James R. Doty has served for over a year as chairman of the Public Company Accounting Oversight Board, and in that time, the board has made progress in its efforts to inspect auditing firms in other countries, although China remains a sticking point.

Chairman Doty talked with Accounting Today last Thursday about the PCAOB’s efforts to conduct mutual inspections of firms in foreign countries, along with how some inspectors from other countries have begun mutual inspections of firms in the U.S.

“We coordinate with our colleagues the registrants and the engagements that will be inspected in some countries,” he said. “There’s a lot of coordination, and a lot of give and take, furnishing of information and techniques and technical assistance, and they have become more accustomed to sending people over here. I think we will frankly see the Chinese do this in time. That’s one of the great advantages they would have.”

However, he acknowledged that the progress on inspections with China has been slow.

“We’re not where we should be,” said Doty. “I do not expect that following the next round of meetings and observations and cooperation-building exercises with the Chinese, we will be where we should be, but we are going to go on working in good faith with our colleagues to try to affect it. We remain convinced that it’s very much in their interest to have this work. It’s in our mutual interest to have it work. It is clear that we cannot shun or shirk our statutory obligations.”

Doty also discussed the board’s controversial proposals in areas such as mandatory audit firm rotation (see PCAOB Plans Meetings Across U.S. on Audit Firm Rotation), along with changes in the audit reporting model, identification of the lead engagement partner on an audit, reporting of related-party transactions and significant unusual transactions, and the PCAOB’s future priorities. He emphasized that the opinions he expressed were his own and did not represent the views of the board or its staff. The interview follows.

I wanted to start off asking you about the concept release that’s come out from the PCAOB proposing mandatory audit firm rotation. I understand that’s attracted over 600 comment letters. What’s your sense of how that will come out in the final version?

We’re a long way from having any knowledge of that. We had planned a two-day open meeting in Washington on March 21 and 22, which is distinguished by the luminaries on many sides of these questions who have commented on the issue over the years. That we could fill up two days of people who really have extraordinary qualifications to speak to the issue of auditor independence and have opinions about auditor rotation demonstrates how complicated the issue is and how important it is, frankly. These are historic meetings that we’ll be having. The comments will go into the public record. They will be written and they will be oral. That record after two days is going to provide a snapshot of where the issue of auditor independence and its relationship to audit firm rotation stands at the 10-year mark.

In other words, we are 10 years out from the adoption of Sarbanes-Oxley. Congress considered the issue then. They requested a report of the GAO, and a year later the GAO rendered their report. They said the SEC and the PCAOB should get more information on it, and here we are. This is honoring or performing the completion of an investigative and information-gathering task, which is at the very center of the act and independence. Independence is at the heart of Sarbanes-Oxley.

We have two days of meetings here. I frankly believe we will hold meetings of similar importance in at least three or four other cities around the country. I want to make sure we get communities across and up and down the axis of the United States because we want to be sure we have the opinions and the views of a lot of people who can’t be fit into a two-day schedule and who might not travel.

So we want to be sure we’ve given the maximum scope to the investigative and the information-gathering phase of it. We’ll be working on this at this time next year. We may be completing and digesting what we have heard. We had to have debate, we had to have opinion, we had to have insight into what people saw was going on out there, and we had to be able to compare that thoughtfully with what we had seen going on in our inspection process. This is a protracted process, and should be for an issue that is this fundamental.

What are you anticipating with the meeting? Do you think there will be much debate or just people presenting their points of view?

I think that in meetings such as this, many of them know what others think. Many of their comments will respond to or address the issues that they know have been raised by various constituencies or interest groups in terms of the debate that has been going on about independence and about this rotation issue for many decades. They will anticipate in their comments what they think others may say. They will be listening to the other panelists, and in the colloquy that they have with the board, and with others, I think some of that will range beyond their prepared remarks. This is an extraordinary panel of people. The fact that these people are willing to come and testify and that there are others that wish to, that we’ll be putting on panels in other cities at other times, shows how much thought has gone into this issue and how many people are interested in it.

The European Commission came out with a green paper calling for mandatory audit firm rotation and other changes a few months ago. What kind of impact do you think that will have?

