Keynote Address

Thank you for inviting me to speak today. It is a pleasure to participate in the 40th occasion for this conference. It is my second year here, and I am honored to be back.

I was also honored to participate in the AICPA's 125^th Anniversary in May. I congratulate you again on what you have put forth for the public interest in those years, and I have high expectations for the years to come.

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.

You have an excellent conference program, offering valuable insights on current technical questions and quandaries as well as an opportunity to discuss important policy issues. I am especially pleased that the conference devotes more attention to auditing each year.

I. High Quality, Independent Auditing is Critical to Our Economic Success.

As I have learned in this job, getting the accounting right is indeed not the same thing as getting the auditing right. My sense from accountants I talk to is that auditing is receiving well-deserved attention in its own right.

Our economic success depends on the confidence of the users of capital and the providers of capital alike. Corporate managers hire internal accountants — many of you here today — to ensure they have accurate and detailed information on which to base management decisions. Managers ignore opportunities to glean trends and insights from this data at their peril.

Mistakes in this information can send a company into a business line or market that squanders resources. We now know that the true cost of financial misstatement is much greater than stock market fallout, concomitant lawsuits and insurance claims.

Researchers from Rutgers and NYU reported in 2009 on the costs of misstatements by companies known to have been managing earnings between 1997 and 2000.^[1] In their words, "the essential point that emerges" is that if management wants to maintain appearances, then hiring and investment must be consistent with reported profits.

Therefore, they found, during the years of earnings management the companies increased hiring by 25 percent. Competitors increased hiring, on average, by only seven percent.^[2]

As soon as the companies came clean, the unneeded employees were fired. The researchers estimated that the restating companies fired between 250,000 and 600,000 workers between 2000 and 2002, slashing payrolls by more than 25 percent, while other companies cut them by just 1.5 percent.^[3]

Investors and employees of misreporting companies are not the only ones hurt. Columbia Business School Professor Gil Sadka did his PhD dissertation at the University of Chicago on the effects of fraudulent reporting on competitor companies.

He found that false reporting leads both companies who misreport and their competitors to overinvest in new technology and engage in misguided price wars.^[4] He did a case study on WorldCom to test the point.

WorldCom's major competitors were Sprint and AT&T, which together made up 60 percent of the telecommunications market. The price war prompted by WorldCom during the period of fraud drove industry pricing down in key product lines.

The artificially low prices took a toll on margins at WorldCom's competitors. Both Sprint and AT&T experienced a decline in their operating margins during the period.^[5]

This is the kind of information we can, of course, only know with hindsight. What it teaches us is that the unanticipated cost of misreporting can be both general in impact and great.

Fudging the financials misleads investors and other companies alike into inefficient allocation of capital. Economists warn that this, in turn, leads workers to train up, and sometimes move families, for jobs in industries that don't need them. Years later, when they lose those jobs, their potential productivity is yet again wasted in unemployment.

These are social costs of financial misreporting in economic terms. When they occur, they imply a market failure: efficient market allocations have been diverted by bad numbers.

That's where the auditing profession comes in. High quality auditing is critical to our economic success because it allows us to allocate capital efficiently. Indeed, it has done so since our country was formed. If it weren't for auditing, our country would likely not have moved forward from frontier land speculation and canal projects to an industrial economy that would employ sophisticated financing through global capital markets.

Accounting standard-setters have rightly spent much of the last ten years exploring ways to close loopholes wedged open by companies that issued fraudulent financial reports at the turn of this century. But it would be a mistake to conclude that, until standard-setters close loopholes, our system permits or tolerates fraudulent exploitation of them.

Both Bernie Ebbers of WorldCom and the Rigas father-and-son team that headed Adelphia learned that lesson the hard way when the Second Circuit Court of Appeals, in separate cases, affirmed their convictions, rejecting their arguments that Generally Accepted Accounting Principles allowed the fraudulent reporting treatments.

