Investor Protection through Audit Oversight
Thank you for inviting me to speak today. I am particularly pleased to be back in China.
I was here almost one year ago as part of our ongoing efforts with the People's Republic of China to forge a cooperative regime for cross-border auditing oversight.
I will speak more about those efforts, but I must begin by telling you 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.
At this very moment 10 years ago, the U.S. Congress was drafting legislation designed to improve the oversight of the auditing profession and restore the confidence of investors who lost billions of dollars in the collapse of Enron Corporation.
In June 2002, Enron's auditor, Arthur Andersen, was convicted in a criminal proceeding in a U.S. federal court of obstruction of justice for shredding Enron documents. Two weeks later, WorldCom, another Arthur Andersen client, collapsed in an accounting scandal, sending shock waves through markets around the world.
Congress sped up its work, and, in July 2002, passed the Sarbanes-Oxley Act, which created the Public Company Accounting Oversight Board.
Before the Act became law, accounting firms policed themselves, checking each other's work based on standards written by private standard-setting bodies controlled by the firms. To investors and lawmakers, the failures of Enron and WorldCom demonstrated that auditors' self-regulation was not working.
Initially, Sarbanes-Oxley was seen as an effort to address strictly an American problem. But the failures of Enron and WorldCom were followed closely by audit scandals at such non-U.S. companies as Parmalat, Vivendi, Hollinger, Ahold, Royal Dutch Shell, China Aviation and others.
As we approach the 10-year anniversary of the PCAOB, the Board believes that the inspections of auditors that we began in 2003, along with the standards we have set for the conduct of audits, have made a difference in the quality of financial reporting. Auditors and, more importantly, investors tell us so.
We are also pleased that the work of the PCAOB has encouraged the creation of similar, independent audit oversight bodies in other countries—oversight that can only benefit investors throughout the world.
The PCAOB is proud to have a leading role in the International Forum of Independent Audit Regulators, which was established in September 2006 to allow regulators to share their knowledge of the audit market environment and the results of their inspection and enforcement activities. Forty-three national independent audit oversight bodies are now members of IFIAR.
Oversight of Global Networks
I was honored recently to be elected Vice-Chair of IFIAR. The IFIAR plenary meeting in April in the Republic of Korea once again demonstrated the value of a cooperative, collegial approach to audit oversight.
It is also fair to say that for the PCAOB and, I believe, all members of IFIAR, the increasing globalization of economic activity, financial markets and audit practice is requiring all of us to focus more closely on cross-border regulatory cooperation.
This is particularly important because the world's largest audit firms operate through global networks, in which a number of individual audit firms—organized and operating under the laws of different political and regulatory jurisdictions—join together in networks in which they share clients, training, audit methodologies and quality assurance practices under a common name such as Deloitte Touche Tohmatsu, Ernst & Young, PricewaterhouseCoopers, KPMG and others.
But it is important to remember that these are networks, not monolithic, unified firms. This has important implications for regulatory oversight of these networks.
In the audit of a major global corporation, a number of different auditing firms, operating under a single trade name, will cooperate to perform the audit of the corporation's far-flung operations.
Many investors are unaware when they look at the audit opinion of a global corporation that the report represents the work of a number of individual audit firms.
At the PCAOB, we are attempting to address this issue by requiring more transparency in the audit report that is filed with a company's financial statements.
In October 2011, the Board proposed amendments to PCAOB auditing standards that would require audit reports to disclose the name of the engagement partner as well as the names of other independent public accounting firms and other persons that took part in the audit.
These amendments, if approved would serve two purposes: First, investors have told us that they want more information about which firms are actually performing work in the audit. Second, this information would make publicly available the names of firms that participate in audits but are located in jurisdictions where the PCAOB cannot yet conduct inspections.
The Importance of Inspections
The heart of the PCAOB's work is the inspections program. Under U.S. law, each registered firm whose audit reports are filed with the SEC or plays certain roles in those audits must be inspected by the PCAOB at least every three years. Firms with more than 100 issuer clients must be inspected once a year, and there are nine such firms. At present, there are over 2,400 firms registered with the PCAOB, including more than 900 firms from over 80 jurisdictions outside the United States. Of these, more than 250 firms are subject to annual or triennial inspection by the PCAOB.
We take our inspections responsibilities very seriously, and we issue reports, parts of which are publicly available, on each inspection. We also periodically publish summary reports on our inspections to illustrate trends and thematic findings for the investing public and other interested parties. As part of our inspection work, we work very diligently with our non-U.S. counterparts, including our colleagues here in China, to obtain agreements that will enable the PCAOB to perform this vital investor protection.
In 2011 alone, the PCAOB inspected portions of more than 825 audits performed by 213 registered firms based inside and outside the United States.
