Date: Dec. 8, 2014
Speaker: James R. Doty, Chairman
Event: AICPA Conference on Current SEC and PCAOB Developments
Location: Washington, DC
Thank you for inviting me to this auspicious conference, now in its 42nd year. As all the other PCAOB speakers over the course of the next three days will say, let me begin by saying that the views I express are my own and should not be attributed to the PCAOB as a whole or any other members or staff.
Over last 12 years, the PCAOB has built a robust and insightful auditor oversight program to promote high-quality, independent audits. As a statutorily established institution, we have an overriding responsibility to serve the investing public by setting auditing and related professional practice standards, inspecting individual audits and firms' quality control systems against those standards, and, when necessary, disciplining auditors and firms that fail to comply with them.
We use these programs to focus auditors on their role as the gatekeeper protecting investors, not just in an initial public offering, when the gates are also manned by underwriters, due diligence counsel and many others, but also in the quarters and years following.
This is about human nature. Managers have a natural incentive to present a favorable picture of their stewardship and success. In many cases, they are under tremendous pressure to do so, or they may hope to reap tremendous gain if they can.
The company hires the auditor to provide investors assurance that the presentation is true. There are obvious incentives for the auditor to back the company's story, but if the market doesn't find the auditor's opinion credible, it won't ascribe value to the opinion.
There are rippling effects when the market loses confidence in the audit. In the particular cases where it appears an auditor missed or acquiesced in misleading assertions, both management and the auditor can be embroiled in the distractions of legal process. The auditor can lose other clients, or be forced to accept lower fees to keep them.
At the company, careers are lost, reputations tarnished.
Not only is there a shake-up at the reporting company, but the business lines, management and employees of the company's competitors can be affected as well. Indeed, multiple industries can be affected when a business model previously thought to be successful turns out to have been a charade.
The PCAOB's job is to maintain a rigorous auditor oversight program to reduce the risk of such events. We continue to take a hard look at how we serve the capital markets for the investing public.
It has been a busy year at the PCAOB. We have pressed forward on many near- and long-term initiatives.
We are doing more in the way of outreach, especially to audit committees, with a view to help raise awareness of audit risks and challenges. We have issued audit practice alerts in critical areas of concern related to controls, revenue recognition and the going concern assumption.
We have adopted a new standard on auditing related party and significant, unusual transactions.
We have also issued new staff guidance for auditors of SEC-registered brokers and dealers, in light of the SEC's new Rule 17a-5 on broker-dealer compliance filings and the PCAOB's related new attestation standards. The staff guidance reflects insights from our inspection program, about which we issued our third public report in August of this year.
We have held hearings to seek public comment on challenges in auditing fair value and other management estimates and potential improvements to the auditor's reporting model.
We've also held public meetings with our advisory groups on these and other topics, including audit quality indicators and fraud.
We have also sought comment on an overall reorganization of our standards in order to make them more accessible to auditors and others who use them.
Through the end of November, we have this year conducted 209 inspections of firms that audit issuers or play a substantial role in an audit of a U.S. public company, including examinations of portions of 218 engagements across the largest four domestic firms, as well as portions of 493 engagements by 153 other U.S. registered public accounting firms and 52 non-U.S. registered firms. In addition, we have inspected 60 firms that audit brokers and dealers, including examinations of portions of 97 audits of brokers and dealers.
In most cases, when we find a problem we can work with the firm to correct it, whether it is specific to an engagement or a more pervasive quality control problem.
Where appropriate, though, we have commenced deeper investigations and disciplinary proceedings. For example, in July we barred the engagement partner for a $1.2 billion medical company for ignoring signs that certain sales revenue was not realized, realizable or collectible.
Our investigation found that the engagement partner had accepted management representations without applying the necessary auditing procedures, evaluating contradictory audit evidence, obtaining sufficient competent audit evidence, or exercising the requisite due care and professional skepticism. In that case, the company experienced a 40 percent drop in its stock value when the revenue misstatement was revealed.
That case involved a partner from a large firm, but we have also brought and settled proceedings against auditors at smaller firms. When necessary, of course we need to take action to protect investors from bad practices. But we have also tried to help auditors at smaller firms keep up on requirements, trends and risks by maintaining daylong small business forums around the country throughout the year. We've held 11 such meetings this year.
The heads of several of the PCAOB's divisions and offices will speak in detail about this work over the course of the next three days. You'll also hear from my colleague on the Board, Jay Hanson.
I will use my time today to talk about what I see as strategic opportunities and challenges for the profession, building on the audit's role in the financial markets. Second, I will speak to how I see the PCAOB's work as supporting a vibrant profession that can continue to meet society's expanding needs.
I believe the profession has a bright future. Society's needs for assurance are expanding. At the same time, the profession faces both old and new challenges that will have to be dealt with to achieve that bright future.
