The Importance of Auditing and Audit Regulation to the Capital Markets

Thank you Dean Ginzberg, Professor Lindsay, and Lee Shriki for those gracious introductions. It is a pleasure to be celebrating the first day of spring with you and your accounting students and colleagues here at the Kogod School of Business at American University.

I also commend you for the high-caliber interns you have provided the Public Company Accounting Oversight Board. David McGarry and Richard Reitman each worked with me and did an outstanding job, and I have received similar complimentary feedback with respect to Lee Shriki and Phil Black, who are interns in our Office of Research and Analysis.

I have been asked to speak about the enactment of the Sarbanes-Oxley Act, provide an overview of the PCAOB, and share with you some of my priorities for the coming year.

Before I continue, our Board policy requires me to inform you that the views I express today are my own, and do not necessarily reflect the views of the other Board members or the staff of the Board.

The Importance of Auditing to the Functioning of our Capital Markets

At the outset I want to congratulate those of you who have chosen accounting and auditing as your field of study. Accounting and auditing professionals serve an absolutely vital role in our capital markets. Transparent, informative and accurate financial reporting are the lifeblood of the capital markets and are essential for investors to make informed decisions as to how to allocate their capital.

Without accurate and reliable corporate disclosures and financial statements — and competent auditors to audit them — our competitive free market system could not function properly.

American households invest their savings in the capital markets — either through mutual funds or by directly buying shares of public companies — to build wealth or fund important expenditures such as college education for their children, home purchases, and their retirement. According to the most recent U.S. Census Bureau survey, 42 percent of households have 401(k) or thrift savings plan accounts with money invested in the markets.

Under our federal securities laws, auditors enjoy a unique franchise because every public company that raises money through our capital markets or has a security listed on an exchange must hire an independent public accountant to audit its financial statements. The Supreme Court, in United States v. Arthur Young, described the audit as a "public watchdog" function that "demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust."[1]

This public watchdog and public trust function are obligations you must never forget.

The Sarbanes-Oxley Act

As most of you know, the Sarbanes-Oxley Act was signed into law in July 2002. I served as the Staff Director and Chief Counsel of the U.S. Senate Banking, Housing and Urban Affairs Committee under Chairman Paul S. Sarbanes during the consideration and passage of that legislation.

Congress acted in July 2002 in the aftermath of the accounting and auditing scandals at Enron and WorldCom. Investors lost approximately $67 billion at Enron alone and $161 billion at WorldCom. There were other failures as well — Tyco, Adelphia, and Global Crossing, to name just a few.

Accounting gimmickry at those companies included phony earnings, undisclosed related party transactions, and inflated revenues, followed by massive restatements.

Investors lost confidence in our markets following these failures. Between April and July 2002 the stock market dropped more than 22 percent — or some 2,400 points.

At the very first hearing of the Senate Banking Committee, Chairman Sarbanes outlined the main issues he wished to focus on. These included: inadequate oversight of accountants; lack of auditor independence; weak corporate governance procedures; stock analysts' conflicts of interest; inadequate disclosure provisions; and grossly inadequate funding of the Securities and Exchange Commission (SEC).

In my view, the most critical result of the Sarbanes-Oxley Act is that it ended the auditing profession's framework of self-regulation by creating the PCAOB to oversee the profession.

The Act also barred audit firms from offering a number of non-audit services to their audit clients, in order to prevent conflicts of interest from arising between them and their clients. Additionally, the Act focused on the need for heightened independence, objectivity and professional skepticism on the part of auditors, as well as on enhanced transparency and accountability on the part of auditors and corporate management.

Overview of the PCAOB

The mission of the PCAOB as spelled out in Section 101 of the Act is "to protect the interests of investors … in the preparation of informative, accurate and independent audit reports…" Basically, we work to ensure that audits are conducted properly by independent auditors.

The PCAOB also oversees the audits of broker-dealers, including compliance reports filed pursuant to the federal securities laws, to promote investor protection.

In addition to overseeing the audits of public companies and broker-dealers, the duties of the Board include:

  • Registering public accounting firms that prepare audit reports for public companies and broker-dealers, including those that are listed on U.S. exchanges. As of March 6, 2014, there were more than 2,300 accounting firms registered with the PCAOB, including more than 900 non-U.S. firms, representing 86 countries.
  • Establishing standards that relate to the profession—including auditing, quality control, ethics, independence and other standards. To date, the Board has adopted 17 new auditing standards, as well as certain ethics and independence rules.
  • Conducting inspections of audits by registered firms. In 2013, the Board conducted more than 220 inspections, including inspecting audits by firms in some 22 countries outside of the U.S.
  • Investigating, conducting disciplinary proceedings, and imposing sanctions on auditors and audit firms, as needed.

