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PCAOB Updates

 Myths and Realities — The PCAOB and Its Role in Broker-Dealer Auditor Regulation 

DATE Oct. 27, 2011 
SPEAKER(S): James R. Doty, Chairman 
EVENT: AICPA / SIFMA National Conference on the Securities Industry 
LOCATION: New York, NY 

Good Morning.

It is a genuine honor to be with you today. In considering the manner in which you categorize the Conference's Fields of Study, I was struck by the considered and appropriate choice of, "A for Accounting," "AU for Audit" and "SKA for Specialized Knowledge and Applications." Recognizing the compliment implied in your assigning me an "AU" designation, I was also relieved that you did not develop solely for me a new category, say "TOB for Totally Off Base." I am sure others here may have even more colorful acronyms for this segment of your program.

But to return to why I am honored to be here, this conference brings together accounting and auditing expertise to explore their particular nexus with the securities markets. That confluence of thought is especially important to the PCAOB.

I have looked forward to this opportunity to provide some context on some of our current standard-setting initiatives, and what the PCAOB's role will be in regulating the audits of brokers and dealers. I hope today's discussion will provide additional clarity around the PCAOB's additional responsibilities under Dodd-Frank and how in filling those responsibilities we as always, expect to follow an open, transparent process, develop effective professional standards and use an efficient inspection program, all without adding undue regulatory burden and meeting our mandate for investor protection.

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.

The PCAOB

Let me start our discussion with brief background remarks on the PCAOB. When I left law practice earlier this year, I was asked whether the PCAOB was a part-time job (No!). Was it a return to the federal government (No!)? The PCAOB is a nonprofit corporation established by Congress 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 has a full-time Board, which I now prefer to call an "over-time" board. One night recently, I was there at 9 pm and noticed two of my fellow Board Members working late, with the other two starting their day in Asia, meeting with foreign regulators.

We are, in several respects, a Board-in-transition. Three of us have been in our Board positions since February. Lew Ferguson was the original General Counsel to the Board and brings a wealth of wit and wisdom from broad private-sector experience. Jay Hanson is our Midwestern philosopher-auditor who can explain to the lawyers what is—and is not — present in "the DNA" of auditors and accountants.

Steve Harris and Dan Goelzer are our veterans. From them, we rookies learn whence we have come as a Board, and why we are where we are. We lose Dan Goelzer this year with his term expiring. There will be a time to recognize all he has contributed, and to say how he will be missed, but for now, just take the oft-used phrase "you cannot imagine …"

This is a collegial Board, who deliberate, listen to each other, work together to do the right thing and get to the right result. Dan's replacement will be, must be, an accountant.

In all this work, we enjoy the support of Chairman Mary Schapiro, the Commissioners and Staff of the SEC, with whom we coordinate our efforts.

A comment on some "factoids" regarding the PCAOB may be in order.

With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), the PCAOB was given oversight authority over the firms that perform the audits of broker-dealers, including annual reports filed pursuant to federal securities laws, to promote protection of both account holders and investors.

As you may know, the Sarbanes-Oxley Act tasked the PCAOB with four main responsibilities:

  1. Register public accounting firms that audit public companies or broker-dealers;
  2. Establish auditing and other professional standards;
  3. Conduct and report on inspections of registered public accounting firms; and
  4. Conduct investigations and disciplinary proceedings in cases where auditors have violated the securities laws or applicable standards or rules.

Currently, over 2,400 firms are registered with the Board, of which over 500 of these registered firms audit broker and dealers.

With a staff of over 400 professionals, the Division of Registration and Inspections is the largest PCAOB division and makes up about 60% of our total staff. As its name suggests, this division is responsible for registering firms and conducting inspections of firms that perform audit work relating to U.S. public companies or broker-dealers.

