Keynote Address 

Thank you for inviting me to this conference. Let me begin by saying that the views I express are my own and should not be attributed to the Public Company Accounting Oversight Board as a whole or any other members or staff.

Today, I would like to talk to you about some of the PCAOB's initiatives to enhance the relevance, credibility and transparency of the audit to promote high quality financial reporting.

We meet in the midst of a robust and wide-ranging global debate on how to promote audit quality. Whatever the outcome, it is clear that the audit is indeed a valued, critical feature of the U.S. financial system, and it enjoys an important position in the eyes of people around the world.

I. High-Quality Audits Are Critical to Capital Formation and Economic Growth.

High-quality audits are critical to capital formation and economic growth. This has been so since the earliest days of our organized securities markets.

Our colleague Bernard Black, on the faculty at Northwestern, may have put investors' predicament best. He once wrote —

[C]reating strong public securities markets is hard. That securities markets exist at all is magical, in a way. Investors pay enormous amounts of money to strangers for completely intangible rights, whose value depends entirely on the quality of information that the investors receive and on the sellers' honesty.^[1]

It is to the credit of the securities bar that we have been able to fashion a system of securities regulation that gives millions of disorganized investors a basis to trust the information they receive, to trust that their capital will be applied to the purpose intended.

One of the best features of our system is that it is not immutable. We have been able to improve it over time, as we develop new forms of capital accumulation and allocation to meet new needs of investors and new uses for public funds.

Through your efforts, among others, the U.S. has become a clearinghouse for the fair allocation and use of capital.

Professional, skilled and independent auditors are key to helping investors separate the credible managers from the charlatans. By building a basis for confidence, auditors reduce financing costs, and contribute to an efficient allocation of capital to fuel economic growth.

But conferences like this do not exist to congratulate ourselves. The bar has reconvened each of the 31 years in the history of this conference to prepare for and channel new developments and evolution.

As with the Holmesian view of the law — not logic but experience^[2] — so also with the audit. We learn and improve from experience.

One principle that continues to stand, upon examination and re-examination, is that, as Bernie Black said, the value of the investor's intangible right — the value of the share — depends entirely on the quality of information the investor receives and on the seller's honesty.

In recognition of Black's insight, I believe we are in a high risk period that merits more attention to the audit, not less. Although we have never needed it more, the audit has, in the minds of some, become a commodity to be contained with other compliance costs.

Academic research confirms that the harm of fraudulent reporting extends beyond the injury to direct stakeholders and reaches whole industries and competitors.^[3] When trust in financial reporting is lost, the markets question competitors' business strategies too.

Unwinding ill-conceived investments may be costly and impractical. Moreover, confidence in new, valid proposals for capital committment can be affected.

As a former securities law practitioner and counsel to boards, I believe the audit is the most cost-effective way to avoid being surprised by errors or malfeasance that have quietly grown to approach a material level. While not foolproof, the audit confirms legitimacy.

But an audit that does not serve the needs of users is false comfort and, over time, loses its relevance to market participants.

To be relevant, the auditor must speak to and for the users of the financial statements. For the audit to be relevant, the public must be confident in the auditor's ability to apply both technical expertise and skepticism to management's assertions.

Fair or not, that is in question today. And this is where the PCAOB's initiatives come in.

I want to see a vibrant audit profession that competes on quality more than price. I want to see a profession that is revered for insight and clarity, not box-checking. I want to see a profession that attracts and retains top graduates who are and remain committed to excellence in public service. I doubt I need to impress upon you the bar's interest in these goals as well.

Audit regulators around the world are engaged in confronting these challenges. The PCAOB is deeply engaged with its counterparts, both through inspection coordination and multi-lateral meetings in venues such as the International Federation of Independent Audit Regulators. I will share some of what we are learning from other regulators.

II. International Audit Oversight Coordination and Results

With that in mind, let me briefly describe our approach to coordinating with our counterparts around the world.

To date, the PCAOB has conducted inspections in 40 foreign jurisdictions. Last year, one-fourth of our inspections took place outside the United States.

