Update on PCAOB Developments

Good morning, and welcome to the October, 2010 meeting of the Public Company Accounting Oversight Board's Standing Advisory Group. I want to thank the SAG members and observers for being here today. As always, I appreciate your willingness to devote time to assisting the Board as it grapples with some of the challenging issues that affect our responsibilities in the area of setting auditing standards. I am looking forward to a day and a half of discussion on a number of important topics.

When this group last met in July, the Board had just received the Supreme Court's decision which — in effect — upheld our Constitutionality. Having survived that near-death experience, the PCAOB has been quite active since the July SAG meeting. I thought it would be useful if I took a few minutes to update you on some of the things we have been doing and to respond to any questions you might have about the Board's work.

The activities of the Chief Auditor's office alone could fill up my allotted time. Since July, the Board has adopted eight standards on risk assessment; issued a concept release on failure to supervise and possible supervision standards; and held a roundtable on the proposed new standard on audit committee communications. There has also been considerable activity behind the scenes in the Office of the Chief Auditor that should result in additional proposals before the end of this year or early next year. Most of these items will be covered in detail in Chief Auditor Marty Baumann's comments in just a few minutes — and elsewhere on the agenda during the next two days. Therefore, I am not going to talk further about OCA's work this morning. Instead, I want to briefly discuss some of the other activities and developments that have occurred in the last three months.

I will touch on five areas. I want to note at the outset that I am speaking only for myself today and expressing only my own views on these topics.

Public Enforcement Proceedings

I want to start with our legislative proposal relating to the Enforcement program. In August, the Board asked Congress to amend the Sarbanes-Oxley Act to permit public disciplinary proceedings.

Under the Sarbanes-Oxley Act as it exists today, the Board's enforcement proceedings are nonpublic, unless the Board finds there is good cause for a proceeding to be public and the parties consent to public proceedings. To date, we have never litigated an enforcement case in public. The auditors and audit firms that we charge with violating PCAOB auditing standards, or with other types of violations, have little incentive to consent to opening the case against them to public view. On the contrary, the fact that, absent consent, our enforcement proceedings are required to be secret creates a considerable incentive to litigate, rather than settle. Litigation postpones - often for several years - the day on which the public learns that the Board has charged the auditor or firm and the nature of those charges.

This secrecy, while it may originally have been well-intentioned, has a variety of unfortunate consequences. Interested parties, including investors, audit committees, issuers and other auditors, are kept in the dark about alleged misconduct. Investors are unaware that companies in which they have invested are being audited by accountants who have been charged, even sanctioned, by the Board.

A case that recently became public only after the completion of SEC review of the Board's decision provides a good example. In Gately & Associates, the firm issued 29 additional audit reports on public company financial statements between the commencement of the Board's proceeding and the public disclosure of the Board's charges, which did not occur until the SEC affirmed the Board's decision to expel the Gately firm from public company auditing. That information, had it been available, may or may not have made a difference to client and investor decisions regarding the firm or the companies it audits. But, in my view, the public should have had the opportunity to see the charges and make their own decision.

The nonpublic nature of the proceedings also results in a somewhat distorted public perception of our enforcement program. The public is not aware of the cases that are in litigation. There is no way to get the full picture of what we are doing in order to assess the activity level and effectiveness of our enforcement efforts.

I have sent letters to the leadership of both the House and Senate committees that have jurisdiction over Sarbanes-Oxley amendments, and the Board's staff has briefed the relevant Congressional staff members on the issue. I am hopeful that an appropriate legislative vehicle will allow this issue to move forward, although I have no basis for a prediction on when or, even if, that will happen.

I want to end this topic by just noting that the Enforcement staff is quite busy. The Division of Enforcement's current work, both in terms of investigations (which are nonpublic and would remain so under our proposal) and in terms of ongoing litigation, includes a mix of small and large firm matters. Many of these matters, especially those involving large firms and companies, are complex and labor intensive. I hope that a more complete picture of that work will eventually be available to the public.

Foreign Inspections

Second, I want to provide an update on the issue that I regard as the greatest impediment to fulfilling our statutory mission - the obstacles to conducting inspections of the auditors of U.S. public companies in certain foreign jurisdictions. There have been several important developments since the SAG last met.

For one thing, the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted. Dodd-Frank provided authority for the Board to share confidential inspection information with foreign auditor oversight authorities. The original Sarbanes-Oxley Act did not permit us to provide such information to non-U.S. regulators. Our inability to share information was one of the things that our foreign colleagues, particularly in the EU, cited as an obstacle to allowing us to conduct inspections in their territory.

After enactment of the Dodd-Frank Act, the European Commission, and later the European Parliament, approved a three-year adequacy determination as to the PCAOB. That determination permits individual member states to enter into bilateral inspections arrangements with the Board, subject to certain conditions. We are in various stages of negotiations with several EU audit regulators, but no agreements have yet been reached. In a sense, it appears that the adequacy determination was more the end of the beginning, rather than the beginning of the end, in terms of re-opening the door to European inspections. We are still working through some tough issues on such matters as joint inspection procedures and data protection. I don't think it is a secret, though, that some of our EU counter-parts would prefer that we rely on their inspections and not conduct our own, joint or otherwise, of firms that operate in their country, notwithstanding that those firms have active U.S. SEC practices.

We are also in active discussions with the Swiss authorities. We have exchanged documents with the Chinese audit oversight body, although I see less progress on that front.

Because of the substantial uncertainty as to when and whether we will be conducting inspections in a number of foreign jurisdictions, the Board has become concerned about the implications of continuing to register additional audit firms in places where we are unable to inspect the auditors that sign opinions that are filed with the SEC. Additional registrations expand the pool of firms that we should inspect, but cannot.

As a result of this concern, the Board has re-evaluated its approach to new registration applications from firms in jurisdictions where we are barred from inspecting. Last week, the Board issued a release announcing its new approach. As explained in the release, the Board will no longer routinely approve registration applications from firms in the countries (which are listed on our website) where the Board is currently unable to conduct inspections. If the firm is unable to represent that we will be able to inspect it, and to provide written confirmation from its regulator, the Board will issue a notice proposing to disapprove the registration application. If the firm chooses to do so, it may have a hearing on the disapproval. At such a hearing, the issue would be whether, in light of the obstacles to inspection, approval of the application would be consistent with the Board's responsibilities under the Sarbanes-Oxley Act. Under the Board's rules, firms that decline to request a hearing will have their applications disapproved.

For my part, I would say that I took this step with some reluctance. I would generally prefer to have an open registration process that permits any firm to participate in U.S. public company auditing, but we had simply come to a point where it was impossible to keep registering firms, knowing that we would be unable to inspect their SEC work. We are required to inspect registered firms that audit SEC issuers, and, in my view, we had little choice but to show that the Board was serious about fulfilling that obligation.

The new policy affects only firms that are seeking to register, not those that are already registered. We are going to consider what other steps should be taken to address those firms, including such things as disclosure in audit opinions and requirements that affiliated firms in the U.S. maintain work papers here relating to the SEC work performed by non-U.S. firms that we cannot inspect. We also have the power to bring enforcement proceedings against registered firms that refuse — or are unable — to cooperate in inspections.

4010 Report on Economic Crisis

The third development I want to mention is the Board's report summarizing inspection observations in audits of financial institutions and other issuers during the economic crisis. This report — released two weeks ago — provides illustrative examples of the kinds of audit deficiencies our inspection program has uncovered during the past three years as a result of the impact of the economic crisis on the work of auditors.

As the report explains, PCAOB inspectors identified instances where auditors appeared not to have complied with PCAOB auditing standards in connection with audit areas that were significantly affected by the economic crisis. Some of the audit areas addressed are fair value measurements; impairment of goodwill, indefinite-lived intangible assets, and other long-lived assets; allowance for loan losses; off-balance-sheet structures; revenue recognition; valuation inventory; and income taxes.

The report and its implications are on the agenda for discussion later today. In my view, the report neither shows that audit failures caused the financial crisis nor that better auditing could have prevented it. What it does show is that the major firms could and must do a better job in adjusting their procedures to address emerging audit risks as economic conditions change. I think the report also illustrates some of the very difficult challenges that changes in the accounting principles, such as those related to fair value, have posed for auditors.

I hope that we can issue more reports like this one. These reports, which are based on Board Rule 4010, give us the opportunity to let the public know what we are finding in our inspections without violating the confidentiality restrictions in Sarbanes-Oxley that prevent us from disclosing the names of specific firms and company engagements that we have inspected. We gather a lot of information about audit practices in our inspections and sharing this information helps the public to better understand our work.

Oversight of Broker-Dealer Auditors

Fourth, I would like to give you a brief update — a preview, really — of a topic touched on at the July SAG meeting — the Board's expanded responsibilities for the audits of SEC-registered securities broker-dealers.

As you know, Dodd-Frank expands the PCAOB's inspections, enforcement, and standard-setting authority to include auditors of brokers-dealers. Those auditors had previously been required to register with the Board, but, until now, had not been subject to any other Board authority. This legislation will have a significant effect on our work. There are currently about 5,500 SEC-registered broker-dealers. In the past two years, over 500 additional audit firms registered with the Board because they conduct audits of broker-dealers, and of course many previously-registered firms are also involved in that work.

We are currently developing an implementation plan for the Board's new responsibilities. Rule-making and standard-setting in the coming months will address three issues —

  • Funding – The new law requires that we allocate our operating expenses between issuer auditor oversight and broker-dealer auditor oversight and create a mechanism for broker-dealers to pay the cost of the oversight of their auditors. Broker-dealers will be assessed an accounting support fee in proportion to their net capital. The Board will need to determine a cost allocation methodology and propose rules to create a broker-dealer funding system in the next few months.
  • Inspections – Rules must also be developed for broker-dealer inspections. The Board will need to address such matters as frequency of inspection and the types of broker-dealers whose auditors are subject to inspection. The Board will likely approach these issues by implementing temporary inspection rules for 2011 and using its inspection authority to gather data and information about audit practices in this area. We can then use that information to develop a permanent inspection regime.

    Many of the 5,500 broker-dealers are very small, and questions have arisen about whether we should devote resources to inspecting their audits. I anticipate that the 2011 "information gathering" inspections will give the Board an informed basis to decide whether there are categories of broker-dealer auditors that can be excluded from Board oversight.
  • Broker-Dealer Audit and Attest Standards – We will also be developing auditing and attest standards applicable to broker-dealer financial statement audits and to the auditor attestation that broker-dealers are required to file as to certain compliance reports. The SEC recently issued an interpretive release advising the profession to continue to apply AICPA standards until the Board's standards are in place. I envision that our standards in this area will be finalized late next year.

ACAP Recommendations

Finally, this group has expressed interest in the Board's progress in implementing the recommendations of the Treasury Department's Advisory Committee on the Auditing Profession — ACAP. We have prepared an update to the status report we distributed at the April SAG meeting on the 13 PCAOB-related ACAP recommendations, and the summary is available both at the registration desk and on our Web site. I want to highlight recent developments in four areas.

A. Academic Fellow

The ACAP recommended that the Board create an Academic Fellow Program. That program is now up and running. Professor Michael Stein, a Professor of Accounting at Old DominionUniversity in Norfolk, Virginia, joined the PCAOB this summer as its inaugural fellow. He is assigned to the Board's Office of Research and Analysis for the academic year 2010-2011. Professor Stein is hard at work helping ORA refine some of the risk models used to aid in selecting engagements for inspection.

B. Fraud Center

The ACAP recommended that the Board establish a center on financial reporting fraud. As I conceive it, the center would study the causes of financial reporting fraud, perhaps including forensic analysis of specific cases; develop techniques and best practices for the prevention and detection of financial reporting fraud; commission research; conduct educational activities; and engage in other work aimed to reducing the incidence of fraud. After considering various alternatives structures for the center, the Board began recruiting for a director last spring. We received a gratifyingly large number of resumes in response to our job posting. The Board is now interviewing finalist candidates for the director of the center. Once selected, the director, in consultation with the Board, PCAOB senior staff, and the SEC, will prepare an organizational plan and initial budget for the center.

C. Engagement Partner Signature

The ACAP recommended that the Board require engagement partners to sign audit reports in their own name, in addition to the name of the firm. The Board issued a concept release on that possibility last year. We have discussed this topic with the SAG and, in May, with the Board's new Investor Advisory Group. The Board's consideration of next steps is still pending. I am very mindful of the importance of this recommendation to many investors, and it remains an active topic on our agenda.

We have of course also discussed this issue with our colleagues at the SEC. I understand that the SEC staff is simultaneously considering a broader project that would explore the possibility of additional disclosure about the auditor and his or her work, including the identity of the engagement partner, and perhaps other audit team members. I want to ask Brian Croteau, from the Commission's Office of the Chief Accountant, to say a few words about the SEC staff's thinking on that initiative.

D. Auditor's Reporting Model

Finally, the ACAP recommended that we rethink the basic auditor's reporting model, including the pass/fail opinion and whether and in what form the auditor should communicate to shareholders additional information about the audit and the auditor's views on the financial statements. The Board has also discussed this recommendation with both the SAG and its Investor Advisory Group. It is clear that there is considerable investor hunger for more insight into the audit and for more insight from the auditor into the company's financial reporting.

Based on these discussions, the PCAOB has added a major new initiative on the auditor's reporting model to its standard-setting agenda. I would anticipate that this will be one of our most important projects in 2011. Here are the first three milestones that are currently envisioned —

  • The Office of Chief Auditor is conducting research on possible changes to the reporting model and to ascertain and identify additional investor and user needs. The staff anticipates that it will present its findings and recommendations to the Board at, what I hope will be, a public meeting in the first quarter of 2011.
  • The standard-setting agenda then contemplates that the Board will issue a concept release on possible changes to the model in the second quarter of 2011.
  • Next, we plan to hold a roundtable on the topic in the third quarter of 2011. Like the recent roundtable on auditor-audit committee communications, I would foresee that the roundtable will afford an opportunity for discussion and debate based on the types of issues that emerge from the comments on the concept release.


That completes my overview of PCAOB activities over the last three months. Obviously, it has been a busy time at the Board. I would be happy to answer any questions SAG members may have. After that, I will turn the floor over to Marty for his discussion of our standard-setting agenda and activities.

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