Good afternoon.

I'm delighted once again to be a part of this AICPA conference. I congratulate the AICPA for this annually successful conference that benefits thousands of professionals and congratulate all of you for attending.

The Office of the Chief Auditor is responsible for advising the Board on the establishment of auditing and related professional standards to strengthen the reliability of audits. As Chief Auditor I'm fortunate to lead an extraordinary group of professionals at the PCAOB who are dedicated to audit quality — and to the development of standards and related guidance to continually improve audit quality.

This afternoon I want to touch on, first, our most recently adopted standard — AS 16, Communications with Audit Committees- and then briefly comment on two standard-setting projects — the Auditor's Reporting Model and Going Concern. Then I want to focus my remarks on a most critical aspect of auditing — Professional Skepticism.

AS 16 was adopted by the PCAOB in August. Subject to SEC approval, it is intended to be effective for audits beginning on or after December 15, 2012. Through appropriate and timely communications with audit committees, this standard can significantly improve audit quality. It also benefits the audit committee in fulfilling the role it was charged with under the Sarbanes-Oxley Act.

Among other things, the standard improves auditor communications regarding the audit strategy, significant risks, information about other firms and specialists participating in the audit, the company's most complex accounting estimates, significant unusual transactions, complaints about accounting matters, and the auditor's evaluation of the company's ability to continue as a going concern.

AS 16 went through an extensive exposure process and generally received strong support for its improvements in audit quality. Some firms are planning to adopt its communications principals early, in this year's audits.

The Auditor's Reporting Model has been referenced a number of times in this conference, including the many commissions or committees that have recommended the need for the audit report to change, the extensive outreach we have made in considering changes to the Auditor's Report, as well as related global initiatives by the IAASB and the European Commission.

We have received significant and valuable input to help in our deliberations. We are being extremely thoughtful and careful in our approach — making changes to the auditor's report has significant support, but making such changes needs the deliberative approach we are taking.

Our plan at this stage, as noted in our current standard-setting agenda, is to issue a proposal for public comment in the first-half of 2013. We expect many comment letters on such an important proposal but we also plan further Roundtables and discussions with our Advisory groups.

Economic Analysis is also an important ingredient in considering any new audit report — so we will be soliciting views there as well. So a lot has been done, but much more is yet to be done as we address this most important matter of revising the Standard Auditor's Report.

We have a very busy standard-setting agenda, but I want to mention just one more item — that is, revising the standard on the auditor's consideration of a company's ability to continue as a going concern.

The financial crisis evidenced a need for improvements in this standard, but just as importantly evidenced the need for improved reporting by Issuers. The FASB has recently approved a project to require periodic evaluations by management and disclosures under certain circumstances about doubts regarding the company's ability to continue as a going concern.

They plan an Exposure Draft in early 2013 and we will plan to propose our revised auditing standard shortly thereafter. This is the holistic approach to this problem that investors, preparers and auditors have asked for.

Now, let me turn away from current standard-setting and comment on a very important existing audit requirement — Professional Skepticism.

In August, 2011, the PCAOB issued a Concept Release entitled "Auditor Independence and Audit Firm Rotation".

Auditors have long recognized that Independence is critical to an audit and critical to the viability of auditing itself. The Concept Release noted, however, that the Board continues to find instances in which auditors did not approach some aspect of the audit with the required Independence, Objectivity and Professional Skepticism.

Sometimes it's interesting to go back to basics - so let me do that. On independence, the second general standard on auditing (written before most of you were born) says that - "In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor." Let me highlight some words again — "IN ALL MATTERS" pertaining to the audit, "INDEPENDENCE IN MENTAL ATTITUDE" is required of the auditor.

There are a plethora of independence rules, as you know — generally they focus on financial interests and services that are deemed to impair independence. But remember at its core — Independence is a matter of maintaining an independent mental attitude in all matters pertaining to the audit.

The third general standard of auditing requires that "Due professional care" is to be exercised throughout the audit and in preparing the audit report. And that standard goes on to say that "Due Professional Care requires the auditor to exercise professional skepticism."

I want to pause for a moment to make sure I'm engaging not only the auditors here, but also so many of you who are the preparers of the financial statements — the controllers, those in accounting policy or operations or other Corporate executives. This message is also important for you.

When your auditor questions your assertions, he or she is not being difficult. They're just doing their job. They're acting like an auditor is required to. And when I talk about the risks of management fraud today, please don't think I'm being difficult. That's just the job of an audit standard-setter.

Under PCAOB standards, the auditor neither assumes management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest.

