I am very honored to be here this morning to address this distinguished group of individuals who have devoted their careers to the development and improvement of the profession that I joined over thirty years ago, when I graduated from college in Minnesota and joined McGladrey and Pullen as a young accountant.
A great deal has happened since then. While accounting has always been a dynamic and evolving profession, its greatest changes have occurred in the last decade, since the collapse of Enron, the bankruptcy of WorldCom and the subsequent passage of the Sarbanes-Oxley Act of 2002. 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. Nevertheless, the 1980's featured the Savings & Loan crisis and a number of other high profile corporate bankruptcies, followed by a series of cases involving earnings management in the 1990's.
Things came to a head in 2001 and 2002 with the discovery of financial reporting and auditing improprieties at some of the largest public companies in the United States: Enron, Global Crossing, Adelphia, Tyco, Qwest Communications, Xerox. This resulted in a national crisis of confidence in the integrity and reliability of public company financial reporting and a focus on the need for enhancements in internal controls over financial reporting and corporate governance. Early in the summer of 2002 both houses of Congress were considering legislation that would, among other things, increase regulation of public companies and their auditors. Then, on July 15, 2002, WorldCom announced an overstatement in its cash flow of over $3.8 billion, resulting in the single largest bankruptcy ever filed in the United States. Less than two weeks later, Congress passed the Sarbanes-Oxley Act almost unanimously, resulting in the most significant legislation relating to the federal securities laws since 1934.
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.
Consistent with the Sarbanes-Oxley Act, 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 quickly ramped up its operations and inspected 99 audit firms in 2004 and 281 in 2005 (including 15 firms located outside the United States). Currently, over 2300 firms, including foreign firms from 85 jurisdictions, are registered with the PCAOB. To date, the Board has conducted over 1800 inspections, including inspections in 37 jurisdictions outside the United States.
Likewise, the Board has actively pursued its standard setting and enforcement obligations. The Board has issued publicly 45 disciplinary orders — many with multiple parties sanctioned — while other cases remain pending in various stages investigation or litigation and must be kept confidential by the Board. Enforcement actions have been brought for auditors' failure to comply with applicable auditing standards and certain provisions of the securities laws, independence violations, and failure to cooperate with Board processes such as inspections, investigations, and the requirements to file annual reports and pay annual fees. Sanctions imposed by the Board have ranged from censures and suspensions to practice bars and revocations of firm registrations, both temporary and permanent. Several enforcement matters also resulted in orders for firms or individual auditors to pay monetary penalties.
Since its inception, the Board also has issued 15 auditing standards — including, for example, on 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. More recently, the Board issued concept releases or proposals to trigger wide-ranging discussions about potential changes to certain fundamental aspects of auditing, including the auditor's report, audit transparency, and auditor independence, objectivity, and skepticism.
Thus, the Board has evolved over time, from a start-up institution focused on establishing a comprehensive, consistent oversight system to a maturing regulatory organization with the experience and resources to adapt to changing times and new challenges. And many challenges there are indeed! The accounting profession as a whole is facing difficult questions as a result of the increasing complexity of business transactions and cutting edge 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 increasingly must tackle fair value measurements and management estimates, consistent with new accounting standards and EITF guidance in connection with derivatives, securitizations, consolidations, debt/equity issues, revenue recognition, leases and other issues. 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 disclosures and internal controls over financial reporting.
Auditors also must master these accounting challenges, while simultaneously overcoming the difficulties associated with auditing numbers increasingly subject to measurement uncertainty. Fair value estimates of financial instruments established through the use of third party pricing services are proving particularly difficult to audit. First, auditors have to consider whether management itself did enough work to understand how the pricing services arrived at their results, including the techniques used, the judgments made, and the controls that are in effect. Likewise, under PCAOB standards, the auditors cannot simply rely on the values established by management's third party pricing services. Rather, they must "get behind" the numbers by doing some testing and critically evaluating the methodologies and assumptions of management. Because this is such a challenging area, the PCAOB convened a Pricing Sources Task Force last year to assist the Board's Office of the Chief Auditor to gain insight into issues related to auditing the fair value of financial instruments. This group of investors, financial statement preparers, auditors and representatives of pricing services and brokers met three times in 2011 to discuss the valuation of financial instruments that are not actively traded and the use of third-party pricing sources to value such instruments. The Office of the Chief Auditor is evaluating the input received from the Task Force and may develop some additional guidance for auditors.
In addition to such technical challenges, auditors face pressures related to tight deadlines, as well as 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. PCAOB inspections also present a challenge to auditors, but one that I hope and believe can provide an effective counter- balance to fee and client service pressures by focusing auditors on the requirements of PCAOB standards and reminding them of their ultimate responsibility to protect the interests of investors.
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, but we are not without our critics. The audit profession, among others, has expressed concerns, often in the form of letters in response to our draft inspection reports, but also in meetings with the Board, in connection with Board advisory groups, and in other forums. One frequent comment from audit firms is that PCAOB inspections are too tough, and that the PCAOB inspections staff does not respect the professional judgment exercised by auditors. Some auditors believe that the positions taken in inspections set an unreasonably high bar and constitute de facto standard setting by the inspection teams. Others charge that the PCAOB takes too long to do pretty much everything, including issuing inspection reports and setting new standards. One result of our activities, according to some, is that the best and brightest auditors become frustrated and leave the profession, having concluded that the negatives — such as their interactions with the Board, increased scrutiny and criticism by investors, and intensifying fee and other pressures — outweigh the positives of continuing to audit public companies.
