Protecting Investors through Reliable Audits

It is my distinct pleasure to be here today as part of the George R. Husband Distinguished Lecture Series. It is impressive that former students and admirers of George R. Husband endowed an accounting professorship, several annual student scholarships, and this annual lecture series in his memory.

Before I get started, 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.

As you know, the PCAOB was created by the Sarbanes-Oxley Act of 2002 in response to numerous failures of the profession to fulfill its trusted role in corporate financial reporting and auditing when numerous financial reporting frauds and auditing failures caused a crisis of confidence in the integrity of the U.S. financial markets.

The creation of the PCAOB ended more than 100 years of self-regulation by the public accounting profession in the U.S., and established the Board's regulatory framework for firms that conduct audits of companies whose securities trade on the U.S. markets. Many other countries also have realized the need for effective audit regulations and have formed audit regulatory regimes. Some of these countries have adopted audit regulatory regimes modeled, at least in part, on the Sarbanes-Oxley Act and the PCAOB.

Today I will provide an update on the basic mission activities of the PCAOB in our four oversight areas — registration, inspections, enforcement, and standards. And as part of that discussion, I will detail the Board's progress in the areas of broker-dealer audits and international inspections.

Firms Registered with the PCAOB

The Sarbanes-Oxley Act and PCAOB rules require all U.S. and non-U.S. accounting firms to register with the Board if they prepare or issue audit reports or play a substantial role in preparing or issuing audit reports of issuers, brokers and dealers.

PCAOB-registered public accounting firms have been given an important role in the capital markets — to provide assurance to investors and others that the audited financial statements fairly present the companies' or broker-dealers' financial results in conformity with applicable accounting and disclosure standards and rules. Registration is a significant oversight area for the Board.

Currently, about 2,360 firms are registered with the PCAOB, including about 910 non-U.S. firms located in 84 countries.

Not all PCAOB-registered firms regularly issue audit reports for issuers, but we inspect those — approximately 750 firms, including more than 240 non-U.S. firms — that do. Additionally, approximately 90 registered firms do not regularly issue audit reports for issuers; however, they report that they play a substantial role in the audits of issuers.

Together, these firms audit or play a substantial role in the audits of more than 9,700 U.S. issuer companies that have approximately $26.4 trillion in market capitalization.

Furthermore, approximately 800 registered firms report that they audit brokers and dealers, including approximately 480 that report that they do not audit issuers.

Clearly, reliable financial statements play a key role in the financial markets, which are integral to the success and well-being of American households and businesses, the U.S. economy, and participants and stakeholders from around the world.

Inspection of PCAOB-Registered Firms

A second area of Board oversight is inspections. In PCAOB nomenclature, we have "annually inspected firms," those that audit more than 100 issuers and are inspected each year, and "triennially inspected firms," which are those that issue 100 or fewer audit reports each year and are subject to inspection at least every three years. PCAOB also inspects certain firms that audit broker-dealers under the Board's interim broker-dealer inspection program, which I will discuss in more detail later.

During 2012, PCAOB inspected nine firms that audited more than 100 issuers in 2011.^[1] We also completed 167 domestic firm triennial inspections and 77 non-U.S. firm triennial inspections.

For annually inspected firms, the PCAOB generally issued most of its completed 2011 inspection reports during the latter part of 2012, with some being issued in early 2013. The timing of our inspections reporting has been a challenge, and the Board is currently working to improve the timeliness of these reports.

In terms of trends in findings, the number of serious audit performance deficiencies we reported spiked in our 2010 inspections, and remained high overall for the large firms in the 2011 inspections. Common areas where we found audit deficiencies included auditing revenue recognition, auditing fair value of hard-to-value financial instruments, testing and evaluating internal controls, and the auditor's assessment of and response to fraud risk, among others.

On Feb. 25, 2013, the Board released a report summarizing observations identified in the 2007 through 2010 inspections of U.S.-based triennial firms.^[2] For these firms in particular, audit areas with frequent inspection findings included auditing related party transactions and auditing share-based payments and equity financing instruments, among others.

