Thank you very much for inviting me to be here today. I am honored to speak to this distinguished group of professionals, academics and students on the occasion of the 12th Annual Financial Reporting Conference here at Baruch College. I am also honored to be included with the distinguished group of speakers assembled here today.
Created by Congress with the passage of the Sarbanes Oxley Act of 2002 ("Sarbanes-Oxley Act"), the PCAOB formally began operations ten years ago, in April 2003. Since then, the audit profession has undergone a transformation. Overall, I believe that investors and the capital markets are better served by auditors now than they were ten years ago, but much work remains to be done. Today, I would like to discuss briefly the PCAOB's evolution over the last ten years, followed by an overview of how we are currently challenging ourselves to think about new approaches to the Board's "business as usual." I would also like to share some personal observations — from my perspective as a former public company auditor and current regulator — about challenges faced by the audit profession today.
But 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.
In the late 1990's and early 2000's, companies like Enron, WorldCom, Tyco, Adelphia and Sunbeam were in the news almost daily. At one time, these companies were rising stars, much like Google, Apple or Facebook today. Unfortunately, the impressive financial results these companies reported, even after they were audited by a major firm, turned out to be erroneous and, in some cases, fraudulent. The need to reform aspects of management responsibility and accountability, as well as corporate governance was clear. The audit profession needed a wake-up call, and the era of self-regulation came to an end. The system of peer review — involving one audit firm reviewing the quality of the work of another firm — was not sufficiently rigorous, and Congress recognized that to protect the interests of investors, an independent regulator was needed to oversee audit work performed in connection with publicly held companies. Thus, Congress passed the Sarbanes-Oxley Act and, among other reforms, created the PCAOB.
Was the Sarbanes-Oxley Act perfect? No, even in the words of Senator Sarbanes and Congressman Oxley. However, the resulting changes in corporate culture, increased rigor in corporate governance and the performance of auditors today exceed the expectations held by many when the Act was passed. While the financial crisis revealed some surprises and challenges, particularly in connection with certain transactions given "off balance sheet" treatment (think repos), we have not seen again the same blatant and fraudulent reporting abuses from a decade ago. As others have mentioned at this conference, the accounting standard setters are working tirelessly to determine whether and how to amend accounting standards to address some of these concerns, while we at the PCAOB continue to consider enhancements for the audit.
Back in 2003, the PCAOB's first Board members and a very small complement of staff set us off on this journey by commencing work on our four primary statutory duties: registering firms that conduct audits of public companies; setting the rules and standards to govern the work of those auditors; inspecting their work to ensure that auditors are complying with the rules; and sanctioning auditors through our enforcement program when we see egregious auditor behavior. Today, these four activities have become our "business-as-usual," performed by a staff of nearly 800, guided by the five member Board, all under the oversight of the SEC.
The Board's registration records currently show over 2,350 firms, including foreign firms from 85 jurisdictions. To date, the Board has conducted over 2,000 inspections of public companies. While we still face challenges gaining access to a number of jurisdictions for inspections (including certain countries in the European Union, China and Hong Kong), we have made substantial progress in the past two years and have now conducted inspections in 40 jurisdictions around the world. After the Dodd Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act") expanded the Board's authority over the audits of broker dealers, we also commenced a pilot program in 2011 for the inspections of the audits of brokers and dealers.
In addition to reporting on our inspection activities through the publication of portions of firm-specific inspection reports (to the extent permitted by the Sarbanes-Oxley Act), the Board also periodically issues summary reports to convey our inspection findings over a period of time and across firms. These reports are often referred to as "Rule 4010 Reports," based on the PCAOB Rule governing their issuance. The Board recently issued two such reports.
First, in December 2012, the Board issued a report called "Observations from 2010 Inspections of Domestic Annually Inspected Firms Regarding Deficiencies in Audits of Internal Control Over Financial Reporting." This report summarized observations drawn from inspections of 309 audits of internal control over financial reporting at public companies. The report expressed concern about the number and significance of deficiencies identified in firms' audits of internal control during the inspections, which generally involved reviews of the integrated audits of financial statements and internal control for issuers' fiscal years ending in 2009.
