Thank you very much for that kind introduction. I am honored to have been invited to speak at this important conference.
I was appointed to the Public Company Accounting Oversight Board as a Board Member almost eight months ago, along with my fellow Board member, Lew Ferguson and the Board's new Chairman, James Doty. The three of us joined founding Board member Dan Goelzer and Board member Steve Harris on the PCAOB Board on February 1. Since then, I have learned an extraordinary amount — from my fellow Board members, our hard working staff and the investors with whom we interact.
Chairman Doty is an amazing man and has an aggressive agenda. The PCAOB staff and Board members have risen to the challenge. During the panel discussion following this session, I will tell you about some of the Board's recent activities. Before that however, I thought I would share with you some of my perspectives on the audit profession and some of the challenges faced by accountants and auditors in the business world today, as well as discuss the role of the PCAOB and how we are trying to respond to some of your challenges.
Before I go further, however, I must 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.
Some of you in the room are auditors, some are in accounting roles in your organization, but may have started your career in public accounting. I want to thank all of you for choosing a career in accounting. The capital markets depend on sound financial information to help management, investors and all financial statement users make better decisions. The founders and entrepreneurs like Steve Jobs often get the headlines, but their businesses would not exist or thrive without good accountants. Unfortunately, if accountants hit the news, it is rarely in a positive light!
Role of Auditors
Auditors play an important role in the capital markets — they provide assurance to investors, owners, lenders and others that the audited company's financial statements and related disclosures fairly present the institution's financial results in conformity with applicable accounting and disclosure standards. That one sentence implies a lot of responsibility: Good auditing requires an expert understanding of technical accounting standards and disclosure rules. Auditors must understand the business of the company they are auditing, and they must gather sufficient audit evidence to provide the required assurance. Auditors spend a lot of time learning — in school and on the job — how to master all of these skills. But the part of that sentence that I would like to focus on is the word "investors" — they are the ultimate beneficiaries of all that auditors do.
Having spent almost thirty-two years as an auditor, I have worked with many professionals, each of whom brought different skills and perspectives to their work. The ones who stood out — and who are best able to conduct their work with the required degree of professional skepticism — are the auditors who kept the interests of investors top of mind.
Professional skepticism underlies the most important basic tenets of auditing. AU 230 states that "[p]rofessional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. . . . The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest."
Thus, professional skepticism requires that the auditor question management's conclusions, decisions and judgments. Auditors must consider whether there is sufficient, appropriate and persuasive audit evidence to support the audit opinion and not accept management representations without corroboration. The auditor must be watchful for and wrestle with any contrary evidence that undermines management's conclusions.
Skepticism, as you can see, is a mindset, which is difficult to teach and even more difficult to police. There can be many distractions that cause auditors to lose sight of investor interests and detract from their professional skepticism. Auditors face long hours, tight deadlines, billing pressures, business development expectations, firm management responsibilities, and perhaps family and other personal demands. And then there is the biggest challenge — something called "client service"! With auditors being influenced by all of these factors — and junior auditors learning on the job — how do auditors maintain their focus on investor needs? How do they maintain their skeptical approach to evaluating audit evidence and challenging management's assertions?
I believe that it is particularly important for audit firms to focus on impressing on their most junior auditors the importance of investor protection. Auditors are the eyes and ears of investors that are not "at the table" as the financial statements are taking shape. Objectivity and professional skepticism must be a significant part of a firm's culture. Every professional in the firm should understand that the craft of auditing is more than just a business and different from the other types of services a firm may be providing to its clients. New auditors need to ask themselves certain important questions. For example:
- How would investors view information that comes to light during the audit?
- Would a skeptical person rely on management for a given assertion, or should the auditor look for independent confirmation?
- Would investors want to dig deeper on any given issue?
- If I were investing in the business or granting a loan, what information would I want to know?
- Would investors agree with the auditor's decisions, especially in connection with any "close calls" or in cases where there are initial disagreements between the auditor and management of the client?
Audit firms also must set appropriate incentives for their staff and partners, provide comprehensive training, and facilitate mentorship of junior auditors by those who have proven their commitment to investor protection and audit quality. Their quality control policies and procedures must demand strict adherence to auditing standards — including AU 230's requirements for a skeptical mindset — and comprehensive documentation of the auditor's work. These basic steps, in my view, will do as much to enhance audit quality as solid technical competence in difficult accounting areas or auditing standards.
Role of the PCAOB
And that brings me to the PCAOB's contribution to enhancing investor protection. The Board's objective — as set forth in the Sarbanes-Oxley Act — is "to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports."
