Auditing: Perspectives on its Role, Relevance and Reliability
Good morning and thank you for that kind introduction.
I am delighted to be a part of this conference. University of South Florida has a remarkable history of rapid growth and extraordinary success. This conference has become an annual highlight in Tampa for sharing ideas and information about accounting, finance and our capital markets, and I am honored to be part of it.
Today I am going to talk about auditing — and its relevance and reliability in the 21st century.
I must say at the start that my remarks are my own and do not necessarily represent the views of the PCAOB, its Board members, or its staff.
Auditing Plays a Vital Role in our Capital Markets
I'll start off with a simple but true, and very important, statement. High quality financial reporting is essential to the effective and efficient functioning of our capital markets. So, everyone here who plays a role in the financial reporting supply chain — academics, preparers, auditors, and audit committees — you contribute greatly to the success of our economy.
Academic research has shown that high quality financial reporting can reduce the information asymmetry between management and investors, resulting in a reduction in the cost of capital.
Research also shows that US markets have relatively lower cost of capital because of our sophisticated financial reporting regime, overseen by high quality regulation and strong enforcement.
Key to the market is the role played by audit. The audit has a deep history, from its early roots in Italy to the Dutch West Indies Trading Company in The Netherlands, of giving confidence to investors, the Principals, who must rely on management, their Agents, for an accurate accounting of their investment and returns.
Audit has long, therefore, played a vital role in the efficient allocation of capital.
Most auditors are truly dedicated professionals who care greatly about their role and responsibilities. I know this first hand. I saw it for 33 years at PwC (and hopefully I exhibited it); I saw it as a CFO of Freddie Mac where I experienced it; and now I've seen it while at the PCAOB — as I've worked with the audit profession for 8 years, including 5 years as Chief Auditor, responsible for establishing and interpreting auditing standards. I can say, with some degree of confidence — I know auditors and I know auditing, and I have the highest respect for both!
Still, auditing seems to be regularly under the microscope. On the one hand, that reflects the importance of the audit to the capital markets. It deserves attention!
On the other hand, that attention reflects uncertainty about what is actually done in an audit, the limited usefulness of the audit report's binary "pass/fail" opinion, concern about audits when headlines tell of surprises in financial reporting, and the rash of adverse inspection findings by audit regulators.
Just recently, at the beginning of April, audit regulators from some 50 countries, all members of IFIAR, the International Forum of Independent Audit Regulators met in Washington DC to address auditing, audit quality, and audit regulation. Maybe you thought the US was unique with its Public Company Accounting Oversight Board. It's not. Audit self-regulation is dead and independent audit regulation and oversight, around the globe, is alive and well.
In a press briefing after the meeting, IFIAR's Chair, Lewis Ferguson, said "the high rate and severity of inspection deficiencies in critical aspects of the audit, and at some of the world's largest and systemically important financial institutions, is a wake-up call to firms and regulators alike." And, in addressing the growth of audit firm consulting practices around the world, IFIAR Vice-Chair, Janine van Diggelen of the Netherlands, noted that "…it raises serious concerns about the different level of profitability, different rates of growth, and to what extent audit quality suffers."
So a variety of audit reforms, which I will address shortly, are in various stages around the world to ensure that audits continue to fulfill their critical role in the capital markets. But audit reform isn't unique to today. Because of the audit's importance, and events that periodically raise questions about its quality, audit reform seems to be on a continuum — ever trying to protect the interests of investors from conditions that might otherwise reduce confidence in audits.
Audit Reforms Over the Years
Every decade or so, issues about auditing have become the subject of national attention. Certainly, auditing is not alone in getting such attention. Banking gets much more attention and others, like the auto, energy and health care sectors, get their fair share as well. Auditing is critically important to the capital markets, so when issues arise, many people get interested. So, before I touch on today's reforms, let's explore some past examples where the audit profession came under the microscope, and how those instances resulted in changes affecting the audit profession.
I won't dwell on what went wrong, or what was perceived to be wrong, in these various examples. But I will say in each case, important reforms were considered. In some cases, such as the Sarbanes-Oxley Act, reforms were adopted; in other cases, reforms were considered, but little was done. Let me give you some highlights.
