The Role of Audit in Economic Growth

Date: Dec. 3, 2014

Speaker: James R. Doty, Chairman

Event: U.S. Chamber of Commerce The Future of Financial Reporting

Location: Washington, DC

Thank you, [David Hirschmann], and good morning everyone. It's a pleasure to be here. I would like to discuss the role of audit in economic growth.

Before I begin, let me first say that the ideas I express are my own and should not be attributed to the PCAOB as a whole or any other members or staff.

From my perspective, a fundamental objective of the Public Company Accounting Oversight Board should be to preserve and enhance the role that the audit can and should play in expanding capital formation and our economy.

The PCAOB's mission is to protect the investing public's interest in informative, accurate and reliable audit reports on the financial statements of public companies, brokers and dealers.

While our focus is on audit, our mission is the same mission that provides the intellectual framework for our federal securities laws generally.

It is the flow of expertly vouched-for information in the marketplace that, when perceived as both reliable and relevant to investment decisions, gives uninformed and dispersed investors the confidence to participate in a market as great as that which we enjoy in the U.S.

The framework is rooted in practice that predates the federal securities laws. It predates the founding of our nation and goes back to the time of the adventurers who needed to amass great sums to fund multi-year trade journeys.

These methods of capital formation were largely based in contract, between the providers and users of capital.

The U.S. federal securities laws emanated from our strategic desire, as a nation, to restore public confidence in our capital markets for the purpose of restoring and enhancing our ability to form capital for private enterprise.

Information about companies that offer securities in the United States is now fairly easy to obtain because of mandated disclosures and, in recent decades, the advent of the internet and other technological tools that aid dissemination and analysis.

Our securities laws lower investors' transactional risks, including what otherwise might be the costs of obtaining information, monitoring management's stewardship and buying and selling securities based on assessment of that information and stewardship.

We don't have markets for markets' sake. That is, market trading is lucrative for traders, but traders' wealth doesn't materially grow our economy. Markets contribute to economic growth by providing a vehicle for capital formation to fund ideas, including the infrastructure we need to run a prosperous society and generate even more ideas.

Investor protection should not be seen as in tension with innovation and risk taking. Rather, the point of investor protection is to promote capital formation to fund innovation, to fund risk taking — that is, entrepreneurial risk on long-term initiatives to grow our economy.

Investor protection cannot substitute for entrepreneurial energy, for "animal spirits," but it is a critical bridge without which we stop short of the full measure of our economic opportunity. It promotes widespread investment, which in turn promotes both business development and jobs as well as the growth of savings; and all of this is accomplished here without nearly as much dependence on government pension plans as many other developed countries still require.

As sophisticated as our markets and economy are, they are dependent on trust. We cannot take trust for granted.

Independent audits provide that trust, and thus bridge the gap between entrepreneurs who need capital and investors who can provide capital. There have been many changes over the years in the nature of the information that capital users provide to markets, changes designed to maintain the relevance of the information to capital providers. Historical cost accounting of the early 20^th century has given ground to fair value reporting today.

Yet the audit itself, including the audit report that communicates the reliability of financial information, hasn't been updated in any meaningful way since FDR was president.

It's critical that we continue to evaluate the audit first and foremost on its economic merits. That is, by no means do I intend to suggest that the audit will be irrelevant unless it becomes more expensive.

Private ordering of audit is always available. In such cases, it is fair to presume that the orderer — for example, a hedge fund, a venture capitalist, or a merger partner — can negotiate for the optimal service at the optimal cost. The orderer can weigh the tradeoffs between the benefit of the service and its cost, and walk away from services that are more costly than they are worth to the orderer.

Not so in the case of audits mandated by the federal securities laws: there is a floor to the cost of every audit, and every public issuer has to have the audit. The federal securities laws require audits for the public good; but precisely because they are a public franchise, we must ensure that they continue to serve the public interest in efficient markets.

For all the benefits the mandated audit has provided our markets and economy — and they are immense — the mandate by its nature runs counter to the competitive, economic forces that in other industries drive innovation.

That means it's up to us, as business leaders and policy makers, together with the audit profession, to protect the value of the public good that is the audit, by innovating it with purpose.

It won't happen naturally, but without concerted effort to maintain and champion a vigilant system of validating the financial information provided to the market, our businesses pay more than they need to for funding. Short-termism becomes the dominant market mentality, stifling innovation and job creation, and, ultimately, hindering economic growth.

Let me give you some statistics.

The average holding period for U.S. equities has dropped from seven years in the 1970s to seven months, less than even one audit cycle.^[1] High-speed traders, which sometimes hold their securities for seconds, now account for 70% of all U.S. equities trading.^[2]

To be sure, short-term investors play an important role in capital markets by providing liquidity and encouraging short-term accountability. But global need for long-term capital has never been greater. Estimates of global infrastructure needs range as high as $3 trillion per year, with public finances increasingly unable to meet these needs.^[3]

The financial crisis has further dampened enthusiasm for long-term investment strategies. Since the crisis, managers apparently feel even more pressure to maximize short-term results. According to a 2013 survey by McKinsey and the Canada Pension Plan Investment Board of more than one thousand board members and senior executives around the world —

• 63 percent said that pressure to generate strong short-term results had increased over the previous five years; and
• 79 percent felt pressure to demonstrate strong financial performance over a period of two years or less.
• Of these, 86 percent believed that using a longer time horizon would positively affect corporate performance by strengthening financial returns and increasing innovation.^[4]

One could say that these changes make the annual audit less relevant to today's markets. But I believe it's the opposite.

