Keynote Address

Good Morning,

Thank you very much for inviting me to be here today. I am honored to have been included as a speaker before this distinguished group of educators and researchers.

As you all know, the Public Company Accounting Oversight Board was created by Congress through the passage of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act"). I celebrated my second anniversary as a PCAOB Board Member a few months ago, and the Board itself has been operating for just over ten years. Since our inception, we have conducted over 2000 inspections in 40 jurisdictions and released 16 new auditing standards as well as amended many others. We have also issued 56 disciplinary orders, including sanctions against 42 firms and 59 individuals. These numbers sound pretty good, but we do not have a textbook teaching us how to regulate, nor an answer key against which to measure our progress. However, we do believe in self-reflection and self-evaluation to ensure that we are doing the best job possible to achieve our statutory mandate. I would like to discuss today some of our efforts to evaluate our processes and outcomes, and, in that context, will discuss some of our recent regulatory activities. In addition, I would like to say a few words about a subject that may be near and dear to your hearts: the preparation of future auditors. Finally, I hope to be able to answer some of your questions (although I hope that you will refrain from grading my answers!).

But before I go further, 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.

Board Near-Term Priorities

In keeping with the spirit of self-examination, the Board recently identified a series of near-term priorities for 2013. These include:

  • Improving the timeliness, content and readability of inspection reports;
  • Improving the timeliness of remediation determinations and providing additional information on the Board's remediation process;
  • Initiating a project to identify and report on audit quality measures;
  • Enhancing our processes and systems to improve analysis and usefulness of inspection findings in order to better understand audit quality and better inform standard-setting and other regulatory activities;
  • Enhancing the framework for our standard-setting efforts in order to improve the effectiveness of the process and the project tracking information provided to the investing public; and
  • Enhancing the Board's outreach to and interaction with audit committees. [1]

Although I won't discuss our progress on each of these priorities in detail, I would like to provide my perspectives on several of them.

With respect to our review of inspection reports, we are evaluating both our firm-specific inspections report (which are made public in part, consistent with the Sarbanes-Oxley Act) as well as our periodic summary reports used to convey inspection findings over a period of time and across firms. This latter category of reports is often referred to as "Rule 4010 Reports," based on the PCAOB Rule governing their issuance. The Board recently issued two such reports.

First, in December 2012, the Board issued a report called "Observations from 2010 Inspections of Domestic Annually Inspected Firms Regarding Deficiencies in Audits of Internal Control Over Financial Reporting." This report summarized observations drawn from inspections of 309 audits of internal control over financial reporting at public companies.[2] The report expressed concern about the number and significance of deficiencies identified in firms' audits of internal control during the inspections, which generally involved reviews of the integrated audits of financial statements and internal control for issuers' fiscal years ending in 2009.

The inspections results summarized in this report include, among others, our inspection staff's observations about deficiencies in auditors' execution of the "top-down" approach to testing controls. One common finding noted in the report that we are still seeing in our inspections reflect the challenges posed by the need to understand the design, operation and effectiveness of such controls, including whether the control operated at a level of precision that would prevent or detect material misstatements.

Second, in February 2013, the Board issued a report summarizing inspection results observed from 2007 to 2010 in the inspections of U.S. firms that audited 100 or fewer public companies and which were required to be inspected at least once every three years.[3] This report built on a prior report, published in 2007, of earlier inspection results at these so-called "triennial firms."[4]

The recent report regarding triennial firm inspections includes observations from 748 inspections of 578 domestic triennial firms conducted from 2007 through 2010 and reflects reviews of 1,801 financial statement audits. Frequent findings during this time period related to audit work in several areas, including:

  • revenue recognition;
  • share-based payments and equity financing instruments;
  • convertible debt instruments;
  • fair value measurements;
  • business combinations and impairment of intangible and long lived assets;
  • accounting estimates;
  • related party transactions;
  • use of analytical procedures as substantive tests; and
  • responding to the risk of material misstatement due to fraud.

While the report showed an overall reduction in the rate of reported significant audit performance deficiencies compared to the prior report issued in 2007, and a decrease in the rate of significant deficiencies noted in firms' second inspections compared to their first, the persistence of deficiencies in audits performed by a large number of domestic triennial firms remains of concern to the Board.