"Professional Skepticism!" Just two words. But so fundamental to the performance of an audit. Observations about the lack of professional skepticism in some audits was at the heart of the Concept Release to which I referred earlier. And the PCAOB is not alone in identifying concerns regarding professional skepticism in audits.

Regulators in many other countries such as Australia, Canada, Germany, The Netherlands, Singapore, Switzerland and the United Kingdom have each cited concerns in public reports about the lack of professional skepticism in audits they have inspected.

So, I want to focus the remainder of my remarks on this topic so essential to the ongoing relevance and quality of audits.

Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. It is essential to the performance of effective audits. Professional skepticism is required in every aspect of every audit by every auditor working on the audit. Audits are performed to provide investors with assurance on the fair presentation of the financial statements prepared by management. If the audit is conducted without professional skepticism, the value of the audit to investors and others is seriously impaired.

While professional skepticism is important in all aspects of the audit, it is particularly important in those areas of the audit that involve significant management judgments , including judgments in areas with great measurement uncertainty, or transactions outside the normal course of business, such as nonrecurring transactions, financing activities, and related party transactions that might be motivated solely, or in large measure, by an expected or desired accounting outcome. Effective auditing involves diligent pursuit of sufficient appropriate audit evidence, particularly if contrary evidence exists.

Professional skepticism is also critical as it relates to the auditor's consideration of fraud in the audit. Company management has a unique ability to perpetrate fraud because it frequently is in a position to directly or indirectly manipulate accounting records and present fraudulent financial information. Company personnel who intentionally misstate the financial statements often seek to conceal the misstatement by attempting to deceive the auditor. Because of this incentive, applying professional skepticism is integral to planning and performing audit procedures to address fraud risks.

PCAOB inspectors continue to observe instances in which the circumstances suggest that auditors did not appropriately apply professional skepticism in their audits. As examples, audit deficiencies like the following, observed in our inspections, raise concerns that a lack of professional skepticism was at least a contributing factor:

  • For certain hard-to-value Level 2 financial instruments, the engagement team failed to obtain an understanding of the specific methods and assumptions underlying the prices that were obtained from pricing services and other third parties and used in the engagement team's testing related to these financial instruments. Further, the firm used the price closest to the issuer's recorded price in testing the fair value measurements, without evaluating the significance of differences between the other prices obtained and the issuer's prices.
  • The issuer discontinued production of a significant product line during the prior year and introduced a new product line to replace it. There were no sales of the discontinued product line during the last nine months of the year under audit. The engagement team did not test, beyond inquiry of management, the significant assumptions management used to calculate its separate inventory reserve for this product line.
  • The engagement team did not evaluate the effects on the financial statements of management's determination not to test a significant portion of its property and equipment for impairment, despite indicators that the carrying amount may not have been recoverable. These indicators in this situation included operating losses for the relevant segment for the last three years, substantial charges for the impairment of goodwill and other intangible assets during the year, a projected loss for the segment for the upcoming year, and reduced and delayed customer orders.

The PCAOB's enforcement activities also have identified instances in which auditors did not appropriately apply professional skepticism. For example, in one recent disciplinary order, the Board found that certain of a firm's audit partners accepted a company's reliance on an exception to GAAP for reserving for expected future product returns even though doing so conflicted with the plain language of the exception and the firm's internal accounting literature. The partners were aware of, but did not appropriately consider, contradictory audit evidence indicating that the returns were not eligible for the exception.

Although auditing standards require auditors to appropriately apply professional skepticism throughout the audit, observations from our oversight activities indicate that, as a practical matter, auditors are often challenged in meeting this fundamental audit requirement. In maintaining an attitude that includes a questioning mind and a critical assessment of audit evidence, it is important for auditors to be alert to unconscious human biases and other circumstances that can cause auditors to gather, evaluate, rationalize, and recall information in a way that is consistent with client preferences rather than the interests of investors.

Certain conditions inherent in the audit environment can create incentives and pressures that can serve to impede the appropriate application of professional skepticism and allow unconscious bias to prevail. For example, incentives and pressures to build or maintain a long-term audit engagement, avoid significant conflicts with management, provide an unqualified audit opinion prior to the issuer's filing deadline, achieve high client satisfaction ratings, keep audit costs low, or cross-sell other services can all serve to inhibit professional skepticism.

I think audit staff too often hear from their leaders about the importance of delivering high quality "client service." That expression, "client service", can have confusing overtones to the audit team — like, keeping the client happy. How about deleting "client service" from the language and have leaders say instead — "audit teams, be focused on delivering the highest audit quality possible." Focus on extraordinary "audit quality", not extraordinary "client service."

