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PCAOB Updates

 We’ve Only Just Begun 

DATE June 21, 2006 
SPEAKER(S): Kayla J. Gillan, Board Member 
EVENT: PCAOB Forum on Auditing in the Small Business Environment 
LOCATION: Seattle, WA 

Introduction

Good morning, and welcome to the half-way point for the PCAOB’s 2006 Forums on Auditing in the Small Business Environment. This is the second year in which the PCAOB has held these forums, which we see as our opportunity to not only share information with the small audit firm community, but perhaps even more importantly receive timely feedback from you.

So far this year we have been to Santa Monica, California; Fort Lauderdale, Florida; and San Antonio, Texas. We’ll also be in Boston, Philadelphia, New York and Chicago. This is the first time that we’ve held a forum in the state of Washington, although our San Francisco-based inspection team has spent quite a bit of time here. Speaking as a transplanted West Coaster, it’s good to be back on this side of the continent.

Today you will hear a bit about the structure and priorities of the PCAOB, and quite a bit more about current “hot ticket items.”

You’ll hear about our inspection program – the auditing and accounting issues that we’re finding with respect to small audit firms; what a small firm inspection looks like from our side of the equation; and perhaps even more interestingly, what a PCAOB inspection feels like from the firms’ perspective.

You’ll hear about our investigation and enforcement programs, and how these programs interact with the PCAOB’s inspection and standards-setting functions.
We’ll also talk about our progress to-date with respect to establishing auditing standards for the profession.

We will spend considerable time on PCAOB Auditing Standard No. 2, concerning An Audit of Internal Control Over Financial Reporting in Conjunction with An Audit of Financial Statements; issues concerning auditor independence, including new PCAOB rules regarding tax services and related matters; and AS3, Audit Documentation.

I am sure that you will find the topics interesting and instructive. Before I turn the dais over to our first panel, I want to take a few minutes to talk about issues that are not on our agenda today, but are (or soon will be) on our agenda back at the office.

Before I begin, I must provide you with two caveats. First, the views that I am about to express are my own, and do not necessarily reflect those of the PCAOB, or my Board or staff colleagues. I say this not to disclaim in any manner my words; to the contrary, I own my words, and urge you to hold me accountable for them. I simply ask that you not hold the PCAOB accountable.

Second, I am an attorney and not an accountant. As you may know, Congress determined that a majority of the PCAOB members must be non-accountants. As I speak about accounting issues, I will rely on my layperson’s understanding of these concepts – an understanding colored by my years on the “buy-side” of the investment community. Of course, if anything I say represents a fundamental misunderstanding of the technical rules, anyone in the audience or among the PCAOB staff should feel free to correct me.

Fair Value & Estimates

In my opinion, the only thing certain about the use of fair value measurement and estimates is that the disclosed values will be 100% wrong, probably 100% of the time. That is not necessarily a bad thing. The devil, as they say, is in the details.

To me, the two most critical details concern, first, the ability of the auditor to evaluate and reach an opinion on the fairness of the value and related disclosures, and second, the transparency of both the company’s and the auditor’s processes around the fair value so that investors can effectively assess risk and reliability. I am very concerned that neither of these details has been given sufficient attention to date, and that they must be before FASB’s much discussed rules become effective.

One of the most significant issues that the auditing profession faces is that the confidence that investors have historically placed on auditors has not more measurably rebounded since the enactment of the Sarbanes-Oxley Act of 2002. Of course, continuing accounting errors – from Parmalat to the backdating of stock options – have not been helpful.

But in my mind the biggest hurdle to restoring investor confidence in auditors’ work rests with the expectation gap created by our current reporting rules. Investors and auditors are not of like mind when it comes to critical concepts such as “reasonable assurance,” “materiality,” and “fair presentation.” We can and must work hard to narrow this expectation gap, for if we do not before new fair value rules become effective, I fear that it will widen so far as to potentially explode.

Risk Assessment

As you know, and as you will hear later today when we discuss the integrated audit of internal control and financial statements, the auditor’s ability to effectively identify, understand and assess the risks that affect the accuracy of a company’s financial disclosures is the cornerstone of a quality audit. Investors, as well as those who affect investment decision-making (such as credit rating agencies), rely in large part on the risk-assessment foundation that the auditor lays when issuing his or her audit opinion.

However, we are nearing six years since the Panel on Audit Effectiveness recommended significant changes to existing auditing standards, changes that aimed to improve the quality of risk assessments. Chief among these was to require auditors to possess a deep understanding of their client’s business and industry, so that auditors can better assess inherent risk. It’s also been over two years since the International Auditing and Assurance Standards Board (IAASB) issued its new risk assessment standards. Given the importance of risk assessments to the quality of the audit, the PCAOB can not afford to lag behind the international community.

Enhanced Disclosure of Pension and Other Post-Employment Benefit Liability

And finally, if new FASB rules go into effect as anticipated, most companies will be required to put the funded status of their pension plans and other post-retirement employee benefits (OPEB) on their balance sheets by the end of this year. According to a June 1, 2006, Moody’s report, companies such as Goodyear, Lucent, GM and Ford would see their shareholders’ equity more than wiped out. A recent study by Watson Wyatt indicates that the aggregated shareholders’ equity in the Fortune 1000 would fall by 10%, with even greater changes in some industries (such as manufacturing). Clearly, with this much at stake, there will be great pressure within some companies to manipulate the numbers.

Conclusion

For all of today’s energy generated around Section 404 and AS2 – important issues, to be sure – we must not lose sight of our responsibility to be on the alert for new ways in which those who wish to do mischief will seek to use accounting practices as their tool.

Do different forms of executive compensation encourage earnings management, and will the risks of this be greater or lesser with the enactment of new anticipated SEC disclosure rules? How can independent auditors help audit committees better perform their oversight responsibilities? Have auditors been party to options backdating, and if so, what can be done to prevent this in the future? With the upcoming pension and OPEB accounting changes, how can auditors be on guard against inappropriate actions by their clients to seek to lesson or disguise the true impact on equity?

So while the courts and Congress sort out the costs, benefits and other nuances of Sarbanes-Oxley, it is important for all of us – you as well as PCAOB employees and Board members – to remember that our work in restoring confidence in the auditing profession has only just begun.