Auditing the Future

Good Morning,

I am very honored to be here this morning to address the Fair Value Measurements and Reporting Conference. I was a presenter at the first AICPA Fair Value conference in 2009 when I was a partner at McGladrey & Pullen LLP. Since then, I have moved on to my new role as a Board member of the Public Company Accounting Oversight Board, where I am dealing with many of the same issues I encountered during my years as a public accountant, but from a different perspective.

I am encouraged that you have all joined this event to explore issues related to fair value measurements. I am going to discuss today some of the Board's activities that may be of consequence to your work and will share with you some of my views from my new perspective as an audit regulator and standard setter.

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.

Introduction – Creation of the PCAOB and its Activities

Historically, basic accounting concepts have not changed often or quickly. The past decade, however, has been a period of unprecedented changes in the areas of accounting and auditing. The collapse of Enron, the bankruptcy of WorldCom and the subsequent passage of the Sarbanes-Oxley Act of 2002, as well as the increasing use of fair value measurements and the financial crisis, all contributed to an environment that drove these changes. "SOX," as so many affectionately call the landmark legislation, was the result of investor losses from financial reporting and auditing deficiencies early in this century at some of the largest public companies in the United States: Enron, Global Crossing, Adelphia, Tyco, Qwest Communications, Xerox and WorldCom. The events involving these companies shook the confidence in the integrity and reliability of public company financial reporting and demonstrated a need for enhancements in internal controls over financial reporting and corporate governance. Ten years ago next month, Congress passed the Sarbanes-Oxley Act almost unanimously, resulting in the most significant legislation relating to the federal securities laws since 1934.

The Sarbanes-Oxley Act created the PCAOB, which commenced operations in 2003. The Board's mission – as set forth in the Act – is "to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports."

As you may know, the PCAOB has four main responsibilities under the Act:

1. Registration of public accounting firms that audit public companies or broker-dealers;
2. Standard Setting;
3. Inspections of registered public accounting firms; and
4. Investigations and disciplinary proceedings in cases where auditors may have violated certain provisions of the securities laws or applicable standards or rules.

Currently, over 2400 firms, including over 900 foreign firms from 88 jurisdictions, are registered with the PCAOB. The PCAOB has built an inspection program comprising over 440 inspection staff members. Of all registered firms, 9 currently are subject to annual inspection because they issue over 100 audit reports each year, while approximately 850 are subject to inspection at least every three years because they issue 100 or fewer audit reports each year.

Our Office of the Chief Auditor is responsible for leading the Board's standard setting activities. When it commenced operations, the Board adopted as its interim auditing standards those standards promulgated by the AICPA's Auditing Standards Board before April 16, 2003. Since then, the Board has issued 15 of its own auditing standards — including, for example, on audit documentation, internal controls, audit planning, engagement quality review, and risk assessment — and has substantially amended a number of interim standards. More recently, the Board issued concept releases or proposals to trigger wide-ranging discussions about potential changes to certain fundamental aspects of auditing, including the contents of the auditor's report, transparency relating to participants in the audit, audit committee communications, and auditor independence, objectivity, and skepticism.

Since it began operations, the PCAOB has conducted over 1800 inspections, including inspections in 38 jurisdictions outside the United States. Our enforcement program has sanctioned 39 firms and 52 individuals to date, including imposing censures, temporary and permanent practice bars, revocations of firm registrations, and civil money penalties up to $2 Million.

In pursuing its mission during the last nine years, the Board has evolved from a start-up institution focused on establishing a comprehensive, consistent oversight system to a maturing regulatory organization with the experience and resources to adapt to changing times and new challenges.

Changes in the Accounting and Auditing Professions and the Increase in Fair Value Measurements

The accounting and auditing professions as a whole are facing difficult questions as a result of the increasing complexity of business transactions and cutting edge financial instruments which are appearing more frequently not only in the financial statements of financial institutions but many other types of companies as well. Thirty years ago, financial statements were dominated by tangible assets and historical cost accounting. Today, after rapid advances in technology and the development of innovative business models, the balance sheets of an increasing number of companies are dominated by valuation estimates, rather than "solid numbers," and it is much more difficult for accountants, auditors and investors to understand the transactions and products that must be captured in financial statements. Management and their accountants increasingly must tackle fair value measurements and management estimates, consistent with new accounting standards in connection with derivatives, securitizations, consolidations, debt/equity issues, revenue recognition, leases and other issues.

As a result, the valuation process used by management, and the auditor's review thereof, have had to evolve during the last several decades. What may have begun as a calculation on a scrap piece of paper – perhaps a simple multiple of EBITDA – evolved into management memos documenting valuation processes; auditors becoming aware of potential pitfalls and increasing their review of management's valuations and estimates; and management ultimately relying increasingly on outside valuation specialists, requiring auditors to gain a better understanding of the assumptions and methodologies employed by these specialists.

And while the sophistication of preparers and auditors dealing with fair value measurements has increased, the recent financial crisis also brought unprecedented attention on the difficulties associated with the valuation of certain types of assets, subjecting the work of accountants to increased scrutiny by regulators and investors.

PCAOB Inspection Findings

So where does the PCAOB come in? In order to maximize our effectiveness and most efficiently utilize our resources, the Board conducts risk-based inspections. This means that our inspectors choose to review those audit engagements that they believe, based on extensive research, present the highest level of audit risk. Within each audit engagement selected, inspectors choose the most challenging and high risk audit areas to review, in order to test the firm's ability to address those challenges and risks. With this approach, it will not come as a surprise that we look extensively at the auditing of fair value measurements and other management estimates.

Common inspection findings reported by the Board included instances where auditors appear not to have complied with PCAOB auditing standards in certain audit areas, including, among others, fair value measurements of financial instruments, impairment of goodwill, indefinite-lived intangible assets, and other long-lived assets.