Public trust in an auditor's ability to examine an assertion critically, with skepticism, based on both independence and subject matter expertise, gives the profession an edge on all competitors. The audit is the linchpin of the financial markets, the foundation of the assurance field.
I continue to believe this notwithstanding the crises in confidence we experienced at the turn of this century. Those financial reporting scandals led the Congress to pass the Sarbanes-Oxley Act by an overwhelming majority of 423-3 in the House and 99-0 in the Senate.
The scandals were not limited to bad apples at Enron and WorldCom. They involved senior-management frauds at numerous companies, scores of audit failures, and many restatements by companies of all sizes.
The economic crisis that emerged in 2008 further damaged public confidence. There were many facets to that crisis, some remaining. It appears a major cause was a pervasive, cultural failure of risk management, beyond the purview of audit. But the fact remains that the crisis resulted in extensive questioning of the audit's relevance: if such a crisis can happen without the profession sounding an alarm, why require the audit?
Public skepticism about the reliability of the audit and the auditor's fealty to the public could have scuttled the profession's future. Congress could have approached the audit the way it approached the public's lack of confidence in credit ratings; that is, by removing regulatory requirements tied to ratings.
Instead, Congress confirmed its commitment to the audit.
There are signs that S-Ox is working. There are indications that fewer companies may be at risk of scandalous financial reporting failures. For example the low level of restatements today could suggest that the hard work on financial controls by both corporate accounting departments and auditors over the last several years is paying off.
But, it will be asked, why attribute this success to S-Ox? As opposed to just better skills by auditors and fewer frauds by management? If auditors are better today, why do we still need S-Ox and, most pointedly, the PCAOB?
To that, permit me this reply:
By many (if not most) accounts, there has been a cultural change in the boardroom. This has gone forward with changes in practice by management wrought by Sarbanes-Oxley and the regime it instituted, including PCAOB oversight.
Corporate culture is better for S-Ox: the Act has for corporate boards, audit committees and the audit profession opened windows on a better future. It remains for the profession to meet some challenges in order to realize the potential benefits.
There is an ever-present danger that we start taking the calm for granted. There will be temptations to coast, temptations to scale back on doing what good audit requires. There are temptations to settle for short-term remission, to draw back from the short-term costs of changes that would be necessary to promote longer-term strength in the system.
It is easy to focus on the burdens of being bonded to a rigorous, high quality system. For our part, the PCAOB spends considerable time and effort considering these burdens, and how to minimize associated costs.
But the cost of losing public confidence is orders-of-magnitude greater.
Loss of confidence is a long-term cost that cannot be managed but must be avoided lest it be endured.
In the decade since the Enron and Worldcom scandals, audit fees in the U.S. initially spiked but have since leveled. Audit practices have shrunk in comparison to audit firms' other client services. If present trends continue, within ten years, audits may yield less than 20 percent of the revenue of the global, networked accounting firms.
There well could have been new demand for audit services in the last several years, had public confidence in audits been greater. But to date it has not materialized. Why has there not been greater demand for auditor assurance on sustainability reporting?
Why is there not greater demand for auditor assurance on XBRL data? And when will auditors offer assurance on non-GAAP metrics adduced by management as their key performance indicators?
This is the challenge for an audit profession pursuing enhanced relevance: to generate the public's "demand pull" for such additional assurance, in the absence of any perceived governmental impulse to push these issues.
The public wants assurance that environmental, safety, social and consumer standards are adhered to. State and local governments want assurance that infrastructure projects are free of corruption and on budget.
But capturing that demand requires attending to the public's desire for confidence that the audit function is the watchdog the public expects it to be.
The public needs to hear auditors bark when there's a problem.
Both the audit profession and audit clients stand to benefit from expanded public commitment to long-term capital formation.
An array of consulting firms have emerged to develop standards in new fields to establish public trust by providing various forms of assurance as to compliance with those standards.
I do believe the audit profession is poised for a bright future that meets public demand for a basis to trust all kinds of reporting. A trusted audit profession can give investors the confidence to look beyond short-term measures to invest patient capital in new businesses we can't even imagine today but that will make our society better.
The difference between consultants and auditors is not expertise but independence. The profession must demonstrate to the public that an auditor's opinion is indeed more reliable than a consultant's.
The PCAOB is acutely focused on helping the profession build public confidence in the audit. Our work is fact-based, founded on what we learn in our oversight and in our outreach.
What that work has taught us is that effective audit oversight is not simply a matter of mandating procedures. For the most part, our body of standards is already impressive. Many are principles-based and timeless — principles relating to independence, skepticism, due care.
When our inspectors find deficiencies in inspections, they are tied to non-compliance with existing standards.