The Board is very cognizant of these concerns and has gone to great lengths to ensure that its inspectors are experienced, well-trained professionals who understand and respect the practice and the business of auditing. Consistency and fairness are our mantras. Our inspection process has evolved over time, and our internal processes have been improved to facilitate a consistent approach to inspections across firms. Much of the time that passes after inspection field work ends and before the report is issued is spent on quality control. Our inspectors compare notes about the interpretation of standards; they involve the Office of the Chief Auditor when in doubt, and we have a number of individuals in the Inspections Division dedicated exclusively to reviewing inspection reports for consistency, clarity and fairness. This process is necessarily time-consuming, but we are taking steps to streamline certain processes and to eliminate delays where possible.
In that context, let me talk a little more about our inspection process, both in terms of how we operate and what we are finding. PCAOB inspections are not intended to establish or provide reports presenting a balanced view of the strengths and weaknesses of each inspected firm. We do not provide grades to firms (as much as doing so might be popular with this particular audience). 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," our inspectors specifically look for audit deficiencies and inspect those engagements where they are most likely to find them.
Inspections are therefore risk-based, both in terms of the engagements and audit areas that are selected for review. Our inspectors work closely with our Office of Research and Analysis to determine what industries or specific issuers present higher levels of audit risk. Within each audit engagement selected, inspectors choose the most challenging and high risk audit areas, in order to test the firm's ability appropriately to address those challenges and risks. Some have criticized this approach, suggesting that we should review audits more randomly. But in order to have the greatest impact on audit quality, in order to help auditors learn from our inspections, and in order to achieve our goal of protecting investors, we need to allocate our limited resources to finding those audits that do not measure up to our standards, rather than spending our time reviewing those that do.
So what have we found? Common inspection findings reported by the Board in late 2010, based on inspections conducted in 2007 through 2009 during the height of the financial crisis, included instances where auditors appear not to have complied with PCAOB auditing standards in certain audit areas, including, for example, 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 results in 2010 showed an alarming increase in inspection findings, particularly, as I noted earlier, in the area of fair value.
In the context of fair value, PCAOB inspectors have observed that:
PCAOB inspection findings related to valuations and fair value issues in general are not limited to financial instruments, however. Inspectors have also found deficiencies in connection with the valuation of non-financial measurements, for example in the areas of business combinations and goodwill impairment, and with other management estimates, such as allowance for loan losses and valuation of inventory and income tax valuation allowances.
In the context of multi-national audits, the Board also has reported that some U.S.-based firms issuing audit reports based on work performed by firms outside the United States were not properly applying PCAOB standards. As a result of these findings, the Board in July 2010 issued a Staff Audit Practice Alert to remind registered firms of their obligations when using the work of other firms or using assistants engaged from outside the firm. The alert describes the circumstances under which the firm issuing the audit report may use the work and reports of another auditor. The alert also explains that auditors who engage assistants from outside the firm are governed by the same standards regarding planning the audit and supervising assistants that apply when audit work is performed by assistants who are partners of, or employed by, the auditor's firm.
So what does all of this mean for you — the educators of future accountants and auditors and the leaders in research relating to this important profession?
Unlike their predecessors five or more years ago, recent and future graduates of accounting programs received their training in the post-Sarbanes-Oxley world. They benefit from the renewed focus by accountants and auditors on investor protection, auditor independence, and internal controls. I was pleased to see in the AAA's Statement of Responsibilities the commitment to "[d]eveloping in students an appreciation for the importance of ethics and professionalism as well as technical expertise." Your agenda for this meeting also provides several opportunities for discussion of research relating to auditor ethics, independence, and professional skepticism, and I applaud you for your continued focus on these important topics. As I mentioned earlier, however, the pressures faced by auditors once they begin to practice in the real world may chip away at some of the important investor protection priorities instilled by all of you. It is up to the firms that the students ultimately join to continue to emphasize the importance of these important principles, and I challenge them to do so through training and leadership by example.
Beyond adhering to these overarching principles of auditor conduct, however, one question we should ask is whether auditors are otherwise equipped for the business world of the 21st Century, and whether there are things we can do collectively to make sure that they are. It is difficult, if not impossible, for accounting programs to teach in real time the accounting developments emerging on a daily basis in the business world. There are certain trends, however, that may merit increased attention, due to the changing business models and accounting practices we have observed in recent years.
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 you 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 of you incorporate these and other emerging themes into your teaching and research activities, and I applaud you for your efforts.
We at the PCAOB also are trying to do our part to support future auditors. The Sarbanes-Oxley Act provides that all monetary penalties collected by the PCAOB must be used to fund merit scholarships for students in accredited accounting degree programs. In 2011, the Board implemented this requirement and announced the inauguration of its scholarship program, awarding 52 scholarships of $10,000 each to students around the country who demonstrated high ethical standards and an interest and aptitude in accounting and auditing. PCAOB Board members and staff also frequently visit colleges and universities around the country to talk to accounting students about the auditing profession and the Board's work, and we periodically welcome groups of students visiting Washington, D.C. to our headquarters for discussions with PCAOB staff and Board members.
Finally, your academic research activities complement the work of the Board to improve audit quality and enhance investor protection. The Board and Board staff review and consider the conclusions of relevant academic studies in formulating Board policies. We have benefited from academic studies looking at the efficacy and relevance of our regulatory activities. Some of you also may be current or former participants in the joint PCAOB-AAA research synthesis projects, while others may have participated in the AAA Auditing Standards Committee's work to provide comments to the Board in connection with our standard setting process. Several of your members also have served on our advisory groups or have participated in our public round tables or the PCAOB's annual Academic Conference. Finally, some of you have visited us at the PCAOB to discuss your research or to work with our staff on a variety of projects, and we welcome such opportunities to hear directly from you. So I would like to end by thanking you for inviting me to speak to you here today and for your continued and tireless engagement in our shared objective of improving audit quality and enhancing investor protection.
 Section 104(a) of the Sarbanes-Oxley Act of 2002.