|DATE||May 5, 2011|
|James R. Doty, Chairman|
|LOCATION:||New York, NY|
Thank you John [Elliott (Dean, Zicklin School of Business)] for that kind introduction. I am honored to be with you today. I also want to commend Norm Strauss for his work to convene this conference. For 10 years now, Norm and the Zicklin Center have fostered a meaningful dialogue among policy makers and practitioners on current accounting and auditing issues.
Accounting and auditing are more important to American society than ever. Auditors may look back on this time as the moment when they turned to seize the future. This may seem odd, given the extent to which they have been questioned since the financial crisis. I am thankful for the opportunity to explain.
I intend to focus my remarks today on auditing. There are obviously important accounting issues to discuss and debate as well. But since February 1, when I became Chairman of the PCAOB, auditing has preoccupied me. The public policy questions relating to the role of the auditor and the societal value of the audit deserve ample attention.
I do have to say, though, that the ideas I express today are my own and should not be attributed to the PCAOB as a whole or any other members or staff.
As was the case nine years ago, before the PCAOB was created, auditors find themselves at a point where their role and relevance are being debated.
Reliable financial and economic data is one of the fundamental assumptions of American society that sets us apart. We value a culture of honest representation and must continue to do so to promote our economic success.
Our system of capital formation relies upon the confidence of millions of savers to invest in companies they trust. The auditor's opinion is critical to that trust. There are, of course, formidable forces that work against that trust.
First, the payment model: the auditor is hired and fired by the company itself. The Sarbanes-Oxley Act's reform to shift hiring and oversight of the auditor from management to the audit committee may in practice have proved insufficient to counteract that conflict and others facing the auditors. As with management, audit committees may see their job as negotiating the lowest audit fee, not championing auditor objectivity and independence from management.
In this environment, not surprisingly, the scope of the audit has not grown, even if society's expectations have. As the guardian of a cultural value, the audit is arguably as important as electricity or water. But if it is to retain that lofty status, auditors and the PCAOB need to do our best to make sure the audit is useful.
This is not a new challenge. The late Sandy Burton was a respected SEC Chief Accountant, thereafter Deputy Mayor of New York City brought in to fix the City's finances when it was on the verge of bankruptcy, and Dean of Columbia Business School. In his time, Sandy put the same challenge to the profession.
Burton was an effective advocate for using accounting and auditing to promote the public interest. He challenged auditors to do more for the public, but as he lamented in a characteristic op-ed piece in April 1980, auditors devote "[a] great deal of effort . . . to limiting responsibility rather than enlarging it."
His advice was clear: "the concept of audit" had to be expanded, and the auditor "must see his role as encompassing the evaluation of effectiveness in meeting goals and efficiency in operations as well as simply expressing an opinion on financial statements."
Second, to protect the investing public, all public companies are required by law to obtain an audit. This statutory franchise protects the profession as a whole from the risks of obsolescence, thereby reducing auditors' need to adapt to investor needs. As a result, auditors don't have a natural incentive to evolve their reports to what investors want.
Third, there are other external conflicts of interest for the audit to overcome. Conflicts are rife in the fundamental issues auditors face in evaluating whether a company's going concern assumption is valid. They inhere in the judgments of people who prepare and market valuations while actively trading. Conflicts also emerge in audit committees compensated substantially in stock.
These forces — the payment model, the statutory franchise, and the incentives of others in the environment auditors operate in — constitute formidable discouragement. They deter the profession itself from innovating the audit to meet public expectations the way, say, a technology company would, or a properly incentivized service company would.
There is no silver bullet to address these challenges. There are as many or more problems with structural alternatives such as a third-party payor or insurance-based system; and in a dispersed ownership society, eliminating the audit requirement would be impractical and outright reckless. Therefore, our initiatives should go to reducing risks that follow from these conflicts and challenging incentives that weaken investor protection by applying counter-weight.
Public expectations demonstrate the audit embodies core societal value and relevance. But we obviously need to work on resolving the debate over the role auditors should be expected to play. In this, we will continue to benefit from the thoughtful involvement and support of Chairman Shapiro, her fellow commissioners and staff, and especially Chief Accountant Jim Kroeker.
I. The Regulatory Interest in the Audit
We are not alone in our re-evaluation of the role and relevance of the audit in light of lessons learned from the financial crisis. The cacophony of ideas currently in play makes for an exciting, but at times confusing, debate. Making sense of the debate requires careful consideration of the relationship between potential reforms and the goals we want to achieve.
European policy makers have contributed substantially to the debate. Many of the problems they have identified are the same that we experienced in the United States. But they attribute the cause of the problems in large part to market concentration. The reforms they propose would go to reducing market concentration — the paucity of choice among global audit firms.
Thus, for example, the European Commission has sought "views on whether the consolidation of the past decades should be reversed" by breaking up the Big Four. The Financial Reporting Council in the United Kingdom has championed "living wills" to plan for the contingency that a large firm will fail and thus concentrate the audit market even further. In the same vein, it supports initiatives to "reduce the level of concentration." The FRC also proposes encouraging banks and other systemically important institutions to use non-Big Four firms and prohibiting the use of "Big-Four only" clauses in banking and loan covenants.