In both cases, the Second Circuit Court of Appeals affirmed the convictions. In Ebbers's case, the Court held —

If the government proves that a defendant was responsible for financial reports that intentionally and materially misled investors, the [securities fraud] statute is satisfied. The government is not required in addition to prevail in a battle of expert witnesses over the application of individual GAAP rules.^[6]

In Judge Wesley's opinion in the Rigas case, "Even if Defendants complied with GAAP, a jury could have found, as the jury did here, that Defendants intentionally misled investors."^[7]

Securities lawyers know that the cases since Enron broke no new ground. They were founded on the long-standing principle articulated in the 1969 case, United States v. Simon. There, three auditors were convicted for their role in the Continental Vending fraud. On appeal, the court rejected the auditors' argument that they could not be found guilty if the company's disclosures complied with accounting standards.

In a thoughtful opinion by Judge Henry Friendly, one of the most respected jurists in U.S. history, the Second Circuit Court of Appeals affirmed the trial court's decision that proof of compliance with GAAP was "not necessarily conclusive that [the auditors] acted in good faith, and that the facts as certified were not materially false or misleading."

Many accounting firms devote inestimable time and attention to the study of the fine points of the applicable accounting regimes.

But with this history, it is high time that we focus on auditing as its own discipline, to be studied, nurtured and trained. All auditors should be versed in the case studies on fraud. It is simply not the case that frauds do not repeat; although there may be new twists, familiar elements reappear.

The economic literature also provides important insights and is worth more than mere browsing.

Just last month, David Larcker of Stanford University and other researchers revealed thought-provoking new evidence of the linkage between certain kinds of equity incentives and misreporting.^[8]

The work of academics and other thought leaders has refocused on the importance of the audit profession. Their new look at the archives of the last decade may lead you to new insights of your own. It could make you a better auditor, and better equip you to recognize and confront a bad situation.

II. Audit Firm Culture Must Support Auditors' Work.

I acknowledge that auditors are in a tough spot. With rare exception, they are an ethical breed. One does not go into, or stay in, auditing just for the tangible benefits. As in all professions, fair compensation is critical to the vitality of the profession.

I never met an auditor who wasn't proud of finding a fraud, avoiding the company's demise, and sparing investors' ruin.

Yet firms are, by design, profit enterprises. The public is the intended beneficiary of the audit. But the public doesn't pay the auditor's bills. Auditees do, and, in the United States, the audit fees that those engagements pay are a decreasing portion of audit firms' revenues.

Large audit firms' revenues from consulting are growing rapidly, at some firms more than 15 percent a year. Audit fees have stagnated at, basically, the inflation rate.

Thus audit practices have shrunk in comparison to audit firms' other client service lines — not all of which are schooled in, or depend upon, the fundamental exercise of skepticism. This threatens to weaken the strength of the audit practice in the firm overall.

After nearly ten years of inspecting the audits of issuers, the PCAOB has identified hundreds of engagements that did not meet PCAOB standards in significant respects.

These are serious audit deficiencies in procedures and actions that mean, essentially, that the audit opinions involved were not adequately supported. Moreover, inspection findings have increased at many firms over the last several years.

This is a hard message. It is to be expected that the inspection findings are a disappointment to a profession proud of its reputation for technical excellence. Some firms have seen even more findings this year.

Yet I say with confidence that I have seen dramatic improvements in audit quality in response to the findings. When a firm accepts the findings, and undertakes a rigorous root cause analysis, it can design actions to reduce and eliminate recurrence.

The audit firm takes a significant step on the road to excellence when it acknowledges that the number and vector of our findings indicate root cause, systemic issues, and not merely episodic failures in execution.

That involves self-monitoring and testing — not just waiting to see if the PCAOB finds the problem in other audits.

Inspectors have seen it done. This requires, when a firm is grappling with evidence of a lack of skepticism in certain past audits, the firm demands — through its words, actions and subsequent testing — pervasive and explicit evidence of skepticism in the work papers.

It means the firm issues meaningful, believable and consistent messages internally that quality is not one of many goals, but the firm's number one priority. It means these communications go to — and are honored by — all professionals, because the firm engages all professionals in the remediation efforts.

I hope you are seeing these actions and improvements in your firm. Not all firms have gone to these lengths. But this is what quality means.

III. The PCAOB's Initiatives are Aimed at Enhancing the Relevance, Credibility and Transparency of Audits.

The PCAOB too is deeply engaged in examining ways to enhance the relevance, credibility and transparency of the audit to better serve investors.

In November 2011, the PCAOB adopted a major new strategic plan to focus its programs and initiatives on ways to do so. It built on the work of the founding board but brought that work forward to address current challenges and expectations for the organization.

The Board reaffirmed that strategic plan last week, in connection with adopting the PCAOB's 2013 Budget. The new plan reflects modest updates and adjustments as well.

In particular, it includes a new strategy to underscore the continuing development of the PCAOB's Global Network Firm Inspection Program, as well as a new strategy related to standard-setting for audits of emerging growth companies, in light of recent legislative developments.

Since last November, we have brought on a new director for our Office of Research and Analysis, Greg Jonas. We have also adopted a new IT governance framework. Therefore, the plan also includes an updated strategy related to managing knowledge and leveraging IT, reflecting enhancements to our IT governance and our vision for research and analysis under Greg's leadership.

In my message accompanying the plan, I set forth certain near-term priorities. They afford some insight into initiatives that our inspections, research and standards-setting programs have undertaken to improve audit quality in the interest of the investing public.

A. Inspection Initiatives Will Focus on Deepening Inspection Analysis and Improving Reporting.

Our inspections initiatives will focus on further deepening our inspection analysis and improving our reporting — both for inspections and remediation.

This past year our inspections program, under the leadership of Helen Munter, has been very active — issuing around 200 reports and completing approximately 265 inspections thus far. While inspection findings for the 2012 inspection cycle are still preliminary, the deficiencies continue to be high relative to prior years and Helen will speak about that on Wednesday.

Helen's group has devoted considerable attention to further develop the infrastructure necessary to reduce the time it takes to produce reports. That effort will continue into 2013 and is one of the near-term priorities of the Board.

Our reports do take time to produce. While we aim to issue reports within 12 months of the inspections fieldwork, and many now beat that target, some reports take longer. The period from the end of the fieldwork to the time a report is produced is an important time period. We issue comments on potential findings, give firms time to respond and then evaluate their responses to develop the draft report.

Once drafted, reports go through several reviews to ensure consistency of approach across firms and findings. Inspectors take care to ensure that findings are appropriate, and that if they criticize conduct, they criticize it consistently wherever they find it.

Importantly, inspectors give time throughout the process for dialogue with firm personnel and leadership. We continue, however, to improve our processes to reduce the time it takes to issue our domestic large firm inspection reports and to improve the content of our other reports.

A note about form: An essential ingredient of the inspection process is candor with firms about the points on which we see a need for improvement. That emphasis may often result in inspection reports that appear to be laden with criticism of a firm's policies, practices, and audit performance, and less concerned with a recitation of a firm's strengths.

Grounded in the vision of the Sarbanes-Oxley Act, the inspection reports are not intended to serve as balanced report cards, rating tools, or potential marketing aids for any firm.

The reports are intended principally to focus our inspection-related dialogue with a firm on those areas where improvement is either required for compliance with relevant standards and rules, or is likely to enhance the quality of the firm's audit practice. That purpose should not be lost.

But in light of these goals, the inspections division will also consider ways to deepen our own analysis of inspection findings, over time and across firms, so that we see more and miss less when we encounter what may be only the tip of a problem.

I anticipate more summary reports on insights from inspections, on more topics. We will prepare these reports always with an eye on, among other things, getting useful information to audit committees. This will build on the release the Board issued in August on how audit committees can learn more from the results and implications of the PCAOB's inspection findings. Armed with more and better information, audit committees should be in a better position to champion audit quality.

PCAOB outreach to audit committees is naturally an important component. An observation here, about outreach to and interaction with audit committees — one of our near-term priorities: Our outreach and interaction should help audit committees promote audit quality.

Audit committees have a role in fostering not just integrity in management's reporting, but the vitality and viability of the independent audit. In my experience, when an audit committee meets with internal audit or compliance staff, the first question they ask is, "do you have enough resources?"

Do the audit committees you interact with ask the same of the external auditor? They should, and the good ones do. The audit is the linchpin of the investing public's confidence in the company; it is not something to be procured from the lowest cost supplier.

B. The PCAOB's Office of Research and Analysis Will Initiate a Project to Identify Audit Quality Measures.

I've mentioned our new Director of Research and Analysis. We've served Greg a full plate. His office works closely with the inspections division on inspection planning. As in past years, the office is responsible for delivering detailed risk analysis to the inspection division in the Fall, to assist with planning for the next year.

This is in addition to the year-round work the office does to spot audit and accounting risks, run them down as far as they can based on public information and their own analysis, and work with others internally to determine the best resource to address the risk.

In 2013, the Office of Research and Analysis will also initiate a project to identify audit quality measures, with a longer-term goal of tracking such measures over time and across firms and networks of firms, and back-testing them for their predictive value.

The fruits of this data analysis could also enable us not only to better inform our own processes, but to provide meaningful analysis to auditors, audit committees, and the investing public.

We are at the earliest stages of this endeavor, but I have high hopes.

C. Evaluating the PCAOB's Standard-Setting Framework.

The PCAOB's standards-setting staff are also hard at work finding ways to make our standards-setting process as effective as possible, including through greater use of economic analysis.

All but fifteen of the audit standards were adopted by the profession itself. The PCAOB adopted those standards as its own in 2003 and called them the "interim standards."

We don't rewrite standards just for the sake of change. Since its earliest days, the PCAOB has endeavored to develop instructive standards that comprise the real intellectual content of what auditors do. The standards ought to be a living set of principles that a learned profession can believe in and resort to for support.

At the same time, they must be sufficiently clear and concrete to be enforceable fairly, for enforcing them is an important element of what we do — a subject that our enforcement director, Claudius Modesti, will talk about later.

To these ends, under Chief Auditor Marty Baumann's leadership, the PCAOB's standards-setting staff have devoted renewed attention to developing a new framework by which to organize and integrate the interim standards with the PCAOB's new standards.

I don't envision that this exercise should result in an immutable set of standards for all time. Each generation will have to evaluate new needs for change, for example as the interim related parties standard is today receiving renewed attention in light of new information about the relationship between executive compensation and audit risk.^[9]

To my mind, the standards — even the reorganization of them — ought to reflect a contemporary review of the challenges that auditors face, which we alone among standards-setters can see through our inspections.

We should also take good ideas from wherever else they come. For example, under Arnold Schilder's leadership, the International Auditing and Assurance Standards Board is moving forward with its paper on using the auditor's reporting model to communicate useful information from the audit to investors.^[10] PCAOB staff and board members have had numerous discussions with Arnold and his team, and our own project on the Auditor's Reporting Model has benefitted greatly from our interaction.

But there should be no presumption for simply adopting, off-the-shelf, other standards-setters' work in order to trade out an interim standard expeditiously.

Above all, emphasis should be placed on identifying and reacting appropriately to risk, and on establishing counterweights to circumstances that could detract from the ultimate goal of obtaining a high level of assurance that the financial statements are free of material misstatement. ^[11]

This is why I believe it is so important to reexamine how we protect the auditor's independence, including by considering term limits.^[12]

Economic analysis can help us in this review of the PCAOB's standards-setting framework. Economic analysis prompts us to ask critical questions: What is the problem? What are our alternatives, both to rulemaking and by rulemaking? What is the most cost-effective solution for society?

Indeed, economic analysis may tell us that if we can drive audit quality improvements through certain kinds of structural changes — such as by enhancing independence, introducing more transparency, or infusing the audit report with more insight, turning the auditor's focus more squarely toward communication with the investing public — we may be able to avoid the incremental cost of requiring additional audit procedures.

Economic analysis may also help us help the profession overcome market obstacles and realign incentives to promote sustainable excellence. I want to see the audit profession compete on quality more than price. I imagine you wish for that as well, but wishing isn't doing. Standards that give audit committees and the public tools to distinguish on the basis of quality may help you get there.

* * *

Historians remind us that each generation is, in a sense, the custodian of and fiduciary for the best ideas the past has given us. The enduring lesson of the past is that men and women do change their worlds.

Through this annual conference, the profession comes together each year to discuss and debate the work you do to serve the public. This conference is not about business development, or client service. It's about serving the public interest. I commend you for showing such initiative, year in and year out, to find new and better ways to do so.

You have been a gracious audience and I thank you very much for your attention.