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 Achieving High Quality Audits to Promote Integrity and Investor Protection 

DATE Oct. 13, 2013 
SPEAKER(S): Jeanette M. Franzel, Board Member 
EVENT: NACD Board Leadership Conference 2013 
LOCATION: National Harbor, MD 

I am honored to be here today to discuss topics of mutual interest to audit committees and the Public Company Accounting Oversight Board (PCAOB) and our complementary roles in achieving reliable audits to promote confidence and integrity in the securities markets.

Before I get started, 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.

I want to commend the NACD on its mission to "advance exemplary board leadership" with the compelling vision of aspiring to "a world where businesses are sustainable, profitable, and trusted; shareowners believe directors prioritize long-term objectives and add unique value to the company; [and] directors provide effective oversight of the corporation and strive to deliver exemplary board performance."

Audit committees are instrumental in achieving this vision and maintaining public trust and investor protection through their oversight of corporate financial reporting and auditing. I would also like to recognize the important role and difficult jobs that each of you have as audit committee members in these oversight functions, as well as the many other areas that are being assigned to audit committees during a time of ever increasing business complexity and risk.

PCAOB's Audit Committee Outreach

Because your oversight role as audit committee members is so important to achieving high quality audits, we, at the PCAOB, are focusing substantial attention on outreach to audit committees. In fact, as part of the PCAOB's 2012-2016 Strategic Plan adopted in November 2012, the Board identified a priority project for 2013 of "enhancing PCAOB's outreach to and interaction with audit committees to constructively engage in areas of common interest, including auditor independence and audit quality."[1]

Among other steps, the Board has adopted strategies to support strong corporate governance in the area of audit oversight by enhancing the Board's communications with audit committees and developing summary-level reporting on the state of audit quality and other relevant information about auditing for use by those in corporate governance.[2]

In addition, we believe that the PCAOB can assist you by providing information about our inspections, standard-setting, and other initiatives to keep you informed about issues that may impact your audits and your auditor. We also hope to benefit from your feedback, questions, and comments regarding current trends you are seeing or other observations you have regarding levels of audit work, composition of audit teams, and the impact of PCAOB oversight activities.

We are interested in hearing about good practices that audit committees have implemented for overseeing auditor independence and promoting auditors' professional skepticism. Further, the Board is interested in working with you to help spread the word within the audit committee community about these issues of mutual interest.

So with that backdrop, today I will discuss several PCAOB standard-setting efforts and other initiatives, as well as observations about recent inspections trends.

Auditor's Reporting Model

The auditor's report has been the subject of a decades-long debate due to questions about its form, content, and overall informational value. Over the years, there have been numerous recommendations regarding improvements to the standard auditors report, yet it largely has remained unchanged since the 1940s. In 2008, the U.S. Treasury's Advisory Committee on the Auditing Profession (ACAP), in its final report, urged the PCAOB "to undertake a standard-setting initiative to consider improvements to the auditor's standard reporting model."[3]

The Board has conducted extensive outreach and analysis on this topic for several years. In 2010 and 2011, PCAOB staff sought the views of investors, auditors, preparers of financial statements, audit committee members, and other interested parties on potential changes to the auditor's report. In June 2011, the Board issued a Concept Release on possible revisions to the auditor's reporting model and received 155 comment letters.[4] In September 2011, the Board held a public roundtable to obtain further insight from a diverse group of stakeholders on the alternatives presented in the Concept Release.

On Aug. 13, 2013, the Board issued its proposed standards and related amendments on the auditor's report and the auditor's responsibilities regarding other information in an annual report.[5] The deadline for comments is Dec. 11, 2013. The PCAOB staff will discuss the proposed standards and comments received to date with its Standing Advisory Group in a public meeting scheduled for Nov. 13-14, 2013.[6] The Board is also considering holding a public roundtable in 2014 to discuss the proposal.

The proposed standard would retain the pass/fail model in the existing auditor's report, and would provide additional information to investors and other financial statement users about the audit and the auditor.