In a rather unprecedented measure, the U.K.'s House of Lords' Select Committee on Economic Affairs has also weighed in on these issues. The Lords focused on the ramifications, during the financial crisis, of the "narrowness of the assurance" auditors gave on systemically important financial institutions, and auditors' "failure to give warning of trouble in the run-up to the financial crash."
But they went on to conclude that "There is inevitably a connection between the assessment of the Big Four's performance and the question . . . of market concentration."
I question how directly these proposals advance the public's call for more relevant information, including "early warnings," from auditors. I do not believe that the global audit firm networks themselves pose systemic risk to our economy. But initiatives to shrink the global firms would likely further weaken their ability to audit the large, multi-national companies that may themselves be systemically important.
The global audit firm is not too big to fail: it is too important to leave unregulated. To protect investors, governments should regulate such firms, not cripple them.
There's no reason to think that if there were more major firms they'd be more likely to stand up to their clients. Audit firms today compete fiercely on the basis of price and client service. They don't compete on the basis of investor protection, and they question whether their corporate clients value audit quality.
This position offers no support for anti-competitive, price-fixing practices. But competition issues are the bailiwick of competition authorities. And I would be concerned about measures to promote competition proposed in name of audit reform and expressed in the rhetoric of market transparency that would, in application, have a negative effect on audit quality.
II. PCAOB Protections
Turning away from reforms aimed at competition, there is still much to be done to meet the public's demand for more and better information from auditors. The PCAOB is engaged in a broad dialogue with investors, auditors, audit committees, preparers and others to consider how the auditor's report can be changed to provide more useful, relevant and timely information. The central questions emerging in our dialogue are: What should auditors' responsibilities to the investing public be? What can auditors be expected to do? And, how do we close the expectation gap in a meaningful way?
We expect to issue a concept release in the early summer summarizing and analyzing the input we've received. That concept release may result in the first substantial changes to the reporting model in more than half a century. The release will explore various possibilities and seek specific feedback.
We are also engaged in efforts to hold auditors to the high standards necessary to protect investors. The financial crisis revealed weaknesses in auditor practices, and we are pursuing them.
Confidentiality and Process
Both our investigations and any contested disciplinary proceedings we bring are by law under Sarbanes-Oxley non-public unless the respondents consent to publication of our complaints and decisions. We have asked Congress to change this.
In the years since Sarbanes-Oxley passed, the PCAOB has built an active enforcement program, but unfortunately for investors, audit committees, and the audit profession itself, it takes place largely behind the scenes. For example, in the last 18 months, the Division has handled three disciplinary hearings against partners of large accounting firms for audit failures, in addition to a caseload of other litigated matters. If, after investigation, the Board determines to file a complaint, it will not be public. Nor will any decision by the Hearing Officer or the Board to impose a sanction, until any appeal to the SEC is exhausted.
The confidentiality of the enforcement process erodes public confidence in our oversight. Moreover, the public is denied any benefit from the deterrent effect that the filing of public complaints would have on other auditors. And other auditors and their counsel are denied the benefit of timely access to the Board's precedents.
Public proceedings are important for public trust. But they are by no means the salve for all of the risks to investor protection that were revealed in the financial crisis. The PCAOB has important initiatives underway relating to improving audits of fair value measurements, improving communications among affiliated firms in global networks engaged in multi-national audits as well as related global quality controls, and improving auditors' communications with audit committees. Our improvements in standards are not intended to be traps or trip-wires for auditors. We write standards so that expectations are clear.
We are also looking for ways to make our own oversight more effective and relevant. Our inspection process is a key early warning tool. I'm therefore troubled about reports that some auditors have downplayed the significance of our findings to their clients. Audit committees should be skeptical of auditors' efforts to do so.
Many aspects of inspection findings are by law confidential other than to the inspected firm. But we are looking for ways to improve audit committee awareness of the risk of accepting overly rosy characterizations of our reports, as well as to discourage firms from making them.
I am also concerned about possible disparities between firms' routine representations, in public responses to PCAOB inspection reports, that they have complied with applicable standards on addressing deficiencies and the inspection staff's view that that is frequently not the case. We intend to increase our scrutiny of firms' follow-up to correct deficiencies and will consider enforcement actions where appropriate.
III. Oversight of Multi-National Audits
I've touched on the global networks a couple of times today. While I don't think they are too big, let me talk about what does concern me.
My first concern is investor and public awareness. I have been surprised to encounter many savvy business people and senior policy makers who are unaware of the fact that an audit report that is signed by a large U.S. firm may be based, in large part, on the work of affiliated firms that are completely separate legal entities in other countries.
For many large, multi-national companies, a significant portion of the audit may be conducted abroad — even half of the total audit hours. In theory, when a networked firm signs the opinion, the audit is supposed to be seamless and of consistently high quality. In practice, that is often not the case.