The findings are serious, and represent deficiencies that are of such significance that it appeared that a firm, at the time it issued its audit report, had failed to obtain sufficient, appropriate audit evidence to support its audit opinion on the financial statements and/or the opinion on internal control over financial reporting. These findings are reported in the public version of firms' inspection reports, which are available on the Board's website.

A second category of inspection findings deal with criticisms identified in the firm's quality control system that, due to statutory restrictions, are not initially included in the public portion of the report. Quality control findings focus on issues that may have caused the audit performance deficiencies, as well as other aspects of the firm's management of its audit practice that could negatively impact audit quality.

Some examples of areas of specific concern regarding quality control that appear in inspection reports include problems in the areas of professional skepticism, tone at the top of firm management, internal inspections, and firms' quality control processes related to specific aspects of auditing, such as testing and evaluating internal control over financial reporting, fair value, and other areas.

As the Sarbanes-Oxley Act provides, if a firm does not take satisfactory action to remediate quality control criticisms within 12 months of the inspection report, that portion of the report is also made public.

Remediation is a very important part of the process. It is through these actions that firms correct their quality control criticisms and drive improvements in audit quality. The Board encourages firms to initiate a dialogue with the Board's Inspections staff about how the firm intends to address the quality control issues.

Based on the timing of the related remediation periods and the firms' efforts in those areas, it is reasonable to expect that firms should start to achieve significant improvements in their 2013 inspection results for those areas identified as problems during the 2010 and 2011 inspections.

I think we will also see improvements in some firms' 2012 inspection reports, which will be issued this year.

Broker-Dealer Audit Oversight Program

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 authorized the Board to establish a program to inspect the auditors of brokers and dealers that are registered with the Securities and Exchange Commission. Congress decided to strengthen the regulatory oversight of securities industry auditors after the revelation of the Ponzi scheme operated out of Bernard L. Madoff Investment Securities.

The law leaves to the Board, subject to the approval of the SEC, important implementation decisions concerning the scope of the program and the frequency of inspections, including whether to differentiate among categories of brokers and dealers, and whether to exclude from the inspection program any categories of auditors.

There are approximately 4,400 brokers and dealers that filed audited financial statements with the SEC for fiscal periods ending during 2011.

The Board is currently conducting an interim broker-dealer audit inspection program, which has been in place for about 18 months, that will help us design a permanent broker-dealer audit inspection program.

The Board issued its first report on the interim inspection program for audits of SEC-registered brokers and dealers on Aug. 20, 2012. The report, which is available on our website, details the findings from inspections of 10 audit firms and portions of 23 audits of securities brokers and dealers. ^[3]

PCAOB inspectors identified deficiencies in all of the audits inspected. Even with this small group of audits, the inspection results are disturbing. The deficiencies fell into three broad categories: (1) audit procedures over customer protection and net capital requirements, (2) audits of the financial statements, and (3) auditor independence.

We inspected another 43 firms and portions of 60 audits during 2012, and will issue another report on those results in 2013. Unfortunately, we continue to find significant issues in this second batch of inspections.

The Board's approach to establishing an inspection program for audits of brokers and dealers is focused on (1) how best to promote investor protection and (2) how to create an efficient and effective regulatory scheme that appropriately addresses the diversity of audits of broker-dealers, weighing the differences in their risk profiles, and the costs and benefits involved.

In 2013, we will begin to work on the design for a permanent program of inspections of auditors of SEC-registered brokers and dealers. The interim inspection program will continue beyond 2013, until rules for a permanent inspection program take effect.

International Inspections and Oversight

Our international inspections and cooperation with foreign audit regulators continue to take on increasing importance. And while we inspect firms around the world that are affiliates of the large global networks, this is not just a big-firm phenomenon.

Small U.S. audit firms are engaged - often as a subsidiary or component auditor - in both the audits of foreign private issuers from Europe, Asia, Latin America, Africa and elsewhere, as well as in audits of U.S. companies that operate in these parts of the world. In addition, 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 U.S.

