About the Speaker

Thank you for reading this post, don't forget to subscribe!

The afternoon sessions included a fireside chat with George R. Botic, PCAOB board member and former director of the division of registration and inspections. Botic spoke with Douglas Carmichael, professor at Baruch College, New York, N.Y. The following is an edited and condensed summary of their conversation. The views expressed are his own and not necessarily those of the PCAOB, other board members, or the staff.

***

George Botic: With my remarks, I’d like to engage on the importance of the auditing profession to society and the need for high-quality audits. And then I’ll also strive to answer the question, “who is responsible for audit quality?”

First, let us begin with the role of the PCAOB. Investor protection is our “why?,” and it is at the heart of all that we do. The PCAOB’s 2022 to 2026 strategic plan charts a four-part course to ensure the PCAOB delivers on this mission, now and into the future. First is to modernize our standards. We’ve heard a lot about that today. We’ve laid out the most ambitious standard setting and rulemaking agenda in 21 years, ensuring our existing auditing standards are modernized as needed and are fit for purpose.

Second is to enhance inspections, something very near and dear to my heart. Our inspection reports have more transparency this year, including a new section on auditor independence and a range of other improvements to make them more transparent, more relevant, and useful. In general, I believe, the more transparency that the PCAOB can provide around all our oversight activities and the data that we collect, the more useful it will be to investors, audit committee members, and other stakeholders.

Third is strengthening enforcement. It’s noteworthy to mention that all of the monetary penalties the PCAOB collects go directly towards scholarships to advance the auditing profession. This year, nearly 70% of the recipients came from households with family incomes under $75,000. In fact, the 369 PCAOB scholars in 2023 are the largest number of recipients in the program’s history, an increase driven largely by the PCAOB’s expansion in the number of institutions eligible to participate in the program. Since the program’s inception in 2011 the PCAOB has awarded $22.4 million in scholarships to approximately 2,240 recipients.

The last year of the strategic plan is focused internally on improving organizational effectiveness. The PCAOB’s efforts to improve organizational effectiveness and streamline our internal processes have resonated with our staff. Most staff now say they would recommend the PCAOB as a great place to work.

I fully support all the priorities in the strategic plan. These initiatives will allow the PCAOB to meet its mission, as stated in Section 101 of the Sarbanes-Oxley Act (SOX). These priorities will serve not only to benefit investors; they will also benefit the entire auditing profession in a number of ways including, as I just mentioned, using scholarships to assist and encourage students from diverse backgrounds to enter the auditing profession, modernizing standards that will help ensure that audits performed by independent auditors meet the needs of investors, ensuring that audits comply with applicable standards, and disciplining those auditors that flout the rules.

The mere fact that Congress created the PCAOB to oversee the audits of public companies underscores the undeniably important responsibility of the independent auditor, and the auditing profession more broadly, to support our capital markets and the efficient allocation of capital. The benefits to society of the independent auditor performing high-quality financial statement audits cannot be overstated.

Who Is Responsible for Audit Quality?

Now that we’ve considered why audits are so important to maintain healthy capital markets, let us turn to the question of just who is responsible for audio quality. I’ll give you six possibilities. The following candidates, I think, are possible individuals or institutions that are responsible for auto quality: First, the auditing profession. Second, audit committees. Third, public companies. Fourth, regulators. Fifth, investors. Sixth, the academic community.

As I’ve thought about this list, and maybe as you’re thinking about it now, this list may be more expansive than you might have initially thought. I would submit to you that each one of these candidates, each one of these six, represents a unique link in the financial reporting chain, and each has a duty to ensure the performance of high-quality auditing.

Certainly, each link varies in significance. A few have a more clear and direct responsibility for audit quality, such as the auditing profession and audit committees, while other links in the chain are more indirect. But make no mistake, each party plays a part in ensuring the auditing profession’s ability to execute high-quality audits year after year.

For our purposes today, we will primarily focus on the auditing profession. Independent financial statement auditors are, by design, at the front lines of investor protection—standing as sentries at the gates of the capital markets.

I always smile when I hear someone say auditing is boring. The truth is that very few professions ultimately have a greater effect on society as a whole than the work of the independent financial statement auditor. Just think of the impact that Enron and WorldCom, among others, had on the broader economy when audit quality was lacking. Since at least the 1933 and 1934 Securities Acts, the role of the independent auditor to serve as a gatekeeper for investors in the public interest has been widely recognized.

