PCAOB inspection reports have consistently identified revenue as one of the most common areas for audit deficiencies.

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1 P a g e 1 Sarbanes Oxley Compliance Professionals Association (SOXCPA) 1200 G Street NW Suite 800 Washington, DC USA Tel: Web: Dear Member, Today we will start with audit deficiencies again. PCAOB Issues Staff Audit Practice Alert on Auditing Revenue in Light of Frequently Observed Significant Audit Deficiencies Washington, DC - The Public Company Accounting Oversight Board issued a Staff Audit Practice Alert to highlight for auditors the requirements for auditing revenue under PCAOB standards, in light of significant audit deficiencies in this area that have been frequently observed during PCAOB inspections. PCAOB inspection reports have consistently identified revenue as one of the most common areas for audit deficiencies. "Revenue is one of the largest accounts in the financial statements and an important driver of a company's operating results," said PCAOB Chairman James R. Doty. "Given the significant risks involved when auditing revenue, auditors should take note of the matters discussed in this practice alert in planning and performing audit procedures over revenue." Staff Audit Practice Alert No. 12: Matters Related to Auditing Revenue in an Audit of Financial StatementsPDF discusses the application of certain requirements in PCAOB standards when auditing revenue that

2 P a g e 2 are relevant to the significant audit deficiencies frequently found during inspections. Specifically, the alert discusses: - Testing the recognition of revenue from contractual arrangements - Evaluating the presentation of revenue gross versus net revenue - Testing whether revenue was recognized in the correct period - Evaluating whether the financial statements include the required disclosures regarding revenue - Responding to risks of material misstatement due to fraud associated with revenue - Testing and evaluating controls over revenue - Applying audit sampling procedures to test revenue - Performing substantive analytical procedures to test revenue - Testing revenue in companies with multiple locations "It is important for the engagement partner and senior engagement team members to focus on these areas throughout the audit and for engagement quality reviewers to keep these matters in mind when conducting their engagement quality reviews," said Martin F. Baumann, Chief Auditor and Director of Professional Standards. "Audit firms should also revisit their audit methodologies and their implementation of those methodologies to assure that auditing standards are appropriately followed in the area of auditing revenue.

3 P a g e 3 In addition, they also should consider whether additional training of their auditing personnel or other steps are needed to assure that PCAOB standards are followed," he said. Due to the significance of revenues to many companies' financial and operating results, auditing revenue also raises matters of potential interest to audit committees. Audit committees might wish to discuss with their auditors their approach to auditing revenue, including the matters addressed in this alert. In May 2014, the Financial Accounting Standards Board and the International Accounting Standards Board jointly adopted a converged accounting standard on revenue recognition. The matters discussed in this practice alert likely will continue to be relevant to auditing revenue under the new accounting standard. Auditors should determine whether and how to respond to the circumstances discussed in this alert based on the specific facts presented. The statements contained in the practice alerts do not establish rules of the Board and do not reflect any Board determination or judgment about the conduct of any particular firm, auditor, or any other person.

4 P a g e 4 STAFF AUDIT PRACTICE ALERT NO. 12 MATTERS RELATED TO AUDITING REVENUE IN AN AUDIT OF FINANCIAL STATEMENTS Staff Audit Practice Alerts highlight new, emerging, or otherwise noteworthy circumstances that may affect how auditors conduct audits under the existing requirements of the standards and rules of the PCAOB and relevant laws. Auditors should determine whether and how to respond to these circumstances based on the specific facts presented. The statements contained in Staff Audit Practice Alerts do not establish rules of the Board and do not reflect any Board determination or judgment about the conduct of any particular firm, auditor, or any other person. Summary For many companies, revenue is one of the largest accounts in the financial statements and is an important driver of a company's operating results. In audits under Public Company Accounting Oversight Board ("PCAOB" or "Board") standards, revenue typically is a significant account, often involving significant risks that warrant special audit consideration. Because of the importance of auditing revenue, it often is a significant focus area in PCAOB inspections of registered firms. PCAOB Inspections staff continue to observe frequently significant audit deficiencies in which auditors did not perform sufficient auditing procedures with respect to revenue.

5 P a g e 5 In light of these significant auditing practice issues observed by Inspections staff, the Office of the Chief Auditor is issuing this practice alert. This practice alert highlights certain requirements of PCAOB standards relating to aspects of auditing revenue in which significant auditing deficiencies have been frequently observed by Inspections staff. Accordingly, this practice alert discusses the following topics, and related significant deficiencies, regarding auditing revenue: Testing Revenue Recognition, Presentation, and Disclosure Testing the recognition of revenue from contractual arrangements Evaluating the presentation of revenue gross versus net revenue Testing whether revenue was recognized in the correct period Evaluating whether the financial statements include the required disclosures regarding revenue Other Aspects of Testing Revenue Responding to risks of material misstatement due to fraud ("fraud risks") associated with revenue Testing and evaluating controls over revenue Applying audit sampling procedures to test revenue Performing substantive analytical procedures to test revenue Testing revenue in companies with multiple locations Auditors should take note of the matters discussed in this practice alert in planning and performing audit procedures over revenue.

6 P a g e 6 Audit firms should also revisit their audit methodologies, and their implementation of those methodologies, to assure that PCAOB auditing standards are followed in the area of auditing revenue. In addition, audit firms should consider whether additional training of their auditing personnel or other steps are needed to assure that PCAOB standards are followed. Because of the nature and importance of the matters covered in this practice alert, it is particularly important for the engagement partner and senior engagement team members to take action to ensure that engagement teams appropriately implement the auditing standards in these areas throughout the audit and for engagement quality reviewers to focus on these matters when conducting their engagement quality reviews. Due to the significance of revenue to many companies' financial and operating results, auditing revenue also raises matters of potential interest to audit committees. Audit committees might wish to discuss with their auditors their approach to auditing revenue, including the matters addressed in this alert. On May 28, 2014, the Financial Accounting Standards Board ("FASB") and the International Accounting Standards Board jointly adopted a converged accounting standard on revenue recognition. The new accounting standard applies to any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets, unless the contracts are within the scope of other standards (for example, insurance contracts or lease contracts are within the scope of other standards). The effective date of the new accounting standard for public companies reporting under U.S. generally accepted accounting principles ("U.S. GAAP") is annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period.

7 P a g e 7 The effective date of the new accounting standard for companies reporting under International Financial Reporting Standards ("IFRS") is on or after January 1, Early adoption is permitted for companies that report under IFRS but not for public companies that report under U.S. GAAP. The Board's staff believes that the auditing matters discussed in this practice alert are likely to continue to have relevance to auditing revenue under the new accounting standard. Introduction For many companies, revenue is one of the largest accounts in the financial statements and is an important driver of a company's operating results. In audits performed in accordance with PCAOB standards, revenue typically is a significant account, often involving significant risks that warrant special audit consideration. For example, PCAOB standards require auditors to presume that improper revenue recognition is a fraud risk, a type of significant risk. Historically, many fraudulent financial reporting cases have involved intentional misstatement of revenue. For example, according to a study published by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO Study"), which is based upon information disclosed by the U.S. Securities and Exchange Commission in accounting and auditing enforcement releases over a ten- year period, 61 percent of the 347 companies cited in such releases recorded revenue inappropriately, primarily by creating fictitious revenue transactions or by recording revenue prematurely. The study identified improper revenue recognition as the most common method used to report fraudulent financial statement information.

8 P a g e 8 Similarly, the PCAOB has settled disciplinary orders against auditors for violating PCAOB rules and standards in an audit, including violations involving failing to: (1) adequately address signs of improperly recognized revenue in significant unusual transactions; (2) sufficiently audit estimates regarding revenue, including sales returns; (3) adequately address contradictory evidence when auditing revenue; and (4) evaluate or sufficiently evaluate whether revenue was properly disclosed in the financial statements. It is important that auditors appropriately apply professional skepticism, including when auditing revenue. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. Company management has a unique ability to perpetrate fraud because it frequently is in a position to directly or indirectly manipulate accounting records and present fraudulent financial information. Company personnel who intentionally misstate the financial statements often seek to conceal the misstatement by attempting to deceive the auditor. Because of this, applying professional skepticism is integral to planning and performing audit procedures to address fraud risks involved in auditing revenue. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest.

9 P a g e 9 Because of the importance of revenue, it often is a significant focus area in PCAOB inspections of firms. Inspections staff continue to observe frequently significant audit deficiencies in which auditors did not perform sufficient auditing procedures with respect to revenue, including: The failure to perform sufficient procedures to test whether revenue was recognized in conformity with the applicable financial reporting framework, including whether revenue was recognized in the correct period; The failure to evaluate, or evaluate sufficiently, whether revenue was appropriately disclosed in the financial statements; The failure to address fraud risks regarding revenue; Unsupported reliance on controls over revenue because either controls were not tested sufficiently or identified control deficiencies were not evaluated sufficiently; Unsupported reliance on company-generated data and reports used to audit revenue because the data and reports were not tested or not tested sufficiently; Insufficient testing of revenue transactions, including failure to appropriately apply audit sampling; The failure to perform sufficient substantive analytical procedures; and The failure to sufficiently test revenue in companies with multiple locations or business units. Testing Revenue Recognition, Presentation, and Disclosure The auditor has a responsibility to evaluate whether the company's financial statements are presented fairly, in all material respects, in conformity with the applicable financial reporting framework.

10 P a g e 10 This includes evaluating whether revenue was recognized in conformity with the requirements of the applicable financial reporting framework. The way in which revenue should be recognized can vary depending on, for example, the type of revenue and terms of the contractual arrangement. To audit revenue effectively, auditors should understand, among other things, the company's key products and services, and business processes that affect revenue. The auditor also is required to evaluate whether the company's selection and application of accounting principles are appropriate for its business and consistent with the applicable financial reporting framework and accounting principles used in the company's relevant industry. For example, if a company's accounting principles for revenue recognition are more aggressive than those of its industry peers, that may indicate a risk of material misstatement. Testing the Recognition of Revenue from Contractual Arrangements Inspections staff observed instances for example, with respect to construction- type or production-type contracts and multiple-element arrangements in which auditors failed to perform sufficient procedures to evaluate whether a company's recognition of revenue was in conformity with the applicable financial reporting framework. In other instances, auditors failed to perform sufficient procedures to evaluate whether the revenue under a company's contractual arrangements was recognized appropriately. For example, it appeared to Inspections staff that the auditors did not perform sufficient procedures to review the company's contracts and as a result did not sufficiently understand the contractual terms and conditions, such as transfer of title, risk of loss, and delivery and acceptance.

11 P a g e 11 Also, in some instances, auditors identified sales contracts whose terms or conditions varied from the company's standard contract language, yet the auditors failed to evaluate the effect of such nonstandard contractual terms on the recognition of revenue. As it relates to construction-type or production-type contracts, Inspections staff identified instances in which auditors failed to perform audit procedures to: (1) test management's estimated costs to complete projects; (2) test the progress of the construction or production contracts; or (3) evaluate the reasonableness of the company's approach for applying the percentage-of-completion method of accounting. With respect to multiple-element arrangements, Inspections staff observed instances in which auditors failed to perform procedures to evaluate the company's recognition of revenue derived from transactions involving the delivery of multiple elements in accordance with the applicable financial reporting framework. Examples of deficiencies observed by Inspections staff included the auditors' failures to: Evaluate each of the deliverables to determine whether they represented separate units of accounting; and Test the value assigned to the undelivered elements (for example, allocation of relative selling price based on vendor-specific objective evidence, third party evidence or best estimate of selling price). Gaining an understanding of the company, its environment, and its internal control over financial reporting includes gaining an understanding of the business, the different types of sales contracts, and the controls over revenue, including the company's development of accounting estimates for revenue.

12 P a g e 12 Such an understanding necessarily includes knowledge of the company's key products and services and the contractual terms by which sales are made, such as the key provisions of contractual arrangements and the extent to which contractual terms are standardized across the company. This understanding can assist the auditor in identifying the contractual terms for standardized contracts relevant to recognizing revenue as well as to identify and evaluate the effects of nonstandard contractual terms. Further, this understanding will assist the auditor in determining the audit procedures necessary to test whether revenue was properly reported in the financial statements in conformity with the applicable financial reporting framework. Revenue recognition often involves accounting estimates, such as estimates of future obligations under the terms of sale in the contract. If the accounting estimate is a fair value measurement, the auditor should apply the requirements of AU sec. 328, Auditing Fair Value Measurements and Disclosures. For other estimates, the auditor should apply the requirements of AU sec. 342, Auditing Accounting Estimates, for example, when auditing accounting estimates used to record revenue in transactions involving seller performance obligations. Those standards address, among other things, the auditor's responsibilities with respect to evaluating the appropriateness of the company's methods and the reasonableness of management's assumptions used in the estimates and related disclosures, as well as the completeness and accuracy of company data used in the estimates. For example, in evaluating the reasonableness of an estimate, the auditor is required to obtain an understanding of how management developed the estimate. Based on that understanding, the auditor should use one or a combination of the following approaches:

13 P a g e Review and test the process used by management to develop the estimate; 2. Develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate; or 3. Review subsequent events or transactions occurring prior to the date of the auditor's report. Evaluating the Presentation of Revenue Gross Versus Net Revenue Inspections staff observed instances in which auditors failed to perform sufficient procedures to evaluate whether a company's presentation of revenue on a gross basis (as a principal) versus a net basis (as an agent) was in conformity with the applicable financial reporting framework. More specifically, Inspections staff observed deficiencies in which auditors failed to evaluate whether the company is a seller that has the primary obligation to the customer or the company is a seller that is acting in the capacity of an agent, and to evaluate the effect that determination would have on presentation of revenue. The auditor's evaluation of audit results is required to include an evaluation of, among other things, the presentation of the financial statements. This includes the auditor's evaluation of whether revenue is presented in conformity with the applicable financial reporting framework. When understanding the contractual terms of sales, as discussed in "Testing the Recognition of Revenue from Contractual Arrangements," it is important for the auditor to evaluate whether the company is the principal or the agent in the transaction in order to evaluate the presentation of revenue relative to whether gross revenue or net revenue is appropriate.

