Written Statement of Cindy Fornelli, PCAOB Public Meeting on Auditor Independence and Audit Firm Rotation, Houston, TX
Monday, October 15, 2012
Public Company Accounting Oversight Board 1666 K Street
Re: CAQ Written Statement for October 18, 2012 PCAOB Public Meeting on Auditor Independence and Audit Firm Rotation
Dear Board Members:
The Center for Audit Quality (CAQ) is an autonomous public policy organization dedicated to enhancing investor confidence and public trust in the global capital markets. The CAQ fosters high quality performance by public company auditors, convenes and collaborates with other stakeholders to advance the discussion of critical issues requiring action and intervention, and advocates policies and standards that promote public company auditors’ objectivity, effectiveness, and responsiveness to dynamic market conditions. Based in Washington, D.C., the CAQ is affiliated with the American Institute of Certified Public Accountants.
The CAQ welcomes the opportunity to participate in the PCAOB’s public meeting on auditor independence and audit firm rotation on October 18, 2012. These remarks represent the observations of the CAQ, but not necessarily the views of any specific firm, individual, or CAQ Governing Board member.
Our views on the PCAOB’s Concept Release, Auditor Independence and Audit Firm Rotation (Concept Release), are contained in our remarks1 at the March 21- 22, 2012 PCAOB Public meeting, as well as the CAQ’s December 14, 2011 comment letter2 on the Concept Release. The CAQ has carefully considered the comments of stakeholders on this important topic, and we believe many constructive ideas and actions have emerged from the public dialogue.
I would like to provide you with an update on several initiatives and developments that we believe are relevant for consideration of how to further enhance audit quality, building on many of the constructive ideas that have emerged from the ongoing public dialogue. Before turning to these developments, allow me to emphasize that the CAQ and its member firms remain wholly committed to the continuous improvement of audit quality. Auditor independence, objectivity and professional skepticism are key attributes of audit quality. Moreover, the CAQ shares with the PCAOB and others the commitment to enhancing investor confidence and public trust in the profession. We believe that addressing the critical topics of independence, objectivity and skepticism should be looked at in the broader context of audit quality. Consequently, in my update that follows, we focus not only on efforts to enhance independence, objectivity and skepticism, but also efforts and initiatives to enhance audit quality.
As we stated in our comment letter and March statement, we believe it is important to observe that the Sarbanes-Oxley Act and related reforms have contributed significantly to enhancing the quality and independence of public company financial statement audits. Without a doubt, the formation of the PCAOB to oversee the public company audit profession and the PCAOB’s programs and activities are a key driver of these improvements. The profession has embraced these reforms, and believes that they have been highly effective in improving audit quality in general, including independence, objectivity and professional skepticism more specifically.
As a profession, we also believe that the improvements of the past decade should not be cause for complacency. Consequently, firms have continued to invest in ongoing efforts, described below, and in collaboration with the CAQ and others, are pursuing a number of important new profession-wide initiatives.
Profession Efforts to Support or Improve Audit Quality
The role of the audit profession in the capital markets is essential, and expectations of auditor performance are understandably very high. Firms continue to make significant investments in their audit practices to increase audit quality. While efforts at each firm vary, initiatives include improving audit methodologies, enhancing the firm’s system of quality control, and supporting the audit committee’s oversight of the auditor. For example:
Consultation Process. Many firms have a consultation process, which typically includes a regional or national office to advise engagement teams on matters involving significant, unusual or complex accounting and auditing issues. Firms are making investments in additional quality-focused resources to consult with engagement teams on difficult and judgmental accounting and auditing matters, fostering consistency throughout the practice and enhancing the objectivity with which decisions are made.
Performance Evaluations and Compensation Determinations that Support Audit Quality. Firms have policies and procedures in place for evaluating, compensating, and otherwise rewarding professionals for high quality audit execution. Firms also have disciplinary frameworks for noncompliance with professional standards that include outcomes ranging from financial consequences and other remedial actions, to termination of employment.