To my mind, we should be alert to opportunities to improve performance but thoughtful in crafting specific performance requirements that would apply to all audits. And we should be reluctant to set uniform procedural requirements that could be performed in an unthinking, mechanistic, and wasteful way.
We've got to enhance the relevance and reliability of the audit, and that takes auditors fiercely committed to investor protection.
We need auditors who know and devise for themselves the procedures that are necessary to expose material misstatements and omissions.
The felt need to specify, with increasing exactitude, how to obtain a high level of assurance belies a misalignment of incentives. It is that misalignment we need to address. Through our initiatives we are trying to do so.
Let me start with economics. Economic considerations underlie the audit, but we need to know more about the levers that move auditor incentives.
Economics provides us a framework for critical thinking. It prompts us to consider alternatives, to maximize the efficiency of our actions.
We have been considering economic impacts, including costs and benefits, for some time. But to advance this work further, in May this year the PCAOB released staff guidance on the use of economic analysis in PCAOB standard setting.
The guidance builds on the PCAOB's existing rulemaking process by establishing an analytical framework for staff to evaluate the economic implications of standard-setting projects that are presented for Board consideration. It is a thoughtful process — dependent on facts, iterative analysis and debate — both deliberate and deliberative.
We have also embarked on a much broader initiative to enhance the use of economic analysis throughout our programs by forming a Center for Economic Analysis. Through the Center, I hope to enlist top economic thinkers for economic research on the role of auditing in capital markets and capital formation to inform our work.
The Center is also working on several internal projects to help our programs use economic analysis and other empirical tools. They include developing a post-implementation review program to evaluate the effectiveness of new auditing and professional practice standards in promoting reliable audits.
Marty Baumann, our Chief Auditor, will speak to our standard-setting agenda and our use of economic analysis in progressing that agenda tomorrow.
Let me just say now that, as Chief Accountant Jim Schnurr said earlier this morning, we are looking closely at our standard-setting process to make sure it is as efficient and effective as possible. We want to make sure we have the full range of skillsets and data for the work we need to do.
We have been reviewing our processes, especially in light of our goal to understand and analyze the economic impact of any potential rulemaking. This past summer's staff consultation paper on auditing estimates and fair value measures is an example of a new tool identified by this review.
The staff paper was a vehicle to gain substantial input before the Board considered any potential rulemaking. We have received dozens of comment letters on the consultation paper, valuable input for deciding how to move ahead. The staff paper also enabled a special meeting of our advisory group, with noted experts presenting, to further explore the pros and cons of rulemaking in this critical area of audits.
We will further expand the review of our processes in the upcoming year to identify efficiencies in the rulemaking process from staff level deliberation and drafting to Board level review and decision-making.
Re-evaluating our processes, like any good organization does, is a constructive effort. We should issue new rules only after thoughtful assessment of the need to improve audit quality and evaluating the economic impact of any rule-making. But once we decide that any such improvement is appropriate, we want the organization, from staff to Board, to be nimble in our execution.
Staff consultation papers are a new tool that promises to help us be more nimble in obtaining public input more often. But the idea of seeking public input before asking the Board to issue a concrete proposal is not new.
We sought public advice and insights to gather information from investors, auditors, preparers and others before embarking on our project on the auditor's reporting model. We've also continued to use that input to monitor investor, auditor and preparer experience in implementing requirements for new, more discursive audit reports in several other jurisdictions, most recently in April, where we heard remarkable testimony from U.K. auditors, among others, about the renewed sense of relevance both investors and auditors feel about the auditor's work with the new reports.
We've also sought extensive public comment already on audit quality indicators, which will inform a concept release I will ask the Board to consider.
And we expect shortly to issue a narrow solicitation to receive comment on a refinement of our proposal to require identification of the name of the engagement partner and other firms that participate in an audit.
All three of these projects — the auditor's reporting model, audit quality indicators, and audit transparency — are intended to be long-term projects. And they have each benefited from extensive public vetting.
The oldest of them — audit transparency — originally started with investor calls for engagement partners to sign their audit reports in their own names, as is customary in many jurisdictions.
Recent studies in Sweden, the U.K. and Chinese Taipei, where partners routinely sign their firms' audit reports, show that disclosure of the engagement partner's name makes a difference to the investing public and the markets.
Nevertheless, it has not been the custom here, and many auditors have expressed concerns about unintended consequences attending personal signature, including liability risks.
The Board's concept release to consider engagement partner signature predated my tenure. But the comment received helped us consider and develop alternatives, for example whether simple disclosure — without signing — could give the market valuable information without increasing litigation risk.
So that is what we proposed, first in 2011 and then again, to seek more comment on costs, in 2013.
