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 Update on Current PCAOB Activities

DATE Dec. 16, 2013
SPEAKER(S): Jay D. Hanson, Board Member
EVENT: SEC Institute 29th Annual SEC Reporting & FASB Forum
LOCATION: New York, NY

Good Afternoon:

I am very honored to be here this afternoon to discuss a few of my views on current PCAOB activities.

I have participated in at least one SEC Institute event each year since 2003, and I always appreciate the opportunity to share information with those of you on the "front lines" of financial reporting. I also find that I always learn something during the course of my discussions with participants, so I look forward to these events.

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 I reflect on the topics of my presentations for the SEC Institute over the course of the last ten years, some difficult accounting issues and standards come to mind. I have spoken in the past about consolidation of variable interest entities (FIN 46 in pre-codification speak), liabilities and equity accounting, stock options and the move to expense recognition for share based payments, business combinations and the related changes brought about by FAS 141 R, as well as a myriad of EITF issues, including the multiple element revenue recognition changes finalized in 2009. Today, the hottest accounting topics are the convergence projects on revenue recognition and leasing, and the changes on the horizon for financial instruments and impairment.

More recently, of course, my presentations at the SEC Institute have focused more on the changes to public company audits and the audit profession that have taken place during the last decade. 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 in April 2003. I joined the Board in February 2011 after spending over thirty years in public accounting.

At the time of my first presentation for the SEC Institute, PCAOB inspections had not yet begun. Ten years later, more than 2300 firms are registered with the Board, including over 900 foreign firms from 85 jurisdictions. The Board has conducted well over 2000 inspections of public company audits, including inspections in 40 jurisdictions outside the United States. After the Dodd-Frank Wall Street Reform and Consumer Protection Act gave us authority in 2010 to inspect the auditors of brokers and dealers, we commenced an interim program of broker-dealer auditor inspections, and we are currently studying that industry and our findings from the interim inspection program to determine the scope of a future permanent inspection program.

Relevance of the Audit

Recently, we have heard discussions about the relevance of the audit and whether fundamental changes in the profession are needed to keep audits relevant. I believe that suggestions that audits and auditors are not relevant are off the mark. Investors are interested in predictions of a company's performance in the future, but confidence in reported past results continues to be a critical anchor. While most of you in the room are currently involved in the preparation of financial statements, many of you started your career as an auditor and you all work closely with your auditors. I hope you agree that auditing continues to be an important and indispensable investor protection tool in the capital markets.

Ten or twelve years ago, however, this may have been a closer call. This room has a mix of experience levels. Some of you were in the middle of your careers when the massive accounting scandals of Enron, WorldCom, Tyco, Adelphia and Sunbeam were in the news almost daily. Some of you were new to the business world, while others may still have been in college. But anyone who was paying attention to the capital markets at the time understood the need to reform management accountability, corporate governance and financial reporting practices. The audit profession needed a wake-up call, and the era of self-regulation came to an end when Congress passed the Sarbanes-Oxley Act and created the PCAOB.

Today, you are all feeling the effects of more diligent auditors, including enhanced audit procedures and, potentially, higher fees. To a limited degree, this is attributable to new auditing standards issued by the PCAOB in recent years. But we also hear suggestions that our inspectors are forcing auditors to do more work in areas where standards have not changed. To the extent that our inspection process is causing auditors to be more diligent, ask more questions, conduct more thorough procedures, or be more skeptical, those are all positive outcomes. Our inspectors question whether a firm's approach or execution is consistent with existing standards, but they do not create new standards by their actions. I find it troubling to hear that auditors on occasion blame the PCAOB for the added work they are doing, when, in fact, this level of audit work actually has long been required by our standards and, in many cases, by the firm's own policies.

One particular audit area where many of you may be observing an increase in auditor effort is the auditor's work around internal control over financial reporting (ICFR.) About a year ago, the Board issued a general report describing our ICFR findings in the 2010 inspection cycle,[1] followed by a Staff Audit Practice Alert in October of this year.[2] Since 2010, the PCAOB inspection reports on many of the larger firms continue to show similar deficiencies. In response to our findings and discussions with firms, you may find that your audit team wants to observe some of your control processes. We are encouraging this more in-depth review. Can any of you tell what was actually done by a control owner just by seeing a signature? I know that I can't. If your process is not well-documented, it is possible that the only procedure an auditor can do to understand a control is to observe it in practice. Ultimately, some of you may realize that your controls are not as good as you thought they were and that you will need to implement enhancements. Though the additional work may be time consuming, thank your auditor for bringing the issue to your attention.

According to data provided by Audit Analytics, the trend in restatements continues to show declines. This is especially true for the more significant types of restatements, sometimes knows as "Form 8K" restatements. Those types of restatements have declined by 42% from 2008 to 2012. The accounting issues that have appeared most frequently in restatements in recent years are relatively consistent. One issue among the top five most comment reasons for restatements in the last five years relates to liability and equity issues, a complex topic indeed. Others near the top include cash flow statement classification errors and income tax accounting problems. Business combination accounting issues also are near the top of the list the past few years, which is not surprising, given the new complex accounting requirements that include substantial fair value measurements. My question for you is: Is the trend of fewer restatements due only to your efforts, as financial statement preparers, or does the diligence of your auditor have something to do with it?