Internal Inspection Programs. Firms monitor and evaluate their own practice through internal inspections and review programs. These internal inspections, along with PCAOB inspections and other reviews, help a firm to identify areas where audit quality can be improved. As part of their on-going commitment to enhance audit quality, firms are devoting additional resources to the internal inspection process, as well as the process of using inspection findings in an overall feedback loop to drive improvements in underlying audit performance.
Remediation of Quality Concerns. Firms respond when quality control issues are identified — whether through internal or PCAOB inspections, peer reviews, or other quality inputs — and consider the causes for those issues and whether they are isolated instances or part of a trend. This enables firms to implement changes that enhance the quality of future audits. Thus, firms are engaged in a continuous process of assessing, improving and reassessing their quality control processes, to address changing circumstances and emerging issues.
- Continuing Training and Development of Professionals. As licensed professionals, auditors must continue their training to meet continuing professional education requirements set by state boards of accountancy on an ongoing basis. Firms also provide additional training for their professionals specific to the performance of high quality audits, including technical training and training on key attributes, such as professional judgment and professional skepticism. Firms have been supplementing their training and development programs to bolster auditor performance in areas most commonly identified for improvement through inspections and reviews.
- Audit Policies, Procedures, Tools and Resources. Firms maintain policies and procedures governing their auditing practices, and those policies and procedures are regularly updated to address new professional developments, emerging audit issues and feedback from inspections and other quality reviews. Firms also often drive consistency in audit quality through an audit methodology that is developed centrally and supported by manuals, software tools, or other forms of standardized documentation, and industry or specific subject matter guidance materials. Some firms also have made or are making additional investments in tools, training and methodology improvements to enhance audit procedures that focus on audit areas that are proving to be the most challenging, such as auditing management estimates, exercising professional skepticism, and auditing internal controls.
This overview of key investments in audit quality by the firms serves to demonstrate the profession’s significant, sincere and ongoing commitment to audit quality and the promotion of independence, objectivity and skepticism.
Given the important role of public company audits in the capital markets, investors and other stakeholders would benefit by knowing more about how firms manage and promote audit quality, and the extent to which they demand that their professionals show they promote the performance of audits in an independent, objective and skeptical manner. The CAQ supports transparency of information regarding the structure, governance and quality control systems firms have in place to support their work. Although their formats and precise elements may vary, a number of firms provide disclosure about their quality control systems beyond what is required in PCAOB registration and annual reports, or the transparency reports some firms are required to file in the European Union.3 Additionally, extensive information on systems of audit quality control are provided to NYSE-listed audit engagements, pursuant to applicable NYSE rules.
Accordingly, as a leading practice, we encourage the largest firms to provide to all of their public audit engagements and to the public at large, information about their efforts to improve audit quality, including actions being taken to enhance their quality control systems. These disclosures could be made by disseminating an expanded transparency report, a separate audit quality report, or by other means. Over time, we hope more firms will adopt this practice.
Specific Efforts to Support or Enhance Audit Quality
In addition to the efforts of many individual firms summarized above, the profession, through the CAQ, has undertaken several specific initiatives to support or enhance audit quality since the PCAOB’s public roundtable last March, in many instances working in close collaboration with other organizations that have a stake in audit quality and the attendant traits of independence, objectivity and professional skepticism. These recent initiatives are outlined below, and where applicable, we have appended the corresponding work product to this statement.