The report describes the most pervasive deficiencies identified during PCAOB inspections in 2010 in firms' auditing of internal control. In 46 of the 309 integrated audit engagements (approximately 15 percent) that were inspected in 2010, the PCAOB found that the firm had not obtained sufficient audit evidence to support its audit opinion on the effectiveness of internal control due to one or more deficiencies identified by the PCAOB. In 39 of those 46 engagements in which the firm did not have sufficient evidence to support the internal control opinion, the firm also had not obtained sufficient audit evidence to support the financial statement audit opinion. The inspections results summarized in this report include, among others, our inspection staff's observations about deficiencies in auditors' execution of the "top-down" approach to testing controls. One common finding noted in the report that we are still seeing in our inspections reflect the challenges posed by the need to understand the design, operation and effectiveness of such controls, including whether the control operated at a level of precision that would prevent or detect material misstatements. Observing a signature is not enough!
Second, in February 2013, the Board issued a report that may be of interest to many of you. This report summarizes inspection results observed from 2007 to 2010 in the inspections of U.S. firms that audited 100 or fewer public companies and which were required to be inspected at least once every three years. This report built on a prior report, published in 2007, of earlier inspection results at such "triennial firms."
The recent report regarding triennial firm inspections includes observations from 748 inspections of 578 domestic triennial firms conducted from 2007 through 2010 and reflects reviews of 1,801 financial statement audits. Frequent findings during this time period related to audit work in several areas, including:
- revenue recognition;
- share-based payments and equity financing instruments;
- convertible debt instruments;
- fair value measurements;
- business combinations and impairment of intangible and long lived assets;
- accounting estimates;
- related party transactions;
- use of analytical procedures as substantive tests; and
- responding to the risk of material misstatement due to fraud.
While the report showed an overall reduction in the rate of reported significant audit performance deficiencies compared to the prior report issued in 2007, and a decrease in the rate of significant deficiencies noted in firms' second inspections compared to their first, the persistence of deficiencies in audits performed by a large number of domestic triennial firms remains of concern to the Board.
Both of the recently issued reports include a discussion of potential root causes for the findings. I urge firms, audit committees, investors and others to consider the information in the reports carefully to gain a better understanding of important issues affecting public company audits. For the academics in the room, you also may find some good "teaching moments" in this report.
Since its inception, the Board also has had an active standard-setting program. So far, the Board has issued 16 auditing standards and amended many others, including enhancing audit documentation requirements, specifying necessary audit procedures for audits of internal controls, establishing standards for audit planning, engagement quality review, and risk assessment, among others. Last year, the Board issued a proposed standard on related parties and significant unusual transactions and a final standard on communications with audit committees. In the near future, you can expect to see a re-proposal of the related parties standard which seeks public comment on certain refinements of the previous proposal and well as information to inform the Board's economic analysis.
Another standard-setting project which is getting a great deal of attention is the auditor's reporting model. In 2011, in part as a response to investor concerns about a lack of information leading up to the financial crisis, the Board issued a concept release to discuss alternatives for changing the auditor's reporting model. Investors are demanding more transparency in the audit process and more insight into the company's financial statements and other information outside the financial statements. Commenters who responded to the concept release — over 150 to date — shared with us a variety of strongly held views. Some investors believe that auditors gain important insight into the companies they audit, which, combined with their independent perspective, makes them uniquely qualified to provide additional color around management's accounting policies and practices, financial statement disclosures, and the audit itself. Yet, many others believe that information about the company itself, and its accounting policies and financial statement disclosures, should come from management, accompanied only by the auditor's attestation. Auditors have been open to the inclusion of some new information in the auditor's report but also have expressed concerns about the potential costs and unintended consequences associated with the more complex alternatives presented in the concept release.
As we consider next steps in connection with this project, we are also monitoring a parallel standard-setting project by the International Auditing and Assurance Standards Board ("IAASB"). The IAASB most recently discussed a potential approach for the auditor's report at its February 2013 meeting and decided that the project's objective would be to establish auditor communications regarding "those matters that, in the auditor's professional judgment, were of most significance in the audit of the financial statements." Thus, the IAASB's current focus is on communications by auditors about the audit, rather than requiring the auditor to comment directly on the company's financial statements or accounting practices and policies. The IAASB plans to issue an exposure draft in June of this year. Our standard setting agenda currently contemplates action by the Board on a possible proposal by September.