The Cohen Commission, led by a former SEC Chairman, addressed the quality of audits back in 1974. In the wake of the massive computer fraud underlying the collapse of insurer Equity Funding and creative accounting in the National Student Marketing case, questions of "Where were the auditors?" were loudly voiced. According to noted academics, Previts and Merino, the tone of the Cohen Commission's report was "sobering." The report suggested auditors should address the process by which auditing standards were set and improve their internal practices and auditor training. The Cohen Commission also recommended changes to the standard auditors report. (By the way, you'll hear a lot more about that in a few moments.)
From 1985 to 1988 accountancy was the subject of more than 20 congressional hearings. Congressman John Dingell led many of these hearings that addressed, among other things, scope of services related to the independence of CPA firms. (By the way you'll hear more about that also in a few minutes.)
Also, in 1985, after a number of high-profile financial reporting scandals, former SEC commissioner James Treadway led the Treadway Commission. It recommended numerous changes to auditing standards and to the standard auditor's report regarding the auditor's responsibility for detecting fraud.
In the early 1990's, hearings reflected what the press characterized as the "S&L backlash against accountants." The Savings and Loan crisis cost taxpayers billions of dollars. In that regard Congressman Ron Wyden proposed legislation for "early warning bells…from auditors…to prevent this kind of debacle from happening again." Wyden stated that "one can't say that accountants caused the S&L mess, but they certainly should have picked up on these financial practices."
Then, amid a raft of independence violations by auditors disclosed in the mid-1990's, then-SEC Chairman Levitt held hearings about auditor independence and scope of services. That resulted in a comprehensive 2001 rule significantly amending auditor independence requirements in light of investments by auditors (or family members) in audit clients, employment relationships between auditors (or family members) and audit clients, and non-audit services provided by auditors to their audit clients that could be thought to impair auditor independence.
And, while that was going on, financial reporting frauds (and some audit failures) of enormous magnitude at companies like Enron, Adelphia, WorldCom, Tyco and Global Crossing, to name but a few, led, after widely publicized hearings and near unanimous approval in Congress, to the significant auditing and accounting reforms of the Sarbanes-Oxley Act of 2002, including the creation of the PCAOB "to oversee the audit of companies that are subject to securities laws …in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports." Confidence in financial reporting and the role of auditors needed to be restored. The provisions of the Sarbanes-Oxley Act demonstrated the critical importance of both reliable financial reporting and reliable, independent audits to the effective functioning of our capital markets.
Shortly after the creation of the PCAOB and the implementation of Section 404 of the Act, there was a rapid and significant spike in the number of accounting restatements. Requirements of the Act surfaced a host of issues. But just as those restatements started to decline, the world was faced with the largest financial crisis, some say, since the Great Depression. Echoing the sounds of some previous crises (like the Savings & Loan), voices again said that, while the auditors were not the cause of the financial crisis, shouldn't they have raised some warning signals of the imminent collapse of the world's largest financial institutions. I don't want to debate the merit of such statements, but they were voiced, and voiced loudly, in the US, the UK, in continental Europe and elsewhere.
So that brings us to today, here in sunny Florida. And audit reforms abound! Those reforms include (and I promised you that words from the past would be repeated again), matters such as:
Before I talk about those big issues of today, let me repeat something, and I say this with conviction:
The relevance and reliability of audits (and auditors) cannot ever be in doubt. As such, the audit profession must work with global regulators to ensure unwavering confidence by investors, in the professionalism and integrity of the auditors who perform the work, and in the relevance, transparency and reliability of audits.
So, let me turn to initiatives at the PCAOB and to other global initiatives and developments addressing these critical matters — audit reforms being considered today.
Audit Reform Initiatives Today
Changes to Auditor Reporting
For some time the PCAOB has had an initiative to address the auditor's reporting model — what the auditor reports to his or her ultimate client — the investors. By the way, this is an incidental but very important point. Company management is not the auditor's client. The company's investors are.
Today's standard auditor's report essentially says only that an audit was performed and that the financial statements are fairly presented, or not — the binary "pass/fail" opinion.
