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 The Future of Financial and Business Reporting from a Standards-Setting and Regulatory Perspective

DATE May 17, 2012
SPEAKER(S): James R. Doty, Chairman
EVENT: 125th Anniversary of the American Institute of Certified Public Accountants
LOCATION: Washington, DC

Good Afternoon,

I am pleased to share this occasion with you. I must tell you that the views I express today are my own and do not necessarily reflect the views of the Board, any other Board member, or the staff of the PCAOB. But I am honored that you have invited me to share my thoughts with you.

I. The U.S. Accounting Profession is Founded on Progressive Era Goals for Social Harmony and Economic Development That Remain Valid Today.

In 1887, your predecessor – the American Association of Public Accountants – was inspired to organize an association of technical experts in accounting modeled on the example of British chartered accountants, who had been sent to the United States to protect the interests of British investors in American industries. In the ensuing 125 years of leading the accounting profession, the AICPA has achieved an enormous amount.

I have immense respect for what you have put forth for the public interest in those years, and I have high expectations for the years to come. Even as the Institute has promoted the welfare of its members, the passion for public service has coursed alongside your endeavors.

You have asked me to speak about the future of financial and business reporting. Let me start by reference to the trajectory you began 125 years ago. Because I believe the future path must take account of what has been achieved, as well as what must still be finished.

The accounting profession in the United States, as an organized profession, was founded during the Progressive movement, and to this day it remains firmly planted on the movement's values. As President Theodore Roosevelt – the Nation's highest-ranking Progressive – said more than a century ago, "Let the watchwords of all our people be the old familiar watchwords of honesty, decency, fair-dealing, and commonsense."[1] You have championed these values through the centuries.

Historians have tended to focus on the social upheaval that framed the Progressives' agenda as the 19th Century turned into the 20th – the clash of agriculture with industry, wage-worker with business man. That was the theme of President Roosevelt's speech at the New York State Fair in Syracuse in 1903, from which I quoted. He was facing class rebellion, yet he rebelled against the notion that the United States could be confined to a set of classes. He rebelled against the notion that the United States could or should be organized according to arbitrary divisions that separated one class from another, one locality from another, those with a degree of property from those with less.

He believed that history had proven that all the great republics had fallen when government championed the benefit of one class – rich or poor – instead of the benefit of the people as a whole. He said, in each case, "The death knell of the Republic had rung as soon as the active power became lodged in the hands of those who sought, not to do justice to all citizens, rich and poor alike, but to stand for one special class and for its interests as opposed to the interests of others."[2]

But the Progressive movement was not only about social harmony. Its adherents hailed from both political parties to champion a modern, lasting and fair society, built on the power of facts and merit.

The Progressives supported scientific methods as applied to economics, government, industry, finance, medicine, education and other fields. They argued the need for government regulation of business practices to ensure competition and free enterprise, and adopted numerous reforms to do so, such as the banking laws which became the Federal Reserve System.

Men such as Charles Waldo Haskins – a prominent Progressive in New York State who opened his own office in 1886 to offer services as a "public expert accountant" – recognized the importance of a learned profession of public accountants who cultivated, through integrity, expert training and knowledge, a reputation for reliable, independent assessments of accounts.[3]

Industrialists expanded demand for analysis of accounts as their empires expanded. And investment bankers such as J.P. Morgan used accounting services to monitor their, and their wealthy clients', increasingly far-flung investments.

But from those early days, the modern profession has also been built on the needs of government in service to the American people. Thus, in 1893, Haskins was engaged by the federal government to examine, with his partner Elijah W. Sells, the accounts of the Executive branch. The work took two years, and when it was done it was described as "in many respects the most important undertaking of the kind in the history of the country," and "his recommendations were promptly embodied in laws for the reform of the public business."[4]

In 1917, the Federal Trade Commission – another Progressive era institution – and the Federal Reserve Board asked the AICPA to draft a technical memorandum for publication by the Board as a bulletin on auditing procedures, to promote uniform accounting and encourage commercial bankers to obtain audited financial statements from their borrowers.[5]

In this period, from the 1880s to the 1920s, the ranks of the profession burgeoned to do all this new work. Some of the original partnerships expanded to comprise hundreds of accountants in various offices, even some abroad. Moreover, many more small partnerships were formed throughout the country.

It was a different Roosevelt who called on the accounting profession, again, to promote the public interest and restore faith in U.S. capital markets after the crash of 1929.

Early in his first term, President Franklin D. Roosevelt signed the acts that required all publicly traded companies to file with the new Securities and Exchange Commission financial statements audited by an independent public accountant.

