I am pleased to have the opportunity again this year to address the AICPA’s Conference on SEC and PCAOB Developments on behalf of the Public Company Accounting Oversight Board. In fact, I am particularly pleased this year, because, last year, just a few hours before my presentation at this conference, the Supreme Court heard argument in a case challenging the Board’s Constitutionality and seeking to put us out of business. However, reports of our death were exaggerated. The Supreme Court's decision, issued last June, essentially upheld the Constitutionality of the Board and kept us in operation. Otherwise, my PCAOB colleagues and I wouldn’t be here today and the AICPA would have had to change the name of this event back to just “SEC Developments.”
While the Board has put behind it the uncertainty of whether the Supreme Court would require a change in its structure, we are now facing a new kind of change – in our membership. The SEC will likely soon appoint three new members to our five-member board. Those new members – who will constitute a new Board majority -- will face a host of challenges – many of which could not have been anticipated eight years ago when the initial group of Board members opened the PCAOB’s doors for the first time.
I thought it would be useful to spend a few minutes this afternoon outlining some of the things the Board has done since our near-death experience in the courts. I will then turn to three items that will be on the 2011 agenda for the new Board. Of course, my views are solely my own, and do not reflect those of the Board or its other members or staff. But, I think I am safe in saying that the issues that the newly-constituted PCAOB will be dealing with in 2011 are likely to have significant effects on those of you who audit SEC filers or who are involved in public company financial reporting.
Accomplishments in 2010
I want to begin with a few highlights of what the Board has done in 2010. Let me first turn to our inspection program.
Inspecting firms that audit SEC-reporting public companies is the Board’s core function. So far this year, the Board has conducted 237 inspections, including 58 outside of the United States. In these inspections, PCAOB inspectors reviewed portions of more than 900 audits.
In September, the Board issued a report that provides insight into what we are finding. That report discusses examples of audit deficiencies inspectors uncovered during the past three years related to the impact of the economic crisis. The areas identified are those you might expect, including deficiencies in the auditing of such things as fair value measurements, especially of financial instruments; impairment of goodwill, indefinite-lived intangible assets, and other long-lived assets; allowance for loan losses; off-balance-sheet structures; revenue recognition; inventory valuation; and income taxes.
In my view, the report neither shows that audit failures caused the financial crisis nor that better auditing could have prevented it. What it does show is that the major firms must do a better job in adjusting to emerging audit risks as economic conditions change so that investors will have reliable information about the performance and financial position of public companies under economic stress. I think the report also illustrates the challenges that changes in accounting principles, such as those related to fair value, have posed for auditors.
Next year, the inspection program will focus again on many of the same issues. We will also be looking at how fee pressures affect audits. It has been widely reported that audit committees are expecting auditors to share in the economic pain that companies are feeling by agreeing to fee reductions. This is occurring at a time when the same economic conditions are adding to the complexity of the audit. There is an obvious risk that the result will be declining audit quality. The Board needs to understand how fee reductions affect audit performance and, where we find audit deficiencies, whether they are the result of the pressures of a reduced budget.
Both the economic crisis inspections report and the focus on the impact of fee reductions underscore the importance that the Board’s inspection program places on identifying root causes of audit deficiencies. We have moved beyond simply trying to detect discrete audit break-downs and then asking for evidence that specific steps have been taken to prevent a recurrence. But firms, particularly the largest, need to be out in front of the Board on this effort. That may require some firms to change the way they manage their practices or to develop stronger tools to exert control over how individual partners approach their work.
B. Auditing Standards
Next, I want to say a few words about PCAOB standard-setting. 2010 was a busy year for the standard-setting group. In particular, the Board adopted eight new standards that provide a foundation for considering risk in the planning and performance of public company audits. The risk assessment standards are designed to better integrate consideration of fraud risk throughout the audit and to dovetail with the risk assessment inherent in internal control auditing.
