(The article featured below is a selection from PCAOB Reporter, which is available to subscribers of that publication.)

Standing Advisory Group Discusses Auditing Issues During Economic Crisis

At a meeting of the Standing Advisory Group of the PCAOB, members offered their views on audit considerations in the current economic environment, which Office of Research and Analysis Director Marty Baumann described as "one of the most challenging auditing environments" he could remember. The PCAOB discussion paper for the event identified several areas which may require heightened audit emphasis given the economic downturn, including issues involving fair value measurements, other than temporary impairment, going concern, credit derivatives, pensions and inventory. SAG members were asked for their views on the PCAOB's list and to offer additional suggestions. Members also discussed whether additional guidance from the Board would be helpful to auditors.

Joseph Carcello of the University of Tennessee proposed additions to the PCAOB's list of emphasized areas, including contingencies such as lawsuits, stock-based compensation and internal control issues. He encouraged auditors to pay closer attention to the disclosures made in Management's Discussion and Analysis, 10-Ks and proxy statements.

Greg Jonas of Moody's echoed this sentiment, noting that even though MD&A is not being audited, reading it can give auditors a more complete story regarding liquidity. Jonas also suggested other areas of emphasis. One area he cited was fraud risk, since in the current economic climate, there is pressure on management to "cook the books." He also noted that customers may not be able to conduct transactions in cash, which can raise issues where auditing rules do not allow revenue recognition. Contractual triggers can also pose a problem, he said, warning that "little bombs" might go off from small print provisions in contracts.

Of the areas listed by the PCAOB, Jonas said that going concern issues were among the most important. According to Jonas, auditors are not good at flagging when going concern troubles might exist because the market has been trained to see the failure of the company "as a done deal." Too often, he said, auditors are reluctant to flag going concern factors until bankruptcy is almost certain, resulting in a "self-fulfilling prophecy." He commented that Board guidance on going concern issues could be helpful to auditors.

Former SEC Chief Accountant Lynn Turner agreed with other SAG members that auditors should consider entire documents and read them "with integrity." He said that if an auditor notices questionable issues in MD&A, the auditor should alert the audit committee. Chuck Noski, former vice chairman of the board at AT&T, urged auditors to "look beyond the balance sheet" and to consider second-factor issues. He noted that the faltering economy has impacted many sectors and that auditors should take into consideration how the downturn has affected a company's distributors, for example.

On the issue of possible new PCAOB guidance, Richard Dietrich of Ohio State University questioned whether the audience for new guidance should be auditors. In his opinion, auditors should be thinking about the PCAOB's areas for heightened scrutiny every year, not just when the economy has turned sour. He suggested instead that the Board consider clients and investors as the target audience for new guidance. He also expressed concern that there is downward pressure on audit fees at a time when auditor workload may increase dramatically.

David Becker of Cleary Gottlieb offered four general purposes that guidance might serve and that the Board should keep in mind when formulating any new guidance. The first is to clear up ambiguity. The second is to remind auditors of their duties. The third he described as a kind of "finger wagging reminder" that auditors need to remember to complete specific tasks. The last purpose, he said, can "strengthen the hand" of auditors in "internal guerrilla warfare with management." This would allow auditors to agree in theory with what management was asking them to do, but also give them ammunition to point to PCAOB guidance to help talk management out of questionable practices, in his opinion. Sam Ranzilla of KPMG took issue with the last item, saying that auditors should be able to explain to clients why they are taking a certain position without having to resort to using the "stick" of PCAOB guidance.

John Kellas of the International Auditing and Assurance Standards Board warned against issuing guidance just for the sake of doing so, noting that "there is a lot of guidance floating about." He also urged the Board to keep consistency in mind when formulating new guidance, particularly with regard to fair value and international accounting standards. He said that it would be detrimental for all auditors if regulatory bodies end up confusing those they intended to help. Tom Linsmeier of FASB noted that FASB tries to issue guidance using the identical words of its international counterparts. He said that FASB also wishes to avoid the "political arbitrage" that would result from a "race to the bottom" in auditing standards.

Treasury's Audit Quality Recommendation

The SAG members also discussed the feasibility of developing key indicators of audit quality and effectiveness. The discussion was held after a recommendation by the Department of the Treasury's Advisory Committee on the Auditing Profession, which released its final report on October 6, 2008. Richard Fleck, Chair of the Auditing Practices Board of the United Kingdom's Financial Reporting Council, gave a presentation detailing his experience in formulating a framework for audit quality in the U.K. Fleck said that usage of the phrase "audit failure" had become too commonplace in the U.K. and was frequently used inappropriately to describe issues revolving around financial statements and external and intervening events which really did not merit the term "audit failure."

