The Accounting Profession: Major Issues: Progress and Concerns (Chapter
Report, 09/24/96, GAO/AIMD-96-98,AIMD-96-98A).
Public confidence in the fairness of financial reporting is critical to
the effective functioning of the securities markets. Federal securities
laws require public companies to disclose information that accurately
describes the financial condition of a company. These laws also require
that financial statements filed with the Securities and Exchange
Commission (SEC) by public companies be audited by independent public
accountants. During the past 20 years, costly, well-publicized, and
unexpected business failures--such as the savings and loan crisis and
the resulting government bailouts--have raised questions about what the
public expects from an independent audit of public companies and how
well the audit function meets those expectations. More recently, the
globalization of business, the increasing complexities of business
transactions, and advances in information technology have challenged the
relevance and usefulness of traditional financial reporting and the
auditor's role in serving the public interest. These issues, along with
major litigation involving independent auditors, prompted many studies
of financial reporting and auditing during the past two decades,
resulting in hundreds of recommendations to the accounting profession.
This report (1) identifies recommendations made from 1972 through 1995,
and actions taken, to strengthen accounting and auditing standards and
the performance of independent audits of publicly owned companies
required by federal securities laws and (2) identifies unresolved issues
and determines their impact on the performance of independent auditors,
the setting of effective accounting and auditing standards, and the
scope of business reporting and audit services. GAO found that although
the accounting profession has made changes to improve financial
reporting and auditing of public companies, several major issues remain
unresolved. These issues include auditor independence, auditor
responsibility for detecting fraud and reporting on internal controls,
public participation in standard setting, the timeliness and relevance
of accounting standards, and maintaining the independence of the
Financial Accounting Standards Board.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: AIMD-96-98
AIMD-96-98A
TITLE: The Accounting Profession: Major Issues: Progress and
Concerns
DATE: 09/24/96
SUBJECT: Financial statements
Auditing standards
Accountants
Audit reports
Financial records
Accounting procedures
Standards evaluation
Quality control
Securities regulation
Reporting requirements
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Cover
================================================================ COVER
Report to the Ranking Minority Member, Committee on Commerce, House
of Representatives
September 1996
THE ACCOUNTING PROFESSION - MAJOR
ISSUES: PROGRESS AND CONCERNS
GAO/AIMD-96-98
The Accounting Profession
(917641)
Abbreviations
=============================================================== ABBREV
AcSEC - Accounting Standards Executive Committee
AICPA - American Institute of Certified Public Accountants
AIMR - Association for Investment Management and Research
AITF - Audit Issues Task Force
APB - Accounting Principles Board
ASB - Auditing Standards Board
AudSEC - Auditing Standards Executive Committee
CAP - Committee on Accounting Procedure
CAuP - Committee on Auditing Procedure
CFO - Chief Financial Officer
COSO - Committee of Sponsoring Organizations of the Treadway
Commission
CPA - certified public accountant
CPE - continuing professional education
EITF - Emerging Issues Task Force
FAF - Financial Accounting Foundation
FASAB - Federal Accounting Standards Advisory Board
FASAC - Financial Accounting Standards Advisory Council
FASB - Financial Accounting Standards Board
FDICIA - Federal Deposit Insurance Corporation Improvement Act of
1991
FMFIA - Federal Managers' Financial Integrity Act of 1982
GAAP - generally accepted accounting principles
GAAS - generally accepted auditing standards
GAGAS - generally accepted government auditing standards
OMB - Office of Management and Budget
PITF - Professional Issues Task Force
POB - Public Oversight Board
QCIC - Quality Control Inquiry Committee
SAS - statement of auditing standards
SEC - Securities and Exchange Commission
SFAS - statement of financial accounting standards
SOP - statement of position
Letter
=============================================================== LETTER
B-258991
September 24, 1996
The Honorable John D. Dingell
Ranking Minority Member
Committee on Commerce
House of Representatives
Dear Mr. Dingell:
This two-volume report responds to your request concerning the status
of recommendations made to the accounting profession over the past
two decades by major study groups. Our objectives were to identify
(1) recommendations made from 1972 through 1995 to improve accounting
and auditing standards and the performance of independent audits
under the federal securities laws and the actions taken on those
recommendations and (2) any unresolved issues to determine their
impact on the performance of independent audits, effective accounting
and auditing standards setting, and efforts to expand the scope of
business reporting and audit services.
We are sending copies of the report to other appropriate
congressional committees, federal agencies, and organizations of the
accounting profession, including the Chairman, House Committee on
Commerce; Chairman and Ranking Minority Member, Subcommittee on
Oversight and Investigations, House Committee on Commerce; Chairman
and Ranking Minority Member, House Committee on Banking and Financial
Services; Chairman and Ranking Minority Member, Senate Committee on
Banking and Financial Services; the Chairman of the Securities and
Exchange Commission; the Chair and President of the American
Institute of Certified Public Accountants; the President of the
Financial Accounting Foundation; the Chairmen of the Financial
Accounting Standards Board, Public Oversight Board, and the Auditing
Standards Board; the Managing Partners of the "Big 6" accounting
firms; and other interested parties. We will also make copies
available to others on request.
This report was prepared under the direction of Donald H. Chapin,
Chief Accountant, and Robert W. Gramling, Director, Corporate Audits
and Standards. Please contact Mr. Gramling on (202) 512-9406 if you
or your offices have any questions. Major contributors are listed in
appendix IX of this report (GAO/AIMD-96-98A).
Sincerely yours,
Charles A. Bowsher
Comptroller General
of the United States
EXECUTIVE SUMMARY
============================================================ Chapter 0
PURPOSE
---------------------------------------------------------- Chapter 0:1
Following the Great Depression, the Securities and Exchange
Commission (SEC) was established in the 1930s to help protect
investors through the regulation of securities, including
requirements for financial disclosures and audits of financial
statements. The public accounting profession, through its
independent audit function, has fulfilled the important role of
attesting to the reliability of financial statements and related
data. The accounting profession's services are critical to the
effectiveness and efficiency of our nation's commerce and capital
markets as well as international markets. In the United States,
there are over 1,000 public accounting firms that audit publicly
owned companies. Six large accounting firms, which employ over
91,000 professionals, audit over 78 percent of the nation's 16,000
publicly owned companies.
Over the past two decades, certain unexpected business failures that
were well-publicized and costly--such as financial institution
failures and large government bailouts--have raised questions about
what the public expects from an independent audit of public companies
and the effectiveness of the audit function to meet those
expectations. More recently, the globalization of businesses, the
increasing complexities of business transactions, and advances in
information technology are challenging the relevance and usefulness
of traditional financial reporting and the auditor's role in serving
the public interest. These issues, coupled with significant
litigation involving independent auditors, prompted many studies of
financial reporting and auditing over the past two decades, resulting
in hundreds of recommendations and many actions by the accounting
profession to address these issues.
Pursuant to the request of the Ranking Minority Member, House
Committee on Commerce, GAO undertook a review of the accounting
profession to (1) identify recommendations made from 1972 through
1995, and actions taken, to improve accounting and auditing standards
and the performance of independent audits of publicly owned companies
required by federal securities laws and (2) identify any unresolved
issues and determine their impact on the performance of independent
auditors, effective accounting and auditing standards setting, and
the scope of business reporting and audit services.
BACKGROUND
---------------------------------------------------------- Chapter 0:2
Public confidence in the fairness of financial reporting is critical
to the effective functioning of the securities markets. Federal
securities laws, which are primarily administered by the SEC, help to
protect the investing public by requiring public companies to
disclose information that accurately depicts the financial condition
and results of company activities. These laws also require that
financial statements filed with the SEC by public companies be
audited by independent public accountants.
Management of a public company is responsible for the preparation and
content of the financial statements which are to be presented in
accordance with generally accepted accounting principles (GAAP).
Company management must also set the appropriate tone and establish
the overall control environment in which it prepares financial
reports. In addition, public companies registered with the SEC must
maintain an adequate system of internal accounting control. The
independent auditor is responsible for auditing the financial
statements in accordance with generally accepted auditing standards
(GAAS).
The SEC, the primary federal agency involved in accounting and
auditing requirements for publicly traded companies, has
traditionally delegated much of its responsibility for setting
standards for financial reporting and independent audits to the
private sector, retaining a role largely of oversight. Accordingly,
the SEC has accepted rules set by the Financial Accounting Standards
Board (FASB)--GAAP--as the primary standard for preparation of
financial statements. The SEC has accepted rules set by the American
Institute of Certified Public Accountants' (AICPA) Auditing Standards
Board--GAAS--as the standard for conducting independent audits of
financial statements. The SEC reviews and comments on various
financial reports required to be filed with the SEC by federal
securities laws and regulations, and issues interpretive guidance and
staff accounting bulletins on accounting and auditing matters. In
addition, the stock exchanges, which are self-regulatory
organizations under SEC authority, require listed companies to
publish annual reports containing financial statements prepared in
accordance with GAAP and audited by independent public accountants.
During the 1970s, a series of unexpected failures by major
corporations and disclosures of questionable and illegal payments to
foreign officials led the Congress and others to review the role of
the SEC and the auditor in the financial reporting process. In 1977,
the Congress enacted the Foreign Corrupt Practices Act to require
that companies registered with the SEC have internal accounting
controls sufficient to provide reasonable assurance that transactions
reflect management's authorization and financial statements are
prepared in accordance with GAAP. In the 1980s, continued business
failures, particularly those involving financial institutions, led to
a series of congressional hearings on auditing and financial
reporting under federal securities laws. Litigation against auditors
emanating from those failures, along with auditor independence
concerns raised by the SEC's Chief Accountant in the early 1990s,
prompted renewed scrutiny of the accounting profession.
These types of concerns over the past two decades have resulted in
considerable debate and study of the accounting profession by the
Congress, AICPA-appointed groups, GAO, and others. Appendixes to
this report contained in GAO/AIMD-96-98A (1) identify the major
studies and provide information on the study groups and (2) list
specific recommendations made by the study groups and related actions
taken by the accounting profession and others. The AICPA, FASB, and
the SEC assisted GAO in identifying the specific actions taken to
address the recommendations. The accounting profession has taken
many actions, ranging from major changes in the structure for setting
accounting and auditing standards and instituting a quality control
program for accounting firms, to alerting auditors about specific
problems.
This report analyzes the major issues addressed by the study groups
and the progress made in addressing the issues, provides GAO's
observations on the significance of unresolved issues, and discusses
the outlook for further progress. GAO identified five major issues
discussed in the various studies from 1972 through 1995: (1) auditor
independence, (2) auditor's responsibilities for fraud and internal
controls, (3) audit quality, (4) the accounting and auditing
standard-setting processes and the effectiveness of financial
reporting, and (5) the role of the auditor in the further enhancement
of financial reporting.
RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3
GAO's analysis of the actions taken by the accounting profession in
response to the major issues raised by the many studies from 1972
through 1995 shows that the profession has been responsive in making
changes to improve financial reporting and auditing of public
companies. Further, GAO's analysis of statistical data on the
results of peer reviews of accounting firms that audit public
companies registered with the SEC shows that most firms now have
effective quality control programs to ensure adherence with
professional standards. However, GAO's review of the studies'
findings shows that the actions of the accounting profession have not
been totally effective in resolving several major issues. Issues
remain about auditor independence, auditor responsibility for
detecting fraud and reporting on internal controls, public
participation in standard setting, the timeliness and relevancy of
accounting standards, and maintaining the independence of FASB.
New complex financial instruments, such as derivatives, and rapidly
developing information technology that is facilitating electronic
commerce and communication, such as the Internet, are significantly
challenging the relevance of historical cost-based financial
statements and the traditional audit of those statements. The
accounting profession is also faced with challenges concerning the
future role of the auditor in providing new services related to
assuring the quality of information that is more timely and relevant
than data contained in traditional financial statements. For the
accounting profession to successfully move to a more modern era of
auditing and provide expanded assurance services, it must more
vigorously continue to address the major unresolved issues.
Several studies have suggested that the auditor review and report on
the effectiveness of entities' internal control systems and that the
accounting profession build a stronger relationship with the boards
of directors and audit committees of public companies. GAO believes
such changes have considerable merit and could be instrumental in
moving the profession forward to effectively address the issues of
auditor independence and auditor responsibilities for detecting fraud
and reporting on internal controls.
Effective internal controls are the first line of defense for
safeguarding assets and preventing fraudulent financial reporting--a
lesson well-learned from the savings and loan crisis and, most
recently, from business losses and failures from internal control
breakdowns in the use of derivatives. Auditor reporting on internal
controls would help ensure sufficient work by the auditor to
determine the effectiveness of internal controls. Reporting on
internal controls is also related to the auditor's ability to provide
more relevant and timely assurances on the quality of data beyond
that contained in traditional financial statements and disclosures.
The auditor will need to know the adequacy of accounting and related
information systems controls to provide timely assurance related to
the quality of data from such systems. However, an increase in
assurance services, coupled with the current large volume of
consulting services provided clients by the largest accounting firms,
could lead to increased concerns over auditor independence because of
perceived economic ties to company management. GAO agrees with the
studies of the accounting profession that suggest changes in the
auditor/client relationship are needed to deal with the continuing
concerns over auditor independence. For example, requiring the
auditor to report directly to the board of directors or audit
committee is a reasonable and effective means to strengthen auditor
independence. GAO also believes that the effectiveness of such a
direct reporting relationship would be further enhanced by having an
audit committee that is independent.