Other important projects are underway. During 2010, the Board issued a concept release discussing the possibility of requiring firms to make and document clear assignments of the supervision responsibilities that are already required to be part of any audit practice. I see this as part-and-parcel of the ongoing effort in our inspections program to get at the root causes of audit failures, since effective supervision is clearly one of the keys to consistent audit quality. In 2010, the Board also proposed a new standard on auditor communications with audit committees and an update to bring the standards relating to the use of confirmations into the digital age.
The Board’s Chief Auditor, Marty Baumann, will lay out the 2011 standard-setting agenda in a few minutes. However, I want to mention one longer-range project – creating a codification of the PCAOB’s auditing standards. We have now issued 15 standards, and those standards supersede significant parts of the AUs. As a result, practitioners who need to find the standards applicable to public company audits have to jump between the remaining AUs and the Board’s standards. A well-organized topical codification would make that easier and would also simplify the task of identifying the similarities and differences between the Board’s standards and other auditing standards, such as the international standards. Codification, as the FASB’s project illustrates, is not a simple undertaking. It is, however, inevitable, and I hope we will start down that road next year.
The Board's Enforcement Division has also been very active in 2010. I will give you a glimpse of the Division’s work, and Claudius Modesti, the Director of the Division of Enforcement and Investigations, will fill in more details later in the program.
So far this year, the Enforcement Division has opened 27 formal and informal investigations. These inquiries include a mix of both large and small firm matters. The Board has publicly announced settlements in seven disciplinary proceedings, and the SEC has released one final opinion in a Board enforcement case that was appealed to the Commission. In addition, the Division is actively litigating a number of nonpublic, contested proceedings involving alleged audit deficiencies or other violations of the Board’s rules.
As the settlements we have announced show, our enforcement cases involve serious violations of our rules and standards and serious deviations from the public’s expectations of the auditing profession. However, under the Sarbanes-Oxley Act, ongoing, litigated enforcement proceedings are nonpublic until a sanction is imposed. In fact, non-public proceedings create a considerable incentive to litigate, rather than settle. Litigation postpones -- often for several years -- the day on which the public learns that the Board has charged an auditor or a firm and the nature of the charges. For example, one firm issued 29 audit reports on public company financial statements between the commencement of the Board’s proceeding and public disclosure of the Board’s charges, which only occurred after the SEC affirmed the Board’s decision to bar the firm from public company auditing.
I do not believe that investors, the general public, or the profession are well-served by enforcement that occurs behind closed doors. This summer, the Board asked Congress to amend the Sarbanes-Oxley Act to make Board enforcement proceedings public, once the investigation is complete and the Board has approved the charges. I can’t predict whether or when Congress will act on that proposal, but I believe that a legislative fix is the only effective approach to enhancing transparency regarding Board enforcement and is squarely in the interest of both the public and the profession.
Agenda for the 2011 Board
That is the end of my quick trip through some of the highlights of 2010. I want now to turn to the future and some thoughts about the 2011 agenda. While I could extend that list well into the rest of the afternoon, I am going to limit myself to three topics.
A. Broker-Dealer Audits
One of the major tasks next year will be implementation of the Board’s new responsibility for auditors of broker-dealers. The Dodd-Frank Act gave the Board authority over auditors of all SEC-registered securities broker-dealers. Those auditors had previously been required to register, but were not otherwise subject to Board authority. You might view this expansion of our mandate as one of Bernie Madoff’s legacies.
This new responsibility will have a significant effect on our work. There are about 5,200 broker-dealers. In the past two years, over 500 accounting firms have registered with the Board because they audit broker-dealers. In addition, many previously-registered firms that audit issuers also have broker-dealer practices.
In the near-term, Board broker-dealer oversight will focus on three issues. First, the Board must create a broker-dealer funding system. The law requires that we allocate our operating expenses between issuers and broker-dealers on an equitable basis. Based on an estimate of next year’s costs, broker-dealers will be funding about seven percent of the Board’s 2011 budget. I expect that the Board will consider a proposal on the new funding system at an open meeting next week.
