The PCAOB’s Initiatives to Bolster Investor Trust in the Audit

It is a pleasure to join you for the 45th year of this conference. In addition to the technical training on current and emerging issues the conference provides, it is an important opportunity for those who care about the accounting profession to reflect on the profession's future in our markets.

Of course, the views I express are my own and should not be attributed to the PCAOB as a whole or any other members or staff.

I believe the profession has a bright future. Society's needs for assurance are expanding. And I believe the profession is well positioned to meet those needs and prosper.

But doing so will require the profession to set its focus firmly on user needs, as all successful enterprises do.

Institutions – and by that I mean both the profession and the PCAOB – have to be more agile and adaptable to investor needs as the pace of change increases.

One of the fundamental lessons I have learned in life is that change is unstoppable. We need to learn to anticipate change and then adjust our activities to be effective.

The fact remains, though, that investors still clamor for better quality assurance, covering a broader set of information.

I. The Audit is the Linchpin of our Public Capital Markets.

Our modern capital markets are founded on a radical and disruptive regulatory solution to address the market crash of 1929 and the Great Depression that ensued.

Proven now by the test of time, the landmark securities acts of 1933 and 1934 rest on a brilliant but initially controversial hypothesis: that we could restart our economy if we could convince dispersed investors to pool their funds for professional managers to pour into enterprises that would increase employment and provide investors worthy returns.

The framers of our modern economic system believed that, given sufficient access to capital, skilled managers could generate both jobs and productive returns. The problem was how to convince other people and institutions to provide that capital.

The scandals and frauds that precipitated the crash taught our predecessors that loss of trust interrupted the efficient flow of capital to fund production and economic growth.

Whatever else might be required – such as, fair trading markets, liquidity – the framework established by the securities acts would need to provide mechanisms of trust.

One such mechanism – the mandatory audit – is the linchpin of trust that holds our system of public market capital formation together.

We know from decades of research and evidence that independent audits do enhance investor confidence, they do reduce the cost of capital, and they do facilitate capital formation.

But they do so only to the extent investors trust the audit.

Nor is it easy to predict how far a loss of trust can run. Robert Shiller, the Nobel laureate in economics, pinned investors' interest in alternative investments such as real estate on the loss of trust in financial reporting after the Enron and other accounting scandals. In his 2009 book, Animal Spirits, published as the subprime mortgage financial crisis was raging, Shiller wrote this –

Investors in 2001 told us in no uncertain terms that the accounting scandals were a major factor in their withdrawal from the stock market, and also a reason for their newfound faith in the housing market. In the housing market they did not need to trust the accountants.[1]

But trust lost in an instant can require a generation or more to restore.

The PCAOB aims to buttress that trust. The PCAOB is founded on an emerging truth that investor protection is enhanced by an independent process that promotes the integrity of audits.

The Sarbanes-Oxley Act established the PCAOB to provide for an independent, expert, and robust audit oversight institution – outside the profession – to set and enforce standards of conduct for auditors to meet to regain public trust, both as individual auditors as well as overall, as a profession.

With these powers, the PCAOB plays a vital role in pushing the profession beyond the comforts of the status quo.

I believe the PCAOB's independence is an important feature of the Sarbanes-Oxley Act – "a feature not a bug," in the parlance of technological innovation.

Since the dark days after Enron, both the profession and the PCAOB have worked hard to reestablish the profession's footing solidly in the public interest.

Here we must face and deal with another emerging – and inconvenient – truth: the existence of the statutory franchise since 1933 has in some respects dulled the natural instincts that should exist to innovate and compete for investor trust.

The profession has now the challenge and the opportunity to make innovation and competition serve trust.

Will new data technology tools in fact serve trust by underpinning better audits, not merely better margins and the recruitment of the new generation of auditors, but also by delivering more reliable estimates and better detection of fraud?

Will new business lines hew to the high standards of professionalism and avoidance of conflict that will enable these skills and services to improve trust in the profession?

Will new skills and services be developed to serve the integrity of the audit, not merely to subsidize the bottom line of the global firm?

Will the global firms compete on the quality of the audit, both in the U.S. and across their vast networks, by showing the public how their own internal quality standards serve investors?

