Statement on Concept Release for Potential Approach to Revisions to PCAOB Quality Control Standards: The Role of Investors and the Public in the Revisions to PCAOB Quality Control Standards

I. Introduction

Today, the Board votes on a Concept Release concerning standards of quality control (QC) for firms that audit public companies and SEC-registered broker-dealers.[1] The importance of this step cannot be overstated. We depend upon, and benefit from, quality control in most things that we do. We need quality control over the food we eat, the medicines we take, the automobiles we drive, and the planes we board. As we all know, when quality control fails, the result could be disastrous.

The same is true with respect to financial reporting.[2] Reliable financial reporting is critical to advancing the public interest and ensuring confidence in our capital markets. Trusted, reliable financial reporting depends on rigorous, independent auditing,[3] which in turn relies on an effective QC system.

The critical importance of an effective QC system to audit quality makes these standards uniquely important to investors and the public.[4] Quality control relates to a firm's audit practice as a whole and is intended to, among other things, ensure that audits are appropriately staffed by highly trained personnel who are capable of assessing relevant risks and have the necessary resources to conduct audits. Quality control does more than provide a set of upfront assurances. Firms monitor the results to ensure audit quality, sometimes in real time.

In considering a potential framework for revisions to the QC standards, our Concept Release relies heavily on the International Standard on Quality Management 1 (ISQM 1), a draft proposal issued by the International Auditing and Assurance Standards Board (IAASB).[5] ISQM 1 is a useful starting point. The Board, however, recognizes that ISQM 1 must be adjusted to meet the particular circumstances of the U.S. markets.

The Concept Release seeks comment on a number of areas of importance to investors and the public, including the objectives of a QC system, which implicates the public interest,[6] the role of quality control with respect to auditor responsibility for fraud, illegal acts and going concern considerations,[7] the responsibilities in overseeing professional skepticism and significant judgments made by engagement teams,[8] and the need for additional or alternative requirements to address firms that audit broker-dealers.[9]

In addition, the Concept Release discusses three areas that I want to emphasize today:

  • Independent Oversight of Audit Firms' QC Systems;
  • Audit Firms' Disclosure and Accountability; and
  • Assessing and Improving the Effectiveness of Audit Firms' QC Systems.

II. Independent Oversight of Audit Firms' QC Systems

Corporate governance has undergone significant changes since the adoption of the first QC standard in the United States in the 1970s.[10] The need for, and role of, independence in connection with the financial disclosure process is now widely recognized and implemented. Listed companies must include independent directors on their boards[11] and have informed and independent audit committees to oversee the audit process.[12] These safeguards strengthen trust by investors and the public in financial disclosure and mitigate concerns over possible misalignments between the interests of management and shareholders.

Audit firms have increasingly adopted these types of safeguards. In 2008, the Advisory Committee on the Auditing Profession, a bipartisan commission convened by Treasury Secretary Paulson, issued a report (ACAP Report) that recommended consideration be given to the addition of independent directors with "full voting power [on auditing] firm boards and/or advisory boards with meaningful governance responsibilities. . .".[13] Since then, two of the largest audit firms have added independent directors to their boards.[14] At least three others use advisory groups with independent members.[15] A number of countries have adopted rules that require audit firms to have independent directors.[16]

The contemplated revision to our QC standards provides an opportunity for a renewed examination of the role of these safeguards with respect to audit quality. Commercial incentives may sometimes conflict with the goal of audit quality. Independent oversight of firms' QC system can help mitigate these concerns.

For example, the Concept Release discusses the need to provide adequate resources for the design, implementation, and operation of a QC system. Safeguards, including an independent oversight mechanism, may provide investors and the public with greater confidence in the resource allocation decisions. The same may be true with respect to other aspects of quality control, including the annual review of the QC system, the effectiveness of remediation of QC concerns, and the integration of audit quality into the system of incentives and rewards for firm personnel.

I encourage comments on these issues. The Concept Release seeks comment on governance matters and structural concerns that could affect the level of investment to ensure audit quality. Specifically, the Concept Release asks:

15. Should a future PCAOB QC standard address quality considerations in the appointment of a firm's senior leadership? If so, how?

16…[S]hould a future PCAOB QC standard emphasize the importance of counterbalancing commercial interests that may lead to underinvestment in the audit and assurance practice, particularly in firms that also provide non-audit services?

17. Should a future PCAOB QC standard incorporate mechanisms for independent oversight over firms' QC systems (for example, boards with independent directors or equivalent)? If so, what criteria should be used to determine whether and which firms should have such independent oversight (e.g., firm size or structure)? What requirements should we consider regarding the qualifications and duties of those providing independent oversight?

46. Should we require the firm's top leadership to certify as to their QC system's effectiveness, either as part of or in addition to the firm's report on their QC system's effectiveness?

