The PCAOB: Mission and Issues

Introduction

On behalf of the Public Company Accounting Oversight Board (“PCAOB”), I want to welcome you to our headquarters and say how delighted we are to have you here this morning.

As I understand it, this week in Washington brings to a close your Masters in Accounting program, after which you will sit for the CPA exam – and some may enter the public accounting profession.

Let me offer my congratulations on your achievements, and encourage you to pursue auditing as a career. I am glad to have this opportunity to tell you a little about the PCAOB and some of the challenging issues that auditors, and audit regulators, face.

But, first, I want to take a moment to pay tribute to my friend, Bill Seidman, founder of The Washington Campus, who died last month at the age of 88. He was responsible for my appointment to the Board of Directors of the Campus, and the reason you are here.

Bill was a Washington institution: a financial counselor to Presidents Ford, Reagan and George H.W. Bush. He was the individual probably most widely credited with providing the leadership that successfully brought our country through the savings and loan crisis 20 years ago.

He was also an accountant, joining the family firm, Seidman & Seidman CPAs, and rising to become its national managing partner. Under his leadership, the firm expanded into one of the nation’s 10 largest accounting firms, with affiliates in 110 countries -- BDO Seidman, LLP.

At the core of auditing standards is a definition of professional skepticism -- it is “an attitude that includes a questioning mind and a critical assessment of … [the] evidence.” That was Bill. He always called them as he saw them, with total integrity, and I hope all of you will do the same throughout your careers.

I had lunch with Bill not long ago, and he was delighted to hear that you would be visiting the PCAOB.

Before I continue, let me say that the views I express today are my own and do not necessarily reflect those of the Public Company Accounting Oversight Board or its staff.

Background on the PCAOB

I thought I would start by giving you a brief description of what we do at the PCAOB.

As you may know, the federal securities laws grant auditors a unique franchise. A public company must hire an external auditor if it wants to sell securities to the public or list them on the nation’s stock exchanges. It does not have to hire an attorney or underwriter – although it might be a good idea – but an independent auditor must examine and publicly attest to the company’s financial statements.

This role places auditors at the very heart of our financial regulatory system – a concept that was upheld by the Supreme Court in its 1984 decision in United States v. Arthur Young.

The Court stated plainly, “By certifying the public reports that collectively depict a corporation’s financial status, the independent accountant assumes a public responsibility transcending any employment relationship with the client. The independent accountant performing this special function owes its ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public. This ‘public watchdog’ function … requires complete fidelity to the public trust.”

Without accurate and reliable corporate disclosures and financial statements -- and competent auditors to audit them -- our free market system cannot function properly. That is why your chosen area of study is vital to our system of capitalism.

Establishment of the PCAOB

That is also why the PCAOB was established in 2002, when the Sarbanes-Oxley Act mandated our mission “…to oversee the audits of public companies … to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports ….”

The Act outlines four primary areas of responsibilities for the PCAOB:

First, we are required to register all accounting firms that audit public companies whose stock is traded on any U.S. exchange.

Second, we are required to conduct periodic inspections of those registered accounting firms and report the results of those inspections.

Third, we are required to establish auditing standards related to the preparation of audit reports of public companies for those registered firms to follow. And,

Fourth, when there is a suspected violation of the Board’s standards or other applicable rules, the law authorizes us to conduct investigations of, and disciplinary proceedings against, registered firms.

In short, the PCAOB registers the auditors, sets the rules for the auditors, “audits” and reports on the auditors, and, when necessary, disciplines the auditors. Under the Act, the SEC has ultimate control over each of these functions, as well as matters related to the membership and operations of the Board.

Passage of the Sarbanes-Oxley Act was triggered by the failures of Enron and WorldCom. Now, recent press reports about alleged fraud investigations of several large financial companies have only sharpened the Board’s focus on its “audit” of the auditors – not only domestically, but internationally, as well.

Since opening its doors in Washington, D.C., in January 2003, with a staff of six and a start-up budget of $68 million, the PCAOB has grown into a staff of more than 500 in nine offices around the country with a 2009 budget of $157 million.

More than half of the PCAOB staff are devoted to the inspection process. Inspection team leaders for larger firms are highly skilled, averaging more than 27 years of relevant experience; all other inspectors average 15 years.

PCAOB Activities to Date

To give you some perspective on the scope of our work, I want to run through a few facts about what the PCAOB has accomplished to date.

Registration

Since its inception, the PCAOB has registered 2,289 firms. Of the 2,006 firms currently registered, 55 percent are U.S. firms, while 45 percent are located in 86 different countries.