A gatekeeper has been described as an independent professional position placed between investors and managers in order to play a watchdog role. In fact, one academic paper asserts, and I quote, ‘absent effective gatekeepers, it is reasonable to believe that market efficiency would be lower, the cost of capital higher, and our structure of corporate governance imperiled, particularly in times of uncertainty.’

The role of the financial statement auditor performing high-quality audits has never been more necessary and important. Consider what is happening in the world today, with wars, high interest rates, inflation, and a generally turbulent economic climate. In the midst of all this, everyday people continue to invest their hard-earned money into our capital markets, assuming highly trained professionals, the independent auditors, are on the beat performing their craft to their utmost ability with due care and professional skepticism. That’s the mission. That’s the calling of the independent auditor.

A Professional Privilege

I have had the distinct privilege of working as a regulator at the PCAOB for over 20 years. I think of myself as an accounting and auditing enthusiast. I recall one of my college professors making the statement that accounting is the language of business, and if you know accounting, you know business.

As crazy as it sounds, that hooked me and inspired me to study and learn the craft, and to be a member of this proud profession. But being a member of the profession is a privilege that should not be taken lightly. The auditing profession is a resilient and noble profession and, I believe, a calling, with the execution of audits, and an act of public service. Trust and integrity are the bedrock of our capital markets and support the efficient allocation of capital.

This trust largely emanates from the work performed by most of the folks in this room. The work of the independent auditor actually supports our way of life. In 1984, the Supreme Court dubbed the independent public accountant a public watchdog and described the role as one demanding complete fidelity to the public trust. According to a Gallup poll, mission and purpose are top reasons why college graduates find a first professional job as a good job; perhaps we should rebrand auditing as a career that makes a difference. We would have more students, something that we sorely need.

While we don’t have time to take on all of the challenges related to the audit talent pipeline—and there are many—I think it is fair to recognize that it has taken a number of years for the profession to get to this place. In fact, the AICPA reports that the numbers of accounting graduates in 2022 are at record lows, and it will likely take many years to get out of where we are today relative to talent.

I also believe that the discussions that are happening again, which I fully support, should include a focus on how the brand of the auditing profession can be refreshed, such that it resonates with today’s high school and college students. Firms should consider whether starting salaries reflect the true value of the independent auditor’s work and have kept pace with other options. As we all know, pay does matter.

I would also encourage educators to consider new and creative ways to bring auditing and accounting to life in the classroom, and I would say that all stakeholders should have an increased focus on encouraging diversity in backgrounds.

Building a Culture

Now let us shift our attention more specifically to audit firms and their responsibility to ensure audit quality. Said differently, do audit firms have a culture of audit quality? This leads to many questions. I wonder how many newly minted auditors think of their chosen profession as purpose- or mission-driven? Do they hear the senior partner of the firm, the head of audit, the local managing partner, or their engagement partner, senior manager, manager, senior supervisor, say that they are responsible for and empowered to ensure a quality audit occurs? Do they talk about auditing as a public service, about how investors in the capital markets depend on their work, and—most importantly—about how the focus of audit quality should surpass client demands and budgetary pressures?

I often wonder whether the answers to these questions should be repeated at the start of each and every firm training course to reinforce these points.

Now this begets other questions: What’s the firm’s tone at the top? The tone at the middle? What’s being rewarded? Coming in under budget, keeping clients happy? Is high-audit quality being rewarded equal to the assessment that may be made for financial penalties when there are instances of poor audits?

I would assert that the answers to all of these questions determine the culture of the firm. Indeed, it’s become increasingly clear to me that audit firms need a clear culture to derive the right behaviors, which in turn are necessary to ensure the consistent execution of high-quality audits. These behaviors will help prevent other matters—such as cheating on training tests or back-dating audit work papers—and can also prevent some of the recent actions that we’ve seen at firms internationally.

A recent academic study asserts that auditors who issue adverse opinions regarding clients’ internal controls can find their careers negatively impacted. This study noted that while auditors historically have been seen as gatekeepers of the capital markets, they often confront trade-offs between fulfilling their fiduciary duties to the public and maintaining positive relationships with their clients. The study concludes by saying, and I quote, those trade-offs have become more apparent as the auditing profession has placed greater emphasis on maximizing profits and embracing a “client is king” culture.

