Speech by SEC Staff:
Panel on Audit Effectiveness
Lynn E. Turner
U.S. Securities and Exchange Commission
Panel on Audit Effectiveness, New York, New York
October 7, 1999
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 or of the other members of the Commission's staff.
Mr. Chairman, I want to thank the Panel on Audit Effectiveness (Panel) for this opportunity to discuss a topic of critical importance to investors and the capital markets in the United States, and around the world. That topic is the quality of audits being performed by independent public accountants. This topic is of keen interest to me as well, not only as Chief Accountant at the SEC, but also as a Certified Public Accountant (CPA) and member of the AICPA, a member of the public accounting profession, and as a former Chief Financial Officer (CFO).
Investors rely on high quality audits as part of the process that assures they receive high quality financial information. Indeed, the federal securities laws give the auditing profession a unique role in the financial reporting process; a role different than any other member of the financial community. The professionís role is to provide enhanced credibility to the financial statements prepared by corporate management. There is a risk that this role could become meaningless unless investors have confidence in the work of the auditing profession. As the U.S. Supreme Court has stated: "It is not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporationís financial statements depends upon the public perception of the outside auditor as an independent professional..."
In the past few years, numerous articles in the press with titles such as "The Auditors Are Always the Last to Know" and "Pick a Number, Any Number" have raised concerns that could ultimately lead investors to lose confidence in the quality of the numbers and in the auditing profession. Companies such as Cendant, Sunbeam, Livent, Waste Management and many more have almost become common place in newspapers and business magazines.
Accounting and Auditing in the Grey Zone
Certainly, the Commission and its staff, as Dick Walker mentioned, will take appropriate actions when investors are defrauded of their hard earned dollars. But these are the extreme cases. Maintaining the confidence of investors depends on the daily practices of auditors that keep the number of such high profile enforcement cases from growing. As a result, I hope that this Panel will focus on auditing practices that accept accounting in what I refer to as the "grey zone." Such practices include those that have resulted in "reserves" intentionally being squirreled away like acorns, large write-offs of acquired in-process research and development costs that bear little resemblance to the business transaction being consummated, and recognition of revenues when the terms of a contract have not yet been fulfilled or when customers can demand a full cash refund. It also includes the practices of companiesí accountants and their auditors who believe an accounting practice must be permitted unless there is a rule that says it cannot be done, as well as those who choose to stretch the rules, like a rubber band. Undoubtedly, it is these types of accounting and auditing practices that erode the confidence of investors, and have a significant impact in lowering the quality of financial reporting.
The point I am making is perhaps best illustrated by some examples. In a conversation I recently had with a Chief Executive Officer (CEO) of a public high technology company. The CEO indicated that he and his CFO had believed that certain types of costs the company was incurring were in reality advertising costs, and should be expensed rather than reported as an asset. The companyís auditor had concurred with the companyís conclusions and issued their audit report on the annual financial statements. However, a major competitor had begun to treat these costs as assets. (I might add that this competitor had also taken a very large IPR&D write-off.) In time, analysts began to pressure the company to change its accounting, to become comparable with the accounting policies used by the competitor. The CEO noted that the analysts said that if the competitor and its auditor had "bought off" on the accounting, then it must be acceptable and that the CEO also should do it. As a result, the CEO and CFO, who to their credit were really trying to give their investors high quality information, were being subjected to business and market pressures caused by very aggressive "grey zone" accounting practices. Ultimately, the CEO and CFO "caved" into these pressures and agreed to an accounting treatment consistent with their competitors. As a team, we need to find ways to address these pressures.
In another situation I became aware of, the "Big Five" firms, to their credit, concluded on the proper accounting for a particular type of transaction that had been in the "grey zone." To me, this demonstrated leadership and a commitment toward ensuring the quality of financial reporting that these firms have a reputation for providing. Unfortunately, later on, one of the firms accepted accounting that undermined the firmsí joint resolution. The moral here may be that we cannot rely simply on the best intentions of the firms at the time they make these kinds of agreements. The pressures on them to agree with their clients are tremendous and very real. As a team, we need to find ways to address these pressures.
And, in a third and final example, I know of a situation where an audit partner agreed to a clientís accounting for certain types of aggressive reserves without first clearing it with his firmís technical consulting partners. Later on, other companies noted the accounting practice and also pressured their auditors to accept the practice. However, one of these firms questioned the accounting and called the first accounting firm to inquire as to how the firm had been able to justify the accounting in accordance with generally accepted accounting principles (GAAP). When the technical partners in the first firm became aware of the accounting practice that had been accepted, they criticized the audit partner for what had been done and the accounting that had been accepted. However, later on when the staff of the SEC questioned the companyís accounting, the firm staunchly and strenuously defended the accounting for which the firm had criticized the audit partner. As a team, we need to eliminate such unprofessional practices.