Inspections

The PCAOB has inspected more than 1,120 firms to date, including 140 foreign firms in 26 jurisdictions. During these inspections, it reviewed portions of more than 5,050 audited financial statements.

Twelve of the larger firms are currently subject to annual inspections, including the “Big Four” firms -- Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, and PricewaterhouseCoopers LLP. These four firms collectively audit about 98 percent of all U.S. public companies, based on their market capitalization. The rest of the audit firms are inspected on a triennial cycle, but only if they have public company audit clients.

In selecting which audits to review during each inspection, the PCAOB uses various levels of risk analysis to provide our inspectors with an early warning of potential audit problems. Our own economists and analysts comb published documents to identify riskier industries and companies, focusing our inspectors on areas of stress that can result in financial statement errors and poor audit quality. Since the creation of our Office of Research and Analysis, hundreds of fact patterns, relationships, and other criteria that have the potential to contribute to high risk audit areas have been identified and reviewed by the PCAOB.

Of the inspection reports issued to date, about 50 percent showed quality control and audit performance problems. All but a few firms addressed those problems to the Board’s satisfaction.

International Inspections

One significant challenge for the PCAOB inspection program is driven by our global mandate. Because audit regulation is new or nonexistent in some parts of the world, it can take time to negotiate agreements to allow the necessary inspections to take place in some foreign countries.

To date, we have established relationships with foreign counterparts that have enabled us to conduct inspections in 26 foreign jurisdictions, including in Asia, the European Union, Israel, and Latin America.

Perhaps most important of all, over the past six years, many countries have taken steps to strengthen their own auditor oversight, in recognition of the role that independent auditors play in protecting investors and the public’s interest in their respective capital markets. The PCAOB has often served as a model for many countries that have created or enhanced auditor oversight. And, by virtually all accounts, the PCAOB has improved audit quality in the United States.

Standard-Setting

In the area of standard-setting, we currently have eight proposed standards on the docket related to risk assessment and engagement quality review.

In addition, the Board works closely with the Financial Accounting Standards Board and monitors its accounting proposals because of their potential impact upon auditing standards. For example, we are reviewing FASB’s draft standard on “going concern” issues. In light of recent economic conditions, the auditor's consideration of going concern is likely to be of heightened interest to investors who are looking for warning signs about a company’s ability to continue to exist.

We also have issued four Staff Audit Practice Alerts. An Alert issued December 2008 focused on emerging audit risks in the current economic environment. The most recent Alert, issued in April, discussed auditing for fair value and other-than-temporary-impairments.

Since 2003, we have completed and issued six new auditing standards, including the well-known standard for auditing internal controls.

Enforcement

Finally, the PCAOB is active in taking disciplinary steps to enforce PCAOB and related securities rules and standards. To date, the Board has instituted and settled 21 disciplinary orders. These disciplinary actions included revocations of registrations, and barring of individuals from working within the profession.

By statute, most of what the PCAOB does in the enforcement area remains confidential, such as open investigations. Our proceedings to date have addressed broad areas of audit risk, including a firm’s failure to assure whether audits are staffed by competent personnel; an auditor’s failure to fulfill his or her duties when confronted with evidence of illegal acts by a client; and an auditor’s failure to be independent from the audit client.

The Board’s largest settlement to date was with Deloitte & Touche LLP. The 2007 order was for violations of auditing standards during a 2003 audit. The settlement included a $1 million civil money penalty – the first fine assessed by the PCAOB.

Current Crisis and Issues Facing the PCAOB

Now let me turn to the current crisis and some of the issues facing the PCAOB and the audit profession.

We are going through a period of extreme economic stress, triggered and then compounded by a meltdown of our financial system. The crisis calls upon every regulator to take a hard look at how it does the public’s business.

President Obama has repeatedly stressed the need for financial regulators to require greater transparency and accountability, and to provide greater enforcement and regulation.

This is particularly applicable to the PCAOB, given the Board’s responsibility “[t]o protect the interests of investors by [ensuring] the preparation of informative, accurate, and independent audit reports …”

It is easy to see why transparency, accountability, enforcement and regulation are so important in protecting investors. With the value of a company’s stock inextricably tied to its financial position and results, if that position and those results are portrayed inaccurately, markets cannot function fairly or efficiently.

It is not surprising, then, that one of the most important themes of the early postmortems on the financial meltdown is the need for a greatly enhanced understanding of all aspects of the financial condition of the institutions we regulate. Over the last two years (2007-2009), the virtually unimaginable has occurred. Investors have incurred massive losses as regulated institutions throughout our financial services industry have either failed or received unprecedented government assistance. A partial list includes: Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Citigroup, Bank of America, Countrywide, Washington Mutual, IndyMac, Fannie Mae, Freddie Mac … and the list goes on and on.

