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 Statement on Auditor's Reporting Model Outreach Efforts

DATE March 22, 2011
SPEAKER(S): Martin Baumann, Chief Auditor
EVENT: PCAOB Open Board Meeting
LOCATION: Washington, DC

Introductions, mention of roles/responsibilities, and objectives

Good morning, Mr. Chairman and members of the Board. We are pleased this morning to discuss our outreach efforts to investors and others about potential changes to the auditor's reporting model.

Joining me in the presentation today is Jennifer Rand, Deputy Division Director and Deputy Chief Auditor. I would also like to recognize the hard work of the other members of the project team who have been critical to this effort. They are Jessica Watts, Dan Mutzig, and Diane Jules. And, I would like to thank them in advance, for the hard work still in front of them as we move toward a planned concept release, roundtable and proposed standard.

Finally, I'd like to thank the many individuals we spoke to in our outreach. Many of them spent over a half-day with us discussing their views on the current auditor's report and how the report could be changed to provide greater transparency to investors. Because of that outreach, we are much better informed about the areas of change where investors seek additional information, how those changes could be reflected in the report, and possible challenges in doing so.

Our objectives for today's open meeting with the Board are to —

  1. Describe the nature and extent of the Office of the Chief Auditor's outreach regarding the auditor's reporting model and the input received from that outreach, and
  2. Seek the Board members' views on the input received from the outreach, and any other topics or areas to further explore as my staff works toward developing a concept release

Importance of project and objectives of meeting

In the Board's October 2010 Standing Advisory Group meeting, the Office of the Chief Auditor discussed the importance of its standard-setting initiative on the auditor's reporting model. This initiative includes considering whether improvements should be made to the standard auditor's report.

The Board's Standing Advisory Group, its Investor Advisory Group, and the Advisory Committee on the Auditing Profession, or ACAP, convened by the U.S. Department of the Treasury, all recommended that the PCAOB consider whether such improvements should be made to the standard auditor's report, and to consult with investors and others in the financial reporting supply chain to obtain their input on this topic.

Consistent with these recommendations, from October 2010 through March 2011, the Office of the Chief Auditor conducted in-person meetings and held conference calls with over 80 individuals, consisting of investors, preparers, audit committee members, auditors, regulators and standard setters, and academia. The participants represented a diverse group of organizations and companies, domestic and international, as well as small, medium and large.

The interactive dialogue among the outreach participants provided us with deep insight into the areas of potential changes in the auditor's report, how those changes could be presented, as well as the benefits and challenges of doing so.

Investors have long-indicated that they are the auditor's customer and, therefore, the auditor's responsibility is to report to the investor in a manner which meets the investors' needs. Investors are seeking more useful and relevant information from the auditor beyond the current pass/fail auditor reporting model.

To quote a simple observation made by the Cohen Commission when it examined the auditor's report in 1978, "For the largest corporations in the country, an audit may involve scores of auditors and tens of thousands of hours of work for which the client may pay millions of dollars. Nevertheless, the auditor's standard report compresses that considerable expenditure of skilled effort into relatively few words and paragraphs."

Although the Cohen Commission highlighted that the communication between the auditor and users of the auditor's report was unsatisfactory, most of the Commission's recommendations were not implemented.

Investors recognize that the audit is a valuable process that requires extensive time, effort and auditor judgment. The main point is that investors are seeking a more innovative product from the auditor. In short, investors see the audit report as the product of the audit for which they are paying, and, in general, note that the product hasn't changed in any substantive way over the last one hundred years.

This view is also consistent with the views expressed in the recent presentation by the working task force of the Board's Investor Advisory Group, or IAG. At last week's IAG meeting, the Board heard a presentation from some of the group's members about a survey they conducted to solicit views regarding changes to the auditor's report. The group surveyed investors in investment banks, mutual funds, pension funds, and hedge funds.

Both the IAG survey and our outreach underscore that investors believe they need more information from the auditor regarding their views on audit risk, management's judgments and estimates, and the quality of management's accounting policies. Investors have indicated that this information would be valuable in informing their investment decisions.


Drivers of need for change or improvements in the auditor's reporting model

As part of our outreach activities, we explored the reasons driving investors' request for changes in the auditor's report. The essence of the issue is as follows -

  1. The current auditor's report states that the financial statements are fairly presented (or not); the binary yes/no, on/off report
  2. The auditing standards allow for circumstances where the auditor can provide emphasis of certain matters, a qualification, or even a disclaimer of opinion; however, these options are rarely used by the auditor. A Chief Investment Officer in a mutual fund who participated in the IAG survey said that "The audit report is largely boilerplate, and only provides meaningful information in extreme circumstances, usually around going concern issue."

Investors have expressed that they are tired of surprises. They believe that if they had a better understanding of some of the types of matters that auditors discuss with audit committees about audit risks and how they dealt with those audit risks, or the auditor's views on management's judgments and estimates, then they —

  1. Might have a better idea of how to anticipate certain events or issues,
  2. May know where to do more research as part of their investment analysis
  3. Can use this additional information as part of their investment valuation process

Investors cite the recent financial crisis as an example of where an expanded auditor's report may have been helpful. Investors have indicated that if the audit report included a discussion of the most significant judgments in the financial statements and the areas, in the auditor's views, of greatest risk of material misstatement, investors would have been able to probe further into such matters as complex valuation models, concentrations of credit risk, the measurement uncertainty in the allowance for loan losses, and the difficult decisions to consolidate or leave off the balance sheet various entities and potential liabilities.

Other factors driving the need for change or improvements in the auditor's reporting model include —

  1. The nature of business becoming more global and complex.
  2. The nature of accounting rules moving towards more principles-based standards, resulting in even more need for management judgment and estimates in the preparation of financial statements

PCAOB's mission to investors and related points

The mission of the PCAOB is to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.

We recognize there are many different views on whether changes should be made to the auditor's report and, if so, what changes should be made. Throughout this process, we aim to be responsive to investors, while being mindful that any potential changes or improvements should enhance or at least preserve audit quality.

We also recognize that some of the potential areas of consideration that you will hear today may require SEC or FASB collaboration and their rule-making, depending on who should provide this additional information for investors, i.e., the auditors through their audit report, management through the financial statements, or the audit committee through the audit committee report.

We also recognize that it behooves us to explore potential challenges to the auditor's reporting model that were noted by the preparers, audit committee members and auditors.

With that, let me now turn the discussion over to Jennifer to provide a discussion regarding the outreach and results. I will then describe possible changes to the auditor's reporting model, and challenges (or unintended consequences) raised by outreach participants in doing so. Jennifer?