"Prizes Captured, Shops Sold, Et Cetera": the Importance of Keeping Investors Properly Informed 

DATE Nov. 3, 2011 
SPEAKER(S): James R. Doty, Chairman 
EVENT: New York State Society of CPAs Auditing Conference 

Thank you for inviting me to speak today. Before I begin, let me first make clear that the views I express today are my own and should not be attributed to the PCAOB as a whole or any other board members or staff.

I. Accountants in New York Have Led Reform Since the Profession Began

The accounting profession in New York has a long and great history. From the early 17th century, when Henry Hudson first explored what are now named New YorkHarbor and the Hudson River for the Dutch East India Company, this city has been a financial center. Whether trading in furs and spices, or exotic derivatives, the City´s business enterprises have needed reliable accounting.

There is an interesting story about the first official bookkeeper of the Dutch settlement called New Netherland, which covered, roughly, the area that is now the states of New York, New Jersey and Connecticut.

In 1621, little more than a decade after Henry Hudson´s famous voyages, the (old) Netherlands – that is the one in Europe – founded the Dutch West India Company to colonize and exploit its American, Caribbean and West African claims.

By 1651, the Company´s business in New Netherland was sufficiently established in the view of its directors in Holland that they appointed Johannes Dyckman, a local settler, to serve as bookkeeper. It happened to be under the famous Governor Peter Stuyvesant – an important name even today. [1]

According to genealogical records, Dyckman too was related to a famous family – the Knickerbockers, an imagined member of which was a central figure two centuries later in Washington Irving´s satirical History of New York. Thus did Knickerbocker become a signifier for New Yorkers.

Dyckman did not enjoy the same lasting recognition. After a year, in 1652, the directors fired Dyckman and hired another man, reportedly because the directors felt they were "not properly informed of prizes captured, shops sold, et cetera." [2] The history of the economic development of New York is intertwined with the development of ideas, measures and policies to avoid recurrence of just such a problem.

Authority over New Netherland trade was concentrated in a few Dutch directors separated by oceans and land from their managers. Today´s large American enterprises are, for the most part, owned by thousands or even millions of individual shareholders who may indeed be neighbors with the managers of the tens or hundreds of companies each owns in his or her 401k account.

Even if not exactly neighbors, they may drive on the same roads, attend the same churches and synagogues, rely on the same doctors and hospitals. Individual, or retail, investment has driven massive economic expansion in the United States over the last century. It has funded our most prized business ventures, from growth in industrial and consumer businesses, to advances in medicine and pharmacology, to the IT revolution, and more.

Yet, just as their Dutch predecessors, these investors are separated from the managers charged to steward their investment.

Venture capital and other private equity investors solve this problem by hiring accountants directly to provide them detailed analyses of management´s stewardship of their investments. Like the Dutch directors, these investors hire accountants who work for them. If such investors have concerns about whether the accountants will "properly inform" them about "prizes captured, shops sold, et cetera," they will hire new accountants.

Not so for retail investors.

Accountants in New York were among the first in the country, as a group, to recognize the importance of a learned profession of public accountants who cultivated, through integrity, expert training and knowledge, a reputation for reliable, independent assessments of accounts.

By the 1890´s, New York was producing a good number of skilled accountants, who were joined by a steady flow of immigrants from the U.K., especially England and Scotland, who had been trained in the busy accounting houses in London and Edinburgh.

This was a period of industrial and financial consolidation more dramatic than even our own. John D. Rockefeller in oil, John Pierpont Morgan in railroads and electricity, and other prominent industrialists in other fields, brought companies together, and modernized them, to achieve efficiencies of scale. They could only oversee their vast holdings from their perches in New York by obtaining reliable reports from trusted accountants.

The accounting profession of New York saw the need and understood the public interest in independent audits of where money had been spent, supplies stored, and profits banked or invested. They also understood the role such audits could and did play in the economic development of our country. And they understood that, to be successful, accounting must be a profession.

Those not steeped in the history of accounting may be surprised to learn that it was a visionary group of New York accountants that lobbied the state legislature to pass the first Act "to regulate the profession of public accountants."

