|DATE||Oct. 26, 2012|
|Jeanette M. Franzel, Board Member|
|EVENT:||CGC Speaker Series|
It is a pleasure to be here today in Knoxville at the University of Tennessee Corporate Governance Center to discuss current issues and trends in public company auditing. I commend the Corporate Governance Center for its focus on issues that impact public policy.
This focus provides important input and new perspectives for regulators and others considering the public policy objectives of protecting investors and promoting the public interest in financial reporting and auditing.
I know there are many accounting students in the audience today, and I'm pleased that you have the opportunity here at the Corporate Governance Center to focus on issues of public policy and investor protection, in addition to all the technical knowledge that you will need to pass the CPA examination.
Before I get started, I must tell you that the views I express today are my personal views and do not necessarily reflect the views of the Public Company Accounting Oversight Board, any other Board member, or the staff of the PCAOB.
Today I will briefly discuss some historical perspectives that lend insight into the current state of the profession and the PCAOB's role. I will also provide details about the PCAOB's key activities in carrying out its mission, including:
Also today, I want to charge you with the duty of knowing that as members of the next generation of CPAs you will play a significant role in the effective functioning of our capital markets. In fact, in your future career as a CPA, you will become a member of a community, an ecosystem if you will, responsible for producing reliable financial reporting with independent and credible audits. That is the essential duty of the profession. And academic experts, such as those here at the Corporate Governance Center, provide invaluable insights into the dynamics and pressures that impact practitioners and their regulators.
Throughout my speech today I will discuss some current trends and significant challenges in the accounting and auditing profession. In facing such challenges, I believe that it is important for members of the profession to understand 1) the context around the auditing standards that you will use, 2) the ethical standards to which you should adhere, and 3) the public policy issues of investor protection that will be the foundation for the professional judgments you will make on a daily basis. And, above all else, remembering that if you are working within or auditing a publicly traded company, your true client is the investor.
The Importance of Historical Perspectives in Accounting and Auditing
Let's start with some history. Students of accounting and auditing — or any other profession, for that matter — should understand the evolution of the major applicable theories and principles of their profession, and where those theories and principles are still subject to tensions, reconsideration, and debate.
The history of the profession, the various public policy choices made along the way, and the tensions that arose during the many business cycles and crises have framed the current governance and accountability model that supports our capital markets.
Although today I will focus mainly on recent and current issues, I want to emphasize the importance of studying the history of the accounting and auditing profession, the major issues that have been debated over the years, and the related responses and evolution within the profession.
Accounting and auditing as they exist in the U.S. capital markets today are the result of a series of actions taken by the Congress, the Securities and Exchange Commission, and the accounting profession over many years, beginning with the stock market crash in 1929 and the Great Depression that followed.
After the loss of public confidence in the U.S. capital markets, a series of hearings were held in the U.S. Senate in 1933 and 1934 to examine the causes of the 1929 stock market crash and explore potential reforms. The central questions dealt with whether and how companies should provide investors with detailed financial statements, and what type of assurance could be provided to the public that those financial statements were reliable.
Over the intervening decades, there have been numerous studies, investigations, Congressional hearings and debates about reforms to the accounting profession. I won't enumerate those today. But to illustrate the substance and magnitude of these activities, I will refer you to a 1996 General Accounting Office (GAO) review of the accounting profession. As part of the review, the GAO identified major recommendations made from 1972 through 1995, and actions taken to improve accounting and auditing standards and the performance of independent audits of publicly traded companies.
The report identified 27 major studies performed during those 23 years. The report summarized major recommendations in the areas of auditor independence, audit quality, accounting and auditing standards, and other reporting and auditor services. The GAO also pointed out areas where additional progress was needed, including auditor independence, responsibility for detecting fraud, reporting on internal controls, and standard setting. Many subsequent studies were also conducted during the 1990s.
For the record, let me say that, before I joined the PCAOB, I worked at GAO for 23 years, most recently as managing director. One of my areas of responsibility involved GAO's oversight and evaluation work dealing with the accounting and auditing profession.
Then in the late 1990s and into the 2000s, a massive number of financial reporting and auditing failures caused a collapse in confidence in financial reporting and in the integrity of the financial markets. After engaging in months of study in light of the significant failures, Congress passed the Sarbanes-Oxley Act in July 2002 to restore confidence in financial reporting and to improve the independence and quality of audits.