Another factor possibly impeding skepticism is that, over time, auditors may sometimes develop an inappropriate level of trust or confidence in management, which may lead auditors to accede to inappropriate accounting. In some situations, auditors may feel pressure to avoid potential negative interactions with individuals they know (that is, management) instead of representing the interests of the unseen investors they are charged to protect.

By the way, that's a good lead-in to some other phrases I think we should re-consider. They are "Relationship Partner" and "maintaining strong client relationships." The term "relationship" can also have confusing overtones to an audit team , like "kinship" or "closeness". Does that feeling support skepticism? As far as I know, Federal Bank Regulators, State Insurance Departments, and Securities Regulators all perform their examinations, getting everything they need to complete their work, without a focus on "relationships". I'd substitute "professional courtesy" for "client relationships." Let's create the right tone from the top.

Other circumstances also can impede the appropriate application of professional skepticism. For example, scheduling and workload demands can put pressure on partners and other engagement team members to complete their assignments too quickly, which might lead auditors to seek audit evidence that is easier to obtain rather than evidence that is more relevant and reliable, to obtain less evidence than is necessary, or to give undue weight to confirming evidence without adequately considering contrary evidence.

Although powerful incentives and pressures exist that can impede professional skepticism, the importance of professional skepticism to an effective audit cannot be overstated, particularly given the increasing judgment and complexity in financial reporting, and issues posed by the current economic environment.

Auditors and audit firms must remember that their overriding duty is to put the interests of investors first. Appropriate application of professional skepticism is key to fulfilling the auditor's duty to investors. In the words of the U.S. Supreme Court:

"By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This 'public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust".

Firms' quality control systems can help engagement teams improve the application of professional skepticism in a number of ways.

They include setting a proper tone at the top that emphasizes the need for professional skepticism; implementing and maintaining appraisal, promotion, and compensation processes that enhance rather than discourage the application of professional skepticism; assigning personnel with the necessary competencies to engagement teams; and appropriately monitoring the quality control system to take necessary corrective actions to address audit engagements lacking professional skepticism.

When professional skepticism is applied appropriately, the auditor does not presume that the financial statements are presented fairly. Instead, the auditor employs an attitude that includes a questioning mind in making critical assessments of the evidence obtained to determine whether the financial statements are materially misstated.

PCAOB standards indicate that the auditor should take into account all relevant audit evidence, regardless of whether the evidence corroborates or contradicts the assertions in the financial statements. Examples of areas in the auditor's evaluation that reflect the need for the auditor to apply professional skepticism, include, among many others, the following:

  • Evaluating uncorrected misstatements. This includes evaluating whether the uncorrected misstatements identified during the audit result in material misstatement of the financial statements, individually or in combination, considering both qualitative and quantitative factors.
  • Evaluating management bias. This includes evaluating potential bias in accounting estimates, bias in the selection and application of accounting principles, the selective correction of misstatements identified during the audit, and identification by management of additional adjusting entries that offset misstatements accumulated by the auditor. When evaluating bias, it is important for auditors to consider the incentives and pressures on management regarding financial results.
  • Evaluating the presentation of the financial statements. This includes evaluating whether the financial statements contain the information essential for a fair presentation of the financial statements in conformity with the applicable financial reporting framework. Do the financial statements really tell the complete story?

When evaluating misstatements, bias, or presentation and disclosures, it is important for auditors to appropriately apply professional skepticism and avoid dismissing matters as immaterial without adequate consideration.

In summary, it was my intent here to remind auditors of the importance of appropriately applying professional skepticism throughout their audits. In upcoming year-end audits, and in all audits, it is essential that every auditor be professionally skeptical in all aspects of their audit work, to maintain a questioning mind and make a critical assessment of audit evidence.

I must respectfully disagree with the notion mentioned by a speaker yesterday that professional skepticism calls for a "trust but verify" approach. I hope my comments have made clear that it is the responsibility of each individual auditor to have a questioning mind throughout the audit. That means to be mindful of the risks of fraud or material misstatements, to obtain sufficient appropriate audit evidence rather than merely available evidence that corroborates assertions, and critically evaluate all evidence — especially when it contradicts those assertions.

The Office of the Chief Auditor has issued an Audit Practice Alert today on "Maintaining and Applying Professional Skepticism in Audits." I consider it essential reading for all auditors. I believe it will also be useful for audit committee members and others in understanding the responsibilities of auditors to maintain an attitude of professional skepticism throughout the audit.

Due to the fundamental importance of the appropriate application of professional skepticism in performing an audit, the PCAOB is also continuing to explore whether additional actions might meaningfully enhance auditors' professional skepticism.

Thank you so much for your attention as I addressed this critically important subject, and other standard-setting matters.

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