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 Keynote Address: Driving Change to Achieve Independent and High Quality Audits

DATE May 3, 2012
SPEAKER(S): Jeanette M. Franzel, Board Member
EVENT: Baruch College Financial Reporting Conference
LOCATION: New York, NY

Good Afternoon,

I am honored to be here today at this important conference. I thank all of you for your interest in advancing and improving financial reporting and auditing, as evidenced by your participation in this conference today.

I am the newest Board Member, appointed in February of this year, and I've been on the job for almost 9 weeks now (not that I am counting). In January 2011, three new members were appointed to the Board, Lew Ferguson, Jay Hanson, and our Chairman, Jim Doty. With 4 of the 5 Board members being relatively new, we are often referred to as the "new Board." Of course, Steve Harris continues as our senior statesman, having been on the Board since 2008.

Today, I will provide my impressions and observations from my first nine weeks on the job, as well as an update on the current activities of this very busy, "new Board."

Before I go further, however, 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.

Reliability, Role, and Relevance of the Audit

Auditors have been given an important role in the capital markets — to provide assurance to investors, owners, lenders and others 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 and rules.

Clearly, reliable financial statements play a key role in the financial markets, which are integral to the success and well-being of American households and businesses, the U.S. economy, and participants and stakeholders from around the world. The securities markets provide a reliable funding mechanism for American — and, increasingly, foreign — businesses. More than half of American households invest their savings in securities to provide for retirement, education, and other goals. Our economy is resilient, even in the face of the recent financial crisis, in part because millions of savers continue to be willing to invest in business enterprises to fuel growth, growth that results in more workers, more savings and more investment. This cycle promotes economic wealth, but it relies on the system of accurate financial disclosures by public companies to the investors who entrust capital to them.

As we approach the 10th anniversary of the Sarbanes-Oxley Act and 9 years of PCAOB operations, we seem to be, once again, in a period of re-examination of the role, relevance, and reliability of financial audits in protecting investors and the public interest. Many of the topics currently being debated have been debated over the decades—auditor independence, the role of audit committees, professional skepticism and objectivity, audit quality, and the auditor's report, among others. One possible line of response to reevaluating these issues is "we decided decades ago on this," or "this has worked fine for the last 70 years." Even if these are some of the "same old topics" that have been debated for decades, we can also look to the many corporate failures and financial crises that have occurred over the decades and recognize the importance of ongoing re-examination and adjustments in the auditing model. First of all, auditing is very difficult and filled with competing tensions, and we can and should continue to learn from years of experience. Secondly, rapid changes in the financial markets, globalization, technology, and how business is conducted continue to drastically impact financial reporting and auditing.

Often, we are inspired to re-examine financial reporting and auditing in reaction to a crisis. In a way, we may be reacting to the financial crisis and serious economic situation over the past several years. But the current efforts are occurring in a measured and forward-looking manner, in addition to looking back to examine the impact of the Sarbanes-Oxley Act and PCAOB's accomplishments to date. Also, the profession and its oversight bodies have new information, including a large body of PCAOB inspection results and recent academic research that shed light on auditor processes, behavior, and judgments.

Role of the PCAOB

As you know, the Sarbanes-Oxley Act of 2002 established the PCAOB to oversee the audits of the financial statements of public companies. In July 2010, the Dodd-Frank Act amended the Sarbanes-Oxley Act and, among other things, vested the PCAOB with the authority to oversee audits of broker-dealers. The statutory 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. The PCAOB is also charged with overseeing the audits of broker-dealer compliance reports under federal securities laws to promote investor protection.

The PCAOB has four main responsibilities under the Act:

  1. register public accounting firms that audit public companies or broker-dealers;
  2. establish auditing and other professional standards;
  3. conduct and report on regular inspections of registered public accounting firms that audit public companies or broker-dealers; and
  4. conduct investigations and disciplinary proceedings in cases where auditors may have violated certain provisions of the Sarbanes-Oxley Act of 2002, the rules of the PCAOB and the Securities and Exchange Commission, and other laws, rules, and professional standards governing the audits of public companies, brokers, and dealers.

Currently, approximately 2,400 firms are registered with the Board. Of those, approximately 516 are firms that reported auditing broker-dealers but no issuers. In addition, the 2,400 total registered firms include approximately 815 firms that reported issuing no audit reports for issuers or broker-dealers, but have nonetheless chosen to register with the PCAOB.