The PCAOB currently is responsible for setting auditing standards for the audits of U.S. public companies, and going forward we also will set professional standards for the audits and other required procedures for auditors of broker-dealers. To date, the PCAOB has issued fifteen auditing standards, nine ethics and independence rules, several concept releases and amended portions of a number of the interim standards that the Board adopted when it commenced operations in 2003. The Board also has released eight staff audit practice alerts to provide additional guidance to auditors in connection with certain difficult audit issues.

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. We cannot send someone to prison, but we can end their career as an auditor of a public company or broker-dealer. That is a responsibility we take seriously.

But first, let's discuss what you are most interested in today, the role of the PCAOB in the firms that perform the audits of broker-dealers.

PCAOB Role in Audits of Broker-Dealers

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 vested the PCAOB with new oversight authority over the firms that perform the audits of brokers and dealers registered with the SEC. This new authority was driven in part by the revelation of the Madoff and Stanford Ponzi schemes, including reports of allegedly lax audit work related to those firms. The new oversight over these auditors includes inspections, enforcement and standard setting authority.

The PCAOB is approaching its new responsibilities in a thoughtful manner. We will use an open and transparent process to develop our professional standards and inspection programs. Our goal is to create programs that have real value for investors and customer of broker-dealers, that reinforce the integrity of the capital markets.

A fundamental part of this deliberative process is gathering information from the professionals in the securities industry and from their auditors so we may act with intelligence and knowledge, not simply on instinct. We are going to gather this information through our temporary inspection program, the Board's broker-dealer small business forums, meetings with representatives of various organizations representing broker-dealers and their auditors, meetings with other regulators, and participation in conferences such as this one.

Providing programs that add value for investors and account holders means that the benefits of our programs should exceed the regulatory costs, in terms of both time and money. In authorizing the Board to oversee the audits of brokers and dealers, Congress decided that the Board's presence in the regulatory structure for safeguarding investors' cash and securities was needed. It is our responsibility now to find how we can fit into that framework in a meaningful way and fill any gaps that previously existed within the structure of existing audits, which may have let frauds, embezzlements and even simple incompetence slip through the cracks. We will be seeking input from those in both the broker-dealer and audit professions to assist us in coming up with cost-effective and constructive programs. The Board looks forward to working with the firms represented in this audience in furtherance of that common goal.

Registration and Inspection

Let me turn to our interim inspection program. Since the end of 2008, auditors of brokers and dealers have been required to register with the Board. The Dodd-Frank Act charged the PCAOB with creating an inspection program for the audits of these brokers and dealers. However, Dodd-Frank did not prescribe a specific program of inspection for these audits. Rather, Dodd-Frank authorized the PCAOB to determine the specific elements of an inspection program.

Recently, the Board adopted — and the SEC approved — a temporary rule to establish an interim inspection program for registered public accounting firms' audits of brokers and dealers. The Board's interim program will be used to learn about the auditors conducting audits of differing types of brokers and dealers.

The Board's goal in the interim inspection program will be to gather information that will be used as the basis to inform the Board's consideration of a permanent inspection program. The Board will focus on gaining a greater understanding of the potential benefits to the investing public and potential cost and regulatory burdens. With this information, the Board will put itself in the best position to determine how to structure the scope of permanent inspection, including whether to differentiate between different classes of brokers and dealers and how frequently the auditors should be inspected.

I know that there have been concerns expressed about the inclusive scope of the interim program. You should not assume that the inclusive nature of the interim inspection program translates to the likely scope of the permanent program. Further, we are not suggesting that every broker or dealer auditor will be inspected as part of the interim program.

The Board has an obligation to obtain the information necessary to design inspections that fulfill its investor protection mandate and as such, needs to gain a broad-based understanding of different types of brokers and dealers and their auditors. However, we expect that we will be able to gather most of the information without having to inspect the majority of firms during the interim program. .

One issue that my fellow Board members and I will carefully consider is whether there should be exemptions to the permanent program. Congress made a deliberate decision not to exempt any class of broker-dealer auditor from Board oversight. With the benefit of the information we will gain through the interim inspection program and the Board's other outreach efforts, we may be able to focus on areas where our oversight would provide the greatest investor protection. In particular, the Board will consider whether to exclude so-called "introducing" brokers and dealers, which do not generally maintain customer cash and securities, in the permanent inspection program.

