Keynote Address

Thank you for inviting me to this conference, now in its 14th year. It is always a pleasure to return to the rarefied air of the Zicklin Center's 14th floor perch at the top of Baruch's unique vertical campus. And it's a pleasure to speak to and with some of the most experienced and progressive thinkers in the accounting and auditing profession today.

I will use my time today to discuss current work at the PCAOB to promote the interests of the investing public in informative, accurate and reliable audit reports.

I will also speak to how this work supports a vibrant profession that can continue to meet society's expanding needs for assurance services. Here, the profession must do its part to innovate in service to the public, which is the key to expanding public demand for assurance services. And I will explain how, as leaders of the profession, you can help.

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.

Since we were together last May, the PCAOB has made substantial strides in our mission to promote the interests of the investing public in informative, accurate and reliable audit reports.

I. The PCAOB Has Pressed Forward on Important Initiatives to Improve Audit Quality and Enhance the Relevance and Reliability of Audits.

In 2014, we conducted 219 inspections of firms that audit or play a substantial role in an audit of an issuer, including examinations of portions of 219 engagements across the largest four domestic firms, including engagements of some of the largest companies in the world. We also examined portions of 570 engagements by 158 other U.S. registered public accounting firms and 57 non-U.S. registered firms. In addition, we inspected 66 firms that audit brokers and dealers, including examinations of portions of 118 audits of brokers and dealers.

We will conduct a commensurate number of inspections in 2015.

In most cases, when we find a problem we can work with the firm to correct it, whether it is specific to an engagement or a more pervasive quality control problem. Each year, our inspectors work with more than 200 firms to evaluate their efforts to remediate the quality control concerns our inspectors had identified in previously issued inspection reports.

Where appropriate, though, we have commenced deeper investigations and disciplinary proceedings. For example, last year we barred the engagement partner on a medical company audit for ignoring signs that certain sales, although recorded as revenue, were not realized, realizable or collectible.

We issued audit practice alerts in critical areas of concern related to controls, revenue recognition and the going concern assumption.

We continue to focus auditors on their responsibilities for detecting fraud. We recently adopted a new standard on auditing related party and significant, unusual transactions, two areas associated with numerous past frauds.

We also finalized our project to reorganize our auditing standards to make them easier for practitioners to use and follow.

We also issued a staff consultation paper on auditing estimates and fair value measurements. The paper was a vehicle to gain useful input on approaches to address practice problems, and the relative costs and benefits, before PCAOB staff developed any rulemaking proposal for Board consideration. We received dozens of comment letters on the paper, which is helping the Board consider how to move ahead. The staff paper also enabled robust and informed discussion at a special meeting of our advisory group, with noted guest experts, to further explore the pros and cons of rulemaking in this critical area.

We have also issued new staff guidance for auditors of SEC-registered brokers and dealers, in light of the SEC's new Rule 17a-5 on broker-dealer compliance filings and the PCAOB's related new attestation standards. The staff guidance reflects insights from our inspection program, about which we issued our third annual public report in August last year. Then in January of this year, we issued a more targeted ad hoc report on the first inspections of audits under our new standards, in time for most auditors in that sector to put to good use.

II. Maintaining Public Confidence is the Key to Expanding Demand for Assurance Services.

There are technical and managerial challenges in maintaining audit quality across a range of companies, of different sizes and presenting different complexities, and increasingly across different jurisdictions with different business and audit cultures.

But from experience we know the greatest challenge is human nature itself. Corporate managers have a natural incentive to present a favorable picture of the results of their work. In many cases, they are under tremendous pressure to do so. Or they may hope to reap tremendous gain if they can.

The company hires the auditor to provide investors assurance that the presentation is true. There are obvious incentives for the auditor to back the company's story. The PCAOB's job is to reduce the risk that auditors will do so without obtaining the requisite evidence, or indeed when it is contrary to the evidence.

