October 03, 2023 • By The UCI Paul Merage School of Business
On Friday, September 8, 2023, the UCI Paul Merage School of Business’ Accounting Area hosted the 10th Annual UCI Audit Committee Summit, featuring keynotes Kara Stein, board member, Public Company Accounting Oversight Board (PCAOB), and Anita Doutt, senior associate chief accountant in the office of the chief accountant at the SEC.
Ian O. Williamson, PhD, dean of the UCI Paul Merage School of Business welcomed everyone to the summit. “Why are we hosting this event?” he asked. “Because as a business school we have a big overarching mission to ensure all members of our community have access to a world-class education. I think we recognize that for us to achieve this, it’s not possible to do it by ourselves. That’s something that has to happen in partnership with industry. We’re at our best as an educational institution when we are codesigning and constantly collaborating with the industry.”
Dean Willamson also referenced the importance of governance, and especially audit committees, in helping organizations manage risk. “Data security and AI provide a tremendous opportunity right now,” he said, “but there’s a lot of economic instability that organizations have to navigate: changing regulations around tax law and ESG-related issues. Another challenge is getting access to talent and retaining that talent. All of these will land on your plates in some way.”
Audit Committee Summit Chair Patricia Wellmeyer, PhD, CPA,CGMA, associate professor of accounting and academic director of the Master of Professional Accountancy Program, welcomed the first keynote speaker, board member Kara Stein. “Audit committees are vitally important to our capital markets,” Stein said. “Both to the public companies seeking capital and to the investors relying on corporate disclosures.”
Stein’s keynote address highlighted the shared purpose of the PCAOB and audit committees. “The US capital markets continue to be the largest, deepest, and most liquid in the world,” she said. “They fuel innovation and help propel our economy. Over half of US households–about 56.2 percent–own equities. Our debt markets are also a stable source of non-banking financing that simply cannot be found in many other countries.”
Stein stressed that the continued success of our capital markets is largely due to the quality of the faith that investors and companies have that our markets are fair and efficient. “The confidence of both investors and management at public companies–as well as vigorous competition, cutting-edge innovation, and sometimes lessons learned from market failures–are all contributing factors to this success,” she said.
The beginning of Stein’s address centered on the importance of the Sarbanes-Oxley Act of 2002, which effectively created a new financial reporting ecosystem, led to the creation of the PCAOB, and elevated audit committees as a necessary component of public company oversight. “These steps fundamentally changed the oversight of the independent external audit,” Klein said. “We now have complementary responsibilities to oversee the public company auditor. We are united in our goal to improve the quality of those audits.”
Next Stein spoke about the PCAOB’s relentless focus on driving the improvement of audit quality. “A little over a year ago, the board issued a new strategic plan that called for us to modernize our standards, enhance our inspections, and strengthen our enforcement,” she said. “We are very focused on this. In setting forth a new era, we’re motivated to modernize our legacy auditing standards, which were originally established over 40 years ago. We need to modernize our quality control standards, which date from the ’70s and ’80s, and outline the basic principles of the audit, which go back to the 1940s.”
Stein said results of their 2022 inspection reports showed alarming deficiencies. “Our results showed us that deficiencies have increased in nearly every category for audit firms we’ve inspected,” she said. “These findings also indicate a concerning–and I would say continuing–trend of audit firms’ failures to obtain sufficient, appropriate evidence to support their audit reports.” In other words, a growing number of inspections show firms are signing off on their audit reports without completing the required amount of work.
Stein also mentioned that in 2022 the PCAOB performed initial inspections of some of the audits formed by Chinese affiliates of the Big Four audit firms. “The inspections in those firms found that the auditor did not have a basis to support its assessment of the financial statements or internal controls over financial reporting,” she said. “This remains concerning.”
She observed that, in an ideal world, the PCAOB would not need to maintain an enforcement component of its oversight program. “However, a capable enforcement and disciplinary program is necessary to address egregious violations of standards or rules and to support the standard-setting and related compliance program,” she said. “We intend to use every tool in our enforcement toolbox to impose significant sanctions where appropriate to ensure there are consequences for putting investors at risk–and that bad actors are removed.”