While the risks presented to account holders by the activities of introducing brokers and dealers may be lower than those presented by "carrying" or "clearing" brokers and dealers, risks do exist. Our interim program, outreach efforts and research have already confirmed that introducing brokers and dealers are not a uniform population. They have a wide variety of business lines and practices which represent varying degrees of risk to their underlying account holders and the larger investing public. We will carefully consider these risks, among others, in determining the scope of the permanent inspection program. We will also continue to consult with the SEC, Financial Industry Regulatory Authority (FINRA), Securities Investor Protection Corporation (SIPC) and others who share the Board's investor protection mandate, in order to consider the role of auditor regulation against the backdrop of direct regulation over brokers and dealers.

In order for the Board to appropriately balance the risks presented by all classes of brokers and dealers against the effectiveness and costs of PCAOB oversight, the Board must gain a full understanding of the role played by the auditors of all types of brokers and dealers in addressing the potential risks to investors. The interim inspection program will be a key part of gaining this understanding.

Decisions about the permanent inspection program are at least a year away. In the meantime, there will be ample opportunity for the public to learn what the Board is finding in the interim program and to participate in the decision process.

The interim inspection program will provide transparency into what the Board is finding in its interim inspections. However, unlike the inspection reports of auditors of public companies, the interim inspection program for the firms that audit brokers and dealers will not initially include firm-specific inspection reports. Instead, the Board will, at least annually, publish reports on the interim program and what our inspectors are finding. The Board will not issue firm-specific reports until inspection work is performed under the permanent program, which is not imminent.

This approach gives investors and the public insight into the Board's activities and oversight during the interim inspection program while allowing the Board's inspection staff and the auditors of broker-dealers to focus, during this transitional period, on adapting to the new interim inspection framework and attestation standards rather than on drafting and responding to public inspection reports.

Having said that, any significant audit issues identified in the interim program should be promptly addressed by the inspected firm. In egregious cases, the Board may initiate disciplinary actions or refer information about potential broker-dealer violations to the SEC, FINRA or other designated examining authority.

Once again, however, our primary goal during this interim program will be to find out more about the current scope and quality of broker-dealer audits, and not to find enforcement cases.

Now let's move on to another program where we have sought your comments and suggestions: the proposed changes in the standards that will need to be applied to future audits and compliance reports of brokers and dealers.

Standards

To date, there have been no changes in the standards used by auditors of brokers and dealers. In September of 2010, the SEC advised auditors of broker-dealers to continue to apply the auditing standards of the American Institute of Certified Public Accountants (AICPA) and the requirements of the current Rule 17a-5 until otherwise indicated.

My point is that, as yet, the Board has taken no action to change the current standards that audits of broker-dealers are conducted under. Our proposed standards and the SEC's proposed changes to Rule 17a-5 are not yet effective. However, we have heard that broker-dealer audit costs have risen, in some case substantially, which may have imposed burdens on smaller brokers and dealers. Any changes in audit fees that have occurred since the passage of the Dodd-Frank Act have not been due to new requirements or procedures coming from the Board. Increases in audit fees and the associated auditor's efforts are likely the result of the attention that brokerage firm auditing has attracted since the scandal involving the auditors of Stanford and Madoff.

As you heard yesterday from the SEC's Deputy Chief Accountant, Brian Croteau, the requirements of Rule 17a-5 are proposed to change, to require a broker-dealer's annual report to include a financial report and either a compliance or exemption report.

The SEC's proposed compliance report would require carrying or clearing broker-dealers — those that maintain custody of customer funds or securities — to report on their compliance in certain areas (such as the broker-dealer's internal control over compliance with specific SEC rules related to net capital requirements, customer protection, reserves and custody of securities, quarterly security counts, as well as compliance with rules of the entity's designated examining authority on sending account statements to customers). The compliance report would be examined by the auditor, under a reasonable assurance standard required by the proposed changes to Rule 17a‑5.

