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 Statement on the Reproposal on Improving Transparency Through Disclosure of Engagement Partner and Certain Other Participants in Audits

DATE: Dec. 4, 2013
SPEAKER: Jeanette M. Franzel, Board Member
EVENT: PCAOB Open Board Meeting
LOCATION: Washington, DC

Before the Board today is a two-part proposal that addresses long-standing calls from investors and other stakeholders for the Board to require disclosure of (1) the name of the audit engagement partner on the most recent public company audit through the partner's signature on the audit report or through identifying the partner in the report and (2) the names, locations, and extent of participation of certain other accounting firms and persons who participated in the audit but are not employed by the principle auditor. The reproposal before us today would require audit firms to disclose, in each audit report on a public company or broker-dealer, both the name of the engagement partner (but not a signature) and the names, locations, and extent of participation of certain other firms and the extent of participation of certain other persons participating in the audit.

I am pleased that we are today considering a reproposal instead of an adopting release, as originally planned earlier this year. In my view, a number of fundamental questions remain to be addressed before we can reach a conclusion about any final standard in this area. I look forward to input in the comment process so that these fundamental questions and issues can be analyzed and considered by the Board.

Disclosure and transparency are vital to our financial reporting system. Robust disclosure is the cornerstone of U.S. securities regulation and supports efficient capital formation and allocation; mandatory disclosure and transparency can be an effective regulatory approach to addressing an identified need or problem. I fully support disclosure and transparency that will provide investors with information needed to make informed investment or voting decisions, reduce information asymmetry, and promote responsible and accountable behavior on the part of individuals and organizations.

The key questions surrounding this proposal are whether and how additional transparency about the identities of engagement partners and other participants in audits would solve a particular need or problem, serve appropriate policy objectives, achieve certain benefits, and impose compliance or other costs. Frankly, it is surprising that we are at this point in the standard-setting process with such basic questions still unanswered.

Disclosure of the Name of the Audit Engagement Partner

The first provision of the proposal would require disclosure of the name of the audit engagement partner in the auditor's report. Since the Board began exploring this issue in 2005, and through its various advisory group meetings and two public releases, the identified objectives of this aspect of the project have shifted, making an evaluation of the relevant evidence and alternative approaches difficult with only the information that we have gathered so far.[1]

The Board first explored the approach of requiring partner signature on the audit report with an objective of improving audit quality, by both providing information (partner name) to investors who could influence the selection of auditors and by incentivizing auditor behavior (through signature and identification) by increasing their sense of personal accountability.

Today's release states that the primary benefits of the current proposal pertain to disclosure, or transparency. The release also suggests that such disclosure may create an incentive for auditors to voluntarily take steps that could result in improved audit quality. Whether disclosure of a partner name would increase audit quality through increased accountability seems to be an open question, despite what we heard, as recently as a few weeks ago, from members of the Board's Investor Advisory Group who said an enhanced sense of accountability is their primary continuing interest in obtaining an engagement partner's signature on the audit firm's audit report.[2]

Today's release does not explain why the Board has changed its objectives for the reproposal from accountability to disclosure of useful information for investment decisions (as names are collected over time and combined with other unspecified information). And, with those changed objectives, the Board is now in a position to surmise how, or hope that, such information may be compiled and made useful over time. Thus, we find ourselves in the position of asking basic questions in the reproposing release that would be expected in a concept release or an initial proposal, such as whether naming the engagement partner would be useful, how it would be useful, and whether and what might be the related costs, including that of the potential for increased liability.

As a result of our current lack of data and analysis to provide answers to the above questions, many of the conclusions reached in the release are based on speculative "beliefs" and, therefore, I cannot agree with them.

Many of those conclusions are attributed to the Board. For instance, throughout the release, numerous statements indicate that the Board "believes" that disclosure of the partner name would or could provide useful and valuable information to investors.[3] The release speculates on various ways that investors would find useful the names of engagement partners when connected with other data, including how they could research such information, "combined with other information over time," to add to the "potential limited initial usefulness" of the identifying information.[4] The release states that the "reproposed amendments are designed to provide investors and other financial statement users with information the Board believes could help them evaluate the quality of individual audits."[5] Other statements in the release suggest that the amendments would make the market for audit services "more competitive and efficient because investors are better able to discern between audit firms" and over time, "…this could promote competition in the audit industry and could lead to more efficient allocation of capital."[6]

I'm starting to think that naming the audit engagement partner in the auditor's report is a solution in search of a problem. First, as I said, the objectives of this project are difficult to follow over its various iterations. Second, the current release does not articulate how the proposed solution addresses any particular problem; nor does it present an analysis of benefits that is supported by data. Finally, many questions remain unanswered about the potential costs and exposure of auditors to additional liability.

