Update on PCAOB Efforts to Enhance Audit Quality

Date: Dec. 5, 2017
Speaker: Jeanette M. Franzel, Board Member
Event: AICPA Conference on SEC and PCAOB Developments
Location: Washington

It is a pleasure to present an update on PCAOB's efforts to improve audit quality at this 45^th annual conference on current SEC and PCAOB developments. The PCAOB remains steadfastly focused on protecting investors and advancing the auditing profession's service to the public through high quality, reliable audits.

Audit quality for the benefit of investors and the public interest is at the center of our mission. The PCAOB contributes directly to audit quality through its oversight functions, including registration and inspections, standard setting, and enforcement, and through the research and analysis activities that support these functions.

Today and tomorrow, the leaders of our oversight programs will provide an update on PCAOB's major programs. In just a few minutes, Marty Baumann, PCAOB Chief Auditor, will present an update on the significant developments and progress made in the area of audit standard setting. Tomorrow, Helen Munter, PCAOB Director of Registration and Inspections, will provide an update on inspection findings and related insights. And Claudius Modesti, PCAOB Director of Enforcement and Investigations, will present the latest trends and results from PCAOB's enforcement activities.

Today, I'll highlight some of the important activities currently underway at the PCAOB. I'll also discuss issues that could significantly impact auditing in the future.

But, before I go further, let me say that the views I express today are my personal views and do not necessarily reflect the views of the Board, any other Board member, or the staff of the PCAOB.

Integrity in Auditing and Financial Reporting

This year marked the 15^th anniversary of the passage of the Sarbanes-Oxley Act. It is important to step back and recognize the tremendous progress and positive change that has occurred in financial reporting, corporate governance, and auditing since the passage of the Act. The wave of financial reporting and auditing failures that led to the passage of the Act damaged confidence in the capital markets and negatively impacted the economy, communities, and families.

The establishment of the PCAOB dealt directly with the issue of audit oversight and audit quality. And I am confident in saying that audit quality has significantly improved since PCAOB opened its doors. Improved audit quality, along with improvements in auditor independence, corporate governance, internal controls, and financial reporting have resulted in a much stronger system aimed at protecting investors and the public interest.

Working as part of the oversight system that governs the flow of financial information across the capital markets, the PCAOB has helped to restore the trust that was lost over 15 years ago.

But we must not become complacent. We can be sure that financial reporting and auditing will come under stress again in the future, due to the rapidly changing business environments and other developments. In fact, the current level of economic, political, technological, and demographic change presents significant stress to the system. We must be vigilant and continually examine the activities of the profession and the regulatory regime to ensure that the core values of investor protection and safeguarding the public interest remain front and center.

Developments and Trends in Audit Quality

I am enthusiastic about PCAOB's current activities and accomplishments and our forward-looking focus on emerging risks and issues.

Overall, we've seen significant improvements in audit quality over the past few years. As Helen Munter will report tomorrow, the percentage of inspected audits with Part I deficiencies among the largest U.S. firms has declined over the past few years, along with the severity of the findings overall. We are, however, starting to see some of these firms "plateau" in terms of reducing the number of findings in Part I of their inspection reports. This plateau may call for a renewed focus on firms' quality assurance systems from the top down.

For the U.S. firms that are inspected triennially – the smaller firms – about half of those firms had no audit deficiencies reported in Part I of their inspection reports for the 2016 cycle.

Across the system, there are still firms that need significant improvement and others that are serious outliers. We've also found significant deficiencies and risks to audit quality across the global networks and in other cross-border audits.

The most frequently identified audit deficiencies continue to persist in similar areas across firms: assessing and responding to risks of material misstatement; auditing internal control over financial reporting; and auditing accounting estimates, including fair value measurements.

Audit firms generally have dedicated significant resources toward responding to PCAOB findings by remediating deficiencies and improving their quality control systems. To varying degrees across the large firms, we've seen improvements in tone at the top, coaching and support to audit teams, training, and monitoring of quality.

In addition to remediating known deficiencies and related quality control issues, firms need to focus on the preventive aspects of their quality control systems – building quality into the audit process in addition to using detective monitoring techniques.

