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 PCAOB Update for Those on the Front Lines of Financial Reporting 

DATE Nov. 19, 2013 
SPEAKER(S): Jay D. Hanson, Board Member 
EVENT: 32nd Annual Current Financial Reporting Issues Conference, Financial Executives International 
LOCATION: New York, NY 

Good Morning:

I am very honored to be here this morning with SEC Chief Accountant Paul Beswick on a panel to provide an update on the PCAOB and SEC. I always appreciate the opportunity to interact with those of you on the "front lines" of financial reporting.

As you all know, the Public Company Accounting Oversight Board was created by Congress through the passage of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") 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 began operations just over ten years ago, in April 2003. I joined the Board in February 2011 after spending over thirty years in public accounting.

I would like to highlight for you today a few of the PCAOB's current activities that may be important to you as preparers. But before I go further, I should 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.

As most of you know, since its inception, the Board has issued 17 auditing standards — including, for example, standards addressing audit documentation, internal controls, audit planning, engagement quality review, risk assessment and audit committee communications — as well as two attestation standards for audits of brokers and dealers. We also have substantially amended a number of interim standards — including, for example, standards addressing communications about control deficiencies, audit reports, audit sampling, and substantive analytical procedures, among others. Some of those standards have had a more direct impact on you as preparers, such as the internal control standards, while others may only have affected you insofar as they changed the work performed by your auditor.

One potential project on which we are currently working, and which many preparers have told us would have potentially significant effects on public companies, involves proposed changes to the auditor's reporting model. The proposal, if adopted, would require auditors to go beyond the current model of providing only a pass/fail opinion on whether the company's financial statements are fairly stated (or whether internal controls are effective) and would require auditors also to discuss in their reports so-called "critical audit matters" in order to provide investors and others with more insight into the audit. As defined, critical audit matters are those matters addressed during the audit that (1) involved the most difficult, subjective or complex auditor judgments; (2) posed the most difficulty to the auditor in obtaining sufficient appropriate evidence; or (3) posed the most difficulty to the auditor in forming the opinion on the financial statements.

I see the proposed "critical audit matters" as a window into the audit, intended to provide more information about the audit process and the difficulty faced by auditors in connection with providing assurance on certain important and complex aspects of the company's financial statements or internal controls. Perhaps you can think of it as auditors providing insight into what kept them up at night.

The Board issued this proposal in the context of its mission to protect "the interests of investors and . . . the public interest in the preparation of informative, accurate and independent audit reports."[1] In the wake of the recent financial crisis, involving the failures or near-failures of systemically important entities that had received unqualified audit reports just months earlier, investors raised questions about whether more communication by auditors focusing on what they learn during audits could provide investors with important insight into the risks associated with the audit clients.

It is important to understand, however, that the proposed standard does not require reporting of all information known by the auditor in which investors may have an interest. There are risks and uncertainties inherent in the financial reporting process and in business that may not be discussed as critical audit matters because the application of the accounting standards are clear, and the audit process is relatively straightforward. Likewise, there may be critical audit matters reported that bear little on investment decisions. But, overall, the proposed enhanced reporting may add helpful context to the mix of information available to investors.

The feedback so far on the proposal has been mixed. Some commenters believe the Board's approach will enhance communications by auditors and provide useful information to investors, while others have suggested the requirements do not go far enough and are not sufficiently specific to require the auditor to report information that investors want. Still others have suggested that most of the matters that will be discussed will largely duplicate disclosures already in the financial statements, while some have expressed concern that the auditor might disclose information that applicable SEC rules and regulations allow the preparer not to disclose. One example of the latter concern is the determination that a deficiency in internal controls is a significant deficiency rather than a material weakness. This may have been a critical audit matter, but under applicable securities laws and SEC regulations, a company may not have to disclose that deficiency. Finally, some skeptics wonder if the end result will be limited to "boilerplate," scrubbed clean by lawyers, that ultimately will not be helpful to investors at all.

Along with the proposed changes to the auditor's reporting model, the Board also proposed a standard governing the auditor's responsibilities regarding certain types of "other information" that is outside the financial statements but that is included or incorporated by reference in annual reports filed under the Securities Exchange Act of 1934. The proposed standard expands the auditor's responsibilities from "read" and "consider" as required under the current auditing standard (AU sec. 550) to require the auditor to "evaluate" whether the other information contains (1) a material inconsistency with amounts or information, or the manner of its presentation, in the audited financial statements and/or (2) a material misstatement of fact. The auditor's responsibilities are limited, however, to basing this evaluation on relevant audit evidence obtained, and conclusions reached during the audit. In other words, if the auditor, through the performance of the financial statement audit or audit of internal controls, did not gather information or evidence against which to evaluate the consistency or truthfulness of the "other information," the auditor need not go further.