Setting accounting and auditing standards is inherently difficult and
controversial. The complexities of the current financial reporting
model, which includes a mix of historical and more current values, is
a contributing factor that generates debate over the effects of
proposed standards in preparing financial statements and contributes
to the pressures placed on FASB. Further, recent studies have
advocated additions of various types of information to traditional
financial reporting. Suggested additions include current values for
soft assets, such as trademarks and other intangible assets, that are
often not recognized in traditional financial statements,
forward-looking information about opportunities and risk, and
nonfinancial data, such as performance measures. In addition, the
studies have advocated that independent auditors be substantially
more involved with checking the reliability of internal systems, and
related controls, that produced information for external consumption.
GAO believes that updating the present reporting model, as well as
increased auditor involvement with assuring the effectiveness of
internal controls, has merit especially in view of the fact that
information technology is rapidly increasing data access and such
data are increasingly significant to investors.
GAO supports the recent successful efforts of the SEC to achieve
increased public representation among the trustees of the Financial
Accounting Foundation--FASB's parent organization that appoints
members of FASB. Additional public participation will enhance the
independence of the standard setters and the acceptability of the
standard-setting process by providing public views to balance those
of financial statement preparers and auditors. GAO also believes
that the leadership the SEC has shown in addressing issues that
concern the independence of the standard setters should also be
extended to working cooperatively with the accounting profession to
address the other important unresolved issues that the studies have
continued to identify. The effective resolution of these issues
cannot be accomplished by the accounting profession alone. The SEC's
responsibilities under the securities laws place it in a pivotal
position to assume a leadership role to work not only with the
accounting profession, but also with the stock exchanges, public
companies, and users of financial reporting to resolve these issues.
PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4
AUDITOR INDEPENDENCE:
PROGRESS MADE BUT CONCERNS
REMAIN
-------------------------------------------------------- Chapter 0:4.1
The independence of public accountants--both in fact and
appearance--is crucial to the credibility of financial reporting and,
in turn, the capital formation process. Various study groups over
the past 20 years have considered the independence and objectivity of
auditors as questions have arisen from (1) significant litigation
involving auditors, (2) the auditor's performance of consulting
services for audit clients, (3) "opinion shopping" by clients, and
(4) reports of accountants advocating questionable client positions
on accounting matters.
The accounting profession recognizes the importance of auditor
independence and has taken various steps to strengthen independence.
For example, the profession revised its code of ethics to help ensure
auditor independence and objectivity and adopted a code of
professional conduct to govern the acceptance of consulting services
and/or other activities that may be perceived as creating conflicts
of interest. In addition, AICPA members are now required to report
annually to the client's audit committee the total fees received for
management consulting services during the year under audit and a
description of the types of such services rendered. Further,
auditing standards require auditors to inform the audit committee of
matters such as disagreements with management, consultations with
other accountants, and difficulties encountered in performing the
audit. The standards also require auditors to report to the audit
committee internal control weaknesses that could adversely affect the
client's ability to safeguard assets and to produce reliable
financial statements.
Others have also acted to strengthen auditor independence. For
example, the SEC requires disclosures when an auditor resigns or is
dismissed from an audit in order to discourage the practice of
changing auditors to obtain a more favorable accounting treatment.
In 1991, the Congress enacted the Federal Deposit Insurance
Corporation Improvement Act (FDICIA), which includes requirements for
independent audit committees in large banks and savings and loans,
such as matters they should discuss with the independent auditor, and
also sets audit committee membership requirements for the largest of
the institutions. In 1995, the Congress enacted the Private
Securities Litigation Reform Act of 1995, which codifies the
auditor's responsibility for reporting illegal acts to audit
committees and requires, in certain circumstances, auditors to report
illegal acts to regulators.
Despite actions taken by the accounting profession and others to
strengthen auditor independence, concerns remain. In 1992 and again
in 1994, the SEC Chief Accountant questioned the independence of
accounting firms in situations in which they condoned or advocated
what he questioned as inappropriate interpretations of accounting
standards to benefit their clients. In addition, study groups have
expressed concern that the growth of consulting services, relative to
a static level of auditing and accounting services, could be
perceived as lessening the objectivity of the auditor.
Both the accounting profession and the SEC have been active in
examining continuing auditor independence concerns. They have found
there is no conclusive evidence that providing traditional management
consulting services compromises auditor independence. Further, they
believe that such services not only benefit the client, but
ultimately benefit investors and other interested parties. GAO
believes measures that would limit auditor services or mandate
changing auditors at set intervals are outweighed by the value of
continuity in conducting audits and the value of traditional
consulting services. However, GAO also believes that questions of
auditor independence will probably continue as long as the existing
auditor/client relationship continues. This concern over auditor
independence may become larger as accounting firms move to provide
new services that go beyond traditional services. The accounting
profession needs to be attentive to the concerns over independence in
considering the appropriateness of new services to ensure that
independence is not impaired and the auditor's traditional values of
being objective and skeptical are not diminished.
GAO supports a recent proposal by the AICPA's Public Oversight Board
to bring the independent auditor into a more direct working
relationship with the board of directors. The proposal also
emphasizes the role of the independent audit committee as an overseer
of the company's financial reporting process, a buffer between
management and the auditor, and a representative of user interests.
Such a change is inherently difficult to accomplish. Further, the
change may not happen voluntarily since a GAO survey of Fortune
Industrial 500 and Fortune Service 500 companies showed that audit
committee chairmen appear satisfied with their present relationship
with the independent auditor. The fear of litigation by boards of
directors and audit committees is another barrier to voluntarily
changing auditor/client relationships and the perceived increase in
their responsibilities that may result. Although the recently
enacted Private Securities Litigation Reform Act of 1995 provides
some liability relief and requires reporting on certain matters that
could involve directors and auditors, the Act does not fundamentally
address existing working relationships between auditors and boards of
directors or audit committees.
As an alternative to voluntary action, the SEC, which has the
responsibility and authority under securities laws to ensure that
accountants who audit companies registered with the SEC are
independent, could more clearly define the roles of boards of
directors and audit committees as they relate to the independent
auditor. The SEC has been reluctant to exercise authority in matters
of corporate governance and may want to seek legislation expressly
authorizing the SEC to act in this area. For example, the SEC could
seek legislation containing audit committee requirements such as
those in FDICIA. Although FDICIA-type requirements do not establish
a formal relationship between the auditor and the audit committee,
they would be an improvement over the current situation. Such
requirements could specify certain audit committee qualifications and
basic responsibilities regarding reviewing with the auditors the
reports on financial statements, internal controls, and compliance
with laws and regulations. An independent and knowledgeable audit
committee as envisioned by FDICIA would enhance the effectiveness of
having the auditor report directly to the audit committee.
As another alternative, the SEC could work through the major stock
exchanges to achieve listing requirements that would more
specifically define audit committee duties and responsibilities and
their relationships with the independent auditor. The listing
agreements of the major stock exchanges already require members to
have audit committees, so the basic principle has been established.
Such an approach by the stock exchanges, backed by the SEC, would not
require legislation.
EXPECTATION GAP STILL EXISTS
FOR DETECTION OF FRAUD AND
DETERMINING EFFECTIVENESS OF
INTERNAL CONTROLS
-------------------------------------------------------- Chapter 0:4.2
Well-publicized cases of financial irregularities and internal
control weaknesses in some companies and many financial institutions,
and seemingly unforeseen business failures, have raised questions
concerning the auditor's role and responsibilities. Studies have
advanced proposals to narrow what has been termed "the expectation
gap" between what the public expects of the accounting profession,
especially as it relates to the audit function, and what the
profession believes is its proper role.
To address the expectation gap, the accounting profession issued
auditing standards to address the auditor's responsibilities and
provide guidance for (1) evaluating internal controls, (2) providing
early warning of a company's financial difficulties, (3) designing
the audit to provide reasonable assurance of detecting material
fraud, and (4) improving communication to the financial statement
user and to the audit committees of public companies. These actions
have not eliminated the expectation gap, particularly with regard to
the auditor's responsibility for detection of fraud and internal
control problems. For example, the public may be holding the auditor
responsible for preventing fraud as well as detecting and reporting
material fraud. The public may also be holding the auditor
responsible for other types of unauthorized behavior resulting from
inadequate risk management controls that are not directly related to
the financial statements. The scope of audit work required by
existing standards is too limited to address these expectations.
GAO believes the issues of the auditor's responsibility for fraud and
internal controls overlap--effective internal controls are the main
line of defense in preventing and detecting fraud. Control
weaknesses were a major contributing factor to many of the notorious
cases of management fraud and failed savings and loans. However, as
part of a financial statement audit, auditors are not required to
evaluate internal controls in a manner sufficient to form an opinion
on their effectiveness in preventing and detecting fraud and other
types of failures in internal risk management systems. In pursuing
reforms these issues should be linked together. GAO believes that
auditor reporting on the effectiveness of internal controls is
fundamental in successfully addressing the public expectation gap for
fraud. GAO's work on internal controls and compliance with laws and
regulations as part of its financial statement audits of federal
entities shows that auditors have the capacity to examine the
adequacy of controls to prevent and detect fraud in financial
reporting and in the acquisition, use, and disposition of assets.
The accounting profession has recently publicly supported auditor
reporting on internal controls. The profession has also recently
issued for comment a new standard that attempts to heighten auditor
initiatives in detecting fraud. The proposed guidance emphasizes the
need for the auditor to exercise professional skepticism and pursue
"red flags" to detect fraud. Such guidance is an important component
of assessing risk and, accordingly, planning and conducting the
audit. However, the proposed standard does not make the important
linkage of reporting on the effectiveness of internal controls with
fraud detection, which will likely limit the standard's effectiveness
in narrowing the expectation gap with respect to fraud.
Performing a full evaluation of internal controls would provide
greater assurance of detecting and preventing significant fraud and
thereby more effectively address the expectation gap. Because these
extra procedures would increase audit costs, management of many
companies may resist expanding auditors' responsibilities for
internal controls. In addition, although the recently enacted
Private Securities Litigation Reform Act provides greater protection
for the accounting profession from unwarranted litigation, the
profession's liability concerns may continue to impede its
willingness to accept additional responsibilities for fraud
prevention and detection. However, GAO believes the public interest
should also be considered. The savings and loan crisis in the 1980s
demonstrated the cost to the public of weak internal controls.
Internal control weaknesses were a significant contributing factor to
the failure of savings and loans. More recently, there have been
large business losses and failures centering on weak controls over
the use of derivatives. GAO has expressed concern that weak
controls, given the large volume of derivatives activity among major
brokers and dealers, pose a systemic risk to the stability of the
entire financial system. Strong internal controls would not only
serve to protect against fraud, but could also serve a broader
function of ensuring that important internal risk management policies
are likely to be followed.
As one option, legislation could be enacted to require management and
auditor internal control reporting for all public companies similar
to that required of banks and savings and loans by FDICIA.
Alternatively, if the auditor/client relationship were to shift to
the board of directors, as suggested in 1994 by the Public Oversight
Board Advisory Panel on Auditor Independence, and the board assumes
more responsibility for overseeing risk management and the
effectiveness of the controls, boards of directors may see the value
of auditors' involvement with internal controls and may call upon
auditors to assist them in their oversight responsibilities.
Accordingly, public reports on internal controls would likely result.
As previously stated, GAO does not believe that many businesses will
likely voluntarily change the auditor/client relationship.
Looking to the future, more pressure to extend the accounting
profession's responsibility for internal controls is likely to
develop as globalization of businesses, complex business
transactions, and advances in information technology increase the
importance of safeguarding controls over assets. Auditors can better
serve their business clients and other financial statement users by
having a greater role in providing assurances over the effectiveness
of internal controls in protecting assets and in providing an early
warning of weaknesses that could lead to business failure.
The accounting profession, the SEC, and boards of directors are each
major stakeholders in reaching the ultimate goal of having an audit
that is more likely to be able to provide reasonable assurance of
detecting material fraud. While the accounting profession now
supports internal control reporting, the SEC has not been convinced
of the merits of reporting on internal controls. SEC support is
critical to further progress in this area. In the long run, GAO
expects that audits will be expanded to include internal control
reporting, either because of market demand or some systemic crisis.
THE ACCOUNTING PROFESSION'S
SELF-REGULATION PROGRAM HAS
IMPROVED AUDIT QUALITY
-------------------------------------------------------- Chapter 0:4.3
Concerns raised in the 1970s with audits of public companies focused
attention on the need to improve quality control mechanisms to ensure
that professional standards were being met. In 1977, the AICPA
instituted a voluntary peer review program that included reviewing
public accounting firms' systems of quality control for their
accounting and auditing practices, creating the SEC Practice Section
within the AICPA to administer the program, and creating the Public
Oversight Board to oversee the SEC Practice Section and to represent
the public interest. In response to critics, the AICPA required all
its members that audit public companies to become members of the
program beginning in 1990. As a result, membership increased from
519 firms in June 1989 to 1,257 firms in August 1995. These firms
audit about 97 percent of the 16,000 SEC registrants.
The current program has had a positive impact on the quality control
processes within accounting firms and on the overall quality of
audits. In 1991--the year in which most initial peer reviews were
conducted--83 of 300 peer reviews (about 30 percent) resulted in
modified reports.\1 GAO's analysis of 724 peer review reports issued
for accounting firms that audited SEC registrants during 1992 through
1994 showed that only about 10 percent of the peer reports were
modified. GAO's analysis also showed that none of these modified
reports were received by the largest accounting firms (firms that
audit 30 or more SEC registrants).