A key element of the proposal would require the auditor to report on "critical audit matters" that are specific to each audit. These matters are defined in the proposal as those that (1) involved the most difficult, subjective or complex auditor judgments; (2) posed the most difficulty for the auditor in obtaining sufficient appropriate evidence; or (3) posed the most difficulty for the auditor in forming the opinion on the financial statements.

The proposed standard would also require new language in the auditor's report related to auditor independence, auditor tenure, and the auditor's evaluation of other information outside the financial statements. The proposal also includes enhancements to existing language in the auditor's report related to the auditor's responsibilities for fraud and notes to the financial statements.

Because this proposal could ultimately result in significant changes to the auditor's report, I strongly encourage audit committee members to comment on this proposal. There are a number of fundamental questions for which we are seeking feedback. I encourage you to consider the questions posed to the public in the Board's August 2013 proposing release.

Additionally, some audit firms may consider conducting an informal "field test" of the proposed standard during the comment period to determine the degree of difficulty and effort involved in reporting critical audit matters. I encourage you to work with your auditors on such efforts and to provide us with feedback on your experiences.

Auditor Independence, Objectivity, and Professional Skepticism

At this time last year, the Board was actively continuing with its exploration of issues raised in its Aug. 16, 2011, Concept Release on Auditor Independence and Audit Firm Rotation.[7] In fact, just days after I attended the 2012 NACD Board Leadership Conference, where I discussed the history behind the Board's project and the themes that were emerging, I headed to Houston for the PCAOB's third public meeting on the issue.[8]

The project has generated significant interest and the Board has heard from a wide range of stakeholders on the importance of understanding and effectively managing the various factors that influence auditor independence and professional skepticism.

The Board's Exploration of Auditor Independence and Audit Firm Rotation

So where are we on this project, one year later?

With each of the three public meetings that we held in 2012, we reopened the comment period for the Concept Release. The latest comment period, which corresponded with our October 2012 public meeting in Houston, closed on Nov. 19, 2012. In total, we received 684 comment letters.[9]

Throughout the project, the fundamental importance of auditor independence and professional skepticism was emphasized in the comment letters and the panelist presentations at our public meetings. The message was loud and clear that auditor independence is the underpinning of confidence in the auditing profession, and commenters supported the Board's efforts to help ensure or enhance auditor's independence, objectivity, and professional skepticism. With that said, the vast majority of the commenters were opposed to a requirement for mandatory audit firm rotation for a variety of reasons.

After more than two years of studying the issue, which included extensive outreach and analysis, we have not found evidence that would allow for generalizable conclusions about the impact of auditor tenure on audit quality that would justify a one-size-fits-all requirement for mandatory audit firm rotation. This result is consistent with academic research that also is inconclusive on the impact of auditor tenure on audit quality.

This lack of generalizable evidence on auditor tenure and independence does not in any way alleviate the need to evaluate auditor tenure and its relationship to independence and audit quality in individual cases. And that is where the audit committee comes in.

Due to the potential risks of long auditor tenure that could manifest in individual situations, audit committees must be vigilant in overseeing auditor independence and determining whether a potential rotation of auditors or retendering of the audit would be beneficial, given the facts and circumstances of their company's situation.

In fact, one of the themes that emerged in the Board's project on auditor independence and audit firm rotation was strong support for the key role of audit committees in overseeing auditor independence. This helped motivate the Board's current outreach efforts with audit committees.

Professional Skepticism and Audit Committees

On our June 30, 2013, standard-setting agenda, the project previously known as "Auditor Independence and Audit Firm Rotation" was renamed "Auditor Independence, Objectivity, and Professional Skepticism" and remains on our current agenda.[10] This change reflects a refocusing of attention and resources from audit firm rotation to other projects related to promoting auditor independence and professional skepticism.

Late last year, the PCAOB issued Audit Practice Alert No. 10, "Maintaining and Applying Professional Skepticism in Audits."[11] The practice alert includes examples from our inspection activities in which PCAOB inspection staff found that auditors did not apply appropriate professional skepticism, including cases where the auditors did not perform basic procedures such as obtaining an understanding of methods and assumptions for estimates of fair value; evaluating evidence that contradicted management's decisions not to test certain assets for impairment; and performing procedures beyond inquiries of management for material financial statement items.