With respect to these audits of carrying and clearing brokers and dealers, the Board's proposed attestation standard would establish a framework of requirements for examining the compliance reports. The proposed attestation standard is designed to elicit the auditor's judgment to identify and focus on the areas that are most important to customer protection. The standard is intended to be scalable to the size and complexity of the broker-dealer's business. This flexibility and additional coordination with the financial statement audit should drive efficiency by eliminating duplication and promoting appropriate use of audit evidence obtained during the audit of the financial statements.

The SEC has also proposed a new exemption report for brokers and dealers that do not maintain customer funds or securities — and therefore meet the exemption conditions of the SEC's proposed Rule 17a-5. These broker-dealers may pose less risk to investors in certain circumstances. The SEC has proposed requiring a broker-dealer filing an exemption report to undergo a review by the auditor of the assertions of the broker-dealer in the exemption report.

Many of these so-called introducing brokers are small operations. As a result, the proposed review standard is intended to take any such reduced size and complexity of the broker into account. The extent of inquiries and review would naturally be less for a small, uncomplicated broker. Therefore, that proposed review standard mandates fewer and less burdensome procedures and, as with the proposed Rule 17a-5, requires the auditor to obtain moderate assurance, as opposed to reasonable assurance, on the broker's or dealer's assertions in the exemption report.

These proposed standards together are intended to increase investor protection by redefining and strengthening the audit requirements applicable to the audits of brokers and dealers. As discussed, they require auditors to focus on the primary risks associated with the activities of brokers and dealers.

Both proposed standards contemplate that the auditor will conduct a risk-based audit and permit the audit to be scaled depending on the broker-dealer's size and complexity. The auditor should be able to make efficient use of the work conducted on the financial statement audit in connection with the examination of management's compliance assertions or the review of management's exemption assertions. The goal is to increase the focus on the broker-dealer procedures intended to safeguard accountholder assets, without increasing the incremental audit costs that may result.

In addition to the standards around the new compliance or exemption reports, brokers and dealers are already required by the SEC to file certain supplemental information along with their audited financial statements. These supplemental schedules show such things as the calculations of reserve requirements and net capital along with information relating to the possession and control of customer assets. Because of the importance of the supplemental information accompanying financial statements of broker-dealers and others, the Board has also proposed a standard that specifies the audit procedures to be applied to test the supplemental information, as well as the auditor's reporting responsibilities. Under the proposed standard, the auditor will audit and report on whether the supplemental information accompanying the financial statements is fairly stated, in all material respects, in relation to the financial statements as a whole. Our intention is to promote meaningful protection of customer assets and not cause wasteful efforts.

I also point out that many of the proposed procedures in the attestation and supplemental information standards follow closely the procedures that are already required. For instance, the proposed attestation standards are closely linked to the existing attestation standards (AT 101 and AT 601). The Board's proposals generally would tailor those procedures to the requirements of the SEC proposed rule 17a-5.

The Board has also spent a great deal of time thinking about how to ease the transition to PCAOB standards, especially for firms who have not used our standards historically. By placing these procedures in separate targeted standards, the Board was attempting to streamline the efforts of smaller audit firms, who may not be familiar with PCAOB standards, enabling such firms more easily to find and use such procedures for their engagements.

Our Staff is also working on "Day 1 Guidance" to assist auditors in the transition from AICPA to PCAOB standards. This guidance will summarize the requirements of the new attestation and review standards, provide practical implementation guidance, and help auditors gain a greater understanding of the expectations for handling audit and other issues common to brokers and dealers.

One other issue I want to highlight: the Board's oversight and the proposed standards generally do not cover the audit work performed in connection with the client-asset-custody arrangements of investment advisors. These arrangements are governed by SEC rules. While certain investment advisors are required to have reports prepared by auditors registered with the Board, neither the Sarbanes-Oxley Act nor the Dodd-Frank Act authorizes the Board to exercise oversight over those audits.