But informative, accurate and reliable audit reports should do more. We also continue to take a hard look at the audit's role in our capital markets. At base, an audit report can't be informative unless it is relevant. Thus we are thinking about how well the audit report is serving the investing public. This should be of intense interest to the profession as well.

Management may not like being audited, but they'll respect the audit if the market does. On the other hand, if the market doesn't find the auditor's opinion relevant and reliable, it won't ascribe value to the opinion. And in that case, neither will the company that has to pay for it.

To be sure, there are burdens associated with being subject to a rigorous, high quality system. The PCAOB spends considerable time and effort considering these burdens, and how to minimize associated costs.

But the cost of losing public confidence is orders-of-magnitude greater, and it can be long-term. It can take a long time to regain confidence.

In the decade since the Enron and Worldcom scandals, audit fees in the U.S. initially spiked but have since leveled. Audit practices have shrunk in comparison to audit firms' other client services. If present trends continue, within ten years, audits may yield less than 20 percent of the revenue of the global, networked accounting firms.

There well could have been new demand for audit services in the last several years, had public confidence in audits been greater. But for nearly a generation of professionals coming of age since Enron, it has not materialized.

Why is there not greater demand for auditor assurance on XBRL data? Why hasn't the public turned to the audit profession for auditor assurance on environmental reporting, or cyber-security?

Implicit in these questions is consideration of whether the cost of the audit would outweigh the value the providers of capital would ascribe to it.

This is the challenge for the audit profession. The client that pays its bill does not need the service for itself. There must be investor demand, and there can be.

The public wants assurance that environmental, safety, social and consumer standards are adhered to. State and local governments want assurance that infrastructure projects are free of corruption and on budget.

But capturing that demand requires attending to the public's desire for confidence that the audit function is the watchdog the public expects it to be.

The public needs to hear auditors bark when there's a problem.

An array of consulting firms have emerged to develop standards in new fields to establish public trust by providing various forms of assurance as to compliance with those standards.

The difference between consultants and auditors is not expertise but independence. To compete for public demand, the profession must demonstrate that an auditor's opinion is indeed more reliable than a consultant's.

This is in reach, but eighty years of a federally chartered franchise may have dulled the instinct for competition on the basis of audit quality. The profession must reach.

III. The PCAOB's Initiatives to Enhance the Relevance and Reliability of the Audit

The PCAOB is acutely focused on helping the profession build public confidence in the audit. Our work is fact-based, founded on what we learn in our oversight and in our outreach.

What that work has taught us is that effective audit oversight is not simply a matter of mandating procedures. For the most part, our body of standards is already impressive. Many are principles-based and timeless — principles relating to independence, skepticism, due care.

These principles inform the scoping and execution of a good audit. They demand creativity in looking for the corners where fraud or other mischief can hide, then testing the efficacy of reporting in those areas.

We've got to enhance the relevance and reliability of the audit, and that takes auditors fiercely committed to investor protection.

A. Facilitating the Work of Audit Committees

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. Audit committees play an important role in protecting investors' interest in accurate financial reports and reliable audits.

The Sarbanes-Oxley Act provided audit committees enhanced authority to play a critical role in hiring, firing, compensating and championing the auditor. Next to establishing the PCAOB, this express authority may be the most significant of the Sarbanes-Oxley reforms.

To help audit committees champion the audit, the PCAOB aims to better equip them with information about the audit, our inspection reports, and the auditor's strengths and weaknesses.

We have been meeting with audit committee members in groups and at conferences for a few years now. Those meetings have given us the background to broaden our outreach, and take it to a new level. To that end, we have developed a communication tool to provide audit committees insights from our work, which should be released shortly.

This is not a regulatory push. We don't oversee the audit committee's work and are cautious not to add to their burden. Rather, we are responding to a demand pull. Audit committee members have asked for our insights, and the bulletin responds.

B. The Development of Standards

We are also taking a fresh look at our standard-setting process to make sure it is as efficient and effective as possible. We want to make sure we have the full range of resources and data for the work we need to do.