To date, the PCAOB has inspected audit firms in 40 non-U.S. jurisdictions. During 2012, almost one-third of the triennial inspections conducted by PCAOB inspection teams were for non-U.S. firms (77 of the 244 firms inspected). To facilitate these inspections, we have signed cooperative agreements with the audit regulators in 16 of those non-U.S. jurisdictions, including six in the European Union. In the other jurisdictions where we inspect but do not have cooperative agreements, we do so because the local authorities have no objection to our conducting PCAOB-only inspections in their jurisdictions.

Unfortunately, PCAOB is currently blocked from inspecting - due to asserted legal conflicts or sovereignty issues - in 15 jurisdictions that have issuers whose securities trade in the U.S. These jurisdictions include China and certain countries in the European Union. While we have not yet reached cooperative agreements with audit regulators in those jurisdictions, we continue to negotiate with them. ^[4]

Our ongoing difficulties with inspecting audit work conducted in China, in particular, has received a lot of attention in the financial press due to the significance of the Chinese economy and the numerous financial reporting problems that have surfaced with respect to some Chinese companies listed on the U.S. markets, among other reasons. In particular, significant problems have surfaced regarding the financial statements of some Chinese companies that were audited by firms in China that the PCAOB has been blocked from inspecting. This has generated significant concern in the investor community about the quality of the audit practices and the accuracy of public disclosures of Chinese companies accessing the U.S. capital markets.

Beginning in the latter part of 2010, approximately 67 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 the 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 here have suffered serious losses of both market value and investor confidence as a result of the problems of other companies. The PCAOB's inability to inspect the work of PCAOB-registered firms in China continues to create a gaping hole in investor protection.

Lately, however, we have been somewhat encouraged by some incremental progress in our negotiations with the Chinese authorities, including an agreement last year on guidelines that enabled us to send an inspection team to observe part of an inspection carried out by the Chinese audit regulator.

We are continuing our efforts to establish a set of protocols that would provide for further cross-border cooperation with China in a manner consistent with our statutory mandate. If we are unable to reach agreement, we will have to make some important decisions about how best to protect investors.

Enforcement Activities Involving Firms and Individual Auditors

As for the Board's third oversight area, a strong enforcement function is essential to the Board's fulfillment of its investor protection mission. To that end, the Board has been developing a robust, active enforcement program that seeks to identify potential cases of serious auditor misconduct, investigate them thoroughly and promptly, and litigate the resulting disciplinary actions. The overriding goal is to ensure that auditors who commit serious violations of our audit standards face appropriate and real remedial or disciplinary consequences.

The Division of Enforcement and Investigations carries out the Board's investigative and disciplinary authority. Under the Sarbanes-Oxley Act, the Board is authorized to investigate auditor conduct that may violate the laws, rules, or standards within the Board's jurisdiction. The Board is further empowered to impose a range of remedial and disciplinary sanctions against registered accounting firms and associated persons who violate those laws, rules, or standards.

The Enforcement Division focuses its efforts on high-priority investigations involving significant investor protection considerations. Its matters arise from a number of sources, including Board inspections of registered firms, analysis conducted by the Board's Office of Research and Analysis, other regulators, public disclosures of restatements and auditor changes, news reports, and confidential tips. Our website has information on how to provide enforcement tips, referrals, and information on potential violations of law or PCAOB rules.^[5]

PCAOB has been building its enforcement program since 2004 when the Board hired a director and started the tips and complaints center. In 2005, the Board announced its first four settlements and opened 17 formal investigations. Since then, we have continued to build a fully functioning enforcement and investigations function.

The first adjudicated orders were publicly disclosed in 2009 and 2010. Then in 2011, the Board settled its largest case to date at that time, imposing censures and a $1.5 million penalty on PwC's India affiliates for their audit failures concerning Satyam Computer Services. The Board coordinated its actions with the SEC's Division of Enforcement, which brought a parallel case against PwC's India affiliate firms.

During 2012, the Board issued eight settled disciplinary orders imposing sanctions on auditors ranging from censures to monetary penalties to bars against their association with registered accounting firms. Those sanctions covered four registered accounting firms and 11 associated persons. In addition, the Board issued three adjudicated disciplinary orders after completing the administrative hearing process.