GAO's review of the peer review reports also showed that they
frequently identify audit documentation weaknesses, such as auditors
not adequately documenting work performed, and financial reporting
weaknesses, such as inadequate financial statement disclosures. GAO
also found no major difference regarding the frequency of such
deficiencies among the smallest firms or the largest firms. Although
the vast majority of these deficiencies are not considered serious
enough by the peer reviewers to modify their reports, continual
finding of these types of deficiencies is troubling, especially in
the cases where such weaknesses were reported in firms' previous peer
reviews. Such weaknesses can detract from the credibility of the
accounting profession and expose the firms to liability in the event
of a business failure and a resulting lawsuit. GAO believes that
closer attention to audit supervision, which may be achieved in part
through the AICPA's enhanced requirements for concurrent partner
review, should help to reduce documentation and reporting
deficiencies.
--------------------
\1 A modified report can either be qualified or adverse, or it may
include a disclaimer of opinion. A qualified opinion identifies
significant deficiencies in the firm's quality control processes or
in compliance with those processes. An adverse opinion indicates the
processes, or compliance with the processes, are not adequate. A
disclaimer of opinion is issued when limitations on the scope are so
significant that the review team cannot form an overall opinion. No
disclaimers of opinion were issued through 1994.
USER PARTICIPATION,
TIMELINESS, AND SPECIAL
INTEREST PRESSURES CONTINUE
TO CHALLENGE STANDARD
SETTERS
-------------------------------------------------------- Chapter 0:4.4
The current structure for establishing accounting and auditing
standards, which has served our nation well in providing generally
accepted standards, is a result of the recommendations made over the
past two decades to improve accounting and financial reporting to
adequately serve the public interest. This is no easy task since, to
be effective, standard setters must be able to address important, and
usually controversial, accounting and auditing issues on a timely
basis and to resolve those issues with credible, conceptually sound
standards that are responsive to the broad public interest. However,
the overall limited amount of user participation in the
standard-setting processes, the timeliness of issuing accounting
standards, and the pressures brought by groups that attempt to
influence accounting standards are still significant concerns.
FASB and the AICPA have made efforts to obtain increased user
participation in setting standards. For example, FASB and Auditing
Standards Board (ASB) meetings are required to be open to the public.
FASB and the ASB also issue exposure drafts of proposed standards and
other materials to the public for comment. To balance views in
setting standards, the Financial Accounting Foundation (FAF)
trustees--FASB's parent organization--have appointed users, as well
as auditors, financial statement preparers, and educators to FASB and
its Financial Accounting Standards Advisory Council (FASAC).
However, user representation and participation remains lower than
other groups, making it difficult to produce standards that have a
balanced perspective in meeting users' needs. In practice, audit
standard setting has been primarily the domain of the accounting
profession. Auditing standards have been influenced by auditors'
liability concerns and perceptions of a lack of cost benefit that
have constrained the scope of audit.
The SEC, which has ultimate authority for standard setting and
responsibility for protecting the public interest, has not always
strongly asserted that role in its relationship with the standard
setters. Recently, the SEC expressed strong views that the majority
of the FAF trustees should be public representatives as a means to
strengthen both the substance and perception of FASB's independence,
and reached agreement with FAF that trustee membership will be
balanced between constituent and public members. GAO believes the
SEC's recent attention to strengthening standard setting is a step in
the right direction.
In response to concerns over the quality and timeliness of accounting
standards, FASB developed a conceptual framework for deliberations on
accounting matters, created an Emerging Issues Task Force to provide
timely accounting and reporting guidance, and began relying on the
AICPA to set standards for certain issues. Despite these efforts,
according to the FASB records, it takes an average of 2 years to
issue specific standards. Complex, controversial accounting
treatments can take considerably longer. FASB's timeliness remains
problematic, particularly in critical areas such as the current need
for accounting standards for derivatives.
FASB has at times been confronted by strong opposition to positions
it has taken in developing proposed standards and has responded
professionally to those positions. GAO believes that FASB's mixed
financial reporting model, which measures some assets and liabilities
at historical cost and others at more current values, and the
difficulties claimed by the companies in implementing such proposed
standards, contribute to the pressures brought to bear on FASB in
developing standards. FASB's ongoing debate over accounting
standards for derivatives and the financial statement consequences of
measuring derivatives at market values and related assets or
liabilities at other values is a prime example. Resolving conceptual
issues surrounding the mixed financial reporting model by moving
toward a model with more consistent accounting treatment for
derivatives' related assets and liabilities may help to improve
timeliness. However, the inherently controversial nature of setting
accounting standards will likely always result in some level of
debate and in continued pressures. Therefore, it is important that
the SEC continue to monitor the operation of the standard-setting
process to ensure FASB's ability to objectively set standards.
FASB recently developed a strategic plan to carry the organization
into the next century. One of the plan's objectives is to build
broader acceptance from users, as well as preparers, educators, and
auditors, for the accounting standard-setting process and the
resultant accounting standards. Another objective of the strategic
plan is to make standard setting more timely and efficient. This
plan is part of FASB's recognition of the need for improvement in the
effectiveness and efficiency in achieving its mission to establish
and improve standards of financial accounting and reporting. The SEC
can play an important role in working with FASB to address questions
that have been raised about the efficiency of FASB's operations. It
is essential that any changes made to improve the efficiency of
FASB's operations do not adversely affect its independence as a
standard setter since independence is critical to achieving
acceptance of the standard-setting process.
THE NEED FOR A COMPREHENSIVE
REPORTING MODEL AND EXPANDED
ASSURANCE SERVICES
-------------------------------------------------------- Chapter 0:4.5
Audited historical cost-based financial statements are important to
our financial markets and are a valuable component of our economy.
Over the years, the accounting profession has issued many standards
to improve disclosures of financial information and audits of those
disclosures. However, the limitations of historical cost-based
financial statements for making investment, credit, and other
decisions are more widely appreciated and growing as technological
advances have improved both the timeliness and accessibility of
information and as business transactions have become more complex.
Much of the information used today for business decisions is outside
the traditional financial statements and therefore is unaudited.
Present day accounting reflects conflicting concepts of historical
cost and market valuation, concepts that do not recognize some
important economic values, and lacks forward-looking information that
is important to investors and other financial statement users.
Analysts and other sophisticated investors who have the capability to
interpret and supplement existing data may not have difficulty with
the current mixed model of reporting. However, the usefulness of
such reporting to the general public is less likely.
By not requiring all financial instruments to be valued at market
value, the current reporting model allows values to be placed on
certain assets that do not reflect economic reality. The mixed model
can facilitate earnings management and, in egregious cases, can
facilitate manipulation of earnings and cover-up of business
failures. Requiring extensive and burdensome disclosures to mitigate
the concerns associated with such reporting is not an acceptable
substitute for adequate accounting, and contributes to concerns over
"disclosure overload."
The current reporting model also lacks certain forward-looking
information about opportunities and risks that is important to
investors and other financial statement users. Soft assets are
another example where the current reporting model does not provide
information about important business assets. As a result, historical
cost-based financial statements are not fully meeting users' needs.
The use of nontraditional financial data in the investment and credit
communities is raising important questions for the accounting
profession with regard to the appropriate business reporting model
and the role auditors should have in providing adequate assurances
for information in a new expanded model. The prominent role of
unaudited information in facilitating business decisions in today's
economy also raises questions for the SEC and whether the basic audit
requirements for financial statements that grew out of the economic
conditions of the 1930s need to be revisited to better protect
shareholders in a much different information world.
Recent studies have identified the need for a more comprehensive
reporting model that would include the traditional mixed attributes
of historical cost and more current values, but also provide users
with more timely and forward-looking information. There is also
ongoing debate about the need for market value measurements of
financial instruments and more expansive disclosures regarding the
reporting entity's risks and uncertainties. The standard setters and
the SEC are currently considering the recommendations of, and varying
reactions to, these studies. FASB's current strategic plan includes
an initiative to develop and enhance the financial reporting model as
a tool for decision-making in a rapidly changing and technological
environment. However, there are significant barriers to expanding
business reporting, such as concerns over the cost of preparing and
auditing expanded disclosures, disclosure overload, and litigation
risk.
The AICPA is performing an ongoing study of the role auditors should
play in providing assurances on information not currently required in
financial statements, given the changing business world and advances
in information technology. Users are placing more importance on
information, in making financial decisions, that is more subjective
and difficult to value or determine its reasonableness, such as
information on soft assets and risks and opportunities facing a
business. Expanding financial statements or related disclosures to
include such information will require professional auditing standards
governing assurance on data that are not susceptible to traditional
methods of verification. GAO believes it should be possible to
accomplish reporting for this information without losing the
historical cost data and basic auditability of financial statements
that now exists. Historical cost data provide an important
foundation for accountability and for audited financial statements
with respect to fixed assets and other nonfinancial assets and
liabilities and should continue to do so.
The accounting profession will need to be more involved with auditing
internal control systems if it is to provide timely assurances on
information produced by computer systems and available to the
markets. Although concerns over auditor independence may increase as
auditors spend the necessary time with their clients in auditing
systems, GAO believes that shifting the auditor/client relationship
away from management and more toward the board of directors should
help to alleviate independence concerns. The accounting profession
must effectively resolve fundamental concerns in the key areas of
independence and auditor responsibility for reporting on internal
controls and fraud, as discussed previously, if it is to be
successful in providing expanded assurance services.
The accounting profession operates in a liability risk aversion mode
that has been a barrier to offering services that increase auditor
responsibility. The Private Securities Litigation Reform Act of 1995
that was supported by the accounting profession may help to reduce
its concerns over possible litigation that could result from
providing expanded services, such as reporting on internal controls
and providing assurances on forward-looking information. However, it
is too soon to tell what effect, if any, this act will have on the
profession's willingness to provide expanded assurance services.
It is not yet clear whether management will value expanded assurance
services from auditors. However, expanded assurance services should
not only be a function of management demand. Users' needs and the
assurance that information affecting the functioning of our capital
markets is reliable are also important. GAO believes it will take a
concerted effort by the AICPA, FASB, the SEC, and other interested
parties to achieve a comprehensive reporting model that meets the
needs of today's financial statement users. How the accounting
profession handles this issue will affect the nature and extent of
its future role in providing business information to users. Absent
strong leadership from the SEC, obstacles to implementing a
comprehensive reporting model will be even more difficult to
overcome.
RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5
This report frames the major issues for the accounting profession and
the SEC. It also provides observations to assist policymakers in
deciding on specific actions to effectively and efficiently address
these important issues. Although GAO is not making recommendations
in this report, GAO believes the SEC, given its responsibilities
under federal securities laws, is in a pivotal position to assume a
leadership role in working with not only the accounting profession,
but also the stock exchanges, public companies, and users of
financial reporting to resolve these issues.
ACCOUNTING PROFESSION AND SEC
COMMENTS
---------------------------------------------------------- Chapter 0:6
The AICPA, the Public Oversight Board (POB), FASB, and the SEC Chief
Accountant provided written comments on a draft of this report. The
AICPA's comments incorporated comments from the Managing Partners of
the six largest accounting firms (Big 6), the Auditing Standards
Board, the AICPA Special Committee on Assurance Services, and the
former AICPA Special Committee on Financial Reporting (Jenkins
Committee). These comments are presented and evaluated in chapters 2
through 6 of the report and are reprinted in appendixes V through
VIII of this report. (See GAO/AIMD-96-98A.)
The accounting profession and the SEC Chief Accountant comments were
complimentary of the comprehensiveness of GAO's study of the many
recommendations to the accounting profession and the thoroughness of
the analysis of the status of the recommendations and remaining major
issues. Their comments also expressed general agreement with GAO's
observations on the importance of the unresolved issues to the future
of the accounting profession and improved financial reporting.
The AICPA, the POB, and the SEC Chief Accountant provided comments on
auditor independence. They agreed with GAO's support of the POB's
suggestion of bringing the independent auditor more into a direct
working relationship with the board of directors and emphasizing the
role of the independent audit committee as an overseer of the
company's financial reporting process, as a buffer between management
and the auditor, and as a representative of user interest. Their
comments reflect a willingness to work toward that result.
They also provided comments on the unresolved issue of the auditor's
responsibility for reporting on the effectiveness of internal
controls. The AICPA also commented on the issue of the auditor's
responsibility for detecting and reporting material fraud. The AICPA
and the POB supported management and auditors' reports on internal
controls to obtain assurance on the effectiveness of internal
controls and to improve investor confidence in the reliability of the
financial reporting process. The SEC Chief Accountant recognized the
benefits of such reporting, but believed the SEC's current focus on
providing investors with more information on market risk related to
derivatives financial instruments may be a more appropriate priority
for the SEC at this time. The AICPA commented that its proposed
auditing standard will provide the auditor with more specific
guidance to detect fraud.
GAO believes that SEC leadership is necessary to achieve reporting on
the effectiveness of internal controls by management and independent
auditors. Such reporting would greatly enhance the auditor's ability
to prevent and detect material fraud. Although GAO supports the
AICPA's efforts to provide the auditor with increased guidance to
detect fraud, GAO believes that the auditor would be more effective
in this role if the effectiveness of internal controls were also
assessed. GAO also believes that the auditor/client relationship
places the accounting profession in a difficult position in achieving
reporting on internal controls and that the SEC is in a key position
to provide the leadership and support to achieve the changes needed
to resolve these major issues.
The AICPA and the POB commented on the accounting profession's
efforts to improve audit quality through the peer review program and
stated they will continue to seek ways to strengthen audit quality.
Although GAO found that program statistics show that peer review has
improved audit quality, GAO identified some audit documentation and
reporting deficiencies. The AICPA commented that it is considering
additional steps to improve these areas of the audit.