The fourth prong of the PCAOB's statutory mission is enforcement of applicable laws, standards and rules. To date, the Board has publicly announced 56 disciplinary orders, including sanctions against 42 firms and 59 individuals. We have revoked the registrations of 27 firms and issued over 50 bars and suspensions. 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 that must remain non-public pursuant to the Sarbanes-Oxley Act. While many of our 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), and against firms who did not file their annual PCAOB reports and pay annual fees.
Our most recently announced enforcement matter involves a settled order in which the Board revoked the registration of a firm in India and imposed sanctions on three partners of the firm, including barring two of them — one permanently —- from being associated with a registered firm. The case involved violations of PCAOB rules, quality control standards, and auditing standards in connection with the audits of an Indian telecommunications company. The firm's quality control standards violations related, in part, to the fact that the Firm staffed the audits with partners who had no formal training or experience with PCAOB standards or U.S. Generally Accepted Accounting Principles. In addition, the Board found that the Firm and one of the Firm's partners violated Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 by issuing an audit report regarding the 2006 and 2007 financial statements of the company, even though the Firm and the partner had failed to perform any audit procedures. The Board also found that the three partners and the Firm violated PCAOB rules and auditing standards by performing few to no audit procedures in connection with the issuance of audit reports for the FY 2008-2011 financial statements of the company.
Challenging Business as Usual
Although the Board has moved from being a start-up organization to one with established processes, our ten-year anniversary provides incentive to consider whether and how we might want to move beyond, or improve, these "business as usual" activities. There are questions we should ask ourselves. For example, has the Board always achieved its objectives in the best way possible? Not in all cases. Have some of our activities resulted in unintended consequences? Possibly. In that spirit of self-examination, the Board recently identified a series of near-term priorities for 2013. These include:
- Improving the timeliness, content and readability of inspection reports;
- Improving the timeliness of remediation determinations and providing additional information on the Board's remediation process;
- Initiating a project to identify and report on audit quality measures;
- Enhancing our processes and systems to improve analysis and usefulness of inspection findings in order to better understand audit quality and better inform standard-setting and other regulatory activities;
- Enhancing the framework for our standard-setting efforts in order to improve the effectiveness of the process and the project tracking information provided to the investing public; and
- Enhancing the Board's outreach to and interaction with audit committees.
A common theme for several of these priorities is to enhance the timeliness and content of information we make available to those outside the audit profession, including investors, preparers and audit committees. In connection with some of our past outreach, including during several public meetings about auditor independence last year, we heard that audit committees, in particular, are interested in and would benefit from more information about the PCAOB's activities and findings. The important auditor oversight role played by audit committees in the capital markets complements the Board's mission, and we are eager to explore ways in which we can work together.
A partial response to the feedback received from audit committees was the issuance, in August 2012, of a release to provide information to audit committees about the Board's inspection process and the meaning of reported inspection results. The objective of the release was to better equip audit committees to engage in meaningful discussion with audit firms about the results of inspections./
Several of the Board near-term priorities also contemplate exploring the extent to which the Board can provide more useful information to audit committees, among others, on a timely basis. For example, we are looking closely at our inspection reports — both firm-specific reports and our general Rule 4010 reports — to determine whether the current process, format and content provides the maximum benefit to potential users of the reports. Likewise, we have initiated a project to begin to identify potential measures of audit quality. This project, if successful, could have wide-ranging implications on many of our activities. It could affect the content or focus of inspection reports, influence potential future standard-setting projects, and may, ultimately, lead to the publication of certain indicators that could help audit committees and investors better evaluate the quality of work by their auditors.
In order to inform these considerations, as well as foster a more robust dialog between the Board and audit committees generally, the near term priorities for 2013 also include increasing our outreach to and interaction with audit committees. We are currently considering potential approaches to such outreach and interaction, ranging from the issuance of additional publications, to attendance at conferences, to hosting meetings or round tables specifically tailored toward audit committees. I would like to see a more regular two-way dialog between the PCAOB and audit committees, so that we can leverage our collective knowledge and experience with the common goal of enhancing investor protection.