The Sarbanes-Oxley Act and 10 Years Later
As we mark the 10th anniversary of the Sarbanes-Oxley Act, it is important for you to understand the context and history surrounding your own "entry-point" into the profession.
One of the major tenets of financial reporting that underwent reconsideration during the debates leading up to the Sarbanes-Oxley Act was the need for effective oversight and monitoring of the financial audits that serve investors and the capital markets.
The financial reporting and auditing failures, corporate bankruptcies, and other major corporate scandals in the early 2000s — involving companies such as Enron, WorldCom, Sunbeam, Xerox, Waste Management, and Global Crossing, among others — highlighted significant problems in the model of auditor self-regulation and prompted Congress to re-examine the issue.
In order to identify for Congress the regulatory structure in place, the GAO depicted the complicated and — what it and the profession's own audit oversight body said was an — "ineffective" self-regulatory model.
U.S. Government Accountability Office, "Accounting Profession: Oversight, Auditor Independence, and Financial Reporting Issues," GAO-02-742R, pg. 13 (May 3, 2002). For an older, but more detailed description of the profession's self-regulatory framework, see Public Oversight Board, "Audit Quality: The Profession's Program," available at www.publicoversightboard.org.
Notice the key players in this model and their relationship to each other: public regulators, practitioners as self-regulators, and the lines of responsibility.
The system of auditor self-regulation shown in the bottom half of the graphic was replaced when Congress passed the Sarbanes-Oxley Act, ending more than 100 years of self-regulation by the public accounting profession in the United States. One of the primary purposes of the Act was to create the Public Company Accounting Oversight Board (PCAOB) to regulate public company auditors; enhance the independence of those auditors; improve public company financial reporting and responsibility; and provide more direct SEC oversight of public company accounting standard setting.
After 10 years of experience implementing these changes to the regulatory framework, we are, once again, in a period of re-examination of the role, relevance, and reliability of financial audits in protecting investors and the public interest. This seems to be, in large part, a result of the most recent financial crisis.
At the PCAOB, we are reflecting on the Board's work and accomplishments, and what they tell us about the current state of the profession and investor protection. We've had many stakeholders and members of the profession tell us that auditor independence and audit quality have been strengthened since the passage of the Sarbanes-Oxley Act, and we also believe that audit quality has improved. We've also heard from public company audit committee members that they believe financial reporting and auditing processes have been strengthened.
However, more work needs to be done. Later, I will discuss in more detail the results of our current inspections and enforcement efforts. What we've learned throughout the history of the profession is that, we can never let down our guard on issues of audit quality and investor protection.
The Role of the PCAOB
The statutory mission of the PCAOB is to oversee the audits of public companies (issuers) to protect the interests of investors, and further the public interest in the preparation of informative, accurate, and independent audit reports. In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act amended the Sarbanes-Oxley Act to, among other things, vest the PCAOB with the authority to oversee audits of broker-dealers.
The PCAOB has four main responsibilities:
The PCAOB's responsibilities extend to registered public accounting firms that are located in the United States and in other jurisdictions around the world. Accordingly, the PCAOB works collaboratively with the relevant audit regulatory bodies in other countries.
The Sarbanes-Oxley Act and PCAOB rules require all U.S. and non-U.S. accounting firms to register with the PCAOB if they perform audits or play a substantial role in audit reports of issuers, brokers, and dealers. PCAOB—registered public accounting firms have been given an important role in the capital markets — to provide assurance to investors, owners, lenders and others that the audited companies' or broker-dealers' financial statements and related disclosures fairly present the institution's financial results in conformity with applicable accounting and disclosure standards and rules.
Clearly, reliable financial statements play a key role in the financial markets, which are integral to the success and well-being of American households and businesses, the U.S. economy, and participants and stakeholders from around the world.
Approximately 2,400 firms are currently registered with the Board, of which about 1,500 are U.S. firms and about 900 are non-U.S. firms located in 84 countries. About 853 registered firms report that they audit issuers or play a substantial role in auditing issuers, and another 518 firms report that they audit brokers and dealers, but no issuers. In total, about 1,371 registered firms report that they currently audit issuers or broker-dealers.
Another 870 firms (about 525 foreign firms and 345 U.S. firms) report that they do not audit issuers or broker-dealers, nor do they play a substantial role in such audits. What about them? Registration alone does not subject an accounting firm's activities to Board oversight and in no way serves as an endorsement of the quality of services a firm is delivering to its clients. Some of these firms registered in the hope of acquiring public company or broker-dealer audit clients.
