Q&A: PCAOB Standard-Setting Initiatives

Question regarding topics of importance to investors: The PCAOB Investor Advisory Group, which you chair, and the Board's Standing Advisory Group recently held separate meetings. What were the most important topics of discussion in your opinion?

Response by Board Member Steven B. Harris: There are two key topics that stand out: (i) the auditor's role with regard to non-GAAP measures; and (ii) the auditor's consideration of a company's noncompliance with laws and regulations. ^[*]

Both topics are of importance to investors and are listed as research topics in our most recent standard-setting update.^[1]

Non-GAAP Measures

Both groups felt that continuing to examine the auditor's role regarding non-GAAP measures should be a high priority for the Board. Some observations included:

• The use of non-GAAP measures has increased over the years. For example, in 2016, approximately 88 percent of S&P 500 companies reported one or more non-GAAP measures in their fourth-quarter earnings releases.^[2]

• Earnings reported under non-GAAP measures often are higher than GAAP reported amounts. For example, approximately 86 percent of companies reported higher non-GAAP net income than what they reported in their GAAP financial statements.^[3]

• Investors are increasingly using non-GAAP measures in their financial analysis. However, there is little standardization in the way companies define and calculate these measures, making comparability difficult among companies.

Both our Investor Advisory Group ("IAG") and Standing Advisory Group ("SAG") encouraged the Board to move forward with making the auditor's responsibilities for non-GAAP measures more rigorous than the current requirements.^[4]

To promote consistent reporting and presentation across companies and industries, the PCAOB's IAG recommended that non-GAAP measures be defined and disclosed as part of the financial statements so that they would be subject to independent validation as part of the audit. If such measures remain outside of the company's audited financial statements, IAG members recommended that they should be clearly defined by management and auditors should examine them for compliance with the company's definition.^[5]

Additionally, I believe – and this was also mentioned at both group meetings – that it is important for the Board to consider the auditor's involvement in environmental, social and governance ("ESG") reporting. Investors increasingly consider ESG metrics when making investment decisions.^[6] This information is provided through supplemental disclosure but, here as well, comparability is difficult due to a lack of uniform standard reporting.

Investors believe they will benefit if the auditors are required to also examine this information.

Against this background, I believe it is very important for the Board to remain focused on this research topic with a view to exploring possible standard-setting approaches. Investors are clearly interested in using this type of information in their analysis and are looking for an enhanced auditor's role.

I would note that ESG reporting is currently required in a number of countries and I firmly believe that such reporting and some form of assurance is the wave of the future.

Auditor's Consideration of Noncompliance with Laws and Regulations

Over the last several years, there have been a number of high-profile cases involving company violations of consumer fraud and banking regulations, as well as laws and regulations that relate to the Foreign Corrupt Practices Act, and environmental and product safety requirements.

The PCAOB's research project on this topic is focusing on whether existing standards are sufficiently clear to investors and auditors, and whether the current scope of auditor responsibility to detect, investigate, and report on illegal acts is adequate from an investor protection point of view.

This topic was also discussed at the recent meeting of the PCAOB's Investor Advisory Group. At this meeting, investor representatives indicated that investors expect auditors to do more in uncovering noncompliance with laws and regulations. They also expressed concerns that auditing standards in this area are outdated, confusing, and inconsistent among audit regulators. They advocated strengthening the auditor's responsibilities to better protect investors by:

• Expanding the auditor's responsibility to detect illegal acts;

• Improving the auditor's assessment of risks relating to illegal acts, including the audit response;

• Developing more robust requirements around the auditor's understanding of a company's whistleblower programs; and

• Expanding management representations to the auditor about illegal acts or possible illegal acts.^[7]

Last week at a meeting of the PCAOB's Standing Advisory Group, some SAG members expressed support for enhancing the auditor's responsibilities, whereas others expressed caution regarding potential overreach of further auditor requirements that would be outside the scope of the auditor's qualifications.^[8]

The PCAOB's work in this area is ongoing but, given the feedback we have received to date, I believe there is considerable room for improvement in the existing requirements for auditors to detect, investigate and report on a company's noncompliance with laws and regulations and that the Board should adopt additional requirements here as well.