PCAOB annually inspects firms that audit over 100 issuers, while firms that issue 100 or fewer audit reports each year are subject to inspection every three years. PCAOB does not inspect firms that do not perform audit work for issuers. In addition, PCAOB is currently conducting an interim inspection program for auditors of broker-dealers, and will use information from this interim program to guide its decisions about a permanent program, including whether to differentiate among classes of brokers and dealers in terms of inspection schedules, and possible exemptions from inspections.

During 2011, PCAOB inspected 10 firms that audited more than 100 issuers. As part of those inspections, PCAOB inspectors examined portions of more than 340 audits. Also during 2011, PCAOB inspected 203 firms in the 3-year category, examining portions of more than 485 audits by those firms. Finally, in the interim inspection program for broker-dealer auditors, PCAOB inspected 8 audit firms in 2011, covering portions of 19 audits of broker-dealers.

Since it began its inspections operations, the PCAOB has conducted over 1800 inspections and reviewed over 7800 audits. PCAOB inspection reports issued to the firms after their inspections identify deficiencies in the firms' audit work as well as weaknesses or deficiencies in the firms' quality control policies and procedures. Certain portions of the inspection reports — those dealing with particularly significant audit deficiencies identified by inspectors — are made publicly available. With respect to any problems found by the Board in the firm's quality control systems, firms are given twelve months to remediate those issues or face publication of the portion of the inspection report describing those issues.

Remediation is a very important part of the process. It is through these actions that firms propose to correct their quality control deficiencies in order to drive improvements in auditing. We have seen most firms take their responsibilities for remedial efforts and improvements seriously.

In addition to our activities in connection with registering and inspecting firms, the Board is responsible for setting auditing standards for the audits of public companies and brokers and dealers. I will talk in a few minutes about some of our priorities in this area.

Finally, the PCAOB also has an active Division of Enforcement and Investigations. To date, the PCAOB has taken 49 disciplinary proceedings against 39 registered accounting firms and 52 persons associated with registered firms. The sanctions have included censures, fines, suspensions or bars from being associated with a registered firm, and revocations of firm registrations. To date, the Board has revoked the registration of 25 firms, barred 41 individuals, and suspended 5 individuals and 1 firm's registration.

In my short time with the Board, I have put the registration, inspection, standards, and enforcement roles that I have just described into a "bucket" that I think of as the Board's "ordinary business operations." The workload associated with carrying out the Board's "ordinary business" is heavy and varied, and is integral to fulfilling the Board's mission and statutory responsibilities. The information and knowledge we gain from our operations also provides input for the Board's priorities and consideration of longer-term initiatives in order to promote independent and high quality audits that protect investors and further the public interest.

PCAOB Priorities and Initiatives

PCAOB is in a unique position given the knowledge and information gained through the inspection program to identify trends and risks in the auditing profession. PCAOB staff and the Board also work one-on-one with firm personnel and firm leadership in discussing issues impacting audits, including effective audit practices and responses and ways to enhance audit quality in light of current pressures and risks. The Board also issues practice alerts, summary reports, research notes, interpretative releases and other communications in order to also communicate these issues broadly. Finally, PCAOB uses input from its inspections, task forces, the Academic community, and other stakeholders in developing its standards setting agenda.

I mentioned earlier the category of the PCAOB workload that I think of as "ordinary business operations." I think of our other work as being in the category of "leadership in protecting investors and the public interest" by being a driving force for change when needed, to ensure independent and high quality audits. In this category, we have several layers:

  • Drive change in the profession to correct gaps in auditing practice under the current audit model in order to achieve needed improvements in the near term.
  • Determine what types of changes are needed in the audit model—including auditing standards, as well as the business model used by the firms in implementing those standards—in order to help ensure reliable audits and investor protection in the future.
  • Determine through ongoing monitoring whether, at any time, immediate actions are needed to mitigate unusual, emerging risks to financial audits from a variety of factors, including rapid changes and increasing complexity in business operations and financial markets, evolving technology, the global business environment, and other factors.

Improvements Needed in Current Audit Practices

Regarding the current gaps in practice, PCAOB inspections continue to find serious audit deficiencies on a regular basis. In fact, our inspection reports issued during 2011 related to the 2010 inspection cycle, including reports on inspections of some of the largest firms, show a significant and concerning increase in inspection findings.

Such deficiencies include cases where auditors issue clean opinions even though:

  • the audit work is incomplete or not properly conducted;
  • financial statement information is contradicted by other available evidence; and/or
  • audit conclusions on material issues are based on management's views without independent verification.

