Thank you very much for that kind introduction. I have always been honored to participate in the programs presented by the SEC Institute, but I am particularly pleased to be here today in my role as a Board member of the Public Company Accounting Oversight Board.
I began my tenure on the PCAOB Board on February 1 of this year. My last job before joining the PCAOB started nearly thirty-two years earlier, when I became a CPA and began my career in public accounting. In some respects, the beginning of my tenure at the PCAOB felt a lot like the beginning of my career as an auditor: I thought I had learned what I would need to know, and it was not until I actually began working that I realized how much more there was to learn — I believe the expression, "drinking from a fire hose," describes my introductory period at both jobs.
Even now, over ten months into my tenure, I still encounter something new every day. I would like to share with you today some of my observations and perspectives about the role and importance of accountants and auditors, the role of the PCAOB, and how what we do affects public companies and their management and, most importantly, their investors. Much of what you hear at this conference about the SEC rules and activities and the challenges of keeping up with the accounting standards and major projects may be why you decided to attend this conference. I hope also to impress upon you how important the PCAOB is and why it will affect everyone in this room.
Before I go further, however, I must 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.
Most of you in this room are intricately involved in the preparation and auditing of public company financial statements. I know that I need not preach to you about the importance of your role in facilitating the fairness and accuracy of financial reporting, but I don't think we can ever emphasize enough the importance of your role in the capital markets and our society at large. We have all experienced during the last decade the damage that can be caused — to companies, their investors, and the economy — by mistakes or malfeasance in connection with financial reporting. As preparers and auditors of financial statements, you are among the first and most important lines of defense in protecting the vital integrity of our capital markets. It is my hope that we at the PCAOB can complement your efforts by driving improvements in audit quality — and thereby work with you toward a common goal of increasing the reliability and integrity of financial reporting as a whole. I think former SEC leaders Arthur Levitt, Jr., and Donald Nicolaisen summed up well what we should collectively thrive for, when they wrote:
A desired outcome is an environment in which savings can be invested with confidence, but the more important outcome is that we can live our economic lives relatively free of suspicion and mistrust about the bedrock of our infrastructure of investor safeguards. Investment risk will always exist, and that is as it should be. The pursuit of higher returns involves greater risk and our markets consistently produce winners and losers. But, investors should have confidence that our infrastructure, including audits of public companies, is fundamentally fair and functioning effectively.
The PCAOB's mission is to oversee auditors "in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports." Our efforts are necessarily focused on establishing the rules and standards governing the work of auditors and policing auditors' compliance with those rules through our inspections and enforcement activities. But what we are finding is that the areas that are most difficult for auditors — and that consistently give rise to findings in our inspections of audit firms — are the same issues that present the greatest challenges for preparers of financial statements. Strengthening management's understanding of these difficult issues, I believe, will help enhance the auditor's ability to do their job effectively.
Fair Value Measurements
One area where the PCAOB inspections staff has consistently found problems is fair value measurements. Rapid advances in technology and innovative business models have made it much more difficult for accountants, auditors, and investors to understand the transactions and products that must be captured in the financial statements. Not only have financial instruments become increasingly complex, more and more companies, and a wider variety of companies, are invested in these complex instruments. As a result, the balance sheets of an increasing number of companies are dominated by valuation estimates, rather than "solid numbers." Combine these developments with the distressed and inactive markets that we have observed periodically during recent years, and we have the perfect storm, creating a whirlwind of challenges for management trying to establish valuations and making it much more difficult for auditors to attest to those numbers.
PCAOB inspections observations in this area have included the following:
- Auditors did not obtain a sufficient understanding of the valuation methods or assumptions used by external valuation services utilized by management;
- Auditors did not test, or test sufficiently, the operating effectiveness of internal controls over various aspects of issuers' valuation processes to support the degree of reliance placed by the firms on those controls;
- Auditors did not evaluate significant differences between independent estimates used or developed by firms and the fair values recorded by management in the financial statements; and
- Auditors did not test, or test sufficiently, significant, difficult-to-value securities, for example, by limiting procedures to inquiries of issuer personnel or extending to year-end conclusions regarding the valuation of investment securities that were reached at an interim date without taking into account volatile market conditions.