So far, the Board has received some support for this proposal by those who believe that it will enhance the assurance provided by auditors on information related to the financial statements. Others have suggested that the proposal may cause confusion about the extent of additional procedures auditors are required to perform and that it may needlessly drive up audit costs. We have also heard that the proposal, if adopted, may widen the expectation gap between auditors and investors, because investors may believe auditors are providing more assurance on "other information" than they actually do.

As you can see, there are important issues involved with these proposals that will affect not only auditors, but also their clients. I urge you to let us know what you think; the comment period ends on December 11.

A second proposal that has received some attention recently is our "transparency" project which involves disclosure of the name of the engagement partner and the names of the other firms used by the signing firm to assist with parts of the audit. We issued a proposal in October 2011 that would have required the disclosure of this information in the audit report. Later this year, the Board will consider a staff recommendation to re-propose this standard in order to seek additional comment and feedback, particularly with respect to the potential consequences of the requirement.

It is hard to be opposed to transparency, and I noted in connection with the proposal two years ago that investors want, and may benefit from, this information. Since our proposal, we have heard from many investors that completing this project is long overdue. Some preparers have told us that identifying the audit engagement partner is similar to — and no more objectionable than — a financial executive having to sign the annual report pursuant to SEC regulations. But others have opposed the project for a variety of reasons, including a potential increase in liability to the engagement partner or firms that would be identified, a lack of context about the engagement partner's role versus the role of the firm, and concern about the potential costs imposed if partners feel compelled to perform more audit work as a result of the potential disclosure and fear of liability. Another fundamental question raised by the different views of commenters is whether the proposed disclosures are intended to provide merely information for investors or whether they will enhance the accountability — and therefore diligence — of engagement partners and other firms.

As you consider whether to comment on the re-proposal, once it is issued, perhaps think about the following: (1) What challenges will you face in obtaining expert "consents" to include in your SEC filings, both from your engagement partner and from the firms around the world that participate in your audit? (2) What are the potential costs to you, the preparer, arising out of the proposed new requirements. Will audit costs increase as a result? (3) Are your shareholders asking for this information, and how will they use it? (4) Are there other ways to achieve the transparency goals of this project?

Let me turn now to another new project, Audit Quality Indicators, that we began about a year ago. This project is related to two questions that I — and others — have asked over time:

  • First, while our inspections are good at highlighting what auditors are doing wrong, have we been able to pinpoint what the engagement team on an audit without deficiencies and firms with clean inspection reports are doing right?
  • And second, how do we know if things are improving in the audit profession? In other words, how do we know whether the PCAOB's regulatory activities have had any positive impact on audit quality?

The answer to both of these questions requires us to be able understand what factors contribute to high quality audits and identify what can be measured. Our Office of Research and Analysis began tackling this question by working on identifying audit quality indicators. This project is focused, in its early stages, on defining audit quality, establishing a framework for thinking about audit quality, and developing specific, quantitative indicators that, ultimately, may be used as objective measures of audit quality, allowing for comparisons and trend analyses of audit firms as well as audit engagement teams. The Board and the staff of the Office of Research and Analysis have discussed this project with our Standing Advisory and Investor Advisory groups and have obtained valuable feedback. Although we see this project as a marathon, rather than a sprint, it could have wide-ranging implications on many of our activities if successful. Measurable indicators of audit quality may provide important information to investors trying to assess risk, audit firms trying to monitor or improve the quality of their work, or audit committees trying to evaluate the performance of their current auditors or the proposals of potential future auditors.

We hope to issue a concept release in the coming months to seek comment on a list of potential audit quality indicators that seem to show the most promise. We hope that all of you will review this document, and that you will provide us your views on whether this project is a good idea, whether the contemplated indicators are appropriate, and what additional steps the Board should take in connection with this project. Perhaps talk to your audit committees about whether and how they might benefit from quantitative and measurable audit quality indicators and whether they have any concerns about potential unintended consequences that could arise as a result.