III. Audit Firms' Disclosure and Accountability

Ensuring the effectiveness of quality control requires accountability. Transparency is an essential element of accountability. Investors and the public cannot be assured of accountability for what they don't know.[17]

A. Transparency

Currently, audit firms in the U.S. are not required to disclose to the public information on their QC systems. Calls have arisen for greater transparency by audit firms. The ACAP Report recommended that the larger firms publish an annual report that includes key indicators of audit quality and effectiveness.[18] The PCAOB's Investor Advisory Group (IAG) recommended similar disclosure by audit firms.[19] Audit committees apparently receive this type of information on a routine basis.[20]

Comments on disclosure would, I believe, be particularly valuable as we consider next steps. The Concept Release seeks input on this topic through the following question:

39. Should a future PCAOB QC standard require public disclosure by firms about their QC systems? If so, what should be the nature and timing of such disclosures (e.g., information about the firm's governance structure)? (see also Question 46)

B. Audit Quality Indicators

With respect to contents of firms' disclosure, in my view, investors and the public would benefit from disclosure of objective, reliable and uniform measures of audit quality. Such measures, frequently referred to as Audit Quality Indicators (AQIs), are increasingly appearing in proxy statements in connection with shareholder ratification of audit firms and in academic research examining their relationship with audit quality.[21] Moreover, investors and shareholders rely on these quality indicators in connection with their investment and voting decisions.[22]

The PCAOB has devoted significant attention to this area. In 2015, the PCAOB issued a concept release on AQIs identifying 28 possible AQIs.[23] In 2018, the PCAOB sought comment on this subject in connection with our Strategic Plan.[24] The issue has been discussed by the PCAOB's Standing Advisory Group and Investor Advisory Group.[25] Other regulators around the world are exploring the issue and many audit firms are using the measures.[26] Academic analysis increasingly has shown a relationship between AQIs and audit quality.[27]

We would, in my opinion, benefit from comments on whether AQIs should, as part of the QC standards, be subject to disclosure and the types of AQIs that would be particularly useful.

The following questions address the topic:

21. Should firms be required to establish quantifiable performance measures for the achievement of quality objectives? If so, how should such measures be determined and quantified? (see also Question 46)

46. Should firms be required to report to the Board on their annual evaluations of QC system effectiveness? If so, what should be included in the report? Should firms be required to disclose any performance measures that were important to their conclusion about their QC system's effectiveness? Should firm reports be publicly available? (see also Question 39)

IV. Assessing and Improving the Effectiveness of Audit Firms' QC Systems

A central theme of ISQM 1 is the need for continuous improvement in the QC system. ISQM 1 calls for no less than an annual evaluation. For a review to be effective, however, there needs to be a robust feedback loop that informs firms of areas for improvement. The Concept Release contemplates that firms will receive feedback from a number of sources, including risk assessments, internal monitoring, and inspections by regulators such as the PCAOB.

Missing from the list is the vital role for investors and the public. Investor outreach by audit firms could facilitate the collection of views on market risks and, in turn, drive continual improvement in QC systems. At least three countries have developed audit firm governance codes that call for investor outreach.[28]

With respect to risk assessment, the Concept Release does not specify the types of risks that should be examined. Risks can arise at a market, industry or individual issuer or broker-dealer level, and can include those that create greater incentive to alter earnings. Similarly, with respect to internal monitoring, the Concept Release does not specify the factors that should be considered by firms in their selection of the particular engagements for internal inspection to assess the effectiveness of the QC system. Academic research suggests that the process used to select audit engagements for internal inspection is often predicable, which may impair investor confidence in a firm's internal monitoring.[29]

Comments on ways to strengthen the feedback loop, including the role of investors and the public would, in my opinion, be useful. The questions in the Concept Release on some of these issues include:

20. Should a future PCAOB QC standard specify certain quality risks that must be assessed and responded to by all firms? If so, what should those risks be?

44. Should a future PCAOB QC standard establish requirements for internal inspection selection criteria? Should a future PCAOB QC standard specify minimum or cyclical thresholds for inspections of completed engagements by the firm? If so, what should the threshold(s) be (e.g., one engagement for each engagement partner, and/or the audit of each issuer, broker, and dealer on a specified basis)? Should we require selection of engagements for internal inspection to include either random selection or an element of unpredictability?

45. Should firms be required to perform an annual evaluation of their QC system's effectiveness? If so, should the required evaluation be as of a specified date or for a specified period? How should the date or period be determined?

V. Conclusion

Let me again emphasize the importance of this Concept Release. On first blush, this may appear to be just a matter of "plumbing" for an audit. Quite the contrary, the direction of any future standard concerning quality control over audits has the ability to meaningfully improve audit quality for the benefit of investors and the public.