The auditor's report has not changed in any meaningful way in some 75 years. Any product that hasn't changed in 75 years is either very good (I can't think of many that are) or is very stale. The consensus around the audit report is the latter — it's stale, not a useful communication of the audit work performed and very much in need of change.
As I said earlier, the auditor's opinion is valued. It provides confidence to the markets. But except for glancing to see who the auditor was and to confirm a clean opinion was issued, investors say they don't read the report and that it has little communicative value.
So against this background, in 2013, the PCAOB proposed two standards and related amendments that would make very significant changes to the auditor's report for the first time in some 75 years: one standard to require auditors to communicate "critical audit matters" specific to the audit in the audit report; a second standard to require auditors to communicate their responsibilities for, and the results of, their evaluation of "other information" that is in a company's annual report filed with the SEC and , amendments, to require the audit report to include the name of the engagement partner.
The proposed auditor reporting standard retains the pass/fail model and the basic elements of the current auditor's report, but requires the auditor to communicate a wider range of information specific to the particular audit.
Communication of critical audit matters in the auditor's report is intended to make the auditor's report more informative, thus increasing its relevance and usefulness to investors and other financial statement users. The proposal defines critical audit matters as those matters addressed during the audit that:
These are the types of matters that would be discussed with the audit committee and some say are "the issues that keep the auditor awake at night."
Under the proposal, the auditor's communication of critical audit matters would be based on information known to the auditor and procedures that the auditor has already performed as part of the audit. Thus, the communication of critical audit matters does not modify the objective of the audit of the financial statements or impose new audit performance requirements.
With respect to the Other Information in an annual report, that is other than the audited financial statements , under existing PCAOB standards, the auditor has a responsibility to "read and consider" that other information with no related reporting requirements. The proposed other information standard would:
Such other information often includes matters of great significance to investors, such as "we are the largest company in our industry." This can be market-moving information but, if the auditor knows that the statement is a misstatement of fact, he has to request the company to revise it. If that doesn't occur, the auditor has to describe the misstatement of fact in the audit report.
Finally, as recommended in the 2008 Treasury Advisory Committee on the Auditing Profession, known as ACAP, and as required in many other countries, we proposed a requirement to name the engagement partner in the audit report. ACAP believed that would heighten the accountability of the audit partner and investors believe knowing who the engagement partner is will provide useful information.
While we are considering changes to the audit report in the US, developments are occurring more rapidly around the world.
In the United Kingdom, the standard-setting project on changes to the auditor's report has already concluded. Specifically, the new UK auditor reporting standard requires auditors to:
The new UK auditor reporting requirements are currently in effect. And we have already seen some of the new auditor's reports on UK companies. The annual report of Rolls Royce, for example, includes one of the most robust new auditor's reports. That auditor's report is six pages long and describes ten different risks of material misstatement that had the greatest effect on the audit. Additionally, the report includes the auditor's response and findings to each of the risks.
Last month the PCAOB held a two-day public hearing in Washington DC on our auditor's reporting model proposal and, among many other very distinguished panelists, also heard from UK panelists who were involved with developing and implementing the new UK requirements. They indicated that early reports in the UK have been very positive about the auditor reporting changes, which seem to have a positive impact on investor confidence in the audit. A recent UK research analyst report also indicates that the new information included in the auditors' reports of UK companies can be useful. We will continue to monitor the developments in the UK, especially users' reactions to the additional information provided in the auditor's report.
With respect to other information in the UK, prior to the changes to the UK's corporate governance regime, the auditor already was required to report by exception in circumstances where the annual report includes other information that, in the auditor's judgment, contains a material inconsistency or a material misstatement of fact.
The European Union has also moved forward with changing the auditor's report. Last month the EU adopted legislation intended to reform the audit market. The reforms are aimed at increasing transparency and confidence in the audit market by enhancing the credibility of the audited financial statements of public-interest entities (PIEs), such as listed companies, credit institutions, and insurance companies. One of the main features of the reform included expanded auditor reporting requirements aimed at enhancing investors' understanding of the audit process, including critical judgments made during the audit. Specifically, the auditor's report is required to provide, in support of the audit opinion, the following:
With respect to Other Information, as part of the reform, the auditor is required to:
The EU legislation is expected to enter into force in June 2014 with a two year transition period.
