Audit Committees, Audit Quality, and Investor Protection

Thank you, Paolo, for the kind introduction.

I should mention at the outset, that the views I express today are my own and do not necessarily reflect the views of the PCAOB, the other Board members, or the staff.^[1]

Molti anni fa ho viaggiato attraverso il vostro paese durante il periodo dei miei studi universitari e ho trascorso un mese a Perugia a studiare italiano presso l'Università per Stranieri. Durante la mia permanenza, ho avuto modo di apprezzare non solo la bellezza e la storia d'Italia, ma anche l'ospitalità e la gentilezza dei suoi abitanti. È sempre un piacere ritornare.^[2]

Regulators play an important role in ensuring audit quality. Inspections can help drive continuous improvement in the quality of the audit. The inspection process at the PCAOB is done on a global basis. Last year, we inspected audits in approximately 30 countries outside the United States. Our ability to do so often requires cooperation with regulators in these different jurisdictions.

In 2016, we entered into a cooperative agreement with CONSOB.^[3] The following year, we conducted our first joint inspection with CONSOB of registered audit firms in Italy. As an organization, I believe that we have benefitted from the close working relationship with CONSOB. I very much look forward to continued collaboration with CONSOB on regulatory and oversight matters under our shared jurisdiction.

Although the PCAOB has not been part of the Committee of European Auditing Oversight Board's initiative on audit committees, I follow with great interest audit-related undertakings by those in this area. I am aware of the important, indeed critical, role played by audit committees in the financial reporting process.

Audit committees participate in the oversight of the external auditors. They may perform this function by asking tough questions, identifying possible areas of risk during the planning phase, reviewing disagreements between auditors and management, and asking about how the planned scope of the audit differs from the prior year. Audit committees also can inquire as to how auditors are fulfilling their responsibilities under the professional standards, including the standards applicable to fraud procedures.^[4]

In performing these tasks, audit committees have increasingly looked to, and relied on, audit quality indicators. AQIs have the potential to provide insight into the quality of a particular engagement or a particular firm and to enhance discussions between the audit committee and the auditor. They can also be used to stimulate competition among audit firms on the basis of quality.

In 2015, the PCAOB issued a concept release asking for comment on 28 possible audit quality indicators.^[5] These indicators fell into three categories: (1) audit professionals; (2) audit process; and (3) audit results. The effort resulted in 50 comment letters.[6] The PCAOB also sought public input on the topic in connection with the strategic planning process undertaken in 2018.^[7]

AQIs can be critical to the retention or selection of an auditor. They can provide metrics and other information that encourage decisions based less on chemistry and more on objective indicia of quality.^[8] They also facilitate the ability to exercise oversight in a more skeptical, challenging, and independent fashion.

Determining which AQIs actually affect audit quality can, however, be challenging. Fortunately, recent academic research – some based upon data provided by the PCAOB — has offered potential help in this area. For example, the expertise of the engagement partner can matter, but so too can the experience and expertise of the other members of the engagement team.^[9] The industry and general expertise of the engagement quality reviewer can also impact the quality of the audit.^[10]

Perhaps unsurprisingly, overworked members of the engagement team can impair audit quality. As academic research has shown, concerns can arise when senior managers work long hours^[11] particularly when this occurs during the fieldwork phase of the audit.^[12]

Academic research also suggests that reducing time compression can improve audit quality. Auditors of the largest US companies must finalize the work for the entire audit within sixty days after the end of the fiscal year.^[13] For most of these issuers, that means the audit report will be issued at the end of February or beginning of March. The timeframe can create time pressure to finish an audit, particularly for issuers with global or complex operations. Research suggests that efforts to conduct more work before year-end can reduce this pressure and have a beneficial impact on audit quality.

Time pressure can also arise where public companies issue earnings releases well before the completion of the audit. Management is generally responsible for the content of the releases. Nonetheless, material differences between the earnings release and the financial statements can cause a noticeable reaction in the capital markets.^[14] Audit firms may sometimes seek to accelerate the completion of important audit procedures prior to the issuance of the earnings release, creating another form of time pressure.

Time compression may cause auditors to skip procedures, pay less attention to matters discovered during the audit,^[15] or otherwise fail to sufficiently exercise professional skepticism.[16] Academic research has shown that reducing the time pressure by getting more work done before the end of the fiscal year can improve audit quality.^[17] Auditors might address concerns in this area through mandatory milestone completion dates, changes in staffing, adjustments made during the planning phase, and increases in the use of technology.

Fraud procedures are another area where audit committees can have an impact. Auditors plan and perform their audits in order to obtain reasonable assurance that the financial statements are free of material misstatement, not only due to error but also to fraud. ^[18] Financial statement fraud, however, presents unique challenges.

