Thanks very much. I appreciate the opportunity to be here and to be part of your program this morning.
Before I begin, I want to note that today marks the 90th anniversary of the armistice that ended one of the bloodiest conflicts in human history -- World War I. The falling silent of the guns at the 11th hour of the 11th day of the 11th month of 1918 is commemorated each year in the United States by Veterans Day, on which we honor those who have fought in all of our wars. I hope each of you will find a moment to remember these brave men and women.
While the suffering of World War I dwarfs the kinds of issues we are contending with today, we too are living in historic times. Among other things, we have witnessed unprecedented turmoil in financial markets and the beginnings of an economic down-turn of uncertain depth and duration. As a result, serious questions are being raised about the basic building blocks of the financial reporting and regulatory system put in place during the nearly 80 years since the 1929 market crash and ensuing depression. It is almost certain that next year will be a watershed in rethinking how our capital markets and banking system are regulated.
Relative to the magnitude of the regulatory issues that the new President and new Congress will face, our piece of the puzzle at the PCAOB is small. However, I think that the Board will itself be confronting some challenging issues in the coming months that will affect the future of public company auditing. I would like to outline some of those for you this morning.
Of course, the views I express are solely my own and don’t necessarily reflect those of the Board, its other members, or the PCAOB’s staff.
I want to turn first to how the current credit and capital markets turmoil has affected the Board’s work. The PCAOB’s job is to inspect the auditors of public companies and to write the standards by which public company audits are conducted. The financial meltdown has put obvious strains on preparers of financial statements and their auditors. The Board has worked hard to make its oversight keep pace with the challenges that auditors face.
For the PCAOB, the most obvious and direct impact of the current economic stress is on the Board’s inspections program.
One of our primary goals has always been to make PCAOB inspections of public company audits risk-focused. Each year, the Board’s staff seeks to identify the major challenges and problems auditors face and to tailor the engagements we look at in inspections to those challenges.
The current inspection cycle involves a review of 2007 audits. The credit crisis was already unfolding last year, and our efforts to focus on risk took that into consideration. Accounting for derivatives and other sophisticated financial instruments is an obvious area of stress, as are financial services sector audits generally. In the current climate, audits of financial services companies can present difficult challenges in such areas as --
Inspection reports on the large firm 2008 inspection effort will be issued early next year, although some reports on smaller firm inspections have already been made public. While I can’t say specifically what will be in those reports, discussion in the press, at the SEC’s roundtables on fair value, and other sources, make clear that auditing the valuation of financial instruments under FAS 157 has been a particular challenge. Some of the practical issues auditors face in auditing FAS 157 valuations include things like --
Inspections look at how audits were performed after-the-fact. The auditing challenges resulting from the financial meltdown raise questions about whether the Board should also provide auditors with more prospective guidance.
In December 2007, in light of the subprime crisis and related credit contraction, the PCAOB issued a practice alert to remind auditors of their obligations under the existing standards relating to fair value measurements and the use of specialists. The issues highlighted in Staff Audit Practice Alert No. 2 included --
Last month, the Board sought feedback from its Standing Advisory Group on whether additional guidance would be helpful in light of the current economic environment. The Board’s staff presented some risk areas that might need guidance, and advisory group members offered further suggestions as well. Some specific audit areas in which guidance was discussed included --
The Board’s staff is giving active consideration to issuing an audit practice alert to address these issues. Like Practice Alert No. 2, such an alert would describe areas to which auditors should give special attention in planning and performing audits in the current environment and catalog the auditing standards that are relevant to those areas.
Practice alerts do not create new requirements. However, the Board’s Office of the Chief Auditor is also evaluating the need to revise the underlying auditing standards. Among the Board’s standard-setting priorities are improving the standards on risk assessment, on auditing fair values, on using the work of specialists, and on auditing estimates.
With respect to risk assessment, on October 21, 2008, the Board proposed for public comment seven auditing standards that would update the requirements for assessing and responding to audit risk during a public company audit. These standards address core concepts underlying the audit, and future auditing standards will build on the fundamental principles in the risk assessment standards.
This project has been in the works for some time and is not a direct response to current financial and economic conditions. However, current conditions make it especially timely, particularly since the failure to properly identify and evaluate risk seems to be at the core of much of what has gone wrong. A sound and sophisticated understanding of the risks of material misstatement, and planning and executing an audit in a way that responds to those risks, are essential to affording investors reasonable assurance that financial statements are free of material error.
The comment period on the risk assessment proposals ends on February 18, 2009. I encourage you to review them and let us know what you think. The AICPA’s Auditing Standards Board recently approved for exposure a revision of certain of its risk assessment standards. I think it would be useful to both the PCAOB and the ASB for practitioners to review the ASB’s clarified risk assessment standards along with the PCAOB’s proposals, and comment on both. Auditors who have both a public company and a private company practice need to be familiar with both our standards and the ASB's. Those who practice internationally need also to take the International Standards on Auditing -- the ISAs -- into account. While we are a long way from convergence of these three sets of auditing standards, I think it is important that we avoid needless differences. Thoughtful public comment can help us attain that goal.