The IAASB, the International Auditing and Assurance Standards Board, also has a project on changing the auditor's report. In July 2013, the IAASB proposed changes to the auditor's report that would require the auditor to determine and communicate key audit matters. Key audit matters are defined as those matters that, in the auditor's professional judgment, were of most significance in the audit of the financial statements of the current period.
At its March 2014 meeting, the IAASB discussed revising the determination of KAM's from the July 2013 proposal to require the auditor to determine key audit matters from matters communicated to those changed with governance, including:
Key audit matters would be communicated in auditor's reports for audits of financial statements of listed entities in those jurisdictions that follow IAASB standards.
The IAASB intends to move forward with the concept of including key audit matters in the auditor's report and plans to adopt a final standard by the end of 2014, although they are continuing to debate certain aspects of the standard.
Last month the IAASB re-exposed for comment its proposal related to other information. Under the re-proposed standard, the auditor would be required to perform limited procedures to evaluate the consistency of the other information with the audited financial statements. In addition, while reading the other information, the auditor would be responsible to consider whether there is a material inconsistency between the other information and the auditor's knowledge obtained during the course of the audit, and to remain alert for other indications that the other information appears to be materially misstated.
Under the re-proposal, the auditor's report would include a separate section addressing other information. In this section, the auditor is required to identify the other information obtained and describe the auditor's responsibilities with respect to the other information. If no material misstatement of the other information has been identified, the conclusion required regarding the other information would take the form of a statement that the auditor has nothing to report.
So while changes to the auditor's report are being contemplated in the US, outside the US change is happening rapidly. We received many thoughtful, reasoned comments on our proposal and we continue to receive valuable feedback. To date we have 246 comment letters on the proposal that expressed diverse view. Investors generally supported CAMs but indicated that CAMs focus solely on information about the audit and do not provide any discussion on the auditor's assessment of the financial statements. Preparers and audit committee members generally were not supportive of CAMs. They believe that the proposed changes may cause auditors to discuss matters that the company is not required to disclose, and believe if investors need new or different information, they should provide it. The large audit firms generally supported CAMs, with some modifications.
As I mentioned, we held a two-day public meeting in April that included a diverse group of US and international panelists. The views expressed at the public meeting by the US panelists were generally consistent with the comment letters received on the proposal. We are in the process of analyzing all the input we have received and forming our thinking on a possible way forward. As several Board members have indicated, a reproposal of the auditor's reporting model standard may be our next step.
Next, let me turn to reforms related to auditor independence, objectivity and professional skepticism.
Auditor Independence, Objectivity and Professional Skepticism
Auditors have long recognized that independence is critical to the viability of auditing as a profession. But auditor independence remains subject to a significant inherent risk: the audit firm is a for-profit enterprise that is paid by the company being audited.
This fee structure was inherent in the decision by Congress in 1933 to have private sector auditors, rather than government employees, audit public companies. Over time, Congress, the SEC, and, more recently, the PCAOB have adopted requirements designed to foster the required state of mind and ban conduct deemed incompatible with independence.
As one example, the Sarbanes-Oxley Act included a number of significant provisions designed to bolster the auditor's independence from the company under audit:
Although SOX has made a significant, positive difference to audit quality the PCAOB continues to find instances in which it appears that auditors did not approach some aspect of the audit with the required independence, objectivity and professional skepticism.
The PCAOB is not alone in identifying these issues: regulators in many other countries including Australia, Canada, Germany, the Netherlands, Switzerland, and the United Kingdom, among others, have cited concerns about professional skepticism in public reports on their inspections.
In Europe, concerns about an apparent lack of professional skepticism — coupled with concerns over why auditors issued clean opinions to their clients during the financial crisis— have resulted in regulatory changes.
For example, in September 2012, the UK's Financial Reporting Council (FRC) announced changes to the UK's Corporate Governance Code that would, among other things, require FTSE 350 companies, essentially the equivalent of our Fortune 500, to put the external audit contract out to tender at least every ten years or explain why they chose not to do so.