In closing, Stein said, “Public company operations span the globe with increasing complexity of both subsidiaries and supply chains. The risk companies face from sudden shifts in demand to cybersecurity and the use of generative algorithms, or AI–all of these call for an evaluation of the way auditors comprehensively assess risk. So I suggest audit committee members and the PCAOB are facing the same challenges in dealing with these technological advances. Your presence at the summit today shows your commitment and your care toward the importance of the work you do. Thank you for what you do to make our capital markets the envy of the world.”
Anita Doutt, senior associate chief accountant, SEC Office of the Chief Accountant, spoke next, addressing questions about critical audit matters (CAMs) with Professor Wellmeyer in a moderated Q&A session. “The guidance highlights that the auditors should avoid language that could be misinterpreted as a separate opinion on a CAM,” she explained. “In practice, the guidance is helpful, but auditor firms appear to have attempted to satisfy the requirements without discussing outcomes or key observations, which has been a disappointment to investors. The expectation is that at least one CAM is expected, but this year it was reported that the average number of CAMs has declined over time, and the proportion of audit reports that communicate a single CAM has increased. We note these trends have arisen in spite of the COVID pandemic and rising interest rates, which seems counterintuitive.”
Overall, with respect to CAMs, Doutt said she still believes there’s an opportunity for auditors to provide tailored and specific information that can be used in an investor’s decision-making process. “Such a narrow focus is detrimental to investors,” she said, “because it could result in material risks to the business going unaddressed and undisclosed, which ultimately diminishes the quality of financial disclosure. Issues that may impact financial reporting and internal controls also present themselves as isolated incidents. The concern is some management or certain auditors could be inadvertently biased toward evaluating these types of incidents individually or rationalizing away potential disconfirming evidence and conclude that these matters do not individually, or in the aggregate, rise to the level of management disclosure or auditor communication requirement.”
Questioning the Answers
When asked about best practices that audit committees can engage in to fulfill their shared responsibilities with other gatekeepers, Doutt was clear: “The importance of an active and engaged audit committee, as we also heard from board member Kara Stein, that has an independent relationship with the auditor and that takes ownership of their oversight responsibilities is key,” she said. “They should consider asking about specific changes regarding business risk. It’s important to ensure it’s not a check-the-box exercise but a comprehensive assessment performed each year both by management and the auditor. More questions and challenges from the audit committee could help identify risk and perform more robust risk assessments, and ultimately reduce these troubling instances where investors don’t obtain relevant decision-making information.”
Doutt was also asked about the deterioration of audit quality and what the OCA and SEC might suggest audit committees do in their oversight role to improve audit quality. “What can’t audit committees do to help improve audit quality is the punchline,” she said. “Auditing standards mandate and emphasize that auditors demonstrate skepticism about the company’s response to changing conditions and consider any additional risks or misstatements that might arise. To promote this exercise of professional skepticism, we encourage auditors to meet with the audit committee and have open dialogue that provides adequate time for in-depth discussions of reporting and ICFR matters, and dedicating time to ask the auditor probing questions to assess the audit quality is very important. The audit committee should frequently evaluate its process for measuring the auditor’s performance.”
State of Independence
Another best practice for auditors to implement in their oversight role includes maintaining independence, which can sometimes be difficult. “I think from the perspective of OCA, we’ve observed through consultations, news articles, etc. that there is an increase in other transactions that increase the complexity, which makes assessing independence all the more complicated. Some of these complex relationships are the result of companies entering into business relationships with audit firms for service offerings, so this endeavor would trip auditor compliance with business relationships in 201C,” she said. “We have also heard private equity firms sometimes invest in accounting firms and certain entities within the private equity structure and become part of the accounting firm, so these relationships could give the appearance of nonindependence of the auditor. From our perspective, audit firm monitoring needs to be vigilant, and it needs to make sure firms understand the issues and how that potential business impacts their existing and prospective clients. There does lie an immediate risk for public companies. As always, OCA staff are available to engage in consultation regarding these matters. In instances where the business relationships with non-audit services can’t or won’t be unwound or discontinued, OCA staff [will] likely view the firm’s objectivity and impartiality as impaired.”
In conclusion, Doutt responded to Professor Wellmeyer’s question about unintended consequences arising from changes in regulations and policies. “If you look at some of the public meetings of the PCAOB and IAG and discussions about the talent pipeline, I do think it’s a cost-benefit analysis, as Kara discussed. A lot of the auditing standards that are currently in existence–the interim standards–they are legacy holdovers,” she said. “Modernization efforts are very important. I think for audit quality and for our capital markets to continue to be the gold standard of the world, the modernization of the standards and all of those efforts to advance disclosure priorities are important for the maintenance of the high reputation of the US capital markets.”