Now, we all would probably admit that culture is a very nebulous topic, encompassing broad formal policies and procedures. But, like any organization, audit firm culture is also informed by the so-called unwritten rules. Without maintaining a keen, unrelenting focus on the importance of audit quality, a firm’s culture might not embody what the organization wants to project, nor what investors expect.

For our purposes today, I would suggest we narrow the discussion to the following areas of the audit firm: first, behaviors, including external and internal communications, the tone at the top, and how the firm responds to client pressures and supports the engagement team. Second, decisions made by a firm with respect to how certain behaviors and actions are rewarded or punished, how the firm minimizes distractions to its engagement teams. And third, systems, including formal policies, procedures, organizational structure, learning and education, the performance management system, code of conduct, and ethics policies. All three of these elements—behaviors, decisions, and systems—work together to establish those written and unwritten rules as to what is expected, and what is viewed as acceptable and appropriate.

Anything that distracts from the performance of high-quality auditing should not be viewed as acceptable and be removed from the firm’s audit culture. To this end, firm leadership should periodically pause and take the pulse of the current state of the firm’s culture and understand whether it is designed to support high-quality audits. Unfortunately, I suspect many firms will likely find, particularly regarding the unwritten rules, that audit quality is not front and center.

Ideally, a firm’s culture inspires every member of each engagement team to start their day with an objective that they will do one thing to improve the quality of audit. Consider the power of that.

Now consider a firm’s system of quality control, and how it impacts a firm’s culture and audit quality. One factor, I think we would agree, is that an effective quality control system is perhaps the single most important puzzle piece in the performance of consistent high-quality audits.

One component of the firm’s quality-control system relates to the engagement quality review. I would call your attention to the PCAOB’s recently issued staff spotlight focused on engagement quality reviews, which highlighted that audit firms are increasingly falling short when performing this function: 42% of firms the PCAOB inspected in 2022 had a quality-control criticism related to quality engagement reviews; that’s up from 37% in 2020. A rigorous engagement quality review performed by a qualified objective reviewer can serve as a meaningful check on the quality of the audit work performed by the engagement team. This is an area where we encourage additional time and attention.

Measuring Quality

Perhaps this is a moment to pause and talk more broadly about how we are defining audit quality. There are many definitions and metrics around audit quality. I like to say that audit quality is like oxygen: You take it for granted when it’s present, and you only really notice it when it’s missing.

For our purposes, we’ll consider the state of audit quality through the lens of inspection results. I believe that inspection results are a significant indicator of audit quality, and while results certainly vary by firm, as a whole the trajectory of audit quality is, unfortunately, trending down. Chair Williams mentioned this earlier: we see that 40% of the audits reviewed have one or more part 1.A deficiencies. Furthermore, the PCAOB staff anticipates the average part 1.A deficiency rate across the six U.S. global network firms will increase from approximately 20% of audits reviewed in 2021 to 30% in 2022.

The apparent slippage in audit quality based on inspection results does beg the question: Are firms reacting with a sufficient sense of urgency? And if not, why not? Is improving audit quality a burning platform? Again, if not, why not? Is it because in the past decade, there have been relatively few restatements of public company financial statements? I contend that the expectations of investors, the current turbulent economic climate, and our current inspection trends create an impetus to improve audit quality.

In looking for explanations for the decline in audit quality, the most likely may be training, mentoring, and talent issues. Specifically, new auditors hired in 2020 during the heart of the Covid pandemic who worked remotely for most of the first three years did not have the benefit of onsite training and, more importantly, the ability to consistently work in an audit room surrounded by team of more experienced colleagues. Auditors hired during 2020 and 2021 who performed only or mostly remote work, are in a unique position. Their experience entering the profession, what is arguably their most formative years, was very different from what previous auditors experienced. It’s not their fault, certainly, but they may be lacking technical accounting and auditing knowledge, potentially taking any competency gaps with them as they advance in their careers.

I’d encourage firms to consider whether learning and education programs, as well as formal and informal mentorship opportunities, are adequate to address the technical accounting and auditing needs of their staff.

Before closing, I do want to briefly mention critical audit matters. This is an area of increasing investor focus and concern as the average number of reported CAMs continues to decline. I’m very pleased that this topic was added to the standard-setting research agenda, and I look forward to potential recommendations coming out of that work as engagement teams will be performing their year-end audits over the coming months. I would encourage a renewed focus to ensure that all potential CAMs are identified and evaluated for inclusion in the auditor’s report. CAMs represent an important vehicle for auditors to provide useful insights about the audit to investors and other stakeholders.