14 P a g e 14 Testing Whether Revenue Was Recognized in the Correct Period Inspections staff observed instances in which auditors failed to perform, or sufficiently perform, procedures to test whether revenue was recognized in the correct period ("cutoff procedures"). Examples of such instances included: The failure to perform cutoff procedures to address the risk of material misstatement; The failure to obtain evidence about whether the necessary delivery of goods had occurred or service had been rendered to enable the company to appropriately record revenue; and Inappropriate reliance on untested company-generated information, such as sales invoices or inventory records, to determine whether revenue was recorded in the appropriate period. The risk of material misstatement involving the recognition of revenue in the incorrect period might be a risk of error (for example, as a result of problems with related company systems or controls) or a risk of fraud (for example, intentionally recognizing revenue prematurely), both resulting in improper revenue recognition. When designing and performing cutoff procedures, the auditor should plan and perform audit procedures that address the risk of material misstatement. This includes determining that the procedures are designed to detect the types of potential misstatements related to the risk and obtaining sufficient relevant and reliable (that is, appropriate) evidence regarding whether revenue transactions are recorded in the appropriate period. Further, if the risk of improper cutoff is related to overstatement

15 P a g e 15 or understatement of revenue, it is important for the cutoff procedures to encompass testing of revenue recorded in the period covered by the financial statements and revenue recorded in the subsequent period. An example of a typical cutoff procedure is to test sales transactions by comparing sales data for a sufficient period before and after year-end to sales invoices, shipping documentation, or other appropriate evidence to determine that the revenue recognition criteria were met and the sales transactions were recorded in the proper period. Evaluating Whether the Financial Statements Include the Required Disclosures Regarding Revenue Inspections staff observed instances in which auditors did not evaluate whether the disclosures of revenue in the financial statements were in conformity with the applicable financial reporting framework. For example, Inspections staff observed instances in which firms did not evaluate whether the company's disclosures regarding its revenue recognition policy regarding multiple-element arrangements and warranty policies were in conformity with U.S. GAAP. In another instance, a firm failed to identify the company's omitted disclosures regarding the revenue recognition policies for the company's new line of business. As part of obtaining an understanding of the company's selection and application of accounting principles, including related disclosures, PCAOB standards require the auditor to evaluate whether the company's selection and application of accounting principles are appropriate for its business and consistent with the applicable financial reporting framework and accounting principles used in the relevant industry. Also, to identify and assess risks of material misstatement related to omitted, incomplete, or inaccurate disclosures, the auditor should develop expectations about the disclosures that are necessary for the company's financial statements to be presented fairly in conformity with the applicable financial reporting framework.

16 P a g e 16 PCAOB standards require auditors to perform procedures to identify and assess the risks of material misstatement of the financial statements, including consideration of the risk of omitted, incomplete, or inaccurate disclosures. Auditors also are required to perform procedures to address the risks of material misstatement regarding significant financial statement disclosures. When evaluating the financial statements, auditors are required to evaluate whether the financial statements contain the information essential for the fair presentation of the financial statements in conformity with the applicable financial reporting framework. More specifically, the auditor is required to evaluate the disclosures, which includes, among other things: Evaluating whether the financial statements, including the related notes, are informative of matters that may affect their use, understanding, and interpretation; and Considering the form, arrangement, and content of the financial statements (including the accompanying notes), encompassing matters such as the terminology used, the amount of detail given, the classification of items in the statements, and the bases of amounts set forth. Evaluation of disclosures also involves evaluation of the effect on the financial statements of uncorrected misstatements in disclosures, such as omitted, incomplete, or inaccurate disclosures. Although evaluation of uncorrected misstatements requires consideration of relevant qualitative and quantitative factors, qualitative considerations are especially important to the evaluation of misstatements in disclosures that are more narrative in nature. PCAOB standards describe the auditor's responsibilities for considering qualitative factors in the context of the auditor's consideration of materiality.

17 P a g e 17 Other Aspects of Testing Revenue PCAOB standards require the auditor to design and perform audit procedures in a manner that addresses the assessed risks of material misstatement for each relevant assertion of each significant account and disclosure, which typically includes revenue. In designing the audit procedures to be performed, the auditor is required to: (1) obtain more persuasive audit evidence the higher the auditor's assessment of risk; (2) take into account the types of potential misstatements that could result from the identified risks and the likelihood and magnitude of potential misstatement; and (3) in a financial statement audit, design the tests of controls over revenue to obtain sufficient evidence to support the auditor's control risk assessments when the auditor relies on controls. As the assessed risk of material misstatement increases, the evidence from substantive procedures that the auditor should obtain to test revenue also increases. The evidence provided by the auditor's substantive procedures depends upon the mix of the nature, timing, and extent of those procedures. Further, for an individual assertion, different combinations of the nature, timing, and extent of testing might provide sufficient appropriate audit evidence to respond to the assessed risk of material misstatement. For example, substantive procedures for testing revenue typically involve a combination of tests of revenue transactions and substantive analytical procedures.

18 P a g e 18 The following topics relate to areas where Inspections staff frequently observed significant deficiencies in the auditing procedures applied to revenue. Responding to Fraud Risks Associated with Revenue As mentioned previously, the most common fraud technique highlighted in the COSO Study involved improper revenue recognition. This underscores the importance of devoting proper audit attention to assessing and responding to fraud risks associated with revenue. Inspections staff observed instances in which auditors failed to sufficiently respond to fraud risks associated with revenue, including the risk of improper revenue recognition. Examples of such deficiencies included the auditors' failures to: Identify and respond to the presumed fraud risk related to improper revenue recognition or to demonstrate how the presumption was overcome under the existing circumstances; Perform procedures to address an identified fraud risk related to revenue; and Sufficiently address an identified fraud risk related to side agreements because the firm's planned response confirmation procedures resulted in a high percentage of nonresponses, for which the auditor's procedures were limited to management inquiries. To effectively address fraud risks, it is important for auditors to devote attention to identifying and assessing fraud risks. With regard to auditing revenue, PCAOB standards require the auditor to presume that there is a fraud risk involving improper revenue recognition and to evaluate which types of revenue, revenue transactions, or assertions may give rise to such risks in the company being audited.

19 P a g e 19 Published studies have identified a number of different fraud schemes involving material misstatement of revenue, including schemes involving fictitious revenue transactions or recording revenue prematurely. Specific examples of techniques involving improper revenue recognition described in the COSO Study include: (1) sham sales; (2) recording transactions even though the sales involved unresolved contingencies; (3) round-tripping or recording loans as sales; (4) improper recording of sales from bill and hold transactions that did not meet the criteria for revenue recognition; (5) recording revenues before all the terms of the sales were completed; (6) improper cutoff of sales; (7) improperly accelerating the estimated percentage of completion method for projects in process; (8) shipping goods never ordered by the customer or shipping defective products and recording revenues at full, rather than discounted, prices; and (9) recording revenue for consignment shipments or shipments of goods for customers to consider on a trial basis. When addressing fraud risks in the audit of the financial statements, PCAOB standards require auditors to perform substantive procedures, including tests of details, that are specifically responsive to the assessed fraud risks. Performing procedures that are specifically responsive involves considering the ways that revenue could be intentionally misstated and

20 P a g e 20 how the fraud might be concealed and designing audit procedures directed toward detecting intentional misstatements. Auditors who merely identify revenue as having a general risk of improper revenue recognition without attempting to assess ways in which revenue could be intentionally misstated may find it difficult to develop meaningful responses to the identified fraud risks. When responding to fraud risks, it is important to design and perform procedures that seek reliable evidence that would be difficult for potential perpetrators to manipulate, such as evidence obtained directly from independent and knowledgeable sources outside the company. Merely increasing the extent of testing (for example, using larger sample sizes) without designing procedures to obtain more reliable evidence is unlikely to adequately respond to a fraud risk of material misstatement in the financial statements. Incorporating an element of unpredictability in audit procedures also is important in responding to fraud risks. Unpredictable audit procedures are more difficult for individuals looking to perpetrate a fraud to anticipate, which can make an intentional misstatement more difficult to conceal. Examples of ways to incorporate an element of unpredictability when testing revenue include: Performing audit procedures related to components of revenue or assertions that would not otherwise be tested based on their amount or the auditor's assessment of risk; Varying the timing of the audit procedures; Selecting items for testing that have lower amounts or are otherwise outside customary selection parameters; Performing audit procedures on an unannounced basis; and

21 P a g e 21 In multi-location audits, varying the location or the nature, timing, and extent of audit procedures at related locations or business units from year to year. As noted previously, the application of professional skepticism is important in assessing and responding to fraud risks. This includes, among other things, performing procedures to obtain evidence regarding management's representations, being alert for contrary evidence, and critically evaluating the audit evidence obtained. Testing and Evaluating Controls over Revenue In many audits, auditors rely on controls to reduce their substantive testing of revenue, for example, reducing the extent of their testing through smaller sample sizes. Auditors typically use this approach in integrated audits of financial statements and internal control over financial reporting and may use this approach in audits of financial statements only. Inspections staff observed instances in which auditors relied on controls over revenue to reduce their substantive testing, but their reliance was unsupported because: The testing of controls was insufficient (for instance, auditors failed to test controls over the entire period for which the firm relied on controls or failed to perform sufficient procedures to test controls over significant categories of revenue); The results of the testing identified control deficiencies indicating that the controls were ineffective; or The auditor failed to perform sufficient procedures to test the design and operating effectiveness of the company's controls over a significant category of revenue because it failed to evaluate whether the control addressed the relevant assertions for revenue.

22 P a g e 22 Unsupported reliance on internal control can lead to inadequate substantive testing of revenue. PCAOB standards provide that, if the auditor plans to assess control risk for a relevant assertion of a significant account and disclosure at less than the maximum by relying on controls and the nature, timing, and extent of planned substantive procedures are based on that lower assessment, the auditor must obtain evidence that the controls selected for testing, and being relied upon, are designed effectively and operated effectively during the entire period of reliance. Not having evidence to support the auditor's reliance on controls for the entire period of reliance results in insufficient audit work. Also, it is important for the auditor to select for testing controls that address the risks of material misstatement for the categories of revenue for which the auditor intends to rely on controls. PCAOB standards require the auditor to test the design and operating effectiveness of the controls selected for testing by determining whether the controls are (1) operating as designed by persons possessing the necessary authority and competence to perform the control effectively, and (2) satisfy the company's control objectives and can effectively prevent or detect error or fraud that could result in material misstatements in the financial statements. When the auditor detects deficiencies in controls over revenue on which the auditor plans to rely, PCAOB standards require the auditor to evaluate the severity of the control deficiencies and the effect on the auditor's control risk assessments. If the auditor plans to rely on controls relating to an assertion but the controls that the auditor tests are ineffective because of control deficiencies, the auditor is required to:

23 P a g e Perform tests of other controls related to the same assertion as the ineffective controls; or 2. Revise the control risk assessment and modify the planned substantive procedures as necessary in light of the increased assessment of risk. Applying Audit Sampling Procedures to Test Revenue Designing substantive tests of details includes determining the means of selecting items for testing from among the items included in an account. The auditor is required to determine the means of selecting items for testing to obtain evidence that, in combination with other relevant evidence, is sufficient to meet the objective of the audit procedure. The alternative means of selecting items for testing are: Applying audit sampling; Selecting specific items; and Selecting all items. Audit sampling is the application of an audit procedure to less than 100 percent of the items within an account balance or class of transactions for the purpose of evaluating some characteristic of the balance or class. AU sec. 350 establishes requirements for planning and performing audit sampling procedures, and evaluating the results of such procedures. Inspections staff observed instances in which auditors did not appropriately design and perform sampling procedures to test revenue transactions. Instances of such deficiencies included:

24 P a g e 24 Using samples that were too small to provide sufficient audit evidence; Failing to select a representative sample of items for testing, which is necessary to be able to extend the auditor's conclusions to the entire population (for example, limiting the sample selection to certain types of revenue transactions or contracts within the population); and Failing to apply audit procedures to all of the sample items selected and inappropriately evaluating the sample results as if the untested sample items were tested without exception. Determining Sample Sizes Under PCAOB standards, to determine the number of items to be selected in a sample for a particular substantive test of details, such as when testing revenue, the auditor should take into account the following factors: Tolerable misstatement for the population; The allowable risk of incorrect acceptance (based on the assessments of inherent risk, control risk, and the detection risk related to the substantive analytical procedures or other relevant substantive tests); and The characteristics of the population, including the expected size and frequency of misstatements. Although auditors may use statistical or nonstatistical sampling methods, PCAOB standards provide that when circumstances are similar, the effect on sample size of the factors discussed in the previous paragraph should be similar regardless of whether a statistical or nonstatistical approach is used. Thus, when a nonstatistical sampling approach is applied properly, the resulting sample size ordinarily will be comparable to, or larger than, the

25 P a g e 25 sample size resulting from an efficient and effectively designed statistical sample. Choosing a Representative Sample Auditors typically use sampling methods to be able to test a portion of a population and extend the conclusions about the sample to the entire population. To do that, the sample of items selected for testing must be representative of the entire population. Otherwise, the auditor's conclusion applies only to the items tested rather than the entire population. Under PCAOB standards, a sample is representative if all of the items in the population have an opportunity to be selected. Items may be selected randomly, systematically, or haphazardly. The following are examples of selection methods for testing revenue transactions that are not representative of the entire population of revenue: Testing all revenue transactions over a specified amount or with specified characteristics; Testing only the unpaid revenue transactions that compose accounts receivable; and Limiting the sample selection to certain days, weeks, or months during the year rather than selecting from the entire population. Testing Sample Items The auditor should apply the planned audit procedures to each sample item selected.