New York´s CPA law was passed in April 1896. It provided for any citizen of the United States (or any immigrant who declared an intention of becoming a citizen) to be styled and known as a Certified Public Accountant, if the person (i) resided in the state, (ii) was over the age of 21, and (iii) had received from the Regents of the University of the State of New York "a certificate of his qualifications to practice as a public expert accountant."

The Act also provided for the Regents to make rules for the CPA exam, and provided that any violation of the Act would be a misdemeanor. This was no casual addition.

Two years after the Act was signed into law, one of New York´s first CPAs, on behalf of the American Association of Public Accountants, secured the arrest of an Englishman who was purportedly practicing without the proper qualifications. [3]

Other states followed with similar CPA laws. In those early years after the CPA law was enacted, CPAs established an important role for the profession in the nation´s economic development, and to this end took on many government projects.

Charles Waldo Haskins, from New York, and Elijah Watts Sells, from the Midwest, worked together on the Dockery Commission to revise the accounting system of the U.S. government.

They went on to found one of the largest American accounting firms. They were also tasked to examine the accounts of the City of Brooklyn before its consolidation with New York. And at the end of the Spanish-American War in 1898, they were hired by the U.S. government to examine the accounts of Cuba and the Philippines after the Spanish left.

Haskins also served as the first President of the New York State Society of CPAs.

The profession, in those days, encouraged public demand for new work to promote the public interest. In this regard, one of the most important steps taken by the profession in the last century, again, emanated from New York as a response to the market crash of 1929.

In April 1933, the Senate Banking Committee was examining lessons learned from the crash and debating ways to better protect investors, and in so doing coax them back into the public markets. Colonel Arthur Hazelton Carter, then President of the New York State Society of CPAs and Managing Partner of Haskins & Sells, offered the accounting profession´s proposal. [4]

At that time, public companies were not required to publish a financial statement audited by an independent public accountant. Carter advocated that such a requirement be imposed.[5] He faced skeptics, including Senator Alben Barkley, who wondered whether the government should protect public investors by performing periodic government audits of company accounts.[6]

But Carter´s vision prevailed. Congress ultimately passed the Securities Exchange Act of 1934, which established the Securities and Exchange Commission and required that companies that issue qualifying securities file with their annual financial statements the opinion of a certified public accountant as to their accuracy.

Leaders in the profession continued to come up with innovative ideas that have advanced the general economic welfare of the country throughout the last century.

Men like Haskins, Sells and Carter had all good intentions. These Progressive era, American founders had imbued in the profession a strong culture of ethics and financial integrity that continues today.

But from the beginning of mandated audits of public securities issuers´ financial statements, the profession has faced an inherent conflict built into the structure of our system of corporate governance, in that the company itself hires, fires, and pays the auditor.

I have found that, for many, this is a difficult conflict to acknowledge. It is not of the profession´s making, but it bedevils the profession.

With each episode of scandal, as a nation we engage in a fact-finding, a self-exploration, and institute reforms to avoid repetition. But the basic systemic conflict remains.

Evidence of the conflict was apparent soon after enactment of the Exchange Act. The McKesson & Robbins scandal, which broke in 1938, was one of the major financial scandals of the 20th century.

The SEC conducted a rare public investigation of the matter, and discovered that senior management of the company had faked approximately $18 million of the $87 million on the company´s balance sheet.

At the time, McKesson & Robbins was a major company, and $18 million was a lot of money. The fraud was a scandal of the first order.

With respect to the auditors, the New York office of the U.K. firm, Price Waterhouse, the Commission found that the overstatement should have been detected if the auditors had tested inventories or confirmed receivables. [7] These are basic auditing procedures today. As TIME magazine reported at the time, "How was it possible, the average investor asked, for $18,000,000 in fictitious inventories to deceive seasoned accountants?"[8]

Indeed, the omitted procedures were basic auditing procedures at the time. The firm agreed.