The future of the profession's franchise, I believe, hangs on the answers to these questions.

II. The PCAOB's Programs and Initiatives are Designed to Reestablish the Profession's Footing Solidly in the Public Interest.

In the 12 months since I appeared before this audience, the PCAOB has made extraordinary progress toward the goal of securing trust.

The heads of several of the PCAOB's divisions and offices will speak in detail about this work over the course of the next three days: Chief Auditor Marty Bauman, Director of Inspections Helen Munter, and Enforcement Director Claudius Modesti. You'll also hear from a Board member, Jeanette Franzel.

I will just cover some of the highlights now.

Over the last two years, the Board has implemented a new standard-setting process to enhance the development of PCAOB auditing standards. It has delivered significant results in greater interdivisional collaboration, better outreach to external parties, and more effective interaction among the Board and staff.

This includes an active research agenda to inform and support a targeted and efficient approach to new standard setting. Interdivisional teams study and monitor current and emerging issues that may affect audit quality.

We have research projects on audit firm quality control systems; on the auditor's role regarding other information that accompanies audited financial statements, including non-GAAP financial disclosures; on the auditor's role regarding an issuer's noncompliance with laws and regulations; and on the expanding use of data and new technology tools in audits.

We've also devoted considerable effort to build our capabilities in research and economic analysis, through inter-departmental work with our Office of Economic and Risk Analysis.

Just last week at a meeting of our Standing Advisory Group, our Chief Auditor Marty Baumann announced a plan to form a new PCAOB Task Force on Data and Technology. This task force will supplement our oversight to explore how auditors use technologies, such as data analytics, and how they can and should audit issuers' use of new technologies, such as block chain.

We are also looking for the task force to provide insights on information about auditor and issuer technologies that might be relevant to audit committees and even to investors. The work may ultimately inform staff recommendations to the Board about practice issues and how the PCAOB might respond to them.

In addition to leading this active research, our standard-setting group made great strides this past year in bringing to the Board proposals to strengthen standards on fair value and estimates, the use of specialists, and a proposal on the auditor's supervision of other firms, such as in multinational audits. Together, I believe these proposed changes will enhance the performance of the audit.

Also, in October the Chief Auditor's staff issued a practice alert on auditing revenue in light of a company's implementation of the new FASB accounting standard.

I also want to commend our standards group for their innovative and pioneering work to bring the value of the audit more closely to investors, through new disclosures about audit participants and critical audit matters they find in each audit.

Investors began to see disclosures on the identity of the engagement partner in February, and disclosures on other firms that participated in an audit in July.

Our Chief Auditor's staff, along with staff from our registration and IT groups, worked closely with audit firms for many months leading up to implementation to make the filing process as simple as possible, including by issuing staff guidance and publishing instructional videos.

The first-year implementation of engagement partner disclosures went very smoothly.

Also this year, the Board adopted a final standard to expand the auditor's report to provide more relevant information to investors, including critical audit matters and audit tenure – the first significant changes to the auditor's reporting model in more than 70 years.

The PCAOB also broadened its communications and outreach to assist firms with implementing new rules and standards, reinventing our Small Business Forums with new targeted content and enhanced outreach through a broader, more efficient webinar series.

Our Economic and Risk Analysis team has also been very productive.

Our economists will soon put us in a position to issue a public report on their first post-implementation review of an existing PCAOB standard. Our economists evaluated the overall effect of the Board's auditing standard on engagement quality review, adopted in 2009.

The review included an econometric analysis of pre- and post-adoption data from PCAOB inspection and enforcement programs, a public request for comment, and third-party data. The results will provide important insights into changes in EQR processes and audit quality over time, as well as a wealth of information that will enrich future analysis of the impact of PCAOB oversight.

I believe this effort has established a solid foundation for future post-implementation reviews for years to come.

This year, we also posted to our website working versions of four new research papers authored by staff economists and fellows.

In fewer than three years, staff economists and fellows have now developed a total of 14 working papers on a variety of topics, including the economic impact of auditing and audit regulation. The papers are at various stages of a rigorous academic peer review process.

