Issues for the Academic Community to Consider

Date: April 15, 2016

Speaker: Steven B. Harris, Board Member

Event: PCAOB/AAA Annual Meeting

Location: Washington

Welcome to the 2016 PCAOB Academic Conference. We appreciate your participation in this year's forum and your role in educating future accountants and auditors. You play an essential role in upholding the integrity of financial statements and promoting investor protection.

Before I continue, I should mention that the views I express are my own and do not necessarily reflect the views of the Board or the PCAOB.

Today I will touch on three topics: auditing and financial matters on the minds of investors, the evolving role of technology in audits, and the future and relevancy of the audit.

I hope that what you hear at this conference will benefit your current and future research.

Investors' Concerns

As many of you know from our previous sessions, I chair the PCAOB's Investor Advisory Group and was the chair of the International Forum of Independent Audit Regulators' Investor and Other Stakeholders Working Group until last April. These positions have afforded me an opportunity to hear directly from investors about some of the topics that are on their mind. They include, in no particular order:

1. Auditor Independence – It is only because investors perceive that the auditor's report is issued by an objective third party that they rely on it. If the auditor is not considered independent, the audit report and the audit do not provide value to investors.

Investors are concerned that firms, while expanding their consulting and advisory practices, are not diligently monitoring the provision of prohibited services by themselves and their affiliates, or have the necessary policies and procedures in place to do so. Their concerns are based on frequently reported independence violations. For example, in the past two years, all of the Global Network Firms or their affiliates have either settled enforcement actions related to independence violations or resigned from a client because they provided prohibited non-audit services. Further, investors note that companies continue to engage auditors even when that auditor provided prohibited services.^[1]

In addition, investors question if independence requirements need to be updated to reflect changes in industry practices. For example, some question the provision of tax structuring and consulting in light of recent press stories.^[2]

2. Audit Reform Recommendations – Investors are also interested in learning about the status of the recommendations put forth by the U.S. Treasury's Advisory Committee on the Auditing Profession (ACAP) in its 2008 report, which included improving the auditor's report, developing audit quality indicators, requiring independent members on the firms' boards, and for firms to provide audited financial statements, to name a few.^[3] They believe that it is time for a review of the Board's actions in relation to those recommendations.^[4]

There is also interest in comparing the audit reform efforts currently underway in Europe to what is happening here in the United States. Noting that European regulators have taken action on certain issues, such as expanding the auditor's report, firm governance, and retendering, some are asking why the U.S. is not leading efforts in these areas.

3. Expanded Auditor's Report – Investors continue to express support for the Board's current project on expanding the auditor's report. The auditor's report is no longer viewed as providing as much meaningful information as it should. Aware that auditors communicate important matters to the audit committee, some believe such information should also be communicated directly to investors, the actual clients of the auditor.

4. Audit Quality Indicators – Investors also support the Board's continued effort to understand and refine audit quality indicators. The Concept Release published last July explored the subject in detail.^[5] The AAA's comment letter was wide-ranging and made a number of suggestions.^[6] I am curious about how, at this point, you would define "audit quality" to test AQIs, how the link between audit quality and particular groups of AQIs should be measured, and what sampling or other methods should be used to track how AQIs are being employed.

5. Role of auditors with respect to information outside of the financial statement – Investors rely not only on the information contained in the financial statements but also what is presented outside of the financial statements, such as non-GAAP measures, sustainability information, and XBRL data. Some are concerned that non-GAAP measures presented by management reflect different results than the audited financial information. As noted in a February Wall Street Journal article, actual GAAP earnings were 25% less than what was reported by companies in non-GAAP measures.^[7] SEC Chair Mary Jo White has also addressed this matter recently.^[8]

Some investors wonder if the auditor should examine and provide some level of assurance on non-GAAP measures, as well as sustainability and XBRL data.

Additional topics of investor concern include an update on the Board's project on going concern, continued examination of the firms' business model and the expansion of consulting and advisory services on audit quality, the role of the audit committee in overseeing the company's audit, financial reporting and investor protection, and the auditor's responsibilities as it relates to fraud.

As you can see, some of these concerns are new and others are not. What this tells me, though, is that we still have much work to do. I encourage you to examine these issues.

Evolving Role of Technology in Audits

The role of technology in audits is not new. For several decades auditors have been using computer assisted auditing techniques. The technology that is used today, however, has evolved and its impact on audits is still unknown but will undoubtedly be profound.

Firms large and small are interested in using technology to make their audits efficient and more comprehensive. They assert that such technological tools allow them to automate certain time-consuming tasks, review nearly all of a client's transactions, and better identify risky areas. Using data analytics software, auditors derive insight from large amounts of data to identify potential signs of fraud and to add value in key audit areas, such as risk assessment and analytical procedures.