An additional challenge to the Board's "business as usual" has been the increased focus on economic analysis of our regulatory activities. Although the Board has always weighed the need for new standards and their potential costs, the Board sharpened its focus on this issue in early 2012, considering whether more could be done to understand the potential economic consequences — positive and negative — of the Board's standard setting activities. Subsequently, in April of last year, Congress passed the Jumpstart Our Business Startups Act of 2012 ("JOBS Act"), which states that any rules adopted by the Board subsequent to April 5, 2012, do not apply to the audits of emerging growth companies unless the SEC "determines that the application of such additional requirements is necessary or appropriate in the public interest, after considering the protection of investors, and whether the action will promote efficiency, competition, and capital formation."/ This development, also, has increased the Board's focus on the potential consequences of its rule-making efforts, and we are currently learning about and evaluating potential approaches to incorporate increased economic analysis into our everyday operations.
Challenges Facing the Audit Profession
So what has been the result of all of this activity at the PCAOB? As I noted earlier, I believe that the audit profession better serves the needs of investors and the public now, a decade after the passage of the Sarbanes-Oxley Act. Auditors are much more conscious today, I believe, of their obligation to audit committees and investors. Based on my experience, audit practice has improved through PCAOB inspections (and enforcement) and increasingly rigorous auditing standards. Restatements reflecting serious audit failures and other adverse events appear to be decreasing. I am hopeful that, in time, our audit quality indicator project can help establish objective measures of audit quality that help us better understand and tailor our regulatory efforts based on what works and what does not. In the meantime, I will share with you some personal views of the challenges still facing the audit profession that I believe affect audit quality.
Tone and Culture
One of the things we discuss regularly with the leaders of the largest firms is tone and culture at the firms. During our inspection process, our staff is alert for messages from firm leaders to the firm's staff, clients and others. When we see messages that are not consistent with independent, objective and high quality audits — such as an unreasonable focus on obtaining or keeping clients or promoting non audit services — we question the firm's tone and culture. It is critical that firm leaders establish a culture that supports audit quality. Tone must be backed up by actions that hold people accountable for quality work — through training, supervision, reward systems and promotions — to build such a culture.
In my two years at the PCAOB, I have seen a positive trend in the tone set by leaders at several firms, and, in time, the improved tone will move firm culture. It is a long term process, and there are countervailing forces that firms must monitor. For example, many of the firms report strong growth in their consulting practices, with flat revenues in the audit practices. In theory, a strong audit practice that serves the needs of investors can coexist with a growing consulting practice, but firm leaders must strike the right balance between the needs of their public interest audit work and those parts of the firm that have more purely profit-making objectives. Without leaders that understand the auditor's responsibility to investors and the need for continual investment in the audit practice, the positive trends in firm culture and tone may be reversed.
Challenges to Objectivity
Also part of the firm's overall tone and culture is the degree to which its auditors are appropriately objective and skeptical. Recently, many have speculated about whether something should be done to improve auditor objectivity and skepticism. One idea that has received a great deal of attention is mandatory audit firm rotation. In my view, auditor objectivity and skepticism — manifested in the auditor's ability and willingness to challenge management — depends on a variety of factors. Does the auditor have the technical competence to know what to challenge? Is the topic a complex area and the auditor lacks the confidence to insist on an adjustment or expanding the scope of audit procedures? Were the time pressures associated with tight filing deadlines creating an incentive to avoid "stirring up trouble"? Were there pressures to reduce hours and fees? Does the auditor have the right personality and temperament to jump into a contentious situation?
One exceptionally troubling issue that I sense is getting worse is the sheer number of hours that audit teams are expected to work. Most professionals understand and accept the need for long hours during the "busy season." If I were an audit committee member, I would be highly concerned if the work plan called for significantly more than 55 hours per week or if the actual sustained hours were much higher than that. How do you function if you are working 16 hours per day on a continual basis? How do you perform basic tasks, much less conduct the more difficult evaluations that require heightened skepticism and objectivity? How do you guard against the temptation to overlook difficult issues that will stretch out your work day even longer? If audit teams are working excessive hours, there is a problem. The audit partner may not have scoped the work properly and the firm does not have enough resources deployed. The firm may not be managing its people effectively. Management may not be providing the auditor timely information to complete the audit. In the interest of audit quality, I urge audit committee members to place a maximum number of hours per week on the table for discussion with their auditors and investigate the reasons for excessive hours.
These are all factors that the Board will have to consider in determining what actions may help to shore up auditor objectivity and skepticism. Several of them, I fear, would be exacerbated, rather than improved, through mandatory auditor rotation.
With that, I will thank you for your attention. I hope that you will provide me with your reactions and questions on the last panel this afternoon.