It is reasonable for the Board to consider whether continued registration is appropriate for a firm that has no interest in providing services that are within the scope of the Board's mandate. I expect that the Board may soon explore mechanisms to address firms that may fall into this category.
So what does the marketplace of issuers look like and who performs their audits in the U.S.? Of the 7,762 issuers that filed reports with the SEC as of June 30, 2012, and that received an audit opinion in the U.S., most of them (4,633) are "non-accelerated filers," generally meaning that they had public float of less than $75 million. And about 1,504 issuers were "accelerated filers," with public float between $75 million and $700 million, and 1,625 issuers were "large accelerated filers" with at least $700 million in public float. Of note, the "large accelerated filers" account for almost 95 percent of the market capitalization of all U.S. issuers.
The four largest U.S. accounting firms audited 3,392 of these issuers, representing 97.6 percent of the market capitalization. The next three largest firms audited 655 issuers, about 1.5 percent of market capitalization, and other U.S. firms audited 3,715 issuers, about 0.9 percent of market capitalization.
The largest registered public accounting firms — those auditing more than 100 issuers — are inspected annually by the PCAOB. Firms that issue 100 or fewer audit reports each year are subject to inspection at least every three years.
The PCAOB also inspects certain firms that audit broker-dealers under PCAOB's interim broker-dealer inspection program. This program is still in an "interim" phase, as the Board just received this authority in late 2010 and is building the program.
The inspection of issuer audits began in 2004. Unfortunately, PCAOB inspections continue to find serious audit deficiencies in public company audits on a regular basis. Among areas of specific concern are problems related to professional skepticism, tone at the top, and supervision.
As accounting students, you probably hear these concepts frequently. As you enter your first jobs in the profession (whether as a preparer or an auditor), your daily lives will be very much affected by the tone at the top in your organization, your supervisors, and the degree of professional judgment that is used by your team.
During 2012, the PCAOB is inspecting nine firms that audited more than 100 issuers in 2011. Those firms are: BDO USA, LLP; Crowe Horwath LLP; Deloitte & Touche LLP; Ernst & Young LLP; Grant Thornton LLP; KPMG LLP; MaloneBailey, LLP; McGladrey LLP; and PricewaterhouseCoopers LLP.
We also expect to complete approximately 170 domestic firm triennial inspections and about 80 non-U.S. firm triennial inspections. We are in the midst of our 2012 inspection season for these firms that performed audits in 2011, and have completed a substantial number of the 2012 inspections.
We have issued the majority of the 2011 inspection reports, and of these, we continue to see the high level of serious inspection findings similar to what we found in the 2010 inspection reports (issued in 2011).
The findings are serious, and represent deficiencies that are of such significance that it appeared that many firms, at the time they issued their audit reports, had failed to obtain sufficient, appropriate audit evidence to support their audit opinions on the financial statements and/or the opinions on internal control over financial reporting. These findings are reported in the public version of the report, which is referred to as "Part I."
Common areas where we find audit deficiencies include revenue recognition, fair value of financial instruments, testing and evaluating internal controls, related party transactions, the auditor's assessment of and response to fraud risk, and the auditing of equity financing instruments, among others. Here are some examples:
Another category of inspection findings deal with deficiencies identified in the firm's quality control system. Quality control deficiencies are reported in "Part II" of the inspection report, which is not initially included in the public portion of the report, due to statutory restrictions. Quality control findings in "Part II" focus on issues that may have caused the audit performance deficiencies reported in "Part I" of the report, as well as other aspects of the firm's management of its audit practice that could negatively impact audit quality.
Some examples of areas of specific concern include problems in the areas of professional skepticism, tone at the top, and supervision. In public feedback on these issues, the Board has heard suggestions that professional skepticism should be emphasized more in the education, training, and standard-setting for auditors, as well as in the firms' cultures, tone at the top, and systems of quality control.
Here are some of the examples we find of problems in these areas within audit firms:
We have also seen deficiencies in the auditing of management's estimates where it appeared that the auditors placed too much reliance on the perceived expertise of the company's personnel and/or experts when evaluating management's assumptions. In other cases, it appeared that firms overemphasized evidence that supported the company's conclusion, without evaluating contrary evidence that seemed to be readily available to engagement team personnel at the time of the audit.