Market participants' monitoring with short-term performance goals will never fully substitute for the trust in the fundamental integrity of the financials that reliable audits can provide.

Enhancing the relevance and reliability of external audits is, to my mind, critical to coaxing the providers of capital back to long-term funding.

To overcome short-termism, and the tyranny of the quarterly earnings call, we need stronger audit, and stronger public confidence that the auditor "has investors' backs."

Yet, at the very moment that we need robust audit, there are signs of vulnerability. In recent years, audit practices have shrunk in comparison to audit firms' other client services. If present trends continue, within ten years, audits may yield less than 20 percent of the revenue of the global, networked accounting firms.

Try as they might, auditors face challenges in competing on the basis of quality. All audit firms deliver the same, standard-form audit report and the partner-in-charge is, as far as the markets are concerned, anonymous.

Indeed, it's not even clear how much or how little of the audit was performed by the firm that signs the opinion, which can vary considerably depending on the client's locations and the engagement partner's decisions about how to conduct the audit.

No global business — and I know we have representatives from several here today — is immune to the risks of poor or even corrupt business practices in the very markets in which global businesses must operate. How audits of operations in those regions are conducted is important not only to investors but to senior management as well.

High caliber engagement teams from each of the large accounting firms are capable of high quality auditing, as are many smaller firms when matched appropriately given the size and complexity of the audit client. Yet the rate of problems found in our inspections indicates that some engagement teams at each of these firms could miss a material misstatement.

The PCAOB recently issued the last of the largest four U.S. firms' inspection reports for the 2013 cycle of inspections of public company audits. Inspectors selected 219 audits among them, based on an assessment of risk, and determined that the opinions in 85 of these audits should not have been issued.

That doesn't mean inspectors determined that the financial statements were materially wrong but rather that, without more work to shore up the audit, the audit report should not have been issued.

PCAOB inspection results are fairly consistent with international results. Audit regulators around the world have identified certain themes that have concerned us, such as the need to exercise more professional skepticism in difficult audit areas, including auditing management estimates and valuations.

These circumstances indicate a need for a deeper examination of how the firms can improve audit quality, such that the audits can be as reliable and useful as required in order to promote capital formation for economic growth and business development, while maintaining cost-effective protection for investors.

PCAOB Initiatives Aim to Enhance the Reliability and Relevance of Audits

Ten years into our brief history, we now have robust inspection and disciplinary programs. PCAOB oversight has changed the environment of the accounting firms and their partners and staff who participate in audits. Sarbanes-Oxley began a cultural change that has triggered a profound shift in auditors' attitudes toward their accountability. The more audits we inspect, the more problems get fixed, the better the auditor's execution.

The PCAOB is now closely examining auditor incentives to avoid deficiencies in the first place. The PCAOB has several long-term initiatives underway.

A. Economic Analysis

Let me start with economics. As I've discussed, economic considerations underlie the audit, but we need to know more about the levers that move auditor incentives.

Regulators need to be mindful of the economic impact of their own actions as well. New audit procedures and quality control measures increase cost, which may be passed on to other market participants. We ask whether these will ameliorate a threat to audit quality and there are benefits that justify the costs.

Economics provides us a framework for critical thinking. It prompts us to consider alternatives, to maximize the efficiency of our actions.

We have been considering economic impacts, including costs and benefits, for some time. But to advance this work further, in May this year the PCAOB released staff guidance on the use of economic analysis in PCAOB standard setting.

The guidance builds on the PCAOB's existing rulemaking process by establishing an analytical framework for staff to evaluate the economic implications of standard-setting projects that are presented for Board consideration.

We have also embarked on a much broader initiative to enhance the use of economic analysis throughout our programs as well as to spur economic research on the role of auditing in capital markets and capital formation

To this end, late last year, we formed a Center for Economic Analysis under the leadership of renowned University of Chicago economists Luigi Zingales and Christian Leuz.

In addition to promoting research on important topics relating to economics and auditing, the Center is working on several internal projects to help our programs use economic analysis and other empirical tools. They include developing a post-implementation review program to evaluate the effectiveness of new auditing and professional practice standards in promoting reliable audits.

B. Facilitating the Work of Audit Committees

Second, the PCAOB is doing more to support audit committee oversight of individual audits. The Sarbanes-Oxley Act provided audit committees enhanced authority to play a critical role in audit quality and auditor independence. To facilitate this work, the PCAOB aims to better equip audit committees with information about the audit, our inspection reports, and the auditor's strengths and weaknesses.

To this end, in 2012, the PCAOB issued a report for audit committees on how they can learn more from their auditors about the results and implications of PCAOB inspection findings.^[5] Audit committee members report that this knowledge has given them new tools to use in overseeing the audit.

