Enhancing Capital Formation, Investor Protection and Our Economy

Thank you for inviting me to speak today. It is a pleasure to participate in the 41st convening of this conference.

Let me begin by saying that the views I express are my own and should not be attributed to the PCAOB as a whole or any other members or staff.

It has been a busy year at the PCAOB. We have pressed forward on both near and long-term initiatives.

We used this year to take a hard look at how we serve the capital markets for the investing public, in light of our now ten years of experience. In several areas, we have developed and implemented refinements, such as identifying the need for and developing changes in standards. We've also re-examined our inspection process, resulting in both faster and more informative inspection reports. We have published remediation criteria, and brought current remediation determinations.

We are doing more in the way of outreach, especially to audit committees, with a view to help raise awareness of audit risks and challenges. We are also looking to the future, and in particular we are examining the role the audit can and should play in enhancing capital formation, investor protection and our economy.

The heads of several of the PCAOB's divisions and offices will speak in detail about these initiatives over the course of the next three days. I will use my time today to talk to you about the thinking behind these initiatives, and some of what you can expect to see from the PCAOB in the next year.

Economic success depends on the confidence of the users of capital and the providers of capital alike. Even in the simplest model of finance, a lender will not lend to one who would borrow, without information sufficient to persuade the lender that the capital will be returned. Interest is set based on the duration of the loan and the risk that it will not be repaid. Implicit in the size of the expected return — or, the cost of the capital investment to the recipient — is the risk that the funds will be misused, wasted or lost.

From derivatives traders to venture capitalists, sovereign funds to micro-financiers, they all assess the risk to their capital, well or poorly, based on the level of confidence in the information they have about the borrower and the borrower's prospects. The absence or inadequacy of information translates to more risk and a higher, perhaps impractically high, return.

The fact we have been able to develop large markets involving multiple millions of individually small and dispersed providers of capital does not mean that those providers need less information.

Rather, it is the flow of expertly vouched-for information that, when perceived as both relevant to investment decisions and reliable, gives uninformed, diverse and dispersed investors the confidence to participate in a market as great as that which we enjoy in the U.S.

Leveling the playing field for these investors — that is, investors who have no ability to collect information directly and trade on it exclusively — is indeed critical to developing and maintaining market liquidity and reducing funding costs to entrepreneurs and businesses.[1]

As sophisticated as our markets and economy are, they are dependent on trust. We cannot take trust for granted.

Independent audits provide that trust, and thus bridge the gap between entrepreneurs who need capital and lenders and investors who can provide capital.

Always angry when a fraud goes undetected, the public has trouble discerning the difference between one audit and another. With little information about particular audits, a conventional wisdom is gradually developing that the audit is largely irrelevant to the investment process today.

The initiatives I will discuss today are aimed at dispelling that notion, raising awareness about how critical the audit is to our economic success, and buttressing investor interest and confidence in it.

I. Robust Economic Analysis is Useful to Evaluating and Enhancing the Role of the Audit in Capital Formation and Investor Protection

Let me start with our announcement last month that the PCAOB is forming a new Center for Economic Analysis, under the leadership of the renowned University of Chicago economist, Luigi Zingales.

The purpose of the Center is, first, to advise us on how economic theory, analysis, and tools can be used to enhance the effectiveness of PCAOB programs. Second, the Center will promote economic research on the role of the audit in capital markets. Through the Center, I hope both to expand PCAOB staff skills, through enhanced access to economists in the development of analytical and other tools, and to bring PCAOB expertise to bear in economic research.

Under Professor Zingales's leadership, we hope to attract other top economists to develop research on the role of the audit in capital formation and investor protection.

Initial areas of work for the Center include —

  • Developing a baseline analysis of the role of the audit in financial markets today, including analysis of the structure of the auditing profession and the effectiveness of audits in facilitating capital formation and protecting investors;
  • Developing a program to evaluate the effectiveness of new auditing and professional practice standards in promoting reliable audits;
  • Developing the framework for an analysis of the role of the audit in promoting access to public markets for small enterprises; and
  • Developing the framework for an analysis of the effects of audit and financial reporting failures on financial markets.

This is one of several ways in which the PCAOB has been growing its economic expertise, especially over the last year. We have had economists deeply involved in the risk assessment work of our Office of Research and Analysis for years. In addition, we use economists in our standard setting program. These existing staff will work closely with the Center, which brings new resources for our existing staff to use.