But in a remarkable defense published in the New York Times in December 1940, the firm said that the procedures were not performed, quite frankly, because management controlled the scope of the audit. Indeed, the firm reported, management had expressly instructed the firm not to perform the omitted procedures, over the firm´s written warning that the scope of its examination was not sufficiently extensive "to reveal either possible misappropriations of funds or manipulations of the accounts." [9]

Under auditing standards today, such instructions would constitute a scope limitation preventing the auditor from expressing an opinion. I recount the story to point to an early, stark sign of how formidable the conflict is.

II. Auditors Face Strong Incentives Not to Challenge Management

Auditing standards have been clarified and made mandatory. Accounting standards too have improved, and become more detailed, to be more effective tools for auditors to use in the ritual coaxing that must take place.

Audit committees have been given oversight of auditors, that they may intercede between management and the auditors. Rigorous enforcement by the SEC and, since 2003, the PCAOB, also presents a powerful counter-incentive to the pressure to accommodate management, and thus significantly strengthens investor protection.

But the underlying conflict has not been resolved. The stories that come out when problems are revealed have changed. The techniques of influence are more sophisticated than the rude authority management of McKesson exerted over the audit. And they are more subtle.

Today, auditors face technical arguments that broad standards don´t apply because they are not specific enough. Or that specific standards don´t apply because they are narrowly focused on some other scenario that is distinguished by the relevancy of minute, circumstantial differences.

Or, if there is indisputably an error, a debate may ensue about whether the error is material, which is supposed to mean that which would be material to the reasonable investor. But it can devolve into a hyper-technical discussion about what percentage change, to what line item or sum, would trigger that hypothetical investor to raise an eyebrow.

With all the talk about the complexity of financial statements, when the need for an adjustment arises, more ink may be used to debate the materiality than would be used to provide the debated disclosure. I fear the most reliable measure might be that the more memos that are generated to explain why the error is not material, the more likely it is. Of course, such a measure too could be gamed.

The incentive to avoid problems with management may also affect the auditor´s procedures, albeit more subtly than McKesson´s President Philip Musica´s refusal to allow McKesson´s auditors to check inventory or confirm receivables.

In the nine years since the PCAOB was established, PCAOB inspectors have conducted inspections of portions of approximately 3,000 audits by major firms, and they have found hundreds of flaws. The case is similar at small firms.

I´m not talking about reasonable judgment calls, or mere deficiencies in documentation. I´m talking about flaws that go to the fundamental objective of the audit – to obtain reasonable assurance about whether the financial statements are free of material misstatement.

In many cases, these flaws were found at firms that are clearly comprised of highly competent and ethical professionals. I am left with the fundamental question: why didn´t the auditor´s skeptical mindset help him see that he needed to challenge management´s assertion or investigate disconfirming evidence?

Skepticism can fail in spite of both fundamental competence and high ethical standards.

Skepticism indeed will fail if not championed in the culture of the firm and, more generally, the business environment in which the auditor works. Today, client service is championed as its own kind of expertise, and yet it is decidedly not the same thing as audit excellence.

Signs of this conflict are evident in auditors´ struggle to reconcile the idea of client service with audit objectivity, when the auditor pitches a potential new audit client.

Signs of this conflict are evident in the seemingly unrestrained enthusiasm for selling services to audit clients that some audit partners have recorded in self-evaluations, and some supervisors' have recorded in their evaluations of partner performance, and in agreed performance goals.

When inspectors shine light on anomalies like these, they get addressed, at least in the specific manifestation. Inspections are thus an important tool to identify ways audits can be improved. There is no telling how many more failures there would have been had auditors not felt the scrutiny of the PCAOB´s fresh set of eyes.

But the underlying conflict has not been resolved. I don´t pretend that it can ever be completely resolved, when the intended beneficiaries of the audit – public investors – are not in privity with the auditor. But we must do better.

Unlike the Dutch West India Company directors I began with, or even the private equity investors of today, if public investors think they are "not properly informed of prizes captured, stores sold, et cetera," as a practical matter, they cannot change accountants.

I have all due respect for the steps that have been taken at many companies to provide for shareholder ratification of the auditor´s appointment. And for the hard work of audit committees to oversee the appointment of auditors, and for calling the balls and the strikes when an auditor-management disagreement does make it´s way to the board room.

