Statement on Adoption of an Auditing Standard on the Auditor’s Report

Mr. Chairman, I support the adoption of the new auditor reporting standard before the Board this morning. This standard has been a priority of mine since my first days at the Board and I am pleased that we are now ready to adopt it.^[1]

The auditor's report is the primary means by which the auditor communicates to investors and other financial users. Yet all it says is whether in the opinion of the auditor, the financial statements present fairly, in all material respects, the financial position of the company as of a given date.

Investors want more. Following the 2008 financial crisis, they reiterated their concerns, and informed us that they wished they had known the auditor's insights into the financial institutions and other companies that were in trouble.

As a result of the Board's action this morning, audit reports will become far more informative and useful to investors.

I want to talk briefly about the important history of this project and then discuss some of the key features of the standard, including critical audit matters, and disclosures regarding independence, tenure and the auditor's responsibilities with respect to error or fraud. Then I will cite a few of the favorable reactions from auditors in the United Kingdom related to their expanded auditor report. I will conclude with a few thoughts about steps for further improvement.

History

By adopting this standard, we are taking a meaningful step toward fulfilling a core part of our mandate which, under the Sarbanes-Oxley Act of 2002, requires the PCAOB "to protect the interest of investors…in the preparation of informative, accurate and independent audit reports."^[2]

The Sarbanes-Oxley Act was passed in the wake of accounting scandals at Enron, WorldCom, Adelphia, Tyco, and a host of other major U.S companies. Some years later, during the 2007-2008 financial crisis, institutions such as AIG, Lehman Brothers, Bear Stearns, Citigroup, and Washington Mutual all received clean opinions from their auditors despite reports of their being on the verge of collapse.^[3]

During the 2011 PCAOB Investor Advisory Group (IAG) meeting, IAG members noted that current audit reports rarely communicate important information to the public.^[4] Further, as noted in a comment letter from Ann Simpson of the California Public Employees' Retirement System, the audit reports on the financial statements of a major financial institution reiterated the same information from 2008 to 2010, despite the fact that the institution received government funds and its audit fees increased by over 60% during the same period.^[5] Those audit reports provided investors in that company with no insight into what additional work was necessary for the auditor to repeatedly provide the same nondescript auditor's report.

Today's action is a direct response to calls from investors for the Board to expand the auditor's report to include information about the difficult parts of the audit, and information that the auditor gained from the audit that he or she would like to know as an investor – basically what "kept the auditor awake at night."

It is also a response to a 2008 recommendation of the Bush Administration's Treasury Department Task Force on the Audit Profession which "urge[d] the PCAOB to undertake a standard-setting initiative to consider improvements to the auditor's standard reporting model."^[6]

As a result of the action the Board is taking this morning audit reports will become far more informative and useful to investors.

Critical Audit Matters

Among the most important provisions of this new standard is a requirement that auditors must communicate in the audit report any critical audit matters arising from the current period's audit or state that the auditor determined that there are no critical audit matters.

A critical audit matter is defined as a matter that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment.

In communicating these critical audit matters, auditors must describe the principal considerations that led the auditor to determine that the matter is a critical audit matter, describe how the critical audit matter was addressed in the audit, and refer to the relevant financial statement accounts or disclosures relating to that matter.

We anticipate that critical audit matters will likely cover areas that have historically been of particular interest to investors, such as significant management estimates and judgments, significant unusual transactions, and other areas that pose high financial statement and audit risk.

Other Features of the New Standard

While retaining the existing pass/fail opinion, this new standard features additional improvements to the auditor's report that investors and other stakeholders should find useful. For example, under the new standard, the report must now include:

1. A statement regarding the requirement for the auditor to be independent, which I believe will reinforce the importance of independence to the auditor.

2. Amended language that adds the phrase whether due to error or fraud when describing the auditor's responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. This amended language is aligned with the auditor's responsibilities under PCAOB standards.^[7]

3. The year in which the auditor began serving consecutively as the company's auditor. I am pleased that this information will now be provided in the audit report. Investors have long asked for it because they consider this information as an important data point in making their investment decisions and assessing the potential risks to the objectivity of the auditor.

I also believe that this provision is aligned with the Board's commitment to providing more transparency about the relationship between the auditor and the company to shareholders who are often asked to ratify the selection of the auditor.

Investor Support

Investors support many of the reforms that are reflected in the standard we are considering today. For example, Anne Sheehan of the California State Teachers' Retirement System commended our efforts to update the audit report by stating in their most recent comment letter:

We believe the proposed rule changes will provide four important attributes—transparency, relevance, reliability, and credibility. Investors are the intended beneficiaries of public company audits, with shareholders' capital paying for the auditor's report.^[8]

I would also note that, since its founding in 2009, the PCAOB's Investor Advisory Group has provided many ideas and perspectives about the audit report that are reflected in today's standard.^[9] For instance, among the changes suggested by the IAG in 2011 was for the auditor to provide more disclosure about significant unusual transactions and areas of high financial and audit risk along with how the auditor addressed these risk areas.^[10] The critical audit matters provision that we are adopting today should provide information about such areas.

I thank the IAG members today for their persistent focus and work on this topic over the years.