We continued to conduct rigorous inspections in both the United States and abroad, to meet mandatory annual and triennial cycles applicable to audits of issuers and broker-dealers. And we monitored firms' remediation of audit and quality control deficiencies found in previous cycles.

Last month we entered a cooperation agreement with the Irish authorities. Without ado, we commenced joint inspections in Ireland today. This is on top of the 60-odd non-U.S. inspections we plan to conduct this year, in nearly 30 different jurisdictions.

There remain just a handful of jurisdictions where we need to but can't yet inspect PCAOB-registered firms – most significantly Belgium and China.

We issued four staff inspection briefs describing the scope and objectives of the 2017 inspection cycle and previewing prior year findings. We also issued a sixth annual inspection report on our broker-dealer audit program.

Where necessary, we commenced investigations of particularly egregious conduct, often identified through our inspections.

So far this year, we have made public 45 disciplinary actions, and I expect more will come before the year closes.

At the time of last year's conference, the Board had just announced its findings in cases brought against Brazil- and Mexico-based members of one of the large global networks.

The Brazilian matter involved materially false audit reports and an attempted cover up by improperly altering documents and providing false testimony, involving 14 former partners and other professionals at the firm, including a number of the former leaders of the firm.

The Mexican matter involved repeated late archiving of audit documentation and improper work paper deletion and alteration by three firm individuals.

Since then, we have continued to see troubling conduct by non-U.S. firms, including improper document alteration and egregious failures of the auditor to perform the fundamental task of obtaining reasonable assurance.

In February 2017, the Board announced a settlement with the Indonesian member firm of a global network for audit failure, noncooperation with a Board inspection and investigation and violations of the Board's quality control standards. The Board found that, shortly before a PCAOB inspection of the firm, members of an engagement team had improperly created dozens of new audit work papers.

In March, the Board disciplined a partner in the Brazilian affiliate of another global network firm, for his failure to exercise appropriate care and skepticism in response to indications that receivables were overstated in the Brazilian operations of a large U.S. company.

In April, the Board disciplined the Hungarian affiliate of a global network for multiple auditor independence violations and the failure to maintain an effective system of quality control.

In July, the Board disciplined a network's Hong Kong affiliate for refusing to cooperate with a Board investigation.

In September, the Board disciplined a global network affiliate in Spain, for audit failures relating to GAAP violations, auditing revenue and poor quality control. It turns out the firm's personnel had received no training on PCAOB standards before undertaking the audit.

And just last week, the Board settled a fraud charge against an unaffiliated PCAOB-registered firm based in Hong Kong, for its failure to perform any audit procedures before issuing an audit report on a China-based issuer.

You may think that these are rare and isolated occurrences. But they are not. In each of the past two years, approximately 40 percent of the enforcement matters the Board has brought have involved non-U.S. firms.

Through these cases, the PCAOB is identifying and bringing impactful cross-border accountability that protects the integrity of the Board's regulatory processes and promotes the integrity of the audit process, including the need for genuine professional skepticism.

Bringing accountability to these cross-border auditors contributes to public trust in the standards of U.S. practice.

III. Transparency through Disclosure is a Way for the Audit Profession to Build and Deepen Trust.

The PCAOB's new engagement disclosures as well as the revised auditor's report are also intended to use transparency as a way to improve the credibility and relevance of the audit to the investing public.

Transparency through disclosure is a way for the audit profession to build and deepen trust.

A. Disclosure of Audit Participants Will Impose Valuable Market Discipline and Lead to Positive Capital Market Effects.

Our growing database on the engagement partners assigned to lead audits will allow investors and audit committees to develop a better understanding of a partner's experience and capabilities.

Because the part of the new rule that relates to disclosure of other auditors only went into effect this Summer, we don't have the full complement of a year's worth of filings yet.

When we do, investors will for the first time gain a sense of the international scope of many audits of both large and even medium-sized issuers, and a more complete understanding of how much audit work for issuers is conducted by firms other than the firm whose name is on the audit report.

Even from the small sample of 220 or so filings made to date, one can see that the aggregate percentage of audit work conducted by other firms can reach up to 97 percent.

