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 A Call to Action for Future Auditors

DATE March 28, 2014
SPEAKER(S): Jay D. Hanson, Board Member
EVENT: Beta Alpha Psi Midwest Regional Meeting
LOCATION: Indianapolis, IN

Good afternoon.

I am honored to have been asked to speak here at the Midwest Regional Meeting of Beta Alpha Psi to such a promising group of young people preparing to enter the accounting profession. I would like to thank the students for choosing accounting as their program of study and the faculty members for all they do in preparing these bright students for their future careers.

As you all know, the Public Company Accounting Oversight Board was created by Congress through the passage of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") to oversee the audits of public companies in order to protect investors and the public interest by promoting informative, accurate, and independent audit reports The PCAOB began operations in April 2003. I joined the Board in February 2011 after spending over thirty years in public accounting.

Before I go further, I should 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.

In our 11th year of operation, more than 2300 firms are registered with the Board, including over 900 foreign firms from 85 jurisdictions. The Board has conducted well over 2000 inspections of public company audits, including inspections in 40 jurisdictions outside the United States. The Board has issued 17 auditing standards — including, for example, standards addressing audit documentation, internal controls, audit planning, engagement quality review, risk assessment and audit committee communications — as well as two attestation standards for audits of brokers and dealers. We also have substantially amended a number of interim standards — including, for example, standards addressing communications about control deficiencies, audit reports, audit sampling, and substantive analytical procedures, among others. And we hope soon to issue a final standard on the auditors' testing of related party transactions.

Our Division of Enforcement is vigilant in investigating and charging firms and individuals for violations of relevant securities laws and professional standards. To date, the Board has publicly announced sanctions against 55 firms and 73 individuals, with sanctions including revocations of firm registrations, orders barring or suspending individuals from practicing before the Board, censures and, in some cases, significant monetary penalties. Our cases have involved Big Four firms as well as smaller firms and sole practitioners and have been brought against firms in the U.S. and abroad. In addition, we have matters currently under investigation and in litigation. While many of our enforcement cases to date have involved audit failures of varying degrees, the Board also has imposed sanctions for failures to cooperate with the PCAOB, including failure to produce documents and the alteration of documents in connection with inspections or investigations. My advice to young auditors is don't try to "clean up" an audit when PCAOB inspectors announce their plan to conduct an inspection, and don't assist anyone who asks you to help them do that.

Our mantra at the PCAOB, and the focus of everything we do, is audit quality. This is because we believe that the audit serves a unique and indispensable function in the capital markets — to provide independent assurance to investors and the public that the securities in which they invest are from companies whose financial statements are fairly stated in accordance with the applicable accounting framework and that those companies have effective internal controls over financial reporting. While audits cannot prevent fraud or mistakes, we hope that, in many cases, the audit can help deter or detect them and thereby provide confidence in the capital markets that fuel so much of our economy.

For those of you considering a career in auditing, one key ingredient to becoming high quality auditors — or high quality accountants of any kind — is your education. The subjects that you have studied in your undergraduate and graduate programs are important. While you will not necessarily use every subject area from every class in your future careers, all the pieces are part of a well-rounded program. But I would like to focus on some important skills that may not be the focus of your accounting courses. These are skills that, over the long term, will be just as important as your technical accounting knowledge.

Let me start with communication skills. I often ask student groups if any of the accounting majors have another major, or a minor, in English. Not surprisingly, the answer is overwhelmingly no. Accounting majors are fond of numbers, while many English majors try to get as far away from mathematics as possible. I think it is important that students in both categories stretch to gain comfort in the other's area of strength. For auditors, numbers obviously are at the core of the job. But a huge part of auditing is documenting your work, and, without a complete, clear and concise description of the auditor's work, it loses its meaning. One of the reasons why documentation is so important is that no single individual can perform and review all the work on any company's audit. Often, especially on larger audits, much of the work is done by relatively junior accountants. Thus, supervision and review of the work of auditors is critical, but the review can only be effective when there the work that has been done is adequately documented.

The PCAOB has issued an auditing standard that sets forth specific documentation requirements. One key requirement of that standard, Auditing Standard No. 3, is that audit documentation be "prepared in sufficient detail to provide a clear understanding of its purpose, source, and the conclusions reached."[1] Thus, the young audit staffer's description must be sufficiently detailed to allow the firm's senior to obtain that clear understanding the next week, the audit manager soon thereafter, and ultimately the partner and perhaps the engagement quality control reviewer. Months later, the firm's internal inspectors may review the work, and, ultimately, the PCAOB staff may inspect the audit engagement. (Hopefully, you will not find yourself in the position of having your work reviewed by members of the enforcement staff at the PCAOB or SEC, but if you do, it will serve you well to have fully documented all of your hard work.)