We have also improved the auditing standard on the auditor's communication with audit committees, to keep audit committees informed of important audit matters. The standard promotes a more robust discussion between the auditor and the audit committee. It is intended to ensure audit committees get the information necessary to probe and understand challenging audit issues and significant auditor judgments in their particular audit.

We are also engaged in small group discussions with individuals who sit on audit committees to identify additional areas where we can develop and disseminate analysis about trends, current issues and risks.

C. Increasing Audit Transparency

The PCAOB also continues work on a project to enhance the transparency of the audit with disclosure of the names of the engagement partner and other firms that participated in a significant way in the audit.

This proposal is a way to use the motivating power of the markets to incentivize higher quality audits.

Most audits of global companies are conducted by a collection of audit firms that can include firms in jurisdictions where there are poor business practices and little auditor oversight. The amount and quality of work performed by auditors other than the firm that signs an opinion can vary considerably.

As an example, yesterday the U.K. audit oversight body reported that the audits of the U.K. subsidiaries of two foreign banks required "significant improvements." Specifically, the U.K.'s Financial Reporting Council said that in both cases it had "identified issues with both the quality of the audit work performed and evidence provided through reporting by other group auditors."^[6]

Markets can enforce better practices. If markets know where, and by whom, an audit was performed, there arises an incentive to assure quality. When markets are in the dark, they can't enforce this incentive.

The same goes for disclosure of the name of the engagement partner, who plays a critical role in the quality of the audit. Auditors in other jurisdictions have long been accustomed to signing audit reports personally. In September, the International Auditing and Assurance Standards Board approved a new standard that requires the engagement partner to be named in the audit report.^[7]

That means that disclosure of the engagement partner's name in the auditor's report of a listed entity will become the norm in those jurisdictions that follow IAASB standards. The U.S. will likely be the only country in the top twenty financial markets that does not require this disclosure.

While the idea has been pending in the U.S., three papers have emerged from accounting researchers showing that disclosure of the engagement partner's name makes a difference to the investing public and the markets. Those studies are in Sweden, the U.K. and Chinese Taipei, where partners routinely sign their firms' audit reports.^[8]

I am intrigued by this evidence, but I have also asked whether signing offers materially greater public benefits than simple disclosure. Disclosure of a name may well give the public the information it needs without increasing litigation risk. So that is what we proposed, first in 2011 and then again, to seek more comment on costs, in 2013.

Investors support the proposal, but some auditors expressed concern that even mere disclosure of a name in the audit report could, without relief, increase exposure to litigation. Nevertheless, many auditors accepted investors' desire for the disclosure, and so they suggested the PCAOB require that disclosure in a form as compared to the audit report.

To my mind, there are solutions here that should work for investors and the profession. I hope to move toward a final standard soon.

As we complete this rulemaking, we plan to turn to a broader research project to identify a set of quantitative indicators to help audit committees and potentially others better assess audit quality. Some might be process, or input-related, measures, such as the ratio of audit staff to partners on an audit. Others might be results, or output-related, such as the history of restatements or warnings about going concern, again providing information to help markets distinguish high quality audits. We expect to issue a concept release on such indicators — or "AQIs" — in the near future.

D. The Auditor's Reporting Model

Let me close on another important disclosure project — the auditor's reporting model. Based on extensive outreach, last year the PCAOB proposed the first significant changes to the auditor's reporting model in more than seventy years, to answer investors' calls for more informative, insightful and relevant audit reports.

The proposal provides a framework to report critical audit matters, which keeps the auditors in their area of expertise — the audit. The intent is to provide markets and investors more value from the audit.

As we consider this new reporting model, we are fortunate to be able to look to examples of considerable experimentation abroad. U.K. auditors have already begun issuing expanded audit reports, in some cases well beyond regulatory requirements, driven by market demand.

Early reactions to the new audit reports bear out the value: readers have praised the insightfulness of some and criticized the boilerplate of others, providing natural incentives for auditors to compete on the basis of quality.^[9]

These reports are the leading edge of a significant wave of change in the audit profession. The move has been well received by investors, auditors and issuers.^[10] Indeed, I hear robust enthusiasm from audit partners, both those involved in the new reports — who feel the renewed relevance of their work — and partners here — who observe it.

The International Auditing and Assurance Standards Board recently approved a standard that will, effectively, require enhanced auditor reporting, including the reporting of key audit matters, in more than 100 jurisdictions that use IAASB standards. The European Parliament has also adopted a broad package of audit reforms for EU companies, including expanded audit reports.

The PCAOB will continue to study these reforms and adapt elements from the best of them. I expect to refine our own proposals in the coming months and to conduct more outreach to find the best course forward.

* * *

Reinforcing market confidence through audit reliability, supporting the effectiveness of audit committees, increasing audit transparency — these are real challenges for a profession striving to stay relevant in the 21^st century. And they are subject to extensive debate and disagreement.

This is one reason why I think deepening our analysis of the economic effects of PCAOB action, including costs and benefits, is so important. It's not that economics necessarily holds all answers. But economics does help us reach more, and better, questions. It helps us approach both conventional wisdoms and our own convictions with skepticism, not to mention pragmatism.