And, in October 2013, the UK Competition Commission concluded that competition in audit services in the UK is restricted due to a number of factors that inhibit companies from changing auditors and by incentives that auditors have to focus on management's needs over those of shareholders. The Competition Commission published changes to open up the UK audit market to greater competition and to ensure that audits better serve the needs of shareholders.
In the Netherlands, audit legislation was passed in December 2012 that aims to increase the independence of auditors of public interest entities (PIEs) by: (1) prohibiting audit firms from performing services other than audit services for their audit clients and (2) introducing audit firm rotation for PIE audits every eight years.
Most recently, in its April 2014 audit reform package, the European Parliament approved EU-wide legislation that, among other things, would require PIEs to change, rotate, their auditors after a maximum engagement period of ten years. The EU defined Public Interest Entities as listed companies on European exchanges, as well as banking and insurance companies. Member States can choose to extend the ten year period up to ten additional years if tenders are carried out, and up to 14 additional years in the case of joint audit. Member States can also establish shorter rotation periods such as the Dutch or existing Italian requirements.
In the US, efforts to impose independence requirements such as the ones recently enacted in Europe have proved contentious. In August of 2011, the PCAOB issued a concept release, not a proposed rule, that sought to solicit public comment on ways that auditor independence, objectivity and professional skepticism could be enhanced, including through consideration of auditor term limits. We received 684 comment letters and held three public meetings to solicit further input.
Many investors, academics, former regulators, and others expressed a view that much more needs to be done to protect auditor independence. Approximately half of this group expressed support for audit firm rotation.
Proponents of a rotation requirement asserted that setting a limit on the continuous stream of audit fees that an auditor may receive from one client would:
Most auditors, issuers and audit committee chairs that commented asserted that the SOX reforms already represent a sound basis for safeguarding the objectivity of the auditor. Almost all auditors, issuers and audit committee chairs that commented opposed audit firm rotation, expressing concerns about costs, limitations on auditor choice, potential impacts on audit quality, and that a rotation requirement might undermine the authority of the audit committee.
In December 2012 my office published an Audit Practice Alert entitled Maintaining and Applying Professional Skepticism in Audits to remind auditors of their requirement to exercise professional skepticism throughout their audits. The practice alert focuses on the importance of professional skepticism, the appropriate application of professional skepticism in audits, and certain important considerations for audit firms' quality control systems. At the time of issuing the practice alert we also noted that the PCAOB was continuing to explore whether additional actions might meaningfully enhance auditors' professional skepticism.
While actions to address auditor independence are occurring in large parts of the world, the U.S. House of Representatives voted out H. R. 1564, (the Audit Integrity and Job Protection Act) which would amend the Sarbanes-Oxley Act to prohibit the PCAOB from requiring public companies to use specific auditors or require the use of different auditors on a rotating basis. The Senate has not introduced similar legislation.
The PCAOB's standard setting agenda no longer includes an active project on audit firm rotation but we are continuing to monitor the introduction of regulatory reforms abroad.
European reforms have already manifested themselves in auditor changes at a number of large multi-nationals including, among others, HSBC, Barclays, Unilever, and Royal Ahold, while other large companies have announced that they will soon be putting their audits out to tender. In the financial institutions space, it will be interesting to see whether required auditor rotation for the European banking or insurance subsidiary of a US financial institution would trigger auditor change in the US business or other non-European segments of the institution.
These events provide opportunities to study concerns that have been raised about audit firm rotation and investigate effects on auditor independence, firm structure and audit quality.
With that, let me turn to the final audit reform I will discuss today — the need to improve audit quality.
Audit Quality Initiatives
Thinking back to the creation of the PCAOB in 2002, it was concerns about audit quality that resulted in Congress setting up the PCAOB as an independent audit regulator. Now, independent audit regulation exists in most countries in the world.
Earlier I noted a quote from the IFIAR annual meeting expressing concern globally about recurring deficiencies in audits. PCAOB inspection results in recent years have noted serious flaws in about 1out of 3 audits we review. I must state that our selection of audits for inspection is risk-based, not random, so that rate cannot be projected to the total population. Yet this has been a significant concern.
