Thank you, Kari and Dan, for that kind introduction. And thank you for inviting me and my colleagues from the PCAOB to join you today for this first ever GWSCPA Issuer and Auditor Conference featuring the PCAOB. I look forward to many more such events here in our nation's capital.
I would like to spend just a few minutes providing some background about the PCAOB and then giving you an overview of some recent inspections initiatives and findings. But before I begin, I should tell you that the views I express today are my personal views and do not necessarily reflect the views of the Board, any other Board member, or the staff of the PCAOB.
As you know, the PCAOB was created by Congress through the passage of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") to oversee the audits of public companies in order to protect investors and the public interest by promoting informative, accurate, and independent audit reports The PCAOB began operations in April 2003.
The PCAOB is led by a five member Board, each of whom is appointed by the U.S. Securities and Exchange Commission ("SEC") to a five year term (with a maximum of two terms permitted). As mandated by the Sarbanes-Oxley Act, two of the five Board members are Certified Public Accountants. After spending over thirty years in public accounting, I was appointed to the Board in February 2011 in order to fill one of these CPA positions. The Board operates under the oversight of the SEC, which, in addition to appointing Board members, must approve our budget and any rules and standards issued by the Board. The SEC also is empowered to hear appeals of our inspection determinations and enforcement orders.
Under the Sarbanes-Oxley Act, the PCAOB has four main responsibilities:
- Registration of public accounting firms that audit public companies or broker-dealers;
- Inspections of registered public accounting firms;
- Setting of auditing standards for the audits of public companies and broker-dealers; and
- Investigations and disciplinary proceedings in cases where auditors may have violated certain provisions of the securities laws or applicable standards or rules.
In order to achieve our mission, we have a staff of over 800 employees, which work in in sixteen offices around the country. The majority of our employees work in our core program areas in the Division of Inspections and Registration, the Division of Enforcement and Investigations or the Office of the Chief Auditor. In addition to our administrative offices, we also have an Office of International Affairs and an Office of Research and Analysis, both of which provide important information and assistance to the Board and staff.
Currently, more than 2300 firms are registered with the Board, including over 900 foreign firms from 85 jurisdictions. The Board has conducted well over 2000 inspections of public company audits, including inspections in 40 jurisdictions outside the United States. After the Dodd-Frank Wall Street Reform and Consumer Protection Act gave us authority in 2010 to inspect the auditors of brokers and dealers, we commenced an interim program of broker-dealer auditor inspections. We are evaluating the findings from the interim inspection program and will consider the effects of our recently issued new broker-dealer audit standards in determining the scope of a future permanent inspection program.
On the standard setting front, since its inception, the Board has issued 17 auditing standards — including, for example, standards addressing audit documentation, internal controls, audit planning, engagement quality review, risk assessment and audit committee communications — as well as two attestation standards for audits of brokers and dealers. We also have substantially amended a number of interim standards — including, for example, standards addressing communications about control deficiencies, audit reports, audit sampling, and substantive analytical procedures, among others. And tomorrow, we are holding an open meeting in order to consider the adoption of an auditing standard on auditing related party transactions, as well as amendments to PCAOB standards relating to significant and unusual transactions and a company's relationships and transactions with its executive officers.
The fourth prong of the PCAOB's statutory mission is enforcement of applicable federal laws, standards and rules. To date, the Board has publicly announced sanctions against over 50 firms and over 70 individuals, with sanctions including revocations of firm registrations, orders barring or suspending individuals from practicing before the Board, censures and, in some cases, significant monetary penalties. Our cases have involved Big Four firms as well as smaller firms and sole practitioners and have been brought against firms in the U.S. and abroad. In addition, we have matters currently under investigation and in litigation, but those remain non-public pursuant to the Sarbanes-Oxley Act.
I want to spend the remainder of my few minutes in this opening session to talk about our inspection findings and reports. Throughout the day, you will hear more from our staff on many aspects of our work, including a deeper dive into some of the most common audit challenges and deficiencies we identify through our programs.
In recent years, I have seen a great improvement in the Board's timeliness in issuing inspection reports. In late 2012, the Board identified a series of near term priorities, including one related to inspection reports. The priority included improving our processes for issuing reports on a more timely basis, as well as a broader project to consider what type of information should be included in each firm's inspection report. On the timeliness front, we have made good progress. Most of the inspection reports from our 2013 inspections of triennially inspected firms have been issued. We also recently issued one of the inspection reports from the 2013 inspections of the nine annually inspected firms. The majority of the annual firm 2013 reports will follow in the next few months, while several, whose inspections took place later in 2013, will be issued in the fall. I commend the Board's staff for the hard work they have been doing to get reports to the Board on a regular and timely schedule.
With regard to the content of inspection reports, we have made some significant changes, but there is more work to do. The 2012 inspection reports included a table referencing the standards associated with each finding in "Part 1" of the report. The 2013 reports on the annually inspected firms will also include this summary table but additionally will feature more specific references to particular sections of the standards implicated in each finding. I hope this additional information will provide all auditors a chance to learn more about how to prevent similar deficiencies in their work, give investors a better understanding of what auditors need to improve upon, and supply audit committees more information to inform the dialogue with their auditors.