This environment, Fleck said, led to a discussion paper that listed several drivers of audit quality: audit firm culture, staff skills and personal qualities, effectiveness of the audit process and the reliability and usefulness of audit reporting. He noted that the project did not try to find ways of measuring these drivers. However, it was clear that measurement could be achieved in some areas such as the structure and experience of the audit firm. Specifically, he mentioned whether there were enough experienced people at a firm to do the bulk of the work and whether there were enough experienced mentors to guide junior staff members.

Damon Silvers of the AFL-CIO, who in addition to being a SAG member was also chair of the Concentration and Competition Subcommittee for the Treasury Department's report, discussed how his subcommittee came to recommend that the PCAOB examine the feasibility of developing audit quality indicators. Silvers noted that an anonymous comment letter from a former auditor sent to the subcommittee had driven the subcommittee's recommendation. Although Silvers stressed that the subcommittee did not want to impose what the metrics of any audit quality framework should be, he suggested three models to consider.

The first model he suggested was looking at firm-level data, such as the number of restatements across an entire audit firm. A second model involves examining engagement-level disclosure, which he noted could also lead to firm-level data. Silvers' third model suggested interaction between the PCAOB and firms to shape disclosure, similar to 1934 Act disclosures to the SEC.

One of the questions posed to the panelists was whether a definition of audit quality is a prerequisite for developing key audit quality indicators. Several SAG members said that a definition is necessary. Greg Jonas of Moody's said that he did not think that the Board could avoid defining audit quality. "How can you get somewhere if you don't know where you're going?" he asked. FASB's Tom Linsmeier agreed, stressing that the Board would "absolutely have to define a measure of audit quality." Otherwise, he said, any independent variables would amount to "a whim." Joseph Carcello of the University of Tennessee was not quite as adamant about defining audit quality, saying that coming up with a perfect definition should not stop the Board from going forward.

Chuck Noski, former vice chairman of the board at AT&T, suggested that the PCAOB look to its own examinations process in formulating key indicators of audit quality. Noski said that PCAOB staff, in the course of its examinations, has identified issues unique to particular industries that would be helpful in determining qualitative and not just quantitative measures of audit quality. Staff expertise could help fill an "information void" for making judgments about particular firms, he said.

Linsmeier of FASB echoed Noski's sentiment about using PCAOB experience in this area. He noted that under the inspections program, the PCAOB staff must have factors that drive inspections and that it would be disadvantageous just to look at academic research on the subject of audit quality because such studies are constrained by publicly available information. The PCAOB has access to nonpublic information and is better suited to be the starting point for devising audit quality indicators, he said. He urged the Board to do an internal study and to make public the results that reveal what metrics are important in determining audit quality.

Audit Quality Indicators

On the second day of the Standing Advisory Group's fall meeting, members reported on the results of the previous day's break-out sessions on the feasibility of developing key indicators of audit quality and effectiveness. The Treasury Department's Advisory Committee on the Auditing Profession recommended that the PCAOB consider the feasibility of developing key indicators of audit quality and require audit firms to publicly disclose the indicators. In the break-out sessions, SAG members considered the key indicators from the point of view of investors, issuers and auditors.

Ted White, the chief operating officer of Knight Vinke Asset Management LLC, said his group reached a general agreement that a definition of audit quality is important but it was unable to reach a conclusion on the definition. The group also concluded that a definition did not have to be in place before the PCAOB can act on the initiative.

The group supported the idea of allowing firms to provide their own statements of quality, but also to require a structured formal report based on the data measured by the PCAOB. The group liked the samples of factors that the PCAOB provided in a paper for SAG's consideration, but believes that the PCAOB has an information advantage in formulating the factors based on its firm inspections.

Charles Noski, a member of several boards, said that his group, which represents the issuer's perspective, agreed on the need to define audit quality. The group considered the U.K. Financial Reporting Council's framework as a useful guide, but did not agree on hardly any measures, he said. The group agreed that information around restatements was important. The group also believes that the information the PCAOB obtains from its inspections is a good source for broad-based indicators of quality.

Noski said the group believes there is a need for audit committee guidance on what to ask for as part of the auditor selection and retention process. The information would be useful to investors when deciding whether to ratify the selection or retention of auditors. The group suggested an enhanced audit committee report in the proxy statement, similar to the Compensation Discussion and Analysis section. The report should include a discussion about the audit firm selection, including firm level indicators and engagement level data relating to audit quality. Noski said that in order for audit committees to provide the necessary guidance, they must "up their game."

Sam Ranzilla, with KPMG LLP, headed the group that represented the auditor's perspective. The group considered whether audit quality must be defined before going forward and concluded that there has to be a goalpost, but the Board should not spend all of its time building it.

Auditors believe the measures should have a direct link to audit quality. Ranzilla warned against the unintended consequences that the measures, and especially quantitative measures, can have. Any qualitative measures must be scalable across different sized firms. He reported anecdotal evidence that smaller firms are concerned about the adoption of key indicators because of the potential costs.