Both of the recently issued reports include a discussion of potential root causes for the findings. While the causes of audit deficiencies are typically complex and are often the result of a combination of factors, inspectors highlighted the following issues in the two reports:

  • a lack of technical competence in a particular audit area;
  • insufficient firm training and guidance, including examples of how to apply PCAOB standards and the firm's methodology;
  • a lack of due professional care, including professional skepticism;
  • ineffective or insufficient supervision, which at times may have been due to heavy partner and professional staff workloads;
  • decreases in audit firm staffing through attrition or other reductions, and related workload pressures;
  • ineffective client acceptance and continuance practices that fail to consider technical knowledge called for in particular audits;
  • ineffective engagement quality reviews
  • improper application of the top-down approach to the audit of internal control as required by AS No. 5; and
  • ineffective communication with firm's information system specialists on the engagement team.

While I believe that these reports, and others like them, provide useful information relating to public company audits, and perhaps some good "teaching moments," we are currently seeking feedback on whether these reports are useful and how they could be improved. One recent addition to these types of reports has been the addition of an "executive summary" that we hope is written in plain English and will be helpful to a variety of readers, including non-auditors. Historically, the Board's general reports have been used primarily to recount inspection findings; more recently we have attempted to provide a little more context and meaning to those results. Next week, we are hosting a meeting of the Board's Standing Advisory Group, and we have scheduled a session dedicated to a discussion about potential improvements to the Board's general reports. I look forward to hearing SAG members' suggestions for improvements, and I would be interested in hearing your input at as well.

Board Members also have challenged themselves and the PCAOB's inspection staff to consider potential improvements to the firm-specific reports. We are often criticized for the time it takes for the Board to issue these reports, and our staff has been working diligently to issue inspection reports more quickly without compromising accuracy or fairness, and they have made substantial progress. Many of our reports are issued within a matter of months, and for those that take longer than a year, there is usually a good reason, such as the need to consult about complex accounting questions or delays in obtaining relevant information. We continue to strive for even more improvements in the timeliness of reports, but I also ask myself and our staff whether more could be done to enhance the content of the reports, to provide more useful information to the investing public, and I anticipate that we will also conduct some outreach in this area. A key question we need to answer in today's environment is "who is the intended reader of the report?"

One particular criticism with respect to our reporting has been the focus of the reports — including firm-specific inspection reports and our general reports — on the negative. In keeping with our regulatory mandate, we tend to look for and report audit deficiencies. Indeed, with respect to quality control deficiencies, we have a specific statutory mandate to include applicable criticisms in the report and to publish that information if firms do not take appropriate actions to remediate the problems. But some of our stakeholders have asked us to consider whether audit quality also could be enhanced through PCAOB reporting of what auditors do right, allowing auditors to learn from each other. Our current programs and resources do not contemplate the collection of data needed to determine and report comprehensively on auditor "best practices," but our work in connection with a near-term priority project to identify and report on audit quality measures may be a step in that direction.

This project is focused, in its early stages, on attempting to define audit quality, establish a framework for thinking about audit quality, and develop specific, quantitative indicators that may, ultimately, be used as objective measures of audit quality. Currently, the staff of the Office of Research and Analysis who are working on this project are recommending a working definition of audit quality that reflects a common understanding of quality used in business endeavors: "meeting customer needs." Customers include investors and audit committees, among others, and their needs are for independent and reliable audits and robust audit committee communications. The staff's preliminary thinking of the framework for audit quality includes three segments: audit inputs, processes, and results. Next week, the staff is presenting this project to the Board's Standing Advisory Group and will seek input on the potential elements of quality within each of the framework segments.[5]

If successful, this endeavor could have wide-ranging implications on many of our activities. It could affect the content or focus of inspection reports, influence potential future standard-setting projects, and may, ultimately, lead to the publication of certain indicators that could help audit committees and investors better evaluate the quality of work by their auditors. While we have input from some that a single score, much like a credit score, should be the goal, my hope is to provide a matrix of indicators to provide information in a range of areas that users can consider and prioritize based on their individual circumstances and needs. I anticipate that we will continue to seek input regarding this project for some time, and I urge the researchers among you to share with us any relevant knowledge, research, theories and studies.

As you can see, a common theme for several of the near-term priorities is to make more useful information available on a more timely basis. A related objective is to make our information more accessible to and useful for groups and individuals beyond the audit profession, including investors, preparers and audit committees. In connection with some of our past outreach, including during several public meetings about auditor independence last year, we heard that audit committees, in particular, are interested in and would benefit from more information about the PCAOB's activities and findings. The important auditor oversight role played by audit committees in the capital markets complements the Board's mission, and we are eager to explore ways in which we can work together.

