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 Governments and the Motion Men Give Them

DATE Nov. 1, 2012
SPEAKER(S): James R. Doty, Chairman
EVENT: Association of Audit Committee Members Annual Meeting
LOCATION: Philadelphia, PA

Thank you for asking me to speak to Association of Audit Committee Members. I have admired your relentless work to provide audit committees important insights and effective tools. Most recently, for example, your work on disseminating best practices for conducting internal investigations and your initiative to improve the effectiveness of corporate whistleblower programs.

As directors of some of the most important companies in America, you represent the best of a generation of business leaders. I am here today to talk about the regulatory initiatives of the Public Company Accounting Oversight Board to improve the quality and usefulness of public company audits.

It is important work, and I believe it is making a difference. But it is not a substitute for the work you do every day to protect the investing public and, in so doing, promote further investment in business, jobs, and wealth creation for our savers. Nor can it fulfill the country's need for your strong leadership in charting a course for American business that will foster a fair and prosperous society for our children and future generations.

I am therefore truly honored to be asked to join you today. I also feel fortunate, after the Storm of the Century, Hurricane Sandy, just landed a direct hit on the Jersey shore and Philadelphia.

On my wet ride up from Washington, I reflected on the resilience of this city, where one could fairly say many of the dreams of our Nation began. I cannot but see some parallels between the work you are doing to strengthen corporate America, after upheaval of the financial sort in our time, and the work and debates our founding fathers did and had, here in Philadelphia, to establish solid institutions, after considerable upheaval in theirs.

A lunch speech is an occasion when a speaker can take some frolics and detours. I will do that. Before I go further, though, it is appropriate to say that my remarks today are my own and should not be attributed to the PCAOB as a whole or any other members or staff.

I. Eighteenth-Century Quaker Philadelphia Set the Foundation for American Political and Economic Models that Persist Today.

Philadelphia was, of course, established out of strife, strife felt by English and Irish Quakers, fleeing persecution by the British government under Oliver Cromwell as well as by Puritan Congregationalists in the new American colonies of Massachusetts and Connecticut.[1]

A. William Penn's Framework of Government is an Early Antecedent to Our Investor Protection Laws

The Restoration Stuart monarch in Britain, Charles II, was much more amenable to Quakers than Cromwell or the Puritans had been: he gave a large portion of mid-Atlantic land to William Penn, the Quaker sympathist whose father had helped restore the monarchy.

Penn was a business man. He had religious goals, but he needed his vast lands to provide him a profit. Indeed, after establishing Pennsylvania for the Quakers, he spent most of his life back in England, but not before establishing an important institution here.

He believed that the best foundation for his venture was a solid legal framework for an ethical society where power derived from the people. (This idea foreshadowed our securities markets and our system of securities regulation for the protection of the investing public. We'll get to that later.)

As with our system of securities regulation, Penn's Framework of Government, as he called it, was a radical departure from European precedent. He adapted the empirical ideas of John Locke and other philosophers of the day, but he allowed for the possibility that even those esteemed ideas require change over time.

Every school child in Philadelphia will know Penn's expression on government —

Governments, like clocks, go from the motion men give them, and as governments are made and moved by men, so by them they are ruined too.[2]

He hoped that his Framework would accommodate dissent and new ideas and also allow meaningful societal change without resorting to violent uprisings.[3]

B. The Revolutionary Leaders

Imbued with the philosophy of self-government, conservative, 18th Century Quaker Philadelphia became the locus of the First and Second Continental Congresses during the American Revolution.

The Revolutionary War was, of course, led in the field by that other conservative revolutionary, the Virginia planter, George Washington. It is significant that Washington's disagreement with Britain began as a disagreement with the English factors, or intermediary merchants, monopolists to whom he was required to ship his tobacco and other crops in exchange for British goods.

Washington's troops were notoriously impoverished, but what they did have was financed by the imagination of Philadelphia financier Robert Morris. Morris was the Superintendent of Finance for the Continental Congress in 1781.

Morris persuaded the Continental Congress to support his establishment of the Bank of Pennsylvania, which was essentially a public bond fund. It raised funds from wealthy merchants for interest-bearing six-month notes. Then it used those funds to buy flour for Washington's starving troops.

Morris also founded the Bank of North America as a private business chartered by the revolutionary Congress. As such, it was the Nation's first de facto central bank. When shares in the bank were sold to the public, the Bank of North America became the Nation's first initial public offering.