Firms need to strengthen their focus on both systemic and engagement-specific elements, such as project management and monitoring, staff supervision, and tone throughout the organization, including at the audit team level. Simply put — firms need to dedicate additional resources to proactively ensure consistent audit quality and prevent audit deficiencies from occurring in the first place.

PCAOB continues to evolve its inspections approach. Inspectors regularly refine their risk-based approach to selecting engagements to address evolving risks, including firm-specific risks. And they have begun to use random selections and other statistical methods of projecting findings across a firm's audits.^[1] I expect that PCAOB's approach to inspections will continue to evolve, especially as firms continue to invest in their quality control systems.

The topic of firm quality control standards has gained renewed focus on PCAOB's standard-setting agenda as a research project.^[2] The staff is exploring whether there is a need for changes to PCAOB quality control standards — including improvements related to assignment and documentation of firm supervisory responsibilities — that would prompt firms to improve their quality control systems and more proactively identify and address emerging risks and deficiencies, thereby enhancing audit quality.

Another technique for tracking aspects of audit quality is the use of audit quality indicators (AQIs). I am happy to see significant advances in the development and use of AQIs since the Board issued its "Concept Release on Audit Quality Indicators" on July 1, 2015.^[3] The release discussed the content and possible uses of AQIs related to: (1) audit inputs, such as the characteristics of auditors and the resources applied to managing audit personnel; (2) audit process, including incentives, independence, and monitoring and remediation, and; (3) audit results, such as the quality of financial reporting, including the frequency of restatements and fraud, timely reporting of internal control weaknesses, trends in PCAOB and SEC enforcement proceedings and private litigation.

Firms and audit committees are experimenting with AQIs at the engagement and audit firm level. At the November 29-30 PCAOB Standing Advisory Group (SAG) meeting, we held a robust discussion on AQIs, including how they are being used by audit firms and audit committee members, along with related findings in the academic literature.^[4]

Many of the potential AQIs related to audit inputs and audit processes are relevant to promoting appropriate professional skepticism throughout all phases of the audit process, which is fundamental for high-quality auditing.

The topic of professional skepticism and its critical function in high-quality audits was also discussed at the SAG meeting last week.^[5] PCAOB oversight activities and firms' root cause analyses have identified the failure to exercise appropriate professional skepticism as a root cause of a variety of audit deficiencies.

These activities, as well as academic research, point to the importance of appropriate audit project management and staff supervision to promote the professional skepticism required under auditing standards. Appropriate application of professional skepticism is necessary for auditors' assessments of fraud risk and determinations about whether the financial statements are free of material misstatement. Interestingly, many of the potential AQIs dealing with staff inputs and processes are related to facilitating the exercise of professional skepticism throughout the audit.

Standard-Setting Process and Research Agenda

Over the past two years, the PCAOB has implemented changes to its standard-setting process after studying the strengths and weaknesses of the previous approach.

As Marty will discuss in more detail, we've made significant progress on advancing and completing projects that have been on PCAOB's standard-setting agenda for years. This progress has allowed for the implementation of an enhanced, multi-disciplinary approach that involves screening various sources of information to identify and understand current and emerging problems that may need to be solved.

The approach includes defined points in the process for seeking diverse perspectives outside the PCAOB and includes research and prioritizing of issues in order to determine whether an item should be placed on the standard-setting agenda. The PCAOB's engagement with other regulators and standard setters, particularly international and non-U.S. standard-setting bodies, also serves as a platform to collaborate and contribute to consistently stronger professional auditing standards around the globe.

The process includes a research agenda with projects where PCAOB is dedicating resources to determine whether further standard setting or other actions are needed. Our current research agenda is included in the Office of the Chief Auditor's quarterly Standard-Setting Update and includes the following research projects:

• quality control standards, including assignment and documentation of firm-level supervisory responsibilities
• changes in the use of data and technology in the conduct of audits
• the auditor's role regarding other information outside the financial statements and company performance measures, including non-GAAP measures
• the auditor's consideration of noncompliance with laws and regulations

At last week's SAG meeting, we discussed the results of the most recent screening process and the current status of the research agenda projects.^[6]

The Impact of Technology on the Accounting Profession

I'd like to briefly highlight one of the items on the research agenda that will affect audits — the use of technology in financial reporting and auditing. The profession has used analytical techniques and tools in auditing for many years, but the expansion of data collection and new technologies gives auditors a new range of data-driven analytic approaches that present opportunities and risks to the audit.

