Regulators, Checklists and Navy SEALs: A Collection of Thoughts for Future Accountants

Date: March 9, 2015

Speaker: Jay D. Hanson, Board Member

Event: Beta Alpha Psi

Location: West Lafayette, IN

Good evening,

I am pleased to be here this evening to speak with the Beta Alpha Psi members at Purdue University. I always enjoy meeting with a promising group of young people preparing for a career in the accounting profession. I started my own career in accounting over 35 years ago as a public accountant at a large accounting firm, and I have enjoyed the varied paths I have been able to explore since that time. For the past four years, I have been at the Public Company Accounting Oversight Board, where I have experienced many things I could not have imagined when I graduated from college.

Speaking of the PCAOB, before I go further, I must note 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 you will start your careers in accounting by working for a public accounting firm, as I did. If you do, you may be faced with a choice of working in audit, tax or consulting. This will be an important choice to consider. The fundamental role of an auditor is to serve the public interest and independently report on whether a client's financial statements are fairly presented, while accountants working in a firm's tax or advisory business primarily serve the client's management and often take on advocacy roles. Of course, some of you will go to work as accountants in businesses, government or not for profit organizations billing customers, collecting cash, paying bills, reconciling bank accounts and preparing financial statements. Whatever role you play, accounting is an essential component of monitoring any organization's performance, valued by operating managers, CEO's, board members, investors, lenders and others.

Accounting information is so important that there are many checks and controls intended to help the company, and the accountants, "get it right." The most basic control in a company involves one person entering accounting transactions and require that another person check that work and document that a review occurred. Other controls are designed to allow a knowledgeable person to review the results for a group of transactions for a period of time, to assess whether the results are reasonable, and to detect any material misstatements. At the financial statement level, an investor or lender, who doesn't have the ability to look directly at transactions or to determine whether controls were followed, may require that an independent, objective third party review the transactions and financial statements to provide a check on management. To ensure that such an independent review takes place on behalf of investors in public companies, the federal securities laws in the United States have long required that public companies engage independent auditors to conduct audits of their financial statements and to issue opinions on whether the financial statements are fairly presented in accordance with the relevant accounting principles.

This sounds reasonable, but if a company is allowed to pick its own auditor to provide this "check," and the company pays the auditor's fees, who makes sure the auditor does their job effectively and independently?

Prior to 2002, the audit profession set its own standards for conducting audits and imposed on itself a requirement that each audit firm hire a "peer" firm to conduct a review of its work every three years. Unfortunately, a number of significant accounting frauds in the 1990s and early 2000's, which went undetected by large audit firms, demonstrated that this self-regulation of the audit profession was not working. Most of the students here are too young to remember these events, but many people from your grandparents' generation had to rethink their retirement plans after companies unexpectedly went out of business and many investments lost significant value.

The PCAOB was created by Congress as a direct result of these events, through the passage of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act"), to oversee the audits of public companies in order to protect investors and the public interest by promoting informative, accurate, and independent audit reports. Because of the importance of the internal controls I mentioned earlier, the Sarbanes-Oxley Act also required auditors to issue an opinion on the effectiveness of the company's internal controls over financial reporting. As a result, almost twelve years ago, the PCAOB opened its doors and began taking over the role of setting standards for audits and reviewing the work of firms (through inspections and enforcement), in order to provide an independent check on the work of independent auditors of public companies.

The PCAOB is led by a five member Board, each of whom is appointed by the U.S. Securities and Exchange Commission ("SEC") to a five year term (with a maximum of two terms permitted). As mandated by the Sarbanes-Oxley Act, at any one time, two of the five Board members must be Certified Public Accountants, and, currently, I am one of these two. The Board operates under the oversight of the SEC, which, in addition to appointing Board members, must approve our budget and any rules and standards issued by the Board. The SEC also is empowered to hear appeals of our inspection determinations and enforcement orders.

Under the Sarbanes-Oxley Act, the PCAOB has four main responsibilities:

1. Registration of public accounting firms that audit public companies or broker-dealers;

2. Inspections of registered public accounting firms;

3. Setting of auditing standards for the audits of public companies and broker-dealers; and

4. Investigations and disciplinary proceedings in cases where auditors may have violated certain provisions of the securities laws or applicable standards or rules.

