Who is Responsible for Audit Quality?

Remarks as prepared for delivery

Good afternoon and thank you, Doug, for the kind introduction. I am delighted to be back in New York City and for the opportunity to be with you this afternoon to share a few thoughts and perspectives. Before I continue, please know that my comments here today are mine and should not be attributed to the PCAOB, my fellow Board Members, or the PCAOB staff.

For the past 17 years, the Baruch Annual Audit Conference has been a leading venue to facilitate and encourage the exchange of information and ideas across all aspects of the financial reporting ecosystem and today, the 18^th annual conference, continues this rich tradition.

In preparing to be with you today, I also reflected on the fascinating and influential life of Bernard Baruch. Mr. Baruch was an accomplished and well-respected financier who served as an advisor to six presidents from 1916 to 1960. He had a remarkable life covering the period when the United States experienced incredible economic growth and became a world leader. Given his success in finance and his influential voice in helping set government policy, I can only imagine that Mr. Baruch would be proud to lend his name to this conference and enjoy the vigorous exchange of ideas on important topics impacting investors and the capital markets that it has come to represent.

I also suspect Mr. Baruch would advocate that a well-functioning capital market is dependent on credible financial reporting underpinned by rigorous independent audits. He famously said “[d]uring my eighty-seven years I have witnessed a whole succession of technological revolutions. But none of them has done away with the need for character in the individual or the ability to think.” So, I suspect he would approve of the title of today’s conference – “Ensuring Integrity.”

With that background in mind, I will focus my remarks on the importance of the auditing profession to society and the need for high quality audits. I will also strive to answer the question, “who is responsible for audit quality?”

Let us start with the role of the PCAOB, which is very clear. In fact, the first three words of the Sarbanes-Oxley Act are “[t]o protect investors.” Section 101 of the Sarbanes-Oxley Act goes on to state that the mission of the PCAOB is “to oversee the audit of public companies that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.” Investor protection is our why and at the heart of all that we do.

The PCAOB’s 2022 to 2026 Strategic Plan¹ charts a four-part course to ensure the PCAOB delivers on this mission now and into the future.

• Modernize standards – We have laid out the PCAOB’s most ambitious standard-setting and rulemaking agenda in its 21 years. Ensuring our existing auditing standards are modernized, as needed, and are “fit for purpose” to meet the expectations of investors now and into the future is imperative.
• Enhance inspections – Our inspection reports have more transparency, including a new section on auditor independence and a range of other improvements to make the reports more transparent, relevant, and useful. In general, I believe the more transparency the PCAOB can provide around our audit oversight activities and the data we collect the more useful it will be to investors, auditors, audit committees, and other stakeholders.
• Strengthen enforcement – You have already heard about our enforcement activities in an earlier session. It is noteworthy to mention that all monetary penalties the PCAOB collects go directly toward scholarships to advance the auditing profession. This year nearly 70% of the recipients came from households with family incomes under $75,000. In fact, the 369 PCAOB Scholars in 2023 are the largest number of recipients in the program’s history, an increase driven largely by the PCAOB’s expansion of the number of institutions eligible to participate in the program. Since the program’s inception in 2011, the PCAOB has awarded $22.4 million in scholarships to approximately 2,240 recipients.²
• Improve organizational effectiveness – The PCAOB’s efforts to improve organizational effectiveness and streamline processes have resonated with our accomplished staff. Most staff say they would recommend the PCAOB “as a great place to work.”³

I fully support the priorities in the Strategic Plan. These initiatives will allow the PCAOB to meet the mission stated in Section 101 of the Sarbanes-Oxley Act. Execution of these priorities will serve to not only benefit investors, it will also benefit the entire auditing profession in a number of ways including:

• Using scholarships to assist and encourage students from diverse backgrounds to enter the auditing profession;

• Modernizing standards that help to ensure that audits performed by independent auditors meet the needs of investors; and
• Ensuring auditors comply with applicable standards and disciplining those auditors who flout the rules.

The mere fact that Congress created the PCAOB to oversee the audits of public companies underscores the undeniably important responsibility of the independent auditor, and more broadly, the auditing profession to support our capital markets and the efficient allocation of capital. The benefits of the independent auditor performing high quality financial statement audits to society cannot be overstated. I think we all can agree on this.

Who is Responsible for Audit Quality?

Now that we have considered our “why” – why audits are so important to maintaining healthy capital markets – let us turn to the question, “who is responsible for audit quality?” Consider the following possible candidates: (a) the auditing profession, (b) audit committees, (c) public companies, (d) regulators, (e) investors, and/or (f) the academic community.

This list may be more expansive than you might have initially thought. I submit to you that each one of these candidates represents a unique link of the financial reporting chain and each has a duty to ensure the performance of high-quality auditing. Each link varies in significance. A few have a more clear and direct responsibility for audit quality such as the auditing profession and audit committees while other links in the chain are more indirect. But make no mistake, each plays a part in ensuring the auditing profession’s ability to execute high quality audits year after year. I welcome your thoughts on this question.

For our purposes today, we will primarily focus our time on the auditing profession. Independent financial statement auditors are, by design, on the front lines of investor protection, standing as sentries at the gates of the capital markets. I always smile when I hear someone say auditing is boring. The truth is that very few professions ultimately have a greater effect on society as a whole than the work of the independent financial statement auditor. Just think of the impact that Enron and WorldCom, among others, had on the broader economy when audit quality was lacking.

Since, at least, the 1933 and 1934 Securities and Exchange Acts, the role of the independent auditor to serve as the “gatekeeper” for investors and the public interest has been widely recognized. A gatekeeper has been described as an independent professional positioned between investors and managers in order to play a watchdog role. In fact, one academic paper asserts “[a]bsent effective gatekeepers, it is reasonable to believe that market efficiency would be lower, the cost of capital higher, and our structure of corporate governance imperilled.”⁴ 

Particularly in times of uncertainty, the role of the financial statement auditor performing high quality audits is never more necessary and important. Consider what is happening in the world today with wars, high interest rates, inflation, and a generally turbulent economic climate. In the midst of all this, everyday people continue to invest their hard-earned money into our capital markets assuming highly trained professionals, the independent auditors, are on the beat performing their craft to their upmost ability with due care and professional skepticism. That is the mission; that is the calling of the auditing profession.

Although I have had the distinct privilege of working as a regulator at the PCAOB for over twenty years, I still consider myself a member of the profession. In fact, I think of myself as an accounting and auditing enthusiast. I recall one of my college accounting professors saying that “accounting is the language of business” and if you know accounting you will know business. That hooked me and inspired me to study and learn the craft and be a member of this proud profession! Being a member of the profession is a privilege that should not be taken lightly.

The auditing profession is a resilient and noble profession and, I believe, a “calling” with the execution of audits an act of public service. As I have mentioned, trust and integrity are the bedrock of our capital markets and support the efficient allocation of capital. That trust largely emanates from the work performed by the independent auditor. Taken a little further, by performing quality audits, the work of the independent auditor actually supports our way of life. In 1984, the Supreme Court dubbed the independent public accountant a “public watchdog” and described the role as one demanding “complete fidelity to the public trust.”⁵

According to a Gallup poll, mission and purpose are top reasons college graduates define a first professional job as a good job.⁶ Perhaps if we rebranded auditing as a career that “makes a difference” we would have more students entering the profession – something we sorely need. I am reminded of the book by Daniel Pink on the carrot versus the stick.⁷ He said the kind of rewards employees really want is autonomy, mastery, and purpose in their jobs. Mastery is described as “the urge to get better at something that matters.” Purpose is described as “the yearning to do what we do in service of something bigger than ourselves.” In both cases, the auditing profession fits the bill. But, with that kind of privilege comes responsibility, to the investing public, to society as a whole, and even to others in the profession.

While we do not have time to take on all the challenges with the audit talent pipeline today, I think it is fair to recognize that it has taken a number of years for the profession to get to this place ­­– the AICPA reports the number of accounting graduates dropped to record lows in 2022⁸ – and will most likely take a number of years to get out.

I also believe this discussion should include a focus on how the “brand” of the auditing profession can be refreshed such that it resonates with today’s high school and college students. Firms should consider whether starting salaries reflect the true value of the independent auditor’s work and have kept pace with other career options. As we all know, pay matters. I also would encourage our educators to consider new and creative ways to bring accounting and auditing to life in the classroom and all stakeholders should have an increased focus on encouraging diversity of backgrounds. As I mentioned earlier, the PCAOB supports this effort through our scholarship program.

In summary, the profession has a clear-cut role to play in ensuring audit quality. Simply put, poor audit quality is not good for the auditing profession.

Culture

Now, let us shift our attention more specifically to audit firms and their responsibility for ensuring audit quality. Said differently, do audit firms have a culture of audit quality? This creates many questions.

I wonder how many newly minted auditors think of their chosen profession as purpose or mission driven. Do they hear the senior partner of the firm, the head of audit, the local office managing partner, or their engagement partner, senior manager, manager, or senior supervisor say they are responsible for and empowered to ensure a quality audit occurs? Do they talk about auditing as a public service? That investors and the capital markets depend on their work? And most importantly, that the focus on audit quality should surpass client demands and budgetary pressures? I often wonder whether the answers to these questions should be repeated at the start of each firm training course.

This begets other questions: What is the firm’s tone at the top, tone at the middle? What is being rewarded (e.g., coming in under budget, keeping the client happy)? Is high audit quality being rewarded equal to assessment of financial penalties for instances of poor audit quality? The answers to all of these questions determine the culture of the audit firm.

Indeed, it has become increasingly clear to me that audit firms need a clear culture to drive the right behaviors, which in turn are necessary to ensure the consistent execution of high-quality audits. These behaviors will also help prevent other matters such as cheating on training tests and backdating audit workpapers, and can prevent some of the recent actions that we have seen at firms internationally. A recent academic study asserted that auditors who issue adverse opinions regarding a client’s internal controls can find their careers negatively affected.⁹

The study noted that while auditors historically have been seen as the “gatekeepers” of the capital markets, they often confront tradeoffs between fulfilling their fiduciary duties to the public and maintaining positive relationships with their clients. The study concludes that “[s]uch tradeoffs have become more apparent as the audit profession has placed greater emphasis on maximizing profits and embraced the ‘client as king’ culture.”

Culture is a nebulous topic encompassing broad formal policies and procedures. But like any organization, audit firm culture is also informed by so-called “unwritten rules.” Without maintaining a keen unrelenting focus on the importance of audit quality, a firm’s culture may not embody what the organization wants to project nor what investors expect.

For our purposes, I suggest we narrow the discussion down to the following areas of the audit firm: first, behaviors including external and internal communications, the tone at the top, and how the firm responds to client pressure and supports the engagement team; second, decisions made by a firm with respect to how certain behaviors and actions are rewarded or punished, and how the firm minimizes distractions to its engagement teams; and third, systems including formal policies, procedures, organization structure, learning and education, the performance management system, code of conduct, and ethics policies.

All three of these elements, behaviors, decisions, and systems, work together to establish those written and unwritten rules as to what is expected and viewed as acceptable and appropriate. Anything that detracts from the performance of high-quality auditing should not be viewed as acceptable and removed from the audit firm’s culture.

To this end, firm leadership should periodically pause and take the pulse of the current state of their firm’s culture and deeply understand whether it is designed to support high quality audits. Unfortunately, I suspect what many firms will likely find, particularly regarding the unwritten rules, is that audit quality is not front and center. Ideally, a firm’s culture inspires every member of each audit engagement team to start their day with an objective that they will do one thing to improve the quality of the audit. Consider the power of that.

Engagement Quality Review

Now, let us consider a firm’s system of quality control and how it impacts the firm’s culture and audit quality. In examining audit quality delivered by audit firms, one factor carries outsized weight: a well-functioning system of quality control. An effective quality control system is perhaps the single most important “puzzle piece” in the performance of consistent high-quality audits.

One component of the firm’s quality control system relates to the engagement quality review. I call your attention to the PCAOB’s recently issued staff Spotlight focused on engagement quality reviews that highlighted audit firms are increasingly falling short when performing this function.¹⁰ 42% of firms the PCAOB inspected in 2022 had a quality control criticism related to engagement quality reviews, up from 37% in 2020.A rigorous engagement quality review performed by a qualified, objective reviewer can serve as a meaningful check on the quality of work performed by the engagement team. This is an area where additional time and attention is needed.

Audit Quality Trends

Perhaps this is the perfect moment to pause and talk about how we are defining audit quality. There are many definitions and metrics, but I like to say audit quality is a lot like oxygen. You take it for granted when it is present and abundant, and you only really notice when it is missing.

For our purposes this afternoon, we will consider the state of audit quality through the lens of inspections results. I believe inspection results are a significant indicator of audit quality. While results vary by firm, audit quality as a whole, unfortunately, is trending down. This disturbing trend calls into question the protection that investors deserve and has the potential to challenge the role of the auditing profession.

From all our 2022 firm inspections, we see that 40% of the audits reviewed will have one or more Part I.A deficiencies.¹¹ Furthermore, the PCAOB staff anticipates the average Part I.A finding rate across the six U.S. Global Network Firms will increase from approximately 20% of audits reviewed in 2021 to 30% in 2022. This apparent slippage in audit quality, again based on inspection results, begs the question – are firms reacting with a sufficient “sense of urgency” and, if not, why not?

Is improving audit quality a “burning platform”? Again, if not, why not? If not, is it because over the past decade, there have been relatively few restatements of public company financial statements or, until the past year, continued favorable macro-economic trends?

Irrespective of low levels of restatements, I contend that expectations of investors, the current turbulent economic climate, and our inspection trends create an impetus to improve audit quality.

In looking for explanations for the decline in audit quality, the most likely may be training, mentoring, and talent issues. Specifically, new auditors hired in 2020, during the COVID pandemic, who worked remotely for most of the last three years, did not have the benefit of on-site training and more importantly the ability to consistently work in an audit room surrounded by a team of more experienced colleagues.

Auditors hired during 2020 and potentially in 2021 who performed only or mostly remote work are in a unique position. Their experience entering the profession, in what is arguably their most formative years, was very different from what previous auditors experienced (and what we all experienced). They may be lacking technical accounting and auditing knowledge and potentially taking any competency gap with them as they advance in their careers.

Those auditors hired in 2020 are now likely senior auditors who are supervising and mentoring more junior staff. Firms should consider whether learning and education programs as well as formal and informal mentorship opportunities are adequate to address the technical accounting and auditing needs of their staff.

Critical Audit Matters

Before closing, I want to briefly mention critical audit matters or CAMs. This is an area of increasing investor focus and concern as the average number of reported CAMs continues to decline. I am pleased this topic has been added to the standard-setting research agenda¹² and I look forward to the potential recommendations. As engagement teams will be performing their yearend audits over the coming months, I encourage a renewed focus to ensure that all potential CAMs are identified and evaluated for inclusion in the auditor’s report. CAMs represent an important vehicle for auditors to provide useful insights about the audit to investors and other stakeholders.

Key Takeaways

We have covered a lot of ground this afternoon, so let me leave you with a few key takeaways:

• The auditing profession is a resilient and noble profession that performs a critical role in our society. It is a privilege to be a part of the profession. Though, it has been said “with great privilege comes great responsibility.”
• Auditors are gatekeepers of the capital markets, standing sentry for the investing public.
• The PCAOB’s Strategic Plan will help investors and also help the auditing profession.
• Audit firms need a clear culture that is conducive to driving the right behaviors, decisions, and systems which in turn are necessary to ensure consistent high-quality audits.

Which brings us back to the question, “who is responsible for audit quality?” While a number of candidates all perform a part, auditors and audit firms play a crucial role and need to take action to reverse the current downward trend.

In closing, let me leave you with one last quote from Mr. Baruch. He said “[w]hatever task you undertake, do it with your heart and soul.” May we bring that spirit to the task at hand.

Thank you for your attention and I welcome your questions.