Value to the Audit Profession

I believe that the new audit report could have a positive and transformative impact on the audit profession if applied as intended. It presents auditors with a genuine opportunity to provide significant value to investors by revealing the key issues underlying the financial report to which investors should direct their attention rather than, as now, simply producing a largely uninformative pass-fail report.

Also, as investors become familiar with the types of critical audit matters that auditors report, the expectation gap between investors' understanding of, and auditors' actual responsibilities for, conducting an audit should be reduced.

In addition, this report should help change auditor behavior for the better by focusing the auditor in a significant and accountable manner on the audit's result and who it affects.

Some auditors tend to forget that their primary client is the investor and not company management. By expanding the information contained in the report, auditors will be directly communicating far more meaningfully with their primary client than they ever did before.

Joining the International Movement

By adopting this standard, the U.S. will join other standard setters, who have already expanded their auditor's reports in light of the financial crisis.^[11]

Audit firms in the U.K. have provided expanded information in their audit reports since 2013 and audit firms in many other countries have issued similarly informative reports since the beginning of this year as a result of requirements passed by the International Auditing and Assurance Standards Board (IAASB) and the European Union.^[12]

Generally these expanded reports have been reviewed positively by the profession and investors alike.

Here are some comments on this development from members of the profession in the U.K.:

· William Touche, senior audit partner of Deloitte's London audit practice, vice chairman of the firm, and leader of Deloitte's U.K. Center for Corporate Governance, sees the new report "as an opportunity to inform shareholders about important work we do on their behalf." He thinks auditors have "been given an opportunity to reestablish the value of the audit" due to this change.^[13]

· Similarly, Tony Cates, head of audit at KPMG in the U.K. has stated, "Auditors have broader access to a company than almost any other entity or profession.... We are in a unique position to deliver more than a binary audit report; to deliver insights to help shareholders better understand and engage with the companies that they own. That is why I am so passionate about the value we can add in our new, expanded audit reports in the U.K."^[14]

· Also in the U.K., in the two years following the implementation of the new requirements, an association of investment managers there has recognized in an annual awards ceremony those specific auditor's reports found to be most clear and most innovative in providing insight into the audit of the company's financial statement.^[15]

It is clear that, at least in the U.K., the reformed audit reporting model, which is similar in a number of ways to the one we are considering today, has been welcomed not only as a means to provide additional information to investors, but also as a means for accounting firms to compete among themselves and distinguish their particular brand and quality.

I hope that the profession in the U.S. will similarly embrace this initiative and view it as an opportunity.

Room for Improvement

Overall, I am pleased with the direction of the standard we are about to adopt and I believe it represents a meaningful improvement from the status quo.

That said, I believe that there is room for future improvement. In May of 2016, when the Board last considered this standard, I noted that the revised definition of critical audit matters still contains an element of subjectivity. I believed then, as I do now, that allowing auditors to decide what matters involved "especially challenging, subjective or complex auditor judgment" grants them too much discretion.

In addition, I remain concerned about the difficulty of effectively inspecting against and enforcing compliance with such a subjective standard.

Investors have also requested a number of features that are missing from this standard. For example, investors recommended that the standard include a precise list of matters that the auditor must discuss in the report such as the auditor's assessment of management's estimates and judgments, unusual transactions, restatements and other changes, and the auditor's assessment of the quality of the issuer's accounting policies and practices.^[16]

Further, in a letter to the Board dated August 15, 2016, members of the Auditor's Report Working Group of the IAG noted another potential improvement to the reproposed standard. As they put it:

"…the Board stopped short of mandating the one item that we believe would provide the greatest value to investors—the discussion of what the auditor found when it addressed the CAM (i.e. what were the results of the auditor's procedures in these areas."^[17]

They went on to write that "we view including CAM-related findings as unambiguously making audit reports more informative."^[18]

A number of investor representatives also opposed the Board's inclusion of a "materiality" threshold for what constitutes a critical audit matter^[19] and would have liked us to address areas relating to an issuer's ability to continue as a going concern.^[20]

Finally, I regret that the Board is exempting critical audit matters for audits of Emerging Growth Companies given that these companies present some of the greatest risk to investors.

Having said that, I reiterate that I am pleased that we have reached this moment after so many years of effort. I would encourage the Securities and Exchange Commission (SEC) to act quickly to finalize it.^[21] Then I think we must monitor its implementation carefully to ensure that the report is not reduced to boilerplate language.

I believe the Board and the profession have quite a long journey ahead to meet the expectations of the investing public and to ensure this report advances the needs of investors and makes the audit more relevant.

Conclusion

I would like to thank the staff members in the various offices at the PCAOB that have contributed to this project, but most especially the staff from our Office of Chief Auditor, Marty Baumann, Jennifer Rand, Jessica Watts, Karen Wiedemann, Elena Bozhkova, and Ekaterina Dizna, as well as Andres Vinelli and Patrick Kastein from the Board's Office of Economic and Risk Analysis. Many of you have worked on this project since its inception and have devoted a large amount of time and effort to it over the years.

I would also like to thank Wes Bricker and Marc Panucci from the SEC's Office of the Chief Accountant for their significant contributions to this project.

Finally, Mr. Chairman, I want to thank you for your leadership on this issue. We are here today due to your perseverance and dedication to seeing this project to its final adoption.