The PCAOB’s Role in Investor Protection 

DATE Sept. 28, 2012 

SPEAKER(S): Jay D. Hanson, Board Member 

EVENT: University of Nebraska Omaha Accounting Speaker Series 

LOCATION: Omaha, NE 


Good Morning,

I am very honored to be here to present at this inaugural speaker series event. I am particularly excited about the mix of participants here this morning — ranging from students who are yet to begin their careers, faculty that are helping to prepare future accountants and auditors, accountants working hard every day to get the numbers and disclosures right, and audit professionals providing important assurance to investors. Thank you all for choosing careers that are so challenging and critical to the capital markets.

Before I go further I must tell you that the views I express today are my personal views and do not necessarily reflect the views of the Board, any other Board member, or the staff of the PCAOB.

I started my career over thirty years ago when I graduated from college in Minnesota and joined McGladrey and Pullen. A great deal has happened since then, particularly in the last decade. As all of you know — although the students among you probably were not reading the Wall Street Journal at the time — the collapse of Enron, the bankruptcy of WorldCom, and a number of other corporate scandals led Congress to pass the Sarbanes-Oxley Act of 2002, which established the PCAOB and imposed some important new requirements on corporate America and the auditing profession.

Before "SOX," as so many affectionately call this landmark legislation, the auditing profession in the United States was subject to self-regulation, and, in response to major corporate bankruptcies and concerns about the quality of public company audits in 1970's, the American Institute of Certified Public Accountants ("AICPA") established a variety of measures to enhance oversight over the practice of auditing, including the Auditing Standards Board, the SEC Practice Section, and the Quality Control Inquiry Committee. In spite of these measures, scandals and business failures continued, often prompting the question: "Where were the auditors?"

Even after the Sarbanes-Oxley Act, we had a major financial crisis and scandals like those involving Madoff, Petters, Peregrine Financial Group and others. Again, questions were raised about the role of auditors. In 2010, Congress again acted, passing the Dodd-Frank Wall Street Reform and Consumer Protection Act, which included a variety of provisions, including expanding the PCAOB's oversight authority to include the auditors of brokers and dealers.

So, with all of this attention on auditors and their role in the capital markets, what has been the role of the PCAOB in investor protection during the last ten years, and where are we headed in the future?

The PCAOB commenced operations in 2003, building programs to meets its four statutory obligations: registration, inspections, enforcement and standard setting. Initially conducting only limited inspections of the four largest firms, the Board's registration records currently show over 2300 firms, including foreign firms from 85 jurisdictions. To date, the Board has conducted over 1950 inspections, including inspections in 38 jurisdictions outside the United States. Last year, we commenced a pilot program of inspections of the audits of brokers and dealers, and, in August, we issued our first public report on the inspection results of that program thus far.

Since its inception, the Board also has issued 16 auditing standards — including, for example, audit documentation, internal controls, audit planning, engagement quality review, and risk assessment — and has substantially amended a number of interim standards — including, for example, AU 325, AU 411, AU 508, AU 350 and AU 329. Last year, the Board issued concept releases or proposals to trigger wide-ranging discussions about potential changes to certain fundamental aspects of auditing, including the content of the auditor's report, audit transparency, and auditor independence, objectivity, and skepticism. More recently, the Board issued a proposed standard on related parties and a final standard on communications with audit committees.

The PCAOB also has regularly issued staff audit practice alerts, intended to highlight new, emerging or otherwise noteworthy issues or circumstances that affect how auditors do their jobs. Examples of topics include auditing during and after the financial crisis, difficult valuation issues, litigation and other contingencies, using the work of other auditors, and several others.

Combined, our work conducting inspections and enforcement proceedings and drafting standards and practice alerts give us a pretty good sense of the areas with which auditors are struggling.

Recent inspection findings tell us that auditors have struggled with auditing fair value measurements, impairment of goodwill, indefinite-lived intangible assets, and other long-lived assets, allowance for loan losses, off-balance-sheet structures, revenue recognition, inventory and income taxes. Our inspection results in 2010 and 2011 showed an increase in inspection findings, particularly in the area of fair value, but also in the auditors' testing of internal controls.

We know that the accounting profession as a whole is facing difficult questions as a result of the increasing complexity of business transactions and complex financial instruments which are appearing more frequently not only in the financial statements of financial institutions but many other types of companies as well. Management and their accountants must tackle an ever growing list of fair value measurements and estimates, which often involve measurement uncertainty or predictions of the future. At the same time, in the wake of the financial crisis, the work of accountants is subject to increased scrutiny by regulators and investors, particularly in the areas of complex accounting applications, disclosures and internal controls over financial reporting.

Auditors also must master these technical challenges while simultaneously overcoming the difficulties associated with tight deadlines, fee pressures, demands for client service, and business development expectations, all of which may undermine incentives to conduct comprehensive, high quality audits. At the same time, auditors face criticism from those who believe that they did not do enough, in the years or months leading up to the recent financial crisis, to sound an alarm about the risks and uncertainties associated with certain companies.