We have seen instances where it appeared that firms may have had a bias toward accepting management's perspective, rather than developing an independent view or challenging management's conclusions. In a number of engagements, firms' support for significant areas of the audit consisted of management's views or the results of inquiries of management, without providing supporting evidence or explanation of the basis for the firms' conclusions. Diagnosing the root cause of these kinds of failures can be difficult. For example, failures to sufficiently evaluate management estimates may be caused by incompetence, time pressures, insufficient staffing or supervision, misaligned firm incentives, or some form of cognitive bias, among other factors.
Our inspection results identified a number of significant audit deficiencies in more complex or subjective areas where a greater degree of supervision and review would be expected, such as the auditing of management estimates, goodwill and indefinite-lived intangible assets, and income taxes. The inspection observations suggested the possibility that more attention needed to be devoted to supervision and review activities in connection with audits of areas involving a high degree of judgment, management estimation, and the application of complex accounting literature.
The Board engages in constructive dialogue with firms to encourage them to improve their practices and procedures. Successful remediation and sustained improvements in audit quality are clearly the goals of this process. Fortunately, we have seen most firms take their responsibilities for remedial efforts and improvements seriously.
As I mentioned earlier, there currently are about 900 PCAOB-registered public accounting firms in 84 other countries around the world. Since its inception, the PCAOB has conducted inspections in 40 foreign jurisdictions and this number continues to grow.
To conduct inspections around the world, the PCAOB works closely with our fellow regulators. These relationships have been helpful to both regulators in overseeing audit quality. For that reason, it is important that we continue to establish strong cross-border regulatory cooperative agreements wherever possible.
Notwithstanding the positive trends in international regulatory cooperation, however, the PCAOB continues to be prevented from inspecting the U.S.-related audit work and practices of PCAOB-registered firms in certain European countries, China, and — to the extent their audit clients have operations in China -- Hong Kong.
In terms of our inspections of foreign firms, the Board has adopted a cooperative framework that allows the PCAOB to rely, to a degree deemed appropriate by the Board, on inspection or enforcement work performed by a home-country regulator. By developing cooperative arrangements and through coordination with our counterparts, the PCAOB endeavors to minimize administrative burdens and potential legal or other conflicts that non-U.S. registered firms may face.
We have found that many countries have adopted audit regulatory regimes modeled, at least in part, on the Sarbanes-Oxley Act and the PCAOB. We have also found that most of the PCAOB's counterparts identify audit quality concerns consistent with those found by PCAOB inspectors.
There are currently about 163 registered public accounting firms in other countries that are affiliates of global audit firm networks and also subject to regular PCAOB inspection. As you know, this means that a global network may use a common brand name, but the firms comprising the network in different countries are separate affiliates.
There are another 73 firms in other countries that are not affiliated with large global networks and they are subject to regular PCAOB inspection. Finally, there are 89 firms in other countries that do not issue audit opinions for issuers that report playing a substantial role in such audits. Unfortunately, a large number of these firms are located in countries in which the PCAOB currently is blocked from conducting inspections.
A third area of PCAOB responsibility is carrying out its investigative and disciplinary authorities. PCAOB's enforcement and investigations function is an essential element of the Board's programs. Effective and robust enforcement is a critical tool in the scheme of protecting investors and the public interest.
Our Division of Enforcement and Investigations initiates and completes investigations, and where appropriate, litigates disciplinary proceedings in cases where auditors may have violated laws, rules, or standards under the Board's jurisdiction.
To date, 55 disciplinary orders have become final and were made public. That number is comprised of 48 settled disciplinary orders and seven adjudicated disciplinary orders.
In each enforcement case in which litigation is initiated, unlike many other regulators including the SEC, the PCAOB is prohibited by the Sarbanes-Oxley Act from publicly disclosing the allegations and the proceedings. This situation results in a variety of unfortunate consequences for investor protection and the public interest.
Disciplinary proceedings involving formal allegations of misconduct against 19 firms and individual auditors are currently pending, but cannot be publicly disclosed. During the most recent Congress, legislation was introduced (HR 3503 and S 1907) that would amend the Sarbanes-Oxley Act to make PCAOB disciplinary proceedings open to the public, but it has not moved forward.
The PCAOB Division of Enforcement and Investigations considers all potential violations of law, rules, or standards, but certain matters attract particular attention. These include matters that are serious audit failures, multiple audit failures, fraud, and other knowing or intentional misconduct, such as non-cooperation:
The last category of PCAOB responsibility is its standard-setting function. The Board uses information obtained from various sources to evaluate the need for changes in auditing standards. The Board also seeks input and advice from a wide variety of interested stakeholders -- including investors, auditors, representatives of public companies, members of the academic community, and the PCAOB Standing Advisory Group -- on ways to improve audits.