We have covered a lot of ground this afternoon, so let me leave you with a few key takeaways. First, the auditing profession is a resilient and noble profession that performs a critical role to our society. Auditors are gatekeepers to the capital markets, standing sentry for the investing public. The PCAOB strategic plan will help investors and, I believe, it will also help the profession.

Audit firms need a clear culture that is conducive to driving the right behaviors, the right decisions, and the right systems—which in turn are necessary to ensure consistent, high-quality audits. Which brings us back to the question: Who’s responsible for audit quality? While there are a number of candidates that play a very meaningful role, auditors and audit firms play a crucial role and need to take action to reverse the downward trend.

Q&A

Doug Carmichael:

Are there any specific priorities that you think should be the focus for the board in the next year or two?

George Botic:

I think the strategic plan charts a very good course for the board over the coming years. I think that the standard-setting agenda, while incredibly ambitious and in some cases a bit contentious, is directionally correct. Within that, I would highlight the QC Standard, which I think is a generational type of standard, given the focus and the broad breadth of it.

I’m optimistic about some of the changes that we’ve made to our inspection reports. I’m hopeful that that we can keep thinking about different ways to make information available to the whole ecosystem of financial reporting, the auditors, stakeholders, investors, academics. So, something that is high on my list is transparency. I think transparency is very, very helpful to the ecosystem.

I think that a rigorous inspection regime is important, not just for the PCAOB. I think that what the PCAOB is doing is actually good for the profession—helping support investors through new standards and through rigorous inspection activities.

Carmichael:

You’ve been at the PCAOB for a long time. How would you evaluate the effectiveness of the inspection program over those years?

Botic:

I think that the staff of the PCAOB is incredibly talented. I think we’ve been incredibly fortunate with the skill sets of our inspectors, in particular. But having said that, I think repetition has helped. I think we’ve gotten better as we’ve grown, in terms not just size, but knowledge of industry and technical matters. I think that’s allowed us to go deeper in areas than when we first started. You know, 20 years ago we used to go for low-hanging fruit. And as firms got better, to the profession’s credit, quite literally our job got more difficult, so we’ve had to up our game to ensure that there is compliance with the standards.

I know, speaking personally, even though one may be a very good auditor, being an inspector is a different skill set, and it does take time to develop and hone those skills. I think over the last couple of decades, that has come to fruition.

Carmichael:

Over that time period, did the relationship with the firms that are being inspected change?

Botic:

That’s a great question. I would start from this perspective: The staff was always open to meeting with firms to understand their positions. Making sure we understand through the eyes of the auditor helps us get to the right answer. I know it was something that that I always welcomed, having calls with firms, irrespective of size, to make sure we truly understood the perspective. Whether we ultimately agree or not is a separate point. We understood.

I think it’s been a journey of how firms have reacted to the PCAOB. We were created out of whole cloth by an act of Congress. Now, we have regular meetings with a number of the firms, whether it be monthly, whether it be quarterly, or just based on the inspection cadence. I think that the relationships have proved beneficial to helping the PCAOB understand issues. I think those conversations have helped us to have advanced knowledge of what firms are doing, particularly system upgrades, how they’re thinking about technology, how they’re thinking about using cutting-edge technology. I think the interactions have been very collaborative, very collegial, very professional, and collectively have helped us do our job as a regulator and drive audit quality higher.

Carmichael:

I do have a question that relates to the relationship to smaller and mid-market firms that are being inspected and come under the PCAOB’s jurisdiction: Why isn’t there more sense of partnership, if the goal is to improve audit quality? I don’t know that there isn’t, but how would you respond to that?

Botic:

I appreciate the question. We think a lot about smaller firms. I had the good fortune of being involved with what used to be called the small-firm program; now it’s called the non-affiliate program. So I do have a great affinity for those firms. I spend a lot of time talking and thinking about how to inspect those firms. Scalability comes up quite often in terms of how our inspection program has basic tenets across all inspections. But certainly, how we look at a major international firm versus the sole practitioner is different, given the nature of the firms and the expectations around what a QC system would look like.