Thus was born the modern system of federal securities regulation. Few mention today that the system might have been significantly different. But when these laws were being developed, many questioned whether anyone other than federally employed civil servants could examine company accounts with the skepticism necessary to protect public investors from fraud and self-dealing.

It was Haskins's partner – and Elijah Sells's son-in-law, the war hero Colonel Arthur H. Carter – who argued to the Senate committee developing the securities laws that private accountants could better serve public investors, because they were indeed independent from corporate management, they were more experienced and better trained than government auditors would be, and there were more of them.

The Senate was not without skeptics, including a future Vice President under President Harry S. Truman, Senator Alben Barkley of Kentucky. But the profession prevailed, and won the franchise that has become the centerpiece of public accounting.

Today, many chafe at government involvement in financial reporting, and in the operation of financial markets generally. Yet it is careful government intervention and regulation that has enabled those markets to flourish, flush with what is often called other peoples' money.

Of course, it is not other peoples' money. It is our own. As with British investors of the 19th century, or the wealthy clients of J.P. Morgan, more than half the families in America – from the most privileged among us to rank-and-file wage earners – bear the risk and reward of having entrusted our savings with professional managers in American – and, increasingly, foreign – industries.

Our federal securities laws were not founded on the notion that business should be micromanaged by the state. They were based on a vision that aggressive investor protection was the best means to pursue our national economic interest in promoting the formation of capital to fund business ventures that would grow our economy as well as jobs.

It worked. Capital allocation through regulated securities offerings in public markets has been an effective component of our nation's economic success, in no small part because of the protections our laws and institutions, including the financial audit, afford investors.

II. The Inherent Conflict Presented by Client Pressures Still Weakens the Commitment to Investor Protection.

But the system depends on rigorous audits, and the challenges inherent in the audit model manifested soon after the federal securities laws were first implemented. In 1938, the President of the publicly listed McKesson & Robbins expropriated company funds for his own use and hid it by overstating inventory and accounts receivable by approximately $20 million – a large sum to steal even today, and an enormous sum in 1938.

The auditors missed the fraud because they had failed to confirm receivables and observe the physical inventory taking. They claimed they should not have been faulted for failing to do so, however, because those procedures were not expressly required and because they had been instructed not to by management.[6]

To its credit, the profession – through a predecessor of the AICPA – promptly began requiring auditors to observe physical inventory taking and confirm receivables.[7] The SEC also required additional disclosure in audit reports, including requirements that the auditor describe the scope of the audit, disclose any omitted procedures, explain any exceptions to the company's presentation, and report on any significant retroactive adjustments to prior period financial statements.[8]

The inherent threat to auditors' independence remained. In the heady pace of reforms in the early 20th century, one feature of the decision to engage private auditors for a public purpose was that corporate auditors would of necessity be hired and fired by, and interact directly with, the very corporate managers that they were charged to police.

Haskins's early job to examine the Executive branch accounts was quite different. Similarly, the British chartered accountants that preceded him were hired directly by the investors who wanted to know about any financial problems, not the managers who might have preferred that any problems remain hidden.

In the Senate hearings in 1934, Senator Barkley inquired about the source of private auditors' independence from the companies they would audit. He asked Colonel Carter: "Who audits you?" The esteemed veteran's answer evoked the strength of his character and the depth of his commitment to public service. He responded: "Our conscience."[9]

Was there a pregnant pause? The record suggests no. The senators moved on to other questions, other witnesses, and other effects and responses to the crisis. We are left to imagine the conversation that could have ensued had they tarried.

Several decades later, the lessons of new corporate scandals – the Continental Vending Machine Company, Penn Central, Westec and others – reminded the public of the unfinished business from the McKesson affair, to resolve auditors' conflict of interest. Continental Vending set records for misappropriation and related party scandals that would stand until Enron. When Penn Central collapsed in 1970 without prior warning, it became the largest bankruptcy in history, at that time.

In the post mortem, the SEC found signs of trouble in problematic transactions described in the auditors' own workpapers. To quote from the SEC's report:

Many of these transactions were presented to the auditors with a variety of sophisticated justifications supporting management's accounting methods to be used in recording the transactions. The Commission believes that the auditors viewed these justifications too narrowly and did not consider whether the justifications were applicable in the circumstances. We consider it an auditor's duty to insist on meaningful application of accounting principles and disclosures in order that the financial statements reflect the business reality of the enterprise.[10]

The profession responded with new reforms to establish a self-regulatory apparatus to organize regular peer reviews and oversee the further development of auditing standards. The profession even considered mechanisms to limit the influence of corporate clients on the long-term welfare of audit firms and their partners. The profession determined that the anticipated expense of audit firm rotation outweighed the unknown, or at least unquantified, benefits of enhanced freedom from client pressure. So the profession did not adopt term limits.