For new accountants, the focus on documentation can be a difficult transition — the world of texting, Facebook postings, and tweeting may not fully prepare you. And, of course, communication skills are important even beyond the accountant's documentation of audit procedures. Being able to express yourself effectively is key to your relationships with your co-workers and supervisors, clients, potential clients and many others. Verbal communication is a large part of this. Whether presenting before a large group like this, or sitting down with a member of the accounting staff of an audit client, making your point effectively is critical. I remember being a young staff accountant, going through a questionnaire with a client, and keeping my fingers crossed that I would not be asked to clarify or rephrase a standard question! The ability to do just that, though, is a sign that the person understands the subject matter, can provide context, and, most importantly, can tell when an answer just doesn't make sense.

So if you believe that your written or verbal communication skills need improvement, I encourage you to begin now to work on writing and speaking clearly, comprehensively and succinctly. Take advantage of any classes or clinics that your schools may offer in this area. Practice! Honing your communications skills is a long journey, and you may find yourself — as I do — continuing to work on these skills throughout your career.

Good organizational skills also are a key ingredient to success as an accountant. Whether in government, industry or public accounting, the accountant's ability to create an organized plan to tackle the many steps in the financial reporting or auditing cycle is critical. Good organization allows you to be proactive by taking steps in advance to prepare for or avoid a problem, initiating actions rather than waiting for things to happen, and generally increasing your efficiency and effectiveness. So I urge you to think about how best to accomplish the tasks at hand, take control, and make things happen.

This is particularly important given that one of the many challenges in almost any accounting career, but especially auditing, is the intense demand on your time. An auditing career is rewarding but involves many long hours. As much as auditors try to do before the company's year-end, there are a lot of procedures that cannot be completed until the final numbers are available. When I hear stories of the workload of some auditors, I question whether the firms are doing enough to monitor excessive workloads and take appropriate real-time measures to ensure both the quality of work being done as well as the toll it takes on the lives of those involved. I have discussed this with several firm leaders, pointing out that audit quality cannot possibly benefit from overworked and exhausted staff.

Another challenge for the new staff auditor is not getting an "A" on every work paper. I have observed many times how humbling it can be for a recent graduate of a top accounting program to receive extensive review comments from the senior. But if this happens to you, it should not dissuade you. Auditing is learned, in large part, through experience. Your first years will be akin to an apprenticeship. Perhaps keep in mind this Japanese proverb: "Fall Down Seven Times; Stand Up Eight." You have to learn from your mistakes and keep going — there is a light at the end of the tunnel, when you will have become a respected and sought-after expert in your field.

But the most important skill or characteristic that every auditor needs to develop is professional skepticism. No matter how much technical knowledge you have or how well you document, and regardless of your organization and hard work, your audit will not be effective if you are not also skeptical. The relevant auditing standard, AU 230, defines professional skepticism as "an attitude that includes a questioning mind and a critical assessment of audit evidence. . . . The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest."[2]

Thus, professional skepticism requires that the auditor question management's conclusions, decisions and judgments. Auditors must consider whether there is sufficient, appropriate and persuasive audit evidence to support the audit opinion and not accept management representations without corroboration. The auditor must be watchful for and wrestle with any contrary evidence that undermines management's conclusions.

Unfortunately, professional skepticism is also an area where we see a lot of problems in our inspections. In 2012, we issued a staff audit practice alert on professional skepticism, after seeing several years of inspection reports with high rates of deficiencies in this area and after spending a year studying and discussing ways to enhance auditor independence, objectivity and professional skepticism.[3] Our work, however, is not done, and we continue look for ways to further improve audit quality in this important area.

I believe there are several factors that are relevant to whether a particular public accountant can be appropriately skeptical. One key factor is competence. If you are going to challenge management's assessment, you need to come armed with knowledge about what you are challenging. This requires not just a solid technical background in applicable accounting and auditing requirements, but also a good understanding of the company and its industry.

Another key factor is confidence. Even some highly competent individuals do not have the confidence to challenge management of an audit client. This can be due to the personalities involved, the respective age or experience of the individuals involved, or the incentive structures in the given situation.

One of the biggest impediments to auditor skepticism, however, in my view, is the calendar. Public companies have filing deadlines to meet, and they are rarely missed. When they are missed, the consequences can be serious, including declining share prices and harm to investors. If potential issues are discovered late in the audit process, or an issue is not resolved in a timely manner, auditors may feel pressure to cut corners. We have seen it in inspections and enforcement matters: Auditors recognize that there may be a problem with management's estimates or conclusions but allow themselves to be talked out of doing anything about it. Staying organized and proactively dealing with problems far ahead of filing deadlines will help the auditor avoid running out of time as well as the pressure to accept insufficient audit evidence.

The best way to deal with such pressures is to remember that the auditor's fundamental obligations are to the investors of the company. The audit is intended to provide assurance that the audited company's financial statements and related disclosures fairly present the institution's financial results in conformity with applicable accounting and disclosure standards. Auditors are the eyes and ears of investors, who do not have the access or resources to take a close look at the information underlying the financial statements. Auditing is more than just a business and different from the other types of services a firm may be providing to its clients. Your "client" in this case, is not the entity that is paying the bill. And if auditors fail to live up to their obligations of conducting an independent and skeptical audit, investors will stop trusting in their investments, and ultimately in the capital markets.