Evaluating our processes, as any good organization does, is a constructive effort. We should issue new rules only after thoughtful assessment of the need to improve audit quality and the economic impact of any rule-making. But once we decide that an improvement is appropriate, we want the organization, from staff to Board, to be nimble in our execution.

We go over our standard-setting agenda at least annually with our standing advisory group. In addition, we publish our standard-setting agenda quarterly on our website.

We expect in the near term to issue proposed new standards on auditing estimates, including fair value measurements, and on supervising auditors outside the firm, such as auditors in foreign affiliate firms.

We also expect to issue staff consultation papers on the use of specialists, including valuation specialists, as well as on the going concern assumption. The paper on the going concern assumption will explore whether changes to our auditing standards are appropriate in light of the FASB's new requirements for management disclosure of uncertainties about an entity's ability to continue as a going concern.

We also continue to develop new standards on audit transparency and reporting in response to investor demand.

C. Audit Transparency

Recent studies in Sweden, the U.K. and Chinese Taipei, where partners routinely sign their firms' audit reports, show that disclosure of the engagement partner's name makes a difference to the investing public and the markets.[1]

Nevertheless, it has not been the custom here, and many auditors have expressed concerns about unintended consequences attending personal signature, including litigation risks.

The Board's concept release to consider engagement partner signature predated my tenure. But the comment received helped us consider and develop alternatives, for example whether simple disclosure — without signing — could give the market valuable information without increasing litigation risk.

So I asked the staff to develop a proposal on mere disclosure, as a compromise, first in 2011 and then again, to seek more comment on costs, in 2013. Based on investor calls, we also proposed disclosure of the names of other firms that substantially contributed to the audit.

Auditors ought to be fighting for the attention of investors, clamoring to meet investor demand better than the next firm, putting forward star auditors known for their integrity, as other professions do.

Sure, big audits will have big teams, just as big deals, big cases and big consulting engagements do. But for confidence, the investing public wants to know who leads those teams on behalf of the firm, just as they already recognize the star performers who lead the big teams in law, medicine and other fields.

Some auditors will still hesitate, concerned that mere disclosure of a name in the audit report could, without relief, increase exposure to litigation. For the most part, they do, however, accept investors' desire for the disclosure.

I believe there is a middle ground, through disclosure in a filing instead of in the audit report. I'd like to offer such an option, and seek comment on some technical points. But I hope to move toward a final standard soon.

More broadly, I think we should step back and consider why the PCAOB needed to step in to broker this compromise. For example, I'd like to see auditors make the names of lead partners on specific engagements public — for example, on their own websites — even without PCAOB action.

Why are incentives so misaligned that auditors are reluctant to find solutions to address market demand? Why is there so little experimentation or competition for that demand among any of the larger firms, where the makeup of the audit engagement team is even harder to discern?

The global audit, and the challenges of coordinating across jurisdictions and cultures, accentuates the need to know, not only the engagement partner but the other firms who participate in the audit as well.

As this project closes, we have more opportunities to explore these questions about demand and incentives even more deeply. We should soon be in a position to issue a concept release on potential audit quality indicators to develop further contextual information for use by audit committees and others, which I consider to be the next stage of enhancing transparency.

D. The Auditor's Reporting Model

In addition, the PCAOB continues to explore opportunities to enhance the form and content of the audit report, to provide the market for value for the investment in the audit.

The PCAOB has conducted extensive outreach with investors, auditors, financial statement preparers, and others, since 2010, in response to calls from major institutional investors and others to make the auditor's report more informative.

To obtain broader public views, we issued a concept release and subsequently a proposal. And we have held two public hearings. Governments around the world have heard the same call and are developing parallel reforms. We spend a lot of time monitoring those developments and analyzing the relative costs and benefits and other economic considerations of various approaches.

1. U.K. Developments

The United Kingdom was the early mover, and so we now benefit from a growing body of evidence and experience. There, the Financial Reporting Council has required what they call extended audit reports for financial statements for periods that began on or after October 1, 2012. There are approximately 900 UK-reporting companies subject to the requirement.