Supporting Audit Committees
The audit committee serves an essential role in the corporate governance framework by protecting investors through its oversight of a company’s financial reporting process, including the hiring and oversight of the external auditor. As envisioned by the Sarbanes-Oxley Act, the independence of the audit committee from management is a crucial element of the audit quality framework that promotes auditor independence, objectivity and professional skepticism. We believe that open and effective two-way communication is important to the audit committee’s oversight of the auditor, and improving this oversight fosters quality audits. To this end, the CAQ has undertaken the following initiatives to support auditor-audit committee communications:
Webcast on Communications with Audit Committees. On August 15, 2012, the PCAOB adopted Auditing Standard No. 16 (AS 16), which, once approved by the SEC, will require enhanced communications between auditors and audit committees regarding significant audit and financial statement matters. Throughout the comment process, the CAQ expressed strong support for the objective of the new standard, offered constructive suggestions, and urged its final adoption. The CAQ is hosting a public webcast on October 24, to help educate and inform auditors and audit committee members on the requirements of AS 16 and to discuss leading practices in the area of audit committee communications. (Appendix A)
Auditor-Audit Committee Communications Practice Aid. In response to the PCAOB’s August 1, 2012 Release on its Inspection Process aimed at audit committees, the CAQ developed a Practice Aid, issued earlier this month, which encourages firms to engage in proactive communications with audit committees on information related to PCAOB and internal inspection findings regarding the company’s audit engagement, and the steps the firm is taking to improve its system of quality control. In alignment with the communication objectives of the PCAOB’s Release, the profession supports engaging in open and candid conversations aimed at providing the information audit committees need to continuously enhance their oversight of the independent audit. This topic also will be discussed during the October 24 webcast. (Appendix B)
Auditor Annual Assessment Tool. Audit committees hire, compensate and oversee the external auditor, and they must make a recommendation to the board of directors whether to retain the auditor each year. Performing an annual assessment of the auditor’s performance obviously should be completed before making that recommendation. To assist audit committees in this independent oversight function, and foster greater consistency, six organizations4 that provide educational and other support to the audit committee community developed an auditor assessment and communication tool for use by their audit committee membership. The CAQ supports this collaborative effort. (Appendix C)
Improving Professional Skepticism
As part of an ongoing effort to improve professional skepticism, the CAQ continues to engage constructively in a collaborative partnership we initiated in 20105 to promote the deterrence and detection of financial reporting fraud across the financial reporting supply chain. Projects are focused on advancing the understanding of conditions that lead to fraud and promoting additional efforts to develop and maintain an appropriately skeptical mindset by independent external auditors, internal auditors, preparers and audit committee members. The collaborative partners are developing educational programs, hosting forums for constructive discussion, and generally drawing attention and focus to this important topic. We also are in the process of developing a dedicated website to provide access to the tools and resources we develop, along with links to other resources aimed at deterring and detecting financial reporting fraud.
Skepticism Webinars. In early October, the collaboration released the first in a series of five webinars focusing on skepticism. The series is designed to enhance the ability of members of the financial reporting supply chain to develop and maintain an environment and mindset that promotes professional skepticism. The remaining webinars will be released throughout October and November. (Appendix D)
Case Studies and Teaching Tools. Deterrence and detection of financial reporting fraud across the financial reporting chain can be one of the more difficult challenges facing external auditors, internal auditors, financial executives, and audit committee members. This month, the collaborative partners will release the first in a series of case studies – hypothetical fraud scenarios – that are designed to augment the understanding of conditions that contribute to fraud, and specifically demonstrate how appropriate professional skepticism in those circumstances can minimize the risk of fraud. The audiences for these case studies are internal and external auditors, audit committee members, and financial executives. We also expect the case studies to be used in undergraduate and graduate courses.