In some cases brokers and dealers are also investment advisors. In some cases, investment advisors use particular broker-dealers to maintain custody of their customer assets. In those situations the Board's oversight responsibilities would extend to the audits of the respective broker-dealer functions. However, the Board does not have the authority to oversee directly the audits of investment advisors or their investor protection procedures. Nothing that I have discussed today is applicable to the customer assets procedures of investment advisors.

Note also the timing of the effectiveness of the SEC's revised Rule 17a-5 and our attestation standards. The proposed effective date for the Board's attestation standards is for fiscal years ending on or after September 30, 2012. Currently, the SEC's revised Rule 17a-5 is proposed to be effective for fiscal years ending on or after December 15, 2011.

I know that concerns have been expressed through comment letters on the proposed effective date of the SEC's revised Rule 17a-5 and our associated attestation standards. I understand the concern that the auditing firms need sufficient time to train their partners and employees and to implement other organizational changes to adopt the new rule. We all have a common interest in making a switch to the revised Rule 17a-5 and the related PCAOB standards in a thoughtful and competent manner. The PCAOB and I are aware of the effective date issue and we are working with our colleagues at the SEC to address this and all the issues raised by the comments in this area.

Funding

Let me now move on to how the PCAOB's oversight of broker-dealers will be funded. The largest source of funding for the PCAOB comes from the companies whose financial statements must be audited by PCAOB-registered firms. Section 109 of the Sarbanes-Oxley Act, as originally enacted, provided that funds to cover the PCAOB annual budget, less registration and annual fees paid by registered public accounting firms, would be collected from issuers based on each issuer's relative average monthly equity market capitalization. The amount due from issuers is referred to as the accounting support fee.

As amended by the Dodd-Frank Act, Section 109 now requires the Board to allocate respective portions of its accounting support fee among issuers and broker-dealers and allows for differentiation among classes of issuers and brokers and dealers.

In establishing rules on the allocation of the accounting support fee between issuers and broker-dealers, the Board was guided by two overarching principles:

  1. The fee must be allocated in a manner that reflects the proportionate sizes of issuers, brokers and dealers.
  2. The fee must be allocated in an equitable manner.

Under the Board's Funding rules, brokers and dealers will be allocated a portion of the broker-dealer accounting support fee based on their average, quarterly tentative net capital. Generally, brokers and dealers with average, quarterly tentative net capital of greater than $5 million may be assessed a share of the fee. This means that the vast majority of broker-dealers will not be assessed any portion of the accounting support fee whatsoever.

The Board expects that the initial allocation and assessment of the accounting support fee for brokers and dealers will take place by year-end 2011.

Let me spend a few minutes discussing some of the many ways that the Board is undertaking to gain a greater understanding of the broker-dealer industry and the auditors that serve it.

Outreach

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 risk over-regulating Some prominent presidential 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.

No matter which camp you might be in, I hope that you are part of the conversation.

In the same light, we want to provide you with a greater understanding of what the PCAOB is and how it anticipates it may regulate the auditors of broker-dealers. We want you to understand that the PCAOB is not an organization applying authority in a vacuum. We want to reach the right balance consistent with our investor protection mandate.

To that end, the Board has the Office of Outreach and Small Business Liaison, which is responsible for executing the Board's outreach strategy, with a particular focus on the small business community, including small broker-dealers. This Office also seeks input from the small business community, including public companies, brokers and dealers, on issues related to the Board's work. The Office of Outreach serves as a point of contact for anyone with questions about the Board's activities. I hope that you take advantage of this resource.

In addition, we are hosting two forums this year on audits of smaller broker-dealers, the first of which is tomorrow in Jersey City, NJ. We will also be hosting another event in Huntington Beach, CA on November 17th. These forums are one-day seminars designed for auditors of smaller brokers and dealers and cover the PCAOB inspection process, compliance with standards, and other issues specific to the broker-dealer auditor community.

