Thank you for inviting me back to the Securities Regulation Institute. It is great to be before a group that cares so much about good financial reporting. I came to the PCAOB with that objective.
I am here today to talk about the regulatory initiatives of the Public Company Accounting Oversight Board. The PCAOB is deeply engaged in examining ways to enhance the relevance, credibility and transparency of the audit to better serve investors.
The auditing profession has developed a highly skilled body of experts capable of analyzing accounts in a way that draws out truths and insights and sheds light on confused or misleading claims. It plays an indispensable role in making our capital markets fair and strong.
But I believe we are in a high risk period that merits more attention to the audit, not less. When companies make lay-offs, as we've seen recently, they often affect the internal audit and compliance staff — the first line of defense for fraud and other corporate malfeasance. This should be a concern to the legal community.
Although we have never needed it more, the audit too has, in the minds of some, become a commodity to be contained with other compliance costs.
In the United States, large audit firms' revenues from consulting are growing 15 percent a year. Audit fees have stagnated at, basically, the inflation rate. Thus audit practices have shrunk in comparison to audit firms' other client service lines.
This can weaken the strength of the audit practice in the firm overall. The problem is compounded when audit firms turn their talents to other endeavors that may further damage public views on the relevance and value of audit.
To be relevant, the auditor must speak to and for investors. Fair or not, that is in question today.
I want to see a vibrant audit profession that competes on quality more than price. I want to see a profession that is revered for insight and clarity, not box-checking. I want to see a profession that attracts and retains top graduates who are and remain committed to excellence in public service.
At John's invitation, I will focus my remarks on six policy initiatives that the PCAOB is pursuing to accomplish these goals, by enhancing the relevance, credibility and transparency of public company audits.
This is not an exhaustive list of our initiatives. We have a robust standards-setting agenda developed through extensive outreach, including with the PCAOB's Standing Advisory Group as well as other standard-setters.
The SAG, as we call it, is comprised of numerous stakeholders, including auditors themselves, as well as preparers and their representatives, investors, and others. John is a member.
We don't rewrite standards just for the sake of change. But through our consultation process we identify areas of auditing that deserve improvement, or updating in light of developments in practice.
I also leave for another day a discussion about our international program, other than to say that we have now entered into bilateral cooperative agreements with regulators in 14 other jurisdictions to conduct inspections jointly with the local regulator. We've recently restarted or begun joint inspections in major financial centers throughout Europe, in the U.K., Germany, Netherlands, Spain, Norway, and Switzerland. We benefit greatly from local insights and can be significantly more effective together.
In cooperation with foreign audit regulators, we are revolutionizing what it means to engage in cross-border audit regulatory cooperation and, in the process, overcoming legal and organizational impediments to sharing information.
I am disappointed that we still face resistance from some countries where there are registered firms we are required to inspect. We are coming to a cross-roads where we will have to make some important decisions and may have more to report in the coming months.
The first two initiatives I will cover focus on arming audit committees with more and better information about the audit, as well as more and better information about the auditor's strengths and weaknesses.
Audit committees cannot make decisions about hiring and compensating auditors on the basis of quality without transparency and insight about quality.
The PCAOB has recently adopted a new auditing standard — Auditing Standard No. 16 — on what the auditor should communicate to audit committees in order to protect the public's interest in keeping audit committees informed of important audit matters. It has been submitted to the SEC for the necessary approval.
AS 16 will require, among other things, that the auditor communicate to the audit committee matters arising from the audit that are significant to the oversight of the company's financial reporting process, including complaints or concerns regarding accounting or auditing matters that have come to the auditor's attention.
AS 16 will also require the auditor to communicate any significant difficulties encountered during an audit, including delays by management, unavailability of company personnel, or an unwillingness by management to provide information needed for the auditor to perform his or her audit procedures.
I would expect the best auditors to communicate this information already, and the best audit committees to demand it. Yet we see — and many law firms have built a good business on — situations where this was not the case.
The PCAOB has also recently issued guidance about how audit committees can learn more from their auditors about the results and implications of the PCAOB's inspection findings.
Description in the public portion of the inspection report of failure to obtain sufficient evidence to support the firm's opinion means that the inspection staff has determined that the firm failed to fulfill its fundamental responsibility in the audit: the firm failed to obtain reasonable assurance about whether the financial statements are free of material misstatement.