But the public outcry we hear when a reporting failure becomes apparent reminds us that the expectation gap is as wide as ever. No one should be surprised that the accounting profession finds itself again, today, at a point where its role is under examination.

It is my hope that, as auditors, you will look back on this time as the moment when you turned to seize the future. With a century of experience responding to the public interest, the New York State Society will be an important voice.

III. The PCAOB´s Policy Agenda to Enhance the Relevance, Credibility and Transparency of Audits

There is no silver bullet to address these challenges. There are as many or more problems with structural alternatives such as a third-party payor or an insurance-based system. This is why I believe we must retain the current system, but do more to counteract the inherent conflict.

The choices we face require debate, and that debate is taking shape. The PCAOB has introduced several initiatives, for broad public discussion and analysis. They go to reducing risks that flow from the conflict I´ve cited, not eliminating them. They challenge incentives that weaken investor protection, by applying counter-weight.

The initiatives bring together the relevance, credibility and transparency of audits. But above all, they are related to the culture of the audit. These projects are founded on the principle that audit regulation should foster conduct and a culture consistent with the franchise that the securities regulatory regime accords the audit profession.

A. The Auditor´s Reporting Model

First, the PCAOB has initiated a broad debate on the form and content of the standard auditor´s report. In June, the PCAOB issued a concept release on potential changes to the auditor´s reporting model.

The Board issued this paper to examine whether the auditor´s report could better serve investor needs. Given the effort involved in an audit of a large company, and the complexity of many financial statements, the paper asks whether the auditor can provide deeper insights.

Just as the Dutch West India Company directors believed their accountant´s reports should properly inform them of pertinent data on company trade, our audits and audit reports ought to reflect the needs of dispersed owners as they would majority owners who hire the auditor directly.

This is a starting principle for me. It is not the conclusion of the analysis. Based on this principle, we will need to consider many practical challenges, such as what auditors are capable of producing for mass consumption within the short filing periods now required.

We will also need to consider ways to enforce consistency of reporting. "Boilerplate" has a negative, even evasive connotation. At the same time, investors ought to be able to expect that differences in reports reflect differences in the quality of the financial reporting subject to audit, not differences between engagement partners.

The alternatives described in the release are focused on enhancing the relevance of the auditor´s communication to investors. They would not change the fundamental role of the auditor to perform an audit and attest to management´s assertions as embodied in management´s financial statements. They are not intended to put the auditor in the position of reporting financial information for management.

That said, they are intended to spur debate over how to change auditing, from a culture that emphasizes client service to a culture that emphasizes public service.

We have received 150 comment letters to date, including a thoughtful comment letter from New York State Society of CPAs. In addition, in September we held a public roundtable to foster further discussion among 32 experienced individuals.

We will be analyzing the comments we have received for some time. This is a major project, and the PCAOB will not rush the process.

B. Auditor Independence

The PCAOB is also focused on auditor independence.

In August, the PCAOB issued a concept release to seek public comment on how to enhance auditor independence, including whether audit firms should be subject to term limits.

There are, of course, considerable implementation challenges associated with mandatory term limits. These changes can be dramatic, and yet there are examples of how they can be managed. Some institutions have fixed term limits for their auditors. In some countries, auditors take term-limited engagements.

How do auditors and companies manage these changes? What do auditors, and the audit committees that oversee them, do to make sure the new auditors are in a position to provide reasonable assurance in the early years of an engagement?

The concept release invites study and consideration of whether there are ways to mitigate the challenges of auditor turnover. But the reason to consider the idea is to resolve the question to which the discussion of independence, skepticism and objectivity always seems to return:

will term limits, set at some appropriate length, with due regard for implementation complexities, reduce the pressures auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets?

Auditors are generally opposed to the idea of term limits. It´s understandable that such a change would be hard to welcome. But I want you to think about it.

You tell me: When a client wants you to agree that an error that you´ve found, say after the earnings release that you were not tasked to audit has already gone out, is immaterial, do you think about how the ensuing discussion will affect your relationship with the client?