26 P a g e 26 In some circumstances, the auditor may not be able to apply the planned audit procedures to selected sample items because, for example, supporting documentation may be missing. The auditor's treatment of unexamined items will depend on their effect on the evaluation of the sample. If the auditor's evaluation of the sample results would not be altered by considering those unexamined items to be misstated, it is not necessary to examine the items. Instead, the untested item should be treated as a misstatement and projected to the population along with other misstatements. However, if considering those unexamined items to be misstated would lead to a conclusion that revenue contains material misstatement, the auditor should consider alternative procedures that would provide him or her with sufficient evidence to form a conclusion. The auditor also should evaluate whether the reasons for his or her inability to examine the items have: (1) implications in relation to his or her risk assessments, including the assessment of fraud risk; (2) implications regarding the integrity of management or employees; and (3) possible effects on other aspects of the audit. Selecting Specific Items Not Involving Sampling Selecting specific items refers to testing all items in a population that have a specific characteristic. For example, the auditor may decide to select for testing all of the revenue transactions that have certain size, risk, or other characteristics ("key item testing").

27 P a g e 27 In those cases, the auditor should remove those selected items from the population and apply audit sampling or other substantive procedures to the remaining transactions. This type of approach can be particularly effective when the revenue account consists of: (1) relatively few transactions that have large amounts or a higher risk of material misstatement, and (2) a great volume of transactions with lower amounts and lower risks of material misstatement. As indicated above, the application of audit procedures to selected specific items does not constitute audit sampling, so the results of those audit procedures cannot be projected to the entire population. Separately testing the largest revenue transactions can lower the size of the sample population and the necessary sample size. Separately testing the higher-risk transactions and applying audit sampling to the low-risk transactions can reduce the assurance needed from the sampling procedure and the necessary sample size. However, auditors cannot limit their substantive procedures solely to key item testing if the remaining portion of the account has a risk of material misstatement, that is, if there is a reasonable possibility that the remaining portion could have a misstatement that, individually or in combination, would result in material misstatement of the financial statements. In those situations, the auditor should design and perform audit procedures to address the assessed risks of material misstatement in that remaining untested portion of the account. Furthermore, the auditor cannot obtain sufficient appropriate audit evidence about one group of items in a population by examining dissimilar items in the population.

28 P a g e 28 Performing Substantive Analytical Procedures to Test Revenue Analytical procedures are an important part of the audit process when they are properly designed and performed. Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. Analytical procedures range from simple comparisons to the use of complex models involving many relationships and elements of data. A basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. Particular conditions that can cause variations in these relationships include, for example, specific unusual transactions or events, accounting changes, business changes, random fluctuations, or misstatements. Analytical procedures are used as a substantive test to obtain evidential matter about particular assertions related to account balances or classes of transactions. Depending on the level of assurance the auditor desires from substantive testing for a particular audit objective, the auditor decides, among other things, which procedure or combination of procedures can provide that level of assurance. For some assertions, analytical procedures are effective in providing the appropriate level of assurance. For other assertions, however, analytical procedures may not be as effective or efficient as tests of details in providing the desired level of assurance. Analytical procedures performed as substantive procedures involve, among other things, investigation of significant differences from

29 P a g e 29 expected amounts and obtaining evidence regarding management's explanations of significant unexpected differences. When properly applied under appropriate conditions, substantive analytical procedures can identify potential material misstatement in an account, such as revenue. Inspections staff observed instances in which firms' performance of substantive analytical procedures for testing revenue were insufficient. For example, Inspections staff observed instances in which auditors, when using substantive analytical procedures that were intended to achieve a high level of assurance: Failed to develop expectations that were sufficiently precise, for example, because the expectations did not appropriately disaggregate data to identify potential material misstatements; Did not determine that there was a plausible and predictable relationship among the data used in the substantive analytical procedure, which is necessary to develop suitable expectations of the recorded amount of revenue; Did not establish an amount of difference from the expectation that could be accepted without further investigation; Did not investigate significant differences from expectations; Failed to perform procedures to obtain evidence to corroborate management's responses regarding significant unexpected differences with other evidential matter; and Failed to test the completeness and accuracy of the information obtained from the company that was used in performing analytical procedures. Designing Substantive Analytical Procedures

30 P a g e 30 It is important for auditors to design their substantive analytical procedures to provide the necessary level of assurance regarding the assertion being tested. The level of assurance that is needed from a substantive analytical procedure depends on: 1. The risk of material misstatement, considering reliance on controls when appropriate, for the relevant assertion being tested; and situations. To achieve the necessary level of assurance from a substantive analytical procedure, the auditor should design and perform analytical procedures that appropriately take into account, among other things, the following: 2. The nature of the assertion; 3. The plausibility and predictability of the relationship; 4. The availability and reliability of the data used to develop the expectation; 5. The precision of the expectation; and 6. The threshold for investigation of differences. Plausibility and predictability of relationships Analytical procedures involve comparisons of recorded amounts, or ratios developed from recorded amounts, to expectations developed by the auditor. The auditor develops such expectations by identifying and using plausible relationships that are reasonably expected to exist based on the auditor's understanding of the company and its environment. Following are examples of sources of information for developing expectations:

31 P a g e Financial information for comparable prior period(s) giving consideration to known changes; 2. Anticipated results, for example, budgets, or forecasts including extrapolations from interim or annual data; 3. Relationships among elements of financial information within the period; 4. Information regarding the industry in which the company operates for example, gross margin information; and 5. Relationships of financial information with relevant nonfinancial information. An understanding of the reasons that make relationships plausible is important for the auditor to understand since data sometimes might appear to be related when they are not, which could lead the auditor to erroneous conclusions. Such an understanding generally requires knowledge of the company and its industry. As higher levels of assurance are needed from analytical procedures, more predictable relationships are required to develop the expectation. Relationships typically are less predictable when there are less stable environments or when amounts are determined from complex processes, subjective judgments, or transactions subject to management discretion. On the other hand, relationships might be more predictable if they are based on established relationships, such as, cash flows based on contract terms (when nonpayment risk is low) and verifiable rate-volume determinations. Inspections staff observed instances in which auditors did not take into account the plausibility and predictability of relationships when performing substantive analytical procedures to audit revenue.

32 P a g e 32 For example: The auditor failed to establish the plausibility and predictability of relationships that would support the expectations by not considering any known changes in revenue, including unusual transactions in the prior period and planned growth; and The auditor established its expectation for revenue based on a historical average of peer companies, without determining that such an average was predictive of the company's current year revenue. Availability and reliability of data Before using the results obtained from substantive analytical procedures, the auditor should either test the design and operating effectiveness of controls over financial information used in the substantive analytical procedures or perform other procedures to support the completeness and accuracy of the underlying information. The auditor also should assess the reliability of the data by considering the source of the data and the conditions under which it was gathered, as well as other knowledge the auditor may have about the data. The following factors influence the auditor's consideration of the reliability of data for purposes of achieving audit objectives: Whether the data was obtained from independent sources outside the entity or from sources within the entity; Whether sources within the entity were independent of those who are responsible for the amount being audited; Whether the data was developed under a reliable system with adequate controls; Whether the data was subjected to audit testing in the current or prior year; and

33 P a g e 33 Whether the expectations were developed using data from a variety of sources. Furthermore, the auditor should evaluate the risk of management override of controls. As part of this process, the auditor should evaluate whether such an override might have allowed adjustments outside of the normal periodend financial reporting process to have been made to the financial statements. Such adjustments might have resulted in artificial changes to the financial statement relationships being analyzed, causing the auditor to draw erroneous conclusions. For this reason, substantive analytical procedures alone are not well suited to detecting fraud. Inspections staff observed instances in which auditors did not test the completeness and accuracy of internal data used in applying substantive analytical procedures to test revenue. For example, in one instance, the auditor did not test the completeness and accuracy of company-generated data used in a substantive analytical procedure for revenue. In another instance, the auditor tested certain information technology general controls for a system that processed revenue transactions. But the auditor did not test controls over the system queries used to obtain the data from the system that processed the revenue for purposes of performing substantive analytical procedures nor perform other procedures to test the completeness and accuracy of the data applied in the substantive analytical procedures. Precision of the expectation

34 P a g e 34 The expectation should be precise enough to provide the desired level of assurance that differences that may be potential material misstatements individually or when aggregated with other misstatements would be identified for the auditor to investigate. The precision of the expectation depends on, among other things, the auditor's identification and consideration of factors that significantly affect the amount being audited and the level of detail of data used to develop the expectation. For example, revenue may be affected by prices, volume, and product mix. Each of these, in turn, may be affected by a number of factors, and offsetting factors can obscure misstatements. More effective identification of factors that significantly affect the relationship is generally needed as the desired level of assurance from analytical procedures increases. Expectations developed at a detailed level generally have a greater chance of detecting misstatement of a given amount than do broad comparisons. Monthly amounts will generally be more effective than annual amounts and comparisons by location or line of business usually will be more effective than company-wide comparisons. The level of detail that is appropriate will be influenced by the nature of the company, its size, and its complexity. Generally, the risk that material misstatement could be obscured by offsetting factors increases as a client's operations become more complex and more diversified. Disaggregation helps reduce this risk.

35 P a g e 35 Inspections staff observed instances in which auditors did not develop expectations, or the auditors' expectations were not sufficiently precise. In some of those instances, the substantive analytical procedures consisted only of comparing the company's total annual revenue to the prior year. Threshold for investigation In planning the analytical procedures as a substantive test, the auditor should consider the amount of difference from the expectation that can be accepted without further investigation. This consideration is influenced primarily by materiality and should be consistent with the level of assurance desired from the procedures. Determination of this amount involves considering the possibility that a combination of misstatements in the specific account balances, or class of transactions, or other balances or classes could aggregate to an unacceptable amount. Inspections staff observed instances in which substantive analytical procedures were aimed at achieving a high level of assurance regarding revenue, but the auditor's threshold for evaluating differences was too high; in some cases, at levels that significantly exceeded the auditor's established level of materiality for the financial statements. Performing the Planned Substantive Analytical Procedures Performance of substantive analytical procedures involves making the comparisons of relationships as designed, including evaluating significant unexpected differences. Although evaluating significant unexpected differences might begin with inquiry of management, management's responses should ordinarily be corroborated with other evidential matter.

36 P a g e 36 When an auditor cannot obtain an explanation for the difference, the auditor is required to perform other audit procedures about the assertion to determine whether the difference represents a misstatement in the financial statements. Inspections staff observed instances in which auditors failed to perform procedures to corroborate management's explanations for significant unexpected differences or alternatively to perform additional substantive audit procedures in response to significant unexpected differences. Testing Revenue in Companies with Multiple Locations Inspections staff observed instances in which auditors did not test, or test sufficiently, revenue at individual locations that had specific risks, including fraud risks, for which there was a reasonable possibility of material misstatement of the financial statements. For example: The auditor relied on entity-level controls to reduce the substantive testing of revenue at certain locations but failed to evaluate the effects of identified deficiencies in those controls; and The auditor planned to use the work of internal auditors with respect to certain locations, but the auditor failed to evaluate whether the work of internal auditors addressed certain identified risks associated with those locations. When a company has operations in multiple locations or has business units that generate or process revenue, the auditor is required to determine the extent to which audit procedures should be performed at selected locations or business units in gathering sufficient appropriate audit evidence. This includes determining locations and business units at which to perform audit procedures, as well as the nature, timing, and extent of the procedures to be performed at those individual locations or business units.

37 P a g e 37 The auditor is required to assess the risk of material misstatement to the consolidated financial statements that is associated with the locations or business units. In determining the amount of audit attention the auditor should devote to the location or business unit, the auditor is required to correlate such audit attention with the degree of risk of material misstatement associated with that location or business unit. Auditing Standard No. 9 lists the following factors that are relevant to the assessment of the risk of material misstatement associated with a location or business unit and the determination of the necessary audit procedures: 1. The nature and amount of assets, liabilities, and transactions executed at the location or business unit, including, for example, significant transactions executed at the location or business unit that are outside the normal course of business for the company or that otherwise appear to be unusual given the auditor's understanding of the company and its environment; 2. The materiality of the location or business unit; 3. The specific risks associated with the location or business unit that present a reasonable possibility of material misstatement to the company's consolidated financial statements; 4. Whether the risks of material misstatement associated with the location or business unit apply to other locations or business units such that, in combination, they present a reasonable possibility of material misstatement to the company's consolidated financial statements; 5. The degree of centralization of records or information processing; 6. The effectiveness of the control environment, particularly with respect to management's control over the exercise of authority delegated to others and its ability to effectively supervise activities at the location or business unit; and

38 P a g e The frequency, timing, and scope of monitoring activities by the company or others at the location or business unit. Sometimes, the auditor might rely on controls at one or more selected locations. These controls might be entity-level controls to address the risk of material misstatement of revenue at certain locations. In those cases, the auditor should determine whether the selected control is designed and operates at a level of precision that would prevent or detect misstatements that, individually or in combination, would result in a material misstatement of the company's financial statements. In some situations, auditors might use the work of internal auditors to obtain evidence regarding revenue at selected locations. In those situations, the auditor should look to the requirements of AU sec. 322, The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements, which describes the extent to which the auditor can use the work of internal auditors and establishes requirements for testing that work. Pursuant to AU sec. 322, the extent to which the auditor can use the work of internal auditors depends on, among other things, the competence and objectivity of the internal auditor and the risk associated with the location at which the work is performed. Conclusion In audits under PCAOB standards, revenue typically is a significant account, often involving significant risks that warrant special audit consideration. For many companies, revenue is one of the largest accounts in the financial statements and is an important driver of a company's operating results.

