DATE: Feb. 28, 2013
SPEAKER(S): Jay D. Hanson, Board Member
EVENT: University of Alabama Culverhouse School of Accountancy Rising Audit Professionals
LOCATION: Tuscaloosa, AL
Thank you for the invitation to speak to you today. During the last two years as a Board member of the Public Company Accounting Oversight Board ("PCAOB"), I have had several opportunities to speak to groups of accounting students and educators, and while I hope that you will benefit in some way from our discussion today, I find that I always walk away from events like these having learned something new and having heard some interesting perspectives.
I would like to thank the faculty here for your work to educate the accountants and auditors of the future. There are many pressures on academics today. I understand that it is no easy task to balance your work to keep up with ever changing standards and practices, perform important research, deal with the practical realities of doing more with fewer resource — all while maintaining your focus on achieving and maintaining excellence as instructors.
I am really here, however, to talk to the students. You are entering a challenging profession. Our capital markets depend on reliable financial information for investors to consider when making decisions about what to do with their money. Your education here may be funded in part by your or your parents' investments, private scholarships or University grants. All of those sources, as well as your future retirement funds, utilize the capital markets to generate income and rely on investors' ability to take risks and earn reasonable returns. Reliable financial information about a company's performance is the cornerstone of this system and is critical to the evaluation of management's story or prediction about what the company's future may hold.
Many years ago, I had a professor refer to accounting as "the language of business." I was never very good at German or Spanish, but over more than 30 years in the accounting profession, I have become a native speaker in accounting and auditing. Your time here at Alabama will teach you the basics of this new language — you will understand the essential vocabulary and know how to structure a sentence. But your real "immersion" starts on your first day on the job as your enter your accounting career.
For our time this afternoon, however, I am going to try to stick to plain English to address three main topics. First, I will share some reflections on the PCAOB, audit regulation and investor protection. Second, I will talk about your careers, professionalism, professional skepticism and some of the challenges you will face as young auditors. And then I will wrap up with some comments about a few of our ongoing projects at the PCAOB and some of the challenges we face.
Before I go further, however, I must tell you 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.
Most of the students in this room were younger than 12 years old when the events giving rise to the creation of the PCAOB took place. I was in my 40's and remember them well. Companies like Enron, WorldCom, Tyco, Adelphia and Xerox were in the news almost daily. At one time, these companies were rising stars, much like Google, Apple or Facebook today. Unfortunately, the impressive financial results these companies reported, even after they were audited by a major firm, turned out to be erroneous and, in some cases, fraudulent. The need to reform aspects of management responsibility and accountability, as well as corporate governance was clear. The audit profession needed a wake-up call, and the era of self-regulation came to an end. The system of peer review — involving one audit firm reviewing the quality of the work of another firm — was not sufficiently rigorous, and Congress recognized that to protect the interests of investors, an independent regulator was needed to oversee audit work performed in connection with publicly held companies. The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") created the PCAOB. We began our operations in early 2003.
The activities of the PCAOB include registering firms that conduct public company audits, and, more recently, auditors of brokers and dealers (we need to know whom to regulate!); setting the rules and standards to govern the work of those auditors; inspecting their work to ensure that auditors are complying with the rules; and sanctioning auditors through our enforcement program when we see egregious auditor behavior. We have a staff of nearly 800 and a five member Board to guide their activities, all under the oversight of the U.S. Securities and Exchange Commission ("SEC").
As you can imagine, some members of the audit profession did not like the idea of an independent regulator. What professional wants to have someone review and potentially criticize their work? At the time, many auditors were doing everything they were supposed to do and believed they were paying for the actions of a few individuals who took shortcuts or closed their eyes to corporate malfeasance. Over time, however, many have come to accept and see the value in independent regulation and know that it's here to stay.
In that context, it is important to understand that the PCAOB is not purely an enforcement agency. It is not our sole goal to find and punish wrongdoing, although sometimes we have no choice, but to do so. Our mission is to protect investors and the public interest by promoting informative, accurate, and independent audit reports. We aim to improve audit quality, reduce the risks of auditing failures in the U.S. public securities market and promote public trust in both the financial reporting process and auditing profession. We do that in part by inspecting firms and discussing with them, at length, where we believe they did not fully comply with the applicable requirements. We point out weaknesses in their quality control policies, procedures and systems, and, pursuant to a specific provision in the Sarbanes-Oxley Act, we encourage them to provide us with evidence that they are making efforts to improve those systems. Then we use what we learn through these activities and through outreach to all of our stakeholders to inform our standard-setting activities. As a result, since we opened our doors nearly 10 years ago, we have seen substantial improvement in audit practices, and even auditors who initially resisted our oversight have told us that they believe the quality of audit work has improved.
