PCAOB Update – Recent Activities and Next Steps

Good Afternoon,

Thank you for that kind introduction and for inviting me to join you at this important conference. It has been a few years since I have attended, but I was a regular during the years I lived in Southern California. I am honored to be here to talk about the work of the PCAOB, along with our Director of Inspections, Helen Munter, from whom you heard during the last panel.

I am going to discuss today some of the Board's work in the areas of inspections, standard setting, and other outreach, and I will close by talking about my view of some important next steps for the PCAOB.

But before I go further, I should note that the views I express today are my own and do not necessarily reflect the views of the Board, any other Board member, or the staff of the PCAOB.

Background

As you know, the PCAOB was created by Congress almost fourteen years ago through the passage of the Sarbanes-Oxley Act of 2002 in the wake of numerous accounting scandals in order to protect the interests of investors. The PCAOB began operations in April 2003 and has responsibility for registration and inspection of public accounting firms; setting of auditing standards for the audits of public companies and broker-dealers; and investigations and disciplinary proceedings in cases where auditors may have violated the securities laws or applicable standards or rules.

The Board is comprised of five members, two of whom must be CPAs, while the other three may not be. We have total staff of over 850 located in 16 cities across the country.

Recent Inspections

In 2015, we inspected over two hundred firms that audited issuers. Ten firms are subject to annual inspections because they audited more than 100 issuers. The other firms are generally on a three-year inspection cycle.

As you just heard from Helen Munter, frequent inspection findings continued to be observed in the area of ICFR. I will give this topic a rest for now, though I will get back to it toward the end of my remarks. Other areas with recurring deficiencies in 2015 included assessing and responding to risks of material misstatement, including instances where auditors did not:

  • Perform sufficient substantive procedures and controls testing
  • Take into account relevant audit evidence that appeared to contradict assertions in the financial statements
  • Sufficiently evaluate the presentation of the financial statements, including disclosures

In addition, some triennially inspected firms insufficiently identified and assessed fraud risk, particularly in the area of revenue recognition (a high risk area that is frequently the focus of PCAOB inspections).

Finally, inspection findings recurred in 2015 in the area of auditing accounting estimates, including fair value measurements, particularly in connection with the valuation of assets and liabilities acquired in a business combination and evaluating impairment analyses for goodwill and other long-lived assets. Deficiencies also were identified in the areas of financial instruments, revenue-related estimates and reserves, allowance for loan losses, inventory reserves, and tax-related estimates.

In some instances auditors did not fully understand how estimates were developed or did not sufficiently test significant inputs and evaluate the significant assumptions used by management. Auditors, in some cases, also did not perform testing beyond inquiry of management in both tests of controls and substantive tests.

Overall, we saw improvements in the inspection findings among the ten annually inspected firms. Each of these firms is at a different point in their evolution of identifying and remediating areas of weakness, but, in my five years as a Board member, I have seen great strides in firms' efforts to make improvements and increase consistency in their audit practice.

Among smaller, triennially inspected firms – including many of the international affiliate firms of the largest U.S. firms – inspection results were a bit more mixed in 2015. Some have made significant efforts to remediate problem areas and are showing improvement, while others continue to struggle. Among the smallest firms, we see some do excellent work, particularly those firms who focus on a particular industry or type of audit and do not stray from their areas of expertise. But we also continue to encounter firms that do not have the resources, expertise or, in some cases, willingness to perform high quality audits. Many of these firms become targets of our enforcement efforts, while others decide on their own to get out of the business of public company audits. We also watch carefully the migration of clients from firms which registrations are revoked through our enforcement efforts, as, in some cases, clients collectively move to another firm that has some relationship to the prior firm or its owners. If we see that type of activity, it is likely that our inspectors will soon be in touch to take a look at the quality of the firm's work.

2016 Inspections

In 2016, our inspectors again will focus on these same areas of recurring inspection findings. In addition, we will focus on certain economic and environmental risks, including appreciation of the U.S. Dollar, segment disclosures, mergers and acquisitions, income taxes, and going concern. We are going to look at risks arising out of technology and cyber-security, particularly risks to the financial statements or implications for internal control over financial reporting arising out of these areas.

Finally, as we often do, inspectors will review the implementation of a recently adopted auditing standard, AS 18, Related Parties, which the Board adopted in 2014. The purpose of this standard is to strengthen audit procedures for identifying, assessing, and responding to the risks of misstatement arising out of a company's related party transactions. Our inspectors will review audits to determine whether firms have appropriately implemented the standard and have complied with its requirements in their 2015 audits.

Standard Setting

Speaking of new standards, let me turn now to several ongoing projects that I believe merit your attention.

