Update on PCAOB Developments

Good morning, and welcome to the March, 2011, 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. I appreciate your willingness to devote time to assisting the Board as it considers some of the challenging issues that affect our responsibilities in the area of setting auditing standards. I am looking forward to today's discussions on a number of important topics.

Since this group last met in October 2010, three new Board members have joined the Board and two of the founding Board members completed their terms. Jay Hanson, Lew Ferguson and I joined together on February 1 of this year. 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.

I will touch on six 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.


Most recently, earlier this week the Board held an open meeting to hear from the Office of the Chief Auditor on the results of the staff's outreach on our project to take a fresh look at the auditor's reporting model. The staff presented views and advice they received over several months from numerous in-depth meetings with dozens of people experienced in using or preparing audit reports, including investors, auditors, preparers, audit committee members, researchers, and others.

The Board's outreach effort, especially at such an early stage in the project, was unprecedented. In addition, the PCAOB's open meeting to discuss the input received was the first of its kind. It reflects the Board's renewed commitment to transparency. There was no concrete proposal before the Board. Rather, the meeting provided the Board an opportunity to hear from the staff, ask questions and share views, in a forum that afforded the public insight into the early thinking and direction on this project.

I understand some of our Standing Advisory Group members attended or tuned into the Web cast of that meeting. I look forward to getting feedback from members on both the usefulness of the format of the meeting as well as the subject matter itself.

Also, last week the PCAOB's Investor Advisory Group held its second meeting. The group's first meeting was in May 2010. Board Member Steve Harris chairs that advisory group. Last fall, he asked the group to convene working groups to focus on specific topics of interest to the group. The working group presented those topics at last week's public meeting. The topics were Lessons Learned from the Financial Crisis; Global Networks and Audit Firm Governance; and the Auditor's Report and the Role of the Auditor.

The IAG meeting was public and an archived Webcast is available on the PCAOB's Web site. The presenters' slides and other materials are also available on the Web page devoted to the group.

The IAG discussed important issues. I want to recognize Steve Harris's leadership in establishing and managing the group. As demonstrated in the Board's open meeting on one of those issues — the auditor's reporting model — we seek input from other sources as well. We will continue to do so. We will cast a wide net to seek input from various interested people and groups on the challenges we need to focus on.

There has also been considerable activity behind the scenes, some of which will result in standards or other rule proposals. 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.


Let me start with Inspections. As you may know, earlier this month Helen Munter became the PCAOB's Director of Registration and Inspections. Helen joined the PCAOB in 2004 as head of our San Mateo office. She also led one of our large firm inspections for several years. She has a proven track record at the PCAOB, having identified and addressed highly complex and stubborn accounting and auditing issues.

This is a critical time for PCAOB inspections. We have been identifying significant issues relating to the financial crisis, valuation of complex financial instruments, inappropriate use of substantive analytics, reliance on business processes entity level controls without adequate evaluation of whether those processes actually function as adequate controls, and other issues. We are also finding more issues. This increase could, in part, be a sign that our own risk assessment is getting better. We're hitting more targets. It's great to be better at finding targets. The challenge is we need to reduce the number of targets.

Some might ask whether the reason we have more findings today is that we have changed our criteria for what we consider to be a deficiency. The answer is no. From inception, PCAOB inspection reports have identified in Part 1 those deficiencies that our inspectors consider to be of such significance that the firm failed to obtain sufficient competent evidence to support its opinion. Moreover, close attention is paid to achieving consistency across the field of inspected firms in the way deficiencies are identified and cited.

The increase in identified deficiencies concerns me. It concerns everyone at the PCAOB, and I believe — and I hope — it concerns the firms as well. We are working on several initiatives to go deeper in our own analysis of the root causes of audit deficiencies we find. We are also encouraging firms to identify root causes and address them.

When we look for root causes, we're essentially talking about finding ways to improve audits going forward. I am also concerned about what firms do to correct the deficiencies we find. Our inspectors will look closely at corrective actions, which in most cases should be more than simply dropping the PCAOB comment form into the audit file.


Let me turn to international matters and our efforts to gain access to firms that have registered with us but are located outside the U.S. Approximately 900 non-U.S. firms have registered with the PCAOB, hailing from 84 jurisdictions. More than 250 of those firms (from 53 jurisdictions) must be inspected at least every three years because they audit a company whose securities are publicly traded in the United States. Many of these firms are extremely large, with thousands of professionals and enormous multi-nationals on their rosters of audit clients.

To date, the PCAOB has conducted inspections in 35 foreign jurisdictions. We are now routinely issuing inspection reports and, when necessary, engaged in ongoing discussions with firms to remediate quality control concerns. Many of the firms we inspect are members of one of the large global networks of firms. Our inspections of members are facilitated by our knowledge of strengths and weaknesses of other member firms. For example, if we know there's a problem in a particular quality area at one firm — say, internal inspections, or the consultation process — we factor that into our risk assessment about what to look for at other member firms.

It is no secret that we have not been able to inspect all of the non-U.S. firms we are required to. Seventy firms in 24 jurisdictions — including in the EU, Switzerland and China — had inspection deadlines in 2010 or earlier that have not been met.

We are working hard to reach accords that will allow our inspectors into those jurisdictions — it is one of our highest priorities. In January, the PCAOB concluded an agreement with U.K. authorities. The U.K. agreement is good deal for U.S. investors. It's not a mutual recognition arrangement, but an arrangement for joint inspections that result in PCAOB inspection reports based on PCAOB inspector findings. Based on this agreement, the PCAOB is planning inspections of two large U.K. firms and several smaller firms this spring.

I hope the U.K. agreement will pave the way for more agreements in the European Union and Switzerland. I also hope to make progress on a joint inspection arrangement with Chinese authorities, but there the progress is slower. Unfortunately, the risks to investors are every bit as great.

In this regard, last week the PCAOB issued a Research Note on Chinese reverse mergers. The Note was prepared by the PCAOB's Office of Research and Analysis to provide further context to the issues discussed in Staff Audit Practice Alert No. 6 issued on July 12, 2010. It identifies a trend that small Chinese companies are increasingly seeking access to capital and trading in U.S. securities markets. The number of reverse merger transactions involving companies from the China region was almost triple the number of initial public offerings conducted in the U.S. by companies from China during that time.

PCAOB-registered accounting firms based in the United States audited 74 percent of the Chinese reverse merger companies, while China-based registered firms audited 24 percent.

The PCAOB is able to inspect the audits of many of these companies, when they were performed by U.S.-based audit firms. In some cases PCAOB inspection teams have identified significant audit deficiencies and, as necessary, made appropriate referrals for enforcement to protect investors' interests in reliable audit reports.

To date, the PCAOB has been denied access to determine through inspection whether Chinese firms have complied with PCAOB standards. This state of affairs is bad for investors, companies and auditors alike. If Chinese companies want to attract U.S. capital for the long term, and if Chinese auditors want to garner the respect of U.S. investors, they need the credibility that comes from being part of a joint inspection process that includes the U.S. and other similarly constituted regulatory regimes.

Finally, before I leave the international area, we are also engaged in working out arrangements to implement our new authority, under the Dodd-Frank Act, 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 counterparts, particularly in the EU, cited as an obstacle to allowing us to conduct inspections in their territory.

Our U.K. agreement includes an arrangement to share information. We expect other agreements, as we enter them, to include similar arrangements. And we are engaged in discussions with regulators in countries where we already conduct joint inspections, to supplement existing bilateral arrangements to include the information-sharing now authorized under the Dodd-Frank Act.

Enforcement Matters

Let me turn to enforcement matters. Since the last Standing Advisory Group meeting in October 2010, the Board announced the settlement and institution of two enforcement proceedings.

First, on December 3, 2010, the Board announced the Matter of Jacqueline A. Higgins, CPA, in which it censured Jacqueline A. Higgins, a large firm manager. The second action was the Matter of J. Crane CPA, P.C. and James Crane, announced on January 19, 2011. In that matter, the Board permanently revoked the registration of J. Crane CPA, P.C. and permanently barred James Crane from being an associated person of a registered public accounting firm for, among other things, failing to cooperate with a PCAOB inspection.

These settlements do not reflect the full scope of the Board's enforcement work, however. In addition, the Division of Enforcement and Investigations continues to be engaged in substantial litigation, particularly in cases relating to some of the largest international registered firm. Earlier this month, for example, the Board instituted a proceeding against a large U.S. accounting firm and several partners, which the PCAOB is litigating.

Under the Sarbanes-Oxley Act as it exists today, the Board's enforcement proceedings are non-public, unless the Board finds there is good cause for a proceeding to be public and the parties consent to public proceedings. 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 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 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 and allowed the Board's sanction to take effect. That information, had it been available, could have made a difference to client and investor decisions regarding the firm or the companies it audits.

This state of affairs is not good for the public or the auditing profession. I support public proceedings. But we can't just wait for Congress to act to make that change. To this end, I also intend to give careful consideration to the tools the PCAOB needs to be effective in enforcing high quality audits for investor protection. I also hope to identify other tools that regulators normally have within their toolkit to protect investors and maintain the public's confidence.

Oversight of Broker-Dealer Auditors

In addition to implementing the information-sharing provisions of the Dodd-Frank Act, the PCAOB is also heavily engaged in implementing its new oversight of auditors of broker-dealers. 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.

Since the last Standing Advisory Group meeting, the Board has sought public comment on proposed rules to establish an interim inspection program as well as implement the Dodd-Frank Act's provisions on funding our new oversight.

As described in the Board's release, the purpose of the interim inspection program is to inform the PCAOB's development of a permanent program, including whether to grant any exemptions. In addition, we intend to use the interim program to assess compliance with relevant laws and standards in broker-dealer audits.

The Board's proposed rules on funding would implement the statutory scheme for assessing and collecting a portion of the PCAOB's accounting support fee from broker-dealers. Under the proposal, broker-dealers would be assessed an accounting support fee in proportion to their tentative net capital.

The comment period on these proposals ended on February 15, 2011. The Board will consider final rules to get these proposals underway later this spring.

In addition, as Marty Baumann will describe, the Board will also consider standards on audits and compliance attestations related to broker-dealers, to align with any amendments the SEC may make to Rule 17a-5. Our intention is to propose our standards in a timely fashion to coordinate with the SEC's proposals. I envision that our standards in this area will be finalized late this year.

Continuing Issues Related to the Economic Crisis

The last matter I want to mention is the Board's continuing engagement on issues related to the economic crisis. In December 2010, the PCAOB published a Staff Audit Practice Alert to inform auditors of public companies about their responsibilities when auditing loss contingencies, disclosures, and related items. The staff took this action in light of reports that began to surface in the fall alleging that companies may have misrepresented the quality of many loans sold for securitization and that those companies could be required to repurchase the affected mortgages, creating an exposure for the banking industry of up to $52 billion. These reports were also the subject of discussion at the last Standing Advisory Group.


Obviously, it has been a busy time at the PCAOB. 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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