Thank you, Chairman Doty.
Three years ago this month, I participated in my first open meeting as a member of the Public Company Accounting Oversight Board. At that meeting, I stated that one of the many reasons that I was delighted to be on the Board was the opportunity to see whether I could "help contribute to making audit reports of public companies more investor friendly." Today, the Board is taking a giant step in the consideration of improvements in those reports.
Improved Communications Decades Overdue
The need for improved communications between auditors and investors was recognized long before I joined the Board. For more than 50 years, investors and various groups that have studied the auditing profession have been calling for changes to the auditor's report.
When Congress drafted the Sarbanes-Oxley Act, it acknowledged the importance of this issue by clearly stating in the Act that the primary mission for the Board is "… to protect the interests of investors … in the preparation of informative, accurate, and independent audit reports."
The events of the last few years have been a case study of the inability of auditors to provide investors with any meaningful signal about increases in financial reporting risks when management assessments or estimates change dramatically, or when debates over significant accounting issues become difficult or contentious.
Going Concern Opinions: A Rarely Used Tool
In the years leading up to the financial crisis, the business press highlighted several significant risks emerging from the credit markets that would impact the financial statements of investment banks, commercial banks, mortgage companies and insurance companies. These risks included inflated debt ratings from the rating agencies, what the press referred to as "sloppy" documentation and recordkeeping practices for derivative contract agreements, and the erosion in lending practices.  As the financial crisis unfolded, many of these risks forced several public companies to file for bankruptcy or seek government assistance. These risks should arguably have been apparent to public company auditors. Yet, the one real tool at the auditors' disposal — a going concern opinion — was rarely used.
Out of the ten largest bankruptcies during the financial crisis, only two had going concern opinions. During the year leading up to their bankruptcy filings, the market capitalization of the eight companies without going concern opinions declined from a collective $75.5 billion in the year prior to their respective bankruptcy filings to a collective market capitalization of just under $700 million at the time of their filing — a 99% loss in investor value. In addition to the $75 billion decline in equity market capitalization, fixed income investors faced even greater losses, potentially amounting to over $200 billion in public debt issued by these eight companies prior to their bankruptcy filings.
Furthermore, none of the top ten institutions receiving Troubled Asset Relief Program (TARP) funds received going concern opinions before accepting a combined $295 billion from the government. The aggregate market capitalization for these ten TARP recipients declined by $211 billion, and the losses most likely would have been greater if these companies had not received government assistance.
There also were no going concern opinions for the major institutions that eventually were forced into mergers that resulted in significant losses to their investors.
Mr. Chairman, when you testified at the Senate Banking Committee hearing last April on the role of the accounting profession in preventing another financial crisis, Securities Subcommittee Chairman Jack Reed said, "… the threshold question is: Why were there no timely warnings about companies that within months of an unqualified report collapsed or were rescued at taxpayers' expense?"
In her December 6, 2010 statement before the AICPA, SEC Chairman Mary Schapiro expressed similar concerns when she said,
"We wonder if the eventual losses to shareholders and investors were multiplied many times because material information was not made available in a timely fashion by people who should have been able to produce accurate disclosures."
Others have asked, "where were the auditors during the financial crisis, what were the auditors' responsibilities and how could companies so close to bankruptcy or in such need of assistance have escaped a going concern opinion?" And, if auditors were correct in not issuing going concern opinions or in not sending any other message to investors about the financial and accounting issues they were seeing inside these institutions, what does that say about the relevance and usefulness of the current auditor reporting model?
Current Reporting Model Lacking
As a member of the Board, I have attended a number of PCAOB inspections, and I know what a PCAOB inspection entails. Very early in my career I worked briefly for the internal audit division of a Fortune 500 company and as the Staff Director and Chief Counsel for the Senate Banking Committee, I worked on a number of accounting and auditing issues. As a result of these experiences, I have a profound respect for the ability and competence of auditors, and I believe public company auditors know much more about their audit clients than they currently are telling investors.
Indeed, the Board's new risk assessment auditing standard requires the auditor to "obtain an understanding of the company and its environment …[and] to understand the events, conditions, and company activities that might reasonably be expected to have a significant effect on the risks of material misstatement" of the financial statements.
Under the current reporting standards, however, there is no effective means for auditors to pass on any of that information to investors and other users of the company's financial statements.
Investor Advisory Group Recommendations
Last March, the Board heard from its Investor Advisory Group (IAG). In particular, one working group of the IAG was led by Professor Joe Carcello and included Brandon Becker from TIAA-CREF; Norman Harrison, formerly from Breeden & Co.; Mike Head from TDAmeritrade; Bonnie Hill from Icon Blue, Inc.; Peter Nachtwey, of Legg Mason; Gus Sauter from the Vanguard Group; Anne Simpson of CalPERS; Eric Vincent from Ospraie Management; and Ann Yerger from the Council of Institutional Investors. This working group surveyed leaders of mutual funds, pension funds, investment banks, hedge funds, private equity funds, and other investments to obtain a sense of what investors would like to learn from auditors.
