I appreciate this opportunity to update you on the Board's audit quality indicator project, or AQI as we call it. As a reminder, my comments reflect my personal views, and not necessarily those of the Board or other staff.
At its root, the Board's project seeks to answer two questions:
We expect to issue a Concept Release in the first quarter seeking public input on these questions.
We premise the project on the notion that audits are a bit like icebergs: the buyers of audit services, audit committees and to a lesser extent, investors, can see only the tip, while important ingredients of audit quality lay opaque, under the waterline.
I have found the AQI project intriguing because it runs to the heart of the incentive system for auditors:
In an ideal world, AQIs assist the dialog between auditors and the market. That, in turn, could promote competition among auditors based on audit quality; a world where auditors win work, retain work and are compensated based on the quality of what they do.
By their nature, regulatory endeavors tend to be long on sticks and short on carrots. We issue rules, inspect for compliance, publicly note deficiencies, and when needed, discipline folks.
Ideally, the AQI project could add a welcome incentive to the regulatory tool kit. By providing audit buyers with insight on quality, we can help align auditor interests with market interests.
There is reason for optimism that measuring quality can affect behavior. Accountants and auditors have long appreciated that people manage what they measure, which we note in many aspects of human endeavor. A few examples include reporting the contents of food in a standardized label on food packaging; reporting formerly off-balance sheet OPEB obligations as liabilities; and reporting health department inspection scores prominently on the windows of NYC restaurants. In each case, users focused on the measures and in doing so affected both user and company decisions.
The notion of measuring audit quality and using the measures to promote quality enjoys widespread support, at least at the conceptual level:
Yet, despite widespread support, as always, the devil is in the details. Ideas for specific AQIs and ideas for possible uses of AQIs are controversial. Let me hum a few bars.
We speculate that a portfolio of about 15 indicators may be sufficient to present a "balanced scorecard." No single indicator is likely to be determinative. AQIs are more likely to cause the user to ask the right questions; they are unlikely to definitively answer those questions.
Thus, AQIs are not algorithms, nor safe harbors or even benchmarks.
AQI data likely requires context, that is, a qualitative analysis of what the data imply. The meaning of the numbers depends on the situation. Thus, AQIs + context = insight.
AQIs will offer the most value if they are comparable, both over time and across engagements or firms. We accountants instinctively understand the importance of comparability.
The AQI project is closely aligned with our Inspection Division's effort to encourage root cause analysis of audit problems and successes by audit firms. Root cause analysis is part of its broader effort on the audit quality improvement cycle. I view root causes and AQIs to be two sides of the same coin: in both cases we need to identify, measure and improve at the root cause level of audit quality.
To do so, we first sought to identify the broadest range of possible indicators, a process that has surfaced over 80 candidates. We considered indicators cited in academic research, previous efforts related to audit quality, and discussions with the Board's advisory groups, firms, other regulators, audit committees and academics.
To ensure a robust array, we created an audit quality framework, a COSO-type model for an audit practice. For framework elements without a candidate measure, the staff brainstormed about indicators that could inform that element, which surfaced more candidates.
The staff is now narrowing the list to the most promising indicators for discussion with the Board. We previously asked members of our advisory groups to rank the usefulness of the indicators. In addition, a cross-divisional team within the PCAOB is evaluating all candidates based on a set of criteria. Examples of criteria include usefulness to audit committees and investors, potential for unintended consequences, availability of data, scalability across firms and correlation to audit quality. We expect the Concept Release will result in comments that will help narrow candidates to a viable and useful portfolio.
I speculate that some of the candidate indicators are likely to be less controversial. Examples include:
Yet, I suspect other candidates will be more controversial. For example:
Deciding on the best use of the indicators requires answers to basic questions: Who can best use the indicators? How can they be used most effectively? How should the necessary data be obtained and distributed? The answers to these questions will determine the scope, timing and potential effect of the ultimate project.
There are alternative ways to provide benefits of AQIs to possible customers. The range of those alternatives depends upon several factors, including:
We view these factors as a menu of items, from which one could devise an AQI program. For example:
We expect the Concept Release will take no position on these questions. Rather, it will identify alternatives and seek comment about them.
Some of you may be fans of AQIs, but question what value a regulator can provide. Why not let the market alone drive the nature and extent of AQIs? Perhaps not surprisingly, I believe the Board can add unique value to the AQI issue, which the market alone is unlikely to provide:
In closing, as the next step, we envision a Concept Release in 3 parts:
Of course, a Concept Release is not a proposal and is not rulemaking. Subsequent steps in the project, which may involve rulemaking, will depend on the nature of public comments and, of course, the Board's deliberations.
Speaking of comments, we encourage as many of you as possible to provide us with your views. We have benefitted greatly from outside input to date, and we're sure to learn a great deal more in the public comment process and possible hearings that follow.
Thanks for your kind attention and we look forward to your comments and suggestions.