And while I am on the topic of audit committees, the Board considers audit committees an important complement to our audit oversight activities. As you know, pursuant to the Sarbanes-Oxley Act, audit committees are charged with hiring and firing the auditors. While regulatory activities like inspections, enforcement and standard setting can and should drive improvements over time, audit committees — equipped with relevant information about how to evaluate the quality of work by auditors — are a powerful market force that can and should drive improvements in audit quality through market incentives. It is for that reason that the Board also has made outreach to audit committees an important priority. We are talking to audit committee members whenever we can, to determine how we can best help them enhance their oversight over audit firms. It is clear that the audit committee members with whom we engage take their role seriously, and some spend significant time discharging their responsibilities. But we also hear that not all audit committee members are performing at the level the Act envisioned.

In one recent effort to ensure that audit committees receive important information about the audit, the Board issued a new standard, AS 16, governing the required communications between auditors and audit committees.[2] This standard is intended to improve the quality of audits by providing both auditors and audit committees with information they need to discharge their respective responsibilities. The standard is effective for the audits of 2013 financial statements, and we look forward to learning about how its implementation has been received by auditors, audit committees, issuers and others.

In addition, in August 2012, we issued a release to provide information to audit committees about the Board's inspection process and the meaning of reported inspection results in order to help audit committees understand the context and meaning behind our inspection reports.[3] The objective of the release was to better equip audit committees to engage in meaningful discussion with audit firms about the process, results and context of PCAOB inspections.

In addition to providing better information to audit committees, the Board also is interested in fostering a better two-way dialog with audit committees so that we can hear more about what they do and what is important to them. We are interested in hearing from audit committees their perspectives on our standards and oversight activities intended to improve audit quality, so we have had discussions, through our Standing Advisory Group and in other forums, to understand how we can best reach audit committee members and what their interests are. We are working on changes to our website to make it easier for audit committee members to find relevant information. We have actively reached out to corporate governance organizations to increase participation by PCAOB Board members and staff in conferences and other events that are targeted toward audit committee members. We are letting audit firms know that we are interested in a dialog with their clients, such as by attending firm forums for audit committee members.

Finally, having discussed some of our currently active projects, let me turn to a few things on the radar screen that you will hopefully hear more about in the near future. There are some important areas in which existing audit performance standards — many of which were adopted by the profession many years ago — need to be updated or replaced. One of these areas is fair value and estimates, where we need to address both the audit procedures that an auditor should perform as well as the degree of supervision an auditor should exercise over a specialist engaged by the auditor to assist in evaluating fair values or estimates. We currently have projects on our standard setting agenda for both estimates, including fair value, and supervision of specialists, so I am hopeful that you will hear more about this important area from the Board in the next twelve months.

A project that is not yet on our agenda but that I am hoping we will tackle soon relates to revenue recognition. As you have heard at this conference, the Financial Accounting Standards Board and the International Accounting Standards Board are very close to completing their joint project to issue updated standards that will fundamentally change the basis for revenue recognition. It is my hope that the PCAOB will soon devote substantial resources to an audit standard project in this area, given that revenue is probably the single most important number to investors. Initially, I believe we should provide guidance on how our standards may be applied to the new revenue recognition model and the transition from the current standards to the new standard. It may be, however, that we ultimately need new standards with a holistic approach to the auditor's responsibilities for auditing revenue under the new accounting standards.

Let me close by thanking you all for your commitment to the accounting profession and high quality financial reporting. Many of you started your careers as auditors. I look back at the situations I faced over the years as an auditor and believe it is more challenging today than ever. Those challenges include keeping investor interests first, attracting and retaining talent, the need to perform high quality audits of increasingly complex and subjective financial statements, and providing appropriate work-life balance. I am directly asking firm leaders what they are doing to ensure their audit teams have the resources to perform a quality audit. An overworked and exhausted audit staff, manager or partner cannot perform the job investors and audit committees expect. The same can be said for you on the front line of financial reporting.

With that, thank you again for listening, and I am happy to take any questions that you may have.

[1] See Section 101(a) of the Sarbanes-Oxley Act, as amended.

[2] See Auditing Standard No. 16, Communications with Audit Committees; Related Amendments to PCAOB Standards; and Transitional Amendments to AU SEC. 380, PCAOB Release No. 2012-004, PCAOB Rulemaking Docket Matter No. 030 (August 15, 2012).

[3] See Information for Audit Committees about the PCAOB Inspection Process, PCAOB Release No. 2012-003 (August 1, 2012).

 

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