Firms' characterizations of inspection results can sometimes distort them. How an auditor approaches inspection results can tell an audit committee a lot about the firm's commitment to excellence.
In addition, how an audit committee addresses these issues affects the tone of the audit. An audit committee that accepts weak arguments may inadvertently signal to the audit firm and audit team that the audit committee is not concerned with quality. An audit committee that, on the other hand, expresses explicit concern for how the auditor has resolved noted deficiencies tells the auditor that quality matters.
As lawyers for corporate boards, you will want to be attuned to these nuances.
The PCAOB has also proposed two new standards. The first, on related party transactions, describes basic tools that good auditors have used for years to identify financial reporting risks. For example, it requires auditors to understand management's compensation as a way to understand management's motivations.
Changes in performance metrics may well be an important clue to understand areas where management's financial story is weak. They offer the auditor — and audit committee — insights about management's incentives that may not be gleaned otherwise.
In addition, the Board has proposed to require disclosure in the audit report of the name of the engagement partner as well as participating firms in the audit. Auditing is more than ever a global endeavor.
Engagement partners supervise audits that span continents and oceans. But the reader of an audit report may not know how much of the actual work was done by the firm signing the report. Participating audit firms practice in markets that exhibit markedly different business cultures, with divergent patterns of transparency.
We are currently evaluating comments on both the related party proposal and the transparency proposal, with a view to moving toward issuing final standards next year.
The PCAOB standards-setting work also includes two rather more broad-ranging projects, commenced not with concrete proposals but with concept releases.
One involves consideration of changes to the form and content of the standard audit report. The current model is boilerplate limited to three paragraphs.
This project is intended to develop a better, more transparent reporting model that will impart the auditors' insights about key aspects of the financial statements and other matters they want to emphasize.
The project is not about changing the nature or scope of the auditor's work. It's about making the results of that work more relevant.
The profession (and various of you as their frequent counselors) generally support changing the report. We are now engaged in deep analysis and development of some of the concepts mooted in our concept release.
In addition, in August 2011, the Board issued a Concept Release on Auditor Independence and Audit Firm Rotation. The concept release notes the importance of auditor independence to the viability of auditing as a profession and highlights the risk to independence arising from the "client-pays" model.
Since 2003, the PCAOB has hired experienced auditors from the field, taken them out of client service, and within weeks — sometimes even days — redeployed them as PCAOB employees to inspect the quality of audits around the country, and now around the world.
Yet from our earliest days, inspectors have identified serious audit deficiencies of such a range that it is not possible to ascribe them to isolated technical weaknesses. These include instances where auditors did not approach some aspect of their audit work with the required independence, objectivity and professional skepticism.
We consistently find strong technical auditing skills at all of the largest firms and many smaller firms, in both new and long-term engagements. Yet we also find explicit policies directing partners to price audits for new clients lower than the cost of auditing for the express purpose of establishing a long-term relationship.
According to a compilation of inspection results from Canada, the U.S., the U.K. and Australia, prepared by the Canadian Public Accountability Board, "Insufficient Professional Skepticism . . . is undoubtedly the most common finding — that auditors are too often accepting or attempting to validate management evidence and representations without sufficient challenge and independent corroboration."
A number of other regulators have also recently issued insightful reports on auditor independence and professional skepticism, including the Netherlands, France, Germany and Switzerland.
Against this background, the concept release seeks public comment on ways to enhance independence, objectivity and professional skepticism and counteract these practices and influences.
The PCAOB has embarked on several public meetings to engage prominent and thoughtful commenters with various, often conflicting, viewpoints.
They have included some of the most authoritative and experienced voices to address the subject of audit quality, auditor independence and the challenges to both. They offered varied perspectives as investors, senior executives and audit committee chairs of major corporations, chief executive officers of audit firms, academicians, and former regulators.
The European Union and its member states are engaged in their own inquiry and are considering their own term limits, possibly six-year terms.
I don't want to rush to decision here. I do want to influence the debate worldwide, by broadening its scope and getting beneath the surface of generalities, coming to grips with the practical. It is not our way of doing things in this country to shy away from large issues and avoid discussion of big, bold ideas.
The commercial world we are part of is wrestling with the challenges of independence in fact and in appearance. We have thoughtful scholars and skillful advocates on all aspects of that question, and they should be heard. Discussion leads to a more robust consideration of alternatives, refinement of the analysis, and in the long run, better solutions.
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With this introduction, I will now turn back to John to begin our panel discussion.