This gets to my second concern. Based on our inspections, I can say the challenges of managing a multi-national audit are great. As our international inspections program matures, we have begun to evaluate the various pieces of the audit performed by different registered firms in multiple jurisdictions.
Our inspectors often see more than the principal auditor — or signing firm — does. In many cases principal auditors rely on high-level reports from subsidiary auditors. They often don't review the work papers of the other auditors. Our inspectors do. And they often find problems in that work.
Inspectors have found obvious errors that could have, and should have, been picked up by the principal auditor if communication between the two auditors had been more robust. Inspectors have found unresolved audit issues between affiliates.
One inspection team found a situation where the affiliate's audit team pervasively failed to perform audit procedures, unbeknownst to the principal auditor until we conducted our review. Once the problem came to light, the firm arranged for the team to be removed. But it fell to the PCAOB to find the problem.
In several cases, inspectors discovered that an affiliate had failed to appropriately audit revenue, even though the affiliate reported to the principal auditor that it had. There's more, but you get the picture.
We intend to enhance our scrutiny of how principal auditors react to deficiencies in the work they refer to other auditors. Findings like those I've described should drive auditors to improve their communications with the affiliates they use as well improve preventative global quality controls.
These findings demonstrate why it's so important that we look at the parts of the audit not performed by the principal auditor, whether the principal auditor was in the U.S. or elsewhere. This month, we are commencing joint inspections with U.K. and Swiss authorities. In addition to the work we perform to protect U.S. investors both here and in those jurisdictions, as appropriate we will share any relevant information we obtain on the U.S. portion of multi-national audits of importance to those authorities.
We are working diligently to reach similar arrangements with other European authorities. In addition, the PCAOB continues to be engaged in discussions with the Chinese authorities and hopes that — over the course of the next several months — significant progress will be made. This is especially important given the growth in the number and size of Chinese companies seeking access to capital in U.S. securities markets.
I believe Chinese authorities understand they have a real interest in solving our impasse. For those who argue that the big Chinese companies don't find the U.S. markets attractive, think again. The Chinese internet social networking giant, RenRen — sometimes referred to as the "Facebook of China" — went public earlier this week, raising in excess of $700 million in its IPO. It has an estimated market value of approximately $70 billion.
U.S. markets continue to be attractive for companies that have their major operations in China. It is critical that investors in these companies are afforded the investor protections that attach to U.S. markets. But as long as we are unable to inspect a registered firm's work, investors are deprived the benefits of our identifying or correcting audit problems like those I've described.
In the case of multi-national U.S. companies, investors may even mistakenly assume their interests have been protected by an audit inspection. This undermines a key component of our investor protection system.
Our markets are the strongest in the world. They provide for formation of capital, and ownership, by U.S. and non-U.S. companies and investors alike. I know my predecessors have pointed this out before, but let me reiterate: Investors are willing to pay a premium for shares purchased in U.S. markets and protected by strong securities regulation and enforcement. Foreign companies can even get a premium in their home market if they are also listed in the U.S.
The premium will only survive, though, if investors believe U.S. investor protections are actually enforced. The laws on the books, including oversight of auditors, won't continue to make a difference for non-U.S. companies if they don't comply.
* * *
As painful as the recent past has been for investors and financial markets, and as complicated and expensive as the future appears, we in the United States can take heart in this: When we acknowledge and focus on issues such as those raised by the recent financial crisis, our system of government and regulation is capable of making corrective — and appropriate — changes. I am pleased to be part of that system. Thank you.
 John C. Burton, Where Are the Angry Young C.P.A.'s?, N.Y. Times, April 13, 1980.
 European Commission Green Paper, Audit Policy: Lessons from the Crisis (Oct. 13, 2010), at 17.
 Financial Reporting Council, Response to Green Paper on Audit Policy: Lessons from the Crisis (Dec. 2010).
 Id. at ¶¶ 2.9, 2.12.
 U.K. House of Lords' Select Committee on Economic Affairs, Auditors: Market Concentration and Their Role, HL Paper 119-1 (Mar. 30, 2011).
 Id. at ¶ 143.
 See AU 390, "Consideration of Omitted Procedures After the Report Date," and AU 561, "Subsequent Discovery of Facts Existing at the Date of the Auditor's Report."
 It is worth noting that the EC's Green Paper on Audit Policy Group expressed the view that "Group auditors should have access to the reports and other documentation of all auditors reviewing sub-entities of the group. Group auditors should be involved in and have a clear overview of the complete audit process to be able to support and defend the group audit opinion." See Green Paper at 13.
 Indeed, some of these examples were in situations where the principal auditor was outside the U.S. but the subsidiary auditor was in the U.S.
 See Doidge, Karolyi, and Stulz, "Why do Countries Matter so Much for Corporate Governance?", Journal of Financial Economics (October 1, 2007); Hail and Leuz, "Cost of Capital Effects and Changes in Growth Expectations Around U.S. Cross-Listings", Journal of Financial Economics (2009). 93(3), at 428-454.