Introduction

At the November 13–14, 2013, PCAOB Standing Advisory Group (SAG) meeting, the PCAOB gave an update on recent developments, including an overview of its current and future standard-setting activities. In addition, the PCAOB and SAG discussed:

• The formation and potential objectives of a SAG Fraud Task Force.
• The PCAOB’s proposed standards addressing modifications to the auditor’s report and the auditor’s responsibilities regarding other information in certain documents containing audited financial statements and the related auditor’s report.
• The PCAOB’s audit quality indicators (AQIs) project.

The next SAG meeting is scheduled for May 28–29, 2014.

Recent PCAOB Developments

Chairman James Doty summarized recent PCAOB activities and policy initiatives that have been completed or are in progress, including:

• The launch of the Center for Economic Analysis on November 6, 2013. Led by economist Luigi Zingales, its founding director, the Center will study the role and relevance of the audit in capital formation and investor protection as well as advise the PCAOB on how the Board can make better use of economic theory, analysis, and tools to enhance its effectiveness in standard setting, inspections, and other oversight activities. The Center is expected to hire permanent staff and begin operations in early 2014. Also next year, the Center will host a conference on the role of the audit in the capital markets that features economic research by participating scholars on related topics.
• Enhanced outreach to audit committees. Chairman Doty reiterated the importance of constructive engagement between the PCAOB and audit committees and commented that all Board members interact with audit committee members in various activities, including conferences and one-on-one meetings. He said that a cross section of audit committee members will have the opportunity to participate in a series of town hall or focus group meetings planned for 2014. In addition, the PCAOB has developed a dedicated Web page for audit committees.
• Identification and development of AQIs. A concept release planned for around year-end will include a point of view and preliminary conclusions (see further discussion below).
• Continued efforts to develop cross-border arrangements for the PCAOB to conduct joint inspections outside the United States. Chairman Doty reported that the Board has made significant progress toward extending cooperative agreements in many foreign jurisdictions and specifically mentioned the PCAOB’s efforts to reach an agreement with Chinese authorities that would allow inspections of PCAOB-registered firms in Mainland China and Hong Kong. On May 24, 2013, the PCAOB announced that it had entered into a Memorandum of Understanding (MoU) on enforcement cooperation with the China Securities Regulatory Commission and the Ministry of Finance.¹ Chairman Doty indicated that the negotiations are slowly progressing.
• Building relationships with audit oversight counterparts outside the United States.² Chairman Doty cited Board member Lewis Ferguson’s role as chairman of the International Forum of Independent Audit Regulators (IFIAR), which consists of 46 regulators from jurisdictions around the world.³ He also noted that Board member Steven Harris continues to chair IFIAR’s Investor Working Group and that Claudius Modesti, director of the PCAOB’s Division of Enforcement and Investigations, has been appointed vice chairman of IFIAR’s newly formed Enforcement Working Group.
• Continuing the interim inspection program for audits of brokers and dealers through 2014. By the end of 2013, audits by approximately 100 firms will have been inspected. On August 19, 2013, the PCAOB released its second report on the progress of the interim inspection program, which (1) describes observations noted from inspections performed, (2) lists considerations pertaining to the scope of a permanent inspection program, and (3) outlines recent developments and next steps of the interim program.
• Standard-setting activities. Chairman Doty expressed pride in the work that has been performed in connection with the auditor’s reporting model. The chairman also provided an update on the PCAOB’s proposals⁴ related to public disclosure of the name of the engagement partner and identification of other public accounting firms or persons not employed by the auditor in the auditor’s report. He indicated that the time had come to repropose these topics and expressed his hope that the Board receives significant feedback on them. He announced that the Board would meet on December 4, 2013, to consider the reproposal for approval. (See the sections below for a more detailed discussion of the standard-setting agenda and the auditor reporting proposals.)

Standard-Setting Agenda

Martin Baumann, chief auditor and director of professional standards, provided an update on the PCAOB’s various standard-setting activities and reviewed its standard-setting agenda.

The following table outlines the current status of PCAOB projects on the Board’s standard-setting agenda:

SAG Fraud Task Force

Keith Wilson, deputy chief auditor, and Michael Gurbutt, associate chief auditor, gave an overview of the PCAOB’s project to develop a SAG task force on the auditor’s approach to detecting fraud.¹² This presentation was a follow-up to a discussion at the November 2012 SAG meeting, in which members agreed that a task force could be a useful vehicle for identifying and considering ways of improving audit practices to detect fraud. (For more information on the November 2012 SAG meeting, see Deloitte’s November 30, 2012, Heads Up.)

Mr. Wilson said that the PCAOB may implement the project in two phases, with separate but related objectives, over a period of approximately 18 months. Phase 1 would focus on researching:

• The economic consequences of fraud.
• The effectiveness of audits in detecting fraud.
• Potential mechanisms to improve the effectiveness of audits in detecting fraud.