No doubt the adopted reforms averted some disasters. Time and time again, the U.S. accounting profession has done better than most to address identified failures. Yet the reforms proved insufficient by the turn of the new century, which met us with a new wave of corporate frauds, deeper and on a grander scale than ever seen before, but disturbingly similar in method to the Penn Central, Continental Vending, McKesson and other frauds of earlier days.

I need not recount the Enron, Worldcom and other scandals that followed. Everyone here experienced them. I will say that the sheer number of revelations of accounting errors that followed Enron's surprise disclosure suggests that the flaws in the framework of public company governance, reporting and audits were hidden in plain sight.

This is the unfinished business that occupies the PCAOB, and I might add audit regulators around the world who have also identified a gap between the purpose of the audit and its fulfillment. This gap threatens the future relevance of the profession's work, as well as public confidence in its credibility.

III. The PCAOB's Initiatives Aim to Help the Profession Realize Its Potential by Enhancing the Relevance, Credibility and Transparency of the Audit.

The Public Company Accounting Oversight Board is the product of the nation's resolve to preserve and champion wide-scale investment. As I see it, the PCAOB is not intended to replace the leadership of the profession in public life, but to prod it to renew the commitment to service that its Progressive founders intended.

Several projects are underway to chart the future course of the accounting profession's role in the nation's future. I am pleased that, true to your history, the profession itself has embarked on important work in this regard. I am speaking of the AICPA's initiative on the Role of the Auditor, led by Bob Moritz and Cynthia Fornelli of the Center for Audit Quality, which is affiliated with the AICPA. In addition, shortly, Arnold Schilder will describe the work of the International Federation of Accountants' International Auditing and Assurance Standards Board.

The PCAOB is also deeply engaged in examining ways to enhance the relevance, credibility and transparency of the audit. Our projects include improvements in basic auditing areas, such as what to look for in transactions involving related parties, including corporate executives. The PCAOB proposed a new auditing standard on related party transactions on February 28. Comments are due at the end of this month. I encourage everyone to review it and comment.

The PCAOB proposed, for a second exposure, a new auditing standard on what the auditor should communicate to audit committees in order to protect the public's interest in keeping audit committees informed of important audit matters. In addition to receiving written comment, the Board has held a productive public roundtable discussion on auditors' responsibilities to audit committees. I expect the Board soon to adopt a final standard that reflects the public advice and comment.

The PCAOB standards-setting work also includes more broad-ranging projects to examine ways to enhance the relevance, reliability and independence of audits in today's world, and in light of lessons both auditors and investors have learned in the recent financial crisis. These projects involve consideration of changes to the form and content of the standard audit report, as well as a deep examination of the behavioral patterns that the current audit model imposes.

A. Auditor's Reporting Model

Last June, the PCAOB released a concept release on potential changes to the auditor's reporting model to respond to investors' call for more insights based on the auditor's work. This is a topic that has not been considered in any significant endeavor since the SEC's McKesson era reforms, which many investors say have been over time reduced to boilerplate.

Embedded in investors' call for more information from the auditor is a call for auditors to better serve investors, for example, "to interpret, rearrange and produce in simple but distinct form self explanatory and free from mysteries of bookkeeping, the narrative of facts."

Don't get excited. I'm not suggesting we put the auditor in the position of reporting financial information for management. If this sounds new, it's not. And it would not change the fundamental role of the auditor to perform an audit and attest to management's assertions as embodied in management's financial statements.

I was merely quoting from one practitioner's summary of the routine work of an accountant in 1896. He reported that the professional accountant is –

a reader of hieroglyphics, however written, for every erasure, altercation, interlining, dot, dash or character may have meaning. He must interpret, rearrange and produce in simple but distinct form self explanatory and free from mysteries of bookkeeping, the narrative of facts, the relation to each other in results. He is the foe of deceit and the champion of honesty.[11]

I am not here today to tell you where the PCAOB should come out on the question of what is the most relevant information auditors should provide the investing public. But I do believe that the PCAOB's evaluation of recommendations on the model form of the audit report should start with the unique nature of U.S. securities markets.

Our audits and audit reports ought to reflect the needs of dispersed owners. This is a starting principle for me. It is not the conclusion of the analysis. Based on this principle, we will need to consider many practical challenges, such as what auditors are capable of producing for mass consumption within the short filing periods now required.

The alternatives described in the release focus on enhancing the relevance of the auditor's communication to investors. Some assert that enhanced communication would bring enhanced litigation exposure. As a career securities lawyer, I believe such fears are overstated.