The Board's 2014 operating budget is approximately $258 million and assumes a headcount of some 864 employees.


Since coming to the Board, my primary focus has been on promoting investor protection through improving audit quality and ensuring that the investor is recognized as the primary client of the auditor.

The very first words of the Sarbanes-Oxley Act of 2002 are, "An Act to protect investors by improving the accuracy and reliability of corporate disclosures.…" And, as noted earlier, Section 101 states that the mission of the PCAOB is: "… to oversee the audit of [public] companies… in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports."

I believe it is important to keep this statutory directive in mind and continually remind both students who plan on entering the profession, and auditors who are currently practicing, that the primary client of the auditor is the investor—not management. I remain concerned that this perspective is still not ingrained in the DNA of the profession.

As a PCAOB Board member, I chair both the Board's Investor Advisory Group and the Investor Working Group of the International Forum of Independent Audit Regulators (IFIAR). The mandate of these groups essentially is to ensure that investor representatives are given the opportunity to be heard in a meaningful way.

Some of the issues that both the PCAOB's Investor Advisory Group and IFIAR's Investor Working Group have focused on include: ways to improve the independence, objectivity and professional skepticism of the auditor; audit quality; firm transparency and accountability; how to make the auditor's reporting model more meaningful to investors; the lessons learned from the financial crisis; firm structure and governance; monitoring the global firm networks; the role, relevancy and value of the audit; going concern and related global initiatives; and audit quality indicators.

Related to these topics are three issues that I would like to discuss further:

  1. Ensuring the independence of the auditor from management.
  2. Monitoring the evolving nature of the large accounting firms' business models.
  3. Greater transparency of financial information by the large accounting firms.


Under an issuer-pay model in which management pays the auditor, the independence, objectivity and professional skepticism of the auditor sometimes becomes skewed or biased towards management.

Investors can only have confidence in the opinion the auditor provides, and in the audit itself, if the auditor is believed to be—and is in fact—an independent third party who "calls them as he or she sees them."

The SEC, when considering whether an auditor-client relationship meets its independence requirement, specifically considers whether such a relationship: (1) creates a mutual or conflicting interest between the auditor and client; (2) places the auditor in the position of auditing his or her own work; (3) results in the auditor acting as management or an employee of the client; or (4) places the auditor in a position of being an advocate for the client.[2]

As I noted earlier, the Sarbanes-Oxley Act prohibited a number of non-audit services to the audit client that created conflicts of interest between the auditors and their clients. In recent years we have seen a drop in the number of independence violations by auditing firms. The fact that the Board continues to see such violations, however, is of concern.

I believe the Board must remain focused on holding auditors accountable to the highest standards of professional independence, objectivity and professional skepticism.

Business Model

Directly related to the issue of independence is the evolving nature of the largest firms' business models. From June 2012 to November 2013, the Big Four global network firms and their affiliates announced more than 36 acquisitions of consulting businesses, with the Big Four U.S. firms accounting for 19 of those acquisitions.

In November 2013, one of these firms announced the creation of an investment fund with the aim to invest in, partner with, and acquire organizations that specialize in data and analytics tools and assets. Shortly afterwards, another firm announced that it had acquired a large consulting firm with practice areas in mergers and restructuring, corporate finance, digital technology and talent management. And, earlier this week, a Big Four firm's foreign affiliate announced its ambitions to become a global top-20 legal services player within the next five years.

At the same time, auditing firms are deriving an increasing share of their revenue from consulting services. Consulting revenue for the Big Four global network firms has increased over the past five years by 33 percent versus only 6 percent in audit revenue. Further, each of the Big Four firms is predicting double-digit increases in their consulting and advisory practices over the next 10 years, while their audit practices are expected to grow at a slower pace.

Firms have asserted that the acquisitions and investments they are making in their consulting and advisory practices improve their auditing capabilities and that they are therefore better able to provide specialized resources and expertise to their auditors. While this may be true, I believe it is the Board's responsibility to ensure that firms indeed continue to maintain and enhance their focus on investor protection through superior audit quality.

Ultimately, how these diversified lines of activity affect audit quality, auditor independence, conflicts of interest, and investor protection is something I believe the Board must carefully monitor and analyze.