I think it will be noted and mentioned. Everyone is looking at this. I understand that the firms are concerned about some of the provisions that are in the paper. If you read the consultation papers and the other papers that are coming out across the Atlantic, there’s a very strong view that competition is a part of this effort in their mind. It’s necessary to develop more competition. The competitive implications of these proposals are very much on their minds, and I think the relationship if any to audit quality and the way it affects either good or bad audit quality is something that U.S. commenters tell us about, and we will be asking about that. I know that, for example, there are audit-only firm issues, there are dual-firm audits. There are procedures that are not typical in audits here, but have been used in Europe, and those as much as firm rotation issues are things that I think people will want to tell us about, and we’ll hear about.

How about the proposal for lead partner identification? I understand that the PCAOB has backed away from requiring the lead audit partner for an engagement to actually sign off on the report, but do you think there will be acceptance or criticism of at least having the name of the lead auditor on the report?

My impression is that while questions are still raised about the impact or the effect on an individual engagement partner who may be named, that across the profession there’s a recognition that the naming of the engagement partner is not regarded as being a very significant step in terms of personal responsibility or personal liability. I think there is still concern harbored in some areas, but the profession knows that investors have wanted this, that they have been expressing a desire for this going back to 2009 and before. It is information. It is not necessarily the case that all the information that could go into an audit report is something we should put in an audit report.

On the other hand, this is information which investors in their countries have had. This is information which has been available to investors in BNP Paribas and Siemens. So the question arises, if it’s available for those investors, why should it not be available for investors in GE or Amazon? Second, it’s information which may give the investor a greater sense of understanding of how the audit is performed. The audit firms will be signing, and they may well take care to point out that the report will be the firm’s report and a release would so state. It may be the firms will want to take some steps and clarify to the extent that an engagement partner is part of a larger team. We have not required that.

But in any event there will be information for the investor, both in the audit report and on our Web site that would enable investors, for example, to determine how many engagements an engagement partner supervises in a particular year. That’s meaningful for some investors. Is the engagement partner supervising six audits in a year? Many people would say that’s too many. So it’s that kind of informational content that this provides. There’s no doubt that the informational content about the extent of participation in the actual audit of members of a global firm network, or firms that are not affiliates of a global firm network but are located abroad, that’s meaningful information and it has not been available.

Our task under the statute is to provide accurate, informative and reliable reporting, and this is the informative part. I think this is probably a step in which the time has come for this kind of transparency, and it doesn’t have cost implications. Personally speaking, I don’t believe it has significant litigation consequences for the firms, but I think we will have some action on that in the summer.

Another one of the concept releases that’s been attracting a lot of attention is the proposal for changing the auditor reporting model. What kinds of changes can investors and auditors anticipate in auditor reports? Do you want to go beyond the boilerplate descriptions that the firms have been providing in a lot of their audit reports?

Well, first I think we’ve made it clear that there’s no inclination here to dispense with the pass/fail judgment, with the auditor actually passing on the client’s accounting, with an applicable accounting regime, and the fair presentation of the company’s performance. We’re not replacing what has been important with the audit report. There is no question that we have had strong cautionary advice that we should not put the auditor, or the public, in the position of assuming that the auditor has furnished the financial information. The responsibility for the financial information and the facts remains with the company. It should be with the issuer.

That said, I personally think this is the most significant regulatory step that any financial regulatory agency can take. We are going to change a practice that has prevailed for over 70 years. We are going to do this in the interest of providing greater relevance to the audit report. We are going to do it with a lot of advice and thoughtful comment, both from auditors, preparers and their counsel, as well as from investors as to what should be seen and what is practical. So I think we are learning here from what has worked and what has not worked in other regimes as well. I think you can look to see a thoughtful rule proposal some time in the third quarter, I hope early in the third quarter.

We will be working through this. It’s a very major undertaking, but I think it will be out there and it will be thoughtful and it will give investors more insight into what the auditor has seen in the course of the audit, what their judgments are about critical matters, critical accounting estimates, and like matters, and it should give the public a better idea of what the audit is, what the limitations of the auditors’ activities are, so I think the auditors will be in position of explaining the audit themselves and articulating what they do in terms that should be meaningful to the public.

Clearly there are all sorts of tensions here, one of which is boilerplate, which you mentioned. Another is the risk that we don’t want to do anything which removes the business decision-making capacity of the audit committee and the board as a whole. We do not want to chill the discussions that the auditor has with the audit committee and the board. And all of those have to go into the mix, but at the end of the day I think we will have a proposal sometime in the late second quarter, early third quarter. This is a very significant step for a better, more relevant, more transparent audit report.