As you may know, the PCAOB has four main responsibilities under the Act:
- Register public accounting firms that audit public companies or broker-dealers;
- Establish auditing and other professional standards;
- Conduct and report on regular inspections of registered public accounting firms; and
- Conduct investigations and disciplinary proceedings in cases where auditors may have violated certain provisions of the securities laws or applicable standards or rules.
Currently, over 2,400 firms are registered with the Board, of which over 900 are non-U.S. firms located in 85 foreign jurisdictions. Of all registered firms, 10 are subject to annual inspection because they issue over 100 audit reports each year, while approximately 850 are subject to inspection every three years because they issue 100 or fewer audit reports each year.
Since it began its inspections operations, the PCAOB has conducted over 1700 inspections and reviewed over 7300 audits. Inspection reports issued to the firms after each inspection identify deficiencies in the firms' audit work as well as weaknesses or deficiencies in the firm's quality control policies and procedures. Certain portions of the inspection reports — those dealing with particularly significant audit deficiencies identified by inspectors — are made publicly available. With respect to any problems found by the Board in the firm's quality control systems, firms are given twelve months to remediate those issues or face publication of the portion of the inspection report describing those issues.
Remediation is a very important part of our process. It is through these actions that a firm proposes to correct their quality control deficiencies in order to drive improvements in auditing. We have seen most firms take their mandate to improve seriously. A common remediation step is more training. Frequently, firms prepare more tools or practice aides. Sometimes they establish new review processes. Some criticisms, like the need for more diligent supervision and review, or the need to improve professional skepticism, are very difficult to "cure" through training or tools and require a cultural shift at the firm, driven through the firm's tone at the top and incentive systems.
In addition to our activities in connection with registering and inspecting firms, the Board is responsible for setting auditing standards for the audits of public companies and brokers and dealers. I will talk in a few minutes about some of our recent activities in this area.
Finally, the PCAOB also has an active Division of Enforcement and Investigations. To date, the Board has announced over 40 disciplinary actions imposing sanctions including censures, fines, suspensions or bars from being associated with a registered firm and revocations of firm registrations. Our enforcement cases have involved a range of violations, from the failure to exercise appropriate skepticism and due care, the failure to plan or perform required audit procedures appropriately, or the failure to properly supervise the work of audit assistants, to issuing audit reports without conducting any audit procedures at all. We cannot send someone to prison, but we can end their career as a public company auditor.
I firmly believe that the reforms established by the Sarbanes-Oxley Act and the actions of the PCAOB have had a positive effect on audit quality, including by driving a change in firm culture to emphasize investor protection. Today, audit committees appoint the auditor, and they show a much greater interest in the audit than in the past. Our inspections in recent years have identified many areas where auditors could improve, and many firms subsequently made significant changes to their approaches. Auditors today are much more focused on challenging accounting areas, such as management's estimates and fair value measurements.
Through our enforcement actions, the Board also has sent strong signals about auditor conduct that is simply not acceptable. Audit requirements also have been clarified and, in many cases, increased, through the adoption and amendment of PCAOB auditing standards. If asked, I believe that most CFOs will tell you that their auditor is challenging them much more today than was the case just ten years ago.
Indeed, a 2008 survey conducted by the Center for Audit Quality found that 65% of audit committee members surveyed agreed that investors should have more confidence in the capital markets as a result of the passage of the Sarbanes-Oxley Act and 82% believed that audit quality improved in the years preceding the survey.
In 2010, an academic study looked at the effect of PCAOB inspections of the Big Four accounting firms on audit quality and found significant decreases in income-increasing abnormal accruals in the first and second years following the initial PCAOB inspection. This empirical study concluded that PCAOB inspections have a significant positive effect on audit quality by reducing earnings management by issuers.
And just recently, in April 2011, the SEC issued a report mandated by the Dodd Frank Act that discusses the costs and benefits of auditor attestation to management's assessment of internal control over financial reporting ("ICFR") under Section 404(b) of the Sarbanes-Oxley Act. The SEC study concluded, among other things, that "[t]here is strong evidence that the auditor's role in auditing the effectiveness of ICFR improves the reliability of internal control disclosures and financial reporting overall and is useful to investors." The study also concluded that the costs of Section 404(b) compliance have decreased in recent years and that investors view the auditor's attestation on ICFR as beneficial.