A partial response to the feedback received from audit committees was the issuance, in August 2012, of a release to provide information to audit committees about the Board's inspection process and the meaning of reported inspection results. The objective of the release was to better equip audit committees to engage in meaningful discussion with audit firms about the results of inspections.[6] Among other things, the release highlights certain matters relating to PCAOB inspections about which an audit committee might benefit from having a discussion and understanding with its audit firm.

In order to foster a more robust dialog between the Board and audit committees generally, the near term priorities for 2013 also include increasing our outreach to and interaction with audit committees. We are currently considering potential approaches to such outreach and interaction, ranging from the issuance of additional publications, to attendance at conferences or webcasts, to hosting town hall-style meetings or round tables specifically tailored toward audit committees. I would like to see a more regular two-way dialog between the PCAOB and audit committees, so that we can leverage our collective knowledge and experience. Ultimately, audit committees hire and fire the auditors. While regulatory activities like inspections, enforcement and standard setting can provide appropriate parameters for audit practice and will drive improvements over time, audit committees — if equipped with relevant information about how to evaluate the quality of work by auditors — are a powerful market force that could complement our regulatory efforts by driving improvements in audit quality through financial incentives.

Future questions facing the PCAOB

In addition to the self-evaluation inherent in the current near-term priorities, there are other areas the Board will have to review and reconsider as we move through our second decade of operations. Our inspection approach is one of these areas that I anticipate will require some attention in the future, both to validate its effectiveness and consider potential improvements. Some relevant questions that have already been posed include whether our current approach of selecting audits for review largely on a risk basis continues to be the most effective approach, or whether we should also incorporate a more random element to our selections. Some also have suggested that we should tailor our future inspections of firms — for example the numbers of audits reviewed or the extent of quality control procedures — on the firms' past inspection results. This might be described as a "carrot" approach to accompany the regulatory "stick": Do a good job and the reward will be a lighter regulatory touch.

Our international inspections, also, may have to evolve as we conduct inspections with an increasing number of foreign regulators. To date, we have conducted inspections in 40 different countries. In 16 of these countries, we have cooperative arrangements with home country audit regulators under which we conduct joint inspections or share information. We continue to actively negotiate such agreements with regulators around the world, many of whom began operations during the last decade and are beginning to mature just as we have over the last several years. My fellow Board Member, Lewis Ferguson, was elected recently as the Chairman of the International Forum of Independent Audit Regulators, and he has an ambitious agenda to enhance information sharing and cooperation among audit regulators around the world. In light of these developments, should we continue to treat our foreign inspections — particularly where we work in tandem with our foreign counterparts — largely as we do domestic firm inspections, or are there efficiencies to be achieved where our counterparts have established robust regulatory oversight? Is the substantially higher cost of non-U.S. inspections, particularly of firms with very small, low-market cap, issuer audit practices, justified by its benefits to investors, or should we take a more risk-based approach in this context as well?

At the same time, the ever increasing globalization of the companies whose audits we must oversee presents significant risks that we must continue to consider. More and more firms have operations — and audits — around the world. Work referred by auditors to countries outside the U.S. presents unique risks, and we have already begun to address such risks through an inspection program that reviews not only audit work performed by principal auditors but also work referred to foreign accounting firms. The Board also has proposed amendments to PCAOB standards that would require firms to disclose publicly other independent public accounting firms that participated in multi-national audits, as well as their locations and certain information about the amount or significance of the work performed by those other firms or accountants. Finally, the Board has addressed related issues in two practice alerts — one intended to remind registered firms concerning a firm's obligations when using the work of other firms or using assistants engaged from outside the firm[7] and a second to discuss fraud risks that auditors might encounter in audits of companies with operations in emerging markets.[8] This, I believe, is a great start. But we must continue to monitor our programs and our cooperative arrangements with our foreign counterparts to ensure that we have in place the necessary regulatory mechanisms to maintain an appropriate level of oversight over these increasingly global and complex audits.

Preparing Auditors of the Future

I have discussed in some detail the Board's regulatory efforts and potential market forces that may influence audit quality. The most important driver of audit quality, of course, is the knowledge, skill, experience and mindset of the auditors doing the work. The foundation for that begins with all of you, in the classrooms at universities that educate future accountants and auditors. And the challenges faced by accounting educators have never been greater.

Thirty years ago, financial statements were dominated by tangible assets and historical cost accounting. Today, after rapid advances in technology, the development of innovative business models and the mind numbing complexity of many investments, the balance sheets of an increasing number of companies are dominated by valuation estimates. 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.