At the PCAOB, the importance of adding skills and taking a broader analytic approach to the world of audit is part of our future. As the global economy has become more complex, the auditing firms have elaborated their business models, growing by acquisition of both audit and non-audit practices.

We have, in recent weeks, seen publicly reported examples of a resurgence of audit firms into consulting to bolster revenue.

Of what consequence are these developments for the audit function? What are the implications for independence of the audit function?

What will firm management do to meet the compensation and cultural challenges that destabilized Arthur Andersen?

How will firms avoid talent misallocation, with the best minds going to consulting at the expense of audit expertise and competence?

What will the effect of all this be on audit quality?

What is the capability of audit leadership to evaluate and manage other business lines away from audit?

What are the risks of other business lines and how do they affect resource allocation and investment in audit?

The PCAOB should focus the best minds on these types of issues. We need roundtables and task force attention on the implications of the regeneration of non-audit consulting at the global firm. The enhanced capacities of the Center for Economic Analysis, in concert with our existing staff, will provide invaluable resources for our analysis of these developments.

II. The PCAOB Has Refined Its Analytical Tools to Produce New Reports and Other Guidance Based on Insights from Inspections

We have also focused on further deepening our inspection analysis and improving the usefulness of our reporting. This involved stepping back after our first ten years to evaluate whether there are ways we could make the public part of our inspection reports more useful to markets.

The goal is not to make our issuer reports more technical, which could obscure the fundamental concerns at issue. We want to know how the public part of our reports are used by investors and their intermediaries — audit committees, investment analysts, and others. We want to know how we can make them more relevant and accessible to the audiences that use them.

Given that the vast majority of equity market capital goes to the largest companies with the most dispersed investors, we are continuing to focus on the presentation of our reports on the largest audit firms that serve them, and have changed the organization of the public portion of those reports, in order to make the reports easier to read.

We have also added information identifying the standards involved in the individual audits discussed and have provided an aggregation of the standards deficiencies in a tabular format. This should make it easier for academics and other analysts to identify and track trends.

In addition, the inspections division has been considering ways to deepen our analysis of inspection findings, over time and across firms, to provide insights about more latent audit risks and challenges. Those efforts have been, and going forward will be, reflected in what we call general reports.

Last week, we issued a Report on the Board's Observations Related to the Implementation of the Auditing Standard on Engagement Quality Review.

The point of an engagement quality review is to catch deficiencies in the audit much as our inspectors do on a selection of audits, but before the report is issued and thus before investors can be harmed by an unreliable audit opinion.

The PCAOB's report on implementation of these reviews found that firms' methodologies generally were consistent with the requirements of the PCAOB's standard on engagement quality reviews, Auditing Standard No. 7. But inspectors nevertheless found execution problems in such reviews.

A reviewer is required to perform certain procedures, following which the reviewer may provide concurring approval if he or she is not aware of a significant engagement deficiency. Significant engagement deficiencies are defined as failure to obtain sufficient appropriate audit evidence, an inappropriate overall audit conclusion, an inappropriate engagement report, or indications that the firm is not independent of its client.

A firm's reviewers may fail to identify a significant engagement deficiency because the reviewer did a poor job, or because the engagement team failed to provide the reviewer adequate information. When that happens, markets may be misled about the integrity of the audit.

The financial statements may or may not be wrong. But reliance on the audit report as the basis for confidence in those financial statements may be misplaced. The bond of trust is weakened.

Another general report we issued earlier this year, was a second annual progress report on the interim inspection program for broker and dealer auditors, as well as a report on the second three-year cycle of inspections of smaller domestic firms.

The report noted deficiencies in the audits of all of the firms inspected, and in 95 percent of the individual audits selected for inspection.

In addition, inspection staff found that, contrary to the requirements of SEC independence rules, some auditors were involved in the preparation of the financial statements that they audited. Inspectors identified that conduct in more than one-third of the audits selected for inspection.

The audits covered in these inspections were governed by AICPA standards, and clearly improvements in execution are needed even under these somewhat outdated standards.

In July, the SEC finalized its amendments to its Rule 17a-5 on broker-dealer reporting and related auditing and examination of those reports. In October, we then finalized the standards we had proposed to accompany the new framework under the SEC's rule. Those standards are now under SEC review and, I hope, will be approved early next year.

