You have heard a number of impressive speakers over the course of today's program. They have shared with you their views on current regulatory challenges, including, among other things, the consequences of - and responses to - the current market conditions. For my part, in the brief time I have today, I will discuss with you an important area of accounting and auditing that has become even more challenging in the face of the market conditions we have seen emerge in 2007 and carry into 2008: that is, the auditing of fair value accounting.
In light of the audience and the PCAOB's global mandate, I also will provide a brief update on the PCAOB's cross-border initiatives. Before I begin, please note that the views I express today are my own, and not necessarily those of other Board members or the PCAOB.
II. Challenges for Auditors in the Current Market
Auditors play an essential role in assuring the investing public that financial statements are both relevant and reliable. Fair value accounting for certain securities was adopted because it was believed to more rationally reflect management's intent for the use of those assets and thereby offer investors more relevant information.
In the United States and elsewhere, accounting standard setters are increasingly making the move to fair value accounting. In light of the current market conditions, I will emphasize this afternoon the challenges that determining fair value measurements can pose, and, talk briefly about the obligations of preparers and auditors in this area. There are three basic challenges worth highlighting that auditors are confronting as companies make the transition:
- First, determining fair value requires training, and many auditors may not have extensive training in valuation techniques.
- Second, financial statement preparers can be biased (even if unknowingly so)in their assessments of fair values. Thus, auditors have to be sure that preparers have considered alternative valuation scenarios.
- Third, internal controls surrounding fair value measurements may be different from controls over typical business transactions. Auditors have to consider that as well.
Last year, when the current market conditions began to emerge, starting first in the area of mortgages and mortgage backed securities, then evolving into collaterized debt obligations (or CDOs) and other more complex instruments, the PCAOB reached out to auditors to discuss potential audit risks that were beginning to emerge. Our dialogue has continued as the credit risks have deepened and spread to a number of other instruments.
Among other things, questions soon emerged as preparers and their auditors began to struggle over the complexity of a number of securities and the need to measure their fair value in an increasingly thin market. Throughout this dialogue, the PCAOB has communicated to auditors the need to stay the course and reminded the audit firms of the need to adhere to existing requirements. To that end, we have discussed the approaches to determining fair value provided for in accounting standards and the relevant requirements for auditors.
The PCAOB issued a Staff Audit Practice Alert on the subject last December. We prepared the Alert due to auditing challenges that were emerging as part of the subprime credit situation. The Alert also was prepared in response to certain issues that might arise in the transition to new accounting standards on fair value measurement.
The PCAOB’s message to auditors throughout this rapidly changing economic environment has consistently emphasized an adherence to existing requirements. We highlighted the following points:
- The need to get behind the prices or estimates provided by brokers and other specialists
- The need for auditors and preparers to understand what they are getting – is it a quote based on an active market, a price based on observable inputs, or an estimate based on a model?
- If produced from a model, fundamentally, preparers and auditors must understand the model and assess the reasonableness of its significant assumptions.
- In sum, the nature of how the fair value measurement was derived drives the work that preparer and auditors must undertake.
Again, these are not new requirements; they are existing requirements that preparers and auditors must apply, even in the current market. You, as international bankers, know first hand that the United States is not alone in facing the challenges of the current market. For reasons such as this, the PCAOB and its auditor oversight counterparts in other jurisdictions regularly discuss the emerging audit risks we face.
So, one of the messages I want to leave you with today is that fair value accounting, while presenting the promise of presenting financial statements with greater relevance, also can pose heightened audit risk, especially in illiquid markets. The PCAOB will continue to monitor this area to understand how audit firms are addressing this potential risk.
III. PCAOB and It’s Cross-Border Initiatives
The intertwined nature of financial markets requires that we, as regulators, carefully consider how to execute our mandates in an increasingly global and complex marketplace. Regulatory coordination within countries and across borders is fundamental. It is particularly important to the PCAOB, which has more than 800 of the 1,840-plus firms registered with it domiciled in about 80 different countries. Some portion of these firms will be subject to PCAOB inspection – currently, about 230 of the 800 registered non-US firms are subject to PCAOB inspection on a triennial basis.
As required by the Sarbanes-Oxley Act, many of these firms are registered with the PCAOB because they audit non-U.S. companies whose securities trade in U.S. markets and file audited financial statements with the SEC. Others, also as provided for in the Act and the Board's rules, are registered with the PCAOB because they audit or wish to audit significant non-U.S. subsidiaries of multinational U.S. companies.
The PCAOB’s approach to oversight of these non-U.S. audit firms continues to evolve, in part due to the fact that similar auditor oversight bodies are being established throughout the world. This is having an important impact on our work.
The PCAOB is in the process of determining how it can enhance coordination with our counterparts. Board rules already enable it to rely on the work of the home-country regulator and to assist non-U.S. authorities in their oversight of U.S. audit firms that are within their regulatory jurisdiction.
In an effort to increase cooperation with other audit regulators, in December, the PCAOB released for public comment a proposed policy statement that articulates certain essential criteria that, if met, would permit the Board to place full reliance on the inspections programs of qualified auditor oversight entities from other countries. The policy statement, if adopted, would not be in the form of a new rule. Instead, it would give further guidance on the implementation of existing rules. The public comment period on the proposal closes tomorrow, and we look forward to carefully reviewing comments to identify areas for improvement.
I look to the future when independent auditor oversight systems worldwide will have spread and matured even more, and the PCAOB is able to place a high level of reliance on its counterparts. Working together, we are better able to strengthen audit quality and protect investors worldwide. Working with our counterparts, we also can seek to minimize the burdens of potential duplicative and/or contradictory regulation. This is to the benefit of the firms we oversee and the investors who rely on the quality of their audits.
So, allow me to conclude where I began -- we are operating in challenging times. As credit markets continue to seek a stable footing, the regulated and the regulators must carefully assess risks and act accordingly. Financial institutions are working through these risks and simultaneously assessing lessons learned. I suspect that many are taking a hard look at their risk management frameworks. As for fair value measurements, I imagine preparers and auditors may be more focused than before on the importance of understanding the assumptions behind fair value measurements of certain complex securities.
As regulators, as we have instructed the firms that we supervise, we must keep a steady course. This is not a time to modify existing requirements or issue new ones. Instead, we should continue to carefully monitor implementation through our supervisory functions.
Thank you for your time today. I believe I have a few minutes for questions.