39 P a g e 39 Auditors should take note of the matters discussed in this practice alert in planning and performing audit procedures over revenue. Audit firms should also revisit their audit methodologies, and their implementation of those methodologies, to assure that PCAOB auditing standards are followed in the area of auditing revenue. In addition, audit firms should consider whether additional training of their auditing personnel or other steps are needed to assure that PCAOB standards are followed. Because of the nature and importance of the matters covered in this practice alert, it is particularly important for the engagement partner and senior engagement team members to take actions to ensure that engagement teams appropriately implement the auditing standards in these areas throughout the audit and for engagement quality reviewers to focus on these matters when conducting their engagement quality reviews. Due to the significance of revenues to many companies' financial and operating results, auditing revenue also raises matters of potential interest to audit committees. Audit committees might wish to discuss with their auditors their approach to auditing revenue, including the matters addressed in this alert. The PCAOB will continue to monitor developments in this area. The Board, or its staff, will determine whether additional steps regarding development of a potentially new standard-setting project or other guidance for auditors to enhance audit quality with the goal of protecting investors should be taken.

40 P a g e 40 Whatever Happened to Promoting Small Business Capital Formation? Commissioner Daniel M. Gallagher Washington, D.C. Thank you, David [Burton], for that introduction. I appreciate all that the Heritage Foundation in general, and David in particular, are doing to focus attention on key issues in the capital markets, and I am honored to have the opportunity to be here today. It s almost a cliché now for political figures of all stripes to state that small business is the lifeblood of our economy and the primary engine of economic growth and job creation in this country. But it s a truth worth repeating, and in this era of partisan polarization, it s good to have some common ground, at least on a conceptual level. But small business has a big collective action problem here in Washington, where it is regularly and systematically underrepresented in the legislative and regulatory process. Small business owners are focused on making ends meet and growing their businesses, not hiring high-priced lobbyists to influence policy. Big businesses and unions, by contrast, can afford to hire lobbyists to develop relationships with politicians and regulators which is the way business in the U.S. increasingly gets done. As an SEC Commissioner, I believe that this issue warrants the agency s highest level of priority. And, as the son of two long-time small business owners, I take this issue personally.

41 P a g e 41 I d like to think that the SEC, with its mandate to promote efficiency, competition, and capital formation would be immune from, or at least could rise above, these trends. But sadly, we at the SEC are not doing nearly enough to ensure that small businesses have the access to capital that they need to grow. We layer on rule after rule until it becomes prohibitively expensive to access the public capital markets. Only rarely do we remove any of our rules, even after they have long since ceased to serve their purpose or have become obsolete or worse. And although we have made significant progress in expanding our economic analysis of new rules and rule amendments, we almost never consider how heavily the weight of the entire corpus of rules bears down on registrants. Of course, not all of this is the SEC s fault. Much of the ever-growing rulebook is a direct result of congressional mandates. But the Commission has discretion, along with exemptive authority, to make these mandates less onerous. Unfortunately, its track record for doing so is mixed. Moreover, on the rare occasions when Congress attempts to help us streamline our rules, the SEC s response is rarely enthusiastic. When the JOBS Act undertook a much-needed liberalization of private offerings under Rule 506, the Commission infamously responded with a proposed rule that seeks not only to undo some of the benefits achieved in that bipartisan statute, but also to impose new burdens on all Regulation D transactions. Given these negative trends for capital formation in general, it s no surprise that issues specific to small business capital formation too often remain on the proverbial back burner.

42 P a g e 42 This lack of attention doesn t just harm small business; it also harms investors and the public at large. Companies are understandably hesitant to incur the ever-increasing burdens of going public. Investors that don t have the resources to buy into a venture capital fund then do not get the opportunity to profit from the potentially explosive growth of early-stage companies. Moreover, when the burdens of going public push venture capital funds to exit their investments through M&A activity rather than an IPO, the public at large loses out on the significant job growth that normally occurs after an IPO. Thankfully, the SEC has the ability to pursue meaningful reforms both substantive and procedural that could significantly improve small business capital formation. Hopefully, some day we actually will, unprompted by Congress. In pursuing these reforms, the SEC must think about its capital formation regime on a big picture level. For example, we need to ask whether our system of registration requirements and exemptions therefrom, as it has evolved over the past eight decades, provides companies with an end-to-end solution for accessing the capital markets. And by end-to-end, I mean that companies at any point in their lifespan should be able to access the capital markets. The alternative is to leave growing companies entirely dependent on the vagaries of bank funding just ask Europe how that is working. We also need to ensure that the rules that apply to small businesses are easily understandable, even without a law degree or expensive lawyers. At least for small businesses, our focus should be on aligning our exemptions with the ways in which companies raise capital, rather than

43 P a g e 43 shoehorning capital-raising techniques into existing, complicated exemptions. I also believe that a fully robust capital markets ecosystem for small companies should encompass both the private and the public capital markets. Our rules should facilitate access to both, equally, as this redundancy can protect against market failures. What does this mean in practice? To start, we need a robust set of private offering exemptions under Regulation D that allow a company to access our capital markets while still remaining private as long as it so desires. But we also need the parallel ability for a company to access the public markets at the time, and through the means, of its choosing: for example, crowdfunding; Regulation A or A+ offerings; IPOs with emerging growth company scaling, including smaller reporting company scaling if applicable; and finally IPOs without any scaling or a registration under Section 12(g) of the Exchange Act. We need to involve the entire Commission staff in promoting small business capital formation. This is not just a matter for the Division of Corporation Finance. Our Division of Trading and Markets, for example, has a role to play. While Corp Fin is focusing on the methods by which a growing company can seek to raise capital from public or private markets, TM should be thinking about how to facilitate secondary market liquidity for that company s shares. This is not a matter of putting the cart before the horse; secondary market liquidity can make or break a primary offering, as we are learning in our Regulation A+ rulemaking.

44 P a g e 44 And TM must constantly be evaluating the application of trading and registration rules to small entities, as they recently did with the longawaited, and well received (certainly by yours truly) M&A Brokers noaction letter. Our Office of the Chief Accountant, in supervising the FASB and PCAOB, needs to ensure that their respective accounting and auditing standards are scaled or scalable for smaller businesses. We need to promote an infrastructure of intermediaries, such as investment banks and accounting firms, with sufficient economic incentives to specialize in smaller companies. And, our Division of Enforcement must also play its part. The SEC should be focused on personal responsibility for individual wrongdoers rather than corporate liability and shareholder penalties for amorphous misconduct. Similarly, we should ensure that we recognize that not every business failure is fraudulent. Entrepreneurs need to have the room to take risks, which means room to fail. Without risk there is no reward for investors. The good news is that we have many of these elements in place already. The bad news is that some of these elements are missing, and some could be improved. So I d like to discuss a number of near- and medium-term fixes to some of our regulations that could help to facilitate small business capital formation. The private securities markets have been an incredibly important part of the small business capital formation story over the past decade, so I am hesitant to advocate any significant changes.

45 P a g e 45 However, looming over these markets is the threat of the Commission finalizing proposed Regulation D rules that would impose new, substantial burdens. As I noted in my dissenting statement for the proposed amendments to Regulation D, certain aspects of the proposal could be acceptable. They could help the Commission gain useful data about the private markets, thereby facilitating a data-driven approach to oversight of these markets. But the majority of the proposal would do more harm than good, stifling the private markets while achieving no clear offsetting investor protection goals. Thus I believe the most productive near-term step we could take in the Regulation D markets today would be simply to withdraw the proposed rule. In the medium term, the Commission needs to do a deeper dive into Regulation D, to consider fundamental questions about who uses it and for what purposes. For example, 99% of capital raised under Regulation D is pursuant to the Rule 506 exemption, even though two-thirds of those offerings are sufficiently small that they could have been done under Rule 504 or 505. The simple reason for this is that Rule 506 offerings are blue sky exempt, while Rule 504 and 505 offerings are not. I believe we should consider broadening the blue sky exemption to help make the choice between types of Regulation D offerings a meaningful one. Taking a closer look at this and a number of additional issues in our private offering rules could reduce regulatory frictions and improve private offerings.

46 P a g e 46 Finally, we need to look at the secondary market for private company shares, where innovation appears to have slowed. We need more facilities to improve trading among accredited investors in the private secondary market. We should also examine whether our resale rules are clear and whether expanded or additional safe harbors might be appropriate to facilitate these transactions. Switching gears now to the public markets, I will start off small and work my way up. To begin, I believe that crowdfunding can play an important role in small business capital formation. A would-be entrepreneur far from Silicon Valley with no contacts in established angel investor or venture capital communities should be given a chance, through the wisdom of the crowd, to get funding for his or her idea. But unfortunately the path forward for interstate equity crowdfunding is not clear. While the initial crowdfunding bill introduced in the House properly balanced the competing interests of investor protection and capital formation, the Senate version eventually included in the JOBS Act so skewed that balance that it threatens to rob crowdfunding of much of its potential. For example, the requirement that companies raising over $500,000 file audited financial statements is far too expensive for the amount of money being raised. If this were the only issue, perhaps we could find an easy way forward. But unfortunately there are many other issues that commenters and others have identified that need to be addressed.

47 P a g e 47 I am committed to finalizing our rulemaking in a workable fashion and, if that is not possible, then the Commission should be loudly telling Congress that we need a legislative fix, and that we need it now. I am genuinely excited by the potential democratization of early-stage capital raising that crowdfunding promises; I am just dismayed by the potentially unworkable, nanny-state construct of Title III of the JOBS Act. One last point on crowdfunding regardless of how we proceed, we need to make sure crowdfunding is fully integrated into our capital markets, rather than treating it as a curiosity, or consigning companies that make use of it to a dead end. In the meantime, we should finish implementing the JOBS Act s robust reforms to Regulation A, and couple these reforms with the formation of venture exchanges. I have not been shy about expressing my belief that these two reforms, taken together, are potentially revolutionary. The JOBS Act breathed new life back into Regulation A, a scaled registration and reporting regime for small issuances. Previously robust, Regulation A fell out of favor after improvements to Rule 506 offerings (particularly the blue-sky preemption) made them significantly more attractive. The Commission has proposed a robust set of rules to implement the JOBS Act provisions, including blue sky preemption for all offerees and for all purchasers in certain larger Regulation A offerings. The resulting outpouring of anger from state regulators in general, and NASAA in particular, wasn t unexpected. After all, state regulators have been protecting investors from investment opportunities that are too risky for decades I m sure the Massachusetts residents who missed out on the offering of Apple

48 P a g e 48 Computer in 1980 because of their regulator s concerns about the risk know this all too well. But nonetheless, the state regulators response to the Regulation A+ proposal was disappointing. I simply do not understand why a federal registration and review regime tailored for smaller companies but nonetheless comprehensive that does not divest states of their antifraud enforcement authority, should be viewed as representing a threat to investors. So I believe we should finalize Regulation A+ expeditiously, as proposed, with only two clarifications: we should raise the cap on the maximum size of offerings from $50 million to $75 or $100 million, and we should exempt shares issued pursuant to Regulation A+ from Section 12(g) of the Exchange Act. While I believe these steps would invigorate the primary issuance of small business securities under Regulation A, attention also needs to be paid to the secondary trading of Regulation A shares. Here, I ve called for the creation of Venture Exchanges : national exchanges, with trading and listing rules tailored for smaller companies, including those engaging in issuances under Regulation A. Shares traded on these exchanges would be exempt from state blue sky registration. The exchanges themselves would be exempted from the Commission s national market structure and unlisted trading privileges rules, so as to concentrate liquidity in these venues. This should in turn bring market makers and analysts to these exchanges and their issuers, thereby recreating some of the ecosystem supportive of small companies that has been lost over the years. Other variables, such as continuous trading versus periodic call auctions, tick sizes, and minimum capitalization, would be left to each

49 P a g e 49 exchange to determine, with the aim of creating different, idiosyncratic venues that could compete with one another. I believe that these exchanges could have a transformative impact on small business capital-raising. But given everything else on the SEC s plate, I would like to engage in a little bit of crowdsourcing here. Specifically, I encourage all of you as practitioners, academics, and interested parties to refine this proposal through evaluating the legal and practical issues, and then to advocate for its inclusion on our agenda. Now, we come at last to the traditional public markets. Companies of many different sizes and at many different stages of development may go through an initial public offering. Our post-ipo disclosure regime needs to effectively address these differences. Here, I believe we should make better use of the smaller reporting and emerging growth company distinctions. Whether to tailor disclosure requirements for these categories, or to exempt them entirely, should be a primary decision point for each new disclosure rule, to be addressed with data and analysis. The JOBS Act was a floor a directive from Congress to do more in this area not a ceiling. In particular, I hope that as part of the Division of Corporation Finance s examination of disclosure effectiveness or, as it used to be called, disclosure overload Commission staff is examining which of our current disclosure rules could be scaled more effectively for smaller reporting and emerging growth companies.

50 P a g e 50 But even putting scaling aside, a reduction in the volume and cost of disclosure that benefits all companies will benefit smaller and emerging companies proportionally more, given the higher marginal cost to them of each dollar spent on compliance. I hope Corp Fin staff is giving serious attention to simplifying disclosure through this project, rather than treating it as largely confirmatory of our existing disclosure regime. There s already a plethora of good ideas out there; we should move forward with them. In the medium term, I believe that we should reconsider the current thresholds for scaled disclosure and the amount of scaling that comes at each level. Currently, a smaller reporting company is defined as a company with up to $75 million in public float, but this definition does not align with commonly-accepted market definitions. Having two tiers of scaling e.g., significant scaling for nanocap companies of up to $50 million in capitalization, and then moderate scaling for microcap companies with a capitalization of between $50 and $300 million may be more appropriate. Finally, liquidity for secondary trading in small businesses should be reexamined. Secondary trading in small cap stocks is a perennial problem, and the Commission should be paying more attention to this area. In particular, we could encourage microcap companies that are not reporting companies to commit voluntarily, or as a condition of participation in a Venture Exchange or some other type of junior exchange tier, to a periodic reporting regime. It could be the Regulation A regime, or some other tailored form of reporting.