Whether you´ve found a potential problem in an engagement or not, do you ever think about how important retaining a client is to your own career or standing in your firm?

And here is the question that I believe you must answer: If you don´t think term limits would help you feel more independent, what would?

We have a long comment period, extending to December 14. We will then hold a public roundtable to further discuss the subject in March of 2012.

Comments are already flowing in. Please submit yours. We are not looking for volume, although we will no doubt get it. We are looking for candid, insider information, specifically from you.

C. Audit Transparency

The third policy initiative the PCAOB has mooted recently relates to audit transparency. Earlier this month, the Board proposed amendments to its auditing standards to improve audit transparency by enhancing disclosure about the participants in audits, including disclosure about the partner in charge of the audit as well as other firms involved in the audit.

Investors have called for this information. As a general matter, auditors don´t relish the idea. But it has become an issue of public interest.

The names of key management executives, not to mention corporate board members, have long been disclosed. The names of audit engagement partners are also disclosed in many countries, but to this point not in the U.S.

The Board also proposed providing more transparency about the firms that contribute to global audits. For many large, multi-national companies, a significant portion of the audit may be conducted abroad, even half or more of the total audit hours.

In theory, when a networked firm signs the opinion, the audit is supposed to be seamless and of consistently high quality. In practice, that may not be the case.

Enhanced transparency about how cross-border audits are conducted should help investors make more informed decisions about how to use the audit report. Shining a light on the composition of the multi-national audit should reward consistent high quality where delivered.

* * *

As a profession, as leaders in governing a just society, and as protectors of the public interest, we must challenge ourselves to challenge our culture. I did not recount the ancient history of accounting in the United States to invoke a nostalgic dream. I did so to remind us all that those early accountants faced choices, and made choices, too. We are called upon to do the same.

I am mindful that culture does not change quickly. It would be naïve to think that any one of these proposals would, in isolation, trigger the culture change we need. This is why I have advocated a holistic approach aimed at enhancing the credibility, transparency, and relevance of audits.

I am also mindful that cultural change is not comfortable and can be painful, even harmful. Look at the Industrial Revolution. At that time, the accounting profession in New York was a voice for integrity, analytical care, and expertise in furtherance of the public interest.

I ask you to confront today´s challenges as they did. Let the change start here, in this city, where the commerce and wealth of our nation began.

[1] Grant, Julia, New York State Society of Certified Public Accountants: Foundation for a Profession (1995), at 6.

[2] Id.

[3] See Flesher, Previts and Flesher, "Profiling the New Industrial Professionals: The First CPAs of 1896-97," 25 Bus. & Econ. History (Fall 1996).

[4] Carter was later promoted to major general, in 1943. From 1941 until the end of World War II, he served as fiscal director of the Army Service Forces.

[5] See Hearings before the Senate Committee on Banking and Currency on S. 875 (Mar. 31 to Apr. 8, 1933), at 58.

[6] Senator Barkley went on to become Vice President of the United States under President Harry Truman.

[7] See Accounting Series Release No. 19 (Dec. 5, 1940). The SEC also found that the failure of Price Waterhouse´s audits to detect the overstatement was due to lack of "that degree of vigilence, inquisitiveness and analysis of the evidence available that is necessary in a professional undertaking and is recommended in all authoritative and well-known works of auditing." Ultimately, though, the SEC did not hold Price Waterhouse accountable because, "these audit steps, although considered better practices and used by many accountants, were not considered mandatory by the profession . . . ."

[8] TIME, Accounting: After McKesson´s (May 22, 1939):

There are some 17,000 Certified Public Accountants in the U. S. To win the coveted initials C.P.A. they had to pass rigorous examinations in accounting. Beyond that, their functions are virtually unregulated by law. Their methods of auditing and analyzing a corporation's balance sheet are their own, the developments of over 400 years of practice. The U. S. public first realized that these methods were not always perfect when the McKesson & Robbins scandal broke last December. How was it possible, the average investor asked, for $18,000,000 in fictitious inventories to deceive seasoned accountants?

[9] Auditors Answer Criticism by SEC, N.Y. Times (December 7, 1940).