After the war, it was here in Philadelphia, that Washington, as the quiet, impartial but influential, presiding chair of the Constitutional Convention, together with delegates from each of the states, transformed our form of government from a confederacy to a republic.

As we watch the debates in Brussels, Berlin and other capitals, engaged today over European unification, we can appreciate what a difference this decision made. Yet in its day it was as controversial.

"Governments, like clocks, go from the motion men give them."

Travel in the late 18th century was difficult, and very few of the selected constitutional delegates were present on the designated day to start the convention, May 14, 1787. (In the aftermath of Hurricane Sandy, we can appreciate this.)

It took nearly two weeks to secure a quorum of representatives. In a room nearby but smaller than the Marvin Comisky Conference Center we now occupy, a group about as large as we here assembled at the Convention. They debated and ultimately agreed to strengthen the national government with a new Constitution, based on the blueprint of another Virginian, James Madison.

It was here, in Philadelphia, where Washington broke with Madison to champion Robert Morris's ideas to promote an industrial economy that would require sophisticated financing through capital markets, rather than the familiar agrarian economy. Another fateful decision, and not at all an obvious one in 1790, especially to a Virginia planter.

Morris's report from his days as the revolutionaries' Superintendent of Finance, On Public Credit, became the basis for the economic plan that Alexander Hamilton, Washington's Secretary of the Treasury, prepared in 1790, under the title First Report on the Public Credit.

C. The B&O Railroad was the Nation's First Large Public Company to Employ an Audit Committee to Protect Investors.

Morris's and Hamilton's work laid the predicate for the development, in the next generation, of the first great American public corporations, beginning with the audacious Baltimore & Ohio Railroad in the early 1820s.

Like Morris's Bank of North America, the B&O Railroad issued shares to investors. The railroad's promoters sought to reassure investors by appointing a committee of merchant investors to audit the financial records on a regular basis. An annual report to investors was also required under the corporate charter.[4]

This is the first audit committee of a large American corporation on record. It had its antecedents in Europe, dating back to the royal charters and joint stock companies of the very adventurers who first settled this land.

What was new was that the merchant investors stood to benefit from the railroad but did not operate it themselves. These investors needed access to and representation in the financial management of the railroad. This was the predecessor to the modern day audit committees on which many of you assembled here sit.

On this foundation, later in the 19th Century and through the 20th Century, we continued to build massive companies on a scale that I doubt Morris could have imagined, including companies with operations not just in multiple states, but in multiple countries.

Unlike Morris's revolutionary investors, or even the merchant investors in the B&O, the vast class of public investors today has no realistic ability to participate in or even monitor the use of funds. There's where we come to a big intangible: trust. And there's where you come in.

We have created audit committees and professional auditors to help investors separate the credible managers from the charlatans. By building confidence, good audit committees and auditors reduce financing costs, and contribute to an efficient allocation of capital to fuel economic growth.

In the B&O Railroad, the auditors were the audit committee and the audit committee was made up of a subgroup of investors. Modern audit committees employ professional auditors (a late 19th century innovation), and modern auditors are not investors themselves. They do not examine accounts to determine their own shares and profits. Rather, their independence derives from disinterest in the company's performance — both in appearance and in fact.

Since the financial reporting debacles at the turn of our 21st century, the institutional framework for audit committees has been strengthened. The Public Company Accounting Oversight Board was established to examine in depth the effectiveness of this external audit model for public companies. We work in parallel to enhance investor protection.

I feel confident in saying that the PCAOB's work and collective findings demonstrate the need for rigorous, skeptical auditing to sustain wide-scale investment by diverse public investors. Time and time again, we see evidence that auditing makes a difference.

To answer a frequent question I am asked, PCAOB inspections have no doubt improved audits. But we also see, as we each deepen our understanding of the various firms that intermediate our capital markets, that the competitive markets present challenges for auditors who are trained for technical excellence but are subject to pressures to compromise audit quality. This should concern us both.

II. The PCAOB's Initiatives Aim to Help the Profession Realize Its Potential by Enhancing the Relevance, Credibility and Transparency of the Audit for the Sake of Investor Protection.

The PCAOB is deeply engaged in examining ways to enhance the relevance, credibility and transparency of the audit to better serve investors.

A. A New Auditing Standard and Additional Guidance Help Audit Committees Oversee the Audit.

Our projects include initiatives to help audit committees perform effective oversight of the auditor's work, as well as improvements in basic auditing areas. In this endeavor, we are not alone: the good work of your Association stands as a significant contribution to the work of enhancing audit committee effectiveness.

