Good Morning,
Thank you very much for inviting me to be here today. I am
honored to have been included as a speaker before this distinguished
group of educators and researchers.
As you all know, the Public Company Accounting Oversight Board
was created by Congress through the passage of the Sarbanes-Oxley
Act of 2002 ("Sarbanes-Oxley Act"). I celebrated my second
anniversary as a PCAOB Board Member a few months ago, and the Board
itself has been operating for just over ten years. Since our
inception, we have conducted over 2000 inspections in 40
jurisdictions and released 16 new auditing standards as well as
amended many others. We have also issued 56 disciplinary orders,
including sanctions against 42 firms and 59 individuals. These
numbers sound pretty good, but we do not have a textbook teaching us
how to regulate, nor an answer key against which to measure our
progress. However, we do believe in self-reflection and
self-evaluation to ensure that we are doing the best job possible to
achieve our statutory mandate. I would like to discuss today some of
our efforts to evaluate our processes and outcomes, and, in that
context, will discuss some of our recent regulatory activities. In
addition, I would like to say a few words about a subject that may
be near and dear to your hearts: the preparation of future auditors.
Finally, I hope to be able to answer some of your questions
(although I hope that you will refrain from grading my
answers!).
But 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.
Board Near-Term Priorities
In keeping with the spirit of self-examination, the Board
recently identified a series of near-term priorities for 2013. These
include:
- Improving the timeliness, content and readability of
inspection reports;
- Improving the timeliness of remediation determinations and
providing additional information on the Board's remediation
process;
- Initiating a project to identify and report on audit quality
measures;
- Enhancing our processes and systems to improve analysis and
usefulness of inspection findings in order to better understand
audit quality and better inform standard-setting and other
regulatory activities;
- Enhancing the framework for our standard-setting efforts in
order to improve the effectiveness of the process and the project
tracking information provided to the investing public; and
- Enhancing the Board's outreach to and interaction with audit
committees. [1]
Although I won't discuss our progress on each of these priorities
in detail, I would like to provide my perspectives on several of
them.
With respect to our review of inspection reports, we are
evaluating both our firm-specific inspections report (which are made
public in part, consistent with the Sarbanes-Oxley Act) as well as
our periodic summary reports used to convey inspection findings over
a period of time and across firms. This latter category of reports
is often referred to as "Rule 4010 Reports," based on the PCAOB Rule
governing their issuance. The Board recently issued two such
reports.
First, in December 2012, the Board issued a report called "Observations
from 2010 Inspections of Domestic Annually Inspected Firms Regarding
Deficiencies in Audits of Internal Control Over Financial
Reporting." This report summarized observations drawn from
inspections of 309 audits of internal control over financial
reporting at public companies.[2] The report expressed concern about
the number and significance of deficiencies identified in firms'
audits of internal control during the inspections, which generally
involved reviews of the integrated audits of financial statements
and internal control for issuers' fiscal years ending in 2009.
The inspections results summarized in this report include, among
others, our inspection staff's observations about deficiencies in
auditors' execution of the "top-down" approach to testing controls.
One common finding noted in the report that we are still seeing in
our inspections reflect the challenges posed by the need to
understand the design, operation and effectiveness of such controls,
including whether the control operated at a level of precision that
would prevent or detect material misstatements.
Second, in February 2013, the Board issued a report summarizing
inspection results observed from 2007 to 2010 in the inspections of
U.S. firms that audited 100 or fewer public companies and which were
required to be inspected at least once every three years.[3] This report built on a prior
report, published in 2007, of earlier inspection results at these
so-called "triennial firms."[4]
The recent report regarding triennial firm inspections includes
observations from 748 inspections of 578 domestic triennial firms
conducted from 2007 through 2010 and reflects reviews of 1,801
financial statement audits. Frequent findings during this time
period related to audit work in several areas, including:
- revenue recognition;
- share-based payments and equity financing instruments;
- convertible debt instruments;
- fair value measurements;
- business combinations and impairment of intangible and long
lived assets;
- accounting estimates;
- related party transactions;
- use of analytical procedures as substantive tests; and
- responding to the risk of material misstatement due to fraud.
While the report showed an overall reduction in the rate of
reported significant audit performance deficiencies compared to the
prior report issued in 2007, and a decrease in the rate of
significant deficiencies noted in firms' second inspections compared
to their first, the persistence of deficiencies in audits performed
by a large number of domestic triennial firms remains of concern to
the Board.