What this tells us is that our financial regulators did not adequately assess the financial conditions or the business models of the institutions they regulated.

I believe that it is the responsibility of every regulator – including the PCAOB – to do a better job in this area.

Advisory Committee on the Auditing Profession

Because of the significance of the auditing profession to our nation’s securities markets and our economy, in 2007, then-Treasury Secretary Henry Paulson formed an Advisory Committee on the Auditing Profession “to examine comprehensively the condition and future of the auditing profession, with emphasis on the sustainability of a strong and vibrant profession.”

The two co-chairs of that committee, former SEC Chairman Arthur Levitt and former SEC Chief Accountant Don Nicolaisen, put it this way in a joint statement:

“Ultimately, it is a combination of transparency and trust that enables our financial markets to function efficiently. A strong and vibrant auditing profession is a critical element of that regime and especially important to the U.S. capital markets where more than 100 million people invest their savings and retirement assets.”

The Treasury Advisory Committee, which included a diverse and talented group of leaders from investor, business, academic and professional organizations, issued its final report and recommendations in October 2008.

I strongly support the work of the Treasury Advisory Committee, and believe that all 16 recommendations relating to the work of the PCAOB should be given serious consideration by the SEC and the PCAOB. Let me focus on just a few:

  • Improving the transparency of the financial condition of registered accounting firms;
  • Monitoring sources of catastrophic risk to registered accounting firms;
  • Requiring the engagement partner’s signature on the audit report;
  • Improving the auditor’s reporting model;
  • Creating a National Center for the Prevention and Detection of Financial Reporting Fraud;
  • Appointing independent members to serve on audit firms’ boards; and,
  • Reducing the barriers to growth for smaller auditing firms.

Improving the Transparency of Registered Auditing Firms

Obtaining a better understanding of the financial condition of registered audit firms was one of the recommendations made by the Treasury Advisory Committee. In the European Union, the larger auditing firms produce public annual transparency reports in accordance with Article 40 of the E.U.’s Eighth Directive. In the United Kingdom, audit firms, as limited partnerships, are required to publish audited financial statements. No such disclosures are required in the United States -- in strange contrast to the role we assign auditors in policing the disclosures of the companies they audit.

There was considerable discussion among Treasury Advisory Committee members about whether major U.S. auditing firms should disclose their financial information either to the public or to the PCAOB. In the end, the Advisory Committee recommended that auditing firms file their audited financial statements on a confidential basis with the PCAOB. The Advisory Committee co-chairs went farther, however, recommending that “at least the largest auditing firms should make audited financial statements available, including to audit committees and the investing public.”

As I have said, I believe we must seriously consider this recommendation. Not only is transparency an extremely important objective in its own right, but it is hard to think of any reasons why transparency of accounting firm financial information should be required in the European Union but not in the United States.

Monitoring Sources of Catastrophic Risk to Audit Firms

I believe that these arguments also hold true for the Treasury Advisory Committee’s recommendation that the PCAOB monitor sources of catastrophic risk to audit firms. To do this effectively, some argue that the PCAOB needs to gain more knowledge, not only of firms’ liability exposures, but also of their structure and operations. In addition, some commentators have said that the global networks of the accounting firms have the potential to create new areas of risk and new gaps in regulatory oversight.

We recently heard this from Paul Boyle, retiring Chief Executive of the Financial Reporting Council and Chairman of the International Forum of Independent Audit Regulators (IFIAR). In a speech at the E.C. International Auditing Conference in Brussels, he said that “the firms which manage the international audit networks … are currently not subject to regulation or oversight. As a first step, we should consider improving our knowledge of the structure, operations and governance of the networks.”

Under Sarbanes-Oxley, the PCAOB has the authority to look at work performed by any person associated with a registered firm in connection with a public company audit, including persons from another part of a firm’s global network. In the current environment where a number of institutions have been deemed “too big to fail,” I believe that the PCAOB should seriously consider gaining a better understanding of the components of these international firms, and the manner in which the global entities influence or control the quality of the work performed at the network firms.

Requiring the Engagement Partner’s Signature

Of course, there is no substitute for increasing the incentives and means for audit firms to police themselves. That is why I also strongly favor the Treasury Advisory Committee’s recommendation that each engagement partner add his or her signature to the audit report of the client. The signature of the engagement partner is another requirement found in E.U. law but not our own. Supporters of this recommendation believe that such signatures foster greater accountability of the individuals signing the auditors’ reports, enhance transparency, and improve audit quality. They also note that the signature will not create any additional liability concerns for the engagement partners.