Auditor's Reporting Model

A few weeks ago, the Board issued a reproposal of amendments to require auditors to expand the content of the auditor's report to include a discussion of so-called "critical audit matters" or "CAMs." Like the original proposal (issued in 2013), this reproposal responds to investor demands for more information about the audit by requiring auditors to say more about the audit than merely issuing an opinion on whether the financial statements are fairly stated. Rather, auditors would be required to determine whether there are any matters that were communicated or required to be communicated to the audit committee and that:

  • Relate to accounts or disclosures that are material to the financial statements, and
  • Involved especially challenging, subjective, or complex auditor judgment.

In addition to identifying the CAM, the auditor would have to describe the principal considerations that led the auditor to determine that the matter is a critical audit matter, describe how it was addressed in the audit, and refer to the relevant financial statement accounts and disclosures. If there are no critical audit matters, the auditor would state that in the auditor's report.

The reproposal differs from the original proposal in several important ways in order to address concerns expressed by commenters in response to the 2013 proposal.

First, in light of concerns that the original proposal was too broad and could result in the disclosure of immaterial information, the reproposal narrows the source of CAMs to matters (1) communicated or required to be communicated to the audit committee and, (2) related to accounts or disclosures that are material to the financial statements.

Second, the proposal includes a less burdensome documentation requirement. While auditors will still be required to document why each material matter communicated to the audit committee is or is not a CAM, the universe of such potential matters is limited by the audit committee communications filter, making the documentation requirement less onerous. And for those matters determined to be a CAM, the audit report itself serves as the auditor's documentation.

Finally, in order to address concerns by preparers that the auditors should not disclose original information about the company that is not otherwise required to be disclosed, the reproposal requires auditors, in describing the CAM, to make reference to disclosures made by management in material financial reporting areas. This should generally eliminate the need for auditor's to disclose any original information about the company (except to the extent the auditor's stated reason for identifying a CAM involves reference to facts not already disclosed by the company).

New in this reproposal is the requirement that the auditor also discuss how the CAM was addressed in the audit. This discussion should utilize language that will make the information useful to investors, which, in my view, means that descriptions of audit procedures should not be overly technical but should convey how and why the procedure helped the auditor become comfortable with the critical matter.

Overall, I am supportive of this project. Borrowing language from our economists, the project is intended to provide information to investors in order to decrease the information asymmetry between auditors and investors. I believe that providing more information about the audit could do so, which could drive increased confidence in the capital markets. However, because the proposed requirement will also impose costs and burdens on preparers, auditors, and others, we need to be sure that the information being provided is actually useful to investors. Here, I believe the jury is still out. I am hoping for thoughtful comments from investors and other financial statement users on this question. I also look forward to more definitive academic research that would demonstrate the value of expanded auditor reporting in jurisdictions where it is already in place.

Finally, I have a request: Of all of the PCAOB's stakeholders, preparers have expressed the greatest opposition to the proposed changes in the auditor's reporting model. We believe we have addressed the most significant concerns, focused primarily on the disclosure of original and immaterial information by the auditor. To the extent you continue oppose the amendments as reproposed, please consider providing us with specific feedback about how the approach could be improved. While blanket opposition to any changes to the auditor's report will, of course, be considered, investor demand for more information is strong, and the momentum of the project is toward expanded auditor reporting. This is particularly the case in light of new requirements for similar reporting around the world. Therefore, I urge you to be part of the solution by helping us understand and address specific concerns, rather than articulating only that you would like no changes at all.

Other Auditors

The second standard setting project I would like to address briefly is our recent proposal regarding the planning, supervision, and performance of audits involving other auditors, meaning auditors who participate in the audit but do not issue the audit opinion. This is an important area in light of the increase in companies with global operations, requiring the referral of audit work to other auditors around the world. Under current standards, there are multiple approaches for the oversight of such other firms or auditors, and the Board has observed varying levels of audit quality in the work performed by other auditors and varying degrees of supervision by the firm issuing the audit report.

To some degree, this project represents the PCAOB catching up to what is already "best practice" by some of the largest public accounting firms. These firms have extensive experience with global audits and have incorporated into their methodologies not only the requirements of international auditing standards but also process improvements designed in response to inspection findings by the PCAOB and other regulators. These firms require frequent, comprehensive communications with other auditors and review of other auditors' work papers in areas of significant risk, steps which go beyond those currently required by PCAOB standards. Other firms, including those who do not follow international standards, continue to base their supervision of other auditors largely on existing PCAOB standards. The proposed amendments are intended to enhance supervision and provide consistency to audits involving other auditors.