Of course, audit committees also have a role to play in ensuring that auditors maintain their focus on investor protection. Audit committees chose the firm and engagement partners that will audit their companies. They set the terms of the engagement. And, during the audit, they can request information and ask difficult questions of both management and the auditors to make sure that each is living up to expectations. We at the PCAOB share many of the same goals as audit committees — to supervise and continue to enhance the performance of public company audits. Over the last two years, we have engaged extensively with audit committees to make sure that we understand their needs and that they benefit from our work and communications. I believe we, and those audit committee members with whom we have met, have learned a great deal. My hope is that young auditors will be exposed to audit committees of their clients early in their careers, allowing them to gain an appreciation for their role as investor representatives.

Let me turn to the last subject I wanted to discuss today, which brings us back to my original focus on the importance of communication. In the wake of the 2008 financial crisis, involving the failures or near-failures of systemically important entities that had received unqualified audit reports just months earlier, investors raised questions about whether more communication by auditors could provide investors with important insight into the risks associated with audit clients. In response to this concern, the PCAOB undertook a standard setting project to consider whether and how auditors should provide public communications beyond those currently found in the standard auditor's report, which, as you likely know, provides little more than a pass/fail opinion on whether the company's financial statements are fairly stated (or whether internal controls are effective).

The Board began by conducting extensive informal outreach to investors, auditors, audit committee members, financial reporting professionals, academics and others, to gain a better understanding of the relevant concerns and issues involved. Subsequently, in 2011, the Board issued a concept release to discuss several possible alternatives for changing the auditor's reporting model. These alternatives ranged from relatively modest tweaks to clarify certain words used in the audit report to fundamental changes that would require the auditor to discuss both the audit and the company in some detail.

After reviewing written comments and conducting an open meeting to seek additional feedback, the Board decided that the best approach would be one where the auditor provides additional insight into the audit, but leaves disclosures about the company's activities, financial results, and risks to the company itself. As a result, we issued in August of last year a proposal to expand the content of the auditor's report.[4] The proposal, if adopted, would require auditors to discuss in their reports so-called "critical audit matters," which are defined as those matters addressed during the audit that (1) involved the most difficult, subjective or complex auditor judgments; (2) posed the most difficulty to the auditor in obtaining sufficient appropriate evidence; or (3) posed the most difficulty to the auditor in forming the opinion on the financial statements.

It is important to understand that the proposed standard does not require reporting of all information known by the auditor in which investors may have an interest. There are risks and uncertainties inherent in the financial reporting process and in business that may not be discussed as critical audit matters because the application of the accounting standards in those areas are clear and the audit process straightforward. Likewise, there may be critical audit matters reported that bear little on investment decisions.

In commenting on the proposal, some have suggested the requirements do not go far enough and are not sufficiently specific to require the auditor to report information that investors want. Others have suggested that most of the matters to be discussed in the audit report would largely duplicate disclosures already included in the financial statements; while yet others have expressed concern that the auditor might disclose information that applicable SEC rules and regulations explicitly allow the preparer not to disclose. Finally, some skeptics wonder if the end result of the changes to the auditor's report will be limited to the addition of new "boilerplate" language to the report that ultimately will not be helpful to investors at all.

We have already received over 240 comment letters in response to the proposal (in addition to the 155 we received in response to the 2011 concept release). Next week, on Wednesday and Thursday, we plan to explore these issues in more depth when we host a public meeting in Washington to discuss the proposed auditor reporting standard. We have invited a series of speakers — including investors, auditors, audit committee members, financial statement preparers and others from the U.S. and abroad — to present to us their views of the proposed standards in a forum that allows us to ask questions and have a two-way dialog to further explore the potential advantages and disadvantages of the proposed changes. Subsequently, the Board will consider what we have heard and decide what action to take. Possibilities include adopting the standard as it is or dropping the project entirely. More likely, however, is that we would make changes to the proposal and re-propose it for additional comment, to try to achieve the best possible balance between disclosing information that will be helpful to investors but not harmful to companies or the capital markets.

Because this standard would represent a significant change for audit practice as we know it, I urge you to pay attention to this important project. Indeed, perhaps your professors would like you to try your hand at writing up some critical audit matters, which would allow you to practice your writing skills while also providing insight into the potential effects of the proposed changes!

With that, I would like to wish you all the best of luck with your studies and accounting careers, and I would be happy to answer questions.

[1] See paragraph 4 of Auditing Standard No. 3, Audit Documentation.

[2] See paragraph .07 of AU Section 230, Due Professional Care in the Performance of Work.

[3] See Staff Audit Practice Alert No. 10, Maintaining and Applying Professional Skepticism in Audits (Dec. 4, 2012).

[4] See PCAOB Release No. 2013-005, The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses and Unqualified Opinion; The Auditor's Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Auditor's Report; and Related Amendments to PCAOB Standards (Aug. 13, 2013).