There are also proposals for enhancing communications between auditors and audit committees. Dan Goelzer said that was something that he wished the PCAOB had made more progress on (see PCAOB Founding Member Daniel Goelzer Reflects on Board’s History and Future). Yet I’ve seen comments from the New York State Society of CPAs that while they support the overall proposal, they have qualms about reporting significant unusual transactions unless there’s a significant risk (see New York CPAs Want Better Audit Committee Communication). How do you feel the communications should be enhanced?

Well, clearly, different audit committees get different kinds of information, and their effectiveness may be limited by the quality of the information they get and the communications they are getting. So we have reproposed that rule at the end of the year, with a view to bringing it to a conclusion this year, and I believe it is very important that we move the rule, the standard, and that we do issue the standard on audit committee communications. The purpose of that standard again is to make the audit committee more effective, and audit committees and auditors talking to audit committees we believe would be benefited from having a standard that is a real guideline as to the matters that should be addressed in that dialogue, in that relationship.

We have been very attentive to where commenters and others have warned us that we need to be mindful of not putting a prior restraint and a chill on what the audit committees learn or what they could talk about with the auditor. We think we’ve achieved that balance.

On the other hand, our related-parties proposal, which just went out last week, clearly does address the issues of unusual transactions, and it addresses them because significant period-end transactions, along with related-party transactions, have been a particularly fertile breeding ground for bad financial reporting and misstatements and restatements. So I think that people expect to have something about that. They expect to have the auditor looking for unusual transactions that could affect the difference between a good and a bad financial result, and audit committees should of course know about what the auditor considers to be areas of risk.

All of these standards align, they’re all designed to align auditing rules and bring auditing rules up to mesh with the risk assessment standards that the board issued in 2010, between AS7 through AS15, so Dan and that board put in place a very important platform for the risk assessment standards for scoping and forming up and assessing the audit. And the audit communication release will include the ability of the audit committee to understand how that was done, to ensure that the audit committee understands what the scope and the plan for the audit is, and then throughout the audit process, see what is happening with that plan. So it’s an important carrying through of risk assessment, which was thought to be an extremely important concept coming out of the financial crisis. It’s one of the things that people were most concerned about.

The purpose here is to make sure that audit committees are more effective and to do that we’re giving auditors guidelines. It probably is not as revolutionary as the audit reporting model, but in terms of the potential for doing good things for corporate America and for investors, the communications with audit committee standard and the related-party standard are right up there.

Let’s talk about the challenges in inspecting foreign firms. I know that has been a big concern of the PCAOB, especially in China, but so far it seems like most of the progress has been in Europe. What do you think will happen with China and some of the other countries that have been resisting inspections?

Well, first with China, we are still engaged. We are informed by our counterparts there that the meetings they had here in July were very constructive and helpful meetings. We are contemplating a follow-on with those meetings. I think there will be further meetings. There will be other opportunities for observations and, as we have said publicly, for enhancing cooperation. Now, how timely, how soon we can get to a satisfactory point, I don’t know. We’re not where we should be. I do not expect that following the next round of meetings and observations and cooperation-building exercises with the Chinese, we will be where we should be, but we are going to go on working in good faith with our colleagues to try to affect it. We remain convinced that it’s very much in their interest to have this work. It’s in our mutual interest to have it work. It is clear that we cannot shun or shirk our statutory obligations.

We cannot not perform the obligations that we have under Sarbanes-Oxley, so that is our limiting principle. But we are engaged, and it is constructive engagement. We are not simply talking past each other. We’re trying to work on the details of what could work. By the way, in this regard Lewis Ferguson has done a wonderful job. Bruce Wilson, who is our new director of our Office of International Affairs, has extensive experience in China negotiations. He negotiated, I think, the China arrangements on telecommunications defense when he was at international trade. So this not a low-level, back-of-the-envelope effort. This is a very formal, very serious effort.

I see that there have been some agreements signed for mutual inspections. Have foreign regulators begun inspecting firms in the U.S.?

Yes, the Canadians have done it, and the British. We and the British sometimes go to the same country, to one of the countries they are interested in. We coordinate with our colleagues the registrants and the engagements that will be inspected in some countries. There’s a lot of coordination, and a lot of give and take, furnishing of information and techniques and technical assistance, and they have become more accustomed to sending people over here. I think we will frankly see the Chinese do this in time. That’s one of the great advantages they would have.

I understand there’s a decree in the European Union that’s going to be expiring in 2013 that allows foreign regulators to exchange confidential information. The Dodd-Frank Act allowed that to go forward in the U.S. Are there going to need to be negotiations this year or next year to extend that?