Both of the recently issued reports include a discussion of
potential root causes for the findings. While the causes of audit
deficiencies are typically complex and are often the result of a
combination of factors, inspectors highlighted the following issues
in the two reports:
- a lack of technical competence in a particular audit area;
- insufficient firm training and guidance, including examples of
how to apply PCAOB standards and the firm's methodology;
- a lack of due professional care, including professional
skepticism;
- ineffective or insufficient supervision, which at times may
have been due to heavy partner and professional staff workloads;
- decreases in audit firm staffing through attrition or other
reductions, and related workload pressures;
- ineffective client acceptance and continuance practices that
fail to consider technical knowledge called for in particular
audits;
- ineffective engagement quality reviews
- improper application of the top-down approach to the audit of
internal control as required by AS No. 5; and
- ineffective communication with firm's information system
specialists on the engagement team.
While I believe that these reports, and others like them, provide
useful information relating to public company audits, and perhaps
some good "teaching moments," we are currently seeking feedback on
whether these reports are useful and how they could be improved. One
recent addition to these types of reports has been the addition of
an "executive summary" that we hope is written in plain English and
will be helpful to a variety of readers, including non-auditors.
Historically, the Board's general reports have been used primarily
to recount inspection findings; more recently we have attempted to
provide a little more context and meaning to those results. Next
week, we are hosting a meeting of the Board's Standing Advisory
Group, and we have scheduled a session dedicated to a discussion
about potential improvements to the Board's general reports. I look
forward to hearing SAG members' suggestions for improvements, and I
would be interested in hearing your input at as well.
Board Members also have challenged themselves and the PCAOB's
inspection staff to consider potential improvements to the
firm-specific reports. We are often criticized for the time it takes
for the Board to issue these reports, and our staff has been working
diligently to issue inspection reports more quickly without
compromising accuracy or fairness, and they have made substantial
progress. Many of our reports are issued within a matter of months,
and for those that take longer than a year, there is usually a good
reason, such as the need to consult about complex accounting
questions or delays in obtaining relevant information. We continue
to strive for even more improvements in the timeliness of reports,
but I also ask myself and our staff whether more could be done to
enhance the content of the reports, to provide more useful
information to the investing public, and I anticipate that we will
also conduct some outreach in this area. A key question we need to
answer in today's environment is "who is the intended reader of the
report?"
One particular criticism with respect to our reporting has been
the focus of the reports — including firm-specific inspection
reports and our general reports — on the negative. In keeping with
our regulatory mandate, we tend to look for and report audit
deficiencies. Indeed, with respect to quality control deficiencies,
we have a specific statutory mandate to include applicable
criticisms in the report and to publish that information if firms do
not take appropriate actions to remediate the problems. But some of
our stakeholders have asked us to consider whether audit quality
also could be enhanced through PCAOB reporting of what auditors do
right, allowing auditors to learn from each other. Our current
programs and resources do not contemplate the collection of data
needed to determine and report comprehensively on auditor "best
practices," but our work in connection with a near-term priority
project to identify and report on audit quality measures may be a
step in that direction.
This project is focused, in its early stages, on attempting to
define audit quality, establish a framework for thinking about audit
quality, and develop specific, quantitative indicators that may,
ultimately, be used as objective measures of audit quality.
Currently, the staff of the Office of Research and Analysis who are
working on this project are recommending a working definition of
audit quality that reflects a common understanding of quality used
in business endeavors: "meeting customer needs." Customers include
investors and audit committees, among others, and their needs are
for independent and reliable audits and robust audit committee
communications. The staff's preliminary thinking of the framework
for audit quality includes three segments: audit inputs, processes,
and results. Next week, the staff is presenting this project to the
Board's Standing Advisory Group and will seek input on the potential
elements of quality within each of the framework segments.[5]
If successful, this endeavor could have wide-ranging implications
on many of our activities. It could affect the content or focus of
inspection reports, influence potential future standard-setting
projects, and may, ultimately, lead to the publication of certain
indicators that could help audit committees and investors better
evaluate the quality of work by their auditors. While we have input
from some that a single score, much like a credit score, should be
the goal, my hope is to provide a matrix of indicators to provide
information in a range of areas that users can consider and
prioritize based on their individual circumstances and needs. I
anticipate that we will continue to seek input regarding this
project for some time, and I urge the researchers among you to share
with us any relevant knowledge, research, theories and studies.