Our commitment to regular and vigorous inspections is more than a matter of meeting the requirements of the Sarbanes-Oxley Act. The PCAOB Board and staff is dedicated to assuring that auditors do their duty on behalf of their true clients—the investors, not the companies that pay them.
In that light, the Board is concerned that while the nature of our inspection findings has changed over the last nine years, we are disappointed that the frequency of our inspection findings has increased over the last two years. Some of these deficiencies, such as revenue and management estimates, have been consistently noted in our inspection reports over the last nine years.
Other deficiencies have resurfaced in an area where we had previously seen improvements as firms are, once again, having difficulties performing appropriate substantive analytical review procedures. Finally, over the last two years, we have seen issues with firms' testing of internal controls and with the procedures firms have performed to assess the reasonableness of fair value measurements for financial instruments.
Many of these problems could be solved if auditors approached their jobs with greater independence, objectivity and, perhaps most important, professional skepticism. Auditors are supposed to challenge management, and the PCAOB would like to see more auditors do so.
The PCAOB is not alone in finding these deficiencies in audits and governance. At the recent plenary session of IFIAR in Korea, more than 30 members presented the results of their audit inspection findings, and I was struck by the number of common findings throughout the world.
Regulators in many jurisdictions reported problems with the work of auditors relating to fair value measurements of financial assets, going concern issues and inadequate professional skepticism.
To obtain a fuller picture of audit quality, IFIAR officers have determined to survey the IFIAR members concerning the results of their recent inspections with the goal of preparing a report on the audit findings of independent regulators on a global basis.
We believe that this will be the first such report ever prepared and hope it will lead to periodic reports. We hope that the information in this report will enable regulators around the world to cooperate more closely in the oversight of audit firms and particularly of the global audit firm networks.
One specific area of common concern is the auditors' attention to the possible risks posed by companies' transactions with related parties—particularly executives and other members of management—as well as significant and unusual transactions.
Such transactions are vulnerable to fraud or material misstatement of financial statements.
Indeed, an examination of the major financial frauds and financial statement restatements in recent years, both in the U.S. and abroad, reveals that one or more of these relationships or types of transactions have been present in many cases.
The PCAOB staff made that point last October in a Staff Audit Practice Alert that directed auditors' attention to the potential risks of related party transactions and significant unusual transactions—as well as other issues—exposed by disclosures of possible improprieties in financial reporting by companies based in certain large emerging markets in Asia.
The PCAOB's own inspection results have shown that some auditors have not given adequate consideration to the risks of material misstatement from related party transactions. Our inspection results have also revealed deficiencies in some auditors' consideration and understanding of off-balance sheet structures that can also be a source of material misstatement.
These facts suggest two things to me: 1) these types of relationships and transactions deserve special scrutiny by auditors and 2) that audit committees should be informed in detail of the work performed by auditors in these areas so that they can fully understand their meaning and implications.
That is why I was part of the Board's unanimous vote in January to propose new standards that should both clarify for auditors those areas that the Board believes require special attention and insure that audit committees are better informed about them.
Cooperation with Non-U.S. Regulators
I have spoken of the PCAOB's involvement with IFIAR, but our involvement and cooperation with our non-U.S. counterparts predates the formation of IFIAR.
As I mentioned, more than 900 audit firms from over 80 jurisdictions outside the United States are registered with the PCAOB, and more than 250 of those firms are subject to periodic inspection by the PCAOB because their audit reports are included in filings with the U.S. Securities and Exchange Commission.
Our staff has conducted 338 inspections of PCAOB-registered firms in 38 non-U.S. jurisdictions since such inspections began in 2005. In 2012, we anticipate conducting approximately 85 inspections of firms outside the United States.
To date, we have entered into cooperative agreements with 13 jurisdictions—including, in Asia, Japan, Singapore, Chinese Taipei and Korea—as a result of which we are able to conduct joint inspections with local regulators or share inspection findings with the regulators.
Most recently, we have entered into cooperative agreements with Germany, the Netherlands and Norway and are actively negotiating such agreements with a number of other audit regulators in Europe and elsewhere.
We have conducted joint inspections of audit firms with regulators in jurisdictions such as Canada, Switzerland, the United Kingdom, Germany, Korea, Singapore, South Africa and Norway. In addition, we have conducted PCAOB-only inspections in approximately 30 other jurisdictions.
We have been able to deal with both data protection laws and confidentiality concerns in negotiating these agreements and while conducting joint inspections we have found that, with a cooperative spirit, legal and cultural obstacles to cooperation can be surmounted.
We have also found these joint inspection activities to be very useful and informative for both the PCAOB and for our non-U.S. counterparts involved and believe that the exchange of knowledge and information between regulators that they entail has improved regulatory oversight both in the U.S. and for our partners.
The PCAOB currently is prevented from inspecting the U.S.-related audit work and practices of PCAOB-registered firms in certain European countries, China, and — to the extent their audit clients have operations in China — Hong Kong.