I would be the first to admit that these three examples are not indicative of what happens daily in the U.S. In fact, our financial reporting process has served as a foundation for our capital markets that are the best in the world.
But these real examples are indicative of cracks in the foundation which need to be repaired before the pressures create a greater problem. They raise serious questions regarding professionalism and whose interests are being served, accounting gimmicks, and accounting firmsí quality controls.
As a former CFO and audit partner in a "Big Six" accounting firm, I have a great deal of respect for my peers who have withstood these pressures and done what is right. The quality of our markets bear proof that the vast majority of the CFOs and auditors get the job done right, and not just done. But as we have seen in recent surveys conducted by Business Week and CFO magazine, a very disturbing number of CFOs are being asked to misrepresent results. The market and business pressures on CFOs and auditors is unbelievable at times and increasing, and some of this pressure is the result of those grey zone players.
Given the fact that accounting is done by people, I do not expect us to be able to totally eliminate fraud. We shouldnít ignore it but rather, we should proceed with timely and appropriate enforcement actions.
But fraud often begins with the grey zone. I hope this Panel clearly focuses on recommendations and solutions to remedy these practices in the grey zone - - practices that enable market participants to deceive and distort their financial results, thereby gaining a competitive advantage over those that do the job right, and harming investors.
Risk-Based Audit Model
Let me switch for a moment to the topic of the risk-based audit approach.
Recent events have caused the Commission and other securities regulators around the world to raise questions about the effectiveness of audits and the audit process, in particular, the perceived strengths and weaknesses of a risk-based audit approach.
Questions have been raised about how a risk-based audit model can be implemented in a manner that continues to assure investors that financial statements are free of material misstatement. In particular, given the judgment required in applying a risk-based audit model, questions have been raised as to whether sufficient auditing procedures have been applied to provide the auditor with an appropriate level of audit evidence.
It is clear, based on the evolution of the audit process over the last decade, that auditors have changed the nature of audit procedures they perform to rely more on analytical procedures rather than more traditional substantive audit procedures, such as the use of external confirmations or detailed testing of transactions, account balances and the related activity in those accounts. These changes have resulted in the auditor obtaining a significant amount of audit assurance from inherent and internal control sources as well as management representations.
While some auditors have asserted that changes to their audit processes are responsive to the increased use of technology in financial reporting and accounting, other market participants have indicated a belief that the accounting profession is discarding the techniques that, in the past, made the financial statement audit a tool that enhances the reliability of information provided to investors.
You only have to look as far as the March 1999 report sponsored by the Committee of Sponsoring Organizations of the Treadway Committee (COSO) on fraudulent financial reporting to understand the problems with todayís audits. One startling fact in that report, which summarizes fraud cases from 1987-1997, is that over 80% of the fraud cases involved the highest levels of management. Keep in mind that top management is the very group responsible for ensuring the adequacy of the control environment. The irony of todayís audit process is that significant audit assurance is derived from internal controls; however, the very group of individuals charged with ensuring the effectiveness of internal controls is responsible for committing fraud.
The COSO report and recent enforcement cases raise questions about whether an audit model that allows the auditor to de-emphasize or eliminate specific types of audit procedures, for example use of external confirmations or observation of assets, is in the best interest of investors. The COSO report notes that over half of the frauds involved overstating revenues by recording revenues prematurely or fictiticously. It also notes that about half the frauds also involved overstating assets, including overstatement of inventory or property, plant and equipment by recording assets that did not exist.
I believe this Panel has an obligation and responsibility to take a serious but balanced look into the auditing profession. This should include an examination of professionalism, the impact on audit quality and independence created by changes in firm structures, how auditors conduct audits, how they address the tough issues, their processes for continuing to react to business changes to assure the quality of audits, the effectiveness of existing quality controls and how they might be improved, and perhaps most importantly what support the firm provides to enable partners to withstand client pressures. I would urge this panel to ask the tough questions of the profession. I have highlighted a number of those questions in my submission to the panel entitled Questions for the Profession Regarding Audit Quality. Answers to these questions should be documented in the public record so that both investors and the public can better understand the panelís ultimate recommendations.