Another high priority project is updating the fair value and specialists standards. I have already mentioned the guidance we have issued in these areas. The Office of the Chief Auditor has devoted significant time to evaluating the current auditing standards relating to these matters. They are considering both topics at the same time because specialists are used increasingly by both auditors and management with respect to fair value measurements.
In revising those standards, the Board may take a somewhat different approach than it has in the past. In order to promote transparency and better understanding of our objectives, I anticipate that the Board will begin this project by issuing a concept release setting forth in general terms what the project seeks to accomplish and how the existing fair value and specialist standards would change. This should give the public and the profession better insight into what we are trying to do before specific proposals are formulated and released for comment. I hope that the fair value and specialists concept release can be issued by the end of the year.
Greg Fletcher from the Chief Auditor’s Office will discuss PCAOB standard setting in greater detail during his session this afternoon.
One of the things that the current financial crisis has underscored is that U.S. capital markets are part of an interconnected global economy. Because capital-raising doesn’t stop at national boundaries, the PCAOB has oversight responsibilities that extend beyond the borders of the U.S. Roughly 1,850 auditing firms are registered with the Board. Almost half, 880 or so of those firms, are located outside the U.S., representing 86 different countries. The global nature of the auditing profession presents some difficult challenges that we will be grappling with in the coming year.
The most immediate problem the Board faces as a result of the internationalization of the capital markets is that we have to inspect the U.S. public company audit practices of the foreign accounting firms that are registered with the Board. To date, we have inspected 117 non-U.S. firms in 23 countries. But, even excluding the foreign firms that merely participate in audits of U.S. reporting companies, but don’t actually sign a U.S. audit report, we still have a long way to go. Under our current inspection-frequency rules, there are 167 firms in 49 countries that will need to be inspected in the next two years alone.
In order to get these foreign inspections done, the Board works with its counterparts that oversee auditing in other countries. Where it is practical, the Board often conducts its inspection of a non-U.S. firm in conjunction with the inspection conducted by the firm’s home country regulator. We have even adopted a rule, Rule 4012, that permits the Board to rely, to an appropriate degree, on the inspection work of a non-U.S. accounting oversight system. The degree of PCAOB reliance is based on a sliding scale; the more independent and rigorous a local oversight system, the greater the Board's ability to rely on that system’s inspections.
Auditor oversight is a growth industry. In the wake of Sarbanes-Oxley, several countries have created new audit regulators, while others have expanded the powers of existing bodies. The European Union has revised the Eighth Company Law Directive to require each Member State to establish an auditor oversight authority. Other countries -- ranging from Canada, Japan and Switzerland to Korea, Singapore and South Africa – have strengthened their auditor oversight regimes.
The evolving nature of auditor oversight and inspection programs in other countries presents the Board with something of a dilemma. On the one hand, it is more practical for us to conduct our inspections of foreign firms in conjunction with the home country regulator, rather than trying to go it alone. But, particularly since many of these foreign bodies are just getting started, or have different inspection cycles and priorities than we have, total reliance on joint inspections could mean long delays before we inspect foreign firms on whose audit opinions U.S. investors are relying.
One of the difficult challenges the Board will have to come to grips with in the coming year is balancing the advantages of working with our non-U.S. counterparts to conduct joint inspections against the need to assure U.S. investors that we are timely in fulfilling our responsibilities under the Sarbanes-Oxley Act. The Board will continue to work with auditor oversight bodies in other countries. However, the requirements of our statutory mandate may mean that we will also seek to perform some first inspections of foreign firms independently of the home country regulator, if that regulator is not ready to participate in a joint inspection. And, for legal or other reasons, in a few cases neither joint inspections nor independent inspections may be possible under the schedule required by Board rules. Therefore, we will need to give serious thought to what kind of disclosure or other protections U.S. investors should get regarding the work of uninspected foreign firms during the period before their first inspection occurs.
Another challenge in the international area is the SEC’s proposal to move U.S. public company financial reporting off of U.S. GAAP and on to International Financial Reporting Standards – IFRS – as issued by the International Accounting Standards Board.
On August 27, 2008, the SEC voted to issue for comment a proposed roadmap laying out a schedule, including a series of milestones, for making the GAAP-to-IFRS transition. The SEC has not yet published the proposed roadmap. When it does, there will be an opportunity for public comment and for future Commission votes before we actually move down the IFRS highway. However, as discussed at the SEC’s open meeting, if the various milestones are met, the roadmap envisions mandatory use of IFRS by all U.S. public companies, including the smallest non-accelerated filers, by 2016.
IFRS proponents argue that there would be benefits to a single, comparable basis for financial reporting worldwide. The challenges would, however, also be great. The necessary educational effort alone would be formidable. IFRS is currently not a part of the accounting curriculum in the United States and is not tested on the CPA exam. Accounting firms would have to undertake extensive programs to re-train their staffs, as would public companies. For companies, significant and costly changes in the systems and processes that support financial reporting would also be necessary. These learning curve challenges apply equally to regulators, like the SEC and the PCAOB.