On the practical front, the complex accounting topics I recall from the past ten years have all been the subject of publications issued by the major public accounting firms. I suspect most of you have copies of all the firm's advisories on the accounting issues that are most relevant to your businesses. Having overseen the writing of some publications at my former firm and participated in countless meetings with representatives from the major firms to deliberate the practical application of certain aspects of the accounting standards, I know first-hand the efforts that go in to "getting it right." Diligently applying new accounting standards, established after substantial due process and consideration of investor needs by the Financial Accounting Standards Board (or other standard setter), is the goal. And auditors, I would argue, are not only relevant, but likely a key part of the system intended to achieve this goal.

Future Audit Standards

On the standard setting front, 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.

Turning to the future, 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.[3] Some have suggested that this proposal will help auditors demonstrate their relevance. 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.

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." In the wake of the 2008 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.

The comment period just closed on this proposal. I have only read a few of the 220 comment letters, but the feedback appears to be mixed. Some have suggested the requirements do not go far enough and are not sufficiently specific to require the auditor to report information that investors want. Others have suggested that most of the matters to be discussed in the audit report would largely duplicate disclosures already included in the financial statements; while yet others have expressed concern that the auditor might disclose information that applicable SEC rules and regulations explicitly 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 of the changes to the auditor's report will be limited to the addition of new "boilerplate" language to the report 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.[4] 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 all of you involved as preparers. Although the comment period has ended, the Board likely will conduct more public outreach on these standards, and I urge you to let us know what you think.

A second project that has received some attention recently is our "transparency" project which involves the recent re-proposal by the Board of standards that would require the disclosure of the name of the engagement partner, and the names of other firms, or individuals not employed by the signing firm, who participate in the audit.[5]. Transparency and disclosure, of course, are important underpinnings to our capital markets, and I noted in connection with the reproposal that investors want and may benefit from this information. At the same time, I and others have raised some practical questions about the potential impact of the re-proposal, and we are interested in receiving wide-ranging input between now and the end of the comment period in early February.

As you consider whether to comment on the re-proposal, 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?

Overall, as I noted in my statement at the open meeting when the Board voted to re-propose these standards, I am troubled by certain aspects of the reproposal and may not be able to support it if the PCAOB proceeds to a final standard without any changes.

In addition to these standard-setting projects, we have an active agenda of reviewing and considering changes to existing audit performance standards, including fair value and estimates, supervision of specialists, related parties, going concern and others. Another area to which we will need to turn our attention in the near future is auditing revenue under what will soon be a newly adopted converged standard on revenue recognition to be issued by the Financial Accounting Standards Board and the International Accounting Standards Board. Guidance to auditors is likely the minimum that the Board will have to consider, and changes to existing standards are possible.

Audit Committees

Let me turn finally to 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 the auditors and providing oversight over the audit. While regulatory activities like inspections, enforcement and standard setting can and should drive improvements in audit quality 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.[6] 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.[7] 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.

A third prong of our work related audit committees is a project by our Office of Research and Analysis, which began work recently to try to identify audit quality indicators that could be used by audit committees, among others, to evaluate the quality of work performed by audit firms. 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. 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.

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 recently made some changes to our website to make it easier for audit committee members to find relevant information, and we hope to add additional content relevant particularly to audit committees. 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.

Let me close by thanking you all for the commitment to high quality financial reporting that you demonstrate by attending conferences like this one. Accounting and auditing may well become irrelevant if investors do not find useful the information reported to them, and financial reporting should not be viewed as a compliance exercise. The types of information and processes on which auditors provide assurance may evolve in the future. In any case, I hope you will include on your list of New Year's resolutions a plan to be as transparent and clear as you can in your reporting and disclosures. Many of us benefitted from investments made by our family members or scholarship foundations that allowed us to pursue higher education. Many of you likely are currently experiencing the challenge of helping to finance educations for your children (or grandchildren). Collectively, we share the belief in transparent and fair capital markets, allowing us to make sound investments based on complete information. If you approach your job, and your auditor approaches theirs, with the attitude that you are looking out for other people's money, and their children's educations, your relevance is assured.

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

[1] See Observations from 2010 Inspections of Domestic Annually Inspected Firms Regarding Deficiencies in Audits of Internal Control over Financial Reporting, PCAOB Release 2012-006 (December 10, 2012).

[2] See Staff Audit Practice Alert No. 11, "Considerations for Audits of Internal Control over Financial Reporting" (Oct. 24, 2013).

[3] See PCAOB Release No. 2013-005, "The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses and Unqualified Opinion; The Auditor's Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Auditor's Report; and Related Amendments to PCAOB Standards" (Aug. 13, 2013).

[4] Id.

[5] See PCAOB Release No. 2013-009, "Improving the Transparency of Audits: Proposed Amendments to PCAOB Auditing Standards to Provide Disclosure in the Auditor's Report of Certain Participants in the Audit" (Dec. 4, 2013).

[6] 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).

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

 

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