As you can see, a common theme for several of the near-term
priorities is to make more useful information available on a more
timely basis. A related objective is to make our information more
accessible to and useful for groups and individuals beyond the audit
profession, including investors, preparers and audit committees. In
connection with some of our past outreach, including during several
public meetings about auditor independence last year, we heard that
audit committees, in particular, are interested in and would benefit
from more information about the PCAOB's activities and findings. The
important auditor oversight role played by audit committees in the
capital markets complements the Board's mission, and we are eager to
explore ways in which we can work together.
A partial response to the feedback received from audit committees
was the issuance, in August 2012, of a release to provide
information to audit committees about the Board's inspection process
and the meaning of reported inspection results. The objective of the
release was to better equip audit committees to engage in
meaningful discussion with audit firms about the results of
inspections.[6] Among other things, the release highlights
certain matters relating to PCAOB inspections about which an audit
committee might benefit from having a discussion and understanding
with its audit firm.
In order to foster a more robust dialog between the Board and
audit committees generally, the near term priorities for 2013 also
include increasing our outreach to and interaction with audit
committees. We are currently considering potential approaches to
such outreach and interaction, ranging from the issuance of
additional publications, to attendance at conferences or webcasts,
to hosting town hall-style meetings or round tables specifically
tailored toward audit committees. I would like to see a more regular
two-way dialog between the PCAOB and audit committees, so that we
can leverage our collective knowledge and experience. Ultimately,
audit committees hire and fire the auditors. While regulatory
activities like inspections, enforcement and standard setting can
provide appropriate parameters for audit practice and will drive
improvements over time, audit committees — if equipped with relevant
information about how to evaluate the quality of work by auditors —
are a powerful market force that could complement our regulatory
efforts by driving improvements in audit quality through financial
incentives.
Future questions facing the PCAOB
In addition to the self-evaluation inherent in the current
near-term priorities, there are other areas the Board will have to
review and reconsider as we move through our second decade of
operations. Our inspection approach is one of these areas that I
anticipate will require some attention in the future, both to
validate its effectiveness and consider potential improvements. Some
relevant questions that have already been posed include whether our
current approach of selecting audits for review largely on a risk
basis continues to be the most effective approach, or whether we
should also incorporate a more random element to our selections.
Some also have suggested that we should tailor our future
inspections of firms — for example the numbers of audits reviewed or
the extent of quality control procedures — on the firms' past
inspection results. This might be described as a "carrot" approach
to accompany the regulatory "stick": Do a good job and the reward
will be a lighter regulatory touch.
Our international inspections, also, may have to evolve as we
conduct inspections with an increasing number of foreign regulators.
To date, we have conducted inspections in 40 different countries. In
16 of these countries, we have cooperative arrangements with home
country audit regulators under which we conduct joint inspections or
share information. We continue to actively negotiate such agreements
with regulators around the world, many of whom began operations
during the last decade and are beginning to mature just as we have
over the last several years. My fellow Board Member, Lewis Ferguson,
was elected recently as the Chairman of the International Forum of
Independent Audit Regulators, and he has an ambitious agenda to
enhance information sharing and cooperation among audit regulators
around the world. In light of these developments, should we continue
to treat our foreign inspections — particularly where we work in
tandem with our foreign counterparts — largely as we do domestic
firm inspections, or are there efficiencies to be achieved where our
counterparts have established robust regulatory oversight? Is the
substantially higher cost of non-U.S. inspections, particularly of
firms with very small, low-market cap, issuer audit practices,
justified by its benefits to investors, or should we take a more
risk-based approach in this context as well?
At the same time, the ever increasing globalization of the
companies whose audits we must oversee presents significant risks
that we must continue to consider. More and more firms have
operations — and audits — around the world. Work referred by
auditors to countries outside the U.S. presents unique risks, and we
have already begun to address such risks through an inspection
program that reviews not only audit work performed by principal
auditors but also work referred to foreign accounting firms. The
Board also has proposed amendments to PCAOB standards that would
require firms to disclose publicly other independent public
accounting firms that participated in multi-national audits, as well
as their locations and certain information about the amount or
significance of the work performed by those other firms or
accountants. Finally, the Board has addressed related issues in two
practice alerts — one intended to remind registered firms concerning
a firm's obligations when using the work of other firms or using
assistants engaged from outside the firm[7] and a second to discuss fraud risks
that auditors might encounter in audits of companies with operations
in emerging markets.[8] This, I believe, is a great start.