Second, the Board will need to develop auditing standards applicable to broker-dealer financial statement audits and attestation standards applicable to their compliance reports. The SEC recently issued an interpretive release advising the profession to continue to apply AICPA standards until the Commission engages in further rulemaking. I anticipate that the SEC’s rulemaking will begin soon and that the Board will propose standards in this area early next year.
Third, the Board must develop a broker-dealer audit inspection program. This will be a formidable task, since the broker-dealer population is diverse, and precisely what the objectives of the inspection program should be is not yet fully clear.
While there are a handful of mega firms, most broker-dealers are very small. Less than one percent -- 33 firms -- have net capital in excess of $1 billion. Those 33 firms hold over 80 percent of the net capital in the entire broker-dealer industry. At the other end of the spectrum, 70 percent of all broker-dealers have tentative net capital under $1 million. Collectively, those firms have less than 1 percent of industry net capital. As to activities, the pattern is similar. About 520 brokerage firms provide clearing or custodial services. Many of the others are introducing firms that, at least in theory, do not have access to client funds or securities. Some are floor brokers without public clients; some are insurance agents that sell products that are technically securities; some are finders active in the M&A market; some are captives that serve the trading needs of a single, affiliated client. Other categories undoubtedly exist.
This diversity raises questions about whether we should devote resources to inspecting the auditors of all of these categories of brokers and dealers or whether some of their auditors can safely be exempted from PCAOB oversight without compromising investor protection. As a step toward answering those questions, I anticipate that the Board will propose rules for an interim inspection program at an open meeting next week. That program would allow the Board to begin inspections with a focus both on reviewing audit work and on gathering facts to inform the Board’s consideration of a permanent program. The information-gathering aspect of the interim inspections will help the Board to decide on possible exemptions from oversight and to determine the nature and frequency of inspections for firms that remain subject to PCAOB jurisdiction.
B. Foreign Inspections
My second agenda item relates to non-U.S. inspections. In 2011, the Board will have to tackle the continuing obstacles to conducting inspections of the auditors of U.S. public companies in certain foreign jurisdictions. Robust oversight of audit work done in other countries is critical to the protection of U.S. investors, given that significant operations of many U.S. public companies are located beyond our shores.
To date, the Board has conducted 268 inspections of firms located in 34 jurisdictions. Many of those inspections were performed jointly with the local auditor oversight authority.
We cannot, however, conduct inspections in some important countries. Specifically, we are currently unable to inspect in China, the European Union, and Switzerland. We are in various stages of negotiation with these jurisdictions, and I hope that we will eventually open the doors to inspections in every country where there are firms that audit U.S. public companies. The Dodd-Frank Act gave the Board an additional tool in this regard by authorizing us to share information with our non-U.S. counterparts, removing one of the obstacles to agreement in some countries.
The Board took two steps this year in response to the foreign inspections problem. First, we put in place a disclosure regime so that U.S. investors understand what we can and cannot do. The Board’s website lists the countries in which we cannot inspect, the firms we cannot inspect, and the SEC-reporting companies whose audits we cannot inspect. Second, the Board announced that it will no longer routinely approve new registration applications from firms in countries where we are unable to inspect. The goal here is to prevent the pool of uninspectable firms from expanding.
I believe that it is becoming clear that the Board will need to explore additional responses. The Board, of course, has the power to bring enforcement proceedings against firms that refuse – or are unable -- to cooperate in inspections. Other steps also need to be considered. One approach would rely on disclosure. In 2008, the Board sought comment on whether to require a principal auditor that had not complied with an inspection demand due to non-U.S. legal restrictions to disclose that fact in its SEC-filed audit reports. Further, a principal auditor that used audit work of a non-U.S. firm that could not be inspected would need to disclose the identity of the uninspected firm, the nature of the work it had performed, and steps the principal auditor took to assure the adequacy of that work. These disclosures could provide important information to investors, who may not be aware that they are relying on firms that cannot or will not allow the Board to inspect them.