I am sure that the pros and cons of moving to IFRS will be hotly debated during the coming year. There are serious and difficult policy issues regarding the governance and independence of the IASB, the comparative quality of IFRS and GAAP, and whether the continuation of a gradual process of converging IFRS and GAAP would be preferable to abandoning GAAP in favor of IFRS. However, unless the SEC reverses course, 2009 will have to be a year in which public companies, accounting firms, regulatory bodies, and universities start to draw up their own roadmaps. We will need to begin to invest in the education and training that will be necessary to prepare for a world in which all public companies report under IFRS.
The final set of issues I would like to mention goes beyond the practicalities of inspections, standard-setting, and international convergence. These issues touch on the fundamental nature and role of public company auditors.
As many of you probably are aware, last year, the U.S. Treasury Department established a federal advisory committee to examine the sustainability of the auditing profession. That Committee, which issued its final report on October 6, made a series of recommendations regarding the future of the profession, many of which are addressed to the PCAOB. Some raise difficult policy issues. Taken together, the recommendations would make significant changes in what it means to be a public company auditor, especially at a large accounting firm.
In my view, the major recommendations to the Board fall into three general categories.
First, several recommendations aim at strengthening the rigor of public company auditing. For example, the Committee recommended that the SEC’s auditor independence requirements and those of the Board be codified in a single document so that they are more understandable and accessible. The Committee also recommended enhanced auditor training aimed at fostering independence and professional skepticism.
Most significantly in the area of auditing rigor, the Committee urged the creation at the PCAOB of a national fraud center. This body would provide a forum for firms and others to share their fraud detection techniques and best practices. As a corollary, the Committee recommended that the Board consider improvements in the auditor’s reporting model, particularly to clarify the auditor’s role, and limitations, in detecting fraud.
A second group of recommendations seeks to promote competition among firms and to minimize the possibility that another large firm will, like Arthur Anderson, disappear, resulting in greater industry concentration. In this regard, the Committee recommended that the PCAOB expand its inspection program to monitor firm exposure to catastrophic risk. Monitoring for risk of failure or collapse would be something of an expansion in the scope and objectives of our inspections, which now focus on audit performance and quality control.
A more provocative recommendation in the competition area is that the PCAOB should explore the feasibility of establishing key indicators of audit quality and that firms should be required to disclose how they are performing under those indicators. The idea here is to promote competition by developing a common set of measures of the quality of a firm’s audit practice so that audit committees have a better basis to select among firms.
Finally, and most far-reaching in my view, the Committee made several recommendations that would underscore that auditors perform a public interest function. The Committee would do this by requiring more public transparency concerning the operations and finances of the major accounting firms. For example, the Committee recommended enhancing individual audit partner accountability by requiring that the engagement partner sign the audit report in his or her own name, not solely in the firm’s name. In addition, the Committee urged that the PCAOB should --
These recommendations raise some challenging and controversial issues. Let me list just a four –
None of these questions have easy answers. Exploring them may however require significant Board time and resources during the coming year.
I want to conclude by suggesting that, ultimately, all of us -- auditors, preparers and regulators -- face the same challenge: to foster and maintain public confidence in financial reporting. We are living in difficult -- even historic -- times and the challenges are great. Now more than ever, our markets and our global economy are critically dependent on reliable financial information. Therefore, the auditor’s role is too important not to get right.
 PCAOB Staff Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists (December 10, 2007), available at http://www.pcaobus.org.
 See Standing Advisory Group Meeting: Emerging Issue – Audit Considerations in the Current Economic Environment, PCAOB Briefing Paper (October 22-23, 2008), available at http://www.pcaobus.org .
 See Standing Advisory Group Meeting: Standards-Setting Accomplishments and Priorities, Remarks by Deputy Chief Auditor Jennifer Rand (October 23, 2008), available at http://www.pcaobus.org .
 See Proposed Auditing Standards Related to the Auditor's Assessment of and Response to Risk; Proposed Conforming Amendments to PCAOB Standards, PCAOB Release No. 2008-006 (October 21, 2008), available at http://www.pcaobus.org.
 See AICPA's Improving the Clarity of ASB Standards.
 See Standing Advisory Group Meeting: Standards-Setting Accomplishments and Priorities, Remarks by Deputy Chief Auditor Jennifer Rand, supra note 3.
 See Final Rules Relating to the Oversight of Non-U.S. Public Accounting, PCAOB Release No. 2004-005 (June 9, 2004), available at http://www.pcaobus.org.
 See “Directive 2006/43/EC of the European Parliament and the Council of 17 May 2006 on statutory audits of annual accounts and consolidated accounts, amending Council Directives 78/660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC,” Official Journal of the European Union, L 157/87 (June 9, 2006), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2006:157:0087:0107:EN:PDF .
 See SEC Proposes Roadmap Toward Global Accounting Standards to Help Investors Compare Financial Information More Easily, SEC Press Release 2008-184 (August 27, 2008), available at http://www.sec.gov/news/press/2008/2008-184.htm.
 See Final Report of the Advisory Committee on the Auditing Profession to the U.S. Department of Treasury (October 6, 2008), available at http://www.treas.gov/offices/domestic-finance/acap/.