In order to achieve our mission, we have a staff of over 800 employees, which work in in sixteen offices around the country. The majority of our employees work in our core program areas in the Division of Inspections and Registration, the Division of Enforcement and Investigations or the Office of the Chief Auditor. In addition to our administrative offices, we also have an Office of International Affairs and an Office of Research and Analysis, both of which provide important information and assistance to the Board and staff. Most recently, we have established a Center for Economic Analysis, intended to help us better understand the economic consequences of our work and evaluate the economic impact of audits on the capital markets.

Currently, more than 2300 firms are registered with the Board, including over 900 foreign firms from 85 jurisdictions. The Board has conducted well over 2000 inspections of public company audits, including inspections in 44 jurisdictions outside the United States. After the Dodd-Frank Wall Street Reform and Consumer Protection Act gave us authority in 2010 to inspect the auditors of brokers and dealers, we commenced an interim program of broker-dealer auditor inspections. We are evaluating the findings from the interim inspection program and will consider the effects of our recently issued new broker-dealer audit standards in determining the scope of a future permanent inspection program.

In 2003, shortly after its inception, the PCAOB adopted the auditing standards of the accounting profession in existence at that time, on an interim basis. Since then, the Board has issued 18 auditing standards — including, for example, standards addressing audit documentation, internal controls, audit planning, engagement quality review, risk assessment, audit committee communications and related parties — as well as two attestation standards for audits of brokers and dealers. We also have substantially amended a number of interim standards, such as those addressing communications about control deficiencies, audit reports, audit sampling, and substantive analytical procedures, among others. Current projects include work on standards governing the supervision by a lead audit firm of other auditors participating in the audit, the use by an auditor of specialists, the auditor's responsibilities for going concern opinions, and several others.

The fourth prong of the PCAOB's statutory mission is enforcement of applicable federal laws, standards and rules. The Board has publicly announced sanctions against many firms and individuals, including revocations of firm registrations, orders barring or suspending individuals from practicing before the Board, censures and, in some cases, significant monetary penalties. Our cases have involved Big Four firms as well as smaller firms and sole practitioners and have been brought against firms in the U.S. and abroad. In general, our cases have involved one or more of the following issues: poor audit work, non-cooperation with PCAOB inspections or enforcement (including submitting false information during inspections), independence violations, and failure to comply with PCAOB rules requiring the filing of firm annual reports and payment of annual registration fees.

In my experience, as a result of the PCAOB's work and the efforts and resources expended by firms, we have seen improvements in the quality of audits and the awareness of auditors of their unique and important role in the capital markets. Of course, there have been challenges for both the PCAOB and audit firms in adjusting to this new regulatory world, but we are committed to working with firms to continue to improve.

Early on during the PCAOB's existence, inspectors were seeing a lot of problems with what I call basic "block and tackling" of auditing. While we still see problems in this area on occasion, the vast majority of our inspectors' findings now are more complex and occur in difficult audit areas. Recently, frequent inspection observations have included findings in the following financial statement areas:

Our inspectors review the audit work on revenue in virtually every engagement selected for inspection, which may explain why we have so many findings. It is, of course, one of the most important metrics in the financial statements, so we believe it is an important area of focus.

The challenges continue in the areas of fair value and estimates. These are complex areas, and generating accounting measurements based on assumptions about the future presents inherent difficulties. But some of the audit deficiencies we see are surprisingly basic mistakes. This includes the auditor not testing the assumptions underlying a fair value measurement, such as a reporting unit for a goodwill impairment test. In other areas, however, such as the use of pricing sources to assist the auditor in testing the fair value of hard to value securities, we have seen a significant decline in the number of deficiencies. Over time, I believe the focus on fair value measurements in accounting program curriculum must increase, since these concepts are at least as important as cost accounting, which virtually all programs still require.

I mentioned earlier the importance of internal controls. Because they are so important, the PCAOB also has focused on reviewing auditors' controls testing. This is still a relatively new area for auditors. We continue to see a high rate of findings in this area, though the nature of our findings is evolving and becoming more granular as auditors are becoming more proficient at complying with the applicable standards (including AS No. 5, issued by the Board in 2007). I applaud the progress that has been made in this area, but it is apparent that there is more work to be done to ensure consistent application. When an auditor does not comply with all of the requirements of AS No. 5, but assumes that the controls testing was sufficient and therefore reduces the amount of substantive testing, the end result is a shortfall in the amount of audit work necessary to support the auditor's opinion.