Still, I am open to the concept of improving disclosure and transparency by naming the engagement partner, and to our using this reproposal process as the basis for gathering information and conducting a solid analysis of the proposal's objectives, benefits, and costs.[7]

For example, after receiving additional input and data, and to the extent that we continue to focus on requiring disclosures with an objective of providing information for investor decisionmaking, we will need to analyze the following basic questions related to this proposal:

  1. How is disclosure of the audit partner name material to investors within the overall financial system of disclosure?
  2. Is the disclosure timely and sufficient to achieve the objectives?
  3. Is the disclosure sufficient for appropriate interpretation — or is other contextual information needed first? Or is the meaning of the information likely to be obscured or confused because other information is unavailable?
  4. What are the costs and the potential adverse impact of providing the information?[8]

We also need to explore more fully and transparently our specific policy objectives through this project, including strengthening accountability and improving audit quality. To the extent that the Board focuses on any accountability aspects of the project, a different type of analysis would be needed. If the objective is to enhance audit quality, the Board should consider in its analysis its other projects and initiatives related specifically to that objective, such as whether and how the performance of engagement partners and other participants in the audit is situated among the indicators of audit quality currently being assessed by the Board.

Naming of Other Firms Participating in the Audit

In my view, the Board has a better supported case for the second part of this reproposal, which would require naming certain other firms that participate in the audit and disclosing the extent of participation by certain other persons. My views are based on the information and analysis supporting this aspect of the project, information gathered through the course of the project, and the consistency of this provision with the overall oversight approach taken by the PCAOB in seeking audit firm-level accountability.

Presently, only the primary audit firm is named in the audit report, even though other firms may contribute significantly. Requiring disclosure of the names of other firms may be useful to investors, particularly if these firms are in jurisdictions where the PCAOB is currently prevented from conducting inspections or investigations of these auditors.

In light of PCAOB's oversight responsibilities, the Board has deemed it in the public interest to provide investors and others with information about those jurisdictions where the PCAOB currently is prevented from inspecting U.S.-related audit work. Investors or potential investors in U.S. capital markets who rely on the audit reports of PCAOB-registered firms in those jurisdictions are deprived of the potential benefits of PCAOB inspections of these auditors. As a result, the PCAOB publishes and regularly updates a list identifying each issuer whose PCAOB-registered primary auditor is located in a jurisdiction where obstacles to PCAOB inspections exist. If, however, an audit firm in a country that does not allow PCAOB inspections participates in part of a public company's audit, the investing public has little or no transparency into that relationship. For example, a global company with some operations in China may use an audit firm that contracts with an affiliate or local company based in China to audit those operations. Under this proposal, the affiliate or local company would be named if the work is more than 5 percent of total audit hours.

As today's release acknowledges, some disclosures about other firms' participation in an audit are currently required under PCAOB rules. Audit firms that play a substantial role in an audit (generally, performing material services for which the engagement hours or fees constitute 20 percent of more of the total engagement hours or fees, or performing a majority of the audit work on certain subsidiaries or components[9]) must register with the PCAOB and identify in their public annual reports to the PCAOB (Form 2) those audits in which they played such a role; but this reporting requirement is limited to firms that do not otherwise issue public company audit reports.

These disclosures do not include the identities of all firms or extent of participation of non-firm persons participating in an audit and they occur through a separate PCAOB reporting process. Providing the disclosure of such information in an audit report is generally supported by information and analysis that we received during the course of the project, although the reproposing release again speculates about how, over time, investors and others would use such disclosures in combination with other information to be compiled.[10]

Fundamental questions remain regarding this proposal also. For instance, today's reproposal calls for disclosing information about other participants in the audit if the contributions of those persons exceeded 5 percent of the total hours in the audit. Some of those firms that meet the threshold for disclosure in this proposed standard may not be registered with the PCAOB or subject to PCAOB oversight if they do not meet the threshold for playing a substantial role in the audit and do not perform other audit work that is within PCAOB's oversight. In those cases, would disclosure of information about those firms provide useful information for investors? In addition, what are the costs and logistical implications for the lead audit firm in obtaining the legal consents needed to disclose information about other firms? What would be the consequences to the issuer and the lead audit firm if consents were not provided by the other firms participating in the audit?

"Uncertainty" About Potential Liability Implications

Finally, there are unresolved liability issues to consider. Under current law, both the audit firms that issue audit reports and, to varying extents, the individuals and other organizations that participate in the audit, can be held accountable for their work under a variety of legal theories by injured private parties as well as by regulators, such as the SEC and the PCAOB.

Audit firms that issue audit reports on public companies and broker-dealers, and those that play a substantial role in those audits, must register with the PCAOB and file certain reports with the Board. These audit firms and persons associated with them, including engagement partners, engagement team members, and engagement quality reviewers, are subject to PCAOB oversight through its inspection and enforcement programs.

Here again, the reproposal recognizes "possible increases" in exposure of audit firms and engagement partners to third-party liability, including possible "uncertainty" over liability of other participating audit firms under section 11 of the Securities Act, but contains conclusions without conveying detailed supporting information or analysis. It contains a discussion of the potential liability implications of the proposed disclosure approach, and states an unexplained conclusion that "…the Board believes that any possible increases in a named engagement partner's or participating accounting firm's exposure to liability should be limited and that the potential risk of such an increase would be justified by the potential benefits to investors and other financial statement users of greater transparency."[11] The reproposal also goes on to state that the "fact that the engagement partner would be subject to Section 11 liability, however, might provide investors with some additional comfort about the engagement partner's work on the audit."[12]

The reproposal does not fully explain the relevant factors, such as the potentially conflicting precedents in recent case law related to the existence of potential liability under section 10(b) of the Exchange Act. Nor does it fully explain the evidence and theories — for and against — related to the potential financial costs of the exposure to additional liability. With respect to the potential costs, the reproposal repeatedly concludes with assumptions about costs associated with additional liability in terms of their likelihood and assumptions about the SEC filing process.