I would like to end by thanking the PCAOB staff for their hard work that went into this Concept Release. These efforts involved a constant process of revision, something that often required late hours and changes right up until the last moment. In particular, I want to thank, Megan Zietsman, Keith Wilson, Jessica Watts, Linnette Klinedinst, Jennifer Williams, and Karen Wiedemann. This release is our first that uses modern graphic design to enhance readability by the public. In that regard, I want to thank Brandi Boykin and others in our Office of External Affairs for the hours spent designing a new layout.

I want to thank staff at the SEC as well for providing their insights and perspectives on this Concept Release.[30]

Thank you, and I look forward to receiving commenters' thoughts and views on what future PCAOB QC standards should be.

[1] I want to thank Wintana Kiflu, an intern in my office, for the research used in these remarks.

[2] SEC Chairman Clayton repeatedly emphasized that audited financial statements are the bedrock of our financial reporting system. See, e.g., SEC Chairman Jay Clayton, Statement on Appointment of New PCAOB Board Members (December 12, 2017), available at https://www.sec.gov/news/public-statement/clayton-2017-12-12.

[3] SEC Chief Accountant Sagar Teotia noted that "[p]reparers, audit committees, auditors, standard setters, regulators, and others all play different but interconnected roles in the process designed to provide high-quality financial information to investors. Ultimately, the strength of our financial reporting system relies on the rigor applied to each of its component parts." See Statement in Connection with the 2019 AICPA Conference on Current SEC and PCAOB Developments (December 9, 2019), available at https://www.sec.gov/news/speech/teotia-speech-2019-aicpa-conference#.

[4] Congress was aware of the importance of these standards. The Sarbanes-Oxley Act specifically directed the PCAOB to establish quality control standards "as may be necessary or appropriate in the public interest or for the protection of investors." Section 103(a)(1) of the Sarbanes-Oxley Act, 15 U.S.C. 7213(a)(1).

[5] See Exposure Draft, International Standard on Quality Management 1, Quality Management for firms that Perform Audit or Reviews of Financial Statements, or Other Assurance or Related Services Engagements, available at https://www.iaasb.org/publications-resources/exposure-draft-international-standard-quality-management-1-quality See also https://www.ifac.org/system/files/publications/files/IAASB-Proposed-ISQM-1-Explanatory-Memorandum.pdf

[6] See Question 8 in the Concept Release ("Would the objective of a quality management system provided in Proposed ISQM 1 be an appropriate objective for a QC system under PCAOB standards? Are there additional objectives that a quality control system should achieve?").

[7] See Question 30 in the Concept Release ("How should a future PCAOB QC standard expressly address firms' actions to support the fulfillment of the auditor's responsibilities under Section 10A of the Exchange Act of 1934, including:

a. With respect to fraud?

b. With respect to other illegal acts?

c. With respect to going concern consideration?").

[8] See Question 26 in the Concept Release ("Should a future PCAOB QC standard expressly address firm responsibilities and actions to support and monitor the appropriate application of professional skepticism and significant judgments made by engagement teams? If so, how?").

[9] See Question 11 in the Concept Release ("Should a future PCAOB QC standard have additional or alternative requirements for firms that audit brokers and dealers? If so, what?").

[10] The American Institute of Certified Public Accountants (AICPA) drafted the first quality control standard (voluntary) for member firms in response to increasing public and Congressional interest in auditing's role in the capital markets (October 1976). See also Audit Quality: The Professions Program, the Public Oversight Board (1984).

[13] See U.S. Treasury Department's Advisory Committee on the Auditing Profession, led by co-chairs Arthur Levitt, Jr. and Donald T. Nicolaisen, Final Report (October 2008), available at https://www.treasury.gov/about/organizational-structure/offices/Documents/final-report.pdf.

[14] See KPMG Appoints Linda L. Addison as Independent Director to Serve on Its U.S. Board (November 12, 2018), available at https://home.kpmg/us/en/home/media/press-releases/2018/11/kpmg-appoints-linda-l-addison-as-independent-director-to-serve-on-its-us-board.html. Also see https://www.pwc.com/us/en/about-us/our-board.html.

[15] See Grant Thornton names three executives to Audit Quality Advisory Council (January 30, 2019), available at https://www.grantthornton.com/library/press-releases/2019/january/GT-names-three-executives-audit-quality-advisory-council.aspx. See also https://www.ey.com/en_us/assurance/independent-audit-quality-committee-strengthens-our-focus-on-audit-quality (Independent Audit Quality Committee); and Deloitte's US Audit Quality Report (2018), p. 3, available at https://www2.deloitte.com/content/dam/Deloitte/us/Documents/noindex/us-regulatory-deloitte-touche-llp-audit-quality-report-2018.pdf (Audit Quality Advisory Council).