When I voted to approve the issuance of this proposal in April, I also raised several questions for commenters. One of these questions that may be particularly relevant to preparers of financial statements deals with the "sufficiency determination" requiring the lead auditor has to determine whether it is performing enough of the audit work to serve as the lead auditor. Under the proposal, this determination is based on the risks of material misstatement associated with the portions of the financial statements audited by the lead auditor relative to the portion audited by the other auditors. There are, however, are no bright lines or minimum percentages to help with this determination. This requirement is intended to increase the likelihood that the firm issuing the auditor's report performs audit procedures for a meaningful portion of the company's financial statements, but it may also raise questions for companies that operate in many different jurisdictions. In those circumstances, it may in some cases be difficult to determine which firm audits a sufficient portion of the company's financial statements to serve as lead auditor, and the criteria may not necessarily point to the firm currently serving as the lead auditor. The PCAOB's release provides extensive discussion of this proposed new requirement, including several examples. To the extent your companies have operations in multiple countries, I urge you to consider reviewing the PCAOB's release and to discuss the proposal with your auditor to better understand whether your existing arrangements would satisfy the proposed requirements.

Fair Value and Estimates

We also have been reviewing for several years now our standards governing accounting estimates and fair value measurements along with those addressing the supervision of specialists who provide information relevant to the audit, including valuation specialists, lawyers, actuaries, geologists and others. We have issued staff consultation papers to seek input in both of these areas and we discussed potential approaches with our Standing Advisory Group and Investor Advisory Group on a number of occasions.

Having conducted extensive outreach, any amendments to our standard governing the auditing of fair value and estimates are likely to focus on the following issues:

  • The auditor's identification and response to significant measurement uncertainty in accounting estimates or fair value measures;
  • The importance of applying professional skepticism in evaluating contradictory evidence;
  • The increasing use of pricing services by both management and auditors; and
  • Aligning any new standards in this area with our risk assessment standards.

Notably, the international standard relating to estimates and fair value, ISA 540, is also currently under review by the International Auditing and Assurance Standards Board, and our staff is in close contact with the staff of the IAASB to monitor developments and share information.

Because of the close link between standards governing fair value and estimates and standards governing the use of specialists (who often provide the information to establish fair values and estimates), we are closely coordinating our projects on specialists and on fair value and estimates. In the area of specialists, we are currently looking at both the definition of a specialist and whether and how the standard should differentiate between the auditor's use of a specialist and the auditor's consideration of the work of a company specialist.

While much work remains to be done, we currently hope to issue proposals in these projects by the end of this calendar year. Stay tuned.

Audit Committee Outreach and Audit Quality Indicators

Let me turn now to some other approaches – beyond inspections and standard setting – by which the PCAOB is trying to drive improvements in audit quality in order to protect investors.

One such effort is the robust dialog we have established in recent years with audit committees. As those responsible for the direct oversight of auditors and accountable to investors for financial reporting quality, audit committee members are a natural ally for the PCAOB. Starting around four years ago, members of the PCAOB Board and senior staff have met on occasion with groups of audit committee members in a variety of settings – large conferences, small gathering organized by groups like the NACD, audit committee gatherings hosted by audit firms, academic conferences, and many others. While this outreach is less formal than our meetings with our Standing Advisory and Investor Advisory Groups, I have found it to be enormously helpful in understanding issues facing audit committees and how our actions impact them and their companies.

One topic that we have discussed extensively with audit committees is our project on audit quality indicators. In late 2012, we announced our intention to study the feasibility of establishing quantitative measures of audit quality, and we have conducted extensive formal and informal outreach on this topic for the past several years. Last July, we issued a concept release to seek public comment on the content and possible uses of a group of 28 potential audit quality indicators.[1]

The feedback in response to our concept release was mixed, with some commenters supporting the project but advocating that we should let practice develop on a voluntary basis. Other commenters supported the project and urged us to act quickly to mandate public disclosure of certain audit quality indicators; however we received very little feedback on the utility of the 28 individual indicators.

Several firms, as well as the Center for Audit Quality, also have been studying this area and have begun to publish certain firm level metrics that they believe may be helpful, especially to audit committees, in evaluating audit quality.

We continue to digest the feedback we have received and to discuss with firms their experiences with the quality indicators they have begun to identify and track. While the Board has yet to make a formal determination about next steps, my expectation is that we are not likely to impose any requirements or new standards in this area in the near future. Rather, I believe we will continue to gather data about promising indicators, encourage academic study in this area, and urge firms to monitor and report publicly on some of the most informative measures. I believe it would also be useful to gather more input on whether to establish standardized definitions for certain indicators, even if their use is voluntary, in order to allow for comparability.

