff Accounting Bulletin 74 and our related September 2016 staff announcement should be made to enable investors to understand the anticipated effects of the new standard.[25]  

Other New Standards

Now, let me turn to implementation activities related to the leases, financial instruments and new credit losses standards, for which Sagar Teotia will be providing further comment on these and revenue recognition implementation as part of the accounting update panel. 

The new leases standard, which will be effective beginning in 2019, will result in lessees recognizing most leases on the balance sheet.  This new standard will require companies to first ensure they, first, evaluate their arrangements in relation to the scope of the new standard and transition provisions and, second, update their system of internal control over financial reporting arising from the impact of the standard.

Similarly, as a reminder, the new accounting standard related to classification and measurement of financial instruments that will be effective beginning in 2018 will enhance financial reporting for many investments. 

For example, equity investments (except for those accounted for under the equity method of accounting) with readily determinable fair values will be measured at fair value with changes in fair value recognized through net income.  Equity investments without readily determinable fair values, companies will be permitted to elect an exception to this measurement.  The election will allow for the equity investment to be measured at cost, less impairment, plus or minus observable price changes.  Companies should be considering the impact of this new accounting standard to ensure the provisions are appropriately understood and analyzed.

Continuing on to the new credit losses standard that is effective beginning in 2020, the scope of the credit losses standard crosses industries, consistent with the variety of financing arrangements that businesses provide.[26]  For example, often, retailers and other vendors provide financing to customers as part of the contract to sell their goods.  These financing receivables, as well as accounts receivable, will be within the scope of the new credit losses standard.

I encourage companies to evaluate the scope paragraphs in these standards to identify relevant transactions and accounts for an assessment and to provide transition disclosure of the anticipated effect of the new standards.  Also, this initial scoping exercise will be one of the key steps in determining the work necessary to implement the standard.

Some companies may find that they are devoting more resources to the adoption of the revenue standard, given its earlier adoption date, as compared to the other new standards.  However, I want to caution against a purely sequential implementation process for the new standards.  I believe effective adoption of the new standards can be bolstered by concurrent implementation planning, given the number of complimentary activities and the coming effective dates.  

Internal Control over Financial Reporting

Ultimately, management's ability to fulfill its financial reporting responsibilities depends on the effectiveness of internal control over financial reporting – controls designed to provide reasonable assurance that the company's financial statements are prepared in accordance with GAAP.[27]

In fact, the books and records provisions of the securities laws have long included a requirement that U.S. public companies must devise and maintain a system of internal accounting controls to provide ''reasonable assurances'' that "transactions are recorded as necessary to permit preparation of financial statements" in conformity with GAAP.[28]

This requirement applies even if a particular company is not subject to the requirements in the Sarbanes-Oxley Act that management of public companies assess the effectiveness of the company's internal control over financial reporting or that a public company's auditor attest to, and report on, management's assessment of its internal control over financial reporting.

Over the next several years, updating and maintaining internal controls will be particularly important as companies work through the implementation of the significant new accounting standards.  Companies' implementation activities will require careful planning and execution, as well as sound judgment from management.  

Companies that apply the COSO framework for assessing the effectiveness of internal control over financial reporting might find its five components and related concepts and principles useful in developing a structured approach for implementation and meeting related documentation expectations.[29] 

As I’ve noted in prior speeches and as Marc Panucci will further discuss later today, each of the five COSO components must be present and operating to conclude that internal control over financial reporting is effective under the COSO framework.  OCA staff are available for consultations with companies and auditors about internal controls over financial reporting, particularly during this implementation period of new GAAP standards.

Well-run public companies have effective internal controls not just because internal controls are a first line of defense against preventing or detecting material errors or fraud in financial reporting, but also because strong internal controls contribute to better internal accountability and information flows, among many other things.[30]  Internal control over financial reporting is scalable; more tailored guidance for smaller companies is available for management and auditors.[31]

Investors tend to incorporate disclosure of material weaknesses in the price they are willing to pay for a security.  For example, disclosure of remediation of material weaknesses tends to be followed by improved financial reporting quality, reduced cost of capital, and improved operating performance.[32]   One study found that companies that have remediated their prior material weaknesses exhibit an average decrease in market-adjusted cost of equity of 151 basis points.[33]  Another study found that some companies voluntarily disclose material weaknesses in their registration statements along with their plans for remediating those weaknesses to benefit from investor response to the disclosure about remediation.[34]   

If left unidentified or even unaddressed, internal control over financial reporting deficiencies could lead to lower-quality financial reporting and ultimately higher financial reporting restatement rates and higher cost of capital.