Even as compromised, the proposal is supported by many investors. But some auditors are still concerned that mere disclosure of a name in the audit report could still, without relief, increase exposure to litigation. For the most part, they do, however, accept investors' desire for the disclosure. So they've suggested requiring the disclosure in a form as compared to the audit report. To my mind, there are solutions here that should work.
I'd like to offer such an option, and seek comment on some technical points. But I hope to move toward a final standard soon.
I want to close on one more important initiative — our work to support audit committee oversight of individual audits. Forty years ago, my mentor and friend, the former SEC chairman Rod Hills, commenced a long and successful campaign to establish independent audit committees on public company boards of directors to oversee the company's financial reporting.
The Sarbanes-Oxley Act provided audit committees enhanced authority to play a critical role in hiring, firing, compensating and championing the auditor. Next to establishing the PCAOB, this new, express authority may be the most significant of the Sarbanes-Oxley reforms.
As Rod once said —
You can't possibly understand the fear. If you are the audit partner in charge of a large account, you need to keep that account. And if you're not protected by the outside audit committee on that board, you will yield on the margin to something management wants you to do that, in your heart, you think you shouldn't do.
To help audit committees champion the audit, the PCAOB aims to better equip them with information about the audit, our inspection reports, and the auditor's strengths and weaknesses. We have issued several reports to raise audit committee awareness of audit trends and risks. Audit committees may in the future also obtain objective and comparative audit quality indicators.
* * *
Rod's death in late October was a great loss to American capital markets. Even days before, he was still writing and fighting the corrupting influence of misaligned market incentives. Having been involved in cleaning up nearly a score of corporate reporting disasters over the course of his long career, he knew acutely of the fragility of investor confidence, and the vulnerability of the audit in the face of client pressures.
These influences don't just weaken one audit. They weaken investor trust in all audits. The PCAOB initiatives I've described, and those you'll hear about later in the conference, are intended to help align auditors with investor needs. But it's going to take commitment from auditors and their clients as well.
 See Sati Bandyopadhyay, et al., Consequences of Auditor Reputation Loss: Market Reaction, Audit Fees, Auditor Change and Audit Quality in the Case of Satyam Ltd. and PriceWaterhouseCoopers India (Working Paper 2014).
[ii] See Gil Sadka, The Economic Consequences of Accounting Fraud in Product Markets, 8 Am. L. & Econ. Rev. 439, 441 (2006).
 There have been situations where inspectors found conduct that they believed impeded audit quality but could not be tied to a standard. But those situations are rare, such as the effect on auditors' independence when they've become involved in marketing aggressive tax shelters, which we've since prohibited, or poor quality concurring partner reviews, which are now required to be more rigorous.
 See W. Robert Knechel, et al., Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions 7 (Working Paper 2013) available at https://www.caaa.ca/_files/file.php?fileid=filerSDAxJgThx&filename=file_Knechel__Vanstraelen__Zerni__Does_the_Identity_of_Engagement_Partners_Matter.pdf; Daniel Aobdia, et al, Capital Market Consequences of Audit Partner Quality 30 (Working Paper 2014) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2321333; Joseph V. Carcello & Chan Li, Costs and Benefits of Requiring an Engagement Partner Signature: Recent Experience in the United Kingdom, 88 (5) The Acct. Rev. 1511, 1542 (2013).
Knechel et al. found "considerable evidence that similar audit reporting failures persist for individual partners over time" and that in Sweden, where engagement partner's names are disclosed, "the market recognizes and prices differences in audit reporting style among engagement partners." Knechel, et al., supra, at 5, 38. Although much of this analysis was conducted using data on private companies, many of the results continued to hold when the authors separately analyze public companies.
Aobdia, et al., used data from Taiwan and also found that both debt and equity markets react to the performance characteristics of engagement partners. Aobdia, et al., acknowledge that their use of estimates of abnormal accruals as a proxy for engagement partner performance is subject to measurement error. They continue to find evidence that engagement partner histories matter to capital markets when they use regulatory sanctions history as an alternative measure of audit quality. Aobdia, et al., supra, at 5, 29.
Carcello and Li examined the impact of the E.U.'s audit engagement partner signature requirement on audits in the U.K., and found improvements in several financial indicators of audit quality, as well as an increase in audit fees. It is worth highlighting that this study evaluated a policy alternative (signature requirement) that may have a more pronounced effect on accountability than the disclosure requirement being reproposed since the engagement partner's signature goes one step beyond just disclosing the partner's name. Carcello and Li, supra, at 1542-43.
The PCAOB's release accompanying the reproposal includes a detailed discussion of the existing research. It is available at http://pcaobus.org/Rules/Rulemaking/Pages/Docket029.aspx.
 See Bigger than Enron (PBS Frontline broadcast June 20, 2002), transcript available at http://www.pbs.org/wgbh/pages/frontline/shows/regulation/etc/script.html.