FASB, the AICPA, and the SEC Chief Accountant provided comments on
various issues of accounting and auditing standard setting. FASB
agreed with many of GAO's criticisms of the current financial
reporting model, but commented that adopting fair value accounting
for all financial instruments would not resolve all major issues,
including reducing controversy and timeliness, and would raise
challenging issues. However, FASB stated that it is studying this
issue again. GAO agrees that adopting fair value accounting for all
financial instruments raises difficult accounting issues. GAO
believes that the benefit of having more current values recognized in
the financial statements outweighs the effort necessary to
successfully resolve remaining issues.
The SEC Chief Accountant commented on another aspect of the current
financial reporting model: the recognition of soft assets in
financial statements. He commented on the importance of these assets
to investment decision-making, but noted that it was currently
difficult to arrive at a consensus on how such information should be
presented. GAO agrees with the SEC Chief Accountant that additional
research would be beneficial. GAO believes that the SEC should work
with FASB to ensure the adequacy of such research and to develop
specific plans to appropriately consider how information on soft
assets can best be reported.
On the related issue of the need for a comprehensive reporting model,
FASB noted that its project to obtain additional views on the Jenkins
Committee recommendations suggested that not all users agreed with
the specific findings. GAO believes such comments are consistent
with the findings of the Jenkins Committee and the 1993 report of the
Association for Investment Management and Research. The findings of
both major studies supported the need for a comprehensive reporting
model, but found disagreement on certain specific components.
Reasons for opposition to certain recommendations include cost,
competitive disadvantage, and liability concerns. GAO's report
points out that FASB should not be expected to resolve these issues
by itself. A concerted effort by all the major players, including
strong SEC leadership, is needed to achieve a comprehensive reporting
model that is relevant to today's financial statement users.
Although FASB's comments indicate general support for FASAC, the SEC
Chief Accountant agreed with GAO's observation that FASAC is not
working as effectively as it could and that he would support a
reconsideration of FASAC's membership criteria. The SEC Chief
Accountant also agreed with GAO's observation that opportunity exists
in setting auditing standards to better meet the public interest by
having more Auditing Standards Board members who are knowledgeable of
standards but are not public practioners.
The SEC Chief Accountant also commented that GAO's discussion of the
SEC's relationship with the standard-setting bodies implied that
there has been a transfer of official statutory responsibility to
FASB and that SEC oversight has been sporadic. He stated that this
is not the case and provided examples of how the SEC works with the
standard setters. GAO's report recognizes that the SEC has statutory
responsibility for administering and enforcing the federal securities
laws, but, in practice, has looked to the private sector to set
accounting and auditing standards and has overseen that process and
the resulting standards. GAO believes that the SEC has not always
strongly asserted leadership in its relationship with the standard
setters and that more progress could be achieved in resolving major
issues facing the standard setters if that were to occur. The SEC's
recent action resulting in restructuring FAF is a prime example of
progress achieved through SEC leadership.
The AICPA and the SEC Chief Accountant provided comments on the role
of the auditor in providing expanded assurance services. The AICPA
commented that its Special Committee on Assurance Services will
report in October 1996 and that its findings suggest an evolution in
the way the accounting profession will service the public in the
future. The SEC Chief Accountant agreed with GAO's findings
regarding the need to resolve concerns over auditor independence if
the accounting profession is to be successful in providing expanded
assurance services. His comments and those of the AICPA and the POB
also show the importance of resolving the issues of internal control
reporting and detecting fraud, as discussed in GAO's report, if the
accounting profession is to be successful in providing expanded
assurance services.
INTRODUCTION
============================================================ Chapter 1
Full, fair, and accurate disclosure of financial information by
public companies is critical to the effective functioning of the
capital and credit markets in the United States. Individuals and
enterprises use financial information to allocate capital among
companies, a process that when done efficiently, fuels economic
growth. Both the independent auditor and the Securities and Exchange
Commission (SEC) play major roles in ensuring that public companies
meet their financial reporting responsibilities.
Over the past two decades, business failures in combination with
public expectations of auditors, large government bailouts, advances
in information technology, the complexity of business transactions,
and other forces have raised concerns about the effectiveness of the
independent audit of public companies and the relevance, reliability,
and usefulness of financial reporting. These concerns, coupled with
a significant amount of litigation against accounting firms, prompted
many studies of auditing and financial reporting. In total, the
studies proposed hundreds of recommendations, principally to the
accounting profession to improve auditing and financial reporting.
Pursuant to the request of the Ranking Minority Member, House
Committee on Commerce, we undertook a review of the progress to
address the recommendations made in the studies and to identify any
major issues that continue to confront the accounting profession.
PARTICIPANTS IN THE FINANCIAL
REPORTING PROCESS
---------------------------------------------------------- Chapter 1:1
Federal securities laws and regulations require publicly owned
companies to disclose financial information in a manner that
accurately depicts the results of company activities. Financial
statements, which disclose a company's financial position, results of
operations, and cash flows, are an essential component of the
disclosure system on which the U.S. securities market is based.
Public companies are responsible for the preparation and content of
financial statements that are complete, accurate, and presented in
accordance with generally accepted accounting principles (GAAP). The
independent public accountant plays an important role through the
audit process. Other entities, most notably the SEC and the stock
exchanges, as well as other regulatory agencies and organizations,
also play important roles in the financial reporting process.
Company management must set the appropriate tone and establish the
overall control environment in which it prepares financial reports.
In addition, public companies registered with the SEC must maintain
an adequate system of internal accounting control. The Securities
Exchange Act of 1934, as amended by the Foreign Corrupt Practices Act
of 1977, requires these controls to ensure that among other things,
transactions are recorded as necessary to permit preparation of
statements in accordance with applicable standards.
The public accountant's audit is an important element in the
financial reporting process because the audit subjects financial
statements, which are management's responsibility, to scrutiny on
behalf of shareholders and creditors to whom management is
accountable. The auditor is the independent link between management
and those who rely on the financial statements. In that role, the
auditor evaluates the judgments made by management in applying
standards for the presentation of financial information. In the
United States, there are over 1,000 public accounting firms that
audit publicly owned companies. Six large accounting firms, which
collectively employ over 91,000 professionals,\1 audit over 78
percent of the roughly 16,000 publicly owned companies that control a
large proportion of the nation's economic wealth. Accounting firms
also perform other accounting related services, such as tax services,
and provide a wide array of nonaccounting and nonauditing services,
such as management advisory or consulting services.
The SEC, through its responsibilities for administering and enforcing
the federal securities laws, is the primary federal agency involved
in accounting and auditing requirements for publicly traded
companies. The SEC traditionally has delegated much of its
responsibility for setting standards for financial reporting and
independent audits under the securities laws to the private sector.
Accordingly, the SEC has accepted rules promulgated by the Financial
Accounting Standards Board (FASB)--GAAP--as the primary standard for
preparation of financial statements. The SEC has accepted rules
promulgated by the American Institute of Certified Public
Accountants' (AICPA) Auditing Standards Board--generally accepted
auditing standards (GAAS)--as the standard for independent audits.
The SEC also reviews and comments on registrant filings and issues
interpretive guidance and staff accounting bulletins on accounting
and auditing matters.
The SEC exercises oversight in the standard-setting processes of both
FASB and the AICPA. The SEC's staff participates in meetings and on
task forces with the FASB and AICPA staff, monitors the development
of new standards, and carries on a continuing discussion with FASB
and the AICPA on the implementation and interpretation of the
standards.
The stock exchanges, which are self-regulatory organizations under
SEC authority, establish accounting and auditing regulations for
listed companies. The major exchanges require listed companies to
prepare and publish annual reports containing financial statements
that have been prepared in accordance with GAAP and audited by
independent public accountants. Financial institution regulators,
such as the Office of the Comptroller of the Currency, the Federal
Deposit Insurance Corporation, the Federal Reserve Board, and the
Office of Thrift Supervision, administer portions of the federal
securities laws applicable to the entities under their jurisdiction.
--------------------
\1 Public Accounting Report, May 31, 1996, based on a 1996 survey of
national accounting firms.
LONG-STANDING ISSUES AFFECTING
THE FINANCIAL REPORTING PROCESS
AND THE ACCOUNTING PROFESSION
---------------------------------------------------------- Chapter 1:2
For over 60 years, since the Great Depression and the origin of the
securities acts in the 1930s, the public accounting profession,
through its independent audit function, has played an important role
in enhancing a financial reporting process that facilitates the
effective functioning of our capital markets as well as international
markets. The public confidence in the reliability of issuers'
financial statements that is provided by the performance of
independent audits encourages investment in securities issued by
public companies. This sense of confidence depends on reasonable
investors perceiving auditors as independent professionals who have
neither mutual nor conflicting interests with their audit clients.
Accordingly, investors and other users of financial statements expect
auditors to bring to the financial reporting process technical
competence, integrity, independence, and objectivity, and to prevent
the issuance of misleading financial statements.
During the 1970s, serious questions were raised concerning the
activities and accountability of publicly owned companies and whether
auditors were living up to the expectations of the investing public.
These questions arose in large part from a series of unexpected
failures of large companies as well as disclosures of questionable
and illegal payments made to foreign officials. Such events
threatened the public's confidence in the integrity of the nation's
financial reporting system, including the value of financial
reporting and the effectiveness of the independent audit function,
and led the Congress and others to review the role of the SEC and the
auditor in the financial reporting process.
In 1975, the staff of the Subcommittee on Reports, Accounting, and
Management, Senate Committee on Government Operations (Metcalf
Subcommittee), began a study of the federal government's role in
establishing accounting practices used by publicly owned companies in
financial reporting.\2 The staff made several recommendations to the
Congress. In 1977, the Metcalf Subcommittee held a series of
hearings that included the findings of the staff's study on the role
of the federal government in ensuring the accuracy of corporate
financial reports of listed companies. Witnesses at the hearings
included representatives from the Congress, academia, public
accounting firms, public interest groups, and the SEC. Many of the
issues discussed at those hearings-- auditor independence, the role
of audit committees, the auditor's role in detecting fraud, and
questions about self-regulation--continue to confront the accounting
profession and are discussed in this report.
In December 1977, as a result of revelations that falsification of
records and improper accounting allowed corporations to make millions
of dollars in questionable or illegal payments, the Congress enacted
the Foreign Corrupt Practices Act. The accounting provisions of the
act require SEC registrants to maintain a system of internal
accounting controls sufficient to provide a reasonable assurance that
transactions are executed consistent with management authorization
and are recorded to permit preparation of financial statements in
conformity with generally accepted accounting principles.
In the 1980s, continued business failures, particularly those
involving financial institutions, led to a series of congressional
hearings on auditing and financial reporting under the federal
securities laws.\3 Litigation emanating from these failures against
auditors, along with allegations made in 1992 and again in 1994 by
the SEC Chief Accountant concerning auditor independence, prompted
renewed scrutiny of the public accounting profession. In addition,
the increasingly pervasive use of information technology and the
changing business world are posing a serious challenge for the
standard setters and independent auditors regarding the usefulness of
audited historical cost-based financial statements. The profession
has responded to these concerns and challenges by identifying steps
to improve the value of financial information and the public's
confidence in the financial reporting process. Also, the profession
is currently considering additional audit services to respond to the
changing needs of users and better serve the public interest.
--------------------
\2 The Accounting Establishment, Staff Study prepared by the
Subcommittee on Reports, Accounting, and Management of the Committee
on Government Operations, United States Senate (ordered to be printed
March 31, 1977).
\3 Hearings by the Subcommittee on Oversight and Investigations,
House Committee on Energy and Commerce, beginning in February 1985.
AUDITORS' LIABILITY
------------------------------------------------------ Chapter 1:2.0.1
The recessions of the early 1980s and 1990s resulted in an increase
in both the number and size of corporate and financial institution
failures in the United States. These failures have led to a number
of lawsuits by those who suffered losses against companies, auditors,
and other professionals. Many of these lawsuits have resulted in
multimillion dollar judgments against accounting firms and a number
of very substantial settlements. The accounting profession believes
that the current legal liability climate is threatening its
viability.
The accounting profession claims that the threat of unwarranted and
excessive liability is not only having a detrimental financial impact
on the profession, but is also affecting the profession's ability to
adequately serve and protect the public interest. For example, large
accounting firms claim they have found it more expensive and harder
to obtain liability insurance, and are experiencing difficulty in
attracting and retaining qualified professionals. In addition,
accounting firms have asserted they have limited the availability of
audit services, particularly for high-risk clients and even entire
industries such as high-technology companies. Also, firms are
reluctant to assume new responsibilities in such areas as providing
assurances on internal controls, disclosure of certain risks and
uncertainties, or forward-looking financial data. For these reasons,
in addition to taking actions to improve auditor independence and
auditor performance, the profession has actively supported
legislative efforts at the federal and state level to reduce its
liability exposure.
