Date. December 7, 2020
Speaker: J. Robert Brown Jr., Board Member
Event: AICPA Conference on Current SEC and PCAOB Developments
On December 7, 2020, I, along with my fellow Board members, spoke on a panel at the AICPA Conference on Current SEC and PCAOB Developments. In response to a question, I addressed the PCAOB’s process of assessing an audit firm’s efforts to remediate deficiencies in the system of quality control. The area is critical to audit quality and is currently undergoing transformation at the PCAOB.
Given the importance of the topic, I am providing some additional thoughts on the subject, particularly with respect to ensuring that transformation results in greater transparency and public accountability for the PCAOB’s remediation process.
I. Firms’ Incentive to Remediate Quality Control Deficiencies
Audit firms are required to institute and maintain an effective system of quality control for their accounting and auditing practices.
The PCAOB’s inspection program, among other things, assesses an audit firm’s compliance with the PCAOB’s standards and rules, including those that govern quality control. During the review, inspection teams may identify criticisms or potential defects in a firm’s system of quality control.
When this occurs, firms are encouraged, but not required, to remediate these deficiencies. In the Sarbanes-Oxley Act (“SOX”), Congress provided a mechanism designed to incentivize firms to timely address quality control criticisms identified in the inspection process. SOX held out the carrot of confidentiality where deficiencies were timely and appropriately remediated but also added the stick of public exposure where they were not.
Under this approach, public versions of the PCAOB’s inspection reports could not include “criticisms or potential defects” in a firm’s system of quality control, at least initially. Instead, firms were given 12 months to remediate the criticisms to the “satisfaction” of the Board. Deficiencies not adequately remediated were made public; those found satisfactory were not.
The PCAOB implemented this carrot and stick approach by establishing broad criteria for assessing firms’ remediation efforts and putting in place a process of review.
Remediation requires a change that is relevant and responsive and appropriately designed to address the criticisms. The process takes into account the repeated and persistent nature of a criticism and reflects heightened expectations for the largest firms performing the audits of the vast majority of market capitalization.
The process provides opportunities for timely interaction with the PCAOB staff concerning remediation efforts. Firms are “strongly” encouraged to engage in a dialog with the inspections staff early in the 12-month remediation period and to develop draft remediation plans that describe how a firm intends to address the quality control criticisms and share those plans with the inspections staff.
Firms also can submit evidence after the remediation period had closed. Firms are informed of the staff’s assessment (including preliminary unsatisfactory determinations) before the Board votes on the staff’s determination and, in those circumstances, have additional opportunities to interact with the staff.
II. The Need for Transparency in Remediation Determinations
The Board has identified the remediation process as an appropriate area for transformation, including the need for greater transparency. Increased transparency can result in access of highly useful information to all PCAOB stakeholders and accountability to the public with respect to the remediation process.
Transparency should start with increased disclosure about a firm’s system of quality control in the public inspection reports. While the PCAOB cannot reveal criticisms or potential defects in a specific audit firm’s system of quality control unless remediation is unsatisfactory, public inspection reports can include a host of other types of information and observations about a firm’s system of quality control. Investors have sought additional disclosure in this area.
In addition, the Board should issue annual reports that summarize the remediation process for each inspection cycle. These reports could identify any criticisms or defects in a quality control system and the number of firms where each deficiency occurred. Data could also reveal the number of firms that had been subject to the same or similar criticism in prior inspection reports.
The annual reports should, once a remediation cycle for a particular year has been completed, disclose the number of firms that successfully remediated any deficiencies and the steps they took. The summary reports should explain why particular efforts were successful. The information could be broken down by categories of firms.
The summary reports should also provide increased insight into instances where firms failed to adequately remediate. The data should include, among other things, the number of firms that failed to remediate in the relevant inspection cycle, including those that failed to take or otherwise identify any remedial efforts, the particular criticisms that were not remediated, and the reasons why the efforts were deemed unsatisfactory.
Including additional descriptive information about a firm’s system of quality control in the firm’s individual inspection reports and providing an annual summary report of the inspection and remediation findings concerning firms’ systems of quality control would generate significant benefits.
Audit firms would better understand areas of PCAOB concern and have an opportunity to proactively address them before they were identified through the inspection process. Firms would also have greater insight into the types of remediation measures that resulted in satisfactory determinations.
Investors would obtain a better understanding of the practical operation of the remediation process. The frequency of failed remediations and the repeated nature of some criticisms could provide additional insight into audit quality and be useful in communications with audit committees and audit firms. Increased transparency on the PCAOB’s remediation process would also help investors hold the PCAOB accountable in assessing remediation efforts and advancing audit quality.
Audit committees would also benefit from additional information in this area. They would have a better idea of the PCAOB’s concerns with respect to firms’ systems of quality control. The information would presumably inform communications between audit firms and audit committees and enhance oversight of an issuer’s audit process.
Finally, the PCAOB would benefit from this increased transparency. The summary reports could facilitate input from investors, academics, and other stakeholders and promote accountability. The input would have the potential to create a “feedback loop” for “continual improvement” in the remediation process.
The importance of a firm’s system of quality control in preventing audit deficiencies cannot be overstated.
Increased transparency in the remediation process would promote accountability and allow all stakeholders in the audit ecosystem to play a more active role in ensuring dynamic and robust systems of quality control. The lack of transparency and accountability during the era of self-regulation ultimately contributed to a decline in trust in the audit process. The Board should use the transformation process to advance transparency and accountability to ensure public confidence in, and integrity of, the capital markets.