Despite the improvements we have seen in auditing since 2003, however, the PCAOB continues to have a high level of inspection findings (including, at some firms, an alarming increase in the rate of audit deficiencies since inspections began). PCAOB inspectors identify instances where auditors appear not to have complied with PCAOB auditing standards in certain audit areas, including, for example, fair value measurements, impairment of goodwill, indefinite-lived intangible assets, and other long-lived assets, allowance for loan losses, off-balance-sheet structures, revenue recognition, inventory and income taxes.
Challenges Faced by Accountant and Auditors
Fair Value Measurements
Some of our inspectors' findings directly reflect some new challenges that auditors and most accountants have faced in recent years. When I began my college accounting courses 35 years ago, accounting and auditing objectives were pretty straightforward. Take depreciation for example. Most accountants master that concept early in their careers and are comfortable applying it. In years past, many of the numbers on a financial statement were that easy to compute. Most of you in the room took a cost accounting class in college, but today I find very few "fair value" accounting courses at even the best institutions.
Fair value measurements are used to establish or evaluate the values of many categories of assets and liabilities. Rapid advances in technology and innovative business models have made it much more difficult for accountants, auditors, and investors to understand the transactions and products that must be captured in the financial statements. Not only have financial instruments become increasingly complex, more and more companies, and a wider variety of companies, are invested in these types of instruments. Combine these developments with the distressed and inactive markets that we have observed periodically during recent years, and we have the perfect storm, creating a whirlwind of challenges for management trying to establish valuations and making it much more difficult for auditors to attest to those valuations.
One of the keys to successfully navigating this process is for management to do enough work in connection with all estimates and valuations — and then to document its actions sufficiently — to allow the auditor to gain a clear understanding of management's processes.
While the PCAOB's authority is over auditors of companies, not the companies themselves, I believe that management should understand the valuation methodology used, whether based on quoted market prices, estimates or valuation models. This level of understanding of the valuation process is necessary even if management uses a pricing service or outside expert to provide valuations and estimates. When using an outside service or expert, management should consider and document the experience and expertise of the individuals involved and the controls in place over the process used.
Management's documentation of these actions should permit the auditor also to gain an understanding of the entity's process for determining fair value measurements and disclosures and of the relevant controls sufficient to develop an effective audit approach. PCAOB inspectors have found that, in some instances where management has utilized external valuation services, firms failed to obtain a sufficient understanding of the valuation methods or assumptions used by the parties providing these external valuations. In addition, inspectors have observed instances where firms failed to test, or test sufficiently, the operating effectiveness of internal controls over various aspects of issuers' valuation processes to support the degree of reliance placed by the firms on those controls.
The auditor also should evaluate the consistency of the methodology used by management and understand how management reconciled any differences in prices obtained through alternative valuation methods. PCAOB inspection teams have, at times, observed failures by firms to evaluate significant differences between independent estimates used or developed by firms and the fair values recorded by management in the financial statements.
Finally, one important aspect of the auditor's work that has given rise to PCAOB inspection findings is the degree and nature of testing conducted by the auditor in connection with fair value measurements. The auditor's general approach to performing substantive tests of fair value measurements might include one or a combination of the following: (a) testing the significant assumptions, the valuation model, and the underlying data, (b) developing an independent estimate of fair value for corroborative purposes, or (c) reviewing subsequent events or transactions occurring prior to the date of the auditor's report.
Inspectors observed instances in which firms sometimes failed to test, or test sufficiently, significant, difficult-to-value securities. For example, in some situations firms' procedures were limited to inquiries of issuer personnel. Inspection teams also observed instances in which firms failed to perform sufficient procedures, in light of the volatile market conditions, to provide a reasonable basis for extending to year-end the conclusions regarding the valuation of investment securities that were reached at an interim date.
I spoke earlier about the importance of professional skepticism, and I cannot stress enough how important the right state of mind is in the context of this difficult audit area. Fair value measurements frequently involve complex valuation techniques, assumptions and judgments that are difficult to evaluate objectively. It may be tempting to rely on management's valuation procedures, particularly when management uses a reputable and experienced pricing service or expert. However, our auditing standards require auditors to get behind the numbers and critically evaluate the methodologies and assumptions of management. Likewise, the auditor should understand and evaluate management decisions made based on valuation results. For example, rather than accepting without question management's choice to utilize a valuation at the extreme end of a range of acceptable prices, or management's selection of one valuation alternative over another, auditors should consider the effects of management's actions and question its rationale. Finally, the auditor should consider whether management has made appropriate disclosures about its assumptions and key estimates in order for the financial statements to present fairly.