Overall, there are around 240 non-U.S. audit firms in over 50 foreign jurisdictions that have issued audit opinions on U.S. issuers and are required to be inspected at least every three years.

A. Audit Regulators Around the World Are Developing a New Paradigm for Working Together.

Gradually, together with our counterparts, we are creating a network of regulators to match the networks of firms. The aim is to work seamlessly together to meet our respective inspection mandates.

We now jointly inspect with local regulators in Australia, Canada, Germany, Korea, the Netherlands, Norway, Singapore, South Africa, Switzerland, Chinese Taipei and the United Kingdom.

Two weeks ago, the PCAOB entered protocols on cooperation and information-sharing with the audit regulators in France and Finland. These agreements will allow the PCAOB to begin conducting joint inspections of PCAOB-registered firms in France and Finland with the local regulators.

Our non-U.S. inspections are important, not only because of the foreign private issuers that sell securities in U.S. markets. Many of the non-U.S. audit firms that have registered with the PCAOB also perform significant audit work for U.S. companies that have operations abroad.

This is the nature of the global audit. The principal auditor — that is, the auditor that signs the audit report — refers a portion of the audit to local auditors in a country or countries where the company has subsidiaries or significant operations.

The local auditor may perform specified procedures that the principal auditor asked it to perform. Or it may perform for the principal auditor a complete audit, with audit report, on the local operation.

In either case, generally speaking, the principal auditor uses the work of other audit firms to form an opinion on the financial statements as a whole.^[4]

B. Regulators Around the World Have Expressed Shared Concerns About Disappointing Inspection Results.

Let me turn to results. What benefit does coordination yield? As we deepen our relationships with fellow independent regulators, we deepen our understanding of audit risks.

We have identified significant audit failures after issues identified jointly with another regulator in an inspection of the principal auditor led us to review a subsidiary audit in a third country.

Our inspectors have also found situations where a U.S. firm has used the work of another audit firm that turned out to be unreliable. Sometimes the work requested by the principal auditor was never performed.

Both in this joint work and independently, regulators around the world have expressed concerns about disappointing inspection results.

In Australia, Greg Medcraft, the Chairman of the Australian Securities and Investment Commission recently commented in the Australian Financial Review about ASIC's review of inspections conducted in the 18 months up to June 30, 2012. He said it "showed an increase in auditors failing to obtain reasonable assurance the audited financial statement was not materially misstated."^[5]

In particular, he called for improvement in three key areas — the sufficiency and appropriateness of audit evidence, auditors' professional skepticism, and auditors' use of other auditors and experts.^[6]

Similar results have been reported across Europe^[7] and in Canada.

According to a compilation of inspection results from Canada, the U.S., the U.K. and Australia, prepared by the Canadian Public Accountability Board's Chairman, Brian Hunt, "Insufficient Professional Skepticism . . . is undoubtedly the most common finding — that auditors are too often accepting or attempting to validate management evidence and representations without sufficient challenge and independent corroboration."^[8]

Since it began operations in 2003, the PCAOB has tackled progressively more of the vexing issues with which the audit profession has struggled for decades — such as the failure to apply professional skepticism in difficult audit areas, including management estimates and valuations.

The PCAOB also performs increasingly refined and sophisticated risk assessments to identify where the most significant challenges to audit quality exist. This contributes to the increase in inspection findings over time.

Tackling these tough issues has also contributed to an improvement in audit quality, I believe. Nevertheless, as other audit regulators around the world have concluded too, the rate of failure is unacceptably high.

III. The PCAOB's Initiatives Aim to Help the Profession Realize Its Potential by Enhancing the Relevance, Credibility and Transparency of the Audit.

There is a lot going on at the PCAOB to examine these issues and find ways to improve auditor performance. We have an active standards-setting agenda developed through extensive outreach, including with the PCAOB's Standing Advisory Group as well as other standard-setters.

In this outreach, we hear from numerous stakeholders, including auditors themselves, as well as preparers and their representatives, experienced members of the bar, investors, and others.