And while I firmly believe changes can be made to improve the accounting profession, just as with any organization or business, the recommendations you ultimately make should be focused on corrective actions that will provide useful and practical solutions. These solutions should be advanced with the audit professionals in the field, who actually have to perform the work, and preparers of financial statements clearly in mind.
In closing let me say that investors have placed their faith and trust in the hands and hearts and minds of those who make up the auditing profession. That faith has been based on the notion that protecting the interests of investors and the integrity of the markets will always come first and foremost, before personal or business interests. The support of all of us here in this room today should be dedicated to maintaining the faith placed in us.
As Franklin Roosevelt once said "To that high concept there can be no end save victory."
SUBMISSION BY THE CHIEF ACCOUNTANT OF THE
U.S. SECURITIES AND EXCHANGE COMMISSION
QUESTIONS FOR THE PROFESSION REGARDING AUDIT QUALITY
OCTOBER 7, 1999
Auditor Professionalism and Independence
In the past, CEOs of the major accounting firms served in leadership roles as chairs of the AICPA and as members of the Financial Accounting Foundation (FAF). They spoke out on the need for auditors to be vigilant in protecting the public interest. Based on the cases reported in the press and the growing importance of nonaudit services to accounting firms, some believe the profession lacks such leadership today, especially on audit and auditor independence issues. How can this apparent void best be filled?
What is the growth rate in your firmís revenues and profits from audit versus nonaudit services? What percentage of your firmís profits come from audit versus nonaudit services?
The culture and critical success factors for an audit practice may and will often vary from the culture and critical success factors for a business providing a breadth of financial services such legal, investment and acquisition advice, and systems consulting. Yet, in many firms, the engagement partner also is the individual who promotes the sale of nonaudit services to the client. In your firm, who is typically responsible for (1) the audit, (2) the client and business relationship including making the client aware of services the accounting firm offers and (3) the quality of the audit? How does this vary between small, medium and large clients? What changes have been made in these responsibilities in the last ten years as the business of the firm has changed?
Over the last 2 years we have seen alternative firm structures develop that involve the provision of audit and other services. Those structures range from public companies acquiring CPA firms to IPOs of roll-ups of CPA firms. What stresses do you think that this will put on the systems in place today? What should be the response to these structures?
How have developments in technologies affected the firmsí ability to perform quality audits?
What do you believe are the critical success factors for a high quality audit?
Today, the profession uses a "risk assessment" model that focuses on risks in the business that can affect the financial statements. This approach requires an assessment of business risks that within the business itself, are often made by personnel with years of on the job training. In addition, some have argued that this approach, when coupled with firmsí reengineered audit approaches, has resulted in less verification of account balances by examining documentation from independent sources, such as invoices, checks, etc. Instead, the firms are relying on analytical analysis, inquiries of company personnel, and when appropriate control testing. In the electronic age of information, has detailed testing become obsolete? If so, why and what types of tests have replaced them to assure the veracity of the numbers? Can these tests be performed by typical audit staff?
Please tell us why the analytical approach in the risk assessment model is considered by the firms to be superior to the "detailed testing" that for so many years gave our markets the credibility that led them to be the most liquid and highly respected markets in the world? What is the appropriate mix among detailed testing of amounts in the accounts, internal controls testing, and analytical procedures?
In discussing the "Nature of the Control Environment (Top Management and the Board)," the recent research report of the Committee of Sponsoring Organizations of the Treadway Committee stated that 83 percent of the frauds involved the CEO or CFO. With the tone at the top being so important, this statistic, as well as those statistics reported in survey of CFOs by Business Week and CFO magazine, is it realistic for the auditors to rely so extensively on controls. If so, do modifications need to be made to ensure that controls are not being circumvented?
What changes could be made to the audit and financial reporting process to reduce the ability of preparers to "push the envelop" and thereby lower the quality of financial reporting to investors?
What percent of the hours on an audit, on average, are spent by nonpartner and nonmanager staff? On average, how many audit hours are spent by a partner during each of the planning, fieldwork and final completion stages?
How many hours of industry-specific business training do (a) audit partners/managers and (b) their audit staff receive on average each year, and how many hours of technical accounting and auditing training do they receive during those same years?
For 1999 and 2000, what are your expected billable hours for each partner and manager, on average? How does this vary for partners responsible for large clients (e.g. a firmís top 200 client) as compared to a partner responsible for a variety of small to medium sized clients? How does this number compare with the same number a decade ago?
What are the specific categories listed on the annual evaluation forms that your firm uses to evaluate its (a) partners, (b) managers and (c) staff?