Clearly improvements are needed in current audit process under current standards. In that regard, the PCAOB staff and Board Members devote considerable attention and time to working with firms to evaluate systemic root causes within a firm's structure, operations, processes or other areas that detract from audit quality or cause deficiencies. When the Board issues inspection reports, the portion of the report containing findings about deficiencies in a firm's system of quality control, referred to as "part 2" of the report, are subject to statutory restriction on public disclosure. The firm has 12 months from the issuance of the inspection report to address the issues to the Board's satisfaction. The PCAOB staff and Board also spend considerable time evaluating firm's remediation plans and actions. If a firm does not satisfactorily address any of the quality control criticisms within 12 months, the portion of the report discussing the particular criticism(s) is made publicly available.

PCAOB Standards-Setting Activities

The Board uses information that it learns in its inspections and from other sources to evaluate the need for changes in auditing standards. In developing new standards, the PCAOB also seeks advice from a wide variety of interested stakeholders on ways to improve audits. The Board's standards activities are informed by meetings and dialogue with investors, auditors, representatives of public companies, members of the academic community, and through its Standing Advisory Group. The Board also holds roundtable discussions and other public meetings to deepen its dialogue with commenters and other interested parties. The Board works closely with the SEC on the development of standards and monitors the work of accounting standard setters, such as the Financial Accounting Standards Board, for developments that may affect auditing.

The Board currently has a full agenda for seeking views on ideas and specific proposals impacting auditing and related professional practice standards through concept releases, proposed standards, and potential future projects.

Concept Releases

The Board is currently evaluating comments and feedback on two concept releases, one dealing with the auditor's reporting model and another with auditor independence and mandatory firm rotation. These concept releases did not propose new auditing standards. Rather, they sought the public's views on particular matters so that the Board can better evaluate the need for future standard-setting.

  • Auditor's Reporting Model — On June 21, 2011, the Board issued a concept release to seek public comment on potential changes to the auditor's reporting model. Such potential changes could include a supplement to the auditor's report in which the auditor would be required to provide additional information about the audit and the auditor's view of the company's financial statements (an "Auditor's Discussion and Analysis"); required and expanded use of emphasis paragraphs in the auditor's report; auditor reporting on other information outside the financial statements; and clarification of certain language in the auditor's report. The concept release was preceded by several discussions with the PCAOB's advisory groups, and extensive outreach by PCAOB staff in 2010 and early 2011. In addition, the Board solicited further comment at a roundtable on Sept. 15, 2011. The deadline for comments on the concept release was Sept. 30, 2011. Staff is currently preparing a proposed standard.
  • Auditor Independence and Audit Firm Rotation — As a result of PCAOB inspections, the experience of other audit regulators and concerns expressed by investors, the Board issued a concept release Aug. 16, 2011, seeking public comment on a variety of possible approaches to improving auditor independence, objectivity and professional skepticism. As part of that concept release, the Board sought comment on whether a rotation requirement would risk significant cost and disruption and how mandatory rotation would serve the Board's goals of protecting investors and enhancing audit quality. The Board also sought comment on whether other measures could meaningfully enhance auditor independence. The deadline for comments was Dec. 14, 2011. The Board held a public meeting to obtain further comment on the concept release on March 21 and 22, for which the comment period was reopened. Future such public meetings are planned.

Proposed standards

The Board is currently evaluating comments on several proposed standards and seeking comment on one proposal.

  • Audits of SEC-Registered Brokers and Dealers — The Dodd-Frank Act gave the PCAOB the authority to oversee auditors of SEC-registered brokers and dealers, including authority to set standards and rules for audits of brokers and dealers. On July 12, 2011, the Board proposed standards dealing with (1) examination engagements for compliance reports, (2) review engagements of exemption reports, and (3) auditing supplemental information. The deadline for comments on the proposed PCAOB standards was Sept. 12, 2011. Further action on the Board's proposals is dependent on the SEC's adoption of the proposed amendments to its Exchange Act 17a-5 rule.
  • Audit Transparency — On Oct. 11, 2011, the Board proposed amendments to its standards that would improve the transparency of public company audits by requiring that audit reports disclose the name of the engagement partner as well as the names of other independent public accounting firms and other persons that took part in the audit. The amendments would also require registered public accounting firms to disclose the name of the engagement partner for each audit listed on the firms' annual reports filed with the PCAOB. The deadline for comments on the proposed amendments was Jan. 9, 2012.
  • Communications with Audit Committees — On Dec. 20, 2011, the Board reproposed a new auditing standard, Communications with Audit Committees, and related amendments. The standard is intended to benefit investors by establishing requirements that enhance the relevance and quality of the communications between the auditor and the audit committee. The deadline for comments was Feb. 29, 2012.
  • Auditing Related Party Transactions — On February 28, 2012, the Board proposed a new standard, Related Parties, as well as amendments to certain PCAOB auditing standards to assist auditors in detecting and addressing the audit risks associated with related parties and other unusual transactions. The comment period expires May 15, 2012.

