Challenges Facing the Audit Profession and PCAOB Initiatives

James R. Doty is chairman of the Public Company Accounting Oversight Board. This post is based on Chairman Doty’s keynote address at the Rice University Director-to-Director Exchange; the full text, including footnotes, is available here. The views expressed in the post are those of Chairman Doty and should not be attributed to the PCAOB as a whole or any other members or staff.

As you know, over the past couple of years, together with the board members and staff of the Public Company Accounting Oversight Board, I have been working to enhance the reliability of the external audit function and its usefulness to U.S. capital markets.

I will start off with an overview of some of the more significant issues confronting the audit profession. And then I’d like to open a more interactive discussion.

I. Corporate Governance Has Evolved to Suit the Needs of Capital Markets.

I have known many of you for years. I have watched and admired how you have navigated the many changes we have seen in both the energy industry and corporate governance.

Many of us have gained significantly more experience than we expected in identifying, addressing and preventing future threats to corporate success, such as differences in cultural expectations and business practices around the world and at home. Enron had a profound effect on Houston.

As this morning’s discussion demonstrated, you recognize that your work is never done. There is no perfect governance regime for all time.

Indeed, the American energy business is nothing if not a testament to the American spirit of discovery and innovation. Other industries have roared in on the back of this spirit, and then, once established, hang up the saddle and become complacent — the story of the railroads, autos, newspapers, cameras.

We haven’t given up the need for transport, or news, or pictures. But if the existing suppliers don’t keep up with changes in demand, or technology, they fall to the side, or away altogether.

It could have been the story of energy in Texas. I need not point out to you how much the energy business has changed in the last few years, not to speak over the course of your careers, and over the last century. For all the busts we’ve weathered, but for the fact that (as the saying goes) there is no quit in Texas, Texas could well be indefinitely depressed.

But consider the role of the boom-and-bust culture. You know that, when you’re on top, you’re not going to stay there unless you continually remake yourself. And you know that when you’re on the way down, if you’ve got grit, determination, imagination and intelligence, there’s no reason you can’t be on the path to new heights.

The auditing profession is subject to changes in demand as well. It faces important choices about whether, and if so how, to meet changes in demand. Those changes were motivated by our need, as a country, to form capital on a large scale to fund innovation and new ideas, and strengthen our economy.

Auditing is a commercial innovation designed to advance capital formation. It is a relatively new entrant in the course of history.

The modern corporation spawned from the quite basic and ancient commercial need to amass large sums to finance high-risk trading expeditions across oceans: competitors vied for control of new land and resources. Thus the beginning of Spanish, Dutch, English, French and Portuguese settlement in America.

The records of those early trading companies show that they were audited. And that those audits were generally conducted by a committee of directors or participants in the company.

But for centuries, the tools of large-scale capital formation passed by and through Texas, without taking hold.

In 1543, Luis de Moscoso Alvarado, who took command of Hernando DeSoto’s expedition after DeSoto’s death on the banks of the Mississippi, recorded the first European discovery of oil in Texas, after the expedition was forced ashore in the area between Sabine Pass and High Island. It was just floating on the water. Unaware of its potential, Moscoso and his explorers used it to caulk their vessel and moved on.

Later, settlers in Texas observed routine crude oil seepage. During his visit to Texas in 1854, Frederick Law Olmsted noted “a slight odor of sulphureted hydrogen” at Sour Lake. The discovery and production of oil occurred sporadically during the second half of the nineteenth century.

It all changed on January 10, 1901, when the Lucas No. 1 well blew out at Spindletop near Beaumont. Texas then became one of the most important users of the corporate form.

Shortly thereafter, J. M. Guffey Petroleum Company built a large refinery for the Spindletop oil at Port Arthur. James Guffey was a wealthy oil well wildcatter from Pittsburgh. He formed Guffey Petroleum by buying out his partners at Spindletop with funds obtained by selling shares to an investment syndicate headed by Andrew and Richard Mellon of Pittsburgh.

In 1907, again backed by financing from Andrew Mellon, Guffey renamed the company Gulf Oil Corporation, and with the Texas Company built the first major pipelines to connect their refineries with the Glenn pool in Oklahoma.

From that beginning, Texas — and Houston in particular — has grown to host the second most Fortune 500 companies of any city in the United States.

The organized auditing profession formed in Britain and the United States not much before Guffey’s time, as the Industrial Age began. Industrial development needed cash investment greater than most individuals or partnerships had. Most of our industrialists sprang from humble means. To convince potential investors with whom the entrepreneur may not have any prior relationship, the entrepreneur submits to audit by an independent expert in financial reports.