PCAOB inspection findings related to valuations and fair value issues in general are not limited to financial instruments, however. Inspectors have also found deficiencies in connection with the valuation of non-financial measurements, for example in the areas of business combinations and goodwill impairment, and with other management estimates, such as allowance for loan losses and valuation of inventory and income tax valuation allowances.
Although specific auditing standards apply to each of these areas, broadly speaking, auditors are required to understand management's assumptions and processes in establishing valuations or estimates, evaluate those assumptions and processes, test management's processes and conclusions, and evaluate any contradictory information that comes to light. Auditors will be able to design and perform appropriate audit procedures more effectively — and management will be in a better position to provide fair and reasonable disclosures — if management also "gets behind" the numbers by doing enough work to understand the valuation methodologies used for all estimates and valuations — even when utilizing outside pricing services or valuation experts.
Because valuation issues have presented a significant challenge to management and auditors alike, the PCAOB this year established a Pricing Sources Task Force to assist the Board's Office of the Chief Auditor to gain insight into issues related to auditing the fair value of financial instruments. This group of investors, financial statement preparers, auditors and representatives of pricing services and brokers has met three times to discuss the valuation of financial instruments that are not actively traded and the use of third-party pricing sources to value such instruments. We plan to evaluate the input and determine if any changes to our standards are necessary, or if more guidance is appropriate. If you are hoping that we will "lighten up" on our audit standards, however, you will likely be disappointed!
Also, last month, the Securities and Exchange Commission hosted its first Financial Reporting Series Roundtable on the topic, "Measurement Uncertainty in Financial Reporting." Chairman Doty and I participated in this event, as did Marc Siegel from the Financial Accounting Standards Board. We heard from investors, preparers, academics and auditors. It was clear from the discussion that investors' goals for transparency, objectivity and consistency in financial reporting are shared by all. One of the more significant discussions, in my view, was one that addressed the challenges of reporting historical facts clearly, but in a way that differentiates those facts from information based one predictions of the future and analysis of the company. Speaking from personal experience, I believe that auditors' skills lie primarily in auditing the past, and not so much in predicting the future!
The Board will consider information provided at these events, along with our experiences in conducting inspections, in determining whether any additional guidance or standard setting activity is warranted in this area.
In the meantime, I would encourage the preparers among you to think about what you can do to "get behind the numbers" in connection with your fair value measurement disclosures, so that you can better provide your auditor with the information they need to provide reasonable assurance on your financial statements. First, I commend to you a speech given by SEC Professional Accounting Fellow Jason Plourde two weeks ago at the AICPA National Conference on Current SEC and PCAOB Developments. Mr. Plourde discussed management responsibilities in connection with the use of pricing service data in informing fair value measurements and disclosure. Among other things, he proposed a series of questions for management to ask itself when it uses third party pricing services:
- Do we have sufficient information about the values provided by pricing services to know that we're complying with GAAP?
- Have we adequately considered the judgments that have been made by third parties in order to be comfortable with our responsibility for the reasonableness of such judgments?
- Do we have a sufficient understanding of the sources of information and the processes used to develop it to identify risks to reliable financial reporting?
- Have we identified, documented, and tested controls to adequately address the risks to reliable financial reporting?
Second, I encourage you to spend some time with your auditors to understand what we are telling them they have to do. First, you may want to read your firm's PCAOB inspection reports to understand where auditors have fallen short in auditing fair value measurements and other estimates. This also would be a good place to direct your audit committee. Discuss with your engagement team what information they will need from you. Educate yourself about your internal valuation processes and assumptions, and think about the ranges and the reasonableness of your choices within those ranges. Finally, step back, take a look at your disclosures, and consider whether the story presented in your financial statements and disclosures clearly and concisely conveys the uncertainty and potential risks inherent in your measurement estimates. One of the analyst participants in the Financial Reporting Series roundtable I just discussed remarked, "if we don't understand it, we assume it is bad." Good disclosure, complemented by thorough auditing, may go a long way toward enhancing investor confidence in the financial reporting process.