To the contrary, if the auditor has concerns or other views about the presentation of a company's financial position, making those concerns transparent may well diminish the auditor's own risk. Courts have long held that mere compliance with GAAP is no defense in the face of "intentional statements that are misleading."[12]

The federal appeals court based in New York reaffirmed this principle in the criminal cases against Bernie Ebbers of Worldcom and John and Timothy Rigas, the father and son who were respectively the former CEO and CFO of Adelphia.[13]

Decades earlier, it was applied to affirm the conviction of three auditors who were found guilty of fraud after they certified the fraudulent financial statements of Continental Vending. I would think, accountants and lawyers alike, we have all learned the hard way that there is no safety in holding one's tongue.

We received more than 150 comment letters on the concept release on the audit reporting model and held a public roundtable last Fall to foster further discussion. We are considering the comments and discussion before we propose new standards or rules. We are also watching closely the profession's own initiative on the auditor's report, which I suspect Arnold Schilder will discuss later in the hour.

B. Auditor Independence, Objectivity and Skepticism

Now turning to independence: through a concept release issued last August, the PCAOB commenced an exploration of ways to enhance auditor independence, objectivity and skepticism.

The project on independence invites discussion on ways to relieve auditors of the pressure to maintain a long-term relationship with the audit client when making tough decisions on an audit.[14] In this regard, I am concerned about both the relatively new audit that the auditor may hope to turn into a long-term engagement, as well as the very long engagement that no partner wants to be the one to lose. The release asked particularly for comment on terms of more than ten years and on the suitability of rotation for the largest issuers.[15]

It is a behavioral pattern, a matter of human nature, that once one gains a client, even if it's a new client, one is not interested in losing the client. Human psychology takes over. It is the rare case in which an auditor knowingly compromises his or her integrity. Documentary evidence of a lack of skepticism rarely exists. But so long as the client pays its bills, it is natural to try to retain the relationship.

We are dealing with the subtle effects of bias. What motivates the auditor to exercise skepticism? What pulls him back from it? How should we provide counter-weight to such influence?

This is not an easy subject. Term limits may not be the answer, but I believe we must explore the possibility that they would help and the feasibility of the range of approaches available to free the auditor to think and act more independently.

The PCAOB received more than 650 comment letters. In addition, in March, the PCAOB convened a public meeting to hear from interested parties and to further discuss the subject.[16] Forty-seven panelists appeared at the two-day public meeting, offering varied perspectives as investors, senior executives and audit committee chairs of major corporations, chief executive officers of audit firms, academicians, and former regulators.

The panelists who spoke to us over two days included some of the most authoritative and experienced voices to address the subject of audit quality, auditor independence and the challenges to both. We have much to digest. And I plan to hold additional such meetings around the country, in an effort to obtain public comment from a wide and diverse set of interested parties on this important topic.

IV. The Global Nature of Auditing Today Requires Enhanced Attention to Address Risks to Investor Protection.

I could not close a discussion on the future of auditing without reflecting on the international dimension. All of the activities and changes I have described must be understood against the backdrop that auditing today is a global endeavor. The possibilities for complexity abound.

Engagement partners supervise audits that span continents and oceans. The reader of an audit report may not know how much of the actual work was done by the firm signing the report. Participating audit firms practice in markets that exhibit markedly different business cultures, with divergent patterns of transparency.

Small U.S. firms around the country are also engaged in audits of foreign private issuers, or U.S. companies that operate, in Asia, Latin America, Africa and elsewhere. Small non-U.S. firms in Asia, Europe and elsewhere are registered with the PCAOB because they audit or wish to audit companies that have issued securities in the United States.

Audit regulation has also become global. Auditors in the U.S. are affected by audit policy ideas discussed in Europe, including proposals to restructure the large global accounting firms. Indeed, audits of private U.S. companies that are not subject to PCAOB jurisdiction must, as of this year, follow new standards that have been converged with the auditing standards of the profession's international board.

The PCAOB is intensely focused on the effect of these various business models on the protection of investors. In any given week, PCAOB inspectors are working in numerous countries, often side-by-side with local audit oversight authorities in joint inspections. We are drawing as broad and as clear a picture as we can about how auditors meet the challenges of different environments and of coordination with other auditors.

To do so, last year we reorganized the inspection division to establish a global network firm program. It covers the inspections of the largest U.S. firms and their foreign affiliates to the extent those affiliates participate in the audits of issuers that file financial statements with the SEC. This year, we plan to inspect approximately 70 non-U.S. affiliates of the global networks that are subject to triennial inspection because they have issued an audit report on an issuer within the last three years.