By the late 19th century, the auditing profession was providing investors — from Andrew Mellon to the dispersed institutional and individual investors of today — a basis to trust the financial position and operating results of the companies in which they had invested their capital.

Today, I want to discuss the challenges facing the audit, and then move on to discuss what the PCAOB is doing about these challenges. In each case, you, as the audit committees and independent directors of important companies, have a particularly important role to play in fostering the conditions that can support audit quality. You are the potential champions of the best auditing practices. I will try to explain how all this relates to today’s program.

First, this is a challenging time for the auditor. Let me explain why this is of concern.

II. The Auditing Profession Must Heed Changes in Public Needs and Demand to Maintain Its Importance to Capital Markets

As with industries and other professions, the auditing profession must heed changes in public needs and demand to maintain its importance to capital markets. Yet significant factors have combined to deter the profession from innovating the audit to meet public demand.

Among them: the statutory franchise. To protect the investing public, all public companies are required by law to obtain an audit. This statutory franchise shields the profession as a whole from the risks of obsolescence, thereby reducing auditors’ need to adapt to the needs of market participants. As a result, auditors have not had a natural incentive to evolve their work and reports to what the providers of capital want.

The Sarbanes-Oxley Act puts the audit committee in charge of retaining the company’s auditor, and yet the audit committee has limited information on which to judge audit quality.

There are also conflicts of interest for the audit to overcome. Regulations have addressed the more obvious ones, such as personal financial interests and business relationships between an audit firm and an audit client. The regulations have also affected the business model, by limiting the scope for audit firms’ escalation of commitment to an audit client with dependence on non-audit service fees.

But in some cases, and certainly to some auditors, the audit fee alone represents a significant income stream that anyone would find hard to put in jeopardy.

In the United States, large audit firms’ revenues from consulting are growing 15 percent a year. Audit fees have stagnated at, basically, the inflation rate. Thus audit practices have shrunk in comparison to audit firms’ other client service lines.

As a result, the auditing profession admits only to a narrow task, notwithstanding the considerable effort expended to perform it. As the University of Chicago economist, Luigi Zingales, said recently, “I don’t know exactly what accountants are supposed to do, because every time I talk to an accountant, they’re not supposed to do what I expect them to do.”

Empirical research that Zingales conducted with his colleague at Chicago, Adair Morse, and University of Toronto’s Alexander Dyck, found that certain groups who have not traditionally been considered important in corporate governance in fact play a key role in fraud detection: in the period 1996 to 2004, employees reported 17 percent of the cases studied, and non-financial-market regulators and the media reported 13 percent each. In contrast, auditors accounted for only ten percent of fraud detection, although their contribution in the post-Sarbanes-Oxley years of the period rose to 24 percent.

According to Zingales and his colleagues, auditors that blow the whistle are more likely to lose accounts: 50% of whistleblowing auditors lose the client shortly after the fraud revelation. In contrast, only 14 to 15 percent of audit firms lose their client when they are not the one to uncover or reveal the fraud.

There is an international debate to consider the role of auditing in our capital markets. The European Commission is considering a wide range of reforms. The Dutch Parliament recently adopted audit firm term limits to promote auditor independence. It appears that some Dutch companies plan to implement auditor switches ahead of the 2016 deadline.

The U.K. does not impose term limits. But there too some companies have announced a change in auditor as a measure, in their view, of good governance.

We are following these developments in the United States.

The debate is affected, if not motivated, by the fact that audit regulators around the world have found that “auditors are too often accepting or attempting to validate management evidence and representations without sufficient challenge and independent corroboration.”

In particular, regulators have called for improvement in key areas — the sufficiency and appropriateness of audit evidence, auditors’ professional skepticism, and auditors’ use of other auditors and experts.

The PCAOB is exploring the best thinking on ways to enhance auditor independence, objectivity and professional skepticism. We have accumulated a lot of information, consisting of comments, analysis and ideas, and are continuing to study. We have also taken several steps.

One such is a staff Audit Practice Alert on skepticism. We are considering changes to our auditing standard on related parties, to focus auditors’ procedures in that area on risk. We have also explored ways to help audit committees in their oversight of auditors. This also gets to your key role in fostering audit quality.

III. PCAOB Initiatives

1. The PCAOB Has Adopted a New Auditing Standard on Communication with Audit Committees.

The PCAOB has recently adopted a new auditing standard — Auditing Standard No. 16 — on what auditors should communicate to audit committees in order to protect the public’s interest in keeping audit committees informed of important audit matters.