In some cases, this is due to the use of many auditors, each of whom might contribute five or ten percent of the audit work. In other cases, quite significant percentages of the audit were conducted by another audit firm.

I have heard from auditors that their efforts to compile the information on other firms have given them a sharper view of risks which they are glad to be aware of.

Over time, I believe these disclosures will enhance investor confidence in well assigned and organized audits.

They will also, though, give markets important warnings when an audit involves an engagement partner assignment or use of other auditors that ring an alarm.

Markets will know when an auditor relies on work of an affiliate that the Board or a local regulator has found to be deficient.

As with corporate disclosures, the requirement to disclose in and of itself gives the market a powerful tool to incentivize firms to organize their audits and networks in ways they can be proud to make known.

Such disclosures have had measurable capital market effects in other jurisdictions where the engagement partner's name has long been a matter of public record, whether by requirement or custom.

B. By Responding to Investor Demand, the New Auditor's Report Will Enhance the Relevance and Credibility of Audit Reports.

Investors had long called for enhancing the auditor's report, given the effort involved and the value the auditor brings to investor confidence. That the changes were responsive to investor demand contributes to investor trust.

In today's complex economy, and particularly in light of lessons learned after the financial crisis, investors in our public capital markets want a better understanding of the judgments that go into an auditor's opinion – not a recitation of the standard procedures that apply to any audit, but the specific judgments that were most critical to the auditor in arriving at the opinion.

We are approaching implementation of our changes to the audit report in the same way we approached implementation of our other transparency disclosures. We will bring all our tools to the task, starting with outreach and guidance as firms prepare to comply.

In a matter of weeks, audit reports will be better organized, provide investors the tenure information they have asked for, and include an express statement about auditor independence beyond just what is implied by the title of the report.

To assist firms in implementing these initial changes to the form and content of the auditor's report, which take effect for fiscal years ending on or after December 15, we plan to issue staff implementation guidance as I speak.

We are also providing webinars on December 12 and one on January 10.

With respect to CAMs requirements, the Board set staggered effective dates, based on the size of the company under audit.

CAMs are required for audits of large accelerated filers for fiscal years ending on or after June 30, 2019, and for audits of other issuers for fiscal years ending on or after December 15, 2020.

CAMs will not be required for audits of emerging growth companies, brokers and dealers, employee stock plans, or investment funds.

The staggered effective dates will allow us to monitor early implementation. As needed, we will develop additional guidance and report on areas where we find common compliance weaknesses.

Successful implementation will also, of course, require firms' commitment to differentiate their reports and provide meaningful insights.

As I've described, we have also developed a robust approach for post-implementation review of a standard's economic impact. Our economists have already begun to plan and identify data to collect for the post-implementation review of the economic impact of the new audit report and transparency disclosures down the road.

In closing, first I want to acknowledge the contributions to our work of Chief Accountant Wesley Bricker, Deputy Chief Accountant Marc Panucci, and most recently Chairman Clayton. The accomplishments I have just described have required their support, encouragement and counsel, and all that has been forthcoming.

Finally, do not forget where we were when self-regulation left public trust to fend for itself in 2002, and do not discount how much the restoration of trust depends on a PCAOB that is independent, and clearly seen to be independent.

Underlying all the PCAOB's initiatives is the goal to help the profession meet increasing demands in a responsible way that preserves integrity, inspires investor trust and promotes economic vitality.

The more audits we can review, the more likely the prospect of scrutiny will deter the kind of audit failures that led to the Sarbanes-Oxley Act. This was the organizing principle underlying the creation of the PCAOB, but we have now put it to the test and demonstrated that it's true.

But the PCAOB does more than merely protect investors from the few bad apples amongst the many hundreds of thousands of professionals who work in public auditing.

It also serves as a counterweight to the contractual tug of the audit client, by pulling the auditor's allegiance back to the investor.

At the end of the day, the purpose of the audit and the audit report has always been to communicate a basis for trust to investors.

Thank you for this opportunity to discuss the PCAOB's work and for all you do to support high-quality audits.

[1] George A. Akerlof & Robert J. Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, Princeton University Press, pg. 35, 2009.