Improving the Auditor’s Reporting Model

Another way to enhance transparency is to improve the reporting model for financial statements. This would contribute to the investor’s understanding of the financial statements and the audit process. Now, financial statements are graded on a pass-fail basis. Either they conform to GAAP or they do not. What if, for example, auditors could report to shareholders, not only that the company prepared its financial statements in accordance with GAAP, but ….

Then the communication between auditor and investor would become more effective. An improved reporting model could clarify the auditor’s responsibility to detect fraud, and provide investors with more useful information and analysis that highlights the important judgments and estimates that a company makes in putting together its financial statements.

Creating a National Fraud Center, Appointing Independent Board Members, and Reducing Barriers to Smaller Firm Growth

Three other recommendations made by the Treasury Advisory Committee could provide significant improvements in the degree of transparency in the marketplace and, thereby, provide advantages to investors. First, the Treasury Advisory Committee recommended that the PCAOB create a National Center for the Prevention and Detection of Financial Fraud, where auditors and possibly other market participants, may share experiences, commission research, and highlight best practices to fight financial reporting fraud. Second, the Committee recommended that the PCAOB explore the feasibility of firms appointing independent members to serve on their governance or advisory boards which could improve board oversight, reduce conflicts of interest, and enhance investor confidence in a firm’s operations. And, finally, the Committee recommended that the PCAOB explore ways to remove barriers to growth for smaller auditing firms through enhanced disclosure of third-party auditor restrictions and their increased participation in committees, roundtables and fellowships. This could create new competition among the firms to the benefit of public companies and their investors.

Other PCAOB Priorities

In addition to the areas covered by the Treasury Advisory Committee’s recommendations that I have discussed – and there are a number of other excellent recommendations as well – there are other important issues the Board is considering. These include:

  • Enhanced investor participation in improving audit quality;
  • Failure to supervise rules; and
  • Greater transparency of the PCAOB’s own work.

I would like to share with you a few final thoughts about these important areas.

Enhanced Investor Participation in Improving Audit Quality

One of the single most important messages that I would like to convey today is the need for enhanced investor participation in improving audit quality. In particular, I believe it is especially important that investor participation be formalized and institutionalized -- both domestically at the PCAOB, and internationally at the IFIAR. Too often in the past, regulators have opened their doors more widely to the industry groups they regulate than to investors, consumers and the public at large.

In my opinion, it is essential that investor groups be held in parity with, and afforded the same opportunities as industry groups. Otherwise, the primary objectives of auditing – to provide reliable, accurate and meaningful financial information to investors – stand the risk of being compromised.

Failure to Supervise

Another issue the Board is considering is the adoption of “failure to supervise” rules. Since joining the Board, I have been struck by the number of supervisory concerns brought to the Board’s attention by the Inspection Division. In the Board’s December 2008 public report on the results of our large firm inspections, we identified “inadequate supervision and review” as an important factor that allowed audit deficiencies to occur. The Board’s public report also identified supervision-related concerns in several other areas, including partner evaluation and compensation processes, internal inspection programs, and the evaluation and control of work performed by firms’ foreign affiliates.

The Sarbanes-Oxley Act states that the Board’s quality control standards should include requirements relating to the supervision of audit work, and the Board is currently addressing this.

Greater Transparency of the PCAOB’s Work

  • Failed remediation reports;
  • Registered but uninspected firms; and,
  • International firm inspection deferrals.

The PCAOB also is continuing to improve the transparency of its own operations, especially regarding the revelation and explanation of activities that may affect investor confidence in audit firms or their work.

The PCAOB is working to find a better way to make known the firms that fail to remediate deficiencies in their quality control systems. The Board currently is considering how to more prominently display such firms on the official record on our Web site, and I anticipate that we will finalize our efforts shortly.

In addition, the Board has undertaken to clarify for investors and other interested parties which registered firms the Board has inspected, and which ones it has not. Firms may not be inspected for a variety of reasons but, regardless of the reason, investors and the general public have the right to be able to distinguish easily between those firms that have participated in our inspection regime and those that have not.

Finally, the Board has taken action to make clear that a number of its international inspections have been deferred, and to explain the reasons for this. To further aid investors, the Board is considering how best to communicate the timetable for its inspections.

Closing Remarks

All of these ideas are variations on a single overarching theme: transparency. No fundamental weakness in our system has been made more apparent by the recent financial crisis than the need to provide greater transparency in the marketplace.

I am pleased to report that the Public Company Accounting Oversight Board is currently considering a number of these initiatives.

Thank you for coming here today to learn about the work of the PCAOB. You are vital to the integrity of our markets. I wish you good luck on your upcoming CPA exam.