Financial Instruments

Often fair values of financial instruments are determined using various modeling techniques. Hard-to-value financial instruments include among others, private debt securities, auction-rate securities, asset-backed securities, collateralized debt obligations, collateralized mortgage obligations, and other mortgage-backed securities.

Both issuers and auditors frequently obtain pricing information for these financial instruments from outside pricing services, which often use modeling techniques due to limited trading information. These models often use assumptions such as prepayment speeds, discount rates, and default rates. PCAOB inspectors have identified instances where the auditor failed to determine whether these prepayment speeds, discount rates, and default rates were supportable and reasonable.

In other situations, auditors did not appropriately consider the weight of both positive and contradictory evidence. For example, auditors in some cases did not evaluate the implications of significant differences in fair value measurements from different pricing sources for the same financial instruments and relied on the price closest to the issuer's recorded price without evaluating the significance of the difference with the other pricing sources. In these situations, auditors did not evaluate how the prices were determined and did not determine whether the assumptions used by one pricing service were more reflective of the market than assumptions that were used by the issuer's pricing service.

We have also seen instances where auditors have neglected to appropriately respond to valuation risk. In those cases, auditors focused their testing of the fair value of financial instruments on easier-to-value securities and excluded or included only cursory testing of hard-to-value securities.

Finally, we have seen several instances where auditors have not performed sufficient procedures to assess the adequacy of the financial statement disclosures for hard-to-value financial instruments. For example, there have been instances where auditors did not determine whether the assumptions used to calculate the fair values, such as prepayment speeds and default rates were observable or unobservable. Whether or not the assumptions are observable dictates whether a financial instrument would be classified as a level 2 or level 3 fair value measurement.

Non-Financial measurements

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 valuations inherent in recording a business combination and performing a goodwill impairment test.

For example, inspectors have identified deficiencies that included auditors' failures to evaluate, or evaluate sufficiently, the reasonableness of significant assumptions used by issuers to estimate the fair value of reporting units in their goodwill impairment assessments or in measuring fair value for other intangible assets and other long-lived assets acquired in business combinations.

Inspectors identified instances in which auditors did not test, or tested only through inquiry of management, issuers' significant assumptions, such as forecasted revenue growth rates, operating margins, discount rates, implied control premiums, and weighted average cost of capital measures. In some of these instances, inspectors observed that auditors did not evaluate the effect of contradictory evidence when concluding on the reasonableness of certain significant assumptions. For example, inspectors identified some instances in which auditors accepted, without a sufficient basis, issuers' assumptions that revenue or operating profit would increase in the near future despite recent declines in revenue or historical operating losses.

Inspectors also found instances in which auditors did not evaluate, or evaluate sufficiently, the reasonableness of significant assumptions used by issuers in measuring fair value for other intangible assets and other long-lived assets acquired in business combinations. Specifically, some auditors failed to test, or tested only through inquiry of management, issuers' significant assumptions, such as future revenue growth rates, customer attrition levels, and estimated useful lives.

Finally, firms sometimes neglected to challenge issuers' conclusions that goodwill did not need to be tested for impairment more frequently than annually despite the existence of impairment indicators, such as recent declines in issuers' stock prices or reduced estimates of future revenue in situations where such declines or reductions appeared to be potentially significant to issuers' most recent impairment analyses.

What Auditors and others can do

So what can preparers, valuation specialists and auditors do to avoid audit failures that can lead to the erosion of investor confidence?

Although specific auditing standards apply to each of these areas – I will discuss some of these standards in more detail later during this session – broadly speaking, management, working with their valuation specialists, should take full ownership of all valuation related assumptions and should gather robust support and documentation for the valuations reflected in their financial statements. Auditors are required to understand and evaluate management's assumptions and processes in establishing valuations or estimates, and to test management's valuations and disclosures. The auditor also must evaluate any contradictory information that comes to light, and do so objectively and skeptically.

Because auditing management valuations of financial instruments is such a challenging area, the PCAOB convened a Pricing Sources Task Force last year 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 met three times in 2011 to discuss the valuation of financial instruments that are not actively traded and the use of third-party pricing sources to value such instruments.

Also, in November 2011, the Securities and Exchange Commission hosted its first Financial Reporting Series Roundtable on the topic, "Measurement Uncertainty in Financial Reporting." PCAOB 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 on 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 financial statement preparers among you to think about what you can do to "get behind the numbers" in connection with your disclosures related to fair value measurements and management estimates. This will allow you to provide to your auditors sufficient information to comply with important auditing requirements. In that context, I commend to you a speech given by SEC Professional Accounting Fellow Jason Plourde in December of last year 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?^[1]

I also encourage preparers to spend some time with your auditors to understand what our standards require. First, you may want to read your firm's PCAOB inspection reports to understand where engagement teams 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.

For those of you who are valuation specialists providing services to financial statement preparers and/or auditors, consider how you can help increase the understanding of preparers and auditors into what you do and how you do it. Proprietary valuation models aside, think about how you can explain the assumptions you are using, the sources of information on which you rely, and the judgments that are inherent in your valuation results. All of the important work that you do will mean very little if investors decide that they cannot trust the process by which important valuations are established and audited.

Finally, I would encourage all of you to stay tuned to regulatory developments in this important area. The PCAOB will issue this summer a series of reports discussing our overall inspection findings in a variety of contexts, including fair value measurements and management estimates. Our Office of the Chief Auditor also plans to issue later this year some guidance or proposed amendments to the auditing standards related to fair value measurements. We are always eager for real time input from experts working in the field to inform our standard setting process, so I urge you to review any proposals that are issued and to send us your comments.

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