In addition to its efforts to enhance audit quality through inspections, the Board also strives to improve audits through its standard setting activities. In many cases, amendments to auditing standards focus on important technical auditing requirements. I have already mentioned that we are considering amending our standard or issuing guidance in the fair value measurement area. In addition, last year the Board issued risk assessment standards, and tomorrow we are having a public Board meeting to consider the re-proposal of a standard governing auditor communications with audit committees. We are also currently working on several other standards, including related parties, going concern, use of specialists, confirmations and others.
In addition to our work on improving such audit performance standards, the Board also is considering, under the leadership of our new Chairman, certain policy changes that could fundamentally change the way the audit profession operates.
Independence, Objectivity and Skepticism
In August, the Board issued a concept release to solicit comment on ways that auditor independence, objectivity and professional skepticism can be enhanced. These concepts underlie everything that auditors do; without them, auditors add little to the "infrastructure of investor safeguards" referenced by Mr. Levitt and Mr. Nicolaisen.
Independence is intended to ensure that auditors share no common interests with their clients in any particular financial outcome, and objectivity and professional skepticism are meant to keep auditors from taking the client's word at face value, without questioning whether the information provided is complete, makes sense, and is not contradicted. After all, as noted many years ago by Sir John Lubbock, "[w]hat we see depends mainly on what we look for." An auditor that lacks independence, objectivity or skepticism may not be looking for anything amiss.
Because of the fundamental importance of these auditor characteristics, the Board's concept release poses a series of questions intended to elicit views on whether there are steps the Board should take to enhance auditor independence, objectivity or skepticism, including potentially through mandatory rotation of audit firms. The release explains that, since its creation in 2003, the Board has conducted hundreds of inspections of registered public accounting firms each year. These inspections provide the Board with a unique insight into the state of the audit profession and the conduct of public company audits. Based on this insight, the Board has expressed its belief that the reforms in the Act have made a significant, positive difference in the quality of public company auditing. Nevertheless, the Board's inspections continue to find audit deficiencies. While the causes for deficiencies vary, professional skepticism lapses are apparent in many findings. Because the independence of auditors from their clients is critical to their effectiveness and credibility, the concept release asks whether more action is warranted to enhance auditor objectivity and skepticism, and, if so, what form such action should take.
Mandatory rotation of auditors — for example every ten years as contemplated in the concept release — would have significant effects on auditors and their clients. The concept release notes that proponents of a rotation requirement believe that setting a limit on the continuous stream of audit fees that an auditor may receive from one client would free the auditor from the effects of management pressure and offer an opportunity for a fresh look at the company's financial reporting. Opponents have expressed concerns about the financial costs faced by issuers as a result of periodic mandatory auditor changes and pointed out that some studies suggest that audit quality may decrease during the first years of a new engagement. Arguably, auditor independence could actually suffer in a mandatory rotation framework if audit firms step up their marketing of non-audit services to audit clients near the end of the permissible term of the audit engagement or if an engagement team adopts an attitude of "kick the can down the road" about difficult issues.
As you can see, before we can determine whether mandatory rotation — or any other measure to enhance auditor independence, objectivity and skepticism — is in the best interests of investors and the public, we will need to weigh carefully the likely benefits, costs and potential unintended consequences. We also have much work to do to make sure we understand what problem we are trying to solve and to consider whether mandatory rotation would solve it. I think we also should take a close look at alternative steps to mandatory rotation that would enhance auditor independence, and we are interested in hearing your ideas on that subject.
The comment period on this project ended last week, on December 14, and we have received over 600 letters to date. We are currently planning a roundtable discussion on this subject in March 2012, and I anticipate that there will be other opportunities for input on this important subject next year.