One of the things Barb [Barbara Vanich] touched upon this morning is expanding the small-business forums to have greater touch points with smaller firms. I think one of the challenges is just the cadence of our inspections. If we’re inspecting a firm annually, we’re in some cases basically year-round with those firms. If it’s once every three years, it’s hard for the firm, and maybe for the PCAOB, to have that level of interaction. I think the small business forums will help immensely with that.

I do pause—just a little bit—on the word “partnership,” and this is a semantic point. Because we both have our roles. I think we do have a common objective of improving audit quality.

I think we want to, through small business forums, issue spotlight documents. I’m also a big proponent, and maybe one of my priorities are just that now, thinking about is spotlights. We’ve had one on SPACs. We’ve had one on crypto. I hope we can have more coming out. I think that is a very good vehicle for the PCAOB at large to communicate in broad terms about things that we’re seeing across the profession. It’s also a good place to lay out good practices.

Doug Carmichael:

Yes, and the PCAOB has a more difficult job in the sense that it’s quite clear that the SEC is a law enforcement organization; they are the cop on the beat. But the PCAOB also has that law enforcement responsibility, so it would be very difficult to have a partnership.

Botic:

What we were created to do statutorily was to protect investors, out of Enron, WorldCom, and the events that happened 20 years ago. Now I would say that the way we can protect investors is by improving audit quality. They’re not mutually exclusive, at least in my view. That’s why the profession is here as well, right? I mean that the profession is here to issue opinions by statute, obviously for listed companies, and that’s done to support investors. So, in my view, all that we do relative to audits of public companies is to protect investors. Having said that, helping improve the profession and helping ensure audit quality go hand in hand with investor protection,

Twenty-one years later, have we lived up to our expectations as an institution if there’s still challenges with audit quality, and maybe it’s even trending in a different direction? I think one can find reasons why our inspection findings are going up, or why audit quality might be perceived as going down—given the pandemic and given turnover, I think those are valid events that that did happen. And I think it’ll take some time to come out of that, and hopefully it will.

Ultimately, we’re assessing compliance with the standards. At the end of the day, if a firm doesn’t follow a standard, and we’re inspecting that audit, our responsibility is to identify those deficiencies, or lack of compliance with a given standard—again identifying those items through the inspection report, through presentations, through spotlights to the broader ecosystem of the auditing profession, and the broader financial reporting ecosystem will hopefully, collectively through education, drive better knowledge and compliance with the standards.

Carmichael:

My understanding, what people tell me, is that litigation is just viewed as a cost of doing business now as an auditor, whereas at one time it was a terrible thing happening. Is it possible that the deficiencies in audit have become so common that they aren’t a big deal anymore to the firms, or not as important as they perhaps should be?

Botic:

Well, I would say that not all firms are in the same place. We have a number of firms that we inspect that have clean inspection reports. We have a number of firms that have very low deficiency rates across all sizes of the firm, so it’s not every single firm. I think that would cut against, at least to some degree—that is, that litigation is accepted as the cost of doing business.

I have thought a lot about firm culture, and I think there are differences in firm culture. I think firm culture does play an aspect, not the only aspect, but an aspect of audit quality is: what is the culture of the firm? Firms are a human nature business, both with our client as well as within the firm itself internally. And I think that does derive different behaviors that have different outcomes in our inspection procedures.

Carmichael:

Looking back over the time that you’ve been at the PCAOB, what are the things that you’re most proud of, either in the inspection program or the PCAOB overall?

Botic:

I would say that the first thing that comes to mind: I had the very good fortune, to be quite candid, to be active in international activities years ago now, and was able to work a lot with our office of international affairs.

One of the things that come to mind is the ability that we have, I would dare say very successfully, to inspect across the globe—not just in China. That’s certainly one piece of it, that’s a big piece, but even going back before that, across Europe. I know in the early days of the PCAOB there were some very open questions on whether we would be able to inspect outside of our borders, and what that would look like. Through a lot of work, we’ve been able to keep that going.

I think that’s been for the benefit, globally, of investors and audit quality through working with IFIAR, the International Forum of Independent Audit Regulators. A few weeks ago, we had our International Institute in Washington, which we do every year, and folks from around the world came to that. Those are great opportunities, I would say, that’s one of the highlights. Also is the ability to be a part of the China inspections, as Chair Williams mentioned.

I think more broadly, that as director, in my prior life of inspections, the changes we’ve made to our inspection reports this year will pay dividends down the road. I think that additional transparency would also come to mind.