In December 1995, the Congress enacted the Private Securities
Litigation Reform Act of 1995\4 (the Act), which contains some
provisions that were supported by the accounting profession. For
example, the Act changes the standard for assessing damages in cases
brought by private parties for violation of the Securities Exchange
Act of 1934. Previously, each defendant found to have committed a
violation of the Securities Exchange Act of 1934 was liable for the
plaintiff's entire loss, jointly and severally with each other
defendant, irrespective of relative fault. The Act adds a system of
proportionate liability. As a result of the Act, persons against
whom a judgment is entered for violating the Securities Exchange Act
of 1934 are jointly and severally liable for damages if they
"knowingly" commit the violation; persons against whom a judgment is
entered who did not knowingly commit the violation are liable only
for that portion of the judgment that corresponds to their percentage
of responsibility for the violation.\5
The Act also provides a "safe harbor" protecting certain
forward-looking statements from liability in private actions under
the Securities Act of 1933 and the Securities Exchange Act of 1934.\6
Forward-looking statements protected from liability under the Act
generally are written or oral statements that project, estimate, or
describe future events that are accompanied by notice that the
information is forward-looking and by meaningful cautionary
statements that actual results may materially differ from such
statements. The Act contains a number of specific exclusions from
safe harbor. For example, forward-looking statements included in
financial statements prepared in accordance with GAAP or made in
connection with an initial public offering are excluded from safe
harbor.\7
The Act also requires independent auditors of financial statements to
include procedures designed to provide reasonable assurance of
detecting material illegal acts, identify material related party
transactions, and evaluate the ability of the entity to continue as a
going concern.\8 In addition, the Act requires independent auditors
to report to the company's management when the auditor determines
that an illegal act likely has occurred and describes circumstances
where the auditor must report illegal acts directly to the company's
board of directors and the SEC.\9 The Act protects the auditor from
liability in any private action for any finding, conclusion, or
statement about an illegal act made in a required report to the SEC.
--------------------
\4 This act amended sections of the Securities Act of 1933 and the
Securities Exchange Act of 1934.
\5 Private Securities Litigation Reform Act of 1995, Section 201.
The Act defines when a person knowingly commits a violation and
addresses how to determine responsibility for persons whose violation
was not knowingly committed. A defendant also may be required to pay
an additional amount if the share payable by another defendant is
uncollectible.
\6 Private Securities Litigation Reform Act of 1995, Section 102.
\7 Refer to Section 102 of the Act for other types of forward-looking
information that are excluded from safe harbor.
\8 Private Securities Litigation Reform Act of 1995, Section 301.
Independent auditors are also required to perform such procedures
under GAAS.
\9 Private Securities Litigation Reform Act of 1995, Section 301.
MANY GROUPS HAVE ADDRESSED THE
ISSUES
---------------------------------------------------------- Chapter 1:3
The accounting profession and other groups, in response to
congressional investigations and their own initiatives, established a
number of special study groups and task forces to address issues
relating to financial reporting and auditing. For purposes of this
review, we have summarized the concerns, recommendations, and actions
taken on five significant issues that have been repeatedly identified
over the past two decades by the major studies of the accounting
profession. These are (1) auditor independence and the role of audit
committees in strengthening corporate governance, (2) the role and
responsibilities of auditors, particularly in detecting and reporting
fraud and assessing the effectiveness of and reporting on internal
controls, (3) the quality of auditor performance and the accounting
profession's self-regulatory mechanisms, (4) the accounting and
auditing standard-setting processes, including the adequacy, quality,
and timeliness of the standards, and the adequacy, relevancy, and
usefulness of financial reporting, and (5) the role of the auditor in
the further enhancement of financial reporting.
The following table provides a timeline of the major issues debated
over the past two decades and identifies the study groups that
addressed these issues. Appendixes I and II to this report
(contained in GAO/AIMD-96-98A), identify the major studies, provide
information on the study groups, and list specific recommendations
made by the study groups and related actions taken by the accounting
profession and others. The study groups' recommendations and actions
taken to address the recommendations are organized in appendix II by
the major issues listed in the table. The status of those major
issues and our observations are discussed as follows: chapter 2,
auditor independence; chapter 3, audit quality relating to the
auditors' responsibilities for fraud and internal controls; chapter
4, audit quality relating to auditor performance; chapter 5, setting
accounting and auditing standards; and chapter 6, expanded reporting
and auditor services.
Table 1.1
Timeline of Major Issues Debated Over
the Past Two Decades
Issue 1972-1976 1977-1981 1982-1986 1987-1991 1992-1995
----------- ----------- ----------- ----------- ----------- ---------------
Auditor Moss Metcalf Anderson Treadway POB
independenc Subcommitte Subcommitte Committee Commission
e e e AICPA Board of
Big 7 GAO Directors
Cohen
Commission GAO
POB Kirk Panel
Audit AICPA Metcalf Price Treadway GAO
quality Special Subcommitte Waterhouse Commission
(includes Committee e POB
auditor's on Equity Anderson GAO
role, Funding Cohen Committee AICPA Board of
responsibil Commission Directors
ities, and Moss Big 7
performance Subcommitte Kirk Panel
) e GAO
Setting Wheat Metcalf FAF AICPA Task POB
accounting Committee Subcommitte Force on
standards e Big 7 Risks and GAO
Trueblood Uncertainti
Committee FAF es Kirk Panel
Moss Cohen FAF Jenkins
Subcommitte Commission Committee
e GAO
Setting Moss Metcalf Big 7 Treadway POB
auditing Subcommitte Subcommitte Commission
standards e e
Cohen
Commission
Oliphant
Committee
Expanded Trueblood Metcalf Big 7 AICPA Task POB
reporting Committee Subcommitte Force on
and auditor e GAO Risks and AICPA Board of
services Moss Uncertainti Directors
Subcommitte Cohen Price es
e Commission Waterhouse AIMR
Treadway
Commission GAO
GAO Kirk Panel
Jenkins
Committee
--------------------------------------------------------------------------------
OBJECTIVES, SCOPE, AND
METHODOLOGY
---------------------------------------------------------- Chapter 1:4
Our objectives were to
-- identify recommendations made from 1972 through 1995, and
actions taken, to improve accounting and auditing standards and
the performance of independent audits of publicly owned
companies required by federal securities laws and
-- identify any unresolved issues and determine their impact on the
performance of independent auditors, effective accounting and
auditing standards setting, and efforts to expand the scope of
business reporting and audit services.
To identify recommendations made and actions taken to improve
accounting and auditing standards and the performance of independent
audits under federal securities laws, we reviewed the many reports,
studies, hearing records, and articles published from 1972 through
early 1996 on accounting, auditing, and financial reporting
pertaining to public companies (companies registered with the SEC).
Appendix I lists the reports and studies we reviewed. We also
consulted with experts on the subject of accounting and auditing.
Appendix IV identifies the individuals that we consulted. Our review
identified five major issues concerning accounting and auditing of
public companies and related financial reporting and over 500
recommendations to address those issues. The recommendations were
addressed to various parties--public companies; the SEC and other
federal entities; independent accountants and auditors; the AICPA,
FASB, and other accounting organizations; and educators. The AICPA,
FASB, and the SEC provided us information on the actions taken in
response to the recommendations. The major recommendations from 1972
through 1995 and actions taken are detailed in appendix II. We did
not verify the accuracy of the responses from the AICPA, FASB, or the
SEC, nor did we analyze the appropriateness of each action taken.
Instead, we considered the actions taken as a whole in evaluating the
progress made toward resolving the five major issues.
To identify any unresolved issues and determine their impact on the
performance of auditors of public companies, we concentrated our
efforts on the accounting profession's self-regulatory mechanisms.
We reviewed annual reports issued by the AICPA's SEC Practice Section
to obtain historical information on the results of the profession's
peer review program, including data on the number of failed audits
identified and the types of opinions rendered on reviewed firms'
quality control processes. We used a data collection instrument to
obtain and analyze data on the 724 peer reviews--of public accounting
firms that audit SEC registrants--performed by the SEC Practice
Section during the period 1992 to 1994.
We also interviewed SEC officials concerning SEC oversight of
independent auditors of public companies. We obtained and analyzed
SEC Accounting and Auditing Enforcement Releases issued from 1982
through March 1995 that pertained to audit quality. In addition, we
identified changes and improvements in professional standards, audit
guidance, and education requirements.
We also studied the involvement of audit committees in corporate
governance. Our work generally encompassed determining the extent to
which the companies in our population (1) reported publicly on their
internal controls and (2) maintained independent, knowledgeable audit
committees that acted to help assure the independence of their
company's independent public accountant. Our methodology consisted
of statistically selecting a sample of 313 public companies from the
1992 Fortune Industrial 500 and 1992 Fortune Service 500 companies.
Using a data collection instrument, we analyzed the fiscal year 1992
annual reports of all 313 companies in our sample to determine the
extent to which these companies reported publicly on their internal
controls. We also surveyed the audit committee chairpersons of 310
companies (3 companies declined to participate in our survey) in our
sample to obtain information about the companies' audit
committees.\10 In addition, we reviewed 134 audit committee charters
submitted by the chairpersons who responded to our survey.
To identify any unresolved issues and determine their impact on the
accounting and auditing standard-setting processes and the usefulness
of financial reporting and auditing, we conducted detailed interviews
with many experts and organizations both in the public accounting
profession and the community of users of financial information.
These interviews involved the SEC Chief Accountant and his staff; the
President and Executive Vice President of the Financial Accounting
Foundation; members, former members, and staff of FASB; the Chairman
of the Financial Accounting Standards Advisory Council (FASAC);
members of the AICPA's Board of Directors; members and staff of the
AICPA's Accounting Standards Executive Committee; members of the
AICPA's Auditing Standards Board; staff members of the AICPA's
Division of Professional Services; the Director of the AICPA's Public
Oversight Board (POB); a member of an AICPA Industry Committee; and a
member of the AICPA's Financial Reporting Coordinating Committee. We
also conducted interviews with representatives of the Association for
Investment Management and Research, Standard & Poor's, Moody's
Investors Service, the Institute of Management Accountants, the
American Accounting Association, the American Bar Association, the
Securities Industry Association, the American Association of
Individual Investors, Robert Morris Associates, the Financial
Executives Institute, and the Business Roundtable. The individuals
of these organizations that we interviewed are listed in appendix IV.
Appendix IV also lists the members of an advisory panel we formed to
consult with in planning and conducting the study, and a consultant
who also provided advice. We also drew upon the experience of senior
GAO staff who served as members of the AICPA Special Committee on
Assurance Services and the FASAC.
We also reviewed documents, articles, and reports obtained primarily
from various groups listed above to corroborate information from our
interviews and to enhance our understanding of the major issues.
We conducted our review between February 1995 and May 1996, in
accordance with generally accepted government auditing standards. We
provided a draft of the report to the AICPA, who obtained input from
the POB,\11 the Auditing Standards Board, the managing partners of
the Big 6 accounting firms that are members of the SEC Practice
Section, and the AICPA's Special Committee on Assurance Services and
its former Special Committee on Financial Reporting; FASB; and the
SEC. Their comments are included in appendixes V through VIII and
are evaluated as appropriate at the end of chapters 2 through 6.
--------------------
\10 Of the 307 audit committee chairpersons who participated in our
survey, 236 responded to our questionnaire. We examined the
characteristics of the 71 nonresponding audit committee chairpersons
and concluded they were similar to the respondents.
\11 The POB oversees the profession's peer review program for AICPA
member firms that audit companies registered with the SEC. The POB
provided us its comments in a separate letter.
AUDITOR INDEPENDENCE
============================================================ Chapter 2
The auditor must be independent in both fact and appearance so that
the results of the auditor's examination are perceived to be fair and
impartial. Concern over auditor independence is a long-standing and
continuing problem for the accounting profession, the business and
financial community that it serves, and public shareholders of
companies. Over the past two decades, several study groups have
addressed this issue.\1
The accounting profession and the SEC have taken various actions to
enhance both the real and perceived independence of auditors, such as
establishing auditing standards governing the auditors' relationship
with audit committees and ethics rules concerning professional
conduct, and limiting certain nonaudit services. These groups have
also established disclosure requirements and performance and
reporting standards to discourage companies from using the threat of
changing auditors--opinion shopping--to gain approval of questionable
accounting practices. Despite these actions, recent events and
actions by the SEC and the accounting profession indicate continuing
concerns over auditor independence, particularly with the
auditor/client relationship, the profession's scope of services, and
in instances where auditors are perceived to be advocating accounting
positions on behalf of their clients.
--------------------
\1 Refer to table II.1, appendix II (GAO/AIMD-96-98A) for the
recommendations made by various study groups to strengthen auditor
independence.
INITIATIVES TO STRENGTHEN
AUDITOR INDEPENDENCE IN THE
1970S AND 1980S
---------------------------------------------------------- Chapter 2:1
The independent audit fills an essential role for the investing
public and creditors by giving assurance as to the reliability of
financial statements. Users of financial statements must perceive
auditors as independent professionals who exercise objective and
impartial judgment on all issues brought to their attention. This
perception is aided when users also perceive that auditors have
neither mutual nor conflicting interests with their audit clients.
The concept of actual and perceived independence was described by a
former AICPA chief staff officer as follows:
"Independence is an abstract concept, and it is difficult to
define either generally or in its peculiar application to the
certified public accountant. Essentially, it is a state of
mind. It is partly synonymous with honesty, integrity, courage,
character. It means, in simplest terms, that the certified
public accountant will tell the truth as he sees it and will
permit no influence, financial or sentimental, to turn him from
that course."\2
Events such as the debates in the early 1930s concerning the
enactment of the federal securities laws, several cases involving
independent accountants,\3 and SEC regulations and enforcement
actions have addressed auditor independence issues, including the
profession's performance of nonaudit services, its professional
conduct, and its relationship with the client versus its obligation
to the public. These events raised questions concerning the
importance of independence, how independence can best be maintained,
and what actions detract from independence.
The importance of auditor independence is recognized in securities
laws, by the Supreme Court, and in auditing and professional
standards. For example, federal securities laws require that
financial statements filed with the SEC be certified by independent
public accountants. Also, the SEC, under its authority to issue
rules and regulations to implement various statutory requirements,
has defined situations where an auditor would not be considered
independent for an audit of financial statements.
The U.S. Supreme Court, in United States v. Arthur Young & Co.,\4
emphasized the public responsibility entrusted to the independent
public accountant and the auditor's need to maintain an independent
attitude. The Supreme Court stated that "The independent public
accountant... owes ultimate allegiance to the corporation's
creditors and stockholders, as well as to the investing public. This
"public watchdog" function demands that the accountant maintain total
independence from the client at all times and requires complete
fidelity to the public trust...."