1. Auditing Standard No. 16 Improves Auditor Communication with Audit Committees

The PCAOB has recently adopted a new auditing standard — Auditing Standard No. 16 — on what the auditor should communicate to audit committees in order to protect the public's interest in keeping audit committees informed of important audit matters.

The final standard benefited from two separate exposure periods and considerable comment from people who sit on audit committees, including a comment letter from the Association of Audit Committee Members. It has now been submitted to the SEC for approval in order to go into effect.

Auditing standards have for some time required the auditor to communicate to the audit committee any material weakness or significant deficiency related to the company's entity level controls, control environment or period end financial reporting process.

AS 16 will require, among other things, that the auditor communicate to the audit committee other matters arising from the audit that are significant to the oversight of the company's financial reporting process.

This communication requirement includes complaints or concerns regarding accounting or auditing matters that have come to the auditor's attention during the audit and the results of the auditor's procedures regarding such matters. I know this was an important point to this Association.

Moreover, AS 16 will also require the auditor to communicate any significant difficulties encountered during an audit, including significant delays by management, unavailability of company personnel, or an unwillingness by management to provide information needed for the auditor to perform his or her audit procedures.

2. The PCAOB Has Issued Guidance on What Audit Committees Can Learn from PCAOB Inspections.

The PCAOB has also recently issued guidance to audit committees about how to learn more from their auditors about the results and implications of the PCAOB's inspection findings.

The Sarbanes-Oxley Act limits what the PCAOB may disclose to an audit committee about its auditor and even about its audit. Apart from the public portion of an inspection report, the only potential source of information about a firm's inspection, for an audit committee or the investing public, is the inspected firm: The Act's confidentiality provisions do not restrict an inspected firm from disclosing nonpublic inspection information.[5]

When PCAOB inspectors identify significant audit deficiencies, they describe their concerns in detail to the auditor. If the auditor disagrees, the auditor has ample opportunity to demonstrate to the inspection team any oversight or error in the inspection team's analysis or its understanding of the facts. The inspection team's conclusions are reviewed by PCAOB staff at multiple levels, in light of input the auditor provides, including any response to a draft of the inspection report.

Description in the public portion of the inspection report of failure to obtain sufficient evidence to support the firm's opinion[6] means that the inspection staff has determined that the firm failed to fulfill its fundamental responsibility in the audit: the firm failed to obtain reasonable assurance about whether the financial statements are free of material misstatement.[7]

Firms' approaches to characterizing these inspection results can sometimes distort them. For example, one common claim is that a cited audit deficiency is based on nothing more than the auditor's failure to adequately document work that the auditor in fact performed. A firm may also argue that the cited audit deficiency reflects merely a difference of professional judgment, between the inspection staff and the auditor, within a range of reasonable professional judgments.

Audit committees should probe such assertions. In the case of every failure cited in the public portion of an inspection report, the inspection staff have considered and rejected any contention that the procedures were performed but just not documented.[8]

Similarly, in the case of every failure cited in the public portion of a report, the inspection staff will have considered and rejected any suggestion that a reasonable judgment could be made that the omitted procedures were not necessary.[9] A comment in the public part of an inspection report means that the inspection staff has concluded that the matter involves neither a mere documentation failure[10] nor an acceptable alternative professional judgment.

How an audit committee addresses these issues affects the tone of the audit. An audit committee that accepts such arguments may inadvertently signal to the audit firm and audit team that the audit committee is not concerned with quality. An audit committee that, on the other hand, expresses explicit concern for how the auditor has resolved noted deficiencies tells the auditor that quality matters.

B. The PCAOB Has Proposed a New Auditing Standard on Related Party Transactions.

Moving on to other projects: the PCAOB proposed a new auditing standard on related party transactions earlier this year. This standard describes basic tools that good auditors have used for years to identify financial reporting risks. Among other things, it requires auditors to understand management's compensation as a way to understand management's motivations.

Changes in performance metrics may well be an important clue to understand areas where management's financial story is weak. They offer the auditor — and audit committee — insights about management's incentives that may not be gleaned otherwise.

We received 37 comment letters on this proposal, which we are now evaluating.

C. The PCAOB Has Issued Concept Releases to Commence Debate on More Broad-Ranging Topics.

The PCAOB standards-setting work also includes more broad-ranging projects, commenced not with concrete proposals but with concept releases, to examine ways to enhance the relevance, reliability and independence of audits in today's world, and in light of lessons both auditors and investors have learned in the recent financial crisis.