Outreach and Education. In an effort to help build awareness and capability, the CAQ and our collaborative partners have led a number of discussions on fraud deterrence and detection to examine the importance of an ethical culture and setting the appropriate tone at the top, the need for auditors and other members of the financial reporting supply chain to have a skeptical mindset, and the importance of good communications between and across the supply chain. We have convened these discussions at annual conferences of the NACD, The IIA and FEI, as well as at the Association of Certified Fraud Examiners, the Ethics and Compliance Officers’ Association, AICPA’s Audit Committee Forum, and the American Accounting Association. (Appendix E)
Support for Academic Research
The CAQ is in its fourth year of providing research grants to academics around the world for work that will augment the available audit-related academic literature and have practical applications to the work of independent auditors. The requests for proposals solicit research on a variety of topics of interest to stakeholders in the financial reporting supply chain that aim to improve audit quality. Of particular relevance to the discussion on improving skepticism, we have awarded the following grants:
“Training Auditors in Professional Skepticism,” by David Plumlee and Brett Rixom, University of Utah, and Andrew Rosman, University of Connecticut
- “Enhancing Professional Skepticism,” by Ken Trotman, University of New South Wales, Australia
The audit profession has sought to learn more about how auditors can enhance their professional skepticism in situations where they must audit in increasingly complex environments. The following grants have been funded to examine these issues:
“Does Context Influence Auditors’ Fair Value Judgments?” by Vicky Hoffman, University of Pittsburgh, Christine Earley, Providence College, and Jennifer Joe, Georgia State University
“A Field Investigation of Auditing Fair Values” by Jean Bedard and Nate Cannon, Bentley University
“Professional Skepticism and Auditing Fair Value: Effects of Task Structure, Time Pressure and Procedure Framing” by Mark Nelson and Eldar Maksymov, Cornell University
- “Learning More about Auditing Estimates Including Fair Value Measurements” by Mark Taylor and Yi-Jing Wu, Case Western Reserve University, and Steven M. Glover, Brigham Young University.
A full list of grants awarded is included in Appendix F.
Continued Engagement in the Dialogue: Mandatory Retendering
In addition to specific actions to promote audit quality and auditor independence, objectivity and skepticism, the CAQ has continued to engage actively and constructively in the dialogue regarding the issues raised in the context of the Concept Release. For example, on July 13, 2012, we submitted a comment letter to the United Kingdom’s Financial Reporting Council (FRC) regarding proposed revisions to the UK Corporate Governance Code.6 The letter outlines our concerns with the risks of mandatory audit firm retendering, which we believe carries with it most of the unintended consequences of mandatory audit firm rotation, including an
erosion of the authority and responsibility of the audit committee to hire, oversee and determine whether to retain the independent auditor. Mandatory retendering also would force auditors to continually market audit services, creating a “sales culture” at firms which, along with other negative consequences, would serve as a distraction for audit professionals, audit committees, and company management. These risks are especially concerning because there is no established benefit to audit quality of mandatory retendering.
Our letter to the FRC also explained that a “comply or explain” provision would do little to limit the negative effects of mandatory retendering in the United States and would undermine the authority and corporate governance function of audit committees. We anticipate that, in the United States, any determination not to retender under a “comply or explain” regime likely would be interpreted as non-compliance. As a result, should a “comply or explain” requirement become the standard in the United States, there would be unremitting pressure for an audit committee to retender the audit, regardless of whether it was satisfied with its existing auditor, effectively resulting in mandatory retendering, and leading to a standardization and commoditization of audits to the detriment of quality, expertise, motivation and innovation.
The CAQ appreciates the opportunity to be a part of the PCAOB’s examination of ideas and actions to enhance auditor independence, objectivity and professional skepticism. We believe these professional traits are just as important as an auditor’s technical competence, and strongly agree with the objective of maintaining and furthering these attributes. As illustrated by just some of the many efforts discussed above, the auditing profession is committed to working with the PCAOB and all other stakeholders to continually improve audit quality and enhance the confidence in audited financial statements.
We commend the PCAOB’s broad outreach to financial statement users, audit committee members, preparers, auditors, academics, and others to further inform thinking around the ideas set forth in the Concept Release, as well as to identify other means to enhance audit quality and auditor independence, objectivity, and professional skepticism. We believe the responses received from a broad cross-section of stakeholders have demonstrated that mandatory audit firm rotation and mandatory tendering of audit engagements do not have support, and would present significant risks to audit quality. However, the public dialogue has surfaced numerous other ideas and prompted constructive actions that we believe will contribute directly to enhanced auditor independence, objectivity, and professional skepticism, and to overall audit quality. As the PCAOB continues to solicit feedback on its Concept Release, we encourage you to focus the ongoing global dialogue on consideration of these alternative ideas and actions that we believe have a direct and demonstrable nexus to audit quality.
Cynthia M. Fornelli
Center for Audit Quality