While the audits of brokers and dealers have unique aspects and issues, they also are tied to many of the issues facing the auditing profession as a whole. Let me briefly touch on some of the challenges I see currently facing auditors and investors.

Extraordinary Challenges Requiring Creative Solutions

The accounting profession again finds itself at a point where its relevance is being debated. Globalization has stretched the frontiers of auditing. Companies are multi-national; audits must be too. But national borders still exist; and inconsistent or even conflicting national economic goals and strategies make multi-national audits all the more challenging, and weaken investor protection.

More fundamentally, inherent clashes of cultural values and norms throw the goal of putting American capital to the highest and best use into uncertainty. U.S. markets and investors have been unfairly taken advantage of by those who want the benefits of American markets but not American rules.

Reliable financial and economic data is one of the fundamental assumptions of American society that sets us apart. We value a culture of honest representation and must continue to do so to promote our economic success.

Our system of capital formation relies upon the confidence of millions of savers to invest in companies they trust. The auditor's opinion is critical to that trust. There are, of course, formidable forces that work against that trust.

First, the payment model: the auditor is hired and fired by the company itself. The Sarbanes-Oxley Act's reform to shift hiring and oversight of the auditor from management to the audit committee may in practice have proved insufficient to counteract that conflict and others facing the auditors. As with management, audit committees may see their job as negotiating the lowest audit fee, not championing auditor objectivity and independence from management. The challenge will be to fashion practices and standards that reinforce the effectiveness of audit committees, not supplant them.

Second, to protect the investing public, all public companies are required by law to obtain an audit. This statutory franchise protects the profession as a whole from the risks of obsolescence, thereby reducing auditors' need to adapt to investor needs. As a result, auditors don't have a natural incentive to evolve their reports to what investors want.

Third, there are other, external conflicts of interest for the auditor to overcome. Conflicts are rife in the fundamental issues auditors face in evaluating whether a company's going concern assumption is valid. They inhere in the judgments of people who prepare and market valuations while actively trading. Conflicts also emerge in audit committees compensated substantially in stock.

These forces — the payment model, the statutory franchise, and the incentives of others in the environment auditors operate in — constitute formidable discouragement. They deter the profession itself from innovating the audit to meet public expectations the way, say, a technology company would, or a properly incentivized service company would.

There is no silver bullet to address these challenges. There are as many or more problems with structural alternatives such as a third-party payor or insurance-based system; and in a dispersed ownership society, eliminating the audit requirement would be impractical and outright reckless. Therefore, our initiatives go to reducing risks that follow from these conflicts and incentives that weaken investor protection, by applying counter-weight.

I want to discuss some of the initiatives we have to create the "counter-weight."

The PCAOB's Policy Agenda to Enhance the Relevance, Credibility and Transparency of Audits

The initiatives are founded on the principle that audit regulation should foster conduct and a culture consistent with the franchise that the securities regulatory regime accords the audit profession.

I expect the PCAOB to play an important role in supporting a full and informed debate about how to counteract the conflicts auditors face. With this role in mind, the PCAOB has issued several policy proposals recently. The objective is to foster broad debate and research about ways to enhance both the relevance and credibility of audits, and to provide the investing public a better understanding of what an audit is through enhanced transparency.

Each of these proposals has a long comment period to allow for evidence-gathering and research. We have held public roundtables to explore these issues through discussion and will continue to do so. We expect interested parties on all sides to do their homework and come back to us in comment letters and to enter into the public dialogue with facts and evidence.

Please let us know your feedback and suggestions. Please also inform investors with whom you interact about these projects and encourage their input. We need constructive insights to help us design effective solutions.

Audit Reporting Model

First, the PCAOB has initiated a broad debate on the form and content of the standard auditor's report. In June, the PCAOB released a concept release on potential changes to the auditor's reporting model.

We issued this paper to examine whether the auditor's report could better serve investor needs. Given the effort involved in an audit of a large company, and the complexity of many financial statements, investors have called for deeper insight from the auditor.