The first phase would be supported in part by the Board’s recently formed Center for Economic Analysis as well as by the staff of the PCAOB’s Office of Research and Analysis. The research would include consideration of when auditors were successful in identifying fraud and lessons learned from situations in which auditors did not identify a perpetrated fraud.

The second phase would focus on exploring recommendations for specific actions as informed by the research performed during Phase 1. Some examples of possible actions were discussed, but PCAOB staff members were careful to note that the examples were not intended to be prescriptive. Phase 2 would incorporate some form of written deliverable, which may include enhancements to PCAOB auditing standards or issuance of PCAOB guidance, among other possibilities.

The task force members are expected to include some SAG members and others with relevant expertise.

The discussion continued with presentations from a panel comprising individuals from the PCAOB, the SEC, and academia.

• Mr. Modesti reminded the SAG that Congress created the Board in response to massive and high-profile financial frauds. He observed that auditors “are uniquely positioned to bring fresh eyes to the process” and that their role, when properly executed, is an important deterrent to management fraud. He reiterated that the PCAOB’s Division of Enforcement and Investigations supports the development of a SAG Fraud Task Force and is committed to working with the task force as activities get under way.
• David Woodcock, regional director of the SEC’s Fort Worth Regional Office, and Margaret McGuire, senior counsel to the SEC’s directors of the Division of Enforcement, described the SEC’s Financial Reporting and Audit Task Force, which was recently created to identify and investigate federal securities law violations related to fraudulent actions by issuers of financial statements and audit failures. They also expressed interest in working with the SAG Fraud Task Force.
• Lastly, three academics presented their current research on financial statement fraud:
  • Urska Velikonja (Emory University School of Law) discussed the economic consequences of financial reporting fraud.
  • Greg Trompeter (Dixon School of Accounting, University of Central Florida) presented research on the auditor’s role in detecting and deterring fraud.
  • Maureen McNichols (Graduate School of Business, Stanford University) discussed the implications of fraud for investors, managers, auditors, and regulators.

The PCAOB concluded the discussion by asking SAG members whether the objectives, structure, and deliverables of the proposed task force were appropriate and whether there were other items that the Board should consider. The SAG members were generally supportive of the recommended plan for the task force.

Auditor’s Reporting Model

Jennifer Rand, deputy chief auditor and deputy division director, and Jessica Watts, associate chief auditor, provided a high-level overview of the two proposed auditing standards¹³ related to the auditor’s reporting model that were released on August 13, 2013. (For more information on this project, see the related SAG meeting briefing paper and slides on the PCAOB’s Web site and Deloitte’s September 5, 2013, Heads Up.)

On the first day of the SAG meeting, Ms. Rand opened the floor to discussion of the most significant aspect of the auditor reporting proposal, the requirement to identify and communicate critical audit matters (CAMs)¹⁴ in the auditor’s report. CAMs were described by Board member Jay Hansen as “those matters that kept the auditor up at night.” The proposed standard includes several illustrative examples of CAM descriptions that may be included in the auditor’s report. SAG members expressed a variety of views about the new requirements and highlighted concerns about implementation challenges, specifically focusing on the clarity of the current proposal and the content in the illustrative examples:

• SAG members voiced concerns that the illustrative examples include descriptions of the audit procedures performed while the proposed standard does not specifically require such descriptions. Some SAG members were generally opposed to including descriptions of audit procedures in descriptions of CAMs and questioned the value of such audit procedure descriptions to investors and other users of auditors’ reports. Other SAG members were more supportive of describing audit procedures, indicating that this kind of information would be informative and valuable to investors.
• SAG members also highlighted that the illustrative examples may introduce new information in the auditor’s report that had not previously been disclosed by management, such as control deficiencies less severe than material weaknesses. Mr. Baumann explained that the inclusion of this type of information in the illustrative examples was intentional and that the PCAOB hopes to obtain views on this matter in the comment letter process. Several SAG members expressed concerns about including information in the auditor’s report not previously disclosed by management.
• Multiple SAG members conveyed concerns about the real possibility that the description of CAMs may become “boilerplate” over time and that auditors may tend toward identifying and communicating too many CAMs. Some SAG members favored making matters communicated to the audit committee the starting point for potential CAMs, noting that an auditor would be unlikely to include in the auditor’s report a CAM that was not a matter previously discussed with the audit committee.
• Several SAG members asked the Board to consider the costs and benefits of adding CAMs to the auditor’s report.
• SAG members also noted that the International Auditing and Assurance Standards Board (IAASB) is also working on revising the auditor reporting model and that its proposal includes requirements to identify key audit matters (KAMs), which are similar to the PCAOB’s CAMs. SAG members encouraged the PCAOB to continue collaborating with the IAASB to attempt to eliminate unnecessary differences and mitigate potential user confusion.