Who sets the compensation for partners and managers in your firm and how is this process done? What are the specific factors in determining compensation?
Revenue recognition seems to be a recurring theme in press articles, restatements by companies, SEC enforcement actions and the COSO report. The COSO report notes half of the SEC enforcement actions involve revenue recognition issues. Yet there is no specific auditing standard addressing revenue recognition. Given that revenue is usually the largest line item in the financial statements, and many of revenue issues involve significant transactions at or near the end of a financial reporting period, what types of auditing guidance would improve and enhance the likelihood of audits detecting these problems?
Members of the business community, analysts, and the SEC staff have noted companies who have aggressively or in some cases, allegedly fraudulently, set aside "reserves" that were not recorded in accordance with generally accepted accounting principles. What procedures could the panel recommend that would result in auditors taking action to prohibit such aggressive practices by those in the business community that want to "push the envelope?"
Based on your experience, are there recurring deficiencies in audits when you consider either cases involving financial fraud or those involving aggressive or earnings management techniques, that this panel should address? If so, what are they and what recommendations would you suggest to remedy the deficiencies?
Peer Review Process
The firm peer review process currently in place was established over twenty years ago. How often have independent reviews been made of this process since its inception? What changes have and/or should be made to this process to ensure that it takes into account (a) changes made in the auditing process, including documentation of the steps performed during the audit, (b) changes occurring in the business and structure of accounting firms, and (c) results in substantive comments being made with respect to the firm under review?
Has any of the fieldwork done in peer reviews of major accounting firms noted a change in the timely involvement of the engagement partner, concurring partner or manager as a result of the firms using the new risk-assessment approach?
A number of recent SEC enforcement actions have cited problems with the independence of accounting firms and their quality control systems. Why havenít these issues been identified as part of the peer review process?
The globalization of the business, financial and capital markets has grown at an increasing pace in the twenty plus years since the current peer review process was established. Given that a U.S. based business may conduct and have a majority of its business overseas, doesnít it make sense to reconsider the existing peer review rules that significantly limit the peer review procedures applied to the audit procedures actually performed by the firmís international affiliates?
Financial Reporting Standards
Some believe accounting standards should be broad, general standards. And others involved with financial reporting have advocated standards based on detailed guidance arguing that it makes for more comparable reporting and provides clearer guidance to preparers.
Do you have any recommendations for the Panel on this topic and the effect (positive or negative) accounting standards may be having on the ability of auditors to verify the information in the financial statements?
Surveys by Business Week and CFO magazine note that a significant percentage of CFOs have been asked to misrepresent results. What steps would you recommend be taken by (a) companies and their management, (b) boards of directors including audit committees, (c) the auditing profession, (d) regulators and (e) others to address this pressure on CFOs? Who should take those steps and do they have the requisite legislative and/or regulatory ability to carry out those steps?
The Blue Ribbon Panel on Audit Committees recommended that the SEC adopt a requirement related to a report by the audit committee. If the Commission adopts such a requirement, then both the auditor and audit committee will issue reports. As recommended in 1987 by the Treadway Commission, do you think the CEO and CFO of a public company, who are responsible for the financial statements, should be required to issue a report addressing their responsibilities and the effectiveness of the Companyís internal controls?
As a financial executive, what steps do you believe the accounting profession could take to increase the level of business and industry knowledge among auditors? What are your observations about the existing level of knowledge?
How is your firmís management and auditing organization structured and organized on an international basis?
What percentage of your firmís international affiliates undergo a peer review by an external independent reviewer such as another firm or independent organization?
Questions have been raised by users of financial statements such as the World Bank, regarding the quality of audits conducted by the "Big Five" firms in international countries. What steps can be taken to address the concerns of these financial statement users, especially in the area of audit, quality control and independence standards? Do you think that when a firm uses a single name on its reports worldwide, that users of financial statements will understand that the standards applied in the audit engagement may vary from country to country?
Questions have been raised, including by the former Secretary General of the International Accounting Standards Committee regarding whether international accounting standards are rigorously implemented and enforced. What steps can or should be taken by (a) the accounting profession, (b) the accounting firms, and (c) regulators to improve enforcement of accounting standards on an international basis? Does your firm have a process in place to assure consistent implementation of IAS worldwide?
In the past ten years, how many AICPA Ethics Committee disciplinary actions have resulted in a suspension or other disciplinary action being taken against a member who was the subject of a Rule 2(e) proceeding of the SEC? How many of these were brought against larger versus smaller firms?