Auditing and professional standards address independence and require
that the audit organization and the auditor be independent in fact
and in appearance. These standards place responsibility on the
auditor and the audit organization to maintain independence so that
opinions, conclusions, judgments, and recommendations will be
impartial and will be viewed as impartial by knowledgeable third
parties.
--------------------
\2 John L. Carey, Professional Ethics of Public Accounting, AICPA,
1947.
\3 For example, cases such as In the Matter of Cornucopia Gold Mines
(1936); In the Matter of McKesson & Robbins (1940); and In the Matter
of A. Hollander & Son, Inc. (1941) discuss auditor independence.
\4 United States v. Arthur Young & Co., 465 U.S. 805, 817-818
(1984).
AUDIT COMMITTEES
-------------------------------------------------------- Chapter 2:1.1
A number of study groups have concluded that independent audit
committees can play an important role in enhancing the public's
perception of the independence and objectivity of auditors. For
example, the Subcommittee on Oversight and Investigations, House
Committee on Interstate and Foreign Commerce (Moss Subcommittee);\5
Metcalf Subcommittee;\6 the Commission on Auditors' Responsibilities
(Cohen Commission);\7 the National Commission on Fraudulent Financial
Reporting (Treadway Commission);\8 and GAO\9 all recommended that
public companies should be required to have independent audit
committees responsible for overseeing the financial reporting process
and assisting the auditor in maintaining independence. The Treadway
Commission also recommended that the SEC require all public companies
to include in their annual reports to stockholders a letter signed by
the chairman of the audit committee describing the committee's
responsibilities and activities during the year. Proposals submitted
to the AICPA Board of Directors by the heads of seven major
accounting firms,\10 referred to as the "Big 7" throughout this
report, included a recommendation to require auditors to communicate
regularly with the audit committee or, absent an audit committee,
with the entire board of directors on such matters as consultation
with other auditors, business and other risks facing the company,
large and unusual transactions, and other situations where
alternative GAAP could materially affect the financial statements.
Federal and state laws governing public corporations generally do not
require audit committees.\11 In addition, the SEC does not require
public companies to establish independent audit committees. While
the SEC encourages audit committees, it believes that the stock
exchanges' experience places them in a better position to exercise
flexibility in the formulation and implementation of audit committee
standards. Accordingly, the SEC has worked with the stock exchanges
and the National Association of Securities Dealers, Inc. to
encourage listed companies to have audit committees. Today, the
largest U.S. securities markets require listed companies to have
audit committees with at least a majority of independent directors.
Based on our sample results of audit committee chairpersons of
Fortune 1,000 publicly traded companies, we estimate that at least 90
percent of the companies required an independent audit committee as a
matter of company policy. The survey also showed that audit
committee duties and responsibilities are not consistently defined in
their charters. For example, the 134 audit committee charters
submitted by respondents varied greatly in specifically stating what
was required in working with management and the independent public
accountant.
As previously mentioned, in 1991, the Congress enacted FDICIA which
requires, among other things, independent audit committees for large
banks and thrifts. FDICIA defined the audit committee's
responsibilities in certain key areas, such as the committee's role
in working with management and the independent auditor in the areas
of financial audit, internal controls, and compliance with laws and
regulations. FDICIA also established certain qualifications for
audit committees of the largest banks and thrifts. FDICIA was a
major step forward in using the audit committee to aid auditor
independence and improve corporate governance. However, it was
limited to only large banks and thrifts.
The Treadway Commission made a recommendation for public companies to
include a letter in their annual reports signed by the audit
committee chairman, discussing the audit committee's responsibilities
and activities during the year. However, because SEC regulations
require certain companies that solicit proxies to disclose
information concerning audit committees' members, functions, and
numbers of meetings, the SEC reasoned that information in the
proposed audit committee letter would duplicate existing proxy
statement disclosure, and would not provide investors with
significant additional information. The Treadway report acknowledged
that certain features of the audit committee letter would duplicate
existing proxy disclosure but felt that a letter from the audit
committee might lead to better disclosures than now provided in proxy
statements.
Statement on Auditing Standards (SAS) No. 61, Communications With
Audit Committees, issued by the Auditing Standards Board (ASB) in
April 1988, requires the auditor to determine that the audit
committee, or others formally designated as having oversight for the
financial reporting process, is adequately informed of matters, such
as disagreements with management, consultations with other
accountants, and difficulties encountered in performing the audit
such as unreasonable delays by management or unavailability of client
personnel. In addition, the auditor is required to report
"reportable conditions," which are deficiencies that could adversely
affect the company's ability to produce reliable financial
statements, to the audit committee. Further, the Private Securities
Litigation Reform Act of 1995, Section 301, requires that independent
public accountants, under certain circumstances, report illegal acts
detected during the audit to management and the audit committee.
--------------------
\5 Federal Regulation and Regulatory Reform, Report by the
Subcommittee on Oversight and Investigations of the House Committee
on Interstate and Foreign Commerce, October 1976.
\6 Improving the Accountability of Publicly Owned Corporations and
Their Auditors, Report of the Subcommittee on Reports, Accounting,
and Management of the Senate Committee on Governmental Affairs,
November 1977.
\7 The Commission on Auditors' Responsibilities: Report, Conclusions
and Recommendations, AICPA, 1978.
\8 Report of the National Commission on Fraudulent Financial
Reporting, October 1987.
\9 CPA Audit Quality: Status of Actions Taken To Improve Auditing
and Financial Reporting of Public Companies (GAO/AFMD-89-38, March 6,
1989).
\10 The Future Relevance, Reliability, and Credibility of Financial
Information, Recommendations to the AICPA Board of Directors by seven
major accounting firms, April 1986.
\11 The Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA) requires audit committees for large banks and thrifts
(institutions with $500 million or more in assets as defined by
regulations issued by the Federal Deposit Insurance Corporation).
Also, as of 1994, Connecticut was the only state that required audit
committees for large publicly held corporations.
SCOPE OF SERVICES
-------------------------------------------------------- Chapter 2:1.2
Over the past two decades, many observers of the auditing profession
have expressed concern about the expanding scope of professional
services provided by the public accounting profession. For example,
the Metcalf Subcommittee in the mid-1970s raised questions concerning
the propriety of performing both audit and nonaudit services for the
same client.\12 The issue has also been raised by the media and at
hearings in the mid-1980s before the House Subcommittee on Oversight
and Investigations.
The potential impact on the auditor/client relationship of accounting
firms' performance of nonaudit services for their audit clients has
also been addressed by several study groups including the Cohen
Commission, the AICPA's Public Oversight Board (POB),\13 the Big 7,
the AICPA's Special Committee on Standards of Professional Conduct
for Certified Public Accountants (Anderson Committee),\14 and the
Treadway Commission, and has also been addressed by the SEC. None of
these studies reported any conclusive evidence of diminished audit
quality or harm to the public interest, or any actual impairment of
auditor independence, as a consequence of public accounting firms
providing advisory or consulting services to their audit clients.
However, several groups studying the issue commented that rendering
some management advisory services to audit clients is perceived by
some persons as creating a situation in which the auditor's
independence could be impaired. For example, the Anderson Committee
concluded in 1986 that if nonaudit services place auditors in a
position where they are viewed as a part of management, they will
lose their appearance of independence, or independence could be
impaired when the results of a nonaudit engagement have a direct and
material effect on the financial statements on which the auditor
expresses an opinion. Similarly, the Cohen Commission concluded in
1978 that certain combinations of services can potentially create a
conflict with the audit functions.\15
Some groups studying the issue, as well as the large public
accounting firms, believed that consulting services could have a
positive impact on audit quality in that these services enable the
auditor to learn more about a company's operations. For example, the
Cohen Commission concluded that providing management advisory
services for an audit client may increase the auditor's understanding
and knowledge and prove advantageous in conducting the audit.
Similarly, the POB's 1979 report states that management advisory
services can enhance a firm's ability to recruit quality
professionals; enhance a firm's expertise and sophistication; and
give auditors an opportunity to assist a company in improvement of
its internal controls, which in turn serves to facilitate the audit
by improving the underlying structure of what is audited. However,
the study groups acknowledged that public confidence in the integrity
of financial reporting can be eroded if there is a perception that
performing management advisory services for audit clients compromises
the auditor's independence.
Proposals advanced by groups studying the issue of auditor services
varied from limiting services to those directly related to accounting
to having auditors make a conscious determination as to whether these
additional services create or appear to create an impairment of
independence and assessing whether these services are consistent with
their role as professionals. In addition, the Cohen Commission
recommended that the profession develop standards and guidance
addressing providing advice on accounting principles.
Recommendations were also made to require companies to disclose
information on nonaudit services provided by their independent
auditor and require audit committees to review management's plans for
engaging the company's independent accountant to perform management
advisory services during the coming year, considering both the types
of services that may be rendered and the projected fees.
In 1978, the SEC adopted a requirement that an auditor disclose each
type of nonaudit service it provided, and in 1979, the SEC issued an
interpretive release describing certain factors that independent
accountants, audit committees, boards of directors, and management
should consider in determining whether independent accountants should
be engaged in nonaudit services. According to the SEC, the reaction
to the SEC's disclosure requirement and interpretive release was
"unexpectedly severe." In commenting on the release, accounting firms
indicated that the disclosure requirements and interpretive release
had resulted in a curtailment of nonaudit services. Based on further
SEC study of the profession's nonaudit services and disclosure of
such services in proxy statements and on the SEC's belief that it had
achieved its objective in increasing the awareness of independence
concerns over nonaudit services, the SEC rescinded the disclosure
requirements and the interpretive release.
The ASB issued SAS 50, Reports on the Application of Accounting
Principles, in July 1986, which established performance and reporting
standards to be used when an accountant provides reports, and in some
cases oral advice, to nonaudit clients on the application of
accounting principles. However, this standard does not fully satisfy
the Cohen Commission's recommendation for standards concerning advice
on accounting principles since SAS 50 does not apply to accountants
who have been engaged to audit financial statements and, as part of
that audit, may be asked by the client to provide advice on the
application of accounting principles to specific transactions.
The POB commissioned a study in 1986 that measured the perceptions of
key members of the public about the accounting profession. The
results of the survey suggested that a number of nonaudit services
performed by certified public accountants (CPA), such as designing a
computer system or performing actuarial services for a company's
pension plan, are not generally perceived as impairing independence.
The survey found that a general perception exists that performing
certain services, such as identifying merger or acquisition
candidates, carrying out searches for senior management personnel,
valuing assets acquired in business combinations, and developing
executive compensation plans can impair objectivity and independence.
Also in 1986, the AICPA commissioned a survey to measure attitudes
toward the accounting profession. As with the POB's survey, many
nonaudit services offered by certified public accountants (CPA) were
thought to be proper; however, the respondents viewed other services,
such as appraisal, executive search, and packaging and selling tax
shelters, as inappropriate services for CPAs to offer.
The Code of Professional Conduct adopted by AICPA members in January
1988 includes a section on "Scope and Nature of Services," which
requires members to use sound judgment in making decisions about
offering nonaudit services and about activities that may be perceived
as creating conflicts of interest. The CPA is also to assess whether
an activity is consistent with the auditor's role as a professional
and the auditor's commitment to the public interest.
The AICPA also developed restrictions for its member accounting firms
that audit SEC registrants on performing certain consulting services
for SEC registrants. Those prohibited services include psychological
testing, public opinion polls, merger and acquisition analysis for a
finder's fee, and certain actuarial and executive recruitment
services. In addition, AICPA member firms that audit SEC registrants
are required to report annually to the audit committee or board of
directors of each SEC audit client on the total fees received from
the client for management consulting services and the types of such
services rendered.
The AICPA objected to the Treadway Commission's recommendation that
audit committees review management's plans for engaging the company's
independent public accountant to perform management advisory
services. It stated that the appropriate role for the audit
committee is one of oversight, not management, and it is not
appropriate to require advance approval from an oversight body for
each management advisory service. The AICPA also cited the
possibility that management or audit committees might arbitrarily bar
all types of management advisory services to avoid possible
criticism. Finally, the AICPA was concerned that the recommendation
could have a counter-productive, negative effect on the quality of
independent audits by depriving the auditor of the broader base of
knowledge that can be derived from performing nonaudit services.\16
--------------------
\12 The Accounting Establishment, Staff Study prepared by the
Subcommittee on Reports, Accounting, and Management of the Senate
Committee on Government Operations, U.S. Senate (ordered to be
printed March 1977).
\13 Scope of Services by CPA Firms, Report of the Public Oversight
Board of the SEC Practice Section, Division for CPA Firms, AICPA,
March 1979.
\14 Restructuring Professional Standards to Achieve Professional
Excellence in a Changing Environment, Report of the Special Committee
on Standards of Professional Conduct for Certified Public
Accountants, AICPA, April 1986.
\15 The Cohen Commission's conclusion was based on its research of
the Westec Case (Carpenter v. Hall, filed August 23, 1968, in
Houston, Texas), in which it was alleged that the independent
auditor's provision of accounting advice combined with the auditor's
involvement in the company's merger and acquisition program reduced
the auditor's ability to independently audit the resulting
transactions.
\16 Letter from the AICPA to the National Commission on Fraudulent
Financial Reporting, July 20, 1987.
CHANGING AUDITORS
-------------------------------------------------------- Chapter 2:1.3
Another area of concern for the profession has been the impact of
auditor changes and "opinion shopping" on auditor independence.