1. The Auditor's Reporting Model

These projects involve consideration of changes to the form and content of the standard audit report, as well as a deep examination of the behavioral patterns that the current audit model imposes.

I am not here today to tell you where the PCAOB should come out on the question of what is the most relevant information auditors should provide the investing public. But I am interested in a better, more transparent reporting model that will align auditors with investors, that will make the audit more relevant, less commoditized, and that will function to more consistently require auditors to demonstrate the requisite skepticism and provide true insight.

2. Auditor Independence

In August 2011, the Board issued a Concept Release on Auditor Independence and Audit Firm Rotation. The concept release notes the importance of auditor independence to the viability of auditing as a profession and highlights the risk to independence arising from the "client-pays" model.

As noted in the concept release, the PCAOB continues to find instances through its inspections where auditors did not approach some aspect of their audit work with the required independence, objectivity and professional skepticism. Accordingly, the concept release seeks public comment on ways that auditor independence, objectivity and professional skepticism could be enhanced.

In this regard, the release notes that there may be risks to professional skepticism in both the relatively new audit that the auditor may hope to turn into a long-term engagement, as well as the very long engagement that no partner wants to be the one to lose.

The PCAOB has embarked on several public meetings to engage prominent and thoughtful commenters with various, often conflicting, viewpoints. Your members, Rod Hills and Richard Roedel, have made significant contributions in these meetings.[11]

The European Union and its member states are engaged in their own inquiry. What we learn through public meetings and on our concept release is highly relevant to that inquiry. How we internalize, how we digest, what we hear in our debate, will inform the debate and process of policy development in Europe.

This is not an easy subject. Some form of term limits may or may not provide more independence. But I believe we must explore the possibility that they would help as well as the feasibility of the range of approaches available to free the auditor to think and act more independently.

If mandatory term limits are a "blunt instrument," we should explore what is needed to develop a customized, scaled approach to independence concerns.

III. The Global Nature of Auditing Today Requires Enhanced Attention to Address Risks to Investor Protection.

I could not close a discussion on the future of auditing without reflecting on some other aspects of the international dimension. All of the challenges and initiatives I have described must be understood against the backdrop that auditing today is a global endeavor.

Firms large and small have chased, and then fled, the plethora of potential Chinese and other non-U.S. clients seeking to draw from the wellspring of U.S. capital markets.

Through their networks, audit firms reach everywhere. Local environments and trends are within their long reach. Engagement partners supervise audits that span continents and oceans.

But the reader of an audit report may not know how much of the actual work was done by the firm signing the report. Participating audit firms practice in markets that exhibit markedly different business cultures, with divergent patterns of transparency.

In any given week, PCAOB inspectors are working in numerous countries, often side-by-side with local audit oversight authorities in joint inspections. We are drawing as broad and as clear a picture as we can about how auditors meet the challenges of understanding different environments and coordinating with other auditors to obtain a full grasp of a company's true results and financial position.

We have identified a number of deficiencies in multi-national engagements. Some of the auditing issues have been related to particular areas such as revenue and fair value. Others seem to be attributed to a failure to adhere to the instructions provided by the principal auditor.

I am also concerned that the public, and even audit committees, know little about how audits are constructed and executed. In this regard, the PCAOB proposed last fall new requirements to disclose to investors how a multi-firm audit was accomplished. I expect to ask the Board to act on it in the near future.

* * *

Historians remind us that each generation is, in a sense, the custodian of and fiduciary for the best ideas the past has given us. Penn in his turn, and the founding fathers in theirs, each challenged and improved upon the human experience. We refer to their progress as an Enlightenment.

The fact that we no longer live in a colonial or agrarian paradigm should not mislead us into thinking we are inherently different from the people who convened in the State House to sign the Declaration. The enduring lesson of the past is that men and women do change their worlds.

Washington shared with some privately, or so he thought, that our Constitution would last twenty years. Morris's vision of broad and dispersed participation in capital formation led us into the 21st century. There were, no doubt, other factors. I don't mean to discount them.

Americans today depend on their investments for their retirement and livelihood. Morris's house no longer stands, but his vision does. What did it take to move the Virginia planter?

You are the founders for the generations to come. Investors today seek value and return as restlessly as Washington sought them from his factors. Your ideas about how to honor those needs will determine not just the course of our economy in the short term. They will also determine the course of our dreams for the Nation's future in the long term.

This is a very serious endeavor you are involved in. Audit committees are the heart of the Sarbanes-Oxley Act. I hope what I've told you will show that the PCAOB is doing its part to help you in your efforts.