This represents a significant increase over 2011 and was made possible, in part, by the number of cooperative arrangements that were finalized with fellow regulators in other jurisdictions last year and earlier this year.

This increase will facilitate the inspection of multi-national engagements and the Division's focus on the quality control mechanisms that global network firms use to ensure and monitor the quality of the work performed by their affiliated firms. I believe it is well warranted.

In the past, we have identified a number of deficiencies when reviewing multi-national engagements. Some of the auditing issues have been related to particular areas such as revenue and fair value. Others seem to be attributed to a failure to adhere to the instructions provided by the principal auditor. These issues are worrisome and our inspectors will be looking to see how firms supervised the audit work performed by their affiliates and how affiliates executed on those instructions.

In the meantime, and irrespective of any evolution of the business model, I believe the credibility of the profession will be enhanced with more transparency about how audits are conducted. In this regard, the PCAOB proposed last fall new requirements to disclose on the face of the audit opinion the identity of the engagement partner and any other firms whose participation in the audit passes an established threshold of significance.

This proposal was subject to public comment last Fall. And I expect to ask the Board to act on it in the near future.

* * *

As Teddy Roosevelt said, "Many qualities are needed by a people which would preserve the power of self-government in fact as well as in name." I hope you will take away from the presentations and discussions on this momentous occasion that the accounting profession has been and is needed still to protect that power. Accountants set out 125 years ago to arm the public with facts necessary to determine our course economically. Your predecessors enlisted in the fight for the public interest.

I applaud you for the self-inquiry you have exhibited. You are the foes of deceit and the champions of honesty.

You navigate an environment laden with economic forces that test your strength. Pressures to ease your vigilance lurk everywhere. Yet the public asks you to press on.

I exhort you to continue to protect the legacy of the profession's founders that we celebrate today, not with nostalgia, but with the clarity of purpose and vigilance that the legacy deserves.


[1] Theodore Roosevelt, Address to the New York State Agricultural Association, Syracuse, NY (Sept. 7, 1903), transcript available at http://www.theodore-roosevelt.com/images/research/txtspeeches/87.txt.

[2] Id.

[3] See 2 New York State's Prominent and Progressive Men: An Encyclopedia of Contemporaneous Biography 149 (Mitchell C. Harrison ed., 1900).

[4] Id.

[5] Id.

[6] Auditors Answer Criticism by SEC, N.Y. Times (Dec. 7, 1940). Specifically, Price Waterhouse claimed –

while the procedures for whose omission we are now criticized were regarded as optional at the time, we were expressly instructed not to follow some of them, and we were not instructed to follow others, notwithstanding our written warning that the scope of our examinations was not sufficiently extensive "to reveal either possible misappropriations of funds or manipulations of the accounts." Furthermore, [the SEC report] quite overlooks the fact that the determination of the scope of our audit was delegated to the president of the company, who has now proved to have been the keystone of the intricately organized conspiracy.

[7] See New Audit Policy for Safety Urged, N.Y. Times (May 10, 1939) ("As a possible offset to any future McKesson & Robbins episodes, the American Institute of Accountants announced yesterday that it had adopted a report by a special committee on auditing procedures calling for the corroboration of inventories by actual physical tests. On the question of accounts receivable, the institute went on record as favoring, where the amounts involved represented a significant proportion of current assets, confirmation by direct communication with the debtor.")

[8] See Accounting Series Release No. 21, 1941 SEC LEXIS 1377 (Feb. 5, 1941); see also Accounting Rules are Revised by SEC, N.Y. Times (Feb. 5, 1941).

[9]See Hearings before the Senate Committee on Banking and Currency on S. 875 (March 31 to April 8, 1933), at 58.

[10] See Peat, Marwick, Mitchell & Co., Rel. No. AS-173, 1975 SEC LEXIS 2516 (SEC July 2, 1975).

[11] See Gary John Previts and Barbara Dubis Merino, A History of Accounting in the United States: The Cultural Significance of Accounting 132 (Ohio State Univ. Press, 1998) (quoting Keister, D.A. 1896. "The Public Accountant." The Book-keeper, July pp. 21–22) (emphasis added).

[12] See United States v. Ebbers, 458 F.3d 110, 1125 (2d Cir. 2006).

[13] Id.; United States v. Rigas, 490 F.3d 208 (2d Cir. 2007).

[14] See PCAOB Release No. 2011-006 at 2–3 (reviewing the concept of audit firm rotation as one way to relieve pressure on auditors and soliciting comments on the issue).

[15] Id., at 20–21.

[16] The agenda and a webcast of the meeting are available at http://pcaobus.org/News/Events/Pages/03212012_PublicMeeting.aspx.

 

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