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. The alternatives discussed in the release include:

  • An auditor's discussion and analysis;
  • Required and expanded use of emphasis paragraphs;
  • Auditor assurance on other information outside the financial statements; and,
  • Clarification of language in the standard auditor's report.

We have received nearly 150 comment letters to date. In addition, in September we held a public roundtable to foster further discussion among 32 experienced individuals, including several corporate directors.

The comment letters reflect a broad range of perspectives, and a full range of comfort or discomfort with some of the proposals. There does appear to be consensus that the pass-fail aspect of the opinion should be retained.

Some believe all information about the company should come from management, and the auditor should only attest to the accuracy of that information. Some investors say they want to hear more from the auditor directly. Determining what changes, if any, to make to the auditor's report will involve some difficult issues, including balancing the benefits of those potential changes to investors with the potential costs of those changes to the companies and their auditors.

If we make changes, they will be focused on enhancing the relevance of the auditor's communication to investors. New communications might, or might not, require new audit procedures. But they would not change the fundamental role of the auditor to perform an audit and attest to management's assertions as embodied in management's financial statements. And, in no event would they put the auditor in the position of creating and reporting financial information for management.

This is a major project and the PCAOB will take the time to get this right.

Auditor Independence

Enhancing the relevance of the auditor's report will do no good if we don't at the same time provide investors a sound basis for confidence in the audit. On the whole, the firms that the PCAOB inspects demonstrate that they are capable of high quality audits. But the fact remains that, based on what PCAOB inspectors have seen, numerous audits by major firms and small firms alike exhibit flaws that go to the fundamental objective of the audit — to obtain reasonable assurance about whether the financial statements are free of material misstatement.

That's what it means when the PCAOB cites an engagement deficiency in the public portion of an inspection report. Inspectors may find other flaws that do not rise to this level. But if the deficiency is described in the public part — or Part I — of the report, that means in the inspection team's view, it did rise to this level.

Now, some firms have argued that engagement deficiencies typically reflect mere documentation deficiencies, or a difference of professional judgment, between the inspection staff and the auditor, within a range of reasonable professional judgments. Those who make decisions based on this notion — policy makers, audit committees, or others — will make the wrong decision.

Acknowledgement is the first step to addressing a problem. In some cases, especially those involving over-reliance on inquiry, or management representations, as audit evidence, the auditor simply has not done enough work to complete the audit. In other cases, it can be a matter of the auditor rationalizing away disconfirming evidence that is already apparent.

In either case, we are left with the fundamental question: why didn't the auditor's skeptical mindset help him see that he needed to challenge management's assertion or investigate the disconfirming evidence?

I am also led back to the fee, and the effect that client service has on an auditor's ability to retain the fee from year to year. It may be that insertion of the audit committee between management and the auditor, while helpful to protect the auditor from undue influence, is simply not a strong enough step, in all engagements, to reverse the effects of the culture of client service that firms have historically deployed to remain viable enterprises.

For the record, I do not by these voiced concerns impugn the ethics, integrity and good faith of the profession. Skepticism can fail in spite of both fundamental competence and high ethical standards, when the cited pressures, for example, result in the audit team skipping over disconfirming evidence. I am talking about casualties of judgment in the heat of the moment. As a standard-setter, the PCAOB is trying to find ways to counter the pressures, and fortify the judgment.

Inspections by other audit regulators have also given rise to concerns about auditor skepticism, as reported by the U.K.'s Audit Inspection Unit, the Dutch AFM, the Australian Securities and Investments Commission, the Canadian Public Accountability Board, the Swiss Federal Audit Oversight Authority and the German Auditor Oversight Commission. Based on such concerns, the European Commission is also reportedly considering reforms to enhance auditor independence. I understand a draft of proposals from the EC is expected in November.

In August, the PCAOB issued a concept release to seek public comment on how to enhance auditor independence, including whether audit firms should be subject to term limits.

There are, of course, considerable implementation challenges associated with mandatory term limits. Some institutions have fixed term limits for their auditors. In some countries the audit firms bid on and take term-limited engagements. These changes can be dramatic, and yet they are managed.