So, what is being done to address concerns about audit quality? At the PCAOB literally everything we do is intended to protect investors by improving the quality of audits. But we also have three closely-linked specific initiatives to improve audits about which I will speak briefly:
Inspections' "Root Cause Analysis"
It is no secret that PCAOB inspections continue to find a high number of deficiencies in important audit areas. These areas include high-risk portions of audits, such as auditing revenue, asset impairments, and management's estimates, as well as in the systems of quality control of the audit firms.
The fact that many inspection findings persist over the years suggests a need for the firms to develop an internal root cause analysis to better understand the reasons underlying the deficiencies. This should allow their remedial actions to be more effective and far reaching.
Since 2012, the staff in the Board's Division of Registration and Inspections has been using a more formal root cause analysis in its review of a firm's system of quality control. Last year the program was expanded by selecting specific quality events for further analysis, both negative (for example, audits with significant inspection findings) and positive (for example, audits with no inspection findings where the audit was perceived as being well-performed). Inspections staff analyzed each quality event using causal analysis techniques. This program is continuing in 2014.
This brings me to the next project — Audit Quality Indicators.
Audit Quality Indicators Project
In November 2012, the Board identified a project to develop audit quality indicators, or AQIs, which seeks to answer two fundamental questions:
The project originated from the Final Report of the U.S. Department of the Treasury's Advisory Committee on the Auditing Profession, which recommended that the Board, in consultation with other parties, (1) "determine the feasibility of developing key indicators of audit quality and effectiveness and requiring audit firms to publicly disclose these indicators," and (2) create an approach to monitoring those indicators on an ongoing basis. The Committee concluded that "requiring audit firms to disclose indicators of audit quality" could promote such quality, and perhaps lower obstacles to competition among auditors.
As a starting point, PCAOB staff in the Office of Research and Analysis sought to identify the broadest range of possible indicators, a process that has resulted in over 70 indicators. To identify a broad range of indicators, the staff created a quality framework defining inputs to the audit (e.g., competent people), control features of the audit process, (e.g., inspections of audit work), and results of the audit (e.g., reliable financial reporting).
The staff is currently narrowing the list to the most promising indicators. Ultimately, we expect that roughly 15 indicators may be sufficient to present a balanced scorecard. We expect that a document will be put out for public comment this summer that will help us narrow the candidates to a viable and useful scorecard of AQIs.
Examples of indicators the staff is considering include:
The AQIs that the staff is developing are quantitative, a factor distinguishing the Board's AQI project from other efforts, which I will discuss shortly, to discuss audit quality in purely qualitative terms. The power of AQI's is expected to come from observing trends in the data or comparing indicators across audit engagements or firms. Our intent is to design them as a "balanced scorecard" to provide broad information about audit quality.
Of course, AQI data always requires context, that is, a qualitative analysis of what the data implies about quality. The meaning of the numbers depends on the situation to which they are applied. Reasonable explanations can exist for divergent numbers and a variety of other factors may affect a particular audit.
Our third audit quality initiative is focused on improving the PCAOB's quality control standards, required of firms' in their oversight of the audit practice.
Standard-Setting Project to Update Quality Control Standards
Deficiencies identified by PCAOB inspectors in their reviews of audits suggest that improvements are needed in firms' systems of quality control. For instance, the PCAOB's inspection staff routinely identifies audit deficiencies that should have been detected and remedied before the audit report was issued.
Improvements of the firms' systems of quality control could have significant potential to improve audit quality by not only detecting more audit deficiencies prior to the issuance of the audit report, but also by preventing and deterring the occurrence of many such deficiencies.
As a result, PCAOB staff is developing a concept release to explore improvements to our quality control standards. The existing quality control standards were developed by the profession in the 1970s to support the AICPA's peer review program. The quality control project will update these standards reflecting developments since the 1970's and observations from our inspection activities.
Topics being explored for improvement in the QC project include:
Also, we are considering how the parallel initiatives in root cause analysis and audit quality indicators can inform the quality control standards, for example, with respect to monitoring and firm risk assessment.