We don't rewrite standards just for the sake of change. But through our consultation process we identify areas of auditing that deserve improvement or updating in light of developments in practice.

We consider alternatives to achieve our intended outcome. We consider potential costs, as well as potential unintended consequences. We are adding resources to involve economists more deeply in our work.

Our agenda is available on our website and is updated periodically. Today, I will highlight a handful of projects that may be of particular interest to the bar.

A. Facilitating the Work of Audit Committees.

The first two such initiatives focus on arming audit committees with more and better information about the audit, as well as more and better information about the auditor's strengths and weaknesses.

According to a January 2013 Global Audit Committee Survey, released by KPMG's Audit Committee Institute, only 38% of audit committees claimed to have a formal and comprehensive annual external auditor evaluation process in place.^[9]

Audit committees cannot make decisions about hiring and compensating auditors on the basis of quality without transparency and insight about quality. Our audit committee initiatives aim to help audit committees obtain that information.

1. Auditing Standard No. 16 Improves Auditor Communication with Audit Committees.

The PCAOB has recently adopted a new auditing standard — Auditing Standard No. 16 — on what the auditor should communicate to audit committees in order to protect the public's interest in keeping audit committees informed of important audit matters.

I know you'll have a panel on the Jumpstart Our Business Start-ups Act of 2012 tomorrow. So it may be of interest that this standard is the first promulgated after the JOBS Act was enacted. Consistent with Section 104 of the JOBS Act, when the PCAOB submitted the final standard for approval by the SEC, we included a discussion of efficiency, competition and capital formation.

The SEC approved the standard on December 17, 2012. It is effective for audits of fiscal years beginning on or after December 15, 2012.

AS 16 is intended to foster a more robust discussion between the auditor and the audit committee. It is intended to focus the audit committee on the importance of probing and understanding challenging audit issues and significant auditor judgments, and championing the auditor's independence and professional skepticism in resolving those issues and making those judgments.

I would expect the best audit committees to demand this kind of dialogue already. Yet we see situations where this was not the case. AS 16 is an attempt to change that.

2. The PCAOB Has Issued Guidance on What Audit Committees Can Learn from PCAOB Inspections.

The PCAOB has also recently issued guidance about how audit committees can learn more from their auditors about the results and implications of the PCAOB's inspection findings.^[10]

Description in the public portion of the inspection report of failure to obtain sufficient evidence to support the firm's opinion means that the inspection staff has determined that the firm failed to fulfill its fundamental responsibility in the audit: the firm failed to obtain reasonable assurance about whether the financial statements are free of material misstatement.

Firms' characterizations of inspection results can sometimes distort them. How an auditor approaches inspection results can tell an audit committee a lot about the firm's commitment to excellence.

Your role as corporate counsel makes a difference: how an audit committee addresses inspection results can affect the tone of the audit. An audit committee that is impatient with the technicalities of an audit, or accepts weak arguments to dismiss the findings in an inspection report, may inadvertently signal to the audit firm and audit team that the audit committee is not concerned with quality.

An audit committee that, on the other hand, expresses explicit concern for how the auditor has resolved noted deficiencies tells the auditor that quality matters.

And then, there is the fallacy of elevating the fee above the quality of the auditor. As counsel for corporate boards, you will want to be attuned to these nuances.

B. The PCAOB Has Proposed New Standards on Related Party Transactions and Audit Transparency.

The PCAOB has also proposed two new standards.

The first would enhance the public's understanding of the audit by requiring disclosure about participating firms as well as the name of the engagement partner who supervises them. Today, only the principal audit firm's name goes on the audit report that the public sees.

We are reminded, from time to time, that even sophisticated business people and government officials who use audit reports do not realize that audits for large companies are often performed by consortiums of separate audit firms.

For companies, and their counsel, concerned about the risk of override of controls and material misstatements in far-flung locations, it is the work of these undisclosed subsidiary auditors, and the rigor of the principal auditor's oversight of their work, that provides the company (and investors) with assurance that the necessary controls are in place and working effectively.