III. The Development of Standards

Turning to standard setting: there have been several developments this year. First, as I mentioned at the outset, we have engaged in an introspective review of our own processes we use to develop new standards.

The goal is to engage the resources of the PCAOB to think broadly and in depth about the future shape of the audit function and the future role and features of the audit profession in performing the audit.

Achieving this goal involves ongoing consideration of (1) the intrinsic significance of the audit, (2) the continuing public interest in the credibility of the audit, (3) the evolving expectations of the audit in the global economy, and (4) the implications of auditing and auditing standards for positively affecting conduct in the audited enterprise.

Late last year we began publishing a quarterly update of the staff's project work, with planned targets for Board action.

Outreach to obtain insights from experienced or affected groups is significant, even before Board action. That outreach can include a discussion at a public meeting of our Standing Advisory Group or other public forum. PCAOB staff may also prepare a consultation or briefing paper as a mechanism to solicit preliminary views and advice.

Economic analysis is also an increasingly significant part of our standard-setting program, from the earliest consideration of whether standard setting could or should be used to address a problem through development, proposal and adoption when standard-setting is the chosen tool.

Economic analysis can play a crucial, early role in defining critical policy questions and in developing and evaluating different approaches to addressing identified problems. When changing or developing a new standard appears to be warranted, economic analysis can also assist in identifying, evaluating, and comparing the advantages and disadvantages of different standard-setting approaches.

Earlier this year, the Board also proposed a reorganization of PCAOB auditing standards. The reorganization would integrate standards adopted since the PCAOB came into existence with the AICPA standards in place when the PCAOB began, which the Board adopted as its interim standards. The reorganization sets forth a more logical structure for the overall, resulting body of standards, including by eliminating material that is no longer relevant.

We asked for comment on the reorganization. After considering the comment, I expect we will finalize it in 2014.

A. Auditing Related Party Transactions

The Board also reproposed in 2013 a new auditing standard and related amendments to strengthen auditor performance requirements in three critical areas: (1) related parties, (2) significant unusual transactions, and (3) a company's financial relationships and transactions with its executive officers.

These critical areas have been a contributing factor in a skein of prominent financial reporting scandals that have resulted in significant investor losses as well as the loss of jobs at affected companies. Despite such scandals, inspectors continue to see execution problems when auditing these areas. Further, there is considerable variation in practice today.

To promote audit quality, the reproposal introduces new procedures, while retaining and strengthening many existing procedures already familiar to auditors. Some of these new procedures appear to be contemplated in many audit firms' methodologies as best practices, many auditors having recognized that such procedures are warranted in view of the high risks of material misstatement in these critical areas.

The new standard and amendments should raise awareness about the risks associated with these three critical areas among all PCAOB-registered firms, and improve compliance throughout the profession.

We are now evaluating comments received. I expect the Board to consider a final standard and amendments early next year, with the goal of it being applied in audits of financial statements for fiscal years beginning on or after December 15, 2014.

B. The Auditor's Reporting Model

This past summer, the Board also proposed the first significant changes to the auditor's reporting model in more than seventy years. Investors have long called for more informative, insightful and relevant audit reports. They asked us to find ways to give investors more value from the audit.

The proposal is based on considerable outreach to investors, auditors, preparers, academicians and others, on what kind of changes would be most useful and achievable.

It provides a framework to report critical audit matters, which keeps the auditors in their area of expertise — the audit. The proposal would also require auditors to report on their evaluation of certain other information, besides the financial statements, such as the company's annual report and management's discussion and analysis. The proposal retains management's responsibility for the financial information.

The proposal presents, in my view, a coherent, intellectually rigorous and disciplined analytical model, designed to promote more useful reporting to the public.

The comment period will close on December 11. We're also closely following the International Auditing and Assurance Standards Board's proposal on this topic. And once we've had a chance to assess comments, we intend, in 2014, to hold a public meeting, with invited commenters and other witnesses, to discuss potential ways forward.

C. Audit Transparency

Just last week, the Board reproposed a new standard on transparency, which would require audit firms to disclose the name of the engagement partner as well as the names of other firms that participated in the audit.

Investors have long asked for the names of engagement partners to be disclosed, in order to give them more information about the auditor.