On Feb. 8, 2012, the Board issued a notable settled order regarding E&Y's audits of Medicis Pharmaceutical Corp. over three years and a related accounting consultation. The Board imposed a $2 million penalty against E&Y — the largest monetary penalty imposed by the Board to date — and imposed sanctions on four partners, including barring two from associating with registered accounting firms. Another significant aspect of this matter is that it started with a Board inspection finding about the same audit deficiencies that led to the enforcement order.

To date, the Board has issued 56 publicly announced disciplinary orders in proceedings brought by the Enforcement Division. In these proceedings, the Board has imposed 42 sanctions on firms (including 27 revocations of registration) and 59 sanctions on individuals (including 50 bars or suspension).

The Enforcement Division currently has more than 80 open informal inquiries, formal investigations, and non-public litigated proceedings in process.

As I mentioned, the Board's disciplinary proceedings are, by law, non-public unless each party consents to public hearings. In the PCAOB's history, no respondent has ever consented to public proceedings.

The confidential nature of our proceedings results in a number of unfortunate consequences for investor protection and the public interest. Among other things, we are unable to discuss the nature of our active disciplinary proceedings except in the most general of terms. This process is not sufficiently informative to investors, audit committees, auditors, or others interested in understanding audit risks and challenges. The non-public nature of our proceedings also provides an incentive for respondents to litigate matters regardless of whether they believe they ultimately will prevail, in order to delay public disclosure.

Legislation, which I support, was introduced in the last Congress to make our proceedings open to the public, but it did not move forward.^[6] I am hopeful that Congress will act to improve the transparency and efficiency of the Board's proceedings.

In addition to the other crucial functions of the Board's enforcement program, the Sarbanes-Oxley Act provides that penalties the Board collects in disciplinary proceedings are to be used to fund merit scholarships for students in accounting programs. The program was inaugurated in 2011.^[7] Since then, the Board has used penalty funds collected in enforcement matters to award 95 scholarships of $10,000 each, for a total of almost $1 million in scholarships.

Auditing Standards

The PCAOB is uniquely positioned to use its insight from inspection and other oversight activities to improve existing auditing standards to support high quality audits to protect investors and the public interest. As we look to what the PCAOB has accomplished through its fourth oversight area, standard setting, and what still needs to be done, we have taken on an ambitious project to broadly reexamine our standard-setting approach.

I won't go through our entire standards-setting agenda today, but it and related information can be found on the PCAOB website.^[8]

We currently have the following projects on our agenda for the first half of 2013:

1. Related parties (adoption or re-proposal)
2. Reorganization of PCAOB standards (proposal)
3. Auditor's reporting model (proposal)
4. Auditor's responsibilities with respect to other accounting firms, individual accountants, and specialists (proposal)
5. Audit transparency: identification of the engagement partner (adoption or re-proposal)

We are also continuing to develop a long-term view and framework for setting standards beyond the current project list. This is a substantive workload, and it is something to watch throughout the coming year.

***

Every aspect of the PCAOB's mission — registration, inspections, enforcement and standard setting — points to the significant role high quality audits play in the effective functioning of our capital markets.

At the PCAOB, we have taken on an ambitious agenda dealing with numerous significant issues to help ensure high quality audits for the benefit of investors and the public interest now and for the long term.

Accounting and business educators, professionals and students also need to have a mindset of working in the public interest with the highest level of ethical conduct and objectivity.

The academic community can do its part by focusing students on these principles, so that they enter the profession mindful of their responsibilities to protect investors. This, in turn, will help maintain confidence in the capital markets and will help ensure that we can continue to pass along opportunity and prosperity to future generations of Americans.

A paper that examines George R. Husband's life and accomplishments in research, service and teaching,^[9] states that Husband's students characterized his teaching principles in the following three basic positions:

1. ethical behavior is of utmost importance;
2. teachers are empowering the future leaders of the accounting profession; and
3. teachers should stretch students' thinking to the limits.

I trust that the educators and students here at Wayne State University are continuing to embody these principles.