In the meantime, we are also closely monitoring events in Europe, where mandatory auditor rotation recently was included by the European Commission in a series of legislative proposals in response to lessons learned from the financial crisis in 2007-2009. The European Commission's proposal, issued on November 30, also included requirements for large audit firms to spin off their consulting services; suggests encouraging joint audits by permitting companies subject to joint audits to rotate their auditors less frequently; and requirements for mandatory tender of audit services.
Like auditors in Europe, auditors in the U.S. also have been subject in the wake of the financial crisis to questions by investors and others about the auditor's role in communicating important information to the public. After watching major, multi-national financial institutions fail overnight during the recent financial crisis, causing massive losses in their portfolios, investors began to question whether they are getting adequate information from companies and auditors to make their investment decisions. While most do not dispute the value of the work of auditors or their opinions on financial statements, investors want more information about what auditors do and what they think of the financial statements and the processes utilized to arrive at those statements.
In an effort to address these concerns, the Board issued a concept release in June to discuss alternatives for changing the auditor's reporting model. The concept release presents several possible alternatives for changing the auditor's reporting model and requests comment on these or other alternatives that could provide investors with more transparency in the audit process and more insight into the company's financial statements or other information outside the financial statements. One challenging concept is auditor discussion and analysis.
Like the discussion about auditor independence, consideration of potential changes to the audit report is global: In May of this year, the International Auditing and Assurance Standards Board issued a consultation paper, Enhancing the Value of Auditor Reporting: Exploring Options for Change, to "obtain views on enhancing the quality, relevance and value of auditor reporting." The European Commission also proposed, along with the recommendations I mentioned earlier, certain limited changes to the audit report to convey information about the auditor's methodology and procedures.
The comment period on the PCAOB's auditor reporting model project ended in September, and the Board received over 150 letters. We also held a roundtable discussion on this topic in September, and we have heard strong viewpoints for and against the potential changes discussed in the release. Some believe information about the company should come from management, and the auditor should only attest to the accuracy of the information. Some investors say they want to hear more from the auditor directly. Others question whether the benefits of increasing the information contained in the auditor's report justify its costs.
Determining what changes, if any, to make to the auditor's report will involve some difficult issues, including consideration of any potential unintended consequences the possibility that costs might be disproportionately borne by small companies and their auditors. We also need to keep in mind the role of management in crafting financial disclosures. To the extent management can provide disclosures that are comprehensive, yet clear and easily understood, there may be less that auditors need to say. Yet, the message from investors appears to be that enhanced management disclosures alone will not suffice. Investors believe that auditors gain important insight into the companies they audit, which, combined with their independent perspective, makes them uniquely qualified to provide additional color around management's accounting policies and practices, financial statement disclosures, and the audit itself.
Finally, in a further effort to increase transparency into the audit process, the Board issued in October a proposed standard to require firms to disclose in the audit report (1) the name of the engagement partner, (2) other persons not employed by the auditor that participated in the audit and (3) other independent public accounting firms that participated in the audit.
The proposed disclosure of the identity of the engagement partner in the audit report arises from the Board's consideration of a 2008 recommendation by the Advisory Committee on the Auditing Profession to the U.S. Department of Treasury. This Advisory Committee recommended that the Board consider mandating engagement partners to sign the audit report, and, in 2009, the Board issued a concept release seeking public comment on such a requirement. Many investors responded enthusiastically, arguing that the identity of the engagement partner is valuable information that would aid their understanding of and ability to evaluate the audit. Some believe that identifying the engagement partner publicly would increase the partner's accountability for the work that goes into the audit, which, in turn, might increase audit quality. Others expressed strong concerns that requiring the engagement partner to sign the audit report could dramatically increase the partner's individual liability in civil litigation — something that the Advisory Committee to the Treasury Department specifically noted should be avoided.
Legal certainty on the liability question continues to be elusive. It is possible that the Board's proposal last month for the identification of the engagement partner, in lieu of his or her signature, will reduce the potential increase in civil liability. The Board's proposing release seeks comment on this question and others related to the likely costs and benefits of the proposed requirement.
