Thank you for inviting me to this important conference. It is great to be before a group that cares so much about high quality auditing. I came to the PCAOB with the same commitment to champion the importance of auditing for the good of our economy and society.
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.
The PCAOB is deeply engaged in examining ways to enhance the relevance, credibility and transparency of the audit to better serve investors. I appreciate this opportunity to talk about our efforts and initiatives.
I also recognize that these essential qualities of the audit ultimately come to rest in the vitality of the auditing profession.
The auditing profession has developed a highly skilled body of experts capable of analyzing accounts in a way that draws out truths and insights and sheds light on confused or misleading claims. It plays an indispensable role in making our capital markets fair and strong.
But we are in a high risk period that merits more attention to the audit, not less. There is still considerable economic volatility, made more difficult by creative, but disruptive, technologies and uncertain fiscal policy. In uncertainty, even those companies that do not experience stress cut back, and those cuts generally affect broad areas of operations and control functions — the first line of defense to identify errors and control weaknesses, and address fraud and other corporate malfeasance. Auditors and audit risk are affected by such reductions.
Moreover, although we have never needed it more, the independent audit too has, in the minds of some, become a commodity to be contained with other compliance costs.
In the United States, 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. This threatens to weaken the strength of the audit practice in the firm overall.
To be relevant, the auditor must speak to and for investors. Fair or not, that is in question today. I want to see a vibrant audit profession that competes on quality more than price. I want to see a profession that is revered for insight and clarity, not box-checking. I want to see a profession that attracts and retains top graduates who are and remain committed to excellence in public service.
The PCAOB's Initiatives Aim to Help the Profession Realize Its Potential by Enhancing the Relevance, Credibility and Transparency of the Audit for the Sake of Investor Protection.
The PCAOB is pursuing several policy initiatives to accomplish these goals, by enhancing the relevance, credibility and transparency of public company audits.
This is not an exhaustive list of our initiatives. As Jennifer Rand discussed earlier today, we have a robust standards-setting agenda developed through extensive outreach, including with the PCAOB's Standing Advisory Group as well as other standard-setters.
The SAG, as we call it, is comprised of numerous stakeholders, including auditors themselves, as well as preparers and their representatives, investors, and others.
Nick Cyprus, who will speak this afternoon, is a past member. I can attest today that Nick's contribution is still valued, and his advice continues to influence our standard-setting projects.
Joe Carcello is a current member. He never fails to call out key points and findings from the academic literature and bring them to bear in our discussions in a practical way.
Doug Carmichael and Tom Ray, both past PCAOB Chief Auditors, have of course chaired the SAG during their respective tenures. As a PCAOB alumnus, Doug later became a member of the SAG.
As these distinguished accountants can attest, at the PCAOB we don't rewrite standards just for the sake of change. At the PCAOB, we hear many voices, and through our consultation process we identify areas of auditing that deserve improvement, or updating in light of developments in practice.
A New Auditing Standard and Additional Guidance Help Audit Committees Oversee the Audit.
The first two initiatives I will cover focus on arming audit committees with more and better information about the audit, as well as more and better information about the auditor's strengths and weaknesses.
Audit committees cannot make decisions about hiring and compensating auditors on the basis of quality without transparency and insight about quality.
Auditing Standard No. 16 Improves Auditor Communication with Audit Committees
As to the PCAOB's recently adopted Auditing Standard No. 16 — on auditor communications to audit committees — it has been submitted to the SEC for the necessary approval.
That new standard, I hope, will become effective for audits of 2012 financial statements. The noteworthy aspect of this pending approval process, for this group (familiar as you are with the purpose, history and content of AS 16), is the inclusion of an analysis of Efficiency, Competition and Capital Formation.
This analysis, performed to support the Commission's determination with respect to Emerging Growth Companies, represents a significant step in our regulatory process, and so far I am encouraged.
The PCAOB Has Issued Guidance on What Audit Committees Can Learn from PCAOB Inspections.
The PCAOB has also recently issued guidance about how audit committees can learn more from their auditors about the results and implications of the PCAOB's inspection findings.
How an auditor approaches inspection results can tell an audit committee a lot about the firm's commitment to excellence. Moreover, the PCAOB has tried, through its outreach, to impress upon audit committee members that how an audit committee addresses these issues also affects the tone of the audit.
An ill-informed audit committee that accepts weak arguments may inadvertently signal to the audit firm and audit team that it will not champion audit quality when resolve is needed. An audit committee that, on the other hand, expresses concern for how the auditor has resolved noted deficiencies tells the auditor that quality matters.
This release, as with AS 16, addresses the inherent information disadvantage of the audit committee.
No one relishes bringing home a bad report card. It's human nature. But of all groups, the audit profession ought to — and I believe does — understand the value of an honest dialogue about weaknesses. Auditors that help audit committees understand problems are in a better position to gain their support for measures that are necessary to address the tough calls.
This August release has been well-received by audit committee members. CFOs of major companies have also spoken favorably to the benefits of both AS 16 and this release.
The PCAOB Has Proposed New Standards on Related Party Transactions and Audit Transparency.
The PCAOB has two outstanding proposals for new audit standards. The first, on related party transactions, describes basic tools that good auditors have used for years to identify financial reporting risks. For example, it requires auditors to understand management's compensation as a way to understand management's motivations.
Changes in performance metrics may well be an important clue to understand areas where management's financial story is weak. They offer the auditor — and audit committee — insights about management's incentives that may not be gleaned otherwise.
For example, just last week, David Larcker of Stanford University and other researchers revealed thought-provoking new evidence of the linkage between certain kinds of equity incentives and misreporting. Compensation structures have a bearing on audit risk.
In a separate, Transparency proposal, the Board has proposed to require disclosure of the name of the engagement partner as well as participating firms in the audit. The interest of investors in this information reflects the public awareness that auditing is more than ever a global endeavor.
We are currently evaluating public comments on both the related party proposal and the transparency proposal, with a view to moving toward issuing final standards next year.
The PCAOB Has Issued Concept Releases to Commence Debate on More Broad-Ranging Topics.
The PCAOB standards-setting work also includes two rather more broad-ranging projects, commenced not with concrete proposals but with concept releases.
When I came to Baruch last, for the 10th Annual Financial Reporting Conference in May 2011, I discussed plans to embark on these substantive inquiries. In the intervening months, the Board's concept releases have facilitated a deep and constructive public dialogue about the role of the independent audit in our financial system, economy and society.
A wide variety of views on this role have been expressed by a wide variety of interested people. The common theme — and I will say it has been a galvanizing theme — is that the audit is more important than ever.
People are awakening to the perils of treating the audit as an antiquated, expendable commodity. People are reawakening to the importance of the audit to corporate governance. People are pushing for more from the audit, not less. More insight, more independence, more reliability.
The Auditor's Reporting Model
The first concept release involves consideration of changes to the form and content of the standard audit report.
This project is intended to develop a better, more transparent reporting model that will impart the auditors' insights about key aspects of the financial statements and other matters they want to emphasize.
The project is not about changing the nature or scope of the auditor's work. It's about making the results of that work more relevant.
With the insights and advice of members of our Standing Advisory Group, we are now engaged in deep analysis and development of some of the concepts mooted in our concept release.
The International Federation of Accountants' International Auditing and Assurance Standards Board has also proposed changes to the report. We are monitoring their project closely as well.
In addition, in August 2011, the Board issued a Concept Release on Auditor Independence and Audit Firm Rotation. The concept release notes the importance of auditor independence to the viability of auditing as a profession and highlights the risk to independence arising from the "client-pays" model.
Since 2003, the PCAOB has hired experienced auditors from the field, taken them out of client service. In the early days, within weeks — sometimes even days — redeployed them as PCAOB employees to inspect the quality of audits around the country, and now around the world.
These inspectors have identified deficiencies that range well beyond isolated technical weaknesses. Our inspectors also consistently find strong technical auditing skills at all of the largest firms and many smaller firms, in both new and long-term engagements.
Yet they also find marketing practices that are in conflict with quality. They have found written instructions issued to partners to inform clients when the firm provides services at a discount from their standard rates in anticipation of a long-term relationship, and to provide for a termination fee if the hoped-for long-term relationship is not realized.
It is a tough subject. I recognize for a profession known for character, esteemed for integrity, it is important to believe that character and integrity triumph. They do triumph.
It is the rare case when an auditor can be corrupted. That is not the issue, nor the charge. An auditor need only look the other way, accept a well-annotated rationalization, focus on corroborating evidence.
An auditor need only say, "I don't object." "It's a matter of judgment." "The literature is unclear."
It is because I hold the profession in such esteem that I believe we must confront these questions, with reason and analysis, not emotion.
Against this background, the concept release seeks public comment on ways to enhance independence, objectivity and professional skepticism and counteract these practices and influences.
The PCAOB has embarked on several public meetings to engage prominent and thoughtful commenters with various, often conflicting, viewpoints.
They have included some of the most authoritative and experienced voices to address the subject of audit quality, auditor independence and the challenges to both. They offered varied perspectives as investors, senior executives and audit committee chairs of major corporations, chief executive officers of audit firms, academicians, and former regulators.
The European Union and its member states are engaged in their own inquiry and are considering term limits at the center of their debate.
We should not rush the process of debate and discussion here. We should continue to influence the debate worldwide, by broadening its scope and getting beneath the surface of generalities, coming to grips with the practical. It is not our way of doing things in this country to shy away from large issues and avoid discussion of big, bold ideas.
The commercial world we are part of is wrestling with the challenges of independence in fact and in appearance. We have thoughtful scholars and skillful advocates on all aspects of that question, and they should be heard. Discussion leads to a more robust consideration of alternatives, refinement of the analysis, and in the long run, better solutions.
Audit Policy and Regulation is a Global Endeavor.
I have illustrated one example of the influence of international initiatives on policy debate here. It is not isolated, and the influence is not only theoretical.
Auditors in the U.S. are increasingly affected by audit policy ideas implemented in Europe and elsewhere. For example, a major part of the 2006 European audit reform was to require that individual audit engagement partners sign the audit report.
Foreign private issuers in Europe have, for years, filed with the SEC audit reports signed by individual engagement partners in their own names as well as on behalf of their firms.
This is not just a big-firm phenomenon. Small U.S. audit firms around the country are engaged in audits of foreign private issuers from, or U.S. companies that operate in, Asia, Latin America, Africa and elsewhere. Small non-U.S. audit firms in Asia, Europe and elsewhere are registered with the PCAOB because they audit or wish to audit companies that have issued securities in the United States.
In any given week, PCAOB inspectors are working in numerous countries, often side-by-side with local audit oversight authorities in joint inspections. To date, the PCAOB has conducted inspections in nearly 40 foreign jurisdictions. This year, one-quarter of our scheduled inspections are outside the United States.
We have now entered into bilateral cooperative agreements with regulators in 14 other jurisdictions to conduct inspections jointly with the local regulator. We benefit greatly from local insights and can be significantly more effective together.
We've recently restarted or begun joint inspections in major financial centers throughout Europe, in Germany, the Netherlands, Norway, Spain, and Switzerland, and the U.K.
These are important inspections. We are fortunate to be able to conduct them now. They will also be important for building strong working relationships with our counterparts there.
We have also concluded inspection arrangements with Japan, Taiwan, Israel and Dubai. And we are engaged in active negotiations with Finland, Sweden, France, Belgium, Luxembourg, Denmark, Poland, Brazil, Chile, and Turkey.
I am disappointed that we still face resistance from some countries where there are registered firms we are required to inspect. Since October 2010, we have not approved any applications for registration submitted by firms in jurisdictions that resist inspections.
I am encouraged that Chinese authorities are at least continuing to talk with us about ways we might work together. We were invited to observe an inspection by Chinese authorities earlier this year. The exercise was helpful. It was educational, and it began to build working relationships among staff.
But we have not been allowed to inspect any Chinese firms that are registered with us, notwithstanding the fact that those firms continue to issue audit reports that are filed with the SEC and relied on by U.S. investors.
The current state is not sustainable. We are coming to a cross-roads where we will have to make some important decisions about how best to protect investors. I may have more to report when I visit again.
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Let me conclude there. It has been a busy time at the PCAOB. Thank you again for the chance to return to the Zicklin Center. I would be happy to answer questions.
 AS 16 will require, among other things, that the auditor communicate to the audit committee matters arising from the audit that are significant to the oversight of the company's financial reporting process, including complaints or concerns regarding accounting or auditing matters that have come to the auditor's attention.
AS 16 will also require the auditor to communicate any significant difficulties encountered during an audit, including delays by management, unavailability of company personnel, or an unwillingness by management to provide information needed for the auditor to perform his or her audit procedures.
 See Armstrong, C., Larker, D., Ormazabal, G. and Taylor, D., The Relationship Between Equity Incentives and Misreporting: the Role of Risk-Taking Incentives, forthcoming Journal of Financial Economics, available as a working paper at the Rock Center for Corporate Governance at Stanford University and on SSRN at http://papers.ssrn.com/sol3/results.cfm?RequestTimeout=50000000.