PCAOB: Protecting Investors and the Public Interest

Since the Public Company Accounting Oversight Board was created 10 years ago by the Sarbanes-Oxley Act, the U.S. system of auditor oversight has been fundamentally reformed to better protect investors and the public interest.

In addition to creating the PCAOB, the Act also vested audit committees with expanded oversight of financial reporting and audit processes.

Initially, the Act was seen as an effort to address problems that appeared to be unique to the U.S., but after numerous financial reporting scandals erupted around the world, the U.S. model of audit regulation was adopted in varying forms in many other countries.

Following the recent financial crisis, we find ourselves in an era with new stresses on financial reporting and auditing around the world, and we are once again evaluating how best to protect investors in this environment.

This is what we are working on at the PCAOB. I would like to tell you about a few “hot topics” related to our core mission of protecting investors through audit oversight, including:

• audit quality and inspection results;
• audits of brokers and dealers;
• Board actions involving audit committees;
• international inspections and cooperation; and
• enforcement and investigations.

As you know, this summer marked the 10th anniversary of the Sarbanes-Oxley Act of 2002. The Act established the PCAOB to oversee the audits of the financial statements of public companies, ending more than 100 years of self-regulation by the auditing profession.

The Act charged the PCAOB with overseeing audits in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.

In July 2010, the Dodd-Frank Act amended the Sarbanes-Oxley Act and, among other things, vested the PCAOB with the authority to oversee audits of broker-dealers.

We’ve had many stakeholders and members of the profession tell us that they believe that auditor independence and audit quality have been strengthened since the passage of the Sarbanes-Oxley Act, and we also believe that audit quality has improved.

Even so, there is still much more that needs to be done and, based on what we’ve learned through various financial crises, business cycles, and the history of the profession, we can never let down our guard.

In fact, PCAOB inspections continue to find serious audit deficiencies in public company audits on a regular basis. In addition, the results of our first round of inspections of audits of brokers and dealers are troubling as well.

Inspection Results

The PCAOB annually inspects firms that audit more than 100 issuers, while firms that issue 100 or fewer of these audit reports each year are subject to inspection every three years.

We are in the midst of our 2012 inspection season, and have completed a substantial number of the inspections. This year, the PCAOB is inspecting nine firms that audited more than 100 issuers in 2011. We also expect to complete approximately 170 domestic triennial inspections and approximately 80 non-U.S. triennial inspections.

At the same time, we are issuing the final reports for the 2011 inspections, with the majority of those reports having been issued for the triennial inspections. We are just starting to issue the 2011 inspection reports for the 10 firms that audited more than 100 issuers in 2010.

In the 2010 reports issued last year, we saw a high level of serious inspection findings, an increase over previous years. Unfortunately, that spike in inspection findings has remained high in the 2011 reports we are issuing this year.

The findings are serious, and represent deficiencies that are of such significance that it appeared that many firms, at the time they issued their audit reports, had failed to obtain sufficient, appropriate audit evidence to support their audit opinions on the financial statements and/or the opinions on internal control over financial reporting. These findings are reported in the public version of the report, which is referred to as “Part I.”

Such deficiencies include cases where auditors issue unqualified opinions even though:

• the audit work was incomplete or not properly conducted;
• financial statement information was contradicted by other available evidence; and/or
• audit conclusions on material issues were based on management’s views without independent verification.

It is important to note that these findings do not necessarily mean that the financial statements are misstated, but that they represent areas of risk where the audit work was not sufficient under the standards to support the audit opinion.

It is also important to note that our inspections are risk-based, and often focused on key areas in particular audits that pose risk to investors. Therefore, the results cannot be generalized to all audits.

Common areas where we find audit deficiencies include revenue recognition, fair value of financial instruments, management estimates, testing and evaluating internal controls, related party transactions, and the auditor’s assessment and response to fraud risk, among others.

An area that is frequently problematic for smaller issuers is the audit work related to the issuer’s use of equity financing instruments to compensate employees, vendors, and others. Many of these agreements and instruments contain complex terms and conditions that impact the manner in which the instruments should be recorded and accounted for by the issuer.

The Part II findings, which may remain nonpublic, are about the firm itself. They deal with deficiencies identified in the firm’s quality control system. These deficiencies indicate areas where a firm’s quality control system is insufficient to provide assurance of quality in the performance of audit engagements.

According to the statute, a firm has 12 months from the issuance of the inspection report to address the issues identified in Part II to the Board’s satisfaction. If a firm does not satisfactorily address them within 12 months, the particular quality control criticism(s) in Part II that was not remediated is made public.