Nevertheless, we also still have many critics. Some members of the audit profession continue to resent our existence and spend their time disputing our inspection findings, rather than learning from the process. As you start your career, no doubt you will hear stories and complaints from some in your organization that question much of what we do. And that's not necessarily a bad thing — we can all continue to learn and improve, and I am working every day to find the right balance between regulating the work of auditors and recognizing the good work that they do. But I urge you to remember that, ultimately, our mission — to protect investors — is aligned with what the audit profession's goal should be. PCAOB oversight is intended to help auditors improve to better achieve that goal.
We also hear from some investors that we are not being tough enough on the audit profession. Some criticisms go to the core of what auditors do and call into question whether the auditor's role should be expanded. Many investors want more transparency about an audit, ranging from the inclusion of each engagement partner's name in the audit report to a requirement that the firm draft a detailed report describing the auditor's work and findings. Thus, you are joining the audit profession at a period of great challenges, deep contemplation and potentially unprecedented change.
Many of you will start your careers with an audit firm like I did in 1979 when I joined what is now known as McGladrey LLP in Minnesota. I will spare you the stories I heard from my mentors at that time, about walking three miles to school in a foot of snow, in temperatures below zero degrees and uphill both ways. But I do want to contrast a few aspects of joining the audit profession today, compared to the experience I had 30 years ago.
When I became an auditor, I did not have a computer. Laptops had not been invented, and the Internet as we know it was still a dream. I was lucky to be issued an adding machine that plugged into the wall. All work papers were written by hand. I developed the early stages of carpal tunnel syndrome from using my adding machine to "foot" ledgers that were hundreds of pages long. Fax machines were not widely available. Mobile phones might have been invented, but it was more than 10 years later before I got one, and then it was installed in my car. Voice mail was many years off. When I took the CPA exam, it was with hundreds of others in a large auditorium, two and half solid days, and we had to take it all at once, without a calculator. Clearly, we have come a long way.
However, despite all of the tools and technology that you now have at your fingertips, your new job will be much tougher than mine was. Accounting complexity has never been greater than it is today. New accounting standards covering revenue, leases and financial instruments soon will affect every company's processes and cause fundamental changes in the numbers reported by many companies. Fair value measurements and management estimates are a common challenge in almost every area of the financial statements. Economic uncertainty raises questions about the viability of companies that just a short while ago were seen as leading powerhouses in their respective industries. Entirely new industries are evolving, while others are fading into the sunset. Investor expectations are higher than ever for the work of auditors, audit committees and regulators. As a result of the work of the PCAOB and other regulators, and due to investor demand, many audit firms are making fundamental changes to their audit practice and firm cultures.
One important cultural issue that we at the PCAOB have been increasingly focused on relates to a concept that most professional service organizations pay a lot of attention to: client service. As a new auditor joining a firm, you will hear a lot about this subject. In other industries, including retail, banking, food service, and many others, customer service is the key to success. Some common themes of good customer or client service include setting expectations, treating customers or clients with respect, being proactive and anticipating problems, being prepared, listening, communicating effectively, planning ahead, and minimizing surprises. All of these qualities are necessary for a good auditor, and they are appropriately fostered by audit firms in their employees.
However, there are some aspects of customer service that do not have a place in an auditor-client relationship. The adage that "the customer is always right" just doesn't work when the auditor's role is to render an independent opinion on the fairness of the financial statements. Activities to "help management achieve its goals" are not consistent with an objective, skeptical audit mindset. Treating the client as a "partner" is counter to the independence required of an auditor. Instructing staff not to upset management does not facilitate the robust, challenging discussions necessary in many audits.
I believe that many audit firms have heard this message loud and clear. We at the PCAOB know that firms have gone to great lengths to eliminate references to these and other problematic customer service-oriented objectives from their training materials and policies. Nevertheless, change takes time, and audit firms are profit-making businesses. Given the pressures arising out of that reality — combined with the long hours often worked by young auditors, who may struggle with new and complex questions one day and mind-numbing and repetitive tasks the next — it is easy to lose track of the fact that your real client is the investor looking to you for assurance about the accuracy and fairness of the company's financial statements. As you start your career as an auditor, I encourage you to think every day about the investor who is relying on you. When you face a difficult decision, ask yourself what the investor — who is planning to fund his retirement or his child's education with stock in your client's company — would expect you to do.
Another challenge for young auditors arises in situations where they have to deal directly and independently with a client's management or accounting staff. In some cases, you will face management with difficult or overbearing personalities. You may be faced with challenging the work or opinion of someone who is your parents' age or someone whose experience and skillset far exceed yours. At times, a difficult interaction may just be a symptom of long working hours and short nights. However, it also may be a symptom of a larger problem.
Just recently, Professor Bradley Bennett, now at the University of Massachusetts, and Alabama's own Professor Richard Hatfield published an academic study titled "The Effect of the Social Mismatch between Staff Auditors and Client Management on the Collection of Audit Evidence." The study suggests that younger auditors are often "mismatched" with the client personnel with whom they interact, with respect to their age, experience and knowledge. As a result of this mismatch, the study suggests, auditors may collect less audit evidence in order to avoid interactions with client personnel. Having been in this position myself, I could relate to many of the situations the authors described in the study, and I recommend that you take a look at it, if you have not done so already.
A good mentor can help guide you through the best ways to handle tough situations. One of my best mentors lived by the motto that while the client might not always like what he had to say, they were going to hear it because he was not paid to agree with them. From my experience with him, he never had a problem getting a client to agree to an adjustment or proposed disclosure. He approached difficult situations directly, proactively and confidently. It helped that he was also very proficient in the necessary accounting and auditing skills, so when you know you will have a difficult discussion with a client, prepare yourself by studying relevant literature and go armed understanding both the facts and the requirements.
Another challenge you will face early in your careers will be long days of doing tasks that may appear mundane, repetitive, and just plain boring. A task that many auditors dread is testing journal entries. PCAOB inspectors have inspection findings at many firms that the journal entry testing was not done at all or not done thoroughly, despite its importance in the auditor's overall response to fraud risk factors. Again, remember how important these basic tasks are to protecting investors and that it is this type of diligent work that very well may turn up things that just don't add up.
A lot of what I have just said is probably not unfamiliar to you, although it bears emphasizing. But one critical skill that many accountants do not consider as important, and one that they struggle with, is written communication. If you are a double major in Accounting and English, you can probably tune me out for the next minute. But I suspect that many of you are accounting majors at least in part because you concluded as a freshman that you were more comfortable with numbers than with your English, writing or literature classes. The ability to write clearly and concisely, however, is a critical skill for an accountant or auditor. A large part of the job of an auditor is about documenting your work and conclusions. PCAOB Auditing Standard No. 3 requires that audit documentation be "prepared in sufficient detail to provide a clear understanding of its purpose, source, and the conclusions reached." The young audit staffer's description must be sufficiently clear and detailed to allow the senior to obtain that clear understanding the next week, the manager soon thereafter, and ultimately the partner and potentially, the engagement quality control reviewer. Months later, PCAOB staff may inspect audit engagements on which you worked, and if you have not clearly documented your work, our inspectors will not know what you did.
More broadly, whatever your future career goals may be — controller or chief financial officer of a company, corporate board member, venture capitalist, regulator, standard setter or pretty much anything else — communicating concisely and effectively is a prerequisite to success in all of them.
Having perhaps frightened you with all of the new challenges facing you in your new profession, let me talk a little bit about the challenges that we at the PCAOB are currently facing.
The Board is recognizing its 10th anniversary this year. Having been in existence for a full decade, there are a number of operational areas that merit re-evaluation and potentially some process changes.
A theme that underlies our approach to this exercise is acknowledging and appreciating the hard work and creativity of our staff and founding Board members in starting the organization from the ground up and establishing necessary processes for the first time. Yet, we recognize the need to step back and holistically assess the current environment and needs for the future. I frequently ask myself and others at the PCAOB how existing processes are working for us and whether we are satisfied with the results. In many areas, we can answer positively. Where we cannot, we need to step back and ask what we should do differently.
Our inspection reports and remediation determinations are often subject to criticism because they are released many months or even years after the relevant inspections. Members of the profession, audit committees, investors, and others also have questioned whether inspection reports provide the right information, or the right level of detail. Some have asked for more transparency in how we select our standard setting projects. We are also increasingly asked — now that we have been doing inspections for nearly a decade — about conclusions and trends that can be observed based on the inspections and other data that we have collected, and about how we, investors, or others can judge whether audit quality has improved.
In light of these concerns and others, the Board recently identified a series of six near-term priorities on which we intend to focus and we will hopefully substantially implement beginning in 2013. These include improving our inspection reports, remediation processes, data analysis, and standard-setting framework, as well as increasing interaction with audit committees and initiating a project to determine and report on audit quality measures.
Another very important — and arguably much more difficult — task that we are currently tackling is the consideration of economic analysis in our standard setting and rules. With the current focus in Washington on reducing the federal deficit and a renewed push by many for thoughtful consideration of the costs, benefits and consequences of new and existing rules and regulations, our attention to economic analysis is critical. Questions are being raised about what we are doing in this area in general. One specific subset of the broader issue relates to assisting the SEC in complying with the requirements imposed by last year's Jumpstart our Business Startups Act, or "JOBS Act." That law states that no PCAOB rule shall apply to the audit of an emerging growth company — meaning certain newly public companies with revenues under a certain threshold — unless the SEC "determines that the application of such additional requirements is necessary or appropriate in the public interest, after considering the protection of investors and whether the action will promote efficiency, competition, and capital formation."