The disclosure would require no new work by the auditor. Yet as with previous accountability reforms like it — such as Sarbanes-Oxley's requirement that CEOs and CFOs personally certify their company's financial statements and internal controls — it holds the promise of improving audit quality by sharpening the mind and reminding auditors of their responsibility to the public.

Auditors in other jurisdictions have long been accustomed to signing audit reports personally, even when those reports are also filed with the SEC in the U.S. Auditors in the U.S have expressed discomfort with disclosure, however.

Some have argued that engagement partners are already held accountable to multiple parties, including their firms, audit committees and even investors, and that firmwide quality controls already provide for consistent performance across engagements.

While we do find outstanding quality in some cases, inspectors also routinely find situations where firms' quality controls do not ensure consistently high performance, particularly in areas that have a pervasive effect on quality, such as professional skepticism.

And some quality control concerns can be particularly challenging to remediate, especially in very large firms with thousands of professionals. Indeed, skepticism appears to be one of them.

Inspectors have also found situations where engagement partners who presided over deficient audits were not held accountable but were even assigned more challenging engagements.

Indeed, over the years, the PCAOB's inspections and disciplinary matters have revealed that firms have not always given the critical task of engagement partner assignment the care it deserves. In many fields, disclosure — Justice Louis Brandeis called it "sunlight" — has given numerous fields and professions the information they need to see and then remedy a problem.

PCAOB inspectors have found that knowing the identity of a firm's engagement partners is a useful piece of data to assess the potential risk for deficient audits. PCAOB inspections are risk-based, and monitoring engagement partner audit work is one of our important indicators of risk. A number of our Part I findings — that is, the most significant audit deficiencies — are identified in audits where the partner assigned was one of the factors our staff used to make the selection.

In a perfect world, all firms would comprise exclusively exceptionally talented partners, each with a wide range of expertise. But we know that's not the case.

This is not a phenomenon unique to the audit profession. It's simply too much to ask the investing public to blindly trust that firms will not respond to the numerous, and potentially conflicting, staffing goals and constraints they face by, at least on occasion, assigning weaker partners than they might like to some audits.

Nor can the responsibility to select only the best engagement partner be placed at the feet of audit committees, unless we provide audit committees better information against which to benchmark. Diligent audit committees try to obtain information about, and pay careful attention to, a proposed engagement partner's history. But today most of that information must come from the very firm putting the partner forward. The lack of generally available information about engagement partners limits audit committees' ability to meaningfully assess and compare the partner's qualifications and experience.

I very much look forward to additional public comment and analysis. I believe it will help us get to the right answer.

There are a number of other projects on the PCAOB's standard setting agenda, at various stages of development. Based on the last decade of experience, we will take a new look at the standard on fraud, initially by convening an expert task force to provide advice. We will also review the existing quality control standards, again in light of our experience inspecting firms' systems of quality control.

We are also engaged in a research project to identify audit quality indicators that are both measurable and reasonably objective. Some might be process, or input-related, measures, such as the ratio of audit staff to partners on an audit. Others might be results, or output-related, such as the history of restatements or warnings about going concern, again providing information to help markets distinguish high quality audits.

* * *

I have merely touched on our programs. But in doing so I have tried to give you a sense of some of the most critical areas.

Helen Munter, the PCAOB's head of inspections, Marty Baumann, the PCAOB's Chief Auditor, and Greg Jonas, the PCAOB's Director of Research and Analysis, will speak to these projects and more over the next two days. Let me just say that they are all focused on improving auditor performance and helping the audit regain its relevance to markets and investors by meeting their needs, including for new information about the audit in order to foster renewed confidence in its reliability.


[1] R. Rajan & L. Zingales, Financial Systems, Industrial Structure, and Growth, at 5 (paper prepared for the Symposium on the International Competiveness of the Swedish Financial Industry organized by the Bank of Sweden Tercentenary Foundation, 1999). The authors explain that —

[e]conomic theory suggests that a market becomes liquid when, somewhat counter-intuitively, there are a large number of uninformed investors willing to grease the wheels of trade. This is because when a market consists only of informed, experienced traders, everyone is trying to second-guess the counterparty's information from the way they trade, and few trades take place. The reasoning is "if you are willing to sell me this stock and I know you are smart, I keep wondering what it is you know that I do not, and am less willing to buy"'. The difficulty of providing uninformed investors the confidence to participate in the market when, by their very nature, they will not collect a great deal of information, is in our view on of the most important impediments to market liquidity.