The Role of the Audit in Capital Formation

Thank you for inviting me to this conference. It's a privilege to speak to and with some of the most experienced and progressive thinkers about the audit's role in our capital markets today. It is also a sincere pleasure to again see so many of our colleagues at this conference.

The PCAOB's work increasingly involves coordination with our counterparts in other jurisdictions, many of whom have representatives here today, and that coordination runs deep. Together, we have begun, and are making stronger still, a foundation upon which our nations can build vibrant programs for capital formation and investment, and economic growth.

Our work is in the trenches, together and literally around the same table as an exam team reviewing audit records and engaging with audit personnel. Our joint inspection teams act as vocal and present representatives for the dispersed masses of savers who comprise the investing public.

We also work together on policy. It has been useful for U.S. policy makers to monitor and learn from the economic effects of experimentation here in Europe and elsewhere.

Both our joint inspections and this policy work support a vibrant profession that can continue to meet society's expanding needs for assurance services. As you demonstrate here in Europe, the profession must innovate to continue to meet the needs of the public.

The FEE has been a leader in bringing the audit profession into the dialogue with policy makers. I want to thank Olivier and Hilde and the staff of FEE for this opportunity. And what a year it is for the FEE to convene us here in Brussels to take stock of where we are!

We come together as a financial summit begins, one which could have an important bearing on the future direction of the Eurozone, with implications for all our economies.

To scan the topics for the conference imparts your focus on change, in some cases potentially transforming change. In such times, we look for reference points that enable us to chart the right course. Does the audit remain critical to robust capital formation and economic growth? What can audit regulators do about that, and what are we at the PCAOB doing?

These are the questions I want to discuss with you, and in so doing I will offer three propositions.

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. Public Trust in the Audit is Critical to Vibrant Capital Markets.

Investor confidence in the auditing of public financial reporting is critical to expand our capital markets. That is my first proposition.

Whether the audit is compulsory or not, the companies seeking capital pay for audits to receive a benefit. That benefit is in the form of a lower cost of capital than capital-market participants would otherwise require, access to more capital markets, and greater investor demand for their securities.

Although it is companies that receive the benefit of the audit, governments, by requiring the audit to enter their capital markets, also invest in audit quality. States do this as a service to the public.

The audit is a critical contributor to economic growth, without which there is jeopardy, we've seen, to social peace and preservation of our democratic institutions.

But the assertions of a broad, public benefit implicit in my first proposition would not now go unchallenged. I think a lot of people today would question this statement as counter-intuitive, even completely wrong. They see the audit as a regulatory cost — a required cost of doing business, best kept as low as possible to meet the compliance objective.

They would point to the fact that the public rarely shows interest in the audit. They do not feel the pull of public demand.

For its part, the public takes the audit for granted and demonstrates little interest in it, except in the breach. Breaches attract acute public interest. But if the breaches are rare, some might yet think that the breaches are a bearable cost of a protection system that is not unbearably costly the rest of the time.

Critics of audit cost ask: why can't we rely on market demand (or lack thereof) to resolve the trade-offs between the benefit of the audit and its cost? Why not let consumers decide what is audited, what is not, and how?

There are indeed circumstances where markets do efficiently, fairly, and without regulatory intervention resolve the benefit of the audit relative to cost. Those circumstances, however, may not hold in broader, public markets.

Take the example of capital markets established by venture capitalists and entrepreneurs. VC investors and entrepreneurs work out in real-time and directly how the VC investors will monitor the entrepreneur's use of the VCs' investment.

With technological advances VC monitoring and entrepreneur reporting has become more efficient and expanded, to suit the information needs of VC investors. VCs and entrepreneurs work out, through direct negotiation, elimination of reporting that is no longer useful.

The investors' monitoring in venture capital markets is as efficient as technology and the imagination of the VCs and entrepreneurs permit. But venture capital is overall a small segment of our capital markets.

That brings us to the public markets as, ultimately, the broadest and longest-term source of funding for business and economic growth, not to mention an important outlet for early stage investors.

Public markets can also offer business a lower cost of capital than systems that rely on bespoke monitoring. But in both kinds of markets, the point of monitoring is trust.