Estimates and measurements are one of our most frequently identified inspection findings, including instances where auditors appear not to have complied with PCAOB auditing standards relating to fair value measurements of financial instruments, impairment of goodwill, indefinite-lived intangible assets, and other long-lived assets. Inspectors have identified occasions on which auditors failed to determine the reasonableness of assumptions applied by management in making the necessary measurements or estimates. In some cases, auditors did not appropriately consider the weight of both positive and contradictory evidence, have not responded appropriately to valuation risk or appropriately evaluated management disclosures. The frequency with which we encounter these issues, and the fact that findings continue year after year, demonstrate how difficult it is to audit these areas.

Our auditing standards require auditors to understand and evaluate management's assumptions and processes in establishing valuations or estimates, and to test management's valuations and disclosures. I was pleased to see that there are presentations on your agenda for this meeting that deal with this important subject (as well as on internal controls, another area that has received much attention from the PCAOB). While many universities and colleges also have begun to include fair value accounting modules in their curriculum, are we doing enough to prepare our students for a world where estimates and measurements predominate financial statements and cost accounting is quickly becoming less relevant? Should accounting programs consider additional changes in their curriculums in order to better reflect this new world? Does the CPA exam reflect the reality of what young accountants need to know today?

The judgment inherent in auditing estimates and measurements, compared to observing inventory or reconciling accounts, also underscores the need for auditor independence, objectivity and skepticism. Not only must auditors understand management's assumptions and processes, they must question them and evaluate contradictory information that comes to light. But how do we teach auditors of the future to have an appropriate mindset? Do auditing courses prepare young accountants for this less tangible challenge? How do we prepare students for the rigors of public accounting and equip them with the mindset to maintain their objectivity and skepticism in the face of countervailing forces, including long hours, the tedium of tasks left to the newest members of the audit team, and client pressures?

Another challenge for young auditors arises in situations where they have to deal directly and independently with a client's management or accounting staff. While texting and Facebook postings may be preferred ways to communicate for some, it does not work well in the audit world. Young accountants may be faced with challenging the work or opinion of someone who is their parents' age or someone whose experience and skillset far exceed theirs. Recently, I came across an academic study that suggests that younger auditors are often "mismatched" with the client personnel with whom they interact, with respect to their age, experience and knowledge. As a result of this mismatch, the study suggests, auditors may collect less audit evidence in order to avoid interactions with client personnel.[9] Is there more we can do to prepare new auditors for this psychological challenge?

I do not pretend to have answers to these questions, although one partial answer may be that you, alone, probably cannot prepare your students to successfully navigate all of these challenges immediately upon graduation. Much of what auditors ultimately need to know is learned by doing, through on-the-job training and effective mentoring relationships. But I urge you to think about whether more can be done to lay the groundwork upon which your students and their future employers can build.

It is clear we, collectively, face many challenges in continuing to build a robust audit profession that earns the public trust.

With that, I will thank you for your attention. I look forward to any questions, feedback and ideas you may have.

[1] See Public Company Accounting Oversight Board Strategic Plan: Improving the Relevance and Quality of the Audit for the Protection and Benefit of Investors 2012-2016 (Nov. 30, 2012) at 5.

[2] See Observations from 2010 Inspections of Domestic Annually Inspected Firms Regarding Deficiencies in Audits of Internal Control over Financial Reporting, PCAOB Release 2012-006 (December 10, 2012).

[3] See Report on 2007-2010 Inspections of Domestic Firms that Audit 100 or Fewer Public Companies, PCAOB Release 2013-001 (February 25, 2013).

[5] For more information about this project, see Briefing Paper: Standing Advisory Group Meeting, Discussion — Audit Quality Indicators (May 15-16, 2013), available at

[6] See Information for Audit Committees about the PCAOB Inspection Process, PCAOB Release No. 2012-003 (August 1, 2012).

[7] See Staff Audit Practice Alert No. 6, Auditor Considerations Regarding Using the Work of Other Auditors and Engaging Assistants from Outside the Firm (July 12, 2010).

[8] See Staff Audit Practice Alert No. 8, Audit Risks in Certain Emerging Markets (Oct. 3, 2011).

[9] G. Bradley Bennett and Richard C. Hatfield, The Effect of the Social Mismatch between Staff Auditors and Client Management on the Collection of Audit Evidence, The Accounting Review, Vol. 88, No. 1, pp. 31-50 (January 2013).

Related Information