Depending on where a company's operations and accounting are, the underlying source of half or more of this assurance work may be performed by a firm or firms other than the firm whose name is on the audit report. But even those who are aware that multiple firms may be involved in an audit generally don't know the extent of work performed by other audit firms. The PCAOB has proposed to address this.

The second proposal is a new auditing standard on related party transactions, describes basic tools that good auditors have used for years to identify financial reporting risks. For example, it requires auditors to understand management's compensation as a way to understand management's motivations.

To be clear, nothing about the standard would put the auditor in the role of setting or passing on management compensation. Some commenters have expressed concerns in this regard, but as the standard itself makes clear it's simply not the case.

I doubt I need to tell you, though, that changes in performance metrics provide important information about management's incentives that may not otherwise be understood. They offer the auditor — and audit committee — insights about where management's financial story could be weak.

We are currently evaluating comments on both the related party proposal and the transparency proposal.

C. The PCAOB Has Issued Concept Releases to Commence Debate on More Broad-Ranging Topics.

The PCAOB standards-setting work also includes two rather more broad-ranging projects, commenced not with concrete proposals but with concept releases.

1. The Auditor's Reporting Model

One involves consideration of changes to the form and content of the standard audit report. The current model is essentially three boilerplate paragraphs. For a long while, investors have called for more insights from the auditor's work.

This project is intended to develop a better, more transparent reporting model, one that will impart the auditors' insights about key aspects of the financial statements and other matters to emphasize.

The project is not about changing the nature or scope of the auditor's work. It's about making the results of that work more relevant.

2. Auditor Independence

The second concept release goes to the issue of auditor independence, objectivity and professional skepticism.

In August 2011, the Board issued a Concept Release on Auditor Independence and Audit Firm Rotation. The concept release notes the importance of auditor independence to the viability of auditing as a profession. It asked for comment on ways to enhance auditor independence, objectivity and professional skepticism, including through auditor term limits, which are being debated around the world today.

As a concept release, it made no specific proposal. Rather, the vehicle of the concept release is designed to pose questions to solicit public input before any proposal is considered or formulated.

Independence and skepticism are complex issues that warrant deep study. The PCAOB has embarked on a series of public meetings to engage prominent and thoughtful commenters with various, often conflicting, viewpoints.

One outgrowth of the meetings so far has been a PCAOB staff audit practice alert on Maintaining and Applying Professional Skepticism in Audits issued in December 2012. The Alert reminds auditors of the critical importance of professional skepticism to effective audits.

The Alert also describes a number of impediments to professional skepticism — including, for example, unconscious human biases and other circumstances that can cause auditors to gather, evaluate, rationalize, and recall information in a way that is consistent with client preferences rather than the interests of external users. Finally, the Alert describes steps that firms and auditors can take to enhance professional skepticism in audits.^[11]

We must also watch and evaluate the implications of international developments. The Dutch Parliament recently adopted audit firm rotation. It appears likely that some companies plan to implement auditor switches ahead of the 2016 deadline.^[12]

The European Commission, Parliament and Member States are engaged in their own inquiry. Their legislative deliberations indicate a real likelihood that some form of term limits could be adopted this year. Firms in Europe have had to factor the possibility into their strategic business planning.

This is not a new issue: concerns over independence and the role of anticipated or established auditor tenure predate the Sarbanes-Oxley Act.

It is now, however, a broad international debate. People disagree on what the best reforms will be, how to implement them, and indeed whether reform is necessary. Costs and any potential unintended consequences will have to be considered.

We should not rush to decision. I don't have the view that independence and skepticism can only be achieved through term limits.

Through the responses to the August 2011 concept release and the substance of our public meetings, we have elucidated many of the questions asked by the concept release. Our job at the PCAOB is to be alert to the changes that are afoot: to understand them, to analyze their effects on the audit, and to consider what it all implies for the future of the audit.

* * *

You have been a gracious audience and I thank you very much for your interest in the PCAOB's work.