In a public market, the providers of capital need to be able to trust the users of capital, which requires confidence in the monitoring of the users in their application of capital.

If the market can trust the company, the cost of capital can be reduced to the measure of the premium for business risk — that is, the risk that the business will fail for operational or competitive reasons, not fraud on the investor — plus the cost of monitoring to establish trust.

The challenge that public markets face is that the direct link between the providers and users of capital to conduct monitoring and establish trust — present in private equity — is not available to specify the nature and form of information provided. Auditing is the critical proxy for that missing link. That's why auditing is critical to expanding our public markets.

And this leads to my second proposition: Intervention to regulate the audit is justified when that will encourage the public to provide capital to business.

That intervention starts with mandating the audit, but for it to be worthwhile we must make sure that it can be effective in serving this purpose and that we mitigate the undesired consequences of intervening.

Critics have observed that, since the audit is required by law, that which might be auditors' natural competitive instinct to meet and grow public demand for their services may be dulled. Moreover, there is counter-pressure from the companies themselves to keep the costs of monitoring low and the scope narrow.

All the public markets know about the audit is that an auditor conducted an examination of the financial statements according to specified minimum standards. The only reputation the market knows is that of the firm.

Without real data on the audit, the market is left to rough estimations of reliability. The handful of great firms are deemed to be more reliable than the rest. And since quality varies inside each of the great firms, as in all other large-scale human enterprises, investors apply the law of averages and assume the firms are on average equally reliable until a problem is revealed.

These imperfections lead some to ask whether we could construct a better world if we left the audit to choice. Would removing the franchise liven the auditor's instinct to strive for public demand?

The franchise does distort the market for audit services. But I think the root issue lies elsewhere. Just as dispersed public investors lack privity with the corporate users of public capital, they also lack privity with the auditors charged with protecting them. That is, the audit is an imperfect substitute for real privity.

For the audit to achieve its intended purpose — to provide the investing public with the kind of monitoring that will adequately fill the void of privity between the providers and users of capital — we must knit tighter the relationship between auditors and the investing public.

It's not practical to fill the void left by the absence of privity with a contract, given the dispersion of investors. We must do it with mechanisms — some of these regulatory — to influence culture, such as by encouraging auditors to compete for investor confidence just as they would for client satisfaction.

Choosing the levers that will positively affect culture requires care. But as Adam Smith said in the Wealth of Nations, "In general, if any branch of trade, or any division of labour, be advantageous to the public, the freer and more general the competition, it will always be the more so."

Evaluating our laws and regulations with this advice in mind is good for investors, users of capital, and auditors alike.

Hence my third proposition: Adopting policies that encourage auditors to compete for investor trust and confidence offers one of the biggest opportunities for global growth we can imagine.

If law and regulation can give the public a stronger basis to trust the audit as a market mechanism for monitoring, despite public investors' dispersion, we have the potential to unlock more capital to fund more entrepreneurs and more jobs. But we must give auditors incentives to meet the investing public's needs to be able to trust that mechanism.

In the remainder of my talk, I'd like to explore how our policy initiatives can draw us closer to this goal. First, I think our audit inspection regimes are motivating enormous strides in quality, but we have more work to do, together, on maintaining high quality in the audits that investors in multiple markets rely on. And second, I'll comment on certain policy initiatives that European regulators and the PCAOB are pursuing to align auditors to investor needs.

II. Audit Regulators Have an Opportunity to Deepen Their Monitoring Work Together.

In 2014, the PCAOB conducted more than 200 inspections of firms that audit or play a substantial role in an audit of an issuer, including examinations of portions of more than 200 engagements across the largest four U.S. firms, including engagements of some of the largest companies in the world.

We also examined portions of 570 engagements by 158 other U.S. registered public accounting firms and 57 non-U.S. registered firms.

We will conduct a commensurate number of inspections in 2015, requiring inspectors to travel this year to more than 25 different countries.

Many of these inspections will be conducted jointly with local regulators. We now have bilateral cooperation agreements with 19 foreign audit regulators, 11 of whom are in Europe.

We are able to jointly inspect with regulators in Australia, Canada, Denmark, Finland, France, Germany, Hungary, the Republic of Korea, the Netherlands, Norway, Singapore, South Africa, Spain, Sweden, Switzerland, Chinese Taipei and the United Kingdom.

I am grateful for the support of the European Commission to continue our inspection work in and with European Union member states, although this will require another renewal of the EC's Adequacy Decision in 2016.

To make our joint work as effective as possible, we have dedicated significant resources, including specialists in information technology as well as coordination on risk analysis in aid of inspection selections. In addition, as our relationships deepen, we naturally but quite deliberately learn ways to work more efficiently together, such that we reduce duplication of work.

The aim is to work seamlessly together to meet our respective inspection mandates, and we are very much on a path to doing so. Together with our counterparts around the world, we are creating a network of regulators to match the networks of firms.

There was a time when national regulators merely aspired to have relationships with other national regulators, to call on in a breach. Cooperation meant keeping each other informed, albeit working separately on separate mandates, with each regulator limiting its own work to its own borders.

But global audit firms don't stop at the border and, as audit regulators have learned from experience, neither can we. Globally active firms affect each of our jurisdictions, sometimes in different ways.

More than a decade ago, we recognized that we have a shared interest in making our network of regulators as strong as possible, and it required a new paradigm.

The commitment of the European Commission and the individual member state authorities with whom we enjoy a great friendship has been critical to designing this new form of partnership, through joint oversight that make us all stronger, more efficient, and more effective.

Investors in our capital markets need to know that we are delivering on that shared interest, by making sure that any auditor that enjoys the privilege of operating in a market will comply with the market's stated standards.

I look forward to working with the EU Commissioner, Lord Jonathan Hill, Director Ugo Bassi, and the Head of Unit for Audit and Credit Rating Agencies, Alain Deckers, on continuing and deepening the cooperative inspection and other oversight arrangements we have built. We can help each other do that.

III. The PCAOB's Initiatives to Enhance the Relevance and Reliability of the Audit

Now let me turn to new policy initiatives. Throughout this two-day conference, there will be much discussion about the reforms of the European Commission and member state authorities. The PCAOB has been attentively watching these developments and considering our own versions.

Our goal is to enhance the relevance and reliability of the audit, and that takes policies and standards that motivate auditors to be fiercely committed to investor protection.

A. Audit Transparency and Audit Quality Indicators

We continue to explore ways to provide investors more information about the audit and the auditors who conduct them.

A cornerstone of this effort is our consideration of disclosure to investors of the identity of the engagement partner and other firms that conduct an audit.

It is the custom in many jurisdictions, including here in Europe, for engagement partners to sign audit reports in their own name in addition to the name of their firms. This has, I believe, significant cultural implications. The identity of the engagement partner plays a key role in investor confidence and capital formation in those jurisdictions where it is provided to investors.

Recent studies in Sweden, the U.K. and Chinese Taipei, where partners routinely sign their firms' audit reports, show that disclosure of the engagement partner's name makes a difference to the investing public and the markets.^[1]

The PCAOB issued a concept release to consider engagement partner signature in 2009, which predated my tenure. It was based on the recommendation of an expert panel convened by the U.S. Treasury Department to examine the sustainability of a strong and vibrant auditing profession.

Since that has not been the custom in the U.S., some commenters on our concept release expressed fears about unintended consequences attending personal signature, including liability risks. These comments helped us develop alternatives, for example whether simple disclosure — without signing — could give the market valuable information without increasing litigation risk.

So I asked the staff to develop a proposal on mere disclosure, as a compromise, first in 2011 and then again, to seek more comment on costs, in 2013. Based on investor calls, we also proposed disclosure of the names of other firms that substantially contributed to the audit.

Auditors ought to be fighting for the attention of investors, clamoring to meet investor demand better than the next firm, with star auditors known for their integrity, as other professions do. But many still express concerns about risk.

I believe there is a middle ground that will provide investors this disclosure in a form that reduces auditors' perception of litigation risk. We have developed such a form, which auditors could file with the PCAOB. At the end of this month I expect to seek comment on such a form and, I hope, bring the U.S. into line with international standards soon.

At the same time, we plan to open a new public dialogue on other potential indicators of audit quality. We have already had several discussions about such measures with our Standing Advisory Group on standard-setting. The Board is now near ready to consider issuing a concept release on a set of measures that could be tracked by firms, audit committees or markets.

B. The Auditor's Reporting Model

The PCAOB also continues to explore opportunities to enhance the form and content of the audit report, to provide the market with value for the investment in the audit.

In response to calls from major institutional investors and others to make the auditor's report more informative, we have conducted extensive outreach with investors, auditors, financial statement preparers, and others.

To obtain broader public views, we issued a concept release and subsequently a proposal. And we have held two public hearings. Governments around the world have heard the same call and are developing parallel reforms. We spend a lot of time monitoring those developments and analyzing the relative costs and benefits and other economic considerations of various approaches.

1. U.K. Developments

The United Kingdom was an early mover on the reporting model. We now benefit from a growing body of evidence and experience. There, the Financial Reporting Council has required what they call extended audit reports for financial statements for periods that began on or after October 1, 2012. I understand there are approximately 900 UK-reporting companies subject to the requirement.

I am encouraged by the FRC's March 2015 report on compliance and user benefits in the first year of extended auditor's reports. Auditors appear not only to have met the new requirements but in many cases have voluntarily made further changes to enhance the informativeness of their reports.

The new requirement thus spurred innovation and competition on the basis of the quality and usefulness of the report. The FRC noted exceptional reporting on detailed audit findings in relation to identified risks, informative use of explanatory diagrams and graphs, and well-organized presentations that located the opinion at the beginning of the report instead of the end.^[2]

The FRC experience is useful for the PCAOB's consideration and analysis. But the real test is whether the new reports affect demand, and in that respect investor reaction is even more illuminating, and encouraging.

I refer, of course, to the Investment Association's inaugural awards to recognize outstandingly useful audit reports. This is the kind of investor interest that had been lacking. This is the kind of intervention that frees markets to motivate auditors toward service that will regain and build investor confidence.

2. Profession-based Developments

I'm also eager to see how implementation of the EU's April 2014 law expanding auditor reporting will play out, through presumably some level of experimentation as member states implement the law in various initiatives to improve the informativeness of audit reports.

There is also the IAASB's new reporting standard to disclose key audit matters, which is effective for audits of financial statements for periods ending on or after December 15, 2016. This means that more than 100 markets across the globe will soon have expanded audit reports. At least one market — the Netherlands — has early adopted.

We are closely following these developments as we advance our own initiative, in order to evaluate results and learn the lessons of experience.

C. Facilitating the Work of Audit Committees

The last initiative I would like to highlight is our work to raise awareness among audit committees of audit risks and challenges. Audit committees play an important role in protecting investors' interest in accurate financial reports and reliable audits.

The Sarbanes-Oxley Act provided audit committees of U.S. companies enhanced authority to play a critical role in hiring, firing, compensating and championing the auditor. Next to establishing the PCAOB, this express authority may be the most significant of the Sarbanes-Oxley reforms.

To help audit committees champion the audit, the PCAOB aims to better equip them with information about the audit, our inspection reports, and the auditor's strengths and weaknesses.

We have been meeting with audit committee members for a few years now. Those meetings have given us the background to broaden our outreach, and take it to a new level. To that end, we have developed a communication tool to provide audit committees insights from our work.

We call this initiative our Audit Committee Dialogue.

This is an interactive, digital publication with charts, data and tips for audit committees based on insights we have gleaned from our inspections. In designing it, we consulted with several audit committee members to get the benefit of their direct input on the kind of information that would be most useful, and actionable, for audit committees.

The Dialogue highlighted key areas of recurring concern in PCAOB inspections of large audit firms as well as certain emerging risks to the audit. The Dialogue also provided targeted questions that committee members may ask their auditors on each topic.

We hope these insights may be useful to audit committees in their 2015 oversight activities and we look forward to continuing the engagement with additional Dialogues at least twice a year.

* * *

The PCAOB initiatives I've described are intended to help align auditors with investor needs. But I believe they also help the profession maintain its vibrancy in the 21^st century.

There well could have been new demand for audit services in the last several years, had public confidence in audits been greater. But for nearly a generation of professionals coming of age since Enron, it has not materialized.

Why is there not greater demand for auditor assurance on XBRL data? Why hasn't the public turned to the audit profession for auditor assurance on environmental reporting, or cyber-security?

The public wants assurance that environmental, safety, social and consumer standards are adhered to, and that our companies and institutions are free of corruption. But capturing that demand requires attending to the public's desire for confidence that the audit is the watchdog the public expects it to be.

The public needs to hear auditors bark when there's a problem. There are numerous reasons why that hasn't consistently happened.

In the last several decades as many countries have expanded their investment in public capital markets, we have learned a lot about the risks and weaknesses in our model. And we've instituted important reforms to address them, including standards, robust inspections, and disciplinary programs.

But it is time again for leadership in meeting the demand of today's markets and investors. I applaud the efforts of both audit regulators here convened and the professional associations in Europe in taking on these structural issues. I look forward to continuing partnership in advancing this important work.

^[1] See W. Robert Knechel, et al., Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions, Contemp. Acct. Res. (forthcoming 2015); Daniel Aobdia, et al., Capital Market Consequences of Audit Partner Quality, The Acct. Rev. (forthcoming 2015); Joseph V. Carcello & Chan Li, Costs and Benefits of Requiring an Engagement Partner Signature: Recent Experience in the United Kingdom, 88 (5) The Acct. Rev. 1511 (2013).

Knechel et al. found "considerable evidence that aggressive and conservative audit reporting persists for individual partners over time" and that in Sweden, where engagement partner's names are disclosed, "the market recognizes and prices differences in audit reporting style when engagement partners have a history of aggressive reporting." Knechel, et al., supra, at 5, 23. Although much of this analysis was conducted using data on private companies, many of the results continued to hold when the authors separately analyze public companies.

Aobdia et al. used data from Taiwan and also found that both debt and equity markets react to the performance characteristics of engagement partners. Aobdia et al. acknowledge that their use of estimates of abnormal accruals as a proxy for engagement partner performance is subject to measurement error. They continue to find evidence that engagement partner histories matter to capital markets when they use regulatory sanctions history as an alternative measure of audit quality. Aobdia, et al., supra, at 5, 29-30.

Carcello and Li examined the impact of the E.U.'s audit engagement partner signature requirement on audits in the U.K., and found improvements in several financial indicators of audit quality, as well as an increase in audit fees. It is worth highlighting that this study evaluated a policy alternative (signature requirement) that may have a more pronounced effect on accountability than the disclosure requirement being reproposed since the engagement partner's signature goes one step beyond just disclosing the partner's name. Carcello and Li, supra, at 1542-43.

The PCAOB's release accompanying the reproposal includes a detailed discussion of the existing research. It is available at http://pcaobus.org/Rules/Rulemaking/Pages/Docket029.aspx.

^[2] See FRC, Extended Auditor's Reports — A Review of Experience in the First Year (March 2015). The survey did, however, reveal areas where further improvements might be made. For example, the FRC suggested that auditors could improve risk reporting by being as entity-specific as possible. The FRC also encouraged auditors make sure the description of work performed in the auditor's report is consistent with the actual work performed, in light of inaccuracies in the descriptions in a few of the auditor's reports examined. In addition, although the overall message from the review was positive, the FRC pointed to emerging from the work of the FRC's Audit Quality Review Team:

During the FRC's Audit Quality Reviews, the FRC assesses whether the descriptions of work undertaken by auditors in extended auditor's reports are consistent with the evidence of the work actually performed. In some instances the FRC has identified inaccuracies in the auditor's descriptions of the nature or extent of the audit procedures performed. The FRC has brought these matters to the attention of the relevant audit firms and reminded all the major firms of the importance of ensuring that their auditor's reports accurately reflect the work performed.

Id. at 56.