Underlying many of these findings, and others, are deficiencies or weaknesses in the firm's systems of quality control. While auditors are generally equipped to do good job, in terms of their education and experience, and the resources provided by the firm to conduct audits, we occasionally observe a break-down of sorts in the systems that are intended to ensure that audit work is consistently at a high level. Some examples of deficiencies in quality control systems that we have observed include problems with a firm's tone at the top — meaning that firm leadership does not consistently demonstrate and communicate that it values audit quality above client satisfaction or attracting new clients— lack of professional skepticism by auditors, inadequate training or audit guidance for staff, ineffective monitoring by the firm of its performance over time, client acceptance and retention policies that lack rigor, and several others systemic problems.

Because these types of problems contribute to deficiencies in audit performance, one of the most effective ways for firms to improve audit quality and avoid negative PCAOB inspection reports is for the firm to remediate deficiencies in that quality control system. The Sarbanes-Oxley Act provided an incentive to do just that, by requiring firms to address quality control deficiencies identified by the Board within twelve months of the date of the inspection report, or risk publication of any deficiencies that are not timely remediated. As the Board observed early on in its existence, this requirement "rested on the hypothesis that firms could be genuinely motivated by the prospect of keeping the Board's quality control criticisms confidential."[1]

In 2006, along with issuing a Board release describing the Board's process for determinations regarding remediation, the Board issued a general report, discussing its observations of the firms' initial implementation of the remediation requirements.[2] Since then, the PCAOB and registered firms have gained nearly a decade of additional experience with the remediation process. With respect to the vast majority of quality control deficiencies, firms have taken appropriate remedial steps, in some cases expending enormous resources to re-vamp audit programs, increase expertise in certain areas, provide better training, improve internal monitoring systems, among many other helpful actions. Nevertheless, the Board has made public some or all of the quality control weaknesses of well over 150 firms, including some that provided no response to the Board to describe their remedial efforts. Of the largest six public accounting firms in the U.S. which are members of global firm networks, five have been subject to publication by the Board of one or more quality control deficiencies as a result of a Board determination that the deficiencies were not timely remediated.

Of course, many positive developments are accompanied by potentially negative, unintended consequences. A variety of individuals have shared with me their view that audits today have become very "checklist" oriented, perhaps as a result, in part, of efforts to prevent future PCAOB inspection findings. With an increase in checklists to complete, some fear that much of the judgment and thinking has been removed from the audit and, as a result, audit quality can suffer. However, I don't believe that checklists can or should take the place of thought and judgment, and I do not believe that audit firms intend them to do so. Imagine a pilot of an airplane having the attitude that the extensive preflight checks they complete are just a "compliance exercise" that does not require careful attention or the exercise of judgment to go above and beyond the list when something seems just a bit "off." I would not want to fly on that plane. Another area where checklists are becoming more common are operating rooms in hospitals around the world. Studies show that such checklists reduce errors and improve patient outcomes. But nobody would suggest that the checklists could take the place of the surgeon paying careful attention during the surgical procedure and using experience and judgment to protect the patient's best interests.

The bottom line is that checklists can be a great addition to help navigate complex processes, but they should not take the place of judgment. They are reminders of all the things you need to think about, but you still need to think — about the various paths you can take, the potential outcomes that may result, and, as an auditor, what would be in the best interests of investors. After all, you and those who came before you did not spend five years studying, so that you can stop using your brain when you start your professional career.

Finally, let me talk about some of the challenges you will inevitably face in your career. I always emphasize several key characteristics that I have observed in successful professionals: communications skills, being prepared, being organized, being proactive, and, perhaps most importantly, professional skepticism and having the courage to stand up for yourself. I am going to borrow from someone else's speech to discuss some of these important characteristics in a little more detail:

Last May, Naval Admiral William F. McRaven, who was then commander of U.S. Special Operations Command, delivered the commencement address at the University of Texas at Austin. (He went on to accept the role of Chancellor of the University of Texas System after his retirement from the Navy.) Admiral McRaven's commencement address focused on "Ten Life Lessons" and reflects his views on Navy SEAL training and his experiences of 37 years in the Navy. I highly recommend you read this speech or watch the video.[3] I am not going to repeat his ten lessons but will pick a few to comment on in the context of the accounting profession.