Evolution of the PCAOB

I have described a number of our outward facing initiatives, all intended to continue the trend of improving audit quality since the establishment of the PCAOB. But in addition to continuing our work in inspections, enforcement, standard setting and related outreach, we also need to take a look inward, at the PCAOB as an organization, and determine how we need to evolve in order to maximize our effectiveness in protecting investors and the public. In recent years, we have made great strides in integrating economic analysis into our standard setting and rule-making. While this was in part a response to political forces, we have found that our understanding of the problems to be solved through our actions, and the impact of potential solutions, has deepened significantly. Hopefully, this will result in standards that are more targeted and effective, while minimizing the burden on auditors and preparers. We continue to work with our economists to improve both the substance and documentation of the relevant analysis.

We are also taking a look at our inspection program. In recent years, the staff has made improvements to PCAOB inspection reports, increasing the information provided, for example, about the audits inspected and the standards giving rise to inspection findings. My colleague on the Board, Jeanette Franzel, spoke last month at Baruch College in New York about the potential evolution of PCAOB inspections in the future, including possible changes such as an increase in random inspections, shifting from a strong emphasis on engagement reviews to increased testing of a firm's system of quality control, or changes in reporting and communications of inspection results. Such changes will take time to design and implement, but I agree with Board Member Franzel's perspective: As audit performance improves, and the nature of risks to audit quality evolves, our inspection approach must be adjusted in order to maintain its effectiveness.

Likewise, the PCAOB has embarked over the last year on a review of its standard setting process. Along with ongoing improvements in our economic analysis, we want to make sure that our standard setting proceeds as efficiently and effectively as possible. We are in the home stretch of this work and potential enhancements include, among others, doing more research in order to define the problem to be solved even before a project is added to the standard setting agenda; more economic analysis earlier in the consideration of possible alternative approaches; better coordination among the various offices and divisions involved in standard setting at the PCAOB; a more phased approach to Board decisions throughout the project; and more standardized documents.

Finally, we embarked this year on our first post-implementation review of an auditing standard, AS 1220, Engagement Quality Review (formerly AS 7). The purpose of this review is to evaluate the effect of the standard, including:

  • Evaluating whether it is accomplishing its intended purpose,;
  • Identifying, wherever possible, costs and benefits; and
  • Identifying unanticipated consequences, either positive or negative.

The staff of our Center for Economic Analysis, which is coordinating the review, has gathered internal data, including inspection results, conducted a review of academic research, and recently issued a request for comment.[2] While we are still learning and developing our approach to post-implementation review, I am pleased that we have taken steps to establish this important process.

I will close with a few comments on the topic covered extensively before lunch: ICFR. As you heard from Helen Munter, frequent inspection findings continued to be observed in the areas of ICFR, including insufficient testing of:

  • The design and operating effectiveness of selected controls, especially in high risk financial reporting areas;
  • Controls that contain a review element;
  • Controls over the accuracy and completeness of system-generated data and reports.

As you also heard during the ICFR panel this morning, there continues to be an expectation gap between preparers, auditors, and the PCAOB and SEC with regard to the appropriate level of scrutiny, testing and documentation by auditors of companies' internal controls. Preparers have expressed concern that auditors are doing unnecessary work as a result of PCAOB inspection findings. Although we are comfortable that our inspectors are not imposing new auditing requirements through inspections, it is possible that firms' concerns about the frequency of our inspection findings in the area of ICFR, and firms' efforts to remediate the related quality control deficiencies, have caused some audit teams to do more work. In some cases, their work may be focused on the wrong areas, resulting in unnecessary burdens on management. As discussed during the last session, we at the PCAOB, in coordination with SEC staff, will continue to focus on this issue in order to make sure we have an appropriate balance between auditors' doing sufficient and meaningful audit work to gather the right amount and the right type of audit evidence, while not imposing unnecessary burdens on management or causing needless delays in the financial reporting process.

After completing the post-implementation review of AS 1220 (AS 7) and making any necessary adjustments to our process, I believe we should give serious consideration to conducting such a review of the standard on auditing internal control, AS 2201 (formerly AS 5). The implementation of this standard represented a sea change in public company audits, imposing extensive costs but also driving what many believe were significant improvements in financial reporting quality. Of course, post-implementation review of such a complex standard would require extensive time and resources. But it is precisely our most controversial regulatory actions that should be subject to such scrutiny to determine whether they have achieved their investor-protection objectives.

With that, let me thank you for your attention this afternoon. I am happy to take any questions.

[1] Concept Release on Audit Quality Indicators, PCAOB Rel. No. 2015-005 (July 1, 2015).

[2] Request for Comment: Post-Implementation Review of Auditing Standard No. 7, Engagement Quality Review (April 6, 2016).