Certain technologies, such as robotics, artificial intelligence, and distributed ledger technologies, also known as blockchain or distributed database technology, have the potential to seriously disrupt financial reporting and auditing processes. These potentially disruptive changes will present challenges and threats, along with tremendous opportunity across the auditing profession.

The general question to be addressed by PCAOB's research project is whether there is a need for guidance, changes to PCAOB standards, or other regulatory actions in light of auditors' increased use of technology-based tools in the conduct of audits. Some areas of uncertainty have been identified where guidance may be needed to clarify how certain auditing standards apply when data analytics are used, including:

• basic terminology and definitions (e.g., what constitutes a data analytic audit procedure and what would be considered items of audit interest and "outliers" identified through data analytics);
• the nature and type of audit evidence produced by various analytic procedures and the extent of audit work and documentation needed when these procedures are applied;
• when and how certain data analytics tools should be considered risk assessment procedures, analytical procedures, substantive procedures, tests of controls, or some combination of these; and,
• how technology tools and data analytics should be integrated with the firm's system of audit quality control to provide assurance that audit teams are effectively using these tools to meet audit objectives and applying due care and professional skepticism.

PCAOB staff has been actively coordinating with other professional standard-setting bodies, investors, academics, and the firms on these issues. This is an area that is developing quickly, and I anticipate that we will provide another update at our SAG meeting in the spring of 2018.

Finally, the emergence and use of new technologies in the audit will require professional skepticism and critical thinking by auditors in new ways. These technology tools and approaches may also highlight the need for stronger skills in more subjective and qualitative areas, as auditors learn to work with data and technology in new ways.

As a profession that relies on professional judgment and adherence to standards and ethics, we need to remain focused on two key objectives. First, accounting education needs to advance to promote relevant critical thinking and analytical skills in addition to core accounting and auditing knowledge for the future entrants to the profession. Second, it is imperative that firms and continuing education providers deliver the necessary lifelong learning and continuing education opportunities for current professionals so that the profession continues to demonstrate the competencies that are critical to the functioning of the capital markets and investor protection.

PCAOB Near-Term Priorities

Of course, the evolving landscape of technological change presents only one area of opportunity and risk for the profession, albeit a significant one. I want to mention some near-term priorities articulated in PCAOB's recently updated 2017-2021 strategic plan that address other opportunities and risks affecting the profession. The plan contemplates goals, objectives, and strategies over the next five years, including the following near-term priorities:

• advancing PCAOB oversight programs to respond to significant emerging trends, risks, and opportunities that may impact the quality and independence of audits, focusing on factors, such as innovations in the use of data analytics, artificial intelligence, and other technology in the audit, and the resulting potential changes in audit firm business models and practices;
• acquiring the technical skills and making the investments in technology that will enable PCAOB to implement needed capabilities to keep pace with a rapidly changing environment;
• monitoring the implementation of new auditing standards, and monitoring the potential audit impact from new accounting standards;
• conducting post-implementation reviews of recently adopted standards and rulemakings;
• strengthening our research and analysis program area to develop integrated research and analysis functions that promote collaboration among disciplines, engagement with top academic scholars, and insights for PCAOB's programs; and,
• further advancing PCAOB's careful stewardship of resources by continuing to identify organization-wide opportunities to further automate, streamline, and improve processes to achieve savings and efficiencies in a manner that does not compromise the PCAOB's mission and is mindful of employee engagement.

Closing

In the past 15 years we have seen significant improvements in audit quality and the integrity of the information on which the capital markets depend. The PCAOB's oversight activities continue to drive further improvement. Much work, however, remains.

The PCAOB's focus on new and emerging trends and issues will contribute to a renewed focus on audit quality and trust in the accounting and financial reporting system. Our leaders remain dedicated and hard at work in overseeing the nuts and bolts of auditing, while evolving our programs and refining our workforce's capabilities to respond to these trends and issues.

The opportunity and risks across the system require coordinated and sustained effort. Clearly we are in a dynamic environment that could put pressures on audit quality if the various players in the financial reporting and auditing system do not appropriately deal with the related risks. I am optimistic that we can all move forward to address these challenges.