Potential future projects

The Board is also considering possible revisions to standards in the following areas to strengthen and clarify requirements:

  • auditors' use of specialists,
  • part of the audit performed by other auditors,
  • assignment and documentation of firm supervisory responsibilities,
  • fair value measurements,
  • going concern,
  • confirmation,
  • quality control,
  • codification of PCAOB standards, and
  • subsequent events.

As you can see, the Board is working on an ambitious agenda including numerous areas of audit practice aimed at strengthening auditing standards themselves, while improving audit practices and approaches.

Risk Monitoring, Assessment, and Research

Through the Office of Research and Analysis, the PCAOB also monitors information obtained from a variety of sources, including PCAOB inspections, public company financial reporting, price and volatility information from debt and equity markets, and corporate governance information in order to identify emerging risks to financial reporting and auditing. This information is then used by PCAOB's inspections, standards setting, and enforcement functions. In addition, information is provided to the public, as appropriate.

On March 15, 2011, PCAOB issued its first public "Research Note" to provide new data on the growth of reverse merger transactions involving companies based in China, Hong Kong, and Taiwan. A reverse merger typically occurs when an operating company merges with a U.S. shell company that had previously registered its securities on a U.S. exchange. The Research Note, along with Staff Audit Practice alerts issued in July 2010 and October 2011, represented an effort by PCAOB to provide more information to investors and other users of financial statements about the audit environment for companies from the China region.

Additionally, the Office of Research and Analysis performs regular research and analysis to support the various efforts of the Board while also monitoring risks and identifying emerging issues.

Current Legislative Initiatives

Currently, legislation is pending (HR 3503 and S 1907) that would amend the Sarbanes-Oxley Act of 2002 to make PCAOB disciplinary proceedings open to the public.

Under the Sarbanes-Oxley Act as it exists today, the PCAOB's disciplinary proceedings are nonpublic, unless the Board finds there is good cause for a hearing to be public and each party consents to public hearings. PCAOB disciplinary proceedings remain nonpublic even after a hearing has been completed and adverse findings made by a disinterested hearing officer, if the auditors and firms opt to appeal and do not consent to make the proceedings public. The auditors and audit firms charged with violating applicable laws, rules or standards have little incentive to consent to public disclosure of disciplinary proceedings against them, and in fact, none have ever done so.

Continued litigation postpones — often for several years — public disclosure that the PCAOB has charged the auditor or firm, the nature of those charges, and the content of adverse findings. In addition, unlike the authority the Securities Exchange Act of 1934 provides the SEC in its administrative proceedings, the PCAOB has no authority, while litigation is pending, to issue temporary cease-and-desist orders in appropriate cases, to prevent potential further harm to investors or the public interest.

This situation results in a variety of unfortunate consequences for investor protection and the public interest. The public is denied access to important information regarding PCAOB cases and respondents' alleged misconduct — no matter how serious. As a result, investors are unaware that companies in which they may have invested are being audited by accountants who have been charged, even sanctioned, by the Board, and meanwhile, the audit firm and associated persons may continue to issue audit reports.

If the SEC were to bring the same case as the PCAOB, alleging the same violations, against the same auditor, the SEC's charges would be disclosed at the time the Commission instituted its proceeding. Any administrative trial would be open to the public. If there were an appeal to the Commission and an oral argument, the public could attend. The ability — or inability — of the SEC's staff to prove its charges would be a matter of public record.

The non-public nature of PCAOB's enforcement proceedings is not good for investors, for the auditing profession, or for the public at large.

*    *    *

The reliability, role, and relevance of financial audits, auditor independence, and audit quality are enduring themes that we must regularly monitor and evaluate in order to protect investors and the public interest in a dynamic, global business environment. This involves looking beyond the status quo and the current business cycle. We also need to carefully consider and analyze the potential costs and benefits of various actions as well as the risks of unintended consequences.

I am pleased to have the opportunity as a Board member to explore the broad range of issues impacting the auditing profession as we seek to make progress to strengthen the reliability and accuracy of audit reports.

 

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