The reproposal recognizes the need for additional evidence and includes extensive and detailed questions to solicit such evidence from commenters. I encourage commenters to share their views and any additional available evidence relevant to the benefits and impact of the alternatives considered by the Board.

Alternative Approaches

In my view, the reproposal does not contain a robust evaluation of alternative approaches to responding to calls from investors and investor advocates for engagement partner signatures and information about key participants in the audit. For instance, is the audit report the proper place for disclosures of the audit engagement partner name and other participants? Is additional context needed for this information to be valuable? Would the information be more useful to investors if placed in the audit committee report in the proxy statement along with additional context about the audit committee's oversight of the audit? Since the release emphasizes that identifying information about participants in the audit is useful in the context of other available information, how soon will all the relevant information be available in an appropriate form? Alternatively, would this information be better placed in a user-friendly application on the PCAOB's website? The Board originally proposed to require audit firms to disclose the name of the engagement partner for each audit report in their annual reports filed with the PCAOB (Form 2). As noted in the proposing release, doing so "would make this information available in one place that could be easily retrieved since such reports are posted on the Board's website."[13]

I encourage commenters to share their views on possible alternatives to responding to investors' calls for this information and on the factors that would be relevant to assessing the relative merits of various alternatives. We need to consider these issues in a holistic manner, across regulatory jurisdictions.

***

The reproposing release before us asks 25 detailed questions on a variety of aspects of the reproposal, including questions about whether the information that would be disclosed would be useful to investors: and, if so, would it be useful in ways that the reproposal predicts? Would it increase the sense of accountability of participants in the audit process and have an effect on audit quality and competition, and would there be additional liability concerns?

I am concerned that commenters are being given only 60 days to consider such a large number of fundamental questions, especially as we approach the holiday season, and public companies, their audit committees, and auditors also prepare to enter the "busy season" of financial reporting and auditing. At the same time, I believe this reproposal can provide an opportunity for them and for investors and other stakeholders to clarify these matters.

I would like to thank the staff for their hard work in developing this project for reproposal and for asking detailed questions in the release that address the many fundamental issues before the Board today.

I support an exploration of the issues surrounding the potential disclosures discussed in the release so that a proper analysis can be performed to support an appropriate outcome.

[1] The original discussion of this issue in 2005 was part of a broader discussion by the Board's Standing Advisory Group about how to make audit reports more informative. Now, contrast the statements made in "Concept Release on Requiring the Engagement Partner to Sign the Audit Report," PCAOB Release No. 2009-005, July 28, 2009, at 5-7, and "Improving the Transparency of Audits," PCAOB Release No. 2011-007, Oct. 11, 2011, at 3, 9-10, 14, 17, and 19-22, with those made today in PCAOB Release No. 2013-009, at 2-3, 5, 11-13, 19-20, and 27-28.

[2] The transcript of the Oct. 16, 2013 discussion of the IAG is available at http://pcaobus.org/Rules/Rulemaking/Pages/Docket029.aspx. Today's reproposing release acknowledges these views, but then cites to some academic research that "leaves open the question" of such "benefits" and asks questions of commenters to solicit further opinions and evidence. PCAOB Release No. 2013-009, at 5, 29, and 42.

[3] PCAOB Release No. 2013-009. See statements on pages 2, 4, 5, 7, 12, 13, 14, 21, 27, 32, 34, A3-3, and A3-5.

[4] Ibid, at 11-12, A3-3.

[5] Ibid, at 27. In addition to speculating about how investors could compile and make use of such information over time, as I just noted, the reproposing release asserts that "by adding granularity to the information about who performed the audit of a particular company, the differentiated information clarifies distinctions between investment alternatives and can empower investors to pursue their investment strategies more effectively." Ibid. at 28. The release then proceeds to cite, as supporting "empirical evidence," limited academic working papers showing a degree of correlation between certain audit quality indicators of engagement partners and stock prices of certain companies. Ibid. at 28-29.

[6] Ibid at 28.

[7] Page 26 of today's release notes that the disclosure requirements of the reproposal would apply to audits of broker-dealers "for similar reasons as the audits of issuers," but does not explain how broker-dealer customers would use the disclosed information in the same way as public company investors.

[8] Further, the Board should undertake this analysis in connection with its other proposal to modify the standard audit report, to which each of these questions is equally relevant. See PCAOB Release No. 2013-005, Aug. 13, 2013. As described in the Board's proposing release, these projects originally began as a single effort.

[9] See PCAOB Rule 1001(p)(ii).

[10] PCAOB Release No. 2013-009, at 20.

[11] PCAOB Release No. 2013-009, at 21.

[12] Ibid, at 22.

[13] PCAOB Release No. 2011-007, pg. 5.

 

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