That means investors in U.S.-traded companies who rely on those firms' audit reports are deprived of the potential benefits of PCAOB inspections of the companies' auditors.
To better inform investors, the PCAOB publishes on its website a list of more than 400 companies whose auditors are located in jurisdictions where obstacles to PCAOB inspections exist. The list is derived from annual reports filed with the PCAOB by registered public accounting firms.
The SEC now also requires issuers to disclose in their public filings whether their auditors are able to be inspected by the PCAOB.
We believe that these disclosures are valuable for informing investors, but we believe a more potent protection for investors would be the ability to inspect all auditors registered with the PCAOB who perform or play roles in the audits of companies seeking access to our capital markets.
Oversight Negotiations with China
In the past year or so, serious accounting problems have emerged with a number of China-based companies whose securities are registered and traded outside of China, particularly in the U.S., Singapore and Europe.
In the U.S. alone, 67 of these China-based issuers have had their auditor resign, and 126 issuers have either been delisted from U.S. securities exchanges or "gone dark," meaning that they are no longer filing current reports with our SEC.
Billions of dollars of market capitalization of such companies have been lost in U.S. securities markets and it is fair to say that all China-based companies listed on U.S. securities exchanges — both large, established firms and smaller ones — have suffered serious losses of both market value and investor confidence as a result of these problems.
Indeed, the number of Chinese-based companies that have successfully filed an initial public offering in the United States in the past year has slowed to a trickle. We understand that Chinese companies have also suffered similar adverse consequences in other non-U.S. and non-Chinese markets.
Against this backdrop, the PCAOB has been working diligently in the last year to reach an agreement on cross-border audit oversight, maintaining a constructive dialogue with both the China Securities Regulatory Commission and the Ministry of Finance.
At this time, 48 firms in the China are registered with the PCAOB. In addition, 56 firms in Hong Kong are registered with the PCAOB.
Both we and the Chinese regulators recognize the importance of improving audit quality and investor protection. The question is how to achieve that in ways that respect the national sovereignty and the legitimate regulatory goals of both countries.
As a first step toward further cooperation, we are working toward observational visits in which PCAOB inspectors would actually observe the Chinese authorities conducting their audit oversight activities and the Chinese could observe the PCAOB at work.
Initially, such observations will focus on the auditing firms' quality control activities, and a subsequent round will focus on the inspection of one or more audit engagements. We hope such exercises will build trust and lead to further cooperation.
The ultimate goal of the PCAOB is to achieve a level of cooperation with the Chinese authorities that will enable us to issue inspection reports on those China-based audit firms whose audit reports are filed with the SEC. As I mentioned earlier, we are required to prepare and issue such reports under U.S. law. We are very hopeful that the Chinese authorities will see their way to accommodating what we believe are reasonable requests for cooperation. Statements by senior U.S. officials at the recent Strategic and Economic Dialogue meeting in Beijing illustrate the seriousness with which the U.S. views this matter.
In the fall of 2010, the PCAOB issued a release announcing that the Board will ask individual firms from certain jurisdictions seeking to register with the PCAOB to state the firm's understanding of whether a PCAOB inspection of the firm would be allowed by local law or local authorities, and, if the response is that the inspection would be allowed, to supply written confirmation from the appropriate local regulatory authority. Since that time, no China or Hong Kong-based firms have been registered with the PCAOB although eight applications from China and six applications from Hong Kong are pending.
Moreover, the PCAOB has been unable to inspect any China-based audit firms that are already registered with the PCAOB or the audits of China-based companies performed by Hong Kong-based PCAOB registrants despite the fact that the statutory deadlines for such inspections have either passed or are fast approaching.
Both the PCAOB and the SEC have also requested the cooperation of Chinese authorities in obtaining documents in enforcement cases relating to China-based companies. While the Board has made no decision about how to proceed in any of these pending registration, inspections or enforcement matters, I believe it is fair to say that how we proceed will depend in substantial part on whether we can make real progress toward a cooperative oversight agreement with regulators during the balance of this year.
In the economic crisis that reached its nadir in 2008, we saw well-known companies—notably Lehman Brothers—whose bankruptcies eclipsed the failures of Enron and WorldCom in 2002.
What's more sobering is that we are once again in uncertain economic times, with weak job growth in the United States, turmoil inside the European Community and a slowing of business growth here in China.
This is just the time that investors most need protection. We may claim a large company as our own because its home office is within our national borders, but, more likely than not, the company is doing business globally and seeking capital in markets in other countries. Many different regulators likely oversee its operations and effective investor protection can only be achieved if those regulators cooperate and work together toward the common end of effective investor protection.
It is our duty as regulators, as auditors and as management of companies to do everything we can to make sure that investments in public companies are vouchsafed by the best audits and auditors possible. It is our duty to protect investors. After all, they are also our citizens.