To be sure, when auditors change, there may be a learning curve for the new auditors. But consider this: according to the research firm Glass Lewis, between 2003 and 2006, more than 6,500 public companies, or nearly 52 percent of all public companies, voluntarily changed their auditors.

How did auditors and companies manage those changes? What did auditors, and the audit committees that oversee them, do to make sure the new auditors were in a position to provide reasonable assurance in the early years of an engagement?

The concept release invites study and consideration of whether there are ways to mitigate the challenges of auditor turnover. But the reason to consider the concept is to resolve the question to which the discussion of independence, skepticism and objectivity always seems to return. That is the central question of the concept release:

will term limits, set at some appropriate length, with due regard for implementation complexities, reduce the pressures auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets?

The idea of audit firm term limits is not new. The debate ebbs and flows, but the contending solutions languish unresolved. In fact, the very size, complexity, and systemic risk found in today's issuer population supports the need for reconsideration of audit firm rotation at this time.

To be sure, partner rotation focuses the firm on a partner's decisions in the audit. But a new partner may feel the need to live with those decisions and agreements; he may have little motivation to reopen them. What is lost is the true "fresh pair of eyes."

We have a long comment period, extending to December 14. We will then hold a public roundtable to further discuss the subject in March of 2012.

Comments are already flowing in, and they are divided. It may well be that the process will generate a range of proposals, combining elements of different approaches, all designed to foster independence with different tools applied to different engagement types.

Audit Transparency

The third policy initiative the PCAOB has mooted recently relates to audit transparency. The Board has proposed amendments to its auditing standards to improve audit transparency by enhancing disclosure about the participants in audits, including disclosure about the partner in charge of the audit, as well as other firms involved in the audit.

This proposal stems from a concept release that the Board issued in July, 2009 to obtain comment on whether the Board should require engagement partners to sign audit reports.

The names of key management executives, not to mention corporate board members, have long been disclosed. The names of audit engagement partners are also disclosed in many countries, but to this point not in the United States.

I fail to see why shareholders in large European banks and other companies should be able to see the name of the engagement partner in the audit report, but shareholders in U.S. banks and companies should not.

Indeed, the names of engagement partners for some European companies that are listed on the NYSE are disclosed in U.S. filings. Why are their shareholders to be favored over shareholders in U.S. companies?

At the concept release stage, the Board received certain objections to requiring engagement partner signature, most notably that the change could unintentionally imply a reduction in the firm's overall responsibility for the audit and the audit opinion. The proposal is intended to address those concerns.

Our audit standards set forth the responsibilities of the auditor. The proposal does not change the responsibilities of the audit firm or the engagement partner.

The second aspect of our proposal would provide more transparency about the firms that contribute to global audits. For many large, multi-national companies, a significant portion of the audit may be conducted abroad — even half or more of the total audit hours.

I have been surprised to encounter many business people and senior policy makers who are surprised to hear that an audit report that is signed by a large U.S. firm may be based, in large part, on the work of affiliated firms that are completely separate legal entities in other countries.

In theory, when a networked firm signs the opinion, the audit is supposed to be seamless and of consistent high quality. In practice, that may not be the case.

Enhanced transparency about how cross-border audits are conducted should help investors and audit committees gain a better understanding of how an audit was conducted and make more informed decisions about how to use the audit report. Shining a light on the composition of the multi-national audit should reward consistent high quality where delivered.

I hope that my remarks today are a first step in getting beyond any myths of how the PCAOB will be approaching the oversight of broker-dealer auditors. I also hope you will engage in a lively but constructive dialogue around the policy initiatives that we have released to drive relevance, credibility and transparency in the conduct of audits.

In closing, let me emphasize that one of the Board's most important tools in ensuring that its actions are in the best interests of investors, is its process for gathering public comment. I encourage you to participate in the dialogue — whether in your role as auditor, broker, dealer or customer.

 

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