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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks to the Panel on Audit Effectiveness

by Lynn E. Turner

Chief Accountant
U.S. Securities & Exchange Commission

New York, N.Y.

July 10, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Turner and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Mr. Chairman, Members of the Committee, I thank the Panel on Audit Effectiveness (Panel) for this opportunity to testify. The Panelís examination is unquestionably the most comprehensive, independent, in-depth analysis to date into the way audits are performed. It is a study of not only the effectiveness of audits, but also the environment in which audit firms operate, the factors that drive their business, their operational management, the types of services they perform as well as the system of self regulation and governance that exists today. The Panel is to be congratulated and commended for such a significant undertaking.

I thank the Panel, its staff, each of the various firms that participated in and supported the work of the panel, and the many individuals and organizations that contributed to this undertaking. Without this outstanding level of support, it would have been difficult to develop the recommendations that are set forth in the Panelís exposure draft.

Let me begin by echoing Chairman Levittís remarks and strongly supporting the Exposure Draft. There is no doubt in my mind that these recommendations -- considered in sum -- can have a positive, resounding impact in the way audits will be conducted in the future.

If appropriately implemented, the Panelís proposals can strengthen investorsí confidence in independent audits and the financial information those investors rely upon in making their investment decisions. Let me comment on a few of the more than 200 significant recommendations that will improve the quality of auditing. I have tried to break them down into the categories of the performance of audits, self-regulation and governance, audit committees, independence, and international.

Performance of Audits

Let me begin with the topic of our original letter in 1998 to the Public Oversight Board (POB), the performance of audits. Concerns have been expressed in public, as noted in the panelís report, about the quality of audits today. The Panelís report notes that some firms may have reduced the scope of their audits and level of testing, at least in part, as a result of redesigning their audit methodologies. However, I agree with the Panelís findings that the Risk Assessment audit methodology is not broken. Rather the model needs to be updated and enhanced. The recommendations put forth in your report will go a long way in accomplishing that goal.

In particular, some of the recommendations that will enhance the performance of audits and investorís confidence in the financial statements they rely on include:

  • Requiring auditors to perform additional forensic-type procedures during the annual audit and reviews of quarterly financial information. Both the 1999 Committee of Sponsoring Organizations (COSO) study and the Panelís analysis of the SECís enforcement cases reinforce the importance of auditors taking specific steps to detect fraudulent financial reporting.
  • Critically assessing existing auditing standards with the objective of revising or replacing some or all of them with more specific and definitive guidance for auditors to follow. Alleviating this problem by recommending that certain Auditing Standards Board (ASB) literature be more authoritative -- along the lines of existing Generally Accepted Accounting Principles (GAAP) hierarchy -- would certainly help.
  • Enhancing the criteria regarding the minimum documentation to be included in audit working papers is another recommendation that will enhance investor confidence in the quality of audits. As the Exposure Draft points out, "working paper documentation often was less than adequate." Clearly, working paper documentation needs to be significantly improved upon and consistently applied from firm to firm.
  • Enhancing audit procedures related to revenue recognition and auditing of estimates and judgments. Your report, as well as the Chairmanís "Numbers Game" speech, have appropriately highlighted the concern about abusive accounting practices that are being used to mask the true performance of a company from its real owners -- investors. The implementation of the Panelís recommendations will go a long way to putting these improper practices under the microscope and making information provided to investors more reliable. As you are aware of, the Office of The Chief Accountant asked the ASB to address these issues in 1998 and we hope the ASB will develop the guidance the Panel and SEC staff has recommended on an expedited basis.

Although there are numerous additional, significant recommendations on the way audits are performed, in chapters two and three of your report, which I hope everyone will carefully read and analyze, I want to say I agree strongly with the discussion of the need for a better assessment of risks in account balances, and the need to consider the linkage to internal controls and audit tests performed. We issued a letter to the ASB in December 1999 that expressed this very concept as it related to auditing of estimates and judgments. I would also note that the COSO report and review of enforcement cases has highlighted auditorís failure to identify the override of internal controls by the very executives responsible for their effective operation.

Self-Regulation and Governance

The profession has a long history of self-regulation and governance. In the 1970ís the POB was established to represent and be a voice for public interests in the oversight of the profession.

The Panel has recommended restructuring of the POB to create a more effective, unified oversight body over the profession. By bringing the quality and investigative review processes, as well as the standard setting processes, directly under the POB, the ability to identify issues and resolve them in a timely fashion will be enhanced, as will investorsí perceptions regarding the quality of self-regulation. Investors will benefit from this change and so will the accounting profession. Similar recommendations have already been made in England and are being implemented.

I echo Chairman Levittís remarks and call for the accounting firms and the AICPA to endorse the POBís recently approved charter now. Even though this charter does not adopt all of the outstanding recommendations of this Panel, it does advance the ball a long way down the field, and it has the support of the Office of the Chief Accountant.

Yet some in the profession say it needs more study. I disagree. This document is not a 700 page Harry Potter book. Rather it is a charter that has been under discussion and review in draft during the past half year. The major firms and American Institute of Certified Public Accountants (AICPA) have all had a chance to review the final version of the charter approved by the POB a couple of weeks ago. I understand the POB has asked the firms and AICPA for their approval. The time to vote is now, not next month or next year. The time and opportunity for the profession to endorse continuous improvement in self-regulation and governance is the present.