Firms are making significant investments in developing technologies in-house or through creative strategic partnerships with analytics service providers. Today, accounting firms routinely join forces with technology firms to incorporate emerging technologies into their audit methodologies. For example, on March 8, 2016, both KPMG and Deloitte announced alliances with different technology companies that will enable them to employ cognitive capabilities to analyze large volumes of structured and unstructured data related to a company's financial information and documents.^[9] In December 2015, Ernst & Young announced a strategic alliance to use SAS' advanced analytics platform.^[10]

While these technological tools may present certain benefits for audit, they also pose some challenges, including:

• Data Integrity issues – Auditors need to ensure that they have access to all of the client's available data. Incomplete or low quality data may provide misleading insights to the auditor.

• Data Security – Security of client information becomes a key consideration for firms as they gain access to their client's databases. How the auditor protects such data and what, if any, liability does the auditor bear for cyberattacks on its systems are open matters.

As I noted at this conference last year, audit firms have also altered their hiring practices as a result of their expanded use of technology.^[11] Expectations of new auditors are changing with the increased investment by firms in new technologies, especially big data analytics. A big four CEO recently said "[b]eyond the core technical accounting and audit skills, the ability to work with large volumes of data is becoming critical."^[12]

A number of the largest firms also assert that technology will allow them to detect industry trends and enhance their predictive analysis. How such trends and predictive analyses are used to benefit investor protection remains to be seen.

The PCAOB and other entities are exploring data analytics to better understand its effects on the audit process.^[13] It is important that you study the impact of technology on audit quality and bring your findings to our attention.

The Future and Relevancy of Audits

Lastly, I would like to leave you with some thoughts about the future and relevancy of audits. Following the recent financial crisis, many asked "Where were the auditors?" I have heard from the profession and others that predicting economic failures of the nature involved in the 2007-2008 financial crisis is not within the scope of an audit.

Whether I agree with that response or not, I can't help but wonder why weren't investors given a warning from the auditors about the potential for failures within the financial industry? With an economic upheaval of that magnitude, how could auditors not have had some insight into the level of risks that were being taken and the pending failures of some of those companies? As James Turley, former Global CEO of Ernst & Young, said in a 2012 interview, "[w]hen almost every set of financial statements are correct, yet the world experiences the biggest financial surprise in decades, something is wrong."^[14]

So it strikes me that maybe the question should be "Why weren't the auditors there?" What is it about auditors' existing responsibilities that precluded them from sounding an alarm about the potential for trouble in the housing market and the financial industry?

Would the outcome have been different if the auditors – as a profession – had been in a position to alert regulators and investors about the now notorious explosion of subprime mortgages and the exposure of the financial industry to these products? I am not expecting auditors to identify bubbles but I do believe that their training and work provides them with a unique understanding of business and market risks within a given sector.

In other words, is it time to rethink the role of auditors in our capital markets? If, for example, the auditing profession as a whole is involved with certain industries and financial institutions, what role should they play in helping regulators and investors better understand the risks these organizations are taking? In short, considering the auditors' skills, knowledge and the fact that they are ubiquitous, should the audit profession play a more macro role?

Expanding the role of the auditor is not a new concept. John C. "Sandy" Burton, the Chief Accountant of the Securities and Exchange Commission from 1972-1979, discussed this concept in an opinion piece published 36 years ago when he said "Accountants…could [make] a significant contribution in developing measurement approaches and in analyzing and presenting data regarding aggregate effects."^[15]

He went on to say that "We must … get across the idea that accountants are not primarily record keepers and checkers, but measurers of economic and social phenomena whose measurements can significantly influence… our society."^[16] And, he argued that "the accountant's task should not be confined to auditing corporate books, but should include forecasts, judgments on the corporation's financial controls and evaluations of management."^[17]

In the 36 years since the New York Times published Mr. Burton's opinion piece we have witnessed failures such as the savings and loan crisis, the financial scandals of Enron, WorldCom, Tyco and others that led to the Sarbanes-Oxley Act of 2002 and the worst financial crisis and economic slump since the Great Depression.

Mr. Burton concluded in his opinion piece that "If a narrow audit focus prevails, the profession runs the danger of being defined out of economic utility and remaining only a regulatory parasite."^[18] Mr. Turley echoed these sentiments in 2012 when he said "The most important issue facing our profession is the relevancy of our audit service product and making sure that we communicate with stakeholders in ways that are of importance to them."^[19]

As educators of accounting students, I would encourage you to consider, and would welcome your thoughts on how we should go about keeping the audit relevant and how to prepare our next generation of auditors for the future that awaits them.

Conclusion

Thank you again for coming today. I look forward to hearing more of your views on actions that the PCAOB should undertake as we continue to work toward protecting investors by improving audit quality.