Last year, I discussed early, anecdotal evidence from the first year of reporting in the UK, and I pointed to reports from analysts, investors and auditors that the new audit reports brought new relevance to the audit.

At the same time, based on looking at more than 200 of the FTSE 350 companies in the first year of implementation of the FRC's new requirement, the median change in their audit fees was zero. A majority of companies reported no change (59 companies) or a decrease in audit fees (52 companies). Of course, other factors might have been at play too. But this data tends to show there was no spike in fees associated with the expansion of the report.

We are further along now, and those first impressions still hold. In March 2015, the FRC issued a formal report on its own in-depth review of both compliance and user benefits in the first year of extended auditor's reports. The review included a detailed analysis of 153 extended auditor's reports (63 from the FTSE 100). Almost all of these reports were issued by the four largest firms (147 out of 153).

The FRC review found that auditors appeared not only to have met the new requirements but in many cases had voluntarily made further changes — sometimes quite radical changes — to the form and content of their reports. The new requirement spurred innovation and spurred competition on the basis of the informativeness and quality of the report. In particular, the FRC praised reporting on detailed audit findings in relation to identified risks, informative use of explanatory diagrams and graphs, and the clarity of presentations that located the opinion at the beginning of the report as opposed to at the end.[2]

The FRC experience is useful for our own consideration and analysis. But the real test is whether the new reports affect demand, and in that respect investor reaction is even more illuminating, and encouraging.

In November 2014, a prominent UK investor group —the Investment Association — held its inaugural awards ceremony to recognize outstandingly useful audit reports. There were two categories of honorees — most insightful and most innovative.

The Investment Association, together with Schroders, the global asset management company, convened a panel of six judges, consisting of investors and audit committee chairs. The "insightful" category recognized reports that provided the most entity-specific and enlightening information. The "innovative" category recognized reports that presented findings in imaginative ways.

Awards were given out in three sub-divisions — FTSE 100, FTSE 250, and FTSE Small Cap and AIM. Of course, with this kind of competition, one can see how the engagement partner's name will help investors and markets differentiate audit quality.

2. Profession-based Developments

Developments in the UK have been exciting and positive, but there are developments elsewhere as well. Last September, the International Audit and Assurance Standards Board approved changes to the auditor's report that would require the auditor to determine and communicate key audit matters.

The IAASB defined key audit matters as those matters that, in the auditor's professional judgment, were of most significance in the audit of the financial statements. Last week, the IAASB issued illustrative examples of key audit matters. Like the FRC, the IAASB encourages auditors to be as "entity-specific and audit-specific as possible in the description of a KAM, in order to mitigate concerns from investors and others that communication of KAM could quickly result in more standardized or 'boilerplate' communications."[3]

The IAASB's new reporting standard is effective for audits of financial statements for periods ending on or after December 15, 2016. This means that more than 100 markets across the globe will soon have expanded audit reports. At least one market — the Netherlands — has early adopted.

3. European Developments

In addition, in April 2014, the EU adopted legislation that, among other things, expanded auditor reporting requirements to include a description of the most significant assessed risks of material misstatement, including assessed risks of material misstatement due to fraud; a summary of the auditor's responses to those risks; and a discussion of relevant, key observations arising with respect to those risks.

We are closely following these developments as we advance our own initiative, in order to evaluate results and learn the lessons of experience.

* * *

The PCAOB initiatives I've described are intended to help align auditors with investor needs.

In business, many changes in demand are implicit. They may happen without the awareness or consent of the supplier. Demand may decrease if the supplier does not continue to provide a product the market wants. Demand may also increase, for example if the supplier can devise innovations to continue to meet market demands over time. But in the latter case, generating and meeting new market demand is something one must choose.

In 1933, the United States was still reeling from the stock market crash and the economic depression that followed. Our government was looking for a way to restore confidence in our capital markets, so that investment would return, and capital could be formed to support business growth and jobs. The accounting profession came forward and offered a way to provide the investing public assurance as to the accuracy of corporate financial reporting.