[16] See U.K. (Audit Firm Governance Code), Japan (Principles for Effective Management of Audit Firms), and Netherlands (Code of Audit Firms of the Oversight and Transparency: A code for audit firms holding a PIE license).

[17] See J. Robert Brown, Jr., "Grading the PCAOB: Transparency, Accountability, and Investor Protection," Remarks at the Fall Conference of the Council of Institutional Investors, Sept. 17, 2019, available at https://www.u0ai.cn/News/Speech/Pages/Brown-Grading-the-PCAOB-Transparency,-Accountability-and-Investor-Protection.aspx.

[18] See Recommendation 7 of U.S. Treasury Department's Advisory Committee on the Auditing Profession, led by co-chairs Arthur Levitt, Jr. and Donald T. Nicolaisen, Final Report (October 2008), available at https://www.treasury.gov/about/organizational-structure/offices/Documents/final-report.pdf.

[19] See PCAOB Investor Advisory Group, Subcommittee on Global Networks and Audit Firm Governance, p. 12, available at https://www.u0ai.cn/News/Events/Documents/03162011_IAGMeeting/Subcommittee_Memo.pdf (proposal by the IAG called for disclosure of "a description of the auditing firm's quality control system both in the U.S. and globally and a statement by firm-management on its effectiveness").

[20] The NYSE listing standards require audit committees to evaluate the auditor's performance. Consequently, audit committees of NYSE-listed companies must obtain and review a report describing the firm's quality controls and any issues noted by internal or external reviewers. See NYSE Listing Standard, available at https://nyseguide.srorules.com/listed-company-manual/document?treeNodeId=csh-da-filter!WKUS-TAL-DOCS-PHC-%7B0588BF4A-D3B5-4B91-94EA-BE9F17057DF0%7D--WKUS_TAL_5667%23teid-75 (charters of listed companies must require the audit committee "[a]t least annually, [to] obtain and review a report by the independent auditor describing: the firm's internal quality control procedures; any material issues raised by the most recent internal quality-control review, or peer review, of the firm, or by any inquiry or investigation by governmental or professional authorities, within the preceding five years, respecting one or more independent audits carried out by the firm, and any steps taken to deal with any such issues.").

[21] See J. Robert Brown, Jr., "Audit Committees, Audit Quality, and Investor Protection," Remarks at Commissione Nazionale per le Società e la Borsa, Sept. 27, 2019, available at https://www.u0ai.cn/News/Speech/Pages/Brown-Audit-Committees-Audit-Quality-Investor-Protection.aspx

[22] See J. Owen Brown and Velina K. Popova, How Do Investors Respond to Disclosure of Audit Quality Indicators?, Auditing: A Journal of Practice & Theory, November 2019.

[23] See Concept Release on Audit Quality Indicators, PCAOB Release No. 2015-005, July 1, 2015, available at https://www.u0ai.cn/Rulemaking/Docket%20041/Release_2015_005.pdf.

[24] See Comments on PCAOB Draft Strategic Plan 2018-2022, available at https://www.u0ai.cn/About/Administration/Pages/Comments-Draft-Strategic-Plan-2018-2022.aspx.

[25] See PCAOB Investor Advisory Group (IAG) meeting, available at https://www.u0ai.cn/Standards/SAG/Pages/SAGMeetingArchive.aspx (topic discussed at five meetings); and https://www.u0ai.cn/About/Advisory/Pages/IAGMeetingArchive.aspx (topic discussed at two meetings).

[26] See Federation of European Accountants, "Overview of Quality Indicators Initiative", available at https://www.accountancyeurope.eu/wp-content/uploads/1607_Update_of_Overview_of_AQIs.pdf

[27] See Aobdia, Daniel and Choudhary, Preeti and Newberger, Noah, The Economics of Audit Production: What Matters for Audit Quality? (July 24, 2019), available at https://ssrn.com/abstract=3300277 or http://dx.doi.org/10.2139/ssrn.3300277.

[28] See U.K. (Audit Firm Governance Code), Japan (Principles for Effective Management of Audit Firms), and Netherlands (Code of Audit Firms of the Oversight and Transparency: A code for audit firms holding a PIE license).

[29] See Daniel Aobdia & Reining Petacchi, Working Paper: Do Audit Firms' Internal Inspection Programs Have Teeth? Evidence from the U.S. Operations of the Largest Audit Firms (July 12, 2019), available at https://www.u0ai.cn/EconomicAndRiskAnalysis/WorkingPapers/Pages/Working-Paper-Do-Audit-Firms'-Internal-Inspection-Programs-Have-Teeth--Evidence-from-the-U-S--Operations-of-the-Largest-Aud.aspx.

[30] Specifically, I want to thank Marc Panucci, Ryan Wolfe, Louis Collins, Godfrey Murangt, Sheena Lam, Giles Cohen, and Peggy Kim for their involvement.