The PCAOB Supervisory Approach and Current Market Challenges

I. Introduction

Two years ago this month, I spoke on the importance of the PCAOB’s supervisory model for auditor oversight. The environment was somewhat different then: The markets were performing significantly higher (as an indicator, the Dow Jones Industrial Average was above 12,000 that year and moved on to reach a historical high in October 2007 of over 14,000). Times have certainly changed -- as we are now in the midst of a well-documented global financial crisis. For these difficult times, the supervisory approach is more important than ever to help us achieve our important mandate of improving audit quality.

While there are a number of significant challenges that must be navigated in the current financial crisis, it also provides a historic opportunity for Congress and the incoming Administration to strengthen our financial system and rethink the U.S. financial regulatory framework, which is more a succession of policy responses to past crises than a model of efficiency. I hope policy-makers are able to make improvements to the U.S. framework, and I am confident that any changes to the framework will retain and enhance the supervisory approach to financial institution and auditor oversight, with a focus on enterprise-wide risk management. Equally important, our globalized markets drive the need for a framework that emphasizes enhanced collaboration and cooperation with foreign financial supervisors. Financial and other risks transcend borders, and so we must strengthen our ability and resolve to cooperate with our foreign supervisory counterparts.

For the PCAOB specifically, even at our young age, we can identify legislative improvements that would enhance our ability to fulfill our mandate. I look forward to sharing my thoughts with the incoming Administration and the new Congress.

At its outset about six years ago, the PCAOB adopted a supervisory model for overseeing public audit firms. Today, I would like to discuss how the PCAOB adopted the supervisory model as a means to improve audit quality. I will share some observations from the inspections of large audit firms and address some aspects of the firms’ remediation efforts (under Sarbanes Oxley, remediation is the voluntary action taken by a firm to fix defects identified during the inspection). The inspection and remediation information to date demonstrate that, while the PCAOB continues to indentify audit deficiencies in the course of its inspections, firms are making a number of efforts to remediate these deficiencies. This is true for larger and smaller firms and is an indication that the PCAOB inspection program is making a positive impact.

In addition to discussing the PCAOB’s supervisory approach, I also will share with you some thoughts on audit challenges in the current market and correlative actions underway at the PCAOB.

I must note before I continue that my remarks today are my own and do not necessarily reflect the views of the PCAOB or other Board members.
 

II. The PCAOB Inspection Program – Enhancing Audit Quality and the Adoption of a Supervisory Approach

When the PCAOB began to design its inspection program, it faced a blank slate. That is, while there were certainly fundamentals of the program set forth in the Sarbanes-Oxley Act, the Board needed to lay the foundation for what would evolve into our current inspection program and oversight approach. The first component of the audit inspection designed by the Board was consistent with the Act: a review of a registered firm’s audits in order to assess whether they were consistent with audit standards. Also in accordance with the Act, the Board included an assessment of the adequacy of certain systems and structures within a firm, including quality controls, management, and internal communication.

But the PCAOB’s inspection program goes beyond simply assessing compliance with standards that govern the performance of specific audits. It has evolved into a model that scrutinizes key factors, such as client selection, compensation practices, leverage, and the overall management approach, including a measure of a firm’s tone-at-the-top. The PCAOB uses essentially the same approach irrespective of firm size, though the inspection of larger firms is significantly more involved.

This begins what is referred to as a “supervisory approach.” The PCAOB relies on its inspection teams to identify deficiencies and track remediation efforts. In a way, the Board has rejected a purely regulatory approach (simply checking for compliance with regulations) and avoided adopting an approach that is solely based on enforcement tools.

In contrast, an enforcement-oriented approach would investigate, rather than inspect, a firm – and with a presumption of potential wrong-doing. I would argue that such an approach would be inconsistent with the Act’s requirement for regular inspections of all registered firms. Of course, enforcement does fall squarely within a supervisory approach – and, for the PCAOB, failure to address significant concerns can – and does -- lead to disciplinary action that includes bars or suspensions and fines.

The supervisory model is designed to identify areas for improvement, with a goal of raising the bar of practices in the profession in the interest of enhancing the quality of auditing overall. Because of my bank regulatory background, I am comfortable with the supervisory model and believe that it can be highly effective. Under the PCAOB’s model, firms are expected to initiate and take ownership of efforts to improve audit quality. Moreover, the PCAOB expects firms to maintain strong quality control environments that extend beyond technical compliance. In this way, the PCAOB not only seeks to identify audit deficiencies but also to find “core” problems and emerging risks that may have a more systemic effect on a firm’s performance.