The then-leaders of the profession saw the demand, and they chose to leap for it. The climate was hot with public anger. In the midst of criminal investigations and congressional hearings to identify culprits, the risks of taking on a gatekeeper role were obvious. But they saw the demand and pitched a product whose explicit value exceeded the implicit cost.

Notwithstanding some skepticism as to how, exactly, auditors could avoid fealty to the companies that would hire them, the Congress accepted the offer and granted the profession what is essentially a franchise. The resulting law required public companies to file financial statements with the SEC, accompanied by the certification of an independent auditor that the financial statements were fairly presented in all material respects.

In the eighty intervening years since then, we have learned a lot about the risks and weaknesses in the model. And we've instituted important reforms to address them, including standards, robust inspections, and disciplinary programs. Those programs go to ensuring minimum quality, which is an important factor in maintaining public confidence.

But it is time again for leadership in meeting the demand of today's markets and investors. Who among you will answer the call?

[1] See W. Robert Knechel, et al., Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions, Contemp. Acct. Res. (forthcoming 2015); Daniel Aobdia, et al., Capital Market Consequences of Audit Partner Quality, The Acct. Rev. (forthcoming 2015); Joseph V. Carcello & Chan Li, Costs and Benefits of Requiring an Engagement Partner Signature: Recent Experience in the United Kingdom, 88 (5) The Acct. Rev. 1511 (2013).

Knechel et al. found "considerable evidence that aggressive and conservative audit reporting persists for individual partners over time" and that in Sweden, where engagement partner's names are disclosed, "the market recognizes and prices differences in audit reporting style when engagement partners have a history of aggressive reporting." Knechel, et al., supra, at 5, 23. Although much of this analysis was conducted using data on private companies, many of the results continued to hold when the authors separately analyze public companies.

Aobdia et al. used data from Taiwan and also found that both debt and equity markets react to the performance characteristics of engagement partners. Aobdia et al. acknowledge that their use of estimates of abnormal accruals as a proxy for engagement partner performance is subject to measurement error. They continue to find evidence that engagement partner histories matter to capital markets when they use regulatory sanctions history as an alternative measure of audit quality. Aobdia, et al., supra, at 5, 29-30.

Carcello and Li examined the impact of the E.U.'s audit engagement partner signature requirement on audits in the U.K., and found improvements in several financial indicators of audit quality, as well as an increase in audit fees. It is worth highlighting that this study evaluated a policy alternative (signature requirement) that may have a more pronounced effect on accountability than the disclosure requirement being reproposed since the engagement partner's signature goes one step beyond just disclosing the partner's name. Carcello and Li, supra, at 1542-43.

The PCAOB's release accompanying the reproposal includes a detailed discussion of the existing research. It is available at http://pcaobus.org/Rules/Rulemaking/Pages/Docket029.aspx.

[2] See FRC, Extended Auditor's Reports — A Review of Experience in the First Year (March 2015). The survey did, however, reveal areas where further improvements might be made. For example, the FRC suggested that auditors could improve risk reporting by being as entity-specific. The FRC also encouraged auditors make sure the description of work performed in the auditor's report is consistent with the actual work performed, in light of inaccuracies in the descriptions in a few of the auditor's reports examined. In addition, although the overall message from the review was positive, the FRC pointed to emerging from the work of the FRC's Audit Quality Review Team:

During the FRC's Audit Quality Reviews, the FRC assesses whether the descriptions of work undertaken by auditors in extended auditor's reports are consistent with the evidence of the work actually performed. In some instances the FRC has identified inaccuracies in the auditor's descriptions of the nature or extent of the audit procedures performed. The FRC has brought these matters to the attention of the relevant audit firms and reminded all the major firms of the importance of ensuring that their auditor's reports accurately reflect the work performed.

Id. at 56.

[3] See IAASB, Auditor Reporting — Illustrative Key Audit Matters, 3 (Apr. 22, 2015).