Again, we are not alone in our initiative to improve audit firm Quality Controls.. Here are a few examples of others' projects related to audit quality:
In 2008 the UK FRC published an Audit Quality Framework. The FRC framework was the result of a two-year consultation process. The framework does not define audit quality nor does it attempt to measure it. Rather, it identifies five key drivers, and related indicators, of audit quality, including:
The framework was intended primarily as a helpful tool for audit committees in connection with their annual assessments of the effectiveness of external audits.
In February 2014 the IAASB published a Framework for Audit Quality: Key Elements that Create an Environment for Audit Quality after a three-year consultation process.
The IAASB framework describes the different input, process, and output factors relevant to audit quality at the engagement, firm, and national levels. It also discusses the significance of interactions among stakeholders, and how they may facilitate improvement to audit quality, as well as perceptions of audit quality. The framework also discusses factors that have the potential to impact the nature and quality of financial reporting and, directly or indirectly, audit quality, such as laws and regulations, corporate governance, and the financial reporting framework.
Similar to the FRC framework, the IAASB framework does not include a definition of audit quality or ways to measure it. Rather, the objectives of the Framework are directed at improving audit quality by raising awareness of the issues that can impact it, and promoting an appropriate dialogue among stakeholders.
I would also like to mention an initiative by the audit profession itself. Just recently, in April, the Center for Audit Quality published the CAQ Approach to Audit Quality Indicators. The CAQ approach is based on two key elements: communications of audit quality indicators should be directed at audit committees and should be focused largely on engagement specific indicators.
The CAQ approach includes a set of potential audit quality indicators encompassing four key elements of audit quality:
Specific Audit quality indicators identified by the CAQ include trends in engagement hours and related timing; allocation of resources by significant risk areas, and findings of internal quality reviews and PCAOB inspections.
The CAQ has begun a profession-wide effort to perform pilot testing of the specific audit quality indicators with engagement teams and audit committees.
Audit Quality Conclusion
Finally, I would be remiss if I didn't note that many audit firms have significant in-house initiatives to address audit deficiencies and improve their audit quality. These are very positive developments at the firms.
At the same time, however, many stakeholders are increasingly concerned about the growth of consulting and other non-audit business at the audit firms. For the bigger audit firms, the audit segment represents less than half of firm revenues and, in some cases, well below half. Some question whether the audit segment is getting sufficient attention from the firms' top management.
Speaking only for myself, I believe audit firm' CEOs are concerned about audit quality. I hope I am right and I hope the CEOs stay focused on it.
Poor audit quality, as we know from the past, can have an incredibly detrimental impact on a firm and on the profession as a whole.
So, let me bring this all together and to a close.
I was recently asked in a prominent setting, "Given all of these audit reforms, would I recommend to a young student or to my child to major in Accounting and to enter into the audit profession?" My answer was short — a clear Yes! In fact, my youngest son majored in Accounting and then joined my former firm.
I believe the profession can benefit tremendously from young, motivated, and well-educated people entering the ranks. I am encouraged by the interest in auditing we see from student groups who come to visit us in DC and from speaking engagements that our Board members and I have on college campuses around the country.
So, what have I told you today?
1. Audit is critical to our capital markets and, because of it, investors have greater confidence in financial reports resulting in a lower cost of capital.
2. Because of the importance of auditing, audit reforms have been a recurring event over the years — they still are and will likely continue to be
3. The crisis in audit quality in the late '90s and early 2000's spurred significant audit and corporate reforms and triggered global audit regulation.
4. The recent financial crisis, and questions about the role of the audit, have led again to a new round of audit reforms — around the world - focused on making the auditor's report more meaningful, increasing confidence in the independence of the auditor, and improving the quality of audits.
The reform efforts now and in the past reflect the critical importance of the audit to an investor's confidence in the reliability of financial reporting. As I have said, audits contribute to a more efficient allocation of capital in our markets which fuels capital formation and economic growth.
I congratulate auditors on the very important and, generally, very good work they do, often in very challenging circumstances. I encourage auditors to stay focused on their work to meet the needs of their clients — the investors who they are hired to protect.
Thank you so much for inviting me to speak to you today and for your kind attention to my remarks!