In light of the importance of this area and the significance and frequency of the Board's inspection findings, the Board is currently considering what steps to take in connection with fair value measurements. In addition to its regular dialog with audit firms in the context of their inspection and remediation activities on valuation related issues, the Board is considering whether further guidance in the applicable auditing standards is warranted. In order to explore important issues relating to the valuation of certain categories of financial instruments, the PCAOB established a Pricing Sources Task Force. This group of investors, financial statement preparers, auditors and representatives of pricing services and brokers is considering the valuation of financial instruments that are not actively traded and the use of third-party pricing sources to value such instruments. The task force is assisting the Board's Office of the Chief Auditor to gain insight into current issues related to auditing the fair value of financial instruments, and the Board will consider the input of the task force in any future standard setting projects in this area.
Auditors also face new challenges due to the increasingly global nature of their audit clients and the capital markets as a whole. In the past, even many large U.S. companies could be audited by an audit firm in the United States without having to worry about auditing multiple foreign subsidiaries, divisions or operations. Today audits of large and small companies frequently involve the performance of audit work abroad, requiring the local auditor either to send its staff to the other countries or to engage the services of a foreign audit firm to participate in the audit. Both scenarios present potential difficulties including language barriers, legal, political and cultural differences, as well as logistical challenges. Indeed, you have likely read in the newspaper recent articles describing instances in which auditors have resigned from foreign audit engagements because they were unable to obtain all of the necessary information or they received false information. The PCAOB is faced with barriers to inspecting registered accounting firms in many countries still.
Issues related to multi-national audits also has attracted the attention of the Board. In July 2010, the Board issued a Staff Audit Practice Alert prompted by observations in PCAOB inspections that some U.S.-based firms issuing audit reports based on work performed by others outside the United States were not properly applying PCAOB standards. The practice alert reminds registered firms of their obligations when using the work of other firms or using assistants engaged from outside the firm, and it describes the circumstances under which the firm issuing the audit report may use the work and reports of another auditor. The alert also explains that auditors who engage assistants from outside the firm are governed by the same standards regarding planning the audit and supervising assistants that apply when audit work is performed by assistants who are partners of, or employed by, the auditor's firm.
In order to provide more context to this Staff Audit Practice Alert, the Board also issued in March 2011 a research note focusing particularly on audits of companies from the China region that entered the U.S. capital markets by a reverse merger transaction. The research note pointed out that over 150 companies from the China region accessed the U.S. capital markets by a reverse merger transaction between January 2007 and March 2010. The note explained that Chinese reverse mergers often result in a company with substantially all of its operations in the China region having its securities trade in the U.S., often with its financial statements audited by a U.S. auditor. Some of the issues pointed out in the staff audit practice alert issued in 2010 may be present in these audits also..
The Board's staff is currently considering a new staff audit practice alert focused on the particular challenges of conducting audits of companies in emerging markets. In addition, the Board is working on potential amendments to certain auditing standards to establish additional transparency measures to provide investors with more information regarding the auditors who participated in audits of multi-national companies.
Other PCAOB activities
Auditor's Reporting Model
The Board also has decided recently to take a fresh look at two important policy issues affecting auditors.
First, the Board issued a concept release on June 21stto discuss alternatives for changing the auditor's reporting model. The concept release presents several possible alternatives for changing the auditor's reporting model and requests comment on these or other alternatives that could provide investors with more transparency in the audit process and more insight into the company's financial statements or other information outside the financial statements.
This project was borne from investor comments in the wake of the recent financial crisis. After watching major, multi-national financial institutions fail overnight, investors are not sure on whom they can rely to provide important information. Investors lost a whole lot of money during the financial crisis, and they're blaming a lot of people. They're blaming management; they're blaming the auditors; they're blaming us.
The Board heard from investors, including through the PCAOB Investor Advisory Group, that they believe that they are not getting adequate information to make their investment decisions. While nobody appears to dispute the value of the work of auditors or their opinions on financial statements, investors want more information about what auditors do and what they think of the financial statements and the processes utilized to arrive at those statements.
At a round table discussion held last week by the Board to explore the pros and cons of potential changes to the auditor's report, Ann Yerger, Executive Director of the Council of Institutional Investors, stated:
The bottom line is that investors want more information from the outside auditors. . . . Audit firms are objective, third-party experts that have unique insights into companies, and it is appropriate and beneficial for the investing public to receive more information directly from these unbiased experts.