Before I move on I would note the Panelís recommendations on discipline do not go as far as what others, such as the United Kingdom has achieved. However, it is a step in the right direction and as the Panel notes, the POB and SEC need to continue to monitor the results from the proposed changes.

Audit Committees

The audit committee plays an important role as representatives of investors. This Panel has made recommendations just as useful as those made by the Blue Ribbon Panel on Improving the Effectiveness of Audit Committees. Recommendations such as those that would have audit committees:

  • Obtain a written report from management on the effectiveness of internal controls over financial reporting,
  • Determine if auditors are receiving the necessary cooperation from management to carry out their duties under enhanced auditing standards,
  • Determine that auditors are appropriately compensated for performing a thorough audit, and
  • Pre-approve nonaudit services, are based on just plain good old common business sense.


The Panel demonstrated its ability to move boldly and take on difficult issues and questions when it chose to discuss auditorís independence. As everyone realizes, this can be a difficult and emotionally charged subject. Yet the chapter in the exposure draft on independence has provided clear and concise, albeit differing viewpoints, on this important topic. The Panel has provided useful insights and comments, which will be given due consideration as the Commission and its staff move forward with the current rule making initiative. In addition, there is a recommendation for the Independence Standards Board, that I also believe deserves consideration.


Finally, on the international front, the recommendations included in the international chapter should receive serious consideration. As we move rapidly towards a global economy and market, we need to move the accounting profession forward on a global basis, to meet the needs of investors. As highlighted in the commissionís concept release, we believe the Panelís recommendations are vital to the future of well functioning global capital markets.

While the Exposure Draft provides many excellent recommendations, let me provide some thoughts for your further consideration. First, the report contains in excess of 200 recommendations for over 13 different organizations or bodies within those organizations (approximately 75 for the Auditing Standards Board, approximately 65 for the accounting firms, approximately 35 for the SEC Practice Section Ė Peer Review Committee, and approximately 10 for the Public Oversight Board). I agree with the Panel that a piecemeal approach to the recommendations will not work. However, given the sheer quantity of good recommendations, the Panel may want to consider if it should prioritize these recommendations for the various constituents. Constituents should not take such a prioritization as meaning only those recommendations with the highest priority need to be implemented.

Second, certain recommendations should provide more detail or can be strengthened to allow more thorough implementation. For instance:

  1. The Panel recommends that senior management of the audit firms deliver frequent messages regarding the importance of performing high quality audit work. The Panel should consider adding guidance to avoid these messages from becoming boilerplate.
  2. Both the Financial Executives Institute and previous Commissions, such as the Cohen Commission, have suggested that management report on internal controls to shareholders. However, the Panelís Exposure Draft refrained from making this suggestion. Given the importance of internal controls as highlighted by the Exposure draft itself, and the long-standing support from other organizations, the Panel should contemplate adding a recommendation requiring a management report on internal controls to shareholders.

Let me now shift gears and discuss where I think the financial reporting community needs to turn its attention from here. The Panel has issued needed recommendations that will improve the efficacy of todayís audits. However, as noted in the Panelís report, the Panelís recommendations undoubtedly will impact Ė to some extent -- audit costs for most entities. In the next couple of months, you will likely hear that various recommendations are unnecessary, represent a systemic cost increase or that the audit failure rate as a percentage of the total number of audits is so de-minimus, that no changes to current audit practices are necessary. Some may argue that the costs of performing additional audit procedures recommended by the Panel will exceed the potential benefits. Letís consider this for a moment.

Based on the amounts reported in the Public Accounting Report, last year audit fees for the top seven accounting firms were approximately $9.5 billion. These accounting firms audited over 80% of all registrants, and virtually every company with a large market cap. In 1999, CNBC reported that investors lost over $32 billion dollars from investments in just five companies as a result of misstatements in previously reported financial statements. The magnitude of these losses is staggering in comparison to the total annual audit fees paid by all companies. So, it seems that investors would benefit from these additional audit procedures, even if these procedures prevented only a fraction of the cases of financial fraud, and where it occurs, a failed audit. Consequently, while listening to these criticisms, we all must remember the unseen casualty of financial fraud, and inadequate audits, the investing public. Without the investing publicís trust in the profession, uncertainty in the numbers will exist that undoubtedly result in a cost to investors and the capital markets.

Given then the tremendous benefit I believe the changes you have proposed can provide investors, it is important that the POB oversee on behalf of the public, that these recommendations are successfully implemented in full. I urge the POB to report on an annual basis to the public the recommendations that have, as well as those that have not been implemented. This will provide sunlight to the process that will need to be commenced in the near future with the issuance of the Panelís final report.

Let me say, once again, the Panelís analysis is the most substantive, comprehensive examination that the profession has undergone in several years. I commend the Panel for its thorough, and what will no doubt prove to be path-charting work in this area so important to the long-term health of our capital markets.

Chairman Levitt and I would be happy to respond to any questions you may have.