University of Tennessee professor Joseph Carcello noted that, in the U.K., a review of the first year of reporting on audit quality tended to reflect "points of pride" from a business perspective. If the Board chooses to adopt a voluntary approach to audit quality disclosure, he said it must include very vigorous oversight or it is likely to fail. As for scalability, he said that compliance with professional standards is critical regardless of the size of the firm.

Richard Fleck, the chair of the U.K. Financial Reporting Council, agreed with Carcello that the initiative so far has not achieved its purpose. The FRC has listed 15 to 20 areas on which it expects firms to report, he said, so it is not completely voluntary. He added that the FRC went through a discussion similar to SAG's on the difficulty of defining audit quality.

Lynn Turner, who served on the Treasury's advisory committee, said he hopes the Board attempts to initially adopt the best product possible, but it must be continuously evaluated to reflect information obtained during inspections. Audit firms and the auditing profession change over time, so the quality review factors need to change too, he said.

Jeffrey Mahoney, the general counsel of the Council of Institutional Investors, said the initiative has significant support from the ultimate customers of financial statements --the investors. The PCAOB should go forward, he said.

Signing the Audit Report

The Treasury's advisory committee also recommended that the PCAOB consider mandating the engagement partner's signature on the auditor's report. SAG considered the issue in 2005. Janice Hester Amey of CalSTRS, Jean Bedard from Bentley College and Robert Kueppers with Deloitte LLP, discussed the pros and cons of mandating the engagement partner's signature and whether other members of the engagement team should also be required to sign.

Amey said that CalSTRS supports the signature on the audit report. Kueppers does not believe the requirement would improve audit quality. He referred to it as an "optical change, but not a substantive change."

Ernest Baugh, Jr., the national director of professional standards at Mayer Hoffman McCann P.C., agreed that the requirement would not make any difference in audit quality. His firm takes the firm signature very seriously, he said. The engagement partner's signature should not be couched as a means to improve audit quality, he said, because that is not going to happen. However, if it improves investors' perception about quality, he said it may be beneficial.

Cynthia Richson, the director of corporate governance at the employees' retirement system of Texas, noted that all of the investors who submitted comment letters to the Treasury supported the signature proposal. She also pointed out that the requirement would harmonize with the EU's 8th Directive. She believes it would create greater transparency and greater accountability.

While some of the panelists considered the issue insignificant, Turner said that if it was insignificant, audit firms would not be fighting it. Kueppers disagreed with that characterization. He believes the firm name is more important.

Standards Setting Priorities

The final session included a review of the Board's accomplishments and an outline of future priorities. The key priorities are fair value and specialists, and derivatives and other financial instruments. The Board expects to publish a concept release by the end of 2008 on the use of specialists.

In 2009, the Board anticipates action on initiatives related to the corroboration of account balances by third parties, the consideration of fraud risk related to confirmations and related party transactions. The Board also plans to finalize guidance by the end of the year for small audit firm compliance with Auditing Standard No. 5. The staff will review all of the interim standards and expects to issue a concept release in early 2009. It may seek additional advice from SAG on the interim standards project. The Board is also reviewing recommendations by the Treasury's advisory group and by the SEC's advisory group on improvements to financial reporting.

Richson suggested that, with a new Administration coming in, the Board may wish to seek legislation to remove the prohibition against making Part II of the Board's inspection findings public. Under the Sarbanes-Oxley Act, the inspection findings must remain confidential for a year.

Bauman said he was astounded by what was lacking from the Board's recent proposal on risk assessment. The proposal contained a detailed comparison to international standards of auditing, he said, but the AICPA's standards, which have already been implemented by all firms, were hardly mentioned at all. It would be helpful to know where they differ, he said.

Carcello encouraged the Board to map the deficiencies it has identified during inspections into its standards where possible. The inspections provide unique information that only the Board has, he said. He said the Board's output of standards over the last five years has been modest and suggested that the Board conduct a detailed analysis to determine whether its staffing is sufficient for the task.

John Kellas of the International Auditing and Assurance Standards Board reported that the IAASB will soon have completed a revision of all of its standards. It will then focus on internal audit practices, he said. Audit reports continue to gain a lot of comments from investors and others. The IAASB is not planning to introduce any new standards in the next two years, he said, but will focus on issues of audit quality. The Board's attention may be directed at audit committees as much as auditors, he said.

The IAASB wants to research how effective its standards have been two years after adoption, he said. The U.S. inspections have helped monitor that. Kellas expressed his support for the comparison to international audit standards in the PCAOB's recent proposal on risk assessment. He believes the comparisons are important for audit quality. During its review of the interim standards, Kellas said he hopes the Board will put a significant premium on achieving convergence.

The October meeting was the last SAG meeting for 2008. About half of the members' terms are expiring. Some sought reappointment, while others did not. The Board recently announced the appointment of new members for two-year terms.