We have already heard strong viewpoints on this project. Some believe information about the company should come from management, and the auditor should only attest to the accuracy of the information. Some investors say they want to hear more from the auditor directly. Some question whether the benefits of increasing the information contained in the auditor's report justify its costs. Determining what changes, if any, to make to the auditor's report will involve some difficult issues, including balancing the costs and benefits of those potential changes and considering whether costs might be disproportionately borne by small companies and their auditors. In considering these questions, we are going to be very interested in the views of investors, auditors, and management of the companies whose audits will be affected. Stay tuned — I believe that this will be an important discussion that could be the start of a fundamental change in the relationship between auditors and the public.
Second, related to my earlier comments about professional skepticism, the Board also recently issued a concept release to solicit public comment on ways that auditor independence, objectivity and professional skepticism can be enhanced, including potentially through mandatory rotation of audit firms, which would limit the number of consecutive years for which a registered public accounting firm could serve as the auditor of a public company.
As required by the Sarbanes-Oxley Act, the U.S. General Accounting Office (now known as the Government Accountability Office or GAO) conducted a study on mandatory auditor rotation in 2003. Its report concluded, among other things, that the GAO did not believe that audit firm rotation was the most efficient way to strengthen auditor independence and suggested that it would be appropriate for the SEC and PCAOB to monitor the effectiveness of the Act's oversight requirements for several years before determining whether further independence requirements are needed.
We now have several years of experience as contemplated by the GAO report. Since its creation in 2003, the Board has conducted hundreds of inspections of registered public accounting firms each year. These inspections provide the Board with a unique insight into the state of the audit profession and the conduct of public company audits. Based on this insight, the Board has stated that it believes that the reforms in the Act have made a significant, positive difference in the quality of public company auditing. But because the Board's inspections continue to find audit deficiencies, and because the independence of auditors from their clients is critical to their effectiveness and credibility, the concept release asks whether even more action is warranted to enhance auditor objectivity and skepticism, and, if so, what form such action should take.
As I noted when the Board issued the concept release, I believe that the Board should proceed cautiously along the path toward mandatory auditor rotation. Before we determine whether that is in the best interests of investors and the public, we will need to weigh carefully whether its benefits would outweigh its costs and potential unintended consequences. In addition to concerns about the financial costs faced by issuers as a result of periodic mandatory auditor changes, some studies suggest that audit quality may decrease during the first years of a new engagement. Likewise, it is possible that auditor independence could suffer in a mandatory rotation framework, because audit firms may step up their marketing of non-audit services to audit clients near the end of the permissible term of the audit engagement.
I expect that these and other important questions raised by the concept release will spark a lively debate!
* * *
As I think about the future, it is part of my job to wonder if we have the balance right. Many of you in the room may think we at the PCAOB are "over the top." Some prominent candidates are actively calling for the repeal of the Dodd-Frank and Sarbanes-Oxley acts. On the other hand, we hear regularly from some of our advisors and critics that we are not doing enough. As I noted earlier, I believe that the Sarbanes-Oxley Act and PCAOB already have made a positive and lasting difference in the quality of auditing and have the potential to drive further improvements. Nevertheless, regulatory requirements imposes costs on all participants in the capital markets. I take very seriously the responsibility to regulate effectively and efficiently. In order to do that, we at the PCAOB need to hear from all of you. One of our most important tools in ensuring that the Board's actions are in the best interests of investors is our process for gathering public comment. I encourage you to participate in the dialog — whether in your role as auditors, financial statement preparers, or investors. And please encourage others, including your clients, audit committees or investors, to weigh in as well. We look forward to your insights.
Accounting scandals dominated the financial news in 2001 and 2002 when the scandals at Enron and WorldCom came to light. Accountants and auditors did not come out looking very good. Much has changed since then. While some have questioned the auditors' role in the financial crisis, there have not been public reports discussing high profile examples of the accounting being wrong. The business models and transactions entered into by some of the largest financial institutions are certainly in question. Some question if the auditors should have done more to "sound the alarm" about the business models and sustainability of the practices. Some are questioning whether investors really understand how "soft" some of the amounts reported at fair value are.
Having been an auditor, an accounting standard setter through my role as a member of FASB's Emerging Issues Task Force, and a leader in the profession for the last several years, I know first-hand the challenges to "get it right" and appreciate the hard work of people like you trying to do the right thing. The right thing is not always apparent. But I believe that if you put investors' interests first in everything you do — particularly when called upon to make tough decisions — you will be doing your job and will sleep better at night!
As you can see, there is a lot to talk about in the context of auditing and auditor regulation — perhaps more than you bargained for when you signed up for this conference!
 J. V. Carcello, C W. Hollingsworth, and S. Mastrolia, The Effect of PCAOB Inspections on Big 4 Audit Quality, Working Paper (2011).