Although the challenges for the audit profession remain numerous, I firmly believe that PCAOB inspections, standard setting and enforcement activities have had a substantial, positive impact on audit quality since the PCAOB's establishment. While I cannot speak for my fellow Board members, several have made public statements indicating that they agree. However, when pressed for details, we find that it is difficult to provide specific measures to support our belief that audit quality has improved. There have been many discussions about audit quality at the PCAOB and among leaders in the audit profession. Everyone agrees that audit quality is difficult to measure, and that unintended consequences may result from attempts to do so. There are many possible ways to look at whether audits are effective, including the trends in restatements of financial statements, revisions to opinions on internal control over financial reporting, litigation against the auditor, investor and audit committee satisfaction, peer review results and our inspection findings, to name just a few. Although this is a difficult area with many uncharted waters, I am hopeful that, with almost ten years of experience under our belt, we can make progress in figuring out how to measure the quality of audit work and our success as a regulator in driving important improvements.

Another important aspect of trying to determine what drives audit quality is understanding what auditor actions or behaviors result in poor audits, and what auditors do that has positive results. Consistent with the requirement in the Sarbanes-Oxley Act that PCAOB inspections "assess the degree of compliance of each . . . firm . . . with th[e] Act, the rules of the Board, the rules of the Commission, or professional standards."[1] our inspectors specifically look for and communicate audit deficiencies. PCAOB inspection reports are not intended to convey a balanced view of the strengths and weaknesses of each inspected firm. We do not provide grades to firms, and what we report should not be the only fact informing anyone's view about audit quality.

Nevertheless, we are frequently asked whether and how we can communicate what we observed in inspections of audits where we found no deficiencies. Said another way, where did things go right and why? In any given firm, PCAOB inspectors may find very different results in different audits of similar companies. Currently, our answer is that — other than anecdotally — we have not been collecting and reporting data about what firms are doing right. I believe we should be, as we consider how best to continue our work to improve audit quality.

Clearly, we at the PCAOB have our work cut out for us, and I look forward to continuing to contribute to the work of the Board as we enter our second decade of operations. However, we cannot do it alone, and we need your help. I have already discussed some of the complexity in business models and transactions that pose unprecedented challenges to accountants and auditors today. Fair value accounting and the auditing of fair value measurements and management estimates play an increasingly important role in today's economy, yet even experienced auditors struggle with these issues every single day. Many universities and colleges have begun to include fair value accounting modules in their curriculum, but I urge the academics in the room to consider whether more can be done. Provide real world examples to your students, and address both the accounting requirements and appropriate audit approaches. Cost accounting is an indispensable building block in any accounting education, but fair value accounting is an indispensable skill in today's business world.

Other developments that auditors increasingly encounter include complex intellectual property arrangements, rapid business cycles where companies move quickly from start-up to IPO to merger and acquisition or sell-out, and, of course, the expansion in the use of International Financial Reporting Standards. I know many accounting programs incorporate these and other emerging themes into your teaching and research activities, and I applaud you for your efforts.

Those among you who are students with the goal of joining the audit profession, my best advice is never to lose sight of the fact that your true clients are the investors in the companies you are auditing, not the company's CFO, or the accounts receivable accountant, or even the internal auditor with whom you may be interacting day after day. When you are working long hours and dealing with difficult issues, it may be easy to forget about the public-interest mission auditors fulfill, but that mission is the only thing that distinguishes the auditor from the legions of others whose work affects the company's financial statements.

Finally, we at the PCAOB need to work closely with audit committees, who have a substantial effect on audit quality, as they work every day to fulfill their investor protection obligations, hiring and firing auditors, directing and supervising their work, and holding them to high independence and performance standards. We try to do our part to make the jobs of audit committees easier and their efforts more effective. Recently, the Board issued Audit Standard No. 16 to expand the matters about which auditors are required to communicate with the audit committee. These matters include, for example, significant risks, critical accounting estimates, difficult or contentious matters, significant unusual transactions, and going concern. Last month, we also issued a document, Information for Audit Committees about the PCAOB Inspection Process,[2] intended to help inform the dialog between audit committees and their auditors about our inspection findings.

We hear from audit committee members frequently, including at our investor advisory group meetings, standing advisory group meetings and roundtables like those held throughout this year to seek input about auditor independence, objectivity and skepticism. We are eager to better understand how audit committees fulfill their role today and what has changed under "SOX." Our interactions with audit committee members have impressed upon us that many audit committee members take their role very seriously and put forth substantial time and effort to ensure that investors receive fair and accurate financial statements. But we also hear from auditors, financial statement preparers and investors that the quality of audit committee performance varies, and there is always room for improvement. We do not regulate audit committees, and, due to confidentiality provisions in the Act, we cannot provide them with non-public information about our inspections or enforcement work relating to the audit firms they oversee. Nevertheless, given the key role of audit committees in the capital markets, it is important that we work together to achieve our common mission of investor protection. Starting a dialog was a great first step. I am hopeful that we can continue these efforts and do even more to help audit committees understand what we do and what we observe about the audit profession. Likewise, we have a lot to learn from them, and I welcome any and all input from audit committees of companies of all sizes.

Thank you again for inviting me here today. I look forward to your questions.

[1] Section 104(a) of the Sarbanes-Oxley Act of 2002.

[2] PCAOB Release No. 2012-003 (Aug. 1, 2012).