In light of these developments, it is critical that we develop a solid framework for robust economic analysis of our rules and standards. Like the SEC, we should establish written guidance to explain how we will approach economic analysis. Most importantly, we should build economic analysis into the core of how we approach rulemaking and other aspects of our operations.
In addition to these organizational challenges, we are also in the process of tackling some challenging standard-setting projects that have the potential to significantly change audit practice in this country.
One of our projects that has received much attention is our August 2011 concept release on auditor independence, objectivity and professional skepticism. As described in that concept release, and as I alluded to a few minutes ago, auditors at times do not exercise sufficient skepticism in dealing with their clients. One contributing factor may be that auditors are paid by the company whose financial statements are being audited; others may include time pressure, fee pressure and personal relationships with client staff that develop over time.
In 2011, the Board sought public comment on possible approaches to increasing auditor independence, skepticism and objectivity, including mandatory audit firm rotation. In the 18 months since we issued the concept release, we have received substantial feedback: more than 600 comment letters were submitted, and 97 panelists provided their views at three public roundtables held around the country to discuss this important issue. The comments and recommendations were substantive and thoughtful. Many commenters suggested insightful ways to help audit committees perform better in their auditor oversight role. Others suggested approaches to consider in our inspection and enforcement processes or other alternatives to mandatory rotation.
Having reviewed the comment letters and feedback from the round table panelists and others, it is clear to me that there is little support for mandatory audit firm rotation. As I noted in my statement when we issued the concept release, our inspection findings over the years have yielded a substantial amount of data. To date, I have not seen an analysis of this data that establishes a causal link between an audit failure and the audit firm tenure. I do not see how the Board could move forward on mandatory rotation without that causal link. I also believe mandatory rotation would be extraordinarily difficult to justify through an economic analysis of its costs and benefits.
Nevertheless, we do know that auditors at times are not sufficiently objective or skeptical and, as a result, do not question management enough, do not collect sufficient audit evidence, and do not rigorously evaluate contrary evidence. In my view, our focus at this point should be on understanding better the underlying causes for this behavior. We need to better understand which of our inspection findings are related to complex areas that everyone struggles to get right, and which were mistakes in basic "blocking and tackling" that no auditor should make. We need to understand which findings likely were caused, at least in part, by a lack of objectivity or professional skepticism. With a greater understanding of the underlying causes, we will be in a better position to evaluate some of the many alternative suggestions for improvement that have been suggested in response to our concept release.
Also in 2011, the Board issued a concept release to discuss alternatives for changing the auditor's reporting model — a second project that may significantly affect audit practice. The concept release presented several possible alternatives for changing the auditor's reporting model and requested comment on these or other alternatives that could provide investors with more transparency in the audit process and more insight into the company's financial statements or other information outside the financial statements.
The Board has received more than 150 comment letters regarding this project. We also held a roundtable discussion on this topic in September 2011, and we have heard strong viewpoints for and against the potential changes discussed in the release. Some believe information about the company should come from management, and the auditor should only attest to the accuracy of the information. Some investors say they want to hear more from the auditor directly. Others question whether the benefits of increasing the information contained in the auditor's report justify its costs.
Determining what changes, if any, to make to the auditor's report will involve some difficult issues. We need to keep in mind the role of management in crafting financial disclosures. To the extent management can provide disclosures that are comprehensive, yet clear and easily understood, there may be less that auditors need to say. Yet, the message from investors appears to be that enhanced management disclosures alone will not suffice. Investors believe that auditors gain important insight into the companies they audit, which combined with their independent perspective, makes them uniquely qualified to provide additional color around management's accounting policies and practices, financial statement disclosures, and the audit itself. The writing skills I mentioned a few minutes ago will be very important to achieving the goals of this project.
The International Auditing and Assurance Standards Board, which sets audit standards adopted by many countries around the world, also is exploring this area, and our staff is working closely with the IAASB staff so we can learn from each other.
In closing, let me thank you again for your attention and for inviting me here today to speak. I look forward to answering your questions and hearing your feedback.
 See PCAOB Mission at http://pcaobus.org/About/History/Pages/default.aspx; see also Sarbanes-Oxley Act § 101(a), 15 U.S.C. §7211 (2002).
 See PCAOB Vision at http://pcaobus.org/About/History/Pages/default.aspx.
 G. Bradley Bennett and Richard C. Hatfield, The Effect of the Social Mismatch between Staff Auditors and Client Management on the Collection of Audit Evidence, The Accounting Review, Vol. 88, No. 1, pp. 31-50 (January 2013).
 See paragraph 4 of Auditing Standard No. 3, Audit Documentation.
 Jumpstart our Business Startups Act §104 (Public Law 112-106) (2012).