51 P a g e 51 This could result in better information reaching the market, which could encourage investment. I m certainly open to other ideas, and I encourage you to weigh in on these issues. While all of these substantive changes are, I believe, important to pursue, I m sure that there are other good ideas out there, and that the list of ideas will change over time. So I believe that we at the SEC also need changes to our mindset and our procedures, with the objective of institutionalizing an enhanced small business focus at the SEC. It is important for Commissioners, as well as senior staff based in Washington, to get outside the Beltway. While I m on the road, I like to speak directly with businesses and particularly small businesses. That takes some extra effort to arrange, but getting outside the Washington bubble is eye-opening. I do this as often as I can, and I never come back to DC without new information and real-life stories from those who are actually working in the real economy. But, there is the ages-old problem of getting the Commission to focus on these issues when there are so many statutory mandates and other initiatives competing for limited bandwidth. And so, I believe the SEC needs to create an Office of the Small Business Advocate, reporting to the Commission. This office would be modeled on the Office of the Investor Advocate created by the Dodd-Frank Act. There s a natural parallel here, in that our staff perennially faces difficulty in receiving views from certain segments of the market that find it difficult and expensive to participate in the normal notice and comment rulemaking process: retail investors and small businesses.

52 P a g e 52 Having a single point of contact for outreach to these underrepresented groups, who can then turn around and advocate their views to the staff, is critical. Finally, just as the Investor Advocate now runs the Investor Advisory Committee, the Small Business Advocate could take charge of the SEC s Advisory Committee on Small and Emerging Companies and the Government-Business Forum, an incredibly important group that does not have the profile it deserves at the Commission. We should also invigorate the process of considering small business issues in rulemaking. The SEC has grown in leaps and bounds in its focus on economic analysis following several key losses at the D.C. Circuit for failure to give adequate consideration to the economic impacts of our rules. While the D.C. Circuit losses gave us an external impetus for reform, the reform the SEC undertook was in fact completely internal: we centralized the economic analysis function in DERA, crafted and adopted the economic guidance, and enforced compliance with it internally in our rule-writing process. The results so far are encouraging, and we need to continue to improve our economics function at the Commission by ensuring that DERA has all the resources and Commission attention it needs to be successful. But while compliance with our economic analysis mandate has thrived, compliance with our small business mandates has languished. The Paperwork Reduction Act, Small Business Regulatory Enforcement Fairness Act, and the Regulatory Flexibility Act all require some form of analysis to be undertaken by the Commission in promulgating new rules. Yet they are all generally treated as afterthoughts on the back end of the rulemaking process.

53 P a g e 53 I believe we should devote the kind of resources to these analyses that we do to economic analysis, not because we are being forced to, but because we should. We already have the tools and statutory mandate to consider the impacts of our regulations on small businesses; we should use them. To assist us in that endeavor, we used to rely on a robust Office of Advocacy at the Small Business Administration providing input on our rulemakings. I was thrilled to see that the SEC recently announced a new partnership with the SBA to engage with small businesses and educate them about capital formation opportunities, thereby fulfilling our mandate under Section 701 of the JOBS Act. Unfortunately, the vitality of our partnership with SBA on rulemaking is lacking. I understand that there may be some hesitancy by the SBA to review the rulemakings of an independent agency. But that review process is beneficial, and if it is not legally mandated, we should voluntarily commit to it. Our rules should be sufficiently robust to stand up to that analysis; if they are not, then we have to work to make them so. Similarly, our engagement with the Office of Management and Budget shouldn t be limited to routine Paperwork Reduction Act compliance. Executive Order 13563, administered by OMB s Office of Information and Regulatory Affairs (OIRA), contains many sound principles for reducing regulatory burdens, such as assessing the cumulative cost of regulations, and conducting a retrospective analysis of existing rules. Executive Order in turn states that independent agencies should comply with these principles, and specifically directs independent agencies to develop and release to the public a plan for periodic review of existing significant regulations.

54 P a g e 54 As you know, I do not shy away from fighting for the SEC s independence. But here, where the principles are bipartisan best practices, the SEC should commit to working with OIRA to achieve compliance. * * * This is an ambitious agenda, but one worth pursuing. Small business capital formation is too important an issue for us to ignore. While the Commission has a busy rulemaking calendar, this is another of the day job items the core competencies of the Commission that we cannot afford to neglect. Thank you again for coming today.

55 P a g e 55 PCAOB Issues Staff Consultation Paper Seeking Comment on Auditing Accounting Estimates and Fair Value Measurements The Public Company Accounting Oversight Board issued for public comment a Staff Consultation Paper on standard-setting activities related to auditing accounting estimates and fair value measurements. The paper was prepared by the Office of the Chief Auditor as part of its outreach efforts to seek input related to the potential need for changes to the PCAOB standards in this important area and a possible approach for a new auditing standard. PCAOB inspection staff have continued to identify numerous audit deficiencies across various types of estimates, across various sizes of audit firms. "Accounting estimates and fair value measurements can be subjective and complex, yet they can be an important part of a company's financial statements and critical to investors' decision-making," said PCAOB Chairman James R. Doty. "The PCAOB and foreign audit regulators have identified compliance with auditing requirements related to fair value measurements as an area of continued concern, and I support the staff's outreach efforts in this important area," he added. The Office of the Chief Auditor staff is seeking comment on current audit practice, the potential need for changes to PCAOB standards, and possible alternative actions related to auditing accounting estimates and fair value measurements, as well as derivative instruments and securities. The staff have discussed these issues on numerous occasions with the PCAOB Standing Advisory Group (SAG) and its Pricing Sources Task Force.

56 P a g e 56 The Staff Consultation Paper advances those discussions by describing the staff's preliminary views on a potential approach to changing the PCAOB's existing standards and seeking views and other information on that approach. "The Staff Consultation Paper raises questions about issues concerning the auditing of accounting estimates and fair value measurements, a matter that the staff have been working on for some time," said Martin F. Baumann, Chief Auditor and Director of Professional Standards. "The public comments we receive on this paper will help to properly inform our analysis regarding a potential proposal for a new auditing standard," he said. The Board also announced today that it will host a SAG meeting on October 2, 2014, in Washington, DC, to discuss matters related to auditing accounting estimates and fair value measurements. The agenda and meeting logistics will be announced closer to the meeting date. The Staff Consultation Paper includes specific questions for commenters and requests pertinent information and related data. Comments may be submitted by postal mail or , and should be sent to the Office of the Secretary, PCAOB, 1666 K Street NW, Washington, DC 20006, or to comments@pcaobus.org. All comments should refer to Staff Consultation Paper, Auditing Accounting Estimates and Fair Value Measurements, in the subject line, and should be received by the PCAOB no later than November 3, All comments will be made public.

57 P a g e 57 Third Progress Report on PCAOB Inspections of Broker and Dealer Auditors Shows Continued High Number of Findings Auditors of brokers and dealers inspected in 2013 had a continued high number of independence findings and audit deficiencies, the Public Company Accounting Oversight Board reported today. Although the percentage of audits with inspection observations was slightly lower than in previous inspections, the Board expressed concern over the nature and number of these continuing observations. In its third progress report on the interim inspection program for auditors of broker-dealers registered with the Securities and Exchange Commission, the PCAOB identified audit deficiencies or independence findings in 56 of the 60 audit firms inspected, and in 71 of the 90 audits inspected. Audit deficiencies were found in portions of 70 of the 90 audits. Independence findings were found in 21 on the 90 audits, where firms helped with the bookkeeping or preparation of the financial statements they audited, contrary to SEC rules. The most frequent audit deficiencies were noted in financial statement audit areas, including auditing revenue recognition, the auditor's response to the risk of material misstatement due to fraud, and audit procedures to rely on records and reports from service organizations, as well as areas specific to the audits of broker-dealers, including auditing the net capital computation and the audit work performed for the auditor's report on material inadequacies. "Many of the observations noted during 2013 have not changed from prior inspections and relate to fundamental auditing principles," said Robert Maday, Deputy Director of the Division of Registration and Inspections and Program Leader of the Broker-Dealer Firm Inspections Program.

58 P a g e 58 "We again urge firms that audit broker-dealers to re-examine their audit approaches and we remind firms that independence rules applicable to broker-dealer audits prohibit bookkeeping or financial statement preparation by the auditor," he added. Inspection Observations Since the Start of the Interim Program Audit deficiencies or independence findings were identified in portions of 151 of the 173 audits selected for inspection (87 percent), since the start of the interim program. The 22 audits without observations came from 12 firms, of which 11 also audited public companies. Independence findings were found in 45 of the 173 audits selected for inspection (26 percent). Inspection staff noted a significant portion of these findings, 89 percent, came from the firms that did not audit public companies. Overall, PCAOB inspectors saw a high percentage of observations across the firms inspected, whether or not the firm audited public companies, and regardless of how many broker-dealer audits were performed by the firm. The results also were high across the broker-dealer audits selected, regardless of the broker-dealer's reported net capital, revenues and assets, or whether it claimed to be exempt from the customer protection rule. Of particular note, observations were identified in 100 percent of audits selected for inspection for auditors with only one broker-dealer audit client, while the percentage was only slightly lower (92 percent) for firms that audited two to 100 broker-dealers, but even lower (63 percent) for firms that audited more than 100 broker-dealers.

59 P a g e 59 In addition, firms that also audited public companies had a lower percentage of audits with observations (78 percent) than firms that did not (99 percent). Generally, there did not appear to be a discernible trend between the percentage of inspection observations and broker-dealer characteristics, other than a lower percentage of findings for audits of broker-dealers that did not claim to be exempt from the customer protection rule (79 percent) compared to those that did (90 percent). The Board noted that the firms and audits inspected, and the observations made, are not necessarily indicative of the total populations of firms and of broker-dealer audits. Next Inspections and Permanent Inspection Program Inspections are well underway for The report notes that the Board plans to inspect approximately 60 audit firms covering portions of about 100 audits. These inspections include firms and audits where observations were found in previous inspections; inspectors also will evaluate whether, or how, firms addressed audit deficiencies or independence findings. During 2015, the Board will continue its interim inspection program. Audits selected for these inspections will have fiscal years ending on or after June 1, 2014, and therefore be required to adhere to PCAOB standards. The Board is taking a careful and informed approach in developing the scope of a permanent inspection program. The Board continues to evaluate the risk of loss to customers of brokerdealers and, in this regard, plans to review new broker-dealer compliance and exemption reports and the respective auditors' reports.

60 P a g e 60 The Board anticipates issuing a proposal for a permanent inspection program in 2016, which will include a consideration of whether to exempt any category of registered firms from the program. The Board has a number of initiatives for broker-dealer auditors, including its Forums on Auditing Smaller Broker-Dealers. The Board also recently issued Staff Guidance for Auditors of SEC- Registered Brokers and Dealers. Auditors are reminded that information obtained through inspections may lead to PCAOB investigations or disciplinary proceedings, or referral by the Board to the SEC and other regulators. The interim inspection program was established in August 2011 in response to the Board's new oversight responsibility over auditors of SEC-registered broker-dealers authorized by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Board issued its first progress report in August 2012, and its second progress report in August A fact sheet on the third progress report is also available.

61 P a g e 61 The Case for User Fees Rick A. Fleming, Investor Advocate 38th Annual Southwest Securities Conference, Dallas, Texas Thank you, David [Woodcock] and Marshall [Gandy] and the other conference hosts, for the invitation to speak today. It is good to be back in what feels like home turf, as I have attended this conference numerous times over the years while working for the State of Kansas and the North American Securities Administrators Association (NASAA), and I have developed many friendships here. As you know, the Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any statement by any of its employees. Therefore, the views I express today are my own and do not necessarily reflect the views of the Commission or my colleagues on the Commission staff. The Office of the Investor Advocate is a brand new office at the Securities and Exchange Commission. In February, SEC Chair Mary Jo White appointed me as the first Investor Advocate, and I have been busy building up the office, meeting many investor and industry groups, and preparing the first of my reports to Congress. The basic purpose of the Investor Advocate is to ensure that the concerns of investors are appropriately considered as decisions are being made and policies are being adopted at the Commission, at selfregulatory organizations, and in Congress. This sounds simple, but the statutory mandate covers a very broad range of potential issues.

62 P a g e 62 My office must not only analyze the potential impact on investors from proposed rules and regulations that are currently under consideration at the Commission and SROs, but we are also expected to identify areas in which investors would benefit from changes in existing rules and regulations. Moreover, we are asked to identify problems that investors have with investment products and financial service providers, and to propose policies to resolve those problems. The Office of the Investor Advocate is part of the SEC and I report to the Chair, but my office is designed to remain somewhat independent from the rest of the Commission. By statute, I file two reports per year directly with Congress. In some respects, my role is to provide a critique of my own agency, which may explain why the position was not filled for nearly four years after the Dodd-Frank Act mandated its creation. But, I want to assure you that Chair White has been fully supportive of my office, and we are both working to make sure my staff has a significant and constructive role in the policymaking process. On June 30, my office filed the first of our reports to Congress. This report, like the reports we will file every year on June 30, describes the issues that my office will focus upon in the coming federal fiscal year. Then, by December 31 of each year, we will file a report that describes our activities during the preceding fiscal year, the recommendations I made, and what was done with those recommendations. As a brand new office that is still in the process of building out a small staff, we will not be able to fully analyze every possible issue impacting investors in the coming year.

63 P a g e 63 So, after seeking advice from knowledgeable people at the Commission and elsewhere, we decided to focus on six core issues during the coming year. I don t have time today to thoroughly cover each of those six areas, but I ll give you a quick glimpse of what my office has in mind. First, as the Commission examines issues surrounding equity market structure, we will be focused on whether the equity markets today are fundamentally fair to investors. We will also look at whether investors have fled from the equity markets in recent years because of fears related to those markets. Another important market for investors is the fixed income market, and especially the municipal bond market, where 50 percent of municipal securities are held directly by individual investors and another 25 percent are owned indirectly by retail investors through mutual funds and other pooled vehicles. My office will work with others at the Commission and relevant SROs to encourage reforms designed to benefit investors in the municipal securities markets, and to the extent that legislation is required to improve disclosures and practices in this market, we will make recommendations to Congress as appropriate. Because hackers and electronic terrorists present a constant threat to the financial security and privacy of investors, my office will survey the efforts of the Commission, the exchanges, and market participants to prevent market disruptions and safeguard the assets and private information of investors. In addition, we will work with the SEC s Division of Corporation Finance as they explore possible ways to make financial disclosures by public corporations more effective for investors. Finally, we will look at the area of elder abuse.

64 P a g e 64 In particular, we are looking for ways to give financial service professionals better tools to protect clients whenever an adviser or registered representative suspects financial or other abuse of a client with diminished capacity. In addition to describing these six areas of focus for my office in the upcoming fiscal year, my recent report to Congress included a recommendation to address a substantial risk to investors. Specifically, I recommended that Congress provide sufficient resources to the SEC to conduct an adequate number of investment adviser examinations. As many of you are aware, the SEC examined only about 9 percent of registered investment advisers in Fiscal Year This equates to a frequency of approximately once every 11 years, a rate that many observers find unacceptable. There are multiple reasons for the lack of exam coverage, but in my view it primarily boils down to the fact that the SEC has not received sufficient resources to keep up with the burgeoning workload. The number of SEC-registered advisers has grown by approximately 40 percent over the past decade to nearly 11,500 today. And, as the number of investment advisers has grown, so too has their complexity. The amount of assets managed by investment advisers is on a steep ascent, climbing from $20 trillion a decade ago to an estimated $55 trillion by the end of Fiscal Year In comparison, staff in the SEC s Office of Compliance Inspections and Examinations ( OCIE ) has grown only about 10 percent in the past decade.

65 P a g e 65 From my own personal experience, I know that investors are exposed to fraud and abuse when regulators cannot maintain an adequate regulatory presence. While most investment advisers are trustworthy and honest, I have personally prosecuted one who stole more than $7 million from his clients. In the course of that case, I met with numerous victims who did everything right they worked hard, saved their money, and entrusted their savings to a licensed person who they thought was investing it in a normal portfolio of legitimate securities only to have their life savings taken by that licensed professional. For those investors, an ounce of prevention would have been worth far more than the pound of cure. With their money gone, a maximum prison sentence did little to help those retirees who had to return to work or face a diminished standard of living, or the individual with diminished capacity whose trust fund was stolen, or the church that lost its building fund. Not surprisingly, then, as my very first recommendation to Congress, I recommended that Congress appropriate the needed funds this year so that the Commission can hire more examiners without further delay. In addition, I voiced support for a more long-term, sustainable solution. I recommended that Congress authorize the SEC to collect an annual user fee from registered investment advisers and to limit the use of those funds to expenses associated with investment adviser examinations. Admittedly, a shorter examination cycle won t stop all fraud, but I believe it will allow the SEC to halt these types of activities sooner and will provide a stronger deterrent to advisers who might otherwise succumb to the temptation to steal.

66 P a g e 66 It will also curtail other unethical practices, including excessive fees, excessive trading, and undisclosed conflicts of interest. Many of you in this room have uncovered these types of practices and can attest to the damage it causes to investors. To some, the idea of a user fee sounds a lot like a tax. But several industry associations that represent investment advisers have actually endorsed the concept of user fees. They recognize that a rogue adviser not only harms investors, but also leaves a stain on the advisory industry, so they support an increased regulatory presence and are willing to pay for it. Let me repeat that they are willing to pay more money to the SEC so that it can conduct more examinations of advisers. Investor advocates have joined with the industry in supporting an increase in SEC resources and the adoption of a user fee. Among others, the SEC s Investor Advisory Committee (IAC) has endorsed the user fee model. On November 22, 2013, the IAC recommended that the SEC seek Congressional authority to impose user fees on SEC-registered investment advisers to fund an enhanced examination program. So, if investors would be better served by giving the SEC greater resources, and the industry is willing to provide those resources, this should be an easy thing to accomplish, right? Well this is where things get tricky in Washington, D.C. As I have discussed this issue with people, it has become fairly apparent that the main objection to a user fee is a philosophical resistance to growing the government. And trust me, I get it.

67 P a g e 67 Just last week, it made news that the federal budget deficit for July was only $95 billion, a decrease of 3 percent from the deficit in July of For a person who has spent most of his career working in Kansas, where the annual budget for the entire state government is approximately $15 billion, the thought of a $95 billion monthly deficit is astounding. And as a taxpayer, I m not thrilled, either. It is important to note, however, that a user fee would not increase the budget deficit, because the increased spending would match the revenue received from advisers. In fact, even without authorizing user fees, Congress could increase the direct appropriation to the SEC without increasing the deficit because the SEC is already required to collect transaction fees from SROs that offset its appropriation. To be fair, critics of user fees are not just worried about the deficit. Some correctly point out that the SEC budget has increased substantially in the wake of the financial crisis, and they wonder why the SEC has failed to bolster its examination rate with these additional resources. I have wondered the same thing, especially considering that the OCIE spending has actually increased from about $208 million in FY 2009 to $271 million in FY But in studying this issue, I have discovered that the growth in the OCIE budget has been dwarfed by the growth in the number and complexity of registrants (as discussed above), leaving OCIE unable to improve its overall examination coverage rate. In addition, a handful of major expenditures have absorbed much of the increase in the overall SEC budget. For example, the Commission has taken significant strides to upgrade its technological resources and keep pace with an industry that spends enormous amounts on technology.

68 P a g e 68 These initiatives include EDGAR modernization, the creation of tool called MIDAS that facilitates the analysis of trading data, and the development of an electronic system for tracking tips, complaints, and referrals. Another major cost driver is the payroll, as the Commission has had to pay better to attract a workforce with more technical expertise and to retain experienced employees. A related cost comes from a heightened focus on economic analysis in our rulemaking, which requires a large team of highly skilled economists and related personnel and led to the establishment of the Division of Economic and Risk Analysis (DERA). These major expenditures have been supported by Members of Congress on both sides of the aisle, but in my view what has not been sufficiently increased is the Commission s ability to do some of its fundamental investor protection work like investment adviser exams a basic blocking and tackling component of the SEC. I remain hopeful that Congress will see the value of investment adviser exams and that bipartisan support will continue to develop for increasing the SEC s examination resources, just as it has for other needs at the SEC. When I talk about bipartisanship, I realize that most people think I must be dreaming. But, believe it or not, my dreams of bipartisanship have often come true, at least outside of Washington, D.C. During the majority of my time at the Office of the Kansas Securities Commissioner, we had a Democrat Governor and a legislature controlled by Republicans, but we managed to advance a number of investor protections. For example, we increased the criminal penalties for securities fraud and obtained authority for the Commissioner to order restitution in administrative proceedings.

69 P a g e 69 In addition, after the disastrous case of the $7 million investment adviser fraud, we were able to get the resources we needed to attain a three year examination cycle. In working to get these and other reforms passed, I have concluded that investor protection is not by nature a partisan issue. I also like to remind people that the very origins of securities law involved both political parties. Yes, the Securities Act of 1933 and the Securities Exchange Act of 1934 were signed by Franklin Delano Roosevelt as part of his New Deal agenda. But, more than 20 years earlier, Kansas was the first state to pass a law to regulate the sale of securities in a comprehensive way. While this became known as the first blue sky law, I can assure you that it was not because Kansas was a blue state. The author of that law, J.N. Dolley, was the Chairman of the Kansas Republican Party and a former Speaker of the Kansas House of Representatives. Aside from the fact that investor protection should appeal to both parties, I believe the idea of user fees makes sense from a public policy perspective. As a starting point, most people would probably agree that the status quo is not acceptable. Investors have a right to expect that their registered investment advisers will be examined more than once every 11 years. So the question becomes, What is the best available solution to the problem? I've already explained why I think user fees represent a viable solution, but it should also be compared with other possible solutions.

70 P a g e 70 One other solution that has been suggested would be to require advisers to hire third-party consultants to conduct SEC-like examinations. While third party audits are presumably better than no audits, some observers have noted the inherent conflict of interest when the auditor is selected and paid for by the firm being audited. In addition, some of the industry associations argue that audits by third parties would actually be more expensive and burdensome than user fees. Thus, even if a proposal for third party audits could be designed to ameliorate some of these concerns, it seems unlikely that it would gain the type of consensus that surrounds the user fee option. For my part, I believe third-party audits are the less desirable option than user fees, and I worry that it will be impossible to reverse course if the Commission starts down that road. But if the Commission isn't given the resources to do the job adequately, and given them soon, it may be left with few options. I am concerned that we may end up with a solution that ultimately is more expensive for the industry and less effective for investors. Accordingly, I have urged and will continue to urge Congress to act quickly to provide additional resources to the SEC so that it can examine investment advisers more frequently. Thank you.

71 P a g e 71 Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 1113, August 2014 Estimating U.S. Cross-Border Securities Positions: New Data and New Methods Carol Bertaut and Ruth Judson Introduction Considerable attention has been paid to how global imbalances and the rapid growth in international capital flows contributed to build-up in financial vulnerabilities that lead to the global financial crisis. More recently, policy makers and researchers have focused attention on the potential vulnerabilities posed by large capital inflows to emerging market economies. These developments highlight the need for comprehensive, accurate, and timely data on cross- border flows and positions. Until recently, such comprehensive data for the United States in particular, data by county of investor or destination were available only annually, and only with a considerable lag. We show how to combine new aggregate (monthly) data collected through the Treasury International Capital (TIC) system on U.S. crossborder securities holdings with existing data sources to generate consistent time series of holdings by security type and by country of foreign holder (for U.S. securities) and country of issuer (for U.S. investment in foreign securities). Section II below provides some background on the growth and composition of the U.S. cross-border portfolio.

72 P a g e 72 We review the components of the TIC system that provide the underlying data for these estimates and the various caveats attached to these data in Section III. Sections IV and V provide more detail on the new TIC form SLT and how we use this new data source in constructing our updated estimates. We also show how changes in the new monthly data can be decomposed into flows, valuation changes, and a residual gap. We discuss how these decompositions provide a richer view of both foreign investment in the U.S. and U.S. investment abroad, while raising some new questions, in Section VI. The new data show, for example, that U.S. investment in emerging market bonds was considerably stronger in 2012 and held up better during the emerging markets financial turbulence in 2013 than implied by transactions data. On the other hand, the data raise a puzzle with respect to transactions and holdings of U.S. Treasury securities in some offshore financial centers: over the past two years, transactions data have indicated very large net sales of U.S. Treasuries by entities in the Cayman Islands, while holdings of Treasuries in the Cayman Islands actually increased slightly over this period. We interpret this inconsistency as potentially pointing to short sales of Treasuries by entities in the Cayman Islands. With our new methodology, we extend the existing Bertaut-Tyron (2007) monthly estimates of country level securities holdings and the estimated monthly decomposition of these holdings through December 2013, and we provide guidance on how these estimates can be extended beyond this date. The significance of cross-border securities positions Current account financing

73 P a g e 73 Cross-border financial flows and portfolio holdings provide considerable information about the financing of external imbalances, changes in a country s foreign indebtedness, and foreign investor attitudes toward domestic assets. Cross-border financial flows are the counterparts to transactions recorded in the current account, the broadest measure of a country s transactions with the rest of the world. When a country runs a deficit in the current account, it must finance this imbalance by on net selling assets to, or borrowing from, foreign investors. These net inflows are recorded in the financial account. For the United States, a sustained trade imbalance has resulted in a deficit in the current account since the early 1990s. This excess of imports over exports has been funded primarily by foreign acquisitions of U.S. securities, from official foreign investors (mostly in

74 P a g e 74 the form of purchases of U.S. Treasury securities) as well as from foreign private investors (mostly in the form of purchases of U.S. corporate securities); these balances are shown in Figure 1. Foreigners willingness to continue investing in U.S. assets is thus an important determinant to U.S. asset prices and the exchange rate of the dollar. At the same time, U.S. cross-border investment flows into foreign-issued securities have also been growing, with the result that gross cross-border securities flows and positions have become ever larger. Having accurate, current information on how cross-border investment patterns are evolving is thus highly relevant for policy makers and market analysts. Appetite for cross-border investment For instance, accurately assessing the magnitude of foreign official purchases of U.S. Treasury and U.S. government agency securities is

75 P a g e 75 necessary for understanding how significant these purchases may have been in holding down yields on these securities in the years leading up to the recent global financial crisis (see for example Warnock and Warnock (2009) and Beltran et al. (2013)). As can be seen in Figure 2, foreign purchases of U.S. Treasuries have accounted for significant portions of net Treasury issuance nearly every year since At a more detailed level, accurately assessing the country of acquisition of different types of securities is necessary for understanding the global pattern of exposures and risk taking that accompanied the years leading up to the crisis. Bernanke et al. (2011) and Bertaut et al. (2012) show how European investors were major buyers of U.S. corporate financial debt including mortgage-backed and other structured investment products in the years leading up to the crisis. More recently, attention has been drawn to the pick-up in capital inflows from advanced economies into emerging market economies and the potential for abrupt reversals of these flows. According to data from the 2012 Coordinated Portfolio Investment Survey, U.S. investors account for more than a third of all cross-border investment in bonds and equity of emerging market economies. Thus, accurately identifying the extent of U.S. portfolio acquisitions of foreign securities and the country composition of portfolio flows and positions are clearly important for analyzing how vulnerable countries may be to changes in investor sentiment. Insights into portfolio allocation Accurate data on cross-border securities holdings and portfolio shares invested in different countries are also necessary for correctly assessing U.S. investor behavior.

76 P a g e 76 Curcuru et al. (2011) show, for example, that contrary to earlier stylized facts, U.S. investors do not exhibit returns-chasing strategies in their cross-border investment but instead appear to sell past winners, consistent with partial portfolio rebalancing. Estimating cross-border positions and flows prior to 2012 The TIC reporting system Cross-border financial flows occur mainly in the form of purchases and sales of securities, lending to banks and firms, and direct investment. The first two types of activity are monitored through the TIC reporting system; the third, direct investment, which we will not review here, is collected and administered by the Bureau of Economic Analysis (BEA). The TIC reporting system comprises several monthly forms as well as annual surveys and more- extensive periodic benchmark surveys of securities holdings. Under the current Treasury International Capital (TIC) reporting system, a variety of monthly and quarterly reports are filed with district Federal Reserve Banks by commercial banks, securities dealers, other financial institutions, and nonbanking enterprises in the United States. These data are centrally processed and maintained at the Federal Reserve Bank of New York, which, along with the district banks, acts as fiscal agent for the U.S. Treasury. Since late 1998, the Federal Reserve Board also has supported the TIC data collection system by providing final review and dissemination of TIC data to the Treasury as well as to other agencies, including the Bureau of Economic Analysis and the Bank for International Settlements. The TIC reports of individual respondents are treated as confidential and access to the respondent-level data is strictly limited by law.

77 P a g e 77 The Texas Jagannatha (with reference to Indian Prime Minister Modi, a Hindu Goddess and Wodehouse s Big Money) Remarks by Mr Richard W Fisher, President and Chief Executive Officer of the Federal Reserve Bank of Dallas, before the US-India Chamber of Commerce, Dallas, Texas The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System. Thank you, Ashok (Mago). I am so honored to have been invited to join Ambassador (S.) Jaishankar this evening to celebrate the U.S.-India Chamber of Commerce and its many distinguished awardees. Mr. Ambassador, I am delighted you are here in Texas tonight. I am going to give you a few statistics in a moment that I think will make readily apparent the reason for this large audience and why so many Indian entrepreneurs and professionals come to Texas. Then I am going to give you a snapshot of where the U.S. economy is at present and what we are grappling with at the Fed. But first, with your indulgence, I want to briefly speak of the relationship between our two great countries, India and the United States. Time to enhance the U.S.-India working relationship The logic of an enhanced strategic relationship between my country and yours is crystal clear, beginning with a harsh geopolitical reality: You live in a tough neighborhood and need us; we, in turn, need all the friends we can muster in your geographic sphere.

78 P a g e 78 It seems very timely that we overcome the history that has separated us and begin working more closely together. During the Cold War, it was the view of many in the United States that India was too closely allied with the Soviet Union. American businesses that looked at India found it afflicted with the legacy of the worst of British bureaucratic administration. (The old joke was that you could never get morning tee times at any Indian golf course because the bureaucrats had locked them up at least until noon). From an Indian perspective, America seemed too hegemonic. Attempts by U.S. companies to invest and do business in your homeland revived memories of the East India Company. We viewed each other through the lens of the time and against a background of our own histories, with suspicion. But the (Berlin) Wall came down, the economy has been globalized and cyberized, and new threats to security have arisen, many of them from nonstate actors or forces who operate from within failed states to inflict damage elsewhere. This is a time for like-minded people to unite and work together. We are like-minded in that we are democracies. But tonight we celebrate something even more fundamental. My reading of India is that, like in the U.S., your country men and women are more pragmatic and business-oriented than they are ideological or inherently bureaucratic. The recent election of Prime Minister (Narendra) Modi offers the promise of making this abundantly clear.

79 P a g e 79 He was, after all, the chief minister for over a decade of the Gujarat, the most probusiness state in India. And almost every U.S. business leader I know has heard of Ratan Tata s experience when he looked to Gujarat for an alternative to the frustration of his attempt to build a new car factory in West Bengal. As I understand it, Mr. Tata went to see Minister Modi, had a handshake deal in 30 minutes, and in 14 months the new factory was up and running. That almost makes Texas look like California by comparison! So Mr. Ambassador, we are all watching for this first prime minister born since Independence to work his probusiness, nonbureaucratic, can-do spirit upon the whole of India. It is in America s interest for India to thrive. We wish Prime Minister Modi, the government you represent with such distinction, and the Indian nation the very best of luck. The Texas Jagannatha Tonight, you and I are surrounded by the smart, probusiness people of Indian heritage who have chosen to invest and operate within the most probusiness state in the United States. I am going to throw up a few slides to quickly summarize the environment in which they operate. Texas is a job-creating juggernaut. I pick that word deliberately, knowing it derives from the Hindi Jagannatha and is, according to the Oxford English Dictionary, a title of Krishna. Specifically, it is: the uncouth idol of this deity at Puri in Orissa, annually dragged in procession on an enormous car, crushing everything in its path.

80 P a g e 80 But Hindu or Muslim or whatever your faith, while one might consider Texans to on occasion be uncouth, there is no denying that our economy is an enormous job-creating car that enables and advances its devotees rather than crushing them. A job is the road to dignity and to the prosperity of any people, and Texas has become the most prosperous of states. Here is a graph depicting job growth in Texas versus the other large states that typically have drawn Indian and other investment and immigration: For over two decades, we have outperformed the rest of the United States in job creation by a factor of more than 2 to 1. Over 23 years, only nine net new jobs have been created for every 100 that existed in New York in 1990, whereas in Texas, 66 jobs have been created.

81 P a g e 81 We have been especially prolific in creating jobs since the Great Recession waylaid the world at the end of Today, employment in Texas is 8.6 percent above its prerecession peak. The nation as a whole is 0.5 percent zero point five percent above its previous peak. However, if you take Texas out of the U.S. economy, statistically speaking, you see that the U.S. ex-texas still has not caught up to its prerecession employment levels. Here is a graph that shows the margin of difference in employment performance:

82 P a g e 82 According to Bureau of Labor Statistics payroll employment data, Texas has created 1,100,600 jobs since November 2007; the rest of America is still 349,600 jobs shy of the prior employment peak. Texas has been the crucible of job creation in America. More than oil and gas; jobs well-distributed It is a common perception that the jobs that have been created here are primarily in the burgeoning energy sector. It is true that Texas is an energy powerhouse: We produce more than 3 million barrels of oil and 21 billion cubic feet of natural gas per day. To put this in perspective, Texas produces more oil than Kuwait or Venezuela or, if you d like, more oil than the amount the U.S. imports from the Middle East. With regard to natural gas, Texas produces more than all 28 countries of the European Union combined.

83 P a g e 83 Of course, the energy sector is a significant driver for the Texas economy. Last year, the state saw an increase of 16,100 jobs related to oil and gas extraction and associated support services. We are grateful for every one of them. Yet there are seven other sectors of the Texas economy that produced more jobs than the energy sector last year. Here is a graphic summary of where jobs were created in the Lone Star State in In terms of number of jobs created, the leading sectors in Texas last year were trade, transportation and utilities (accounting for 73,700), professional and business services (44,600), leisure and hospitality

84 P a g e 84 (42,300), educational and health services (33,500), construction (26,800), government (19,700) and financial activities (18,100). This year through July, Texas employment has already increased by 238,200 jobs, a 3.6 percent annualized growth pace. Over the 12 months ending this July, Texas added just shy of 400,000 jobs more jobs than any other state. Clearly, Texas employment is growing at an impressive clip. Another misperception is that all of these jobs created in Texas are lowpaying jobs. Wrong. We have been creating jobs in every income quartile, unlike the rest of the country. This graph, recently updated, covers the 13-year period from 2000 to It charts job creation by wage quartile in Texas and in the nation ex- Texas. As you can see, Texas has had healthy growth in every income quartile, while, without Texas, the United States has actually seen job destruction, on net, in the two middle-income quartiles. (This fact deeply concerns me because middle-income groups are the backbone of America.)

85 P a g e 85 U.S. economy is on the mend The reality, Mr. Ambassador, is that Texas is part of the United States and, all told, our economy is on the mend from the frightful shock of the financial and economic implosion of This is the dashboard that we at the Dallas Fed use to track our national economy:

86 P a g e 86 The Federal Reserve is mandated by the laws of the United States to manage monetary policy to achieve full employment while maintaining price stability and moderate interest rates over time. A Hindu goddess As you can see from this graphic, unemployment has declined to 6.2 percent, and the dynamics of the labor market are improving. At the Federal Open Market Committee, where we set monetary policy for the nation, we have been working to better understand these employment dynamics. This is no easy task. Bill Gross, one of our country s preeminent bond managers, made a rather pungent comment about our efforts.

87 P a g e 87 He noted that President Harry Truman wanted a one-armed economist, not the usual sort that analyzes every problem with on the one hand, this, and on the other, that. Gross claimed that Fed Chair (Janet) Yellen, in her speech given recently at the Fed s Jackson Hole, Wyo., conference, introduced so many qualifications about the status of the labor market that instead of the proverbial two-handed economist, she more resembled a Hindu goddess with a half-dozen or more appendages. Whether you analyze the labor markets with one arm or two, or six or 19, the issue is how quickly we are approaching capacity utilization, so as to gauge price pressures. After all, a central bank is first and foremost charged with maintaining the purchasing power of its country s currency. Like most central banks around the world, we view a 2 percent inflation rate as a decent intermediate-term target. Of late, the various inflation indexes have been beating around this mark. Just this last Friday, the personal consumption expenditure (PCE) index for July was released, and it clocked in at a 1 percent annualized rate, a pace less than the run rate of April through June. Does this mean we are experiencing an inflation rate that is less than acceptable? I wonder. At the Dallas Fed, we calculate a trimmed mean inflation rate for personal consumption expenditures to get what we think is the best sense of the underlying inflation rate for the normal consumer. This means we trim out the most volatile price movements in the consumer basket to achieve the best sense we can of underlying price stability.

88 P a g e 88 In the July statistics, we saw some of the fastest rates of increases in a while for the largest, least- volatile components of core services, such as rent and purchased meals. So the jury is out as to whether we have seen a reversal in the recent upward ascent of prices toward our 2 percent target. As to achieving moderate interest rates, the dashboard shows that we have overshot the mark. Interest rates on the lowest-quality credits on junk are historically low, as are the spreads they are priced at above the current historically low nominal rates for investment- grade credits. I have been involved with the credit markets since I have never seen such ebullient credit markets. The 30-year Treasury yield is trading at a hair over 3 percent. If Ambassador Jaishankar and I were to abandon our service to our respective nations and form a company, we would use our good names to borrow as much money as we could at current rates. And this, indeed, is happening. U.S. companies have used this bond market and borrowing rate hiatus from normalcy to pile up cheap, nearly cost-free balances. This cheap and abundant monetary fuel, with the proper incentives from the fiscal and regulatory authorities, can be deployed to the benefit of company stakeholders (shareholders and employees) to enrich and grow the economy. In this sense, we are unique in the world. Mr. Ambassador, American businesses are rich and muscular. And those muscles are being flexed.

89 P a g e 89 For example, just two days ago, the Institute for Supply Management (ISM) released its Purchasing Managers Index. The data surprised most all forecasters to the upside. Activity was broad based: 17 of 18 industries surveyed reported growth in August, and new orders reached a 10-year high. Today, the ISM released its nonmanufacturing index, which registered the highest level in nine years. These reports echo a string of others including the Beige Book survey of regional economic conditions released yesterday by the Federal Reserve that underscore the healing that is taking place in the U.S. economy despite our having what is, in truth, a dysfunctional and counterproductive fiscal and regulatory environment. All we need now is for the fiscal and regulatory authorities Congress and the executive branch to unleash the animal spirit of business that is well nourished with the feed of cash and ready to roll. Wodehouse s perspective I happen to share a common bond with Indians: I have long been a reader of P.G. Wodehouse. In his book, Big Money, published in 1931, he has a wonderful passage in which a young lad nicknamed Biscuit describes the woman he has fallen in love with: when I think that a girl can be such a ripper and at the same time so dashed rich, it restores my faith in the Providence which looks after good men. Be it Providence or the Fed, the American business community is at present a ripper it looks darned good and is dashed rich. We are poised for a healthy, sustainable expansion. The men and women in this room see it in Texas.

90 P a g e 90 I trust they will see it in the whole of the United States. And I trust they and others like them will use it to lead the world, including India, to expanded economic prosperity. Thank you for having me here this evening.

91 P a g e 91 The economic outlook Speech by Mr Charles I Plosser, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia, at the Pennsylvania Association of Community Bankers' 137th Annual Convention, Amelia Island, Florida The views expressed are my own and not necessarily those of the Federal Reserve System or the FOMC. Highlights - President Charles Plosser gives his views on the economy and shares some thoughts about the stance of monetary policy. - President Plosser believes that forward guidance should be adjusted to reflect economic realities and to give the FOMC the flexibility to respond gradually to the evolution of the economy. - President Plosser counters the view that rates cannot be raised because the labor market has not "completely" healed. He discusses two major risks with this strategy. First, economists do not know what maximum employment is and cannot easily measure it. Second, waiting until we are completely confident the labor market has fully recovered risks that monetary policy will be behind the curve and could lead to a return to abrupt "go-stop" policies of the past that led to unwelcome volatility. - While he is not suggesting that rates should necessarily be increased now, President Plosser sees that the first task is to change the language and to begin signaling that liftoff may occur sooner than many now anticipate and sooner than suggested by the current FOMC guidance.

92 P a g e 92 Introduction Good morning. Thank you for the opportunity to speak at this 137th annual convention of the Pennsylvania Association of Community Bankers. Community banks have a long and venerable history in our nation, and the 137 years of the PACB is a powerful testament to your roots as stalwarts in our financial system. I would note that the longevity of this convention means that your organization significantly predates the Federal Reserve System, which is observing its centennial this year. My suspicion is that there are a number of community bankers here today who can trace their corporate histories to firms that petitioned for the establishment of a Federal Reserve Bank in Philadelphia 100 years ago. I actually have two letters here. One from the New Tripoli National Bank dated December 27, 1913, and one from the First National Bank of Mifflintown dated December 26, 1913, both addressed to William McAdoo, Secretary of the Treasury, requesting the establishment of a Federal Reserve Bank in the City of Philadelphia. Over the years, community banking organizations, whether they are state member banks or not, have provided important links between the Federal Reserve Banks and the businesses and communities your institutions serve. We have reached out and listened to community bankers through their representation on our boards of directors and advisory councils, as well as through our ongoing contacts with individual firms and the business organizations you serve.

93 P a g e 93 The insights we gather from community bankers in our District help me as a policymaker bring Main Street perspectives to the national policy table each time the Federal Open Market Committee, or FOMC, meets in Washington. When such information from all the Districts comes together at our meetings, it forms a rich mosaic of our economy that helps shape our monetary policy decisions. So, I want to thank Nick DiFrancesco, president and CEO of the PACB, and Dennis Cirucci, your chairman, for inviting me here today. I also want to publicly thank Dennis for serving so ably on our Bank's Community Depository Institutions Advisory Council, or CDIAC, and as our council's representative to the Board of Governors. My last opportunity to address the PACB was in September 2007, a very different economic environment than we find ourselves in today. I used that speech seven years ago to discuss the Federal Reserve's initial responses to growing financial instability in the housing sector. I explained that the Fed's role in promoting financial stability rather than its monetary policy responsibilities had prompted the short-term injection of some $68 billion in liquidity through open market operations in early August 2007, a mere 12 months after I joined the Fed. That seems like a long time ago and much has transpired since then. At the time, the FOMC had yet to lower the federal funds rate from its target of 5.25 percent. Weeks later, though, the FOMC began to lower the federal funds rate target and then kept lowering it to essentially zero in December 2008, as the global financial crisis and the ensuing Great Recession enveloped economies around the world. The rate has been near zero for nearly six years now, and the Fed has augmented its aggressive policy actions through large-scale asset

94 P a g e 94 purchases, now tallying in the trillions, rather than in the billions of dollars. Today, I would like to give you my assessment of the U.S. economy and then share some thoughts about the stance of monetary policy. I should note that my views are my own and not necessarily those of the Federal Reserve Board or my colleagues on the FOMC, which will shortly become apparent. Economic conditions So, let me begin with an overview of the U.S. economy. We are more than five years into a recovery that began in June While the pace has been sluggish and uneven, I believe the progress is undeniable. In fact, despite a winter cold spell in the first quarter, I remain mostly positive about the prospects ahead. The severe winter led to a decline in gross domestic product (GDP) during the first quarter of the year, but second-quarter growth rebounded to 4.2 percent, according to the most recent estimate. This largely confirmed that the disappointing performance in the first quarter was mostly a temporary weather-related slowdown rather than a more persistent retrenchment in the ongoing recovery. In the second quarter, the strongest recoveries were in categories most directly affected by the first quarter's severe weather, including investment in equipment, residential structures, inventory accumulation, and exports. Exports declined sharply at an annual rate of 10.1 percent in the first quarter and then jumped 9.5 percent in the second.

95 P a g e 95 Total private domestic investment fell 6.9 percent in the first-quarter freeze but then grew 17.5 percent during the second-quarter thaw. Personal consumption, the largest spending sector of the economy, slowed during the first quarter to 1.2 percent. In the second quarter, personal consumption growth approximately doubled to 2.5 percent. Durable goods, which advanced at an annualized rate of 14 percent, were the strongest component of personal consumption in the second quarter. I believe consumer and business spending will help real GDP to grow at about 3 percent for the remainder of this year and next before reverting to trend, which I see as about 2.4 percent. The Philadelphia Fed's Manufacturing Business Outlook Survey in our region has proven to be a reliable indicator of national manufacturing trends in the U.S. In August, the diffusion index of current activity increased for the third consecutive month and had its strongest reading since March The survey also indicated that expectations for manufacturing activity six months ahead remained strong. Underlying details of the report included strong results for new orders and shipments. The current indicators for labor conditions also suggested continued expansion in employment. The employment index has been positive for 14 months, and the workweek index was positive for the sixth month. These data suggest continued improvement in U.S. labor market conditions, despite a somewhat softer August number yesterday, which showed that 142,000 jobs were added to nonfarm U.S. payrolls.

96 P a g e 96 However, I prefer to look at longer-term trends rather than monthly numbers that are still subject to revision. Year-to-date monthly average job growth has amounted to 215,000 jobs this year, compared with a monthly average of 194,000 jobs added last year. Despite the slowdown in August, job creation has improved markedly this year. The economy has created 1.7 million jobs since the start of the year, nearly 10 percent more than the same period in 2013, 20 percent more than in 2012, and 30 percent more than in The unemployment rate was 6.1 percent in August, down more than a full percentage point from a year ago. This means the unemployment rate continues to fall faster than many policymakers had been forecasting. For instance, in the Summary of Economic Projections (SEP) submitted in December 2013, the central tendency of FOMC participants was to end 2014 with an unemployment rate of 6.3 to 6.6 percent, and by the end of 2015, the central tendency was expected to be 5.8 to 6.1 percent. We have clearly exceeded expectations. The unemployment rate is below where the Committee thought it would be at the end of 2014 and is now within the range expected at the end of Thus, it is fair to say that we are at least a year ahead of where we thought we would be when we started to taper asset purchases. In Pennsylvania, job growth has been positive as well. The state added more than 54,000 jobs over the past 12 months.

97 P a g e 97 July's unemployment rate in Pennsylvania was 5.7 percent, down from 7.5 percent a year ago and from a peak of 8.7 percent immediately following the recession. It is not just that the unemployment rate has fallen, other measures of labor market conditions have improved as well. Long-term unemployment in the nation, those unemployed for more than 27 weeks, has dropped by about 1.3 million from a year ago; the duration of unemployment spells has declined; job openings have returned to prerecession levels; and the rate at which employees voluntarily leave their jobs, called the quit rate, has risen. This is not to claim that all is rosy in the labor markets. Many Americans remain frustrated and disappointed in their jobs and job prospects. For example, there remains a large contingent of those working part time for reasons economists don't fully understand. Nonetheless, we have to acknowledge that significant progress has been made. Inflation remains somewhat below the FOMC's long-run goal of 2 percent, but it appears to be drifting upward. Headline inflation as measured by year-over-year change in the consumer price index, or CPI, was 2 percent in July, the fourth month at or above that level. The Fed's preferred measure of inflation is the year-over-year change in the price index for personal consumption expenditures, or PCE inflation. In December of last year, that figure stood at 1.2 percent. The most recent reading for July 2014 was 1.6 percent. Compare that with December 2013 SEP estimates for 2014, and you will find that we are

98 P a g e 98 already at the top of the FOMC's central tendency of 1.4 to 1.6 percent for PCE inflation. In the June SEP, FOMC participants modestly increased their assessment of inflation, raising the central tendency for PCE inflation by the fourth quarter of 2014 to between 1.5 and 1.7 percent. The Philadelphia Fed's most recent Survey of Professional Forecasters also increased its average estimate of headline PCE inflation to 1.8 percent in 2014, up from 1.6 percent in the last survey. The survey also increased the estimate of PCE inflation to 2.0 percent in 2015, up 0.1 percentage point from the previous estimate. All of these figures suggest that inflation appears to be gradually moving closer to our target of 2 percent and doing so more quickly than anticipated in December Monetary policy Let me turn to some thoughts on monetary policy, including why I departed from the majority view at the July FOMC meeting. As I noted in the beginning of my remarks, the Fed has taken extraordinary monetary policy actions, keeping the federal funds rate near zero for nearly six years and expanding its balance sheet to more than $4 trillion. Indeed, the balance sheet continues to expand, so the Fed is still trying to increase accommodation even though the pace of purchases is slowing and is expected to end in October. Yet, the recovery began over five years ago, and the unemployment rate has declined from 10 percent in October 2009, to 6.1 percent now. Whether you believe that the labor market has fully recovered or not, it is clear that we have made considerable progress toward full employment and price stability.

99 P a g e 99 We are no longer in the depths of a financial crisis nor is the labor market in the same dire straits it was five years ago. In its July statement, the FOMC reaffirmed its highly accommodative stance. The statement noted that "in determining how long to maintain the current 0 to ¼ percent target range for the federal funds rate, the Committee will assess progress - both realized and expected - toward its objectives of maximum employment and 2 percent inflation." In assessing this progress, the Committee reported that it will look at a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The FOMC also noted, based on its assessment of these factors, "that it likely will be appropriate to keep its target federal funds rate near zero for a considerable time after the asset purchase program ends..." I objected to this forward guidance regarding the expected timing for raising the funds rate because I believe this language is no longer appropriate or warranted. Appropriate monetary policy must respond to the data. I believe that by indicating that the FOMC continues to anticipate that it will be a "considerable time" after the end of asset purchases before it is likely that the Committee will raise interest rates does not reflect the significant progress toward our goals. It also limits the Committee's flexibility to take action going forward. We have moved much closer to our goals since last December, and, as we do so, the stance of monetary policy should reflect such progress and begin to gradually adjust.

100 P a g e 100 That is the essence of being data dependent. In the current context, we must acknowledge and thus prepare the markets for the fact that interest rates may begin to increase sooner than previously anticipated. I felt that adjusting our language was the appropriate first step in responding to better-than-anticipated economic conditions. My view is informed, as I have indicated, by realized and projected economic progress toward our goals. But it is also influenced by guidance gained from the historical conduct of past monetary policy. In particular, my views on the appropriate funds rate setting are - and continue to be - informed by Taylor-type monetary policy rules that depict the past behavior of monetary policy. I find such rules useful for benchmarking my policy prescriptions. These rules have been widely investigated and have been shown to be robust, in that they deliver good results in a wide variety of models and circumstances. The guidance I take from such robust rules is that we should no longer consider monetary policy as being constrained by the zero lower bound. A variety of these rules, which I discussed in a speech earlier this summer, indicates that under current conditions the funds rate should already be above zero or should be lifting off in the very near future. I am not suggesting that rates should necessarily be increased now. Our first task is to change the language in a way that allows for liftoff sooner than many now anticipate and sooner than suggested by our current guidance. Raising rates sooner rather than later also reduces the chance that inflation will accelerate and, in so doing, require policy to become fairly aggressive with perhaps unsettling consequences.

101 P a g e 101 Thus, I believe that our forward guidance should be adjusted to reflect economic realities and to give us the flexibility to respond sooner and more gradually to the evolution of the economy. There is a point of view that rates cannot be raised because the labor market has not completely healed. That is, we must wait, maintaining our current stance of policy until we have achieved our goals. I think this is a risky strategy for two reasons. First, we do not know how to confidently determine whether the labor market is fully healed or when we have reached full employment. In January 2012, the FOMC affirmed in its statement of longer run goals and strategies that, "The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable." Chair Yellen gave an excellent speech at the Jackson Hole conference just a couple of weeks ago that highlighted some of the structural and nonmonetary factors affecting the labor market. Economists don't fully understand how these factors may be influencing our efforts to assess the meaning and measurement of full employment. Second, if monetary policy waits until it is certain that the labor market has fully recovered before beginning to raise rates, policy will be far behind the curve. One risk of waiting is that the Committee may be forced to raise rates very quickly to prevent an increase in inflation. In so doing, this may create unnecessary volatility and a rapid tightening of financial conditions - either of which could be disruptive to the economy.

102 P a g e 102 This would represent a return of the so-called "go-stop" policies of the past. Such language was used to describe episodes when the Fed was viewed as providing lots of accommodation to stimulate employment and the economy - the go phase - only to find itself forced to apply the brakes abruptly to prevent a rapid uptick in inflation - the stop phase. This approach to policy led to more volatility and was more disruptive than many found desirable. For these reasons, I would prefer that we start to raise rates sooner rather than later. This may allow us to increase rates more gradually as the data improve rather than face the prospect of a more abrupt increase in rates to catch up with market forces, which could be the outcome of a prolonged delay in our willingness to act. Conclusion To summarize, my own forecast is positive. Second-quarter growth has rebounded, confirming that the disappointing performance in the first quarter was mostly weather related rather than a retrenchment to the ongoing recovery. Unemployment continues to improve more quickly than many had expected, and inflation appears to be drifting up toward our 2 percent goal. If monetary policy is to be truly data dependent, then our stance of policy must begin to change. I'm not suggesting a rate increase now, but changing the forward guidance would at least afford us the flexibility to gradually raise rates beginning earlier than currently anticipated.

103 P a g e 103 Waiting too long to begin raising rates - especially waiting until we have fully met our goals for maximum employment - is risky because we cannot know when we have arrived. That could also put monetary policy behind the curve and could lead to a return to abrupt go-stop policies that in the past led to unwelcome volatility.

104 P a g e 104 PCAOB Announces the Agenda and Panelists for the October 2 Standing Advisory Group Meeting on Auditing Accounting Estimates and Fair Value Measurements Washington, DC The Public Company Accounting Oversight Board announced the agenda and panelists for the October 2 meeting of its Standing Advisory Group to discuss the potential need for changes to PCAOB standards for auditing accounting estimates and fair value measurements. On August 19, the PCAOB issued for comment a Staff Consultation Paper on standard-setting considerations for auditing accounting estimates and fair value measurements and announced the October 2 SAG meeting. The SAG meeting agenda includes panel discussions offering unique perspectives on the potential need for changes to the standards for auditing estimates and fair value measurements. The panels invite discussion not only on challenges accounting estimates and fair value measurements pose for auditors, but also on audit committee and investor perspectives, and observations from academic research. The discussion also will include developments in the accounting rules and valuation practices that affect auditing in this area. Panelists include investors, auditors, academics, valuation experts and other standard setters. The staff paper and SAG meeting are part of outreach efforts by the Office of the Chief Auditor to seek public input into whether PCAOB standards need to be updated. PCAOB inspections, and inspections by other audit regulators around the world, continue to find significant audit deficiencies across various types of estimates.

105 P a g e 105 "Accounting estimates, including fair value measurements, are critical components of many public company financial statements. The staff's outreach efforts are instrumental in determining a possible approach for a new auditing standard in this important area," said Martin F. Baumann, Chief Auditor and Director of Professional Standards. "We are excited to have such notable panelists, along with our distinguished SAG members, contributing their expert views to this important topic," he added. The SAG meeting, which is open to the public, will be held at 1825 Connecticut Avenue NW, Washington, DC. The meeting also will be available via webcast on the PCAOB website. The SAG includes investors, auditors, public company executives, and others. The group is chaired by Mr. Baumann. More information is available on the Standing Advisory Group page on the PCAOB website.

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