At the inaugural meeting of the PCAOB’s Investor Advisory Group, members discussed lessons learned from the financial crisis and the establishment of the PCAOB’s Financial Fraud Resource Center. The Fraud Center is being established in response to a recommendation from the Treasury Department’s Advisory Committee on the Auditing Profession (“ACAP”) and its primary objectives are to maintain and develop information related to financial reporting fraud. Members also discussed issues related to transparency of audit firms and the audit process.

Regarding the PCAOB’s Fraud Center, Ann Yerger of the Council of Institutional Investors believes that its establishment is critical and that it should be owned by the Board, rather than the auditing profession, a recommendation with which members of ACAP agreed. She also advocated that the new Fraud Center should not simply be a “library of fraud,” but should also address the potential for future frauds.

Anne Simpson of CalPERS, on the other hand, did not see the Fraud Center as a priority for the Board. In her view, the banality of the run-up to the financial crisis was more troubling. Auditors generally were not committing outright fraud, she said, and the behavior of auditors was better than that of other culprits such as credit rating agencies. Instead of fraud, Simpson believes the PCAOB should concentrate on other issues, such as transparency, audit standards that do not reveal all elements of a transaction, internal controls and the role of boards of directors and why boards were in the dark regarding many activities that led to the financial crisis. She acknowledged the importance of tackling fraud, but urged the Board to also focus on issues of transparency and accountability.

Former SEC Chief Accountant Lynn Turner also contrasted the activities that precipitated the recent financial crisis with past crises, particularly those of the early 2000s. He noted that compared to Enron and WorldCom, auditors were not among the chief transgressors. The problem was not with misstatements, but rather disclosure issues, he said. He supported the creation of a Fraud Center but with the idea of dissecting the cases to find out not only what went wrong, but also how to improve practices in the future.

Brandon Becker of TIAA-CREF argued that calling the new entity a fraud center would be a mistake because such a name would limit its scope to fraud. He said that if regulators only look at instances of fraud, they will miss situations where good people followed the right rules and still went off the cliff. Sometimes auditors follow the correct procedures, but the procedures do not always work, he said. Peter Nachtwey of The Carlyle Group echoed this sentiment, noting that the securitization of mortgages led to well-meaning people cutting corners four or five times in the process at different banks, compared to the S&L crisis where problems arose because of activities in the same place.

Some members preferred that the Board focus its attention on potential frauds, rather than looking at the past. Norman Harrison of Breeden Capital Management noted that regulators do a good job of solving the last crime, but situations like Enron and WorldCom will not happen again, and the PCAOB should try to identify situations that lead to new risks. Bonnie Hill of Hill Enterprises agreed that the next big fraud is not going to be one that has already been perpetrated. Joseph Carcello of the University of Tennessee disagreed, however. He said that the “flavor” of fraud changes, but the past does repeat itself. He gave credit to the work of PCAOB staff, noting that auditors were not the main culprits in the most recent financial crisis. Becker also noted that one of the most notorious recent frauds, the Madoff scandal, was simply a new twist on a very old fraud, the Ponzi scheme.

Carcello suggested that the Fraud Center replicate the National Transportation Safety Board’s role in investigating major accidents for major frauds. Under this model, the issue of obtaining company data for the purposes of investigation only could alleviate concerns about confidential information being released to the public. In addition, the Fraud Center should act with the objective of informing the Board about standard setting, he said.

Michael Head of TD AMERITRADE said that Madoff’s scheme showed that investor trust in broker-dealers is misplaced. He noted that although the PCAOB requires nonpublic broker-dealers to register, they are not subject to inspection by the Board. According to Head, the average retail investor is not aware of the gap in oversight. He also expressed support for subjecting custodial broker-dealers to the SEC’s custody rules.

IAG members also discussed transparency and governance of audit firms and the need for greater transparency in the audit process. On the issue of audit firm transparency and governance, Nachtwey said the Board should focus on three issues: client acceptance, global networks and insurance. Regarding client acceptance, he noted as an example that Arthur Andersen should not have kept Enron as a client, an action that ultimately led to the firm’s demise. He also advocated that audit firms have a stream of different clients for revenue rather than reliance on a few large clients. He said that as firms grow larger and more global, attention must be paid to the quality of the their affiliates. On the issue of insurance, there is not as much available now compared to when there were more big firms, he said.

Meredith Williams of the Colorado Public Employees Retirement Association suggested that, because of the inherent conflict in paying for a particular service, companies should rotate their auditors every five years. He acknowledged that such a requirement would come at additional cost, but because it would minimize conflicts of interest, the value of rotation would outweigh the cost. Others disagreed with this suggestion, however. Hill said that whenever a public company changes auditors, the market perception is to ask what is wrong.

Damon Silvers of the AFL-CIO also agreed with this concern and noted that audit business is concentrated in the “Big Four” firms, an obstacle to creating a competitive market. Nachtwey was also skeptical that a new firm would be able to get up to speed every five years, especially with very large companies.

Others were more receptive to the idea of firm rotation, however. Turner said the negative connotation in the market that goes along with changing audit firms would be lessened or eliminated if rotation was mandatory because the market would be aware that a change was coming. Simpson noted that CalPERS is required by state law to rotate its auditor every five years.

Some members of the IAG also advocated requiring the audit partner’s signature on the audit report, which was met with resistance among audit firms when the PCAOB proposed such a requirement. Yerger spoke in favor of the proposal, comparing it to officer certification of financial statements. Robert Tarola of Right Advisory LLC was more skeptical of this suggestion, describing the certification as going much farther in scope for officers than for auditors, particularly for issues of fraud and internal controls.

Members discussed the possibility of requiring audit firms to make public their financial statements. Turner said the information in the financial statements would help improve transparency because it contains relevant data with regard to the firm’s liquidity and leverage, and how the firm’s resources are being invested, such as technology and personnel. Yerger said, at the very least, the PCAOB should be able to review the financial statements in order to do its job well. She also said that audit committees should have access to an audit firm’s financial statements and supported the release of a truncated report to the public that would disclose information such as firm governance, affiliate networks and audit quality indicators.

Kelvin Blake spoke in favor of more transparency in audit firms, but cautioned against going the corporate route and requiring firms to disclose all the information that public companies must disclose. He noted that the duty of a corporation is to its shareholders to maximize profit, and corporatization of audit firms in this manner could result in audits of lesser quality.

On the issue of transparency in the audit process, members advocated more useful audit reports. Harrison noted that, in its current form, the audit report is really more of a letter that tends to be highly formulaic. An audit report should be a narrative, he said, with information about how the audit was staffed, what kind of expertise the staff had and what the principal risks were. He also favored a discussion of issues that did not quite rise to the level of material weakness, but still raised the concern of auditors.

George Sauter of the Vanguard Group compared the audit report to a pass/fail situation where there is no indication of how close or far away a company is from failing an audit. He said that there should be a range rather than a simple good or bad opinion. Blake also favored expanding the audit report with more plain English geared toward the average investor and disclosure of quantitative and qualitative indicators that led the auditor to its opinion.

Silvers proposed that as part of the audit report, auditors should disclose a certain number of issues that the auditor felt were the most “debatable” but were not necessarily material. He said that investors would want to know about these issues, even if they did not meet the technical definition of material weakness.