The summit ended with a panel on “The Audit Committee’s Role in Times of Uncertainty,” moderated by Stephen Cooke, independent director, Farmers and Merchants Bank of Long Beach, adjunct professor, UCI Paul Merage School of Business.
Distinguished panelists were Aimee Weisner, audit committee member, Glaukos Corporation, and board member of Lensar and STAAR Surgical; David Rosenblum, vice chair, board and audit committee, risk, compliance and planning committee, Hanmi Financial Corporation; Karen Saunders, partner, audit, KPMG; and Donald J. Patterson, PhD, professor of computer science, data analytics, Westmont College and UCI.
Audit Committee and HR Constraints
Moderator Stephen Cooke first quoted a survey from earlier this year in which 1,300 executives and directors across a variety of industries identified the top risks for 2023 and the next decade in relation to retaining talent. “Globally this risk is at a significant impact level,” Cooke said. “When we look at what happens with accounting firms, we see the accounting industry has been hit hard. We’re at critical levels now, and it seems to be an ongoing problem. Fewer people are sitting for the exam, and fewer students are taking accounting courses here in the US. All of this leads us to examine whether companies have material weaknesses related to accounting.”
Aimee Weisner said, “The first experience I had with this particular issue with a board I joined in 2019, they had material weakness of this exact kind. That was the first I’d ever heard of it at the time. How do you know if you have enough staff on hand? You can look at published ratios and peer analysis, etc., but ultimately you all have to go about it in your own way. This is really an issue about what risks the internal team is able to audit and which risks they agree won’t be covered for lack of personnel.”
Karen Saunders said, “We should look for new types of talent that need to be added. When you think about attracting new talent, how do your leaders do that? Is there continuity? How are they mentored and trained? Is there cross-training?”
David Rosenblum believes the issue of talent is also impacted by work-from-home policies. “You need to look at any impact of remote work on your operations model and see what your controls are,” he said. “Is remote work changing that? Professional development and mentorship can be hindered by a remote worker policy.”
Cooke followed up with another question for the panel: “There’s a lot more pressure on audit committees to understand how auditors are using technology. How realistic is it for the audit committee to assess this?” Weisner said the question applies beyond the internal audit. “I think audit committees should continue to question how technology is being used and if it’s supplanting or enhancing human judgment,” she said, adding, “How transparent is that process?”
Donald J. Patterson urged the importance of studying human interaction with technology. “One of the big things that has hit the economy has been the large language model ChatGPT and Bard,” he said. “I think knowing how to use those effectively is very important. They’re out there in the wild, and being able to use those tools is as important as using Google is now. The question is when can you use these, and when will they create a liability for you?”
Saunders added, “I think we have to reimagine how we do our work and how we utilize technology more fully. More importantly, you have to make the accounting profession a place where people want to be. So the ability to attract the talent has a salary component, and that will trickle down into audit fees and other costs. We have to look at recruiting at nontypical universities, and we need to ask who can do audit work? Does it have to be a CPA, or could we leverage other resources and the use of technology?”
Audit Committee and AI
Cooke asked Patterson to explain where AI stands today and what our framework for understanding it further should be. “I’ll try to answer that impossible question,” Patterson said. “Over the next year or so we’re going to see some pretty big moves with AI. Just like any statistical model, the generative chat AI models are just reproducing the text found on the internet. The technology is out there. My students are using it. Employees are using it. Knowing what your model is trained on, using test cases, and understanding exactly how AI is being used and what consequential decisions are being made without human oversight is pretty important. People need to be held accountable for the text they turn in, regardless of whether they generated it or not.”
As a lawyer, Weisner had additional concerns about the use of AI. “There are so many issues here,” she said. “When you input your company’s financial information into a third-party system outside of your control, or if you collect competitive information that gets shared, there are so many liabilities to be concerned about.”
Cooke quoted a famous philosopher to end the panel: “Voltaire once said that you can judge someone by the strength of the questions they ask rather than their answers, but we hope you’ve enjoyed both the questions and answers you received here today and found them both invigorating and interesting.”