Most frauds are deliberately concealed, often start out small, and are often qualitatively material. The standards address this concern, in part, through a requirement that auditors incorporate elements of unpredictability in the design of their audit procedures.^[19] In other words, auditors should make an effort to look where they are not expected and test what is not anticipated.^[20]

Academic research suggests, however, that the "unpredictable" procedures used in an audit are sometimes "predictable."^[21] This may occur where auditors examine the same accounts each year for fraud or do so in a predictable rotation. Responses to fraud risks also may be predictable where they result in increased sampling but not changes in procedures.^[22]

Audit committees can have conversations with audit firms to better understand their approach to unpredictability and to emphasize the importance of this requirement. This does not mean a discussion of specific procedures employed in the audit but can entail a discussion about the need to incorporate elements of unpredictability in the design and timing.

Regulators can assist audit committees in performing their gatekeeper function. With respect to U.S. audit firms, the PCAOB regularly conducts interviews with certain chairs of audit committees of engagements subject to inspections. As of August of this year, the PCAOB had spoken to more than 250 audit committee chairs of US issuers. The interviews provide audit committees with an opportunity to learn about what we do, particularly in connection with the inspection process. They may also increase awareness of an ongoing inspection, something that may promote interaction and discussion between the auditor and the audit committee.

The interviews also give the PCAOB an opportunity to have a robust exchange of ideas with audit committee chairs on areas of mutual importance. Inspectors may ask about their views and perspectives on the auditor or about the AQIs used to assess quality. The interviews can provide greater awareness of the communications received from auditors and the deployment of new or emerging technologies during the audit.

The interviews can also address the effect of any new auditing and accounting standards. This occurred, for example, in connection with the introduction of critical audit matters or CAMs. Similar to Key Audit Matters (KAMs with a "K") adopted throughout Europe, the standard requires auditors to disclose in their report certain matters that arose during the audit that involved especially challenging, subjective, or complex judgments.

In advance of the effective date of this requirement, auditors engaged in practice runs. As I understand it, this involved the preparation of draft CAMs, submission of the drafts to management and audit committees, and dialogue over the process. We asked about this during some of our interviews and understand that audit committees generally viewed this as a useful exercise.

The disclosure of CAMs has since moved from the practice phase to actual implementation. The standard became effective for the largest public companies in the United States on June 30 of this year. We are monitoring the disclosures and have sent inspection teams into the field to take a closer look at auditor's efforts in implementing this new requirement. They will examine the approach used to determine the CAMs and to communicate them in the reports. Depending upon what is learned, the staff may issue additional guidance to help improve the effectiveness of the standard.

Finally, I want to talk briefly about the importance of communications with investors and other consumers of the financial statements. Rigorous, challenging, and effective oversight of the external auditor by the audit committee improves trust in the financial disclosure process. I believe trust can be further enhanced through increased communications with shareholders and the public.^[23]

In the U.S., public companies are, on a voluntary basis, increasingly disclosing in their proxy statements the AQIs used by audit committees to evaluate audit firms. The AQIs range from the quality of the engagement partner and team, to the technical expertise of the audit team in industries such as insurance, financial services, oil & gas, telecommunications or government contracts, to the quality of the engagement partner and team, to the candor of the communications between the auditor and the audit committee.

Audit committees may also consider the system of quality control employed by audit firms.^[24] Proxy statements indicate interest in how audit firms ensure independence, the relationship between the engagement team and the national office, and the results of any assessment of the system of quality control. Audit committees also consider the insight provided by auditors with respect to the company's system of internal controls.

Regulators can also play an important role in the communication process by publishing information learned about audits and audit quality, whether in the form of inspection reports or other types of public disclosure.^[25] Recognizing this, the PCAOB is working on revisions to inspection reports in an effort to make them more accessible, informative, and useful. Hopefully, this will provide a more transparent picture of what was learned through the inspection process.

The PCAOB is also planning to issue a concept release later this year on potential revisions to our standards governing the quality control systems used by audit firms. One of the areas of possible examination concerns the disclosure by audit firms about their system of quality control. As my colleague on the Board, Duane DesParte, recently observed, the proposal could address the need for the public disclosure of AQIs or other standard metrics in audit quality reports issued by the firms so that audit committees, investors, and others can better understand the quality of the audit.^[26]

Let me end by again expressing my appreciation for the hard work done by everyone here who sits on boards, particularly those serving on audit committees, for the important role played by CONSOB in helping to ensure audit quality, and the contribution all of you make in protecting investors and promoting capital formation.

Molte grazie per questa opportunità.^[27]