The individuals who responded to the survey manage more than eight trillion dollars in investments. Professor Carcello and his working group members did an excellent job summarizing and presenting the survey results for the Board at our March 16 meeting, and two points stood out. First, investors want auditors' reports to include the auditor's assessment of the estimates and judgments used by management to prepare the financial statements. And second, investors want auditors to discuss how they addressed the areas that presented the most significant risks that the financial statements might be materially misstated.
Other IAG working groups also provided important information. One of the more striking moments of the meeting was when the Board was shown audit reports on the financial statements of a major financial institution from 2008, 2009 and 2010. During the financial crisis, the institution received TARP funds and the audit fees from 2008 to 2009 for that institution increased by over 60%. But, there were no changes in any of those audit reports. It was impossible to tell from those reports what insights the auditor may have had about the company at any particular point in the company's financial history. Anne Simpson from CalPERS, who led this discussion, said that this backdrop gives a sense of urgency to the need for a narrative report by auditors that "would be actually useful."
It was almost 97 years ago when Justice Brandeis wrote that "sunlight is said to be the best of disinfectants; electric light the most efficient policeman." This phrase became the foundation for the disclosure system that applies to public companies, but today little light shines on the auditor's work or on the information that is gathered and analyzed during the audit process. Investors are saying it is time to turn on that switch.
There has been discussion that rather than the auditor, management and the audit committee should provide better disclosures to investors about the financial reporting risks facing the company. I don't disagree that management and the audit committee could help to fill the void in investor communications through improved reporting to the shareholders.
The concept of an improved audit committee report to investors deserves careful consideration by the SEC, particularly given the audit committee's role in protecting the interests of investors. However, as capable as audit committees are, auditors still hold a unique and important perspective in the financial reporting process. It would not be realistic to ask an audit committee to be a surrogate for the auditor and try to match the level of expertise and acquired judgment that an experienced and independent audit team brings to the table.
Hearing more from the audit committee, therefore, is not enough. Investors still want to hear directly from the auditor about the potential risks of material misstatements in the company's financial statements and how the auditor addressed those risks during the audit process.
Investors want to hear directly from auditors because they expect auditors to be independent and skeptical professionals who have neither mutual nor conflicting interests with their audit clients, and who are willing to exercise unbiased judgment and report honestly on what they find. Auditors, in turn, need to understand that to maintain the confidence and trust of investors they must fully embrace the concept that the company paying their fee is not their client. The ultimate client of an auditor of any publicly traded company must be investors. The U.S. Supreme Court confirmed this notion in the Arthur Young case, which described the audit as a "public watchdog" function that "demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust." Clearly, that "public watchdog" responsibility cannot be handed over to the company.
As a general rule, investors are not looking for more audit work to be performed by auditors but for a public discussion of those things that should be obvious to an auditor following a well-performed audit. At a basic level, investors want auditors to ask themselves what is it that, if they were investing in the company, they would want to know — and for the auditors then to highlight or provide that information. Investors also want to know those issues that came up during the audit and "kept the auditor up at night."
Because the primary goal is improved transparency rather than more audit procedures, I would hope that this project would not result in an undue increase in audit costs. All investors are asking for is what auditors already know. Nonetheless, I recognize that each alternative we consider may require an additional investment of time and money in preparing and issuing audit reports, and we will need to consider carefully the costs and other consequences of each alternative.
In that regard, the Board does not have to make an all or none decision about any of the alternatives discussed in the concept release. The Board might decide to create a proposal that blends selected elements of one or more of these alternatives. And I encourage those writing comment letters to be similarly creative in suggesting alternatives and approaches that will help us make audit reports more informative and useful for investors while not over-regulating auditor reporting.
In closing, as the leaders of the profession recently told us, and as Michel Barnier, the Commissioner for Internal Market and Services at the European Commission, has said, "the status quo is not an option." This concept release is well designed to help us move forward.
Mr. Chairman, I would like to thank you for your leadership in looking comprehensively at where the profession is headed, for taking on the tough issues, and, in particular, for bringing this issue before us today. I also would like to recognize Dan Goelzer for his efforts while Acting Chairman to continue to push these ideas forward.
In addition, I want to thank Marty Baumann, Jennifer Rand, Jessica Watts and Dan Mutzig for their efforts, as well as the investors, auditors, audit committee members, members of management, other regulators, and past leaders of the accounting profession, among others, who participated in the Board's outreach efforts. This project is an excellent example of the PCAOB staff and members of the public working together to turn a long-standing problem into a concise list of current ideas and alternatives for the Board and others to consider.
Finally, I want to thank our Investor Advisory Group and, in particular, Professor Joe Carcello and the members of his working group for their hard work and clear articulation of what it is that the surveyed investors — as a group — want to learn from auditors.
Mr. Chairman, I support the publication of this concept release, and look forward to reading the comment letters.