Firm Transparency

As the major firms continue to offer more services, they have become larger and more essential to the economy. The Big Four in the U.S. had combined revenue for 2013 of approximately $39.8 billion, and alone audit approximately 98 percent of the U.S. market by capitalization.

In 2008, the Bush Administration's bipartisan Treasury Department Advisory Committee on the Auditing Profession (ACAP) recommended that the larger auditing firms submit audited financial statements to the PCAOB, and the ACAP co-chairs specifically recommended that at least the largest auditing firms make their audited financial statements available to the public. In their statement, the co-chairs asserted that the "[i]ssuance of audited financial statements provides greater transparency and increases discipline and helps sharpen focus, accountability and trust."[3]

Certain jurisdictions currently require accounting firms to provide such audited financial statements. For example, accounting firms in the United Kingdom, the Netherlands and Austria include audited financial statements in their annual transparency reports, which are posted on their respective websites. [4]

Many find it ironic that auditing firms in the United States, whose business is providing assurance about the transparency provided by others, resist publicly providing their own financial statements. I see no apparent reason that the auditing firms that act as gatekeepers to our securities markets should not be as transparent to investors as the companies they audit.

The Board, in my opinion, should similarly require audited financial statements from the profession in order to better monitor and identify trends and potential risks that may affect audit quality.

Incorporating Economic Analysis

Now I would like to say a few words about the Board's standard-setting process. The Board recognizes that its efforts to address standard setting must be balanced. Accordingly, the staff of the PCAOB—following the directive of the Board—has developed specific guidance on the use of economic analysis as part of the standard-setting process.

Under this guidance, each of the Board's proposed standards would address the following elements: (1) the need for the proposed action; (2) the baseline against which to measure the likely economic consequences of the proposed regulation; (3) the alternative regulatory approaches considered; and (4) an evaluation of the economic impact, including the benefits and costs—both quantitative and qualitative—of the proposed action and the main alternatives identified by the analysis.

The Board also considers whether the proposed action is in the public interest, whether it will protect investors, and if it promotes efficiency, competition and capital formation.

My goal as a regulator of the auditing profession is to oversee a targeted, effective, cost-efficient, regulatory process. Incorporating economic analysis into our standard-setting process will, I believe, enhance our ability to craft straightforward, streamlined, and targeted standards, and hopefully also will reduce needless complexity and regulation.

Other Issues

Finally, I want to speak of a few other issues the Board is considering, which I support. The first is the development of audit quality indicators. The Board's project on audit quality indicators seeks to develop a portfolio of quantitative measures that provide new insight into audit quality and explore how those measures might be deployed in a manner that best promotes quality. These indicators would be designed to help audit committees, investors, and others seeking the services of auditors to evaluate a firm's potential performance. The Board expects to issue a Concept Release in the near future seeking public input on the direction of this project.

Second, the PCAOB staff is developing additional guidance that will address the Board's expectations with respect to root cause analysis. In assessing a firm's remediation efforts when responding to inspection findings, our inspections staff assesses whether the firm performed an appropriate root cause analysis in developing its remedial action. I support the issuance of additional guidance in this area because a thoughtful root cause analysis hopefully will lead to effective remedial actions that will reduce and eliminate the recurrence of deficiencies in the audit.

And, third, I support the Board's focus on the role of the auditor with respect to cybersecurity and have suggested the Board consider forming an internal task force on the subject or issuing an audit alert related to cybersecurity risks and their potential impact on audits.


In conclusion, I want to again commend those of you who plan to enter the accounting and auditing profession for choosing such an intellectually rigorous and dynamic field. Your future profession is vital to the integrity of our capital markets and to the infrastructure of our entire financial system that so effectively promotes competition and remains the envy of the world.

I also hope that you will seriously consider, for at least a part of your professional experience, spending meaningful time in the public sector. The public sector, like the private sector, needs you.

Thank you. I welcome your questions.

[1] United States v. Arthur Young, 465 U.S. 805, 818 (1984).

[2] Preliminary Note 2 to Rule 2-01 of Regulation S-X. Pursuant to its rules, the SEC will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issued encompassed with in the engagement. See Rule 2-01(b) of Regulation S-X.

[3] U.S. Department of the Treasury, Final Report of the Advisory Committee on the Auditing Profession to the U.S. Department of the Treasury (Oct. 6, 2008), II:9.

[4] The Financial Reporting Council, for example, brought into force legal requirements on the auditors of certain public interest entities to publish annual Transparency Reports in 2008, in accordance with the Statutory Audit Directive. The requirement came into force for financial years ending on or after March 31, 2010. See