Because of the potential abuse of changing auditors to gain approval
of questionable accounting practices, the Cohen Commission, the Big
7, the Treadway Commission, and the AICPA have all made
recommendations to improve disclosure when a company changes
independent public accountants. In addition, the Big 7 proposals
would require peer reviewers to scrutinize all engagements assumed
since the last peer review where there was disclosure of a
significant disagreement with the former accountant or where the
former accountant resigned. Also, the Treadway Commission
recommended that management advise the audit committee when it seeks
a second opinion on a significant accounting issue.
Since the early 1970s, the SEC has required disclosures to discourage
the practice of changing auditors to obtain more favorable accounting
treatment.\17 The required disclosures for SEC registrants for
reporting a change in accountants are normally filed in a Form 8-K\18
which is available to the public and is required to be filed within 5
business days after the resignation, dismissal, or declination of the
former accountant to stand for reelection, or the engagement of a new
independent public accountant.\19 These required disclosures, which
the SEC has expanded over the years, include whether the accountant
resigned, declined to stand for reelection or was dismissed, and the
date thereof; whether the former accountant qualified the audit
report or disclaimed an opinion during the past 2 years; whether the
change in accountants was approved by the audit committee or the
board of directors; and whether in connection with the audits of the
2 most recent fiscal years (plus any subsequent interim period) there
were any reportable events or disagreements concerning accounting,
auditing, or financial disclosure issues, which, if not resolved,
would have caused the auditor to refer to the issue in connection
with its report.\20 Disclosure is also required for consultations
with the newly-engaged accountant that occurred within approximately
2 years prior to engagement if those consultations (1) were or should
have been subject to SAS 50\21 or (2) were the subject of a
disagreement or reportable event with the former accountant.
The predecessor accountant is required to state whether he or she
agrees with the disclosures and, if not, the respects in which he or
she does not agree. In this disclosure process, the successor
accountant also has an opportunity to respond and clarify any
disclosed information or provide new information. In addition, SAS
61, issued by the ASB in April 1988, may help to discourage opinion
shopping since it requires auditors to communicate certain
information to audit committees, including disagreements with
management.
In order to further deter the abuse of opinion shopping, in 1989, we
recommended that auditors directly notify the SEC upon their
resignation or termination. In making this recommendation, we stated
that we believed that this direct notification can serve as an early
warning to alert the SEC to possible problems that may have caused
the company to change auditors. As of May 1989, the AICPA's SEC
Practice Section required its members to send a letter to the SEC
when a change in accountants occurs.
Another action aimed at enhancing auditor independence is the SEC
Practice Section's requirement that establishes a maximum term of
generally 7 consecutive years over which an individual partner may
serve a particular SEC-registrant client.
--------------------
\17 SEC Accounting Series Release No. 165, "Notice of Amendments to
Require Increased Disclosure of Relationships Between Registrants and
Their Independent Public Accountants," December 20, 1974.
\18 Rules promulgated pursuant to the Securities Exchange Act of 1934
require registrants to file a report (Form 8-K) if any of several
events occur. Among those events is a change in the registrant's
independent public accountant.
\19 In March 1989, the SEC accelerated the timing for filing Forms
8-K related to changes in registrants' independent accountant from 15
calendar days to 5 business days.
\20 Currently, item 304(a) of Regulation S-K contains the disclosure
requirements concerning changes in a registrant's independent
accountant.
\21 SAS 50, which established performance and reporting standards to
be used when accountants provide written reports (or oral advice in
certain circumstances) to nonaudit clients on the application of
accounting principles, is intended to discourage the potential abuse
of opinion shopping.
INDEPENDENCE CONCERNS CONTINUE
INTO THE 1990S
---------------------------------------------------------- Chapter 2:2
Even though basic rules to guide the public accountant in achieving
and maintaining independence exist and the accounting profession and
others have taken actions to help ensure auditor independence,
auditor independence continues to be an area of concern for the
profession and the users of financial statements. This was evidenced
most recently by a 1993 congressional request for the SEC to study
the importance of, and any impediments to, the independence of public
accountants in performing their responsibilities under the federal
securities laws.\22 In addition, a 1993 report by the POB\23
and speeches made by the SEC Chief Accountant in 1992 and 1994,
discuss concerns regarding situations in which accounting firms
condoned or advocated their clients' positions in financial reporting
matters.
In response to these continuing concerns, the POB appointed an
advisory panel on auditor independence (Kirk Panel) to study whether
additional steps were needed to better assure the independence of
auditors. Both the SEC and the Kirk Panel\24 concluded that the
combination of the extensive systems of independence requirements
issued by the SEC and the AICPA, coupled with the SEC's active
enforcement program, provides investors reasonable safeguards against
loss due to conduct of audits by accountants who lack independence
from their audit clients. Therefore, both agreed that the enactment
of detailed legislation or the promulgation of additional rules
governing independence was not necessary. However, the POB and the
Kirk Panel, in 1993 and 1994, respectively, warned that while much
has been done to enhance auditors' integrity, objectivity, and
independence, fundamental developments, such as skepticism about
auditor performance in areas such as fraud detection, could result in
a loss of confidence in the audit function and over time undermine
the value of the independent role of the profession in the private
sector. As recognized before by several groups, the POB and the Kirk
Panel also believed that a more interactive role by corporate boards
of directors and audit committees with the independent auditor would
lead to more effective corporate governance and more credible
financial reporting.
--------------------
\22 Staff Report on Auditor Independence, prepared by the SEC's
Office of the Chief Accountant in March 1994, responds to a request
by the Chairman of the Subcommittee on Telecommunications and
Finance, House Committee on Energy and Commerce.
\23 In the Public Interest, Issues Confronting the Accounting
Profession, a special report by the Public Oversight Board of the SEC
Practice Section, AICPA, March 1993.
\24 Strengthening the Professionalism of the Independent Auditor,
Public Oversight Board Advisory Panel on Auditor Independence,
September 1994.
CLIENT ADVOCACY
-------------------------------------------------------- Chapter 2:2.1
Responding to accounting questions from clients and developing firm
positions on accounting questions under consideration by FASB, the
SEC, or other accounting standard-setting bodies is part of an
accounting firm's public responsibility. However, client-related
motivations, or even the appearance thereof, in reaching or
communicating accounting policy decisions can contribute to a decline
in the integrity, objectivity, and professionalism of public
accounting firms and in public respect for the accounting profession.
In 1977, the Metcalf Subcommittee raised concerns involving
situations where accountants testify before public bodies advocating
positions that are favorable to their clients. The Cohen
Commission's 1978 report also discusses client advocacy concerns.
The AICPA strongly objected to these concerns, contending that
accounting firms advocate positions based on the firms' convictions
concerning the issues rather than on the interests of clients. The
AICPA also stated that it should not be surprising that in many
instances, professionals deeply concerned with financial matters
would find their own views corresponding to those of some of their
clients.
In 1992 and again in 1994, the SEC Chief Accountant questioned the
independence of accounting firms in situations where they condoned
what he called "incredible" accounting principles in financial
statements, advocated such principles to the SEC, or were overly
influenced by client views in formulating their own positions on
subjects under scrutiny by FASB. The 1994 staff study by the SEC put
the comments made by its Chief Accountant in perspective by reporting
that while the SEC staff is concerned that accounting firms may have
compromised their objectivity with respect to proposed or actual
client accounting treatments, the number of instances in which
questionable client advocacy has been established is very small in
relation to the number of audited financial statements filed with the
SEC.
In its 1993 report, the POB addressed matters of client advocacy.
The POB pointed out a distinction between client advocacy and client
service, explaining that client advocacy is a willingness of the
auditor to serve the immediate interests of the client in any way
requested as long as the law permits that activity. Client service,
as defined by the POB, means serving the client's best interest
without coming into conflict with professional standards, the best
interest of the audit function, or the auditor's best judgment. The
POB urged the accounting profession to give this subject prompt
attention and recommended that the AICPA undertake a project to
sharpen further the distinction between client advocacy and client
service and incorporate that distinction into the profession's Code
of Professional Conduct. The POB's 1993 report also recognized that
special care is needed to ensure that accounting firms'
"participation in the standard- setting process is characterized by
objectivity and professionalism," and accordingly, recommended that
standard setters and leaders of the profession regularly discuss and
address issues related to client advocacy in the standard-setting
process.
The Kirk Panel endorsed the POB's recommendations with regard to
client advocacy. The Panel also believed that the firms' internal
organization and processes for developing accounting positions should
be insulated from undue client pressure and that accounting firm
positions on FASB proposals should be communicated in a judicious,
professional way that does not appear to gain favor with clients or
appear to be part of an organized campaign. In addition, the Kirk
Panel suggested that the POB, through its oversight of the peer
review process, should identify effective policies and procedures
that accounting firms have adopted for (1) internal technical
consultation, (2) providing technical guidance to professional staff,
and (3) developing firm positions on technical standards. The Panel
further suggested that the POB should encourage adoption of the "best
practices" it identifies.
MANAGEMENT ADVISORY AND
OTHER NONAUDIT SERVICES
-------------------------------------------------------- Chapter 2:2.2
Another area of concern is the growth of the accounting profession's
consulting services relative to a static level of auditing and
accounting services. As discussed earlier, these services and their
perceived impact on accounting firms' independence have been the
subject of many studies. According to information provided by the
Big 6 firms, the large public accounting firms earned less than half
of their revenue in 1995 from auditing and accounting services.\25 In
its 1994 report, the Kirk Panel asserted that some of the firms
considered themselves multiline professional firms, not as accounting
and auditing firms. The Kirk Panel noted that the threat of
litigation, along with competition and fee-cutting, have made
auditing less and less financially attractive. The Kirk Panel, large
accounting firms, and others in the profession also have asserted
that the percentage of top college graduates going into the
accounting profession is declining and that there is a general
unattractiveness of beginning a career in auditing.
A 1991 report by the six largest accounting firms discussed the
benefits to the investing public and clients of a broad scope of
services and pointed out that there has been no conclusive evidence
that providing management advisory services compromises auditor
independence.\26 The report downplayed concerns about the appearance
of conflicts of interest in arrangements with clients. For example,
the report stated, "Business relationships between public accountants
and audit clients do not impair independence as long as they result
from the ordinary course of business and are not material to either
party." However, the Kirk panel pointed out that such a position
fails to recognize the special responsibilities of the independent
auditor and the importance of avoiding the appearance of a conflict
of interest.
The 1991 report by the six accounting firms suggested a new framework
for defining independence and gave examples of four principles
relating to the scope of services that would be included in the
framework. These principles are (1) public accountants and their
firms should be financially independent of audit clients, (2) public
accountants should not serve as directors, officers, or employees of
audit clients, (3) public accountants should not exercise management
decision-making responsibilities in the performance of service for
audit clients, and (4) business relationships between public
accountants and audit clients do not impair independence as long as
they result from the ordinary course of business and are not material
to either party. The six accounting firms believed that these four
principles, combined with others covering such matters as financial
interests, family relationships, and litigation, would create an
effective structure for determining and governing independence.
According to the Kirk Panel, the independence framework proposed by
the six accounting firms was rejected by the SEC and not adopted by
the profession.
Study groups, such as the Kirk Panel, acknowledge that the trend away
from auditing services could lessen the objectivity of the auditor
and the value of the independent audit, although there has been no
conclusive evidence. Nevertheless, the controversy is likely to
persist as the auditing environment continues to change in the face
of worldwide competition, global markets, technological innovations,
and complex business structures. These developments have resulted in
new demands from clients for a wider range of professional services.
The largest accounting firms seem inclined to meet these demands by
expanding their scope of services, believing that the interests of
clients, investors, and the public will be better served.\27
Recently, the SEC and others have expressed concern with a public
accounting firm's performance of internal audit services for audit
clients, referred to in the professional accounting literature as
extended audit services. Companies are increasingly outsourcing
various staff and support functions, including internal auditing, as
part of the reengineering efforts taking place in the 1990s. The POB
believes that, based on an analysis of professional literature, the
conduct of internal audit services for audit clients need not impair
the auditor's independence if the auditor does not assume
management's operational or decision-making responsibilities.
However, others, such as the Institute of Internal Auditors, see
these types of services as a potential conflict of interest for the
entity's independent auditors. The AICPA's Professional Ethics
Division worked with the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), the SEC, the POB, and other interested
observers in developing an ethics interpretation that provides more
specific guidance to CPA firms providing such services.\28 The new
interpretation, issued in August 1996, reaffirms that these extended
services would not impair independence with respect to audit clients
as long as the auditor does not act or appear to act in a capacity
equivalent to a member of management or as an employee.
The SEC has also continued to express concern about certain other
types of expanded services provided by accounting firms. On June 6,
1996, the Chairman of the SEC cautioned the accounting profession
about what he saw as recent developments concerning expanded services
that go far beyond traditional services, such as activities in
investment banking, franchising the use of the auditor's name, and
providing outsourcing for a variety of services in addition to
internal auditing services, that threaten the accounting profession's
credibility.\29
The Kirk Panel believed that existing conflict-of-interest rules and
the various mechanisms for improving those rules were appropriate and
adequate. However, the Panel concluded that growing reliance on
nonaudit services had the potential to compromise the objectivity or
independence of the auditor by diverting firm leadership away from
the public responsibility associated with the independent audit
function, by allocating disproportionate resources to nonaudit lines
of business within the firm, and by reducing the audit function to a
means to sell other services. Accordingly, the Kirk Panel cautioned
accounting firms to focus on how the audit function can be enhanced
and not submerged in large multiline public accounting/management
consulting firms.