Findings in Part I and Part II are often related. Part II focuses on issues that may have caused the audit performance deficiencies reported in Part I of the report, as well as other aspects of the firm’s management of its audit practice that could negatively impact audit quality. These types of findings can include the firm’s procedures in areas such as:

• management structure and processes, including tone at the top;
• partner management, including allocation of partner resources and partner evaluation;
• policies and procedures for considering and addressing risks involved in accepting and retaining clients;
• monitoring quality control and audit performance, including correcting known deficiencies;
• maintaining independence; and
• systemic issues, such as professional skepticism and expertise.

The Board engages in constructive dialogue with firms in order to encourage them to improve their practices and procedures. Successful remediation and sustained improvements in audit quality are clearly the goals of this process. We have seen most firms take their responsibilities for remedial efforts and improvements seriously.

It is my hope that we will see some significant improvements in the inspections we conduct in 2012 and 2013, as the firms’ remedial actions will have had time to begin to show an impact.

Interim Inspection Program for Audits of Brokers and Dealers

This year, we also conducted our first inspections of broker-dealer auditors. As I mentioned earlier, the Dodd-Frank Act amended the Sarbanes-Oxley Act and, among other things, vested the PCAOB with the authority to oversee audits of broker-dealers. Congress decided to strengthen the regulatory oversight of securities industry auditors after the revelation of the Ponzi scheme operated out of Bernard L. Madoff Investment Securities.

There are approximately 4,400 brokers and dealers that filed audited financial statements with the Securities and Exchange Commission for fiscal periods ending during 2011, and they were audited by approximately 800 audit firms.

The Board issued its first summary report on the interim inspection program for audits of SEC-registered brokers and dealers on August 20, 2012. [1] The interim inspection program has been in place for just over a year, and is being used to assist the Board in assessing the current state of auditors’ compliance with the requirements and professional standards applicable to the audits of brokers and dealers. The interim program will continue beyond 2013, until rules for a permanent inspection program take effect.

The Board’s approach to establishing a permanent inspection program for audits of brokers and dealers is to focus on (1) how best to promote investor protection, and (2) how to create an efficient and effective regulatory scheme that appropriately addresses the diversity of audits of broker-dealers, weighing the differences in their risk profiles, and the costs and benefits involved.

The report we issued in August is a “must read” report for auditors doing business in the broker-dealer audit space. The report details the findings from inspections of 10 audit firms and portions of 23 audits of securities brokers and dealers. These inspections took place over a five-month period from October 2011 to February 2012.

Because it is still an interim program, the auditors’ names are not revealed. But PCAOB inspectors identified deficiencies in all of the audits inspected.

The deficiencies fell into three broad categories: (1) audit procedures over customer protection and net capital requirements, (2) audits of the financial statements, and (3) auditor independence.

While the auditors and audits selected are not representative of all broker and dealer audits and their auditors, the results are of concern to the Board. The results indicate that in the audits that we inspected, the auditors were not properly fulfilling their responsibilities to provide an independent check on brokers’ and dealers’ financial reporting and compliance with SEC rules.

Even with this small group of audits inspected thus far, the results are disturbing. We urge auditors of brokers and dealers to read the full report, and consider whether any of the audit deficiencies described in the report could be present in the audits that they perform. We will continue to provide progress reports on the interim inspection program, as well as guidance and training through our forums for auditors of brokers and dealers.

In 2012, we are inspecting approximately 45 firms and 65 audits, and will issue another report on those results in 2013. This is an area to watch. In 2013, we will begin to work on the design for a permanent program of inspections.

Inspection Information for Audit Committees

Another development related to inspections is the Board’s August 1, 2012, release, Information for Audit Committees about the PCAOB Inspection Process. [2] The Board issued the release to help audit committees understand the information provided in public PCAOB inspection reports and to alert audit committees to the nature of the nonpublic inspection information that they may find useful to explore with their auditor.

We directed this release to audit committees due to their important role in corporate governance through the oversight of financial reporting and the independent audit. In its recent projects and outreach efforts, the Board has received hundreds of comments that emphasized the importance of audit committees and support for Board efforts to facilitate effective communications between auditors and audit committees, including communications about PCAOB inspection results.

We have also heard audit committee members express concern regarding a lack of information about PCAOB inspections of their audit firm, and we’ve had questions from audit committee members about how to understand what their auditors say about inspection results.

If you advise audit committee members, you’ll want to be sure to direct them to this release. It describes the contents of the inspection reports, including the public and nonpublic portions, and also describes the inspection process. The release also contains possible questions that audit committees may wish to ask their audit firms about PCAOB inspections, including:

• 1. Was the company’s audit selected for PCAOB inspection? Committees may want real time updates about whether their audit has been selected for inspection, and if so, what is being looked at, and whether the PCAOB have identified any deficiencies in the audit.
• 2. Did the PCAOB identify deficiencies in other audits that involved auditing or accounting issues similar to issues presented in the company’s audit? Audit committees may want to understand whether similar deficiencies could occur in the company’s audit, and what the firm is doing to prevent such deficiencies.
• 3. What were the audit firm’s responses to the PCAOB findings? The PCAOB is aware of certain audit firm responses that should be viewed with skepticism, such as: “It was just a documentation problem.” Or, “There was a difference in professional judgment.” The release contains additional information about how to interpret such responses.
• 4. What topics are included in Part II findings? Audit committees may want to ask for certain information about the findings and the firm’s efforts and actions to address any quality control deficiencies. Audit committees may also want to inquire about the status of the PCAOB’s evaluation of the firm’s progress on remediation.

Auditor Communications with Audit Committees

So, while that release talks to audit committees about what they may ask their auditors about their inspections, the Board also recently issued a standard that updates what an auditor is required to tell an audit committee about their audit, Auditing Standard No. 16. [3] This standard requires the auditor to communicate key issues about the overall audit strategy, timing, and significant risks, as well as audit results surrounding critical accounting policies and estimates, an evaluation of the quality of the company’s financial reporting, and difficult and contentious issues encountered during the audit, among other areas.

In addition, Auditing Standard No. 16 requires the auditor to inquire of the audit committee about whether it is aware of matters relevant to the audit, including, but not limited to, violations of laws or regulations. These auditor inquiries will supplement and enhance the current requirements under Auditing Standard No. 12 for the auditor to inquire about the audit committee’s knowledge of the risks of material misstatement, including fraud risks.

Both the auditor and the audit committee benefit from a meaningful exchange of information regarding significant risks of material misstatement in the financial statements and other matters that may affect the integrity of the company’s financial reports.

The standard was approved by the Board on August 15, 2012, and is currently with the SEC. The standard will become effective, subject to SEC approval, for audits of fiscal years beginning on or after December 15, 2012.

Oversight of Global Network Firms and Non-U.S. Firms

I’ve talked about audit quality and inspection results for audits of public companies and some broker-dealers. Let me switch gears to focus on international issues.

There are approximately 915 foreign public accounting firms registered with the PCAOB located in 84 countries, and more than 240 of those firms are subject to periodic inspection by the PCAOB because their audit reports are included in filings with the SEC.

Section 106 of the Sarbanes-Oxley Act provides that non-U.S. auditors of issuers are subject to the Act and to PCAOB rules in the same manner and to the same extent as are U.S. auditors. Our international inspection program continues to evolve as we reach cooperative inspection agreements with more and more countries.

Last year, the PCAOB established a separate Global Network Firm (GNF) inspection program for the seven largest annually inspected firms and their network affiliates. In these global networks, member firms are locally owned and managed, and are linked together through membership agreements. Each network is generally governed by an umbrella membership entity that has the objective of achieving consistency of brand, services, quality, and methodology across its member firms.

We also separately track firms that are not associated with these seven largest global networks. In 2011, PCAOB inspected 42 foreign registered accounting firms. In 2012, PCAOB budgeted to conduct inspections of about 90 foreign registered public accounting firms, more than two-thirds of which are part of the GNF inspection program. However, over a dozen of those inspections may not occur due to regulatory cooperation obstacles that I will discuss later.

The Board’s GNF program takes into account some of the unique aspects of global audit practice, and it enhances PCAOB’s inspection program in several ways. Inspectors are assigned to the same GNF inspection team throughout an inspection cycle, so they are familiar with their assigned firm’s global audit methodology, regardless of which of the firm’s affiliates they are inspecting. Also, if the inspection team detects similar deficiencies in one or more of the firm’s affiliate inspections, it can decide to look for those deficiencies in other affiliate inspections.

Further, PCAOB inspectors have the ability to look at the work performed by an affiliate that was referred to it by another affiliate and determine if it was done in accordance with the instructions of the referring firm affiliate and whether it met U.S. auditing standards. Often, our inspectors see the actual work performed where the referring firm only received notification of the results of that work.

We believe this gives us a well-rounded view of the global firms’ auditing practices.

International Audit Regulator Cooperation

Since its inception, the PCAOB has conducted inspections in some 40 foreign jurisdictions and this number will continue to grow. To conduct inspections around the world, the PCAOB works closely with our fellow regulators. For that reason, it is important that we continue to establish strong cross-border regulatory cooperative agreements with many other audit regulators and share information through the International Forum of Independent Auditor Regulators (IFIAR).

To facilitate information sharing and promote collaboration and consistency in audit regulation, 18 national audit regulators, including the PCAOB, established the International Forum of Independent Audit Regulators (IFIAR) in September 2006. Membership has since grown to 43 regulators as more countries establish independent audit regulators. PCAOB Board Member Lewis Ferguson currently serves as the Vice Chair of IFIAR.

At a recent plenary session of IFIAR in Korea this spring, the Officers of IFIAR were asked to conduct a survey of the IFIAR membership regarding their audit inspection findings. This will be the first ever global survey of this type. The Officers will present the results of this survey to the membership at the next IFIAR meeting, which is scheduled to take place in London in early October. It is expected that the IFIAR membership will agree to make public the results of this survey sometime after the London meeting.

In terms of our inspections of foreign firms, the Board has adopted a cooperative framework that allows the PCAOB to rely, to a degree deemed appropriate by the Board, on inspection or enforcement work performed by a home-country regulator. By developing cooperative arrangements and through coordination with our counterparts, the PCAOB endeavors to minimize administrative burdens and potential legal or other conflicts that non-U.S. registered firms may face.

We have found that many countries have adopted audit regulatory regimes modeled, at least in part, on the Sarbanes-Oxley Act and the PCAOB. Most of the PCAOB’s counterparts consistently identify audit quality concerns consistent with those found by PCAOB inspectors.

Regulatory Non-Cooperation

Notwithstanding the positive trends in international regulatory cooperation, the PCAOB currently is prevented from inspecting the U.S.-related audit work and practices of PCAOB-registered firms in certain European countries, China, and — to the extent their audit clients have operations in China — Hong Kong.

The lack of cooperation means that investors in U.S.-traded companies who rely on those firms’ audit reports are deprived of the benefits of PCAOB inspections of the companies’ auditors. In 2009, PCAOB amended its Rule 4003 to allow it to postpone the inspections of certain foreign registered public accounting firms for up to three years to provide time to conduct the inspections cooperatively with the Board’s non-U.S. counterparts. However, this “deferral rule” expires later this year. While the Board has begun to conduct inspections in a number of European countries as a result of being able to conclude cooperative agreements in those countries, it still faces considerable challenges in resolving obstacles to its inspections in other European countries as well as in China.

This will be an area to watch during the remainder of this year.

Currently, the Board publishes a list of issuers that have filed with the SEC financial statements audited by a PCAOB-registered firm located in a jurisdiction where obstacles to PCAOB inspections still exist. The PCAOB also publishes a list of auditors that it has been unable to inspect in foreign jurisdictions.

PCAOB Enforcement and Investigations

Lastly, I want to mention PCAOB’s enforcement and investigations function, which is an essential element of the Board’s oversight. Effective and robust enforcement is a critical tool in protecting investors and the public interest. Our Division of Enforcement and Investigations initiates and completes investigations, and where appropriate, litigates disciplinary proceedings in cases where auditors may have violated laws, rules, or standards under the Board’s jurisdiction. Tomorrow morning, Claudius Modesti, the Director of PCAOB’s Division of Enforcement and Investigations and Marion Koenigs, Deputy Director, will present an update on PCAOB’s enforcement activities.

I also want to mention my support for current legislative initiatives to make PCAOB enforcement actions public. Under current law, the PCAOB’s contested disciplinary proceedings are nonpublic, unless each party consents to public hearings. PCAOB disciplinary proceedings remain nonpublic even after a hearing has been completed and adverse findings made by a disinterested hearing officer, if the auditors or firms opt to appeal and do not consent to make the proceedings public. This situation results in a variety of unfortunate consequences for investor protection and the public interest.

Concluding Thoughts

And that is the PCAOB’s mission – to protect investors and the public interest. Clearly, reliable financial statements play a key role in the financial markets, which are integral to the success and well-being of American households and businesses, the U.S. economy, and participants and stakeholders from around the world. High quality, reliable, independent audits are essential in our system of investor protection, and we must regularly monitor and evaluate the profession’s performance in carrying out the audit function.

I am pleased to have the opportunity as a Board member to explore the broad range of issues impacting the auditing profession as we seek to make progress to strengthen the reliability and accuracy of audit reports in order to protect investors and the public interest.

Endnotes

[1] Report on the Progress of the Interim Inspection Program Related to Audits of Brokers and Dealers, PCAOB Release No 2012-005, August 20, 2012.
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[2] Information for Audit Committees about the PCAOB Inspection Process, PCAOB Release No. 2012-003, August 1, 2012.
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[3] Auditing Standard No. 16 – Communications with Audit Committees; Related Amendments to PCAOB Standards; and Transitional Amendments to AU sec. 380, PCAOB Release No. 2012-004, August 15, 2012.
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