"If you want to change the world, start off by making your bed." This is not something a college student wants to hear! However, the point the Admiral makes is to start the day with a task completed. He notes that if you can't get the little things right, you will never get the big things right. To me, this reflects the importance of being organized, starting when you get up, and pressing forward the entire day. After all, accountants and auditors deal with a lot of little things that cannot be ignored or glossed over lest they add up to a big problem.

"If you want to change the world, find someone to help you paddle." The Admiral describes paddling a boat in the surf off the coast of San Diego and the need for every crew member to coordinate to help the boat reach its goal. Starting a career in accounting or auditing is difficult. You will need lots of on the job training, and you will need to learn to work as part of a team. I was very lucky to have incredible people that cared about me over the years and helped me along. I returned that by trying to be a solid trainer and mentor for others that came after me. So pull your weight on the team, ask for help when you need it, and provide assistance to others when you can.

"If you want to change the world, measure people by the size of their hearts, not the size of their flippers." This comment is about diversity in ethnicity, background, education, social status, and in the case of the Admiral's SEAL training classmates, size. My observations over the years in public accounting are consistent with his — that none of these matter except the "will to succeed." I know that the accounting profession can do a better job on the diversity front, and many firms are working to increase the diversity of their staff. At the PCAOB, we have significant diversity, which helps with everything we do, including, for example, international inspections where language skills and awareness of cultural differences are vital. As you move forward in your careers, as Admiral McRaven advised, focus not on superficial characteristics — your own or those of others — but base your judgment on hard work and the desire to succeed.

"If you want to change the world, get over being a sugar cookie and keep moving forward." The sugar cookie reference is to the consequence of a less than perfect uniform inspection: the SEAL candidate would have to take a fully clothed trip into the surf, roll in the sand, and subsequently wear that same uniform all day. In public accounting, it can feel like your work papers are never good enough. A senior may ask you to rewrite something. A manager will ask for even more clarification. It goes on and on. Sometimes comments are substantive; other times the request may be as silly as changing the font color or size to match a personal preference. Sometimes you will feel like you received a failing grade on every paper. Over time, however, your auditing and writing skills will improve, and, soon enough, you will be writing similar review notes for others (though hopefully not the one about the fonts!). So keeping going — much like the SEAL in the itchy uniform, you, too, will get through the day.

"If you want to change the world, don't back down from the sharks" and "If you want to change the world, you must do your very best in the darkest moment." I won't pretend that accountants face nearly the darkness that members of the armed forces face every single day. But there are time pressures demanding supervisors and other challenging aspects to being a young public accountant. There are a lot of sharks in the world, and sometimes a member of your client's management team may act like one. Deadlines for public company press releases and filing are rarely missed, no matter the challenges involved. The push to "get it done" is extreme. Diligent planning, staying organized, and proactively addressing problems can help avoid a last minute crisis. But in the final push, you have to bring your best work — most importantly by never compromising your professional skepticism and the courage to do what is right.

Admiral McRaven concludes with these words:

Start each day with a task completed.

Find someone to help you through life.

Respect everyone.

Know that life is not fair and that you will fail often, but if you take some risks, step up when the times are toughest, face down the bullies, lift up the downtrodden and never, ever give up—if you do these things, then next generation and the generations that follow will live in a world far better than the one we have today and—what started here will indeed have changed the world—for the better.

I will never be able to top these words, but I will pass them on often. I thank Admiral McRaven for his service to our country and these fine words to live by.

Thank you for joining me this evening.

[1] Observations on the Initial Implementation of the Process for Addressing Quality Control Criticisms within 12 Months after an Inspection Report, PCAOB Release No. 104-2006-078 (March 21, 2006).

[2] Id.

[3] See University of Texas at Austin, "Admiral McRaven urges Graduates to find Courage to Change the World" May 16, 2014 [Press Release]. Available at: