Keynote Address

Thank you for inviting me to this conference. You have an excellent program, and I appreciate Mark Olson's including me.

We are fortunate to be able to hear directly from two preeminent accounting standard-setters this morning — Pat McConnell, of the International Accounting Standards Board in London, and Larry Smith, a current member and former technical director of the Financial Accounting Standards Board here in the U.S.

One of Larry's roles at the FASB has been to participate in meetings of the Public Company Accounting Oversight Board's Standing Advisory Group. Larry provides the PCAOB invaluable comment to help us stay coordinated with accounting standard-setters.

I also look forward to hearing from the SEC's Deputy Chief Accountant for Professional Practice, Brian Croteau, after lunch.

The views I express are my own and should not be attributed to the Public Company Accounting Oversight Board as a whole or any other members or staff.

I. The Renewed Global Commitment to Vibrant Financial Markets Has Spurred Audit Reforms.

We meet in the midst of a robust and wide-ranging global debate on how to promote audit quality, spurred both by public dismay over the uncertainties surrounding global financial institutions as well as resurgent national and regional hopes to build vibrant, competitive financial markets to strengthen local economies by giving local entrepreneurs better access to capital.

The European Commission has mooted proposals on audit policy intended to enhance auditor independence and audit quality. They are currently under consideration in the European Parliament. The reforms would restrict non-audit services, impose audit firm term limits, and encourage the use of joint audits in certain cases.

These proposals also include an expanded audit reporting model and an expanded role for the audit committee in statutory audits of public interest entities.

Some European member states have already acted and are implementing changes now. The Dutch recently adopted legislation that mandates the rotation of audit firms every eight years and prohibits a firm from providing non-audit services to audit clients that are considered public interest entities.^[1]

Last fall, the United Kingdom's Financial Reporting Council updated the U.K.'s Corporate Governance Code to provide for mandatory retendering on a comply-or-explain basis.^[2]

Meanwhile, a Competition Commission in the United Kingdom has been convened to investigate the U.K. audit market. The Competition Commission has provisionally concluded that the U.K.'s audit market is not serving shareholders and is now exploring a combination of possible remedies including term limits.^[3]

The move for stronger financial markets has become something more than a response to the obvious weaknesses in some markets as they have functioned. It is a strategic decision to develop the infrastructure necessary to broaden access to capital through free and vibrant markets. All of this governmental activity, to which I have just referred, reflects a shared conviction that markets do deliver economic success.

The "Occupy" movement tried to convince people and their elected representatives in government to recoil from free financial markets. Instead, these European proposals demonstrate a renewed commitment to markets as a way to provide for the brave ideas of the worlds' entrepreneurs.

Economic success depends on the confidence of the users of capital and the providers of capital alike. For years, American markets have been the envy of the world. But we have no lock on the blueprints.

They are available to be copied, and indeed improved upon, as the founding citizens of our country once improved upon the financial system of their European counterparts — including right here in Williamsburg. What we are now seeing is that the world is assessing and adapting what they can take from the best of existing models, to create the markets of the future.

Professional, skilled and independent auditors are key to helping investors separate the credible managers from the charlatans. By building a basis for confidence, auditors reduce financing costs, and contribute to an efficient allocation of capital to fuel economic growth.

Academic research, for example, tells us that financial misreporting can induce flawed business decisions, not merely by the misreporting entity, but by legitimate competitors.^[4] The misallocation of capital results in meaningful costs to the economy and society.

It is clear that the audit is indeed a valued, critical factor in the public's confidence in the U.S. financial system, and it enjoys an important position in the eyes of people around the world.

Nevertheless, even now, when we have never needed it more, the audit has, in the minds of some, become a commoditized expense to be contained. Much as in compliance!

In the United States, large audit firms' revenues from consulting are growing 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 can weaken the relative strength of the audit practice in the firm overall. The problem is compounded when audit firms turn their talents to other endeavors, such as aggressively marketing non-audit services that may further damage public views on the relevance and value of the audit.

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, from top schools such as William & Mary's Mason School of Business, who are and remain committed to excellence in public service.

As our financial markets evolve to meet the needs of new generations of entrepreneurs with broader sources of capital, so too the audit can and must change. I don't know whether the reforms being considered by the European Parliament will resolve these issues. But I do believe change is coming in Europe, and that we need to understand what they do there, and why.

In this regard, the PCAOB has embarked on two long-term projects to examine how the relevance, reliability and credibility of audits can be enhanced. They were commenced with concept releases — meant to elicit and explore the best ideas — on the auditor's reporting model and on ways to enhance auditor independence, objectivity and professional skepticism.

We are looking closely at auditor incentives, especially in light of the fact that auditors are in the position of being paid by the very companies that they audit.

This is a structural conflict that over time has worried auditors, users of financial statements, and regulators.

We are looking at the source of the auditor's objectivity. We are exploring ways to free them from client pressures.

We are considering whether a different form of report, oriented toward the needs of the users of the report, could expand the auditor's mindset to identify key insights about the audit that will help a user understand the quality of financial reporting.

As I will describe in a bit, we have many projects underway to improve the specific procedures auditors perform. But these two projects are different. They are intended to consider and find ways to address impediments to audit quality that transcend the auditor's procedures and are rooted in structural constraints.

The PCAOB is thus not merely watching audit reforms take shape elsewhere. But it is deeply engaged in the global public policy debate, both through our own outreach and in multi-lateral meetings in venues such as the International Federation of Independent Audit Regulators.

We also work closely with our counterparts — to a greater degree and in greater number each year — particularly in the area of inspections. Indeed, this cooperation has become integral to our overall effectiveness.

In this regard, let me turn now to more near-term endeavors to promote high quality audits. First, I will cover recent developments in our oversight of the large accounting firm networks that play a role in the audits of companies that figure prominently in most Americans' savings and retirement accounts. Then I will discuss certain near-term initiatives to enhance our effectiveness at doing so.

II. International Audit Oversight Coordination and Results

More than 2,300 firms have registered with the PCAOB, a testament to the interest of accounting firms in performing audit work for companies that have issued securities in U.S. markets.

Approximately 40 percent of these firms are located outside the United States, reflecting the reach of U.S. companies that have established significant operations abroad as well as the extent to which non-U.S. companies have sought capital in U.S. markets. Overall, there are around 240 non-U.S. audit firms in over 50 foreign jurisdictions that have issued audit opinions on U.S. issuers and are required to be inspected at least every three years.

Many of these firms are affiliated with one of the global networks of accounting firms that are known in board rooms and households around the world. And the vast majority of capital in U.S. markets — very near one hundred percent — is attributable to companies whose financial statements are audited by one or more firms affiliated with one of these global networks.

In 2011, Helen Munter, Director of our Division of Registration and Inspections, reorganized the Division to better align our inspections activity with the manner in which the audits we inspect are performed. We now have a Global Network Firm program, which is headed by Richmond native, Senior Deputy Director Chris Mandaleris.^[5]

The Global Network Firm program covers inspections of the largest U.S. firms and their foreign affiliates, to the extent those affiliates participate in the audits of issuers that file financial statements with the SEC. Currently there are approximately 180 non-U.S. registered firms that we consider to be affiliated with a global network and are subject to triennial inspection because they have issued an audit report on an issuer.

This new organization allows our inspectors to better identify trends among firms in a network. It also facilitates inspection of multi-national issuer audits and gives us a more complete understanding of the quality control mechanisms used by the firms to determine whether they are effective.

To date, the PCAOB has conducted inspections in 40 foreign jurisdictions. Last year, one-fourth of our inspections took place outside the United States.

We now jointly inspect with local regulators in Australia, Canada, Finland, France, Germany, Korea, the Netherlands, Norway, Singapore, South Africa, Spain, Switzerland, Chinese Taipei and the United Kingdom.

Gradually, together with our counterparts, we are creating a network of regulators to match the networks of firms. The aim is to work seamlessly together to meet our respective inspection mandates.

As we deepen our relationships with fellow independent regulators, we have deepened our understanding of audit risks. We are now able to review different components of multi-national audits performed by different firms in a global network, all in the same inspection cycle. We can follow audit risks across borders and into the interstices between affiliated firms.

In this joint work and independently, regulators have identified certain themes that cause concern, such as the failure to apply professional skepticism in difficult audit areas, including management estimates and valuations.

As other audit regulators around the world have concluded too, the rate of problems presents an unacceptable risk that an audit of a company's financial statements could miss a material misstatement.

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

Let me turn now to the PCAOB's near-term initiatives to address these concerns. In November 2011, the PCAOB adopted a new strategic plan.

The plan built on the work of the founding board, and the leadership of past chairs, including Mark Olson, bringing that work forward to address current challenges and expectations for the organization.

The Board reaffirmed that strategic plan in connection with adopting the PCAOB's 2013 Budget. In my message accompanying the plan, I set forth certain near-term priorities for our inspections, research and standards-setting programs. The ultimate success of the plan depends upon engaging the creative energy of the PCAOB staff, who know better than anyone, what can be done to further these initiatives.

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

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

Inspection reports do take time to produce. While we aim to issue reports within 12 months of the inspections fieldwork, and many will 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 comment forms explaining 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 the firm's conduct to be inappropriate.

Importantly, inspectors give time throughout the process for dialogue with firm personnel and leadership. After this detailed dialogue, the final report is intended to memorialize the core problems inspectors have identified.

How can one tell from our reports the difference between deficiencies that are significant or egregious failures and those that are less significant technical noncompliance?

We do not describe in the public portion of a report every failure to comply with PCAOB standards that inspectors identify. Inspection reports describe only those deficiencies that appear to inspectors to result in the auditor failing to have a reasonable basis for its opinion that the financial statements are fairly stated.

If a deficiency is described in the public portion of a report, it is because the auditor left insufficiently audited an aspect of the financial statements that could include an undetected material misstatement.

This has been the standard for inclusion in the public portion of inspection reports since the PCAOB's inception.

Inspected firms, of course, have detailed information about what has raised our inspectors' concerns, including detailed recitations of the facts and applicable standards and the dialogue I just described.

It is not our goal in public reports to make them more technical, obscuring the fundamental concerns at issue. But we do plan to engage in broad outreach on how our public reports are used, and how we can make them more relevant and accessible to the audiences that use them. In addition, the inspections division is also considering ways to deepen our own analysis of inspection findings, over time and across firms.

Among other things, I anticipate more summary reports on insights from inspections, on more topics. Audit committees are an important audience for all of our reports, both general and firm-specific. This leads me to another important near-term initiative — to enhance PCAOB outreach to audit committees.

B. Facilitating the Work of Audit Committees.

The Sarbanes-Oxley Act elevated the audit committee to play a critical role in improving audit quality and defending the auditor's independence. Accordingly, the focus of the PCAOB's outreach is to find ways to help equip 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.

To this end, in August 2012, the PCAOB issued information for audit committees on how they can learn more from their auditors about the results and implications of the PCAOB's inspection findings.^[6] It is my hope that our outreach to audit committees will reveal additional areas and topics that we can elucidate in future releases.

In addition, in the same month, the PCAOB adopted a new auditing standard — Auditing Standard No. 16 — on what auditors should communicate to audit committees in order to protect the public's interest in keeping audit committees informed of important audit matters.

AS 16 is intended to foster a more robust discussion between the auditor and the audit committee. It is intended to give the audit committee the information necessary for it to be able to probe and understand challenging audit issues and significant auditor judgments.

I would expect the best audit committees to demand this kind of dialogue already. Yet we see situations where this was not the case. AS 16 is an attempt to change that.

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

I've mentioned one standard-setting project — AS 16 — just completed. We have a robust standard-setting agenda to update other audit standards. The latest agenda was just posted on our website last week.

Among other things, we have an active project on related party transactions. Last year, the Board proposed an updated auditing standard in this area. The proposal 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.

We received useful comment on that proposal, considered it carefully, and are now ready to propose what will likely be the final version soon.

Under Chief Auditor Marty Baumann's leadership, 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."

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. Two weeks ago, the Board approved release of a potential new framework for public comment.^[7]

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.^[8]

To my mind, the standards — even the reorganization of them — ought to reflect a contemporary review of the challenges that auditors face.

Economic analysis can help us in this review of the PCAOB's standards. 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?

And here is a still longer-term thought: how will our standards shape the audit and profession in the years to come?

D. Audit Transparency.

Finally, we are also evaluating ways to enhance disclosure about audits in order to give the public a better understanding of how the audit was conducted and thus a better basis to discern the quality of an audit, as opposed to the lowest cost.

We have proposed certain transparency measures, specifically to require disclosure in the audit report of the name of the engagement partner as well as participating firms in the audit.

Today, only the principal audit firm's name goes on the audit report that the public sees. Yet we are reminded, from time to time, that even sophisticated users of audit reports do not realize that audits for large companies are often performed by consortiums of separate audit firms.

It is the work of these undisclosed subsidiary auditors, and the rigor of the principal auditor's oversight of their work, that provides financial market participants with assurance that the necessary controls are in place and working effectively.

If we want the audit profession to compete on quality more than price, we've got to provide markets more information about the audit. Knowing the name of the engagement partner on an audit, and the various other firms that participate in a global audit, is just a start. But it may help the investing public begin to identify and judge quality, leading to better auditing.

More robust audit reports that demonstrate the strength and value of the audit should also lead to better public awareness, and appreciation for, auditors' skill and insight, providing further opportunity for the public to discern — and audit firms to compete on the basis of — quality.

We are also engaged in a research project to identify audit quality indicators that are both measurable and reasonably objective. Some might be process, or input-related, measures, such as the ratio of audit staff to partners on an audit. Others might be results, or output-related, such as the history of restatements or warnings about going concern, again providing information to help markets distinguish high quality audits.

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You have been a gracious audience and I thank you very much for your interest in the PCAOB's work.