Monday, June 04, 2012

PCAOB Chair Says Cross-Border Audits of Financial Statements Require Enhanced Attention to Investor Protection

The PCAOB is deeply engaged in examining ways to enhance the relevance, credibility and transparency of the independent audit of financial statements to better serve investors, noted PCAOB Chair James Doty. In remarks at the SEC and Financial Reporting Institute conference, he said that the Board is interested in a more transparent reporting model that will align auditors with investors, de-commoditize the audit and make it more relevant, and require auditors to demonstrate the requisite skepticism and provide true insight. He emphasized that this effort is taking place against the backdrop of the globalization of the financial statement audit.

Through their international networks audit firms reach everywhere, he observed. Local environments and trends are within their long reach as engagement partners supervise cross-border audits. Investors and other users of audit reports may not know how much of the actual work was done by the audit firm signing the report. Participating audit firms practice in markets that exhibit markedly different business cultures, noted the PCAOB Chair, with divergent patterns of transparency. Small U.S. firms around the country are also engaged in audits of foreign private issuers, or U.S. companies that operate, in Asia, Latin America, Africa and elsewhere.
The Chair assured that the PCAOB is focusing on the effect of these various business models on the protection of investors. In any given week, he noted, PCAOB inspectors are working in numerous countries, often side-by-side with local audit oversight authorities in joint inspections. The Board is drawing a broad and clear picture about how auditors meet the challenges of understanding different environments and coordinating with other auditors to obtain a full grasp of a company's true results and financial position. The Board has identified a number of deficiencies in multi-national engagements, he said, with some of the auditing issues related to revenue and fair value.
Chairman Doty is also concerned that the public knows little about how audits are conducted by global audit networks. In this regard, the PCAOB proposed last fall new requirements to disclose to investors how a multi-firm audit was accomplished. He plans to ask the Board to act on that proposal in the near future.
With sunlight on how the audits are done, he reasoned, they may improve in coordination and quality as well. Bu if darkness persists, he fears that some auditors will find themselves on the wrong side of the debate when the lights go on and they are called to account for how a ``fraud could have eluded a vast network of soldiers in what is supposed to be a fight for truth.’’ These are choices made today, he cautioned, that will need to be explained tomorrow.
Expanded on the dual and interlocked theme of professional skepticism and investor protection, Chairman Doty said that Board inspectors have found deference to management in key reporting areas. For example, in the critical area of fair value reporting of financial instruments, instead of skeptically testing the reasonableness of managements' assumptions and resulting assertions, one firm's method involved obtaining valuations from a number of external parties and picking the one that was closest to management's claimed value.
The work and expense to obtain the various outside valuations may have created an appearance of rigor, said the Chair, but the explicit acknowledgement that the test was designed to support management's number called into question whether the auditor approached the audit with appropriate skepticism.
In his view, it is rare when an auditor knowingly acknowledges or documents the conflict between maintaining objectivity and maintaining a good client relationship. Indeed, the auditors who explicitly aimed for the number closest to management's claimed value may not have consciously sought to obscure valuation errors.
But he advised that auditors who merely confirm managements' estimates and don't challenge them with the basic tools at their disposal may have squandered a chance to avert later investor ruin. In effect, they run the risk that the company's estimate was unreasonable when made.
The great unfinished business that occupies the PCAOB and global audit regulators is the gap between the purpose of the audit and its fulfillment, emphasized Chairman Doty, who added that this gap threatens the future relevance of the audit profession's work, as well as public confidence in its credibility. These concerns have also been expressed by regulators in Canada, Germany, the U.K., the Netherlands, Australia and elsewhere.
In a February 2012 report on auditing in foreign jurisdictions, the Canadian Public Accountability Board found a lack of professional skepticism when auditors were confronted with evidence that should have raised red flags regarding the risk of potential fraud. Similarly, inspections by the German Audit Oversight Commission indicated that some audits had not been conducted with the necessary professional skepticism, especially in the audit fields which were exposed to increased risks in the context of the financial crisis and consequently required particular professional skepticism on the part of the auditor.

Turning to specific Board projects, Chairman Doty noted that the PCAOB is involved in a number of projects to enhance the audit of company financial statements to better serve investors.  Some of the projects are designed to improve basic auditing, such as what to look for in transactions involving related parties, including corporate executives. The PCAOB has proposed a new auditing standard on related party transactions, which describes basic tools that good auditors have used for years to identify financial reporting risks. Among other things, it requires auditors to understand management's compensation as a way to understand management's motivations. Indeed, in the Chair’s view, changes in performance metrics may well be an important clue in understanding areas where management's story is weak. They offer the auditor insights that may not be gleaned otherwise.
The PCAOB has also recently proposed, for a second exposure, a new auditing standard on what the auditor should communicate to audit committees in order to protect the public's interest in keeping audit committees informed of important audit matters. In addition to receiving written comment, the Board has held a productive public roundtable discussion on auditors' responsibilities to audit committees. Chairman Doty expects the Board soon to adopt a final standard that reflects the public advice and comment.
The PCAOB standards-setting work also includes more broad-ranging projects, such as concept releases to examine ways to enhance the relevance, reliability and independence of audits in light of lessons both auditors and investors learned in the financial crisis. These projects involve consideration of changes to the form and content of the standard audit report, as well as a deep examination of the behavioral patterns that the current audit model imposes.
The Board’s project on auditor independence invites discussion on ways to relieve auditors of the pressure both to foster and maintain a long-term relationship with the audit client when making tough decisions on an audit and relieve auditors of the tie between their engagements and their careers. In this regard, as with the revisions of the auditor's reporting model, the focus of the European Union becomes a factor in the Board’s process.
The Chair observed that the EU and its member states are engaged in a process that he believes will take them through 2013 and into 2014. What the Board is learning through roundtables and public meetings on its concept releases is highly relevant to the process in the EU. This is not an easy subject, he averred, adding that some form of term limits may or may not provide more independence. Nevertheless, the PCAOB Chair believes that the Board must explore the possibility that term limits would help and the feasibility of the range of approaches available to free the auditor to think and act more independently.