Well, it’s the adequacy determinations and the equivalency determinations that are at risk in the sense that they do have an expiration date attached. First, the fact that we have European nations coming in and joining us in these agreements as we speak, in these statements of protocol, suggests that they see the benefit of it, and it suggest they’re not going through a sterile exercise. They expect those inspections to occur. We have had such good experience with countries where we have had joint inspections for a long time that we don’t have any reason to believe that the countries who are interested in the cross-border oversight of audit quality aren’t going to continue to do it.

The sentiment for cross-border oversight and cooperation and joint efforts here is growing, as everybody realizes it’s the way you have to do it to be effective. So I think we are hopeful that notwithstanding the date of summer of 2013 that was put there, when it gets to the summer of 2013 it will be renewed. And I think that we are using all of our good offices to be sure that when asked or when it becomes relevant, our colleagues in the regulatory structure in the European member states will have had good experiences with this. I think they will.

Switzerland is a very important country. They’re not a member of the E.U., but they’re there. We’re working effectively with them. We have high hopes of Germany. We have signed with the Netherlands. I think we will be doing some things with the Netherlands very shortly. With Norway and the Scandinavan tier, we are also in a very strong relationship that has a good history. Spain, I think, is very interested in doing this. We continue to talk to France. I think in France and Italy, bandwidth is bandwidth. In any governmental structure, you have only so much time and energy. They’ve been preoccupied with a very serious fiscal crisis, so we want to be supportive and not an additional problem for them in that regard.

So we continue to hope that we will get something. We meet with them. We talk to them. They’re fully aware of what we’re prepared to do and how we’re prepared to be helpful and to try to work with them. I think, although you’re talking about smaller organizations there, they have resource allocation issues just as any governmental agency does.

The PCAOB has also been pushing to make disciplinary proceedings public because sometimes they can drag on for years and years before anybody finds out there’s a problem with an auditing firm, and there has been some legislation introduced in Congress to amend Sarbanes-Oxley to allow that. Do you think we will see that happen, or are the auditing firms going to put up a fight?

First of all, I believe it’s the right thing to do. Not to have public knowledge of litigation between ourselves and an auditor, or auditing firm, does deprive the public of necessary information. It may in fact have collateral consequences on the willingness of firms to settle or the determination of firms to litigate. That can happen, and we see some examples of it. But, at the end of the day, I think you’ve got to believe that this is the right thing to do, that Congress will determine it is as well. And I think that’s where we are.

Our position is very simple. We believe that the SEC and other civil regulatory authorities’ programs have not been injured, but instead enhanced and advanced by that, and it has been good for the long-range goals of trying to get better audit quality, and better financial reporting. So it should be here.

The PCAOB was created 10 years ago with the passage of SOX. With the 10-year anniversary, do you think SOX has been successful?

If you look back at the pre-Enron era, and you look back at what happened at Enron, I do not believe that one can argue credibly that there has not been great improvement in investor protection and audit quality. I think the audit firms don’t have any doubt about that. The audit firms believe that audit quality has been enhanced, that investor protection has been enhanced, that their own role has been clarified and made more important. It is one of the things we have seen confirmed as recently as the financial crisis. We will continue to have financial crises and they may be bad, but it’s hard to imagine how they would be if there were in fact no statutory underpinning to define the role of the audit committee, to require the audit to be conducted under the auspices of an independent auditor.

Enron was a case in which accounting policies eventually were a casualty, but along the way transactions were entered into with insiders that had no substantial benefit for the corporation, that were sham transactions that had solely accounting purposes. Any auditor would feel very concerned about that. He would send up an alarm. He would be very concerned about that. The fact that our standards require it isn’t necessarily the point. The fact is, the public’s expectations and the behavior of auditors and audit committees are just much better.

Lately there has been talk from some of the Presidential candidates about repealing SOX. If that ever happened, what would become of the PCAOB? Would this be similar to the battle in the Supreme Court?

Well, first, we of course were created by Sarbanes-Oxley. Second, we are going to be here as long as Congress wants us here. In a Presidential campaign, there are many issues that are raised, but that are blurred. After Presidential campaigns, when people begin to focus on what the implications of the issues are, they’re seen in a different light. I have absolute trust in the Congress. I have been over there. I have worked with the Congress. I have met members of the Congress who happen to be auditors. One of them in particular is someone who has found corporate fraud in an internal control context.