Another approach to the problem of uninspected non-U.S. firms would build on the fact that many of these firms are members of global networks that have affiliates in the United States or elsewhere that we can and do inspect. The Board could establish a system under which firms that cannot be inspected would have to arrange for their U.S. public company audit work to be supervised by a firm that can be inspected. This sort of "special supervision" would at least provide for indirect Board oversight of the uninspectable firm's audit work through inspections of the supervising firm.
Both the disclosure approach and the special supervision approach would raise some difficult issues in terms of our relationships with other regulators and in terms of the way cross-border issuer audits are conducted. I believe, however, that the Board needs to give serious consideration to both ideas.
Congress said quite clearly in the Sarbanes-Oxley Act that it expected the Board to inspect the audits of all companies, wherever located, that have chosen to raise money in the U.S. capital markets. If there are to be further delays in fulfilling that mandate, I think that it is incumbent on the Board to make sure in the interim it has done everything in its power to make sure that uninspectable audits are being properly performed.
C. The Auditor's Reporting Model
My final 2011 agenda item is revisiting the auditor's reporting model. From discussions with the Board's Standing Advisory Group, as well as with our Investor Advisory Group, it is clear that there is considerable investor hunger for more insight from the auditor into the audit process and the company’s financial reporting. Further, the 2008 report of the Treasury Advisory Committee on the Auditing Profession recommended that the Board reconsider the audit report. In addition, several influential bodies outside the United States, including the International Organization of Securities Commissions, the International Auditing and Assurance Standards Board, the European Commission, and the United Kingdom’s Financial Reporting Council are studying ways in which the auditor's report could be expanded.
The Board will have to make some difficult choices next year if it decides to change the time-honored pass/fail report. There is no shortage of ideas. During a discussion of the reporting model at our Standing Advisory Group meeting last April, some suggested that the auditor should provide more information about the audit itself and how it was performed. Others want the auditor's views on the management judgments embodied in the financial statements regarding such things as estimates and the selection of accounting policies. Auditors have proposed that their reports should be clearer about limitations on the ability to detect fraud. Some users have suggested expanding the auditor's current opinion to include new material; others have suggested that the pass/fail report should be accompanied by a separate auditor's report akin to the MD&A.
Of course, there is also no shortage of questions that these ideas raise. What standards would apply and what audit work would have to be performed if there are new auditor disclosures? Would the additional information be a free-writing exercise, or would there be standard reporting models applicable to particular circumstances? What liability would the auditor have if statements in these new reports proved to be inaccurate?
Expanding the substance of what auditors communicate to users is clearly an investor priority. Therefore, it should be a priority for both the profession and the Board. The Office of the Chief Auditor is currently conducting research, including focus group discussions, to explore reporting model alternatives. The staff plans to present its findings to the Board at a public meeting in early 2011. If the Board decides to proceed, the current standard-setting agenda contemplates a concept release in mid- 2011, followed by a public roundtable.
As I mentioned earlier, although the Board’s agenda for next year will have many more items on it, I am going to stop at three. I would, however, like to conclude by reminding you that the Board’s agenda has ultimately the same goal as does your day-to-day work.
More than half of American households invest their savings in securities to provide for retirement, education, and other goals. The auditor’s job is to protect these investors’ interest in accurate, complete, and fairly presented financial information by independently reviewing and reporting on management’s financial statements. Reliable financial reporting is one of the linchpins on which our capital markets depend.
Congress created the PCAOB to strengthen confidence in public company auditing and to serve as a counterweight to the pressures and incentives that sometimes make it difficult for auditors to perform their job. It is critical that the Board, as well as the auditing profession and preparers, not lose sight of their common objective – to foster and maintain confidence in financial reporting and further the interests of investors.