On the second day of the SAG meeting, Ms. Rand and Ms. Watts focused the discussion of the proposed auditing standards on the new elements of the auditor’s report and the auditor’s responsibilities regarding other information.

Ms. Rand opened the floor to discussion of the new elements of the auditor’s report, including statements to address auditor independence and auditor tenure. The following views were expressed:

• While many SAG members were supportive of a required statement addressing independence, some SAG members questioned the wording of the required statement, noting in particular that it lacked specific language to indicate that the auditor is independent. Mr. Baumann acknowledged the concern and explained that because of the way the independence rules are written for auditors of public companies, the staff had to be careful about how it described the independence requirement. He provided his perspective that this requirement was directed at focusing auditors’ attention on the importance of having an independent state of mind.
• Many SAG members raised questions and concerns about the requirement to include disclosure of auditor tenure in the auditor’s report, noting the lack of demonstrated connection to audit quality and the possibility that the information might be misinterpreted, especially if the disclosure is next to the independence statement. Other SAG members noted that it is a data point and that if investors are interested in the information, it should be disclosed. Some SAG members suggested that such a disclosure would be more appropriate in the proxy statement than in the auditor’s report. One SAG member (Bill Platt), acknowledging the inability of the PCAOB to impose requirements related to proxy statement disclosures, suggested that an alternative solution the PCAOB might consider would be to require disclosure of auditor tenure in the auditor’s report only if it was not previously disclosed in the most recently issued proxy statement.

Next, Ms. Rand outlined the requirements in the proposed standards related to the auditor’s responsibilities regarding other information in certain documents containing audited financial statements and the related auditor’s report. Under existing PCAOB standards, the auditor has a responsibility to “read and consider” whether such other information is materially consistent with the financial statements. The proposed standard addresses the auditor’s responsibility for other information and describes procedures for the auditor to perform in evaluating the other information on the basis of relevant audit evidence obtained and conclusions reached during the audit. The PCAOB’s proposal also requires additional communication in the auditor’s report about the auditor’s responsibilities for, and the results of, the auditor’s evaluation of the other information.

• Many SAG members expressed support for requiring the auditor’s responsibilities for other information to be more clearly communicated in the auditor’s report but raised concerns that the proposed standard was not sufficiently clear about expected auditor performance requirements (i.e., many members raised questions about the meaning of the term “evaluate” as used in the proposal, particularly when applied to qualitative or nonfinancial information). SAG members were concerned that the proposal would significantly expand the auditor’s responsibilities relative to those under current PCAOB standards.
• SAG members noted that because the scope of other information has been expanded to include information that was not derived from the accounting books and records or subject to the entity’s system of internal control, the auditor may have little basis for evaluating unrelated information obtained during the audit. Some SAG members questioned the ability of the auditor to identify material misstatements of fact in such information, noting that in some cases, such an assessment might be a legal one and therefore outside the scope of the auditor’s expertise.
• SAG members emphasized the need to carefully consider the costs and benefits related to this proposal and recommended field testing and additional outreach.

Ms. Rand thanked the SAG members for their feedback and reminded the SAG that the deadline for comments on the proposed standards and related amendments is December 11, 2013. The Board may hold a public roundtable in 2014 to discuss the proposed standards and comments received.

Audit Quality Indicators

Office of Research and Analysis Director Greg Jonas and Deputy Director George Wilfert provided an update on the AQI project. (For more information on this project, see the related SAG meeting slides on the PCAOB’s Web site and Deloitte’s June 25, 2013, Heads Up.)

Mr. Jonas thanked the SAG for the feedback it provided on potential AQIs at the May 2013 SAG meeting. He expressed his enthusiasm for the project, noting that the Board’s project is unique in that it is identifying quantitative, as opposed to qualitative, AQIs.

Largely on the basis of feedback from the SAG surveys, the project narrowed down its initial list of approximately 70 potential AQIs to 30 promising AQIs. Shortly after year-end, the Board expects to have a concept release that will include 20 to 30 promising AQIs. Of that group of AQIs, Mr. Jonas believes that some can be released without reservation while others may present challenges. The Board plans to consider the comments received on the concept release and the results of field testing during its redeliberation of the proposal, which is expected to culminate in 15 AQIs for a future proposal.

Mr. Jonas explained that the concept release will most likely consist of three parts:

• Objectives and Background.
• Definition, Framework, and Top AQI Metrics.
• Potential Use of Metrics.

He indicated that the next steps are to (1) continue soliciting feedback and (2) develop models for testing the selected AQIs.

SAG members showed overwhelming support for the AQI project and believe that it will promote audit quality.