As I noted when the Board issued the proposed amendment, I believe that most engagement partners take seriously their public interest obligations and fully understand what is on the line in each audit they perform: their careers, their reputations, their financial well-being, along with the reputations and incomes of their partners. Nevertheless, auditors ultimately work for investors, and investors believe the engagement partner's identity is important information. I believe we should be responsive to these requests, while taking care, as my fellow Board Member Lewis Ferguson put it in another context, not to do harm.
The Board also proposed amendments to PCAOB standards that would require firms to disclose in the audit report other independent public accounting firms, and individual accountants not employed by the auditor, that took part in the current-period audit, as well as their locations and certain information about the amount or significance of the work performed by those other firms or accountants.
The proposed disclosures are particularly important in the context of audits of companies with multi-national operations where the auditor issuing the audit report refers certain audit procedures to firms or accountants located in other countries. Currently, investors have little or no information about whether other firms or accountants participate in such audits or about the identity or role of such other firms or accountants in conducting the audit procedures that ultimately support the opinion of the firm issuing the report. In some cases involving multi-national audits, the other audit firm is unrelated to the firm issuing the opinion. In other cases, the firm issuing the audit report and the other firm are members of an international network, which may subject both firms to similar governance and quality control procedures. Investors have little or no insight into which of these scenarios applies.
Moreover, even where the other firm is a member of the international network of the firm issuing the audit report, the network affiliate firm may be subject to different, and potentially conflicting, legal and regulatory requirements that investors may want to consider in evaluating the overall audit. For example, some jurisdictions have blocked PCAOB inspections of firms based on sovereignty concerns or other legal conflicts. The Board discloses these jurisdictions on its website, but, without the proposed disclosures, investors have no way of knowing when auditors in these countries have been asked to participate in an audit.
Finally, the proposed disclosures about participants in the audit will permit investors to consider other relevant information available about that auditor. This may include basic information such as the size of the firm or the expertise and experience of the firm or the accountant, whether the firm is registered with the PCAOB, whether the firm is subject to PCAOB inspection, and, if so, whether the firm has been inspected, and its inspection results.
The comment period on this project ends on January 9, 2012.
As you can see, the Board is seeking input on a number of important initiatives that could have far-ranging effects on auditors and their clients, and it is important that we hear from you. We need to understand and consider all potential implications of the actions we are contemplating, and I urge you, your companies, your audit firms, your audit committees and especially your investors to monitor our standard setting activities and to share your views.
And, getting back to where I began my remarks today, we also need your help to achieve our common goal of increasing the reliability and integrity of financial reporting. Regulators can only do so much. Our authority is — and indeed should be — narrowly tailored. We cannot be everywhere at once. In order to raise the bar for the quality of financial reporting and auditing, all participants in the capital markets must work together, and I challenge you to do so:
I have already discussed how important it is for preparers and auditors to do as much work as necessary to get a full understanding of the processes underlying accounting measurements and estimates and internal controls. Also consider if there are ways to enhance your communication with investors, for example by increasing the transparency and clarity of your disclosures, to tell a comprehensive story about your business. And please monitor the PCAOB's standard setting activities and chime in when you have views to share — we would like to hear from all of you.
But most importantly, whether you are preparing or auditing financial statements, try always to keep investor interests in mind in everything you do. I realize how difficult this can be in the high pressure environments that can exist at public companies and audit firms. I know from first hand experience that auditors, particularly those who are new to the profession, may get caught up in the day-to-day work, the need to meet deadlines, the desire to impress partners. Thinking about the needs of investors likely will not top your to-do list unless you make a conscious effort to put it there, consistently, day after day. One great approach shared with me recently is for audit firms to ask the chair of the client's audit committee to speak to all members of the audit engagement team to remind them that each individual makes important contributions to the audit and furthers investor protection. Accounting staff within your companies may benefit from a similar approach. If you work with or serve on an audit committee, please consider this idea — or other creative means — to remind all participants in the financial reporting process about the important role they play in enhancing the integrity of our capital markets and contributing to the growth and stability of our economy.