I don’t think that the broad-brush issues that are raised by a Presidential campaign—whether it’s the environment or the economy or national defense, foreign policy—none of those can be taken to be prescriptive of what Congress will do. Frankly, it is a personal belief of mine that people observing us from overseas always believe that what they hear from the successful candidate in a Presidential campaign is going to be the policy of these United States going forward. And they are always shocked that when the President takes office, in fact there is much more continuity, not only in all of the executive departments, but also in the Congress, than they had ever expected before.

The country has much more momentum and inertia, if you will. I don’t worry over much. We have to do our job. We have got to be prepared to show Congress that we are worth what we are costing the economy and that we’re doing it right.

You were involved in that Supreme Court case. How did it feel when you essentially won, even though the court technically decided in favor of the other side?

My position is that they didn’t decide for the other side. They decided that the Constitution required that the SEC be able to remove us at will. That’s what they decided, that the SEC could remove the chairman and all of the board members at will, and we did not have to be removed for cause. Beyond that, they said the board is lawfully constituted and enjoys all of the authorities conferred and all of the responsibilities conferred by Congress and by Sarbanes-Oxley. So it was a resounding victory. It was a matter of great relief. The board here was freed from the overhang of that case to go forward and to do everything that they have done by way of making all of these initiatives possible.

I didn’t argue the case. One of my partners argued it, a talented lawyer who was a former clerk and Solicitor General alumnus, so the board was well represented. But the case raised difficult issues of Constitutional construction and I think the court resolved them properly. They resolved them correctly.

You have just marked your one-year anniversary. What would you say are the main accomplishments of the past year?

The accomplishments all belong to the staff of the Public Company Accounting Oversight Board. There’s the tremendous effort that has gone into the Division of Registration and Inspections. The new director, Helen Munter, has restructured the division so that it has a focus on global network firms and how you conduct the inspection of a global network firm in an engagement. With changes in the recruiting and the retention of people, the staff has been able to grow. The prodigious output of the standards group, the Office of the Chief Auditor, much of this being initiatives and issues that were being worked on long before I got here. The very credible work of the Division of Enforcement in establishing an enforcement program in which the cases have been well-chosen cases involving reckless behavior and not simple negligence or understandable oversight. The expansion of the ability to get access in foreign jurisdictions, over 50 foreign jurisdictions now, a remarkable achievement of our Office of International Affairs. Tremendous efforts on behalf of the General Counsel’s Office, our legislative affairs director and our communications officer here to make sure we articulate and communicate our message properly.

The staff is a very talented, elite corps, very hardworking people, and they are tremendously qualified. All of them have tremendous job opportunities outside the board, and we work to hold them and keep the work interesting here. But this is a comparatively small organization that has a very broad and demanding scope of activity.

We’ve got to get new broker-dealer inspection rules in effect to address the Madoff issue, and we’re going to issue a report in the summer on what we have learned about the brokerage industry and how it fits with the need for scaling and scoping the rules and the inspections and the reviews, the timing of those inspections and those reviews, so that we don’t have an inappropriate amount of audit work go into that. That’s been a very complicated and difficult exercise, but we have staffed up for it and the work is being expertly discharged.

I’m very impressed that the staff takes on all of these very demanding tasks, and they discharge them with consummate aplomb and skill. My entire experience has been one of admiration and respect for what the agency accomplishes through its people.

There have also been a lot of changes on the board over the past year. Do you think that will mark a change in the future path of the board?

I think it’s very refreshing and very healthy. The board just had Jeanette Franzel from the GAO take office, so there are three of us now who came in February 2011, and then Jeanette in March of 2012. Steve Harris is a very important and valuable board member. The long and short of it is that we have a very strong and collegial board. We work very hard and we work together effectively.

What kinds of issues do you think will be coming up before the board in the future? Do you think there will be proposals like in Europe for splitting audit and advisory firms or having joint audits between firms?

The most difficult issues that were identified in the financial collapse were the valuation of instruments that had no market value, no really ascertainable market value. We have a task force on valuation. The volatility of markets has created a special issue. When volatility and valuation are difficult, the information that is sought there becomes more relevant and more important for investors. So we have to look at that. We have to look at the effect of all of this on going concern. We have got to be able to deal with the anticipation of when the company has or has not got the means of knowing it has a going concern issue, and what it says about that. We have task forces on these and we have announced that these will occupy some attention going forward.

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