The PCAOB also expects firms to remediate quality control deficiencies that are identified by our inspectors or the firms risk having their quality control criticisms in the nonpublic part of the inspection report made public. Firms should maintain effective quality control processes that are designed to identify and correct all significant audit quality deficiencies, irrespective of whether the deficiencies are first identified internally or by the PCAOB. Firms’ processes and controls should be designed and implemented to identify, evaluate, and respond appropriately to all indications of weaknesses or deficiencies in audit quality and to incorporate lessons learned when the controls fail to identify instances of poor quality on a timely basis.

Firms may accomplish these goals in a number of ways. There are any number of formal and informal quality control processes within the firms and specific processes will vary based on a number of factors, including a firm’s size and organizational structure. However, if sufficient controls do not exist or are not functioning in a manner that can be observed and tested by our inspectors, we will conclude that the quality control systems are defective.

Key to the success of the PCAOB’s supervisory approach is the fact that the PCAOB has the tools, both formal and informal, to undertake inspections, oversee remediation efforts, and take additional action, if necessary. The enforcement tools available to the PCAOB are a critically important element of its supervisory model. While our approach to inspections recognizes the fact that firm management is typically in the best position to design and implement effective controls for its particular organization -- and we expect firms to be committed to maintaining strong quality controls – the PCAOB stands ready to utilize the full complement of enforcement remedies when appropriate.

Report on Large Firm Inspections since 2004

On December 5, the PCAOB issued a report that discusses observations identified in the course of our inspections of the eight firms that we’ve been inspecting every year since the PCAOB’s full inspections program began in 2004.^[1] These eight firms are the largest in the United States – at least in terms of issuer audit clients. I will share with you this morning some observations contained in the report and, as I am only emphasizing a handful of the issues identified in the report, I encourage you to read the full version. Before I begin, I should note that PCAOB inspections are risk-based, and therefore our inspectors seek to review higher risk audits in the course of an inspection. Overall, the inspection results indicate that, while inspectors continue to identify certain fundamental deficiencies, public company auditors are changing – and improving – their programs.

In the December 5 report, the PCAOB communicates some important trends. First, inspectors continue to find deficiencies in important audit areas. Some of these deficiencies relate to areas where accounting and auditing guidance is long-standing, such as certain aspects of revenue recognition and some types of management estimates.

For example, in some cases, firms failed to evaluate specific terms in sales contracts that could have an effect on the timing of revenue recognition, such as customer acceptance provisions or terms specifying when title would pass to the buyer. In other instances, firms did not appropriately test the estimated total costs to complete long-term contracts when they needed to do so in order to audit the revenue earned under the percentage-of-completion method of accounting. Our inspectors also observed deficiencies in planning audits and evaluating audit results, including the failure to accumulate all passed adjustments identified and situations where the firms did not evaluate the effect of known misstatements on prior-period financial statements.

Other deficiencies relate to areas where the accounting guidance is evolving, as is the case with fair value measurements. A number of the deficiencies, both in fundamental areas and emerging ones, occurred in the situations where the issues can be complex and the judgments, difficult.

In some cases, the deficiencies appear to have been caused (at least in part) by the failure to apply the right degree of professional skepticism, which is always critical to the conduct of a quality audit. In fact, some of the deficiencies occurred in some of the larger audits, where one may assume that the depth of experience and expertise of the audit team should not be an issue. You can be assured that PCAOB inspectors will continue to focus on the significant areas where they have encountered deficiencies, as well as new areas that emerge as economic conditions and accounting and auditing guidance continue to evolve.

While it is critical to keep in mind that continued focus on avoiding deficiencies in these important audit areas is called for, we should not ignore the encouraging signs that have appeared. For example, in certain areas, we are seeing fewer deficiencies than we did in the earlier years of our inspection program. This trend is apparent in a few well-established audit areas, such as the confirmation of accounts receivable.

In addition, in certain other audit areas (such as analytical procedures), we are still seeing deficiencies, but the nature of those deficiencies has narrowed during the course of the first four years of full inspections. Lately, the deficiencies are more likely to be focused on just one or only a few aspects of the requirements (such as the requirement that the auditor’s expectation must be sufficiently precise). This suggests that auditors are paying more attention to the specifics of the auditing requirements, although in some cases, continued focus is required.

Additional evidence of progress came from inspection procedures that we employed in recent years. In these procedures, inspectors selected certain audits that they had previously inspected where they had found significant deficiencies, and then reviewed the more recent audits – of the same issuers by the same auditing firms – in order to see whether the auditors continued to commit the same errors. In the majority of these specific audits, PCAOB inspectors observed improvements in the auditing procedures where inspectors had previously identified deficiencies. It is significant to note that this occurred both when the auditing firm had agreed with our prior observations, and when the firm had expressed disagreement with the existence of a deficiency.

Finally, we see firms creating systemic solutions to some of the problems we have noted. Our inspectors have observed numerous changes to various firms’ processes and systems. They have ranged from firm-wide changes, such as modifications to a firm’s structure or organization -- designed to enhance the emphasis or monitoring of audit quality -- to specific changes to audit methodologies or procedures, designed to satisfactorily address specific deficiencies in audit performance or in the quality control systems.

Under the Sarbanes-Oxley Act, descriptions of quality control defects will remain nonpublic if the Board determines that the firm is appropriately addressing the defect. The remediation actions described in the December 5 report successfully addressed applicable quality control defects, as they constituted good faith, reasonable progress toward remediation of that defect. I am sharing this information with you today, not to imply that these are solutions that all firms should adopt, but rather, as communicated in our report, to highlight the breadth and variety of actions that various firms have taken to improve audit performance in response to the contents of PCAOB inspection reports.

I will briefly highlight two of the five remediation areas discussed in the report. First -- partner evaluation and certain other aspects of firm structure, organization, and management. In this area, we have made the following three observations:

• One, firms have taken steps to more closely align audit partner compensation with audit quality, and to place a consistent emphasis on professional excellence.
• Two, firms have also tried to diminish the chances that the economic priorities of the audit business can inappropriately influence decision-making on technical accounting and auditing matters.
• Three, some firms have created national- or regional-level positions and/or committees to promote and monitor audit quality issues such as (a) training, (b) audit tools and techniques, (c) client acceptance and retention, and (d) auditing fair value.

We have also seen significant changes to some firms’ internal inspection programs. These programs are, of course, an important element in the firms’ monitoring systems. Some firms have moved from a part-time reviewer model to one where many of the internal inspectors are assigned to that task on a full-time, year-round basis. Other firms increased the time commitment of their part-time internal inspectors in an effort to drive consistency in their own inspections.

All of these changes are positive, but work remains to be done. The PCAOB will continue to monitor the performance of audits and the adequacy of the quality control systems of registered firms so as to fulfill our mission of protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports. 

III. Current Audit Challenges

This brings us to the current financial crisis. It has been referred to as a once-in-a-century event, and we all hope so. Marked by a high degree of market turbulence, including a startling contraction in credit markets, the impact of the crisis has spread significantly since it began to unfold in subprime markets well over a year ago.

Because the crisis has not run its full course, policy-makers and regulators have not yet had the opportunity to undertake a “post-mortem” and outline the range of lessons learned. It is not too hard to forecast that Congressional hearings will continue and intensify next year.

While we weather the financial turbulence at hand, many of us have begun to contemplate the questions that should be asked in the post-mortem, and the impact of this crisis on the regulatory landscape as we know it. At the foundation of any lessons-learned analysis, undoubtedly, will be a look at off-balance sheet entities, underwriting standards, gaps in regulatory coverage, and flawed risk management -- in part due to what appears on all accounts to have been a fundamental misunderstanding and mispricing of risk by many financial institutions.

The PCAOB, of course, has been closely following market developments and communicating with our fellow regulators and standard-setters, the audit firms that we oversee, public companies, and investors. Because we take a risk-based approach to supervision, the PCAOB has devoted significant resources to gathering information and monitoring developments in the financial crisis in addition to the information gathered through our inspections. The Board will continue to adjust its programs, training, and staffing levels as needed to meet its oversight responsibilities in the current environment.

This is necessary because auditors face a number of exacerbated audit risks in this current environment, and the PCAOB is monitoring these areas closely. In response to concerns, also on December 5, the PCAOB issued an alert that highlights for auditors areas of potential concern in the current audit cycle.^[2]

As is the case in any audit, but even more important in the current environment, adequately assessing and appropriately responding to the risk of misstatement of the financial statements is key. Open communication about these risks among the members of the audit team, and with client management and the company's Audit Committee, will increase the chances that the risks will be appropriately addressed.

I would like to outline a few areas of audit risk this morning. Specifically, I will address three areas of concern that I am hearing a great deal about from auditors and issuers: fair value measurement, other than temporary impairment, and going concern. Tom Ray, the PCAOB Chief Auditor and Director of Professional Standards, will speak about this in detail tomorrow. 

Fair Value

The debate over fair value continues. We have heard a great deal about the challenges surrounding fair value measurements in the current environment, and we also have heard from a number of investors and others of the important benefits of fair value accounting. The PCAOB is not the accounting standard-setter. Instead, through our oversight role, we assess whether auditors apply PCAOB standards appropriately in their auditing of fair value measurements. We have been engaged in a dialogue with auditors throughout the course of last year regarding the audit challenges in this area. Our response, among other things, was to issue an alert last year – as concerns were emerging -- to assist auditors with audit issues in this area.^[3]

Early next year, the Securities and Exchange Commission will release a study that considers the impact fair value accounting standards have on the quality of financial information provided to investors, as well as the Financial Accounting Standards Board's process for developing accounting standards, and whether existing fair value measurement guidance should be modified or replaced with an alternative approach I expect that you have heard, or will hear, about the study from SEC representatives today. The PCAOB will provide input into the SEC study, where appropriate, and looks forward to hearing its conclusions. The application of FAS 157 will be a critical issue for audits of 2008 financial statements, and the PCAOB’s inspections in the coming year will review auditors' compliance with existing audit guidance -- as auditors evaluate their clients' accounting in light of the FASB standard and any applicable guidance. 

Other Than Temporary Impairment

Over the last few months, in discussions with issuers and auditors, several have raised the challenges involved in the evaluation of other than temporary impairment. As accountants are aware, accounting rules require a charge to earnings for impairment that is "other than temporary" in held-to-maturity and available-for-sale securities. There is further guidance from the SEC and FASB providing direction regarding "other than temporary" impairment and when a write-down should be accounted for and a realized loss should be recorded. For auditors, there are a variety of considerations with respect to other than temporary impairments, such as management’s intent and ability to hold a security to recovery, the anticipated recovery period, and the need to quantify an impairment. As a consequence, this is an area likely to continue to require significant attention and audit judgment. 

Going concern

Going concern considerations is another topic of many interesting discussions recently with auditors and issuers. As you know, an auditor must consider whether an issuer’s use of the going concern assumption is appropriate, or whether there is substantial doubt as to an issuer's ability to continue as a going concern that needs to be reflected in the financial statements and in the auditor’s report. Because of the challenges in this area, we will continue to monitor going concern assessments closely.

We know that the year-end audits for 2008 will present these and a number of other audit challenges that I expect will not be limited to the audits of large financial institutions. With the spread of the crisis, auditors need to be alert to risks in other sectors and plan their audits accordingly. The current economic climate will likely require auditors to take a hard look at other areas, such as the collectability of receivables, potential inventory obsolescence, and the impairment of other assets, such as deferred taxes and goodwill. Moreover, as history has shown, fraud risk can also be elevated in times like these, when there may be pressure on earnings. The PCAOB will continue to monitor economic developments closely and engage in discussions with auditors as new issues arise.

IV. Conclusion

Before I conclude, I would like to mention a recent enforcement action taken by the Board. In November, the Board announced settled disciplinary proceedings against an audit partner in a case that should be an important reminder to auditors that they must always act with the due care and professional skepticism required by PCAOB standards -- particularly when faced with a client's interests in avoiding correction of earnings announcements and in meeting filing deadlines. The order was for violations of Board standards in connection with an audit of the finance subsidiary of a Fortune 500 manufacturer. It marked the first time that an individual auditor has been assessed a civil money penalty under the Sarbanes-Oxley Act.

To conclude, as we all work through the current financial crisis, the PCAOB will continue to reevaluate and determine how best to use its tools for overseeing auditors and serving as the audit standard-setter for auditors of public companies. In so doing, the PCAOB will continue to look for ways to improve its own effectiveness in light of the knowledge and insights gained from the current financial crisis. As we do so, we will continue to consult with auditors, fellow regulators, our Standing Advisory Group, investors and other interested parties on the impact of the current financial crisis on auditing.

With all that is going on in the financial arena, I think we can expect that the coming year will be an interesting and challenging one. In addition to seeing what we hope will be the end of the financial crisis, discussing a potential new regulatory landscape, and working closely and collaboratively with the new Administration, the PCAOB will continue to meet its statutory mandate and strategic priorities for our inspections, standard-setting, and enforcement programs. We also will work to anticipate audit risks and respond appropriately.

In addition, we plan to invest time in the coming year exploring a number of the recommendations made by the Department of the Treasury’s Advisory Committee on the Audit Profession. This will include taking a fresh look at the auditor’s report, assessing the nature and structure of a possible national fraud center, considering additional transparency reporting, and evaluating the feasibility of identifying meaningful indicators of audit quality. As we close out a year replete with historic events in our financial markets, we look forward to working to meet the challenges that lie ahead.

Thank you.

Endnotes

^[1]Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections of Domestic Annually Inspected Firms. (See Release 2008-008 .)

^[2]Audit Practice Alert No. 3., Audit Considerations in the Current Economic Environment (December 5, 2008) (See Staff Q & A .)

^[3]Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists (December 10, 2007) (See Staff Q & A. )