We also have discussed the content of inspection reports with our advisory groups, academics and others and have received a lot of good feedback. We plan further outreach in 2014 to consider additional changes in future reports. I have previously stated my belief that we should provide more context around the individual deficiencies and find a way to categorize their severity.
Turning now to our actual inspection findings in recent years, we have observed some common findings in the following financial statement areas:
- Fair value and other estimates, particularly:
- Business combinations and impairment of goodwill and other assets;
- Investment valuation; and
- Allowance for doubtful accounts/loans
The standards that relate to these deficiencies include
- Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements ("AS No. 5")
Auditing Standard No. 13, The Auditor's Responses to the Risks of Material Misstatement ("AS No. 13")
Auditing Standard No. 15, Audit Evidence ("AS No. 15")
AU Section 328, Auditing Fair Value Measurements and Disclosures ("AU sec. 328")
AU Section 329, Substantive Analytical Procedures ("AU sec. 329")
AU Section 342, Auditing Accounting Estimates ("AU sec. 342")
AU Section 350, Audit Sampling ("AU sec. 350")
Our inspectors review the audit work on revenue in virtually every engagement selected for inspection, which may explain why we have so many findings. It is, of course, one of the most important metrics in the financial statements, so we believe it is an important area of focus. Recently, we also have focused on controls testing, as well as the sample size for the substantive test of details. With the number of audit deficiencies in this important area, I am hopeful that we can provide more information focused on these issues to help all auditors avoid such problems in the future.
The frequency of findings in the internal control area are still high for many firms. But, as auditors are becoming more proficient at complying with AS No. 5 overall, the nature of our findings is evolving and becoming more granular. I applaud the progress that has been made in this area, but it is apparent that there is more work to be done. When an auditor does not comply with all of the requirements of AS No. 5, but assumes that the controls testing was sufficient and therefore reduces the amount of substantive testing, the end result is a shortfall in the necessary substantive audit work. In some cases this translates into in adequate sample sizes and, ultimately, an unsupported audit opinion.
Our findings relative to sample sizes have increased even in engagements where there was no reliance on controls. These findings are more commonly observed at audit firms that are subject to inspection on a triennial basis. Some firms may have used "conventions" or a "back of the napkin" approach to selecting the number of individual items to test. For example, a standard approach could be to pick 25 sales transactions, without consideration of the individual circumstances. In determining its sample sizes, an auditor needs to consider appropriate factors set forth in AU sec. 350.16, including the relationship of the sample to the audit objective, the established quantitative tolerable misstatement, the allowable risk of incorrect acceptance (the risk that the sample supports the conclusion that the recorded account balance is not materially misstated when it is), and the characteristics of the population of revenue for each segment. Sometimes, simply picking 25, or a similar predetermined number, results in a sample size that is too small to achieve the planned objective.
The challenges continue in the areas of fair value and estimates. I appreciate that these are complex areas, and I understand the inherent difficulty of generating accounting measurements based on assumptions about the future. But some of the audit deficiencies we see are surprisingly basic mistakes. This includes the auditor not testing the assumptions underlying a fair value measurement, such as a reporting unit for a goodwill impairment test. In other areas, such as the use of pricing sources to assist the auditor in testing the fair value of hard to value securities, we have seen a significant decline in the number of deficiencies.
For the annually inspected firms, our approach to selecting the audit engagements for review is heavily risk weighted. By this I mean that we select engagements to inspect, and focus on particular audit areas within those engagements, after doing intensive screening for audits and audit areas where we believe the risk of audit deficiencies is the greatest. In my view, with this type of approach, we will probably always find at least some deficiencies, as the areas reviewed are generally the most challenging areas of the audit. However, the current level of deficiencies is too high by any standard, and I hope the efforts the firms are making to remediate their quality control deficiencies will result in fewer engagement deficiencies. We are seeing some progress that is encouraging.
There will, of course, always be new areas of focus for us and for auditors, depending on a variety of events and circumstances. For example, the Financial Accounting Standards Board and International Accounting Standards Board recently issued a new standard on revenue recognition that will replace virtually all existing revenue-related standards, developed over many years. Transition to this new standard will take substantial effort for all preparers. Even though the effective date for U.S. issuers is several years off, planning for system changes, internal control changes and capturing the information necessary for transition should begin soon. Auditors will need to carefully monitor how their client's implementation is progressing and make strategic decisions about when to begin audit procedures. The PCAOB will be carefully monitoring developments, including through outreach to our advisory group and observing the standard setters' Joint Transition Resource Group for Revenue Recognition. This monitoring will help inform us about whether we need to initiate any standard setting or other activities to amend or replace standards to guide auditors in transition and on an ongoing basis.
And, finally, we will always be concerned about auditor independence, objectivity and skepticism. We see few violations of the specific SEC or PCAOB independence rules in connection with firms' issuer practices, but with the growth of non-audit services in many firms, we will remain vigilant in this area. We will also continue to question whether auditors have an appropriate independent, objective and skeptical mindset.
There are many other topics I could cover this morning, but my time on the agenda is limited, and our staff has a lot they want to share with you, including our project on audit quality indicators, our current standard setting projects, and the results of our intensive enforcement efforts.
Thank you very much for your attention. As members of the public accounting profession, I know that you all share my interest in investor protection, and I appreciate that you are willing to spend this day with us to learn more about what we do and, hopefully, to share some of your insights with us as well.