Auditor Independence

Public trust in financial reporting is also maintained by protecting the independence of the outside auditor from its audit client.  Audit committees of listed companies play an important role in this regard by protecting auditor objectivity, in part, through direct oversight of the audit relationship.  For this relationship to work well, it must be nourished.  The audit committee must own the selection of the audit firm, make the final decision when it comes time to negotiate the audit fee, and oversee the auditor’s independence.[35] 

While audit firms are generally more active in bringing independence issues to the staff, audit committees and management may also address with the staff independence matters that impact their filings or other interpretive questions.  Audit committees and management should also keep in mind that the staff does occasionally reach out to the audit committee to understand its position about an independence matter that has been submitted to the staff for its consideration.

When selecting a successor auditor, an audit committee should request information to be satisfied that the successor is independent at the start of the audit and professional engagement period.  Audit committees should consider circumstances that might require the company to make adjustments to prior period financial statements.  Those circumstances commonly include, for example, the reporting of discontinued operations, a retrospective application of an adoption or change in accounting principle, or the correction of an error.  While an audit committee, in certain situations, may select either the successor auditor or the predecessor auditor to audit the adjustments made to the prior period financial statements, the auditor would need to be independent under the Commission’s rules (and registered with the PCAOB) to be in a position to audit the adjustments. 

Accordingly, an audit committee may wish to consider those types of circumstances as part of its determinations about selecting a successor auditor and also keep this in mind before entering into any relationships that would impair the predecessor auditor’s independence after the end of the predecessor’s professional engagement period.[36]  OCA is available to consult on these matters, as necessary.

Reminders to the Audit Profession

The tone at the top of public accounting firms that audit public companies is just as important as that set by top management of public companies.    

Many public accounting firms are large organizations in which personnel face institutional and individual pressures not unlike those that personnel of public companies face.  In both large and small public accounting firms, it is important to identify and then mitigate these pressures, which if left unaddressed can have the potential to compromise the skepticism and professional judgment that are critical to audit quality and the detection of material misstatements.  

Just as management needs to allocate sufficient time and resources to the preparation of their books and records (with good internal controls), so too should public accounting firms work with the audit committee (and management) to agree on appropriate deadlines and audit fees to ensure that audit quality is consistently maintained. 

As an example, pressure can arise from tight deadlines.  That is, deadline pressures may inadvertently encourage auditors to prematurely stop pursing identified problems.  Proper planning of the audit, therefore, should anticipate and address tight deadlines when implementing project management disciplines, and allocating personnel and other resources to address these issues.  This may require particular emphasis in this and next year’s audit cycle as audit engagement teams prepare to audit management’s application of the new GAAP standards.  Identifying and addressing these pressures are particularly important because manipulation of financial results typically occur near the end of a reporting period.[37]

I urge audit engagement teams to address these and any other potential pressures (and mitigating plans) with the audit committee, ensuring that there is sufficient time and resources allocated to the work necessary, and firms to maintain a system of quality control to recognize the organizational and individual pressures in today’s audit environment and control them sufficiently.    

Continuing to Advance through Innovation

Increased competition and rapid advances in technology are driving dramatic changes in business processes.  To survive and compete, companies are consistently enhancing the way they listen to their customers, the way they operate and develop new products, the way they manage risks, and their relationships with other organizations. 

Financial reporting is not (and should not be) immune from the same types of changes.  In times of rapid and substantial change, the risk increases that financial reporting will fall behind the pace of change, failing to provide what investors need to know.  Today, more than ever, financial reporting must keep up with the changing needs of investors, who rightly demand that it does.

There have been significant advances in technology in recent years with an accompanying increase in the use of technology by auditors, which has the potential to enhance audit quality and the auditor’s detection capabilities among other areas.  Many firms have made significant investments in technological tools and methods.  We understand some audit firms now use data analytics to review large populations of data to help engagement teams assess risk and plan substantive audit procedures. 

Other market participants are also employing the use of technology in new and innovative ways.  We also understand some ratings agencies and data aggregators now utilize data scraping technology and machine learning to review filings made with the Commission and analyze trends over time.  This technology has the potential to help auditors and users of the financial statements identify inappropriate bias in the financial statements. 

Even as individual firms continue to invest in their own proprietary systems, methods, and techniques, I also encourage firm leadership to remain focused on supporting and fostering an open approach to innovation through supporting professional standard setting activities, so that the audit profession as a whole is well-positioned to advance the role of audit in meeting the needs of investors and other stakeholders.

Closing

I want to thank you again for the opportunity to be with you today.  We all have a shared responsibility to advance the role of high-quality information in our capital markets, which leads to better decisions and outcomes for all Americans.  Thank you.