But we must continue to monitor our programs and our cooperative
arrangements with our foreign counterparts to ensure that we have in
place the necessary regulatory mechanisms to maintain an appropriate
level of oversight over these increasingly global and complex
audits.
Preparing Auditors of the Future
I have discussed in some detail the Board's regulatory efforts
and potential market forces that may influence audit quality. The
most important driver of audit quality, of course, is the knowledge,
skill, experience and mindset of the auditors doing the work. The
foundation for that begins with all of you, in the classrooms at
universities that educate future accountants and auditors. And the
challenges faced by accounting educators have never been
greater.
Thirty years ago, financial statements were dominated by tangible
assets and historical cost accounting. Today, after rapid advances
in technology, the development of innovative business models and the
mind numbing complexity of many investments, the balance sheets of
an increasing number of companies are dominated by valuation
estimates. It is much more difficult for accountants, auditors and
investors to understand the transactions and products that must be
captured in financial statements. Management and their accountants
increasingly must tackle fair value measurements and management
estimates, consistent with new accounting standards in connection
with derivatives, securitizations, consolidations, debt/equity
issues, revenue recognition, leases and other issues.
Estimates and measurements are one of our most frequently
identified inspection findings, including instances where auditors
appear not to have complied with PCAOB auditing standards relating
to fair value measurements of financial instruments, impairment of
goodwill, indefinite-lived intangible assets, and other long-lived
assets. Inspectors have identified occasions on which auditors
failed to determine the reasonableness of assumptions applied by
management in making the necessary measurements or estimates. In
some cases, auditors did not appropriately consider the weight of
both positive and contradictory evidence, have not responded
appropriately to valuation risk or appropriately evaluated
management disclosures. The frequency with which we encounter these
issues, and the fact that findings continue year after year,
demonstrate how difficult it is to audit these areas.
Our auditing standards require auditors to understand and
evaluate management's assumptions and processes in establishing
valuations or estimates, and to test management's valuations and
disclosures. I was pleased to see that there are presentations on
your agenda for this meeting that deal with this important subject
(as well as on internal controls, another area that has received
much attention from the PCAOB). While many universities and colleges
also have begun to include fair value accounting modules in their
curriculum, are we doing enough to prepare our students for a world
where estimates and measurements predominate financial statements
and cost accounting is quickly becoming less relevant? Should
accounting programs consider additional changes in their curriculums
in order to better reflect this new world? Does the CPA exam reflect
the reality of what young accountants need to know today?
The judgment inherent in auditing estimates and measurements,
compared to observing inventory or reconciling accounts, also
underscores the need for auditor independence, objectivity and
skepticism. Not only must auditors understand management's
assumptions and processes, they must question them and evaluate
contradictory information that comes to light. But how do we teach
auditors of the future to have an appropriate mindset? Do auditing
courses prepare young accountants for this less tangible challenge?
How do we prepare students for the rigors of public accounting and
equip them with the mindset to maintain their objectivity and
skepticism in the face of countervailing forces, including long
hours, the tedium of tasks left to the newest members of the audit
team, and client pressures?
Another challenge for young auditors arises in situations where
they have to deal directly and independently with a client's
management or accounting staff. While texting and Facebook postings
may be preferred ways to communicate for some, it does not work well
in the audit world. Young accountants may be faced with challenging
the work or opinion of someone who is their parents' age or someone
whose experience and skillset far exceed theirs. Recently, I came
across an academic study that suggests that younger auditors are
often "mismatched" with the client personnel with whom they
interact, with respect to their age, experience and knowledge. As a
result of this mismatch, the study suggests, auditors may collect
less audit evidence in order to avoid interactions with client
personnel.[9] Is there more we can do to prepare
new auditors for this psychological challenge?
I do not pretend to have answers to these questions, although one
partial answer may be that you, alone, probably cannot prepare your
students to successfully navigate all of these challenges
immediately upon graduation. Much of what auditors ultimately need
to know is learned by doing, through on-the-job training and
effective mentoring relationships. But I urge you to think about
whether more can be done to lay the groundwork upon which your
students and their future employers can build.
It is clear we, collectively, face many challenges in continuing
to build a robust audit profession that earns the public trust.
With that, I will thank you for your attention. I look forward to
any questions, feedback and ideas you may have.