[1] New Haven Puritans actually tried to settle nearby on the Schuykill River first, in 1642, but the Massachusetts Governor John Winthrop soon dissolved the settlement due to sickness, mortality, and pressure from Dutch and Swedish colonists who also sought to put down roots.

[2] William Penn, Preface to the First Frame of Government for Pennsylvania (April 25, 1682).

[3] Hans Fantel, William Penn: Apostle of Dissent, William Morrow & Co., New York, 1974,

[4] D.L. Flesher, G.J. Previts and W. D. Samson, "Auditing in the United States, A Historical Perspective," Abacus, February,2005.

[5] See Statement Concerning the Issuance of Inspection Reports, PCAOB Release No. 104-2004-001 (August 26, 2004) at 4 n.9. The Board has acknowledged that some firms may be wary of voluntarily disclosing nonpublic inspection information for fear of waiving any privilege that Section 105(b)(5)(A) of the Act might afford them against compelled disclosure in a different context (such as a private civil lawsuit). Whether Section 105(b)(5)(A) affords a firm any such privilege, and whether a firm's voluntary disclosure of inspection information to an audit committee would result in a waiver of any such privilege, are questions for the courts to resolve. An auditor and audit committee sensitive to the risk of waiver, however, can likely still find ways to communicate about matters that might bear on the audit or on the company's financial statements without necessarily disclosing information specifically about the inspection.

[6] As explained in each inspection report, PCAOB inspections are designed to identify and focus on weaknesses and deficiencies, and the reports are not intended to serve as balanced public report cards or overall rating tools. The Board counsels caution about attempting to judge the relative merits of firms solely from a comparison of the public portions of inspection reports. The information provided in public portions of the reports, though, does have a specific meaning that should be properly understood.

[7] The Board has no authority to prescribe the form or content of a public company's financial statements. That authority, and related authority concerning public companies, rests with the Commission. Any description in a PCAOB inspection report of perceived misstatements reflects the inspection staff's view that there was, at the time of the audit, a misstatement that the auditor failed to detect and appropriately address, but should not be understood as an indication that the Commission has made any determination concerning the financial reporting in question. In some cases involving unusual accounting or financial reporting issues, however, the inspection staff's conclusions may be informed by consultation with Commission staff.

[8] A similar point was recently addressed in the annual report of the Audit Inspection Unit ("AIU") of the Professional Oversight Board, which is part of the United Kingdom's Financial Reporting Council. The report noted that comments received by the AIU from audit committee chairs indicated that they "sometimes had difficulty in assessing the significance" of AIU inspection issues communicated to the audit committee by the firm. The AIU observed that "[t]his difficulty could be caused by firms characterizing some of the AIU's findings as relating to the sufficiency of documentation rather than the underlying audit evidence and judgments and therefore of less significance," and the AIU noted that it "disagrees with this characterization of its findings." Audit Inspection Unit Annual Report 2010/11 (July 19, 2011) at 9, available at http://www.frc.org.uk/pob/audit/.

[9] An auditor is, of course, always free to explain to an audit committee the auditor's position that the necessary procedures were performed but just not documented, or that in the auditor's judgment the procedures were unnecessary. It would be another matter, however, for an auditor to suggest to an audit committee that such a view is essentially shared by the inspection staff. Audit committees should understand that any such suggestion would be incorrect.

[10] Deficiencies are sometimes described in reports in terms of the absence of any evidence in the audit documentation, or any persuasive other evidence, that the firm had performed certain procedures. As a matter of practice, the Board employs that formulation when a firm claims — however improbably — that it performed the procedures in question. But that formulation should not be understood as describing a mere documentation deficiency, and an audit committee should not be swayed by a firm's assertion that that formulation indicates that the inspection criticism is only a documentation criticism. In each case, the criticism reflects the inspection staff's conclusion that the firm failed to perform the procedure.

[11] See PCAOB Release No. 2011-006 at 2—3 (reviewing the concept of audit firm rotation as one way to relieve pressure on auditors and soliciting comments on the issue). Forty-seven panelists appeared at the two-day public meeting in Washington and 30 more appeared in San Francisco. They included some of the most authoritative and experienced voices to address the subject of audit quality, auditor independence and the challenges to both. They offered varied perspectives as investors, senior executives and audit committee chairs of major corporations, chief executive officers of audit firms, academicians, and former regulators. Twenty additional panelists presented their views in a public meeting on October 18, 2012, in Houston, Texas.

 

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