Depending on the nature of the project, the Board may issue a concept release to solicit public comment on issues or potential new standards prior to developing a proposed standard for public comment. It also may hold roundtable discussions and other public meetings to deepen its dialogue with commenters and other interested parties.
The Board works closely with the SEC, which must approve all PCAOB standards. The Board also monitors the work of international and foreign audit oversight bodies, as well as accounting standard setters, such as the Financial Accounting Standards Board, for developments that may affect auditing.
The Board currently has a full agenda and is seeking views on ideas and specific proposals impacting auditing and related professional practice standards:
Concept Releases — The Board is currently evaluating comments and feedback on two concept releases it issued in 2011, one dealing with the auditor's reporting model and another with auditor independence and mandatory firm rotation. These are issues that have been debated over decades in the profession, and are examples of the re-examination happening in the current environment.
New standards — The Board recently approved a new auditing standard and is evaluating three proposed standards that it previously released for public comment.
Potential future projects: The Board is also considering possible revisions to standards to strengthen and clarify requirements in the following areas:
As you can see, the PCAOB is working on an ambitious agenda including numerous areas of audit practice aimed at strengthening auditing standards themselves, while improving audit practices and approaches.
In conclusion, I want to say that, as accounting students, you have chosen to enter a profession rich that is in history and plays a significant role in the effective functioning of our capital markets. Throughout your career, you will be faced with multiple and often-times competing pressures, as well as difficult professional judgments. If you are working within or auditing a publicly traded company, you must remember your client is the investor.
Once you have passed the CPA exam and have entered the profession, I urge you to spend some additional time and effort to study the context around the standards that you are using, the ethical standards to which you should adhere, and the public policy issues of investor protection that will be the foundation for the professional judgments you make on a daily basis.
I wish you all the best in your future careers as CPAs.
For those of you who choose to focus on research and teaching, such as the professors on the faculty here at the Corporate Governance Center, I cannot overstate the importance of your analysis and insights into how practitioners learn and apply professional standards. Together, we have an obligation to understand as best we can the dynamics and pressures affecting the accounting and auditing profession and the different regulatory and other means to address them.
 Now called the Government Accountability Office.
 United States General Accounting Office: The Accounting Profession: Major Issues, Progress and Concerns, Sept. 1996 (GAO/AIMD-96-98).
 These reviews and regulatory initiatives include, among others, a number of evaluations prompted in 1998 by the SEC after significant financial reporting failures resulting from abusive "earnings management." See SEC Press Release No. 98-95, Sep. 28, 1998. See, for example, Public Oversight Board, Panel on Audit Effectiveness, "Report and Recommendations" (Aug. 31, 2000); SEC Release No. 33-7919, Nov. 21, 2000 (final rule on amendments to SEC auditor independence requirements); SEC Release No. 34-42266, Dec. 22, 1999 (final rule on amendments to public company audit committee disclosure requirements).
 See H.R. Rpt. No. 107-414, Apr. 22, 2002; H.R. Rpt. No. 107-418, Apr. 23, 2002; S. Rpt. 107-205, July 3, 2002.; H.R. Conf. Rpt. 107-610, July 24, 2002.
 Pub. L. No. 107-204, July 30, 2002.
 On Jan. 20, 2002, the Public Oversight Board of the American Institute of Certified Public Accountants, which was a key self-regulatory oversight body for public company auditors for 20 years, announced its termination, concluding that the self-regulatory structure was "largely ineffectual." See www.publicoversightboard.org/about.htm.
 Pub. L. No. 111-203, July 21, 2010.
 As of October 2012, about 825 firms previously registered with the PCAOB withdrew their registrations.
 Approximately 4,400 brokers and dealers filed audited annual financial statements with the SEC for fiscal periods ended during 2011. Approximately 800 registered public accounting firms audited broker and dealer filings for these periods.
 I should note that some of these registered firms also audit other regulated entities in the securities industry either voluntarily or as required by the rules of their primary regulator. However, PCAOB does not have jurisdiction over those particular audits. For example, the SEC requires certain investment advisors to be audited by a PCAOB-registered public accounting firm that is subject to regular PCOAB inspection even though PCAOB lacks jurisdiction to oversee those particular audits. 17 C.F.R. § 275.206(4)-2. See SEC Release Nos. IA-2968 and IA-2969.