The practice alert also discusses challenges and pressures in the audit process and actions that firms, engagement partners and individual auditors can take to promote the appropriate applications of professional skepticism throughout the audit process.

In their oversight role, audit committees can take a number of actions to help promote appropriate professional skepticism on the part of the audit team. For instance, through regular communications with the audit partner, the audit committee can reinforce the importance of conducting thorough audit work in key areas by asking questions about the auditor's procedures, alternatives considered, and difficult judgments made.

Other areas that audit committees can inquire about include the adequacy of resources and expertise assigned to the audit, how the engagement partner supervises the engagement, and how the engagement partner has ensured that members of the audit team have implemented a thorough and questioning approach to the work in key audit areas and throughout the audit.

With auditors' implementation of Auditing Standard No. 16 this year, audit committees will have additional opportunities for communications with their auditor about important areas of the audit.[12] The standard requires the auditor to communicate key issues about the overall audit strategy, timing, and significant risks, as well as audit results surrounding critical accounting policies and estimates, an evaluation of the quality of the company's financial reporting, and any difficult and contentious issues encountered during the audit, among other areas. The objective of the standard is to increase the relevance of communications between the auditor and the audit committee and emphasize the importance of effective, two-way communications.

Inspection Results and What They Mean

Audit committee members frequently ask about our inspection results — including trends in the number and types of inspection findings, and how they should use and interpret that information.

Last year, the Board issued a release, Information for Audit Committees about the PCAOB Inspection Process, to help audit committees understand the information provided in public PCAOB inspection reports and to alert audit committees to the nature of the nonpublic inspection information that they may find useful to explore with their auditors.[13]

Today, I will use information from that release together with information from the public versions of our 2012 reports (issued in 2013) and 2011 reports (issued in 2012) for the Big Four firms in the U.S. to discuss our inspections.

Part I of our inspection reports is the public portion that includes audit deficiencies where PCAOB inspection staff concluded that the auditor failed to gather sufficient audit evidence to support the audit opinion. These deficiencies may relate to the opinion on the financial statements, or the opinion on the effectiveness of internal controls over financial reporting, or both.

The deficiencies presented in Part I are organized by issuer, and one issuer may have multiple deficiencies. The tables below summarize the numbers of issuers cited in Part I of the 2012 and 2011 inspection reports for the Big Four firms in the United States.

2012 Inspection Reports (Issued in 2013)

Firm

Number of Issuer Audits Inspected

Number of Issuers with Part I Deficiencies

Percentage of Audits Inspected with Part I Deficiencies

Deloitte

52

13

25%

E&Y

52

25

48%

KPMG

50

17

34%

PwC

54

21

39%

Total

208

76

37%

2011 Inspection Reports (Issued in 2012)

Firm

Number of Issuer Audits Inspected

Number of Issuers with Part I Deficiencies

Percentage of Audits Inspected with Part I Deficiencies

Deloitte

53

22

42%

E&Y

56

20

36%

KPMG

53

12

23%

PwC

63

26

41%

Total

225

80

36%

1. What do these numbers mean?

First, keep in mind that the percentages of audits with Part I deficiencies should not be thought of as representing an overall deficiency rate for a firm's audits. The audit work selected for inspection is based on various risk factors and is not intended to be representative of a firm's audit practice.

In the August 2012 release that describes the inspection process, the Board cautioned against extrapolating the results presented in the public portion of the report (Part I) to form broader conclusions about the frequency of deficiencies throughout a firm's practice. The Board also cautioned against judging the relative quality of firms' audit practices solely on the basis of the number of deficiencies described in the public portions of inspection reports.[14]

That said, we are, however, concerned about the high number and serious nature of the audit deficiencies found in these inspections. And we also consider the number and types of audit deficiencies to be an important indicator of potential weaknesses in a firm's system of quality control, which could impact its audit practice and audit quality more generally.