In our April 1991 report on failed banks,\30 we discussed auditor
independence concerns that should be addressed to enhance the
credibility of independent audits. In developing our report
recommendations, we considered both scope of service limitations and
requirements for auditor rotation. Considering the value of the
auditors' traditional management service capabilities and the value
of continuity in conducting audits, we decided not to recommend such
actions. We believed that improved corporate governance provided a
strong opportunity to enhance auditor independence and would not be
disruptive to the free market. We continue to hold that position.
As discussed below, we believe that the corporate governance approach
suggested by the Kirk Panel, in which the auditor looks to the board
of directors as its client, is a fundamental change needed to address
auditor independence concerns.
--------------------
\25 Public Accounting Report, May 31, 1996, based on a 1996 survey of
national accounting firms.
\26 The Public Accounting Profession: Meeting the Needs of a
Changing World, Arthur Andersen & Co., Coopers & Lybrand, Deloitte &
Touche, Ernst & Young, KPMG Peat Marwick, and Price Waterhouse,
January 1991.
\27 The Public Accounting Profession: Meeting the Needs of a
Changing World, Arthur Andersen & Co., Coopers & Lybrand, Deloitte &
Touche, Ernst & Young, KPMG Peat Marwick, and Price Waterhouse,
January 1991.
\28 Interpretation 101-13 Under Rule of Conduct 101: Extended Audit
Services, AICPA, August 1996.
\29 Speech by SEC Chairman Arthur Levitt on June 6, 1996, before the
SEC and Financial Reporting Institute, University of Southern
California.
\30 Failed Banks: Accounting and Auditing Reforms Urgently Needed
(GAO/AFMD-91-43, April 22, 1991).
PROPOSALS TO STRENGTHEN
CORPORATE GOVERNANCE
-------------------------------------------------------- Chapter 2:2.3
Many studies, such as those conducted by the Treadway Commission,
GAO, the POB, and the Kirk Panel, have recognized that corporate
boards and their audit committees could and should play a more
significant role in strengthening the independence of auditors;
however, little has been done to define the responsibilities of audit
committees. As previously discussed, FDICIA was an important step
forward by requiring independent audit committees, but it was limited
to large banks and thrifts. In 1993, the POB identified several
responsibilities that audit committees should assume, including
reviewing the annual financial statements, conferring with management
and the independent auditor about them, receiving from the
independent auditor all information that the auditor is required to
communicate under auditing standards, assessing whether the financial
statements are complete and consistent with information known to
them, and assessing whether the financial statements reflect
appropriate accounting principles. In addition, the POB recommended
that the SEC should require registrants to include in a document
containing the annual financial statements a statement by the audit
committee or the board of directors as to whether its members have
carried out their responsibilities as described above. The POB
believes the auditor should assist the audit committee and the board
in understanding their responsibilities and the best practices to
follow.
The SEC has been reluctant to establish registrant requirements that
it believes may be intrusive into matters of corporate governance,
such as requirements for internal control reporting and audit
committees. For example, in the 1980s, the SEC twice withdrew
proposals for management reporting on internal controls. Cost was a
primary consideration in withdrawing the proposals. Also, in
response to our May 1994 report on derivatives,\31 the SEC did not
support requiring management to report on internal controls over
derivatives and related risk-management activities or requiring
auditors' attestation on such reports. The SEC also did not support
our recent suggestion for the SEC to issue guidelines governing
boards of directors' responsibilities for derivatives activities. In
addition to concerns over the cost of internal control reporting, the
SEC believed that such SEC-imposed requirements or guidelines may be
viewed as setting risk-management requirements that are part of
corporate governance matters. Similarly, even though the SEC has
encouraged the use of audit committees in public companies, the SEC
is reluctant to set requirements for audit committees concerning
their composition and role in overseeing risk-management systems,
believing such matters are best left to the stock exchanges.
The Kirk Panel's 1994 report discusses the necessity for fundamental
changes in relationships of boards of directors and audit committees
with the independent auditor in order to strengthen the objectivity
and professionalism of the independent auditor and to enhance the
value of the independent audit. The Panel explained that too close a
relationship between the auditor and management can inhibit
independent judgments. The Kirk Panel noted that, in most companies
today, management selects or recommends auditors and changes in
auditors, negotiates fees, guides the audit, prepares the financial
statements, selects accounting principles, and makes estimates. The
Kirk Panel acknowledged that a smooth working relationship between
the auditor and management is important, but explained that too close
a relationship can discourage the auditor from speaking up if the
auditor questions the accounting principles selected, the clarity of
disclosures, or the estimates and judgments made by management. The
Panel believed that such a relationship could inhibit the auditor
from openly communicating with the board of directors or audit
committee.
The Kirk Panel pointed out that to bring the audit function into the
mainstream of corporate governance will require an environment in
which boards of directors, audit committees, and management of public
companies have high expectations about the auditing firms' integrity,
objectivity, and professional expertise and in which the auditor, in
meeting those obligations, recognizes an overriding public
responsibility. Accordingly, the Kirk Panel suggested that
-- the independence of boards of directors and their accountability
to shareholders needs to be enhanced;
-- auditors need to consider the boards of directors--the
representatives of the shareholders--as the clients, not
corporate management;
-- boards of directors should expect to hear from the auditors
candid evaluations of the appropriateness, not just technical
acceptability, of accounting principles, financial statement
estimates, and the clarity of the related disclosures in company
reports; and
-- auditors should be willing to express their views as experts to
audit committees and full boards of directors about the
appropriateness of the accounting principles and financial
disclosure practice, particularly, the degree of aggressiveness
or conservatism of accounting principles used by the companies
and their application in developing estimates used in preparing
the financial statements.
In 1995, the POB published a summary report, Directors, Management,
and Auditors: Allies in Protecting Shareholder Interests, to assist
SEC Practice Section member firms, corporate financial management,
and audit committees in implementing a principal suggestion from the
Kirk Panel--that corporate boards and audit committees should expect
to receive, and the independent auditor should deliver, forthright,
candid oral reports in a timely manner on the quality--not just the
acceptability--of a company's financial reporting. The POB has
distributed the report to the chief executive, financial officers,
and each director of all companies on the New York Stock Exchange and
of other SEC-registered companies with revenues of at least $250
million. The Kirk Panel's suggestions pertaining to strengthening
corporate governance through more auditor involvement with audit
committees are also emphasized in the POB's 1994-1995 annual report.
The Executive Committee of the SEC Practice Section, with the
encouragement of the POB, has pledged active support of the Kirk
Panel's suggestions. In its written response on the Kirk Panel's
suggestions, the SEC Practice Section Executive Committee stated it
will work with the POB in developing an appropriate plan of action
for the accounting profession and will also help other groups address
the Panel's recommendations directed to them. Also, the AICPA's
January 1996 Journal of Accountancy, contains an article, "How
Directors and Auditors Can Improve Corporate Governance," written by
a member of the POB and a member of the Executive Committee of the
SEC Practice Section.
We identified several barriers to voluntarily achieving the needed
changes in the auditor/client relationship. State laws govern the
incorporation of public companies; the functions and powers of the
directors; and the legal relationships among shareholders, directors,
and management. Most states, however, do not establish statutory
requirements for independent audit committees. Given concerns over
litigation, neither boards of directors, management, nor the
accounting profession are likely to voluntarily change the
auditor/client relationship to having the auditor report directly to
the audit committee. Further, in response to our 1994 survey of
Fortune Industrial 500 and Fortune Service 500 companies' audit
committees, audit committee chairpersons stated they are actively
involved with their independent auditors. For example, based on the
sample results, we estimate that at least 94 percent of the audit
committees met privately with the company's independent public
accountant, 93 percent monitored changes in the company's independent
public accountant, 81 percent monitored management's evaluation of
the auditor's independence, and 63 percent monitored management's
plans for using the auditor to perform consulting services.
Therefore, audit committees may be comfortable with their current
relationship with the independent auditor and may not want to take
additional steps of having the independent auditor reporting directly
to the audit committee rather than to management without additional
direction from the SEC.
Further, independent public accountants' principal working
relationship with the company is with the company's financial
management as the preparer of the financial statements. We believe
this makes it difficult for auditors to achieve the "Carey" ideal of
independence previously discussed. Reporting to users is not
practical, but reporting to directors who have a more direct
stockholder concern or orientation might be feasible. However,
directors may object to this potential expansion of their legal
liabilities or to the more modest change in the auditor/director
relationship made by FDICIA for the regulated banking industry, which
may also be viewed as possibly expanding directors' legal exposure.
FDICIA requires large banks and thrifts to have independent audit
committees and that the committees' responsibilities include
reviewing with management and the independent public accountant (1)
management's responsibilities for preparing financial statements, the
effectiveness of internal controls, and complying with laws and
regulations, (2) management's assessment of the effectiveness of
internal controls and the institution's compliance with laws and
regulations, and (3) the auditor's reports on the financial
statements and on management's assertion on the effectiveness of
internal controls. The Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA) also (1) requires that audit
committee members in larger financial institutions have certain
expertise and (2) prohibits membership from including any large
customers of the institution.
Without revamping the present free market system for obtaining audit
services, the audit committee offers within the system the
opportunity to have a financial report user as the employer of the
independent public accountant. FDICIA, through its audit committee
requirements, steers the auditor toward the audit committee, but
stops short of the more expansive auditor/audit committee
relationship envisioned by the Kirk Panel. Although FDICIA defined
certain duties for the audit committee, it did not make the audit
committee directly responsible for the audit function, which remained
with management. Therefore, auditors are likely to spend most of
their time during the audit working with management and continuing
the relationship that currently exists.
--------------------
\31 Financial Derivatives: Actions Needed to Protect the Financial
System (GAO/GGD-94-133, May 18, 1994).
OBSERVATIONS
---------------------------------------------------------- Chapter 2:3
Despite actions taken by the SEC and the AICPA in the 1970s and the
1980s to strengthen auditor independence, questions of auditor
independence stemming primarily from auditor/client relationships in
providing audit and other services have continued into the 1990s.
The SEC and the accounting profession through the Kirk Panel both
have been active in examining the continuing concern over auditor
independence. Although both agreed that additional legislation or
rules were not needed at this time, the Kirk Panel recognized that
the continuing concern over auditor independence is a serious problem
for the accounting profession that could over time undermine the
independent role of the accounting profession. We believe that
questions of auditor independence will probably continue as long as
the existing auditor/client relationship in which the auditor
effectively reports to corporate management continues. Without a
change in that relationship, independence questions may become a
larger concern given the sizable nature of management advisory
services provided by the accounting firms. Further, new services
that go beyond traditional services may increase concerns over
auditor independence, and for that reason the appropriate nature of
such services needs to be carefully considered by the accounting
profession.
We continue to believe that measures that would limit auditor
services or mandate changing auditors are outweighed by the value of
continuity in conducting audits and the value of traditional
consulting services. We believe the more reasonable action is the
Kirk Panel's idea of bringing the independent auditor more into a
direct working relationship with the board of directors and
emphasizing the independent audit committee's roles as an overseer of
the company's financial reporting process; a buffer between
management and the auditor; and a representative of user interests in
full, fair, and reliable financial reporting. This is an inherently
difficult change to accomplish, and the Kirk Panel's suggestions for
voluntary change have a high risk of not succeeding for a number of
reasons.
Boards of directors have the responsibility of overseeing management,
but this responsibility does not make them directly responsible for
the propriety of the relationship between management and the auditor.
Similarly, audit committees oversee the audit, but are not directly
responsible for the effectiveness of the audit or for full and fair
reporting. As long as boards of directors and audit committees have
their present corporate governance roles, auditors will have a
difficult time strengthening their relationship with boards and audit
committees. Accordingly, we agree with the Kirk Panel that taking
steps toward making the board of directors serve as the auditor's
client offers a major opportunity to address concerns about auditor
independence.
Audit committees may not see the need to strengthen their role in
working with the auditor. Audit committee chairpersons' responses to
our survey show that the committees are working with the auditors and
are satisfied with present relationships. Another barrier to the
Kirk Panel's proposal is that boards of directors may be reluctant to
accept responsibility for the effectiveness of the audit function as
the representatives of shareholders and other users of the financial
statements. Boards of directors, as well as the auditors, have
concerns about their potential legal liabilities. Our work also
shows that the duties of the audit committees are not well defined.
A strengthened working relationship as envisioned by the Kirk Panel
that would in effect specify certain audit committee duties is a
major change from the existing structure of audit committees.
Although the Private Securities Litigation Reform Act of 1995
provides some reporting responsibilities on matters that could
involve directors and auditors, the Act does not formally address
existing auditor/client relationships. For these reasons, we doubt
that the Kirk Panel's proposal will be voluntarily accepted by boards
of directors and independent audit committees.
As an alternative to relying on voluntary action, the SEC could more
clearly define the roles of the board of directors and audit
committee with the independent auditor. Under the Securities Act of
1933 and the Securities Exchange Act of 1934, the SEC has broad
responsibility for full and fair financial reporting and the related
role of the auditor. However, the SEC has previously been reluctant
to exercise authority in matters of corporate governance, and it
might want specific legislation to support an initiative to alter the
existing auditor/client relationship.
Seeking legislation to amend the securities laws to contain audit
committee requirements like those in FDICIA is another option that
the SEC could take. This might be viewed as less intrusive by
corporate management and not raise significant concerns by directors
over their legal liabilities. It would be an improvement over the
current situation by specifying certain audit committee
qualifications and basic important audit committee responsibilities
regarding reviewing with the auditors the financial statements,
internal controls, and compliance with laws and regulations. An
independent and knowledgeable audit committee as envisioned by FDICIA
would enhance the effectiveness of requiring the auditor to report
directