From: Lon Taylor [mailto:ltaylor@winstarmail.com]
Sent: Wednesday, July 03, 2002 3:40 PM
To: rule-comments@sec.gov
Subject: auditing rules

To Harvey Pitt - SEC

Some reasoning for the failures to detect and report financial manipulation - 

The rash of undetected auditing failures over the last three years can be found in a fallacy in
the infrastructure of auditing firms, especially the large ones.  There have been over 1,000
public company financial re-statements during this period that were not detected on a timely basis
by the independent auditor’s.  Under ideal circumstances detecting deliberate financial statement
misrepresentations is often very difficult.  My credentials for expressing this point of view is
based on the experiences of a former big eight, ah, big five, no, big four audit partner.

Roman Weil, University of Chicago accounting professor, was quoted, concerning Andersen’s work on
WorldCom, “Its basic accounting stuff – An auditor who looked into this would say its wrong.”  The
quote is unfortunate because it represents a lack of understanding of how a large company audit
engagement is conducted.

You have to commence a discussion of audit effectiveness with the fundamental premise that one in
twelve of the college graduates that commence their careers in large firm public practice rise
through the ranks to become partners in that firm.  The usual firm profile reflects a 20 to 30%
annual attrition rate.  This means that if you have a significant engagement with 10 to 12 people
on the audit team, there will be one audit partner and one audit manage, both of whom will be well
qualified and experienced plus one or two audit seniors, usually with two or three years
experience but more than likely struggling to find their gluteus maximus with both hands in the
world of complex financial transactions.  The remainder of the team would probably be comprised of
fresh grads with less than one year’s auditing experience.

So within this context Professor Weil should have said “An experienced auditor who looked into
this would say its wrong.”  Add to this the time pressures to complete the work within some
preconceived hourly budget and a performance rating system that treats that budget as sacrosanct,
you have a formula that has frequently ended in audit failures like Enron, WorldCom and Global
Crossing.

Once I asked an audit partner mentor how to perform our attest function with the confidence needed
to sign the so called “clean opinion” report.  He said it was simple, you should only do work for
honest clients.  In his opinion, and mine also after twenty five years of auditing, 90% of
management inspired financial manipulations could not be detected by the independent auditing
firm.

As has been reported, Cynthia Cooper of the internal audit staff discovered the World Com debacle
and the Enron accounting pyramid was defined by Sharon Watkins an experienced internal staff
member with extensive audit experience at Arthur Andersen.  To diffuse any assumption about gender
responsibility, you need to recall that the Andersen conviction was predicated upon the actions of
a female legal counselor.

Although most of the high profile audit failures have been laid at Andersen’s door step, public
accounting in general is failing to meet the challenging complexity of the twenty-first century
financial transactions.  What was the proven standard brought on by the famous 1939 McKesson-
Robbins fraud does not work in the derivative driven, special purpose entity environment of the
twenty-first century business economy.  The public accounting profession needs to be realistic and
challenge the fabric and structure of the current financial attest system.  The SEC proposals made
by Harvey Pitt sound as if they came from a strategy meeting of one of the Big Four (or is it
three now?) accounting firms.  The simple fact is that adding a different type of supervisory body
to the audit process will not do anything more than consume dollars that could be better spent on
improving the financial reporting attest system.

Arthur Levitt, former head the Securities and Exchange Commission, crusaded for better policing of
public accounting firms but he was stymied by the power of lobbyists. George W. replaced him with
Harvey Pitt, who has promised a "kinder and gentler" S.E.C.  Almost a year after the Enron
debacle, the Bush administration has consistently opposed any significant accounting firm reforms.

Levitt was correct in his perception of the current large accounting firm environment.  These
firms are culturally so selfishly bottom line oriented that they have aborted their public
fiduciary responsibilities.  They disavowed the public trust and have been trying to change their
image by referring to themselves as independent accountants and not as auditors.  There has been a
constant lobbying assault on attempts to make AICPA member firms more responsible for financial
fraud.  Apparently the goal was to profess to their clients “clean skirts” with out disclosing
what was going on behind closed doors.

A simple review of the facts is that the auditing services revenues in the large firms have become
a loss leader used as an entrée’ for the more lucrative consulting practice.  With auditing
revenues at 40% of the total revenue base and consulting, including tax consulting, a majority
revenue source, the hen house guard has become the hen house concierge.  The only way to right the
floundering audit ship is for these firms to make a decision as to whether they want to be
auditors or business and tax consultants because they can’t effectively be both.

A bi-product of public accountings sojourn into entrepreneurship has been to reduce the time
honored and essential financial statement auditing function into a commodity that is bid upon like
hay or pork bellies.  With auditing a loss leader, the pressures increases to reduce time spent
developing information for the formation of a valid audit opinion.

When you are a 21 or 22 year old, smart, neophyte auditor, who is typically a B average student,
hoping to advance in a profession that demands a performance level of an experienced financial
auditor, you find a way to perform his assigned duties in a manner that will reflect well on your
efficiency by meeting budgeted time constraints imposed on your task list.  The time constraints
and budget limits inherent in the current audit process have been as much at fault as the so-
called “independence” element that is so prominent in the public discussion of the Enron audit
failure.  Consequently, until we reach a compromise and eliminate the competitive bidding imposed
by the Federal government through the Federal Trade Commission, we will be buying pork bellies
instead of competent and independent financial statement auditing functions.

In my opinion, another element that is a horrendous obstacle to a free and transparent financial
reporting system is the manner in which the auditing firms are compensated.  A system that allows
the Company’s financial group to engage, negotiate and/or govern the auditors’ compensation is a
fatal flaw in the entire process.  Most large firms will cite the functioning audit committee as
the necessary buffer to assure independence.  There are two problems with this excuse.  Most audit
committees are a rubber stamp for the CFO as witnessed by Skilling and the Enron Committee.  You
also have the example of Xerox and KPMG negotiating in private a matter that should have been made
public by the auditor much earlier.  The other problem is that most public companies do not have
an independent audit committee.

Audit committees need a vehicle to insure their creditability.  My suggestion would be to make the
details of auditor’s fee arrangements public when the engagement letter is executed.  When the
engagement is completed, a detail reconciliation of the differences between the estimate and the
final fee should be included in the annual report.  Significant variations between the two can be
attributed to such factors as – 1) poor company record keeping and controls, 2) marginal or
aggressive accounting principles that requires substantial additional audit work, 3) poor
budgeting or performance on the part of the auditor.

Numbers 1) and 3) are important to the investor in assessing the quality and creditability of the
financial statements.  Number 2) should be a forewarning of potential WorldCom or Enron accounting
problems.  The accountants’ reconciliation should encompass a discussion of the quality of the
company’s application and use of generally accepted accounting principles.  In my mind the
profession should move back to something that resembles the old “long-form” audit report to
disclose this kind of additional information.

Finally, the SEC's proposed rules for sworn CEO and CFO financial representations are
mercurochrome on a melanoma wound.  Someone needs to recognize a reality that 30% to 40% of the
stock market capitalization, outside the Fortune 500, is represented by many smaller company's
with distinctively unbridled accounting misrepresentation.

Most of this group’s financial information is manipulative or incomplete because the majority of
these companies is growing and has an intense appetite of additional  capital.  And,
unfortunately, the capital providers focus on prescribed growth rates that strain the
creditability of the smaller company’s financial representations.  By limiting the proposed rules
to companies with revenues in excess of $1.2 billion, the legislation and rules will benefit the
billion dollar accounting and legal firms with larger consulting fees and protect the very rich
that invest in these blue chip enterprises.

The cost for all companies to attest to their financial statements and public representations is
nominal and such attestation should make the entire public company horizon more credible.  

This paper focuses on the auditing of publicly owned company’s under the jurisdiction of the SEC. 
However, these principles should also be utilized for all entities that have audits performed in
accordance with generally accepted auditing standards.

In summation, are we, as investors, creditors and fiduciaries, going to allow this critically ill
patient to go forward with a band-aid or major corrective surgery? 

Lon W. Taylor