2. What types of trends are in the "Part I" inspection results?

There is almost no change in the overall percentage of inspected audits with Part I deficiencies in the 2012 Big Four inspection reports when compared to 2011. In 2012, the overall percentage was 37 percent, compared to 36 percent in 2011. There were some changes among the firms. While one firm had a significant drop in its percentage of inspected audits with Part I deficiencies, other firms had increases, which resulted in the overall percentage for the four firms remaining fairly steady.

In 2012, some of the more frequent findings of audit deficiencies noted in Part I included testing and evaluating

  • internal control over financial reporting;
  • revenues;
  • inventory;
  • business combinations; and
  • fair value measurements and disclosures.

We have seen the number of Part I findings trend downward since 2010 in the areas of auditing financial instruments and fair value measurements and disclosures. Yet, fair value measurements and disclosures remains as an area of frequent findings, even if the numbers are lower. At the same time, we've seen a spike in deficiencies related to internal control over financial reporting and business combinations. And audit deficiencies in the areas of revenues and inventory continue to be frequently cited in Part I.

3. What is in the non-public portion of inspection reports?

The nonpublic portion of the inspection report, or Part II, describes criticisms in the firm's overall system of quality control such that the Board has doubts that the system provides reasonable assurance that professional standards are being met. The Board is prohibited by law from publicly releasing Part II findings unless the audit firm fails to remediate the criticisms to the Board's satisfaction within 12 months of issuing the inspection report.

The inspection staff's analysis of potential quality control problems takes into account the audit deficiencies described in Part I of the report, as well as other auditing deficiencies detected during the inspection that do not cross the same significance threshold as audit deficiencies reported in Part I. Other quality control criticisms may relate to aspects of the firm's management of its audit practice.

In addition, Part II findings may also result from how the inspection staff views certain matters such as:

  • how the firm's management structure and processes, including the tone at the top, affect audit quality;
  • how the firm's partner management practices, including evaluation, compensation, admission, and disciplinary practices, affect audit quality;
  • how the firm considers and addresses risks in connection with client acceptance and retention decisions; and
  • how the firm seeks to ensure compliance with independence rules; and other matters.
4. How should audit committees use inspection results?

The Board has encouraged firms to communicate effectively with audit committees about inspection matters. Information about the results of a PCAOB inspection of a company's audit, as well as more general inspection results, can help an audit committee carry out its oversight role.

Audit committees may want to ask their auditors the following questions:

1. Was your company's audit selected for PCAOB inspection? If yes, the audit committee may wish to receive regular updates on the scope and progress of the inspection; details about any deficiencies that were identified or other feedback received during the inspection; and if deficiencies were found, what additional actions are needed.

2. Did the PCAOB identify deficiencies in other audits that involved auditing or accounting issues similar to issues presented in your company's audit? Audit committees may want to understand whether deficiencies found on similar audits could occur in their company's audit, and what the audit firm is doing to prevent such deficiencies.

3. What were the audit firm's responses to the PCAOB findings? What types of actions has the firm taken in response to specific Part I deficiencies or types of deficiencies?

4. What topics are included in Part II findings? Audit committees may want to ask about the quality control findings and the audit firm's efforts and actions to address any quality control deficiencies. Audit committees may also want to inquire about the status of the PCAOB's evaluation of the firm's progress on remediation.

Audit Quality Indicators

As part of its audit oversight function, another fundamental concern of the audit committee is the quality of the audit.

As I discussed earlier, the results of the Board's oversight activities, including its inspection findings, provide audit committees and others with an important source of information about some of the deficiencies found in audit engagements. That information does not, however, typically provide a complete picture of the quality of a particular audit engagement or audit practice.

To that end, the Board has made it a 2013 priority to begin a project to identify audit quality indicators. A longer term goal is to track such measures for domestic global network firms and report on those measures over time.[15] This project is well underway and will include the identification of audit quality indicators in the areas of audit process and results, as well as the development of methods to objectively measure those indicators.

The goals of the project are to:

  • inform PCAOB regulatory processes and policy making with additional insight into the status and trends of audit quality;
  • possibly provide audit committees, investors, management, audit firms, other regulators, and the public with audit quality indicators to provide insight into audit quality for their decisions and policy making; and
  • provide firms with additional incentives to compete based on audit quality.

So far, the project has involved extensive research and consultation with a wide range of stakeholders, including audit committees, investors and investor representatives, audit firms, and academics. The PCAOB staff has begun to develop a working definition of audit quality, a framework for thinking about audit quality, and a preliminary inventory of possible audit quality indicators.

The next steps in the project involve identifying potential primary users of audit quality indicators and developing an understanding of how they would use such information in their decision making. PCAOB staff continues to seek input from stakeholders in an effort to analyze the strengths and weaknesses of the possible audit quality indicators.

The Board plans to publish the results of this work soon to seek public input on these possible audit quality indicators and the PCAOB staff's analysis of them.

Because audit committees are charged with engaging and supervising their companies' auditors, I would expect audit committee members to be active contributors and commenters on this project. Indeed, PCAOB board members and staff already have sought input from many audit committee members and groups. We would like to understand how you view audit quality, how you make decisions about the quality of your auditor, and what information you need to make those decisions. I encourage you to engage with your fellow audit committee members and professional associations on these questions and provide us with the benefit of your insights.

Concluding remarks

The PCAOB and audit committees share many areas of mutual interest, including the goal of achieving high quality and reliable audits. A reliable system of auditing that instills confidence in the financial information used in our markets is essential to the effective and efficient functioning of the capital markets.

Today I've outlined for you several priorities of the Board. We are interested in hearing from you about these and other areas of interest to you in your role in overseeing corporate financial reporting and auditing.

The overarching point is that the PCAOB's oversight activities can benefit from engagement with important stakeholder groups such as audit committees. In turn, the PCAOB believes that we can assist you by providing information about our inspections, standard-setting efforts, and other initiatives that may impact your audits and your auditor.

Together we can explore ways for the entire system to function effectively to produce reliable financial reporting with independent and credible audits, which are instrumental to maintaining public trust and investor protection.

[2] Ibid., 19.

[3] U. S. Department of the Treasury. "Final Report of the Advisory Committee on the Auditing Profession to the U.S. Department of the Treasury" (Oct. 6, 2008), VII:13.

[4] PCAOB Release No. 2011-003, "Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards" (June 21, 2011).

[5] PCAOB Release No. 2013-005, "The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses and Unqualified Opinion; The Auditor's Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Auditor's Report; and Related Amendments to PCAOB Standards" (Aug. 13, 2013).

[6] PCAOB. "Standing Advisory Group." http://pcaobus.org/Standards/SAG/Pages/default.aspx.

[7] PCAOB Release No. 2011-006, "Concept Release on Auditor Independence and Audit Firm Rotation" (Aug. 16, 2011).

[8] Jeanette M. Franzel, "Protecting Investors through Independent, High Quality Audits" (speech at the National Association of Corporate Directors 2012 Board Leadership Conference, National Harbor, Md., Oct. 14, 2012).

[9] PCAOB. "Comment Letters for Docket 037." http://pcaobus.org/Rules/Rulemaking/Pages/Docket037Comments.aspx.

[12] PCAOB Release No. 2012-004, "Auditing Standard No. 16: Communications with Audit Committees; Related Amendments to PCAOB Standards; and Transitional Amendments to AU Sec. 380" (Aug. 15, 2012). AS No. 16 is effective for audits of fiscal years beginning on or after Dec. 15, 2012.

[13] PCAOB Release No. 2012-003, "Information for Audit Committees about the PCAOB Inspection Process" (Aug. 1, 2012).

[14] Ibid., 3.

[15] PCAOB's Global Network Firm Inspection Program, established in 2011, involves the inspections of certain U.S. domestic annually inspected audit firms and their non-U.S. affiliates.

 

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