AS 16 is intended to foster a more robust discussion between the auditor and the audit committee. It is intended to give the audit committee the information necessary for it to be able to probe and understand challenging audit issues and significant auditor judgments, and champion the auditor’s independence and professional skepticism in resolving those issues and making those judgments.

I would expect the best audit committees to demand this kind of dialogue already. Yet we see situations where this was not the case. AS 16 is an attempt to change that.

2. The PCAOB Has Issued Guidance on What Audit Committees Can Learn from PCAOB Inspections.

The PCAOB has also recently issued guidance about how audit committees can learn more from their auditors about the results and implications of the PCAOB’s inspection findings.

Description in the public portion of a PCAOB inspection report of failure to obtain sufficient evidence to support the firm’s opinion means that the inspection staff has determined that the firm failed to fulfill its fundamental responsibility in the audit: the firm failed to obtain reasonable assurance about whether the financial statements are free of material misstatement.

Some have asked how, when reading a public PCAOB report, they can tell the difference between deficiencies that are significant or egregious failures and those that are less significant technical noncompliance. My answer is that we do not describe in the public portion of a report every auditing deficiency that our inspectors identify, but only those that appear to our inspectors to result in the auditor failing to have a reasonable basis for its opinion that the financial statements are fairly stated.

Whatever the details may be, I would expect that a company’s audit committee and investors would view that result as critical — and, for their purposes, not under any circumstances close to the result for which they paid. If a deficiency is described in the public portion of a report, it is because of a view that the auditor left insufficiently audited an aspect of the financial statements that could well include an undetected material misstatement.

Your role as a director makes a difference: how your audit committee addresses inspection results can affect the tone of the audit. An audit committee that is impatient with the technicalities of an audit, or accepts weak arguments to dismiss the findings in an inspection report, may inadvertently signal to the audit firm and audit team that the audit committee is not concerned with quality.

An audit committee that, on the other hand, models to management a mindset that the auditor plays an important role in testing their assertions protects the company’s capital and promotes its expansion.

An audit committee that probes how non-public PCAOB concerns about quality control have been addressed — and whether the PCAOB has determined that they have or have not been resolved — tells the auditor that quality matters.

The usefulness of our reports, to you, is getting close attention at the PCAOB. We want these reports to be relevant and to contribute to improvement in audit quality. Stay tuned.

Finally, permit me a few comments on what we are pursuing on a more long-term basis.

3. The PCAOB is Considering Changes to the Standard Form Audit Report.

The PCAOB is also considering changes to the standard form audit report. The current standard form audit report is essentially three boilerplate paragraphs. For a long while, investors have called for more insights from the auditor’s work.

This project is intended to develop a better, more transparent reporting model, one that will make auditor reporting more relevant and useful to investors and other financial statement users.

Consider that, outside the public markets, auditors routinely provide what is known as long-form reports to private clients, such as acquirers, private equity investors, or others.

A different form of report, oriented toward the needs of the users of the report, could redirect the auditor’s mindset from meeting minimum criteria to identifying key insights about the audit that will help a user understand the quality of financial reporting.

On the other hand, I would not expect any such proposal to eliminate the current auditor’s opinion on compliance with the applicable accounting regime, substitute the auditor for management’s ultimate responsibility for reported financial information, or result in the auditor becoming involved in an audit of management’s non-financial information.

4. The PCAOB Has Proposed New Standards on Audit Transparency and is Developing Audit Quality Indicators.

The PCAOB has also proposed to require disclosure in the audit report of the name of the engagement partner as well as participating firms in the audit.

Auditing is more than ever a global endeavor. Engagement partners supervise audits that span continents and oceans. But the reader of an audit report may not know how much of the actual work was done by the firm signing the report. Participating audit firms practice in markets that exhibit markedly different business cultures, with divergent patterns of transparency.

We may never have needed the external audit more. Yet the audit has, in the minds of some, become a commodity to be obtained from the lowest cost provider.

We need the audit profession to compete on quality more than price. We need a profession that is revered for insight and clarity, not box-checking. Knowing the name of the engagement partner on an audit, and the various other firms that participate in a global audit, may help the investing public identify and judge quality, leading to better auditing.

In this regard, we are also engaged in a research project to identify audit quality indicators that are both measurable and reasonably objective. Some might be process, or input-related, measures, such as the ratio of audit staff to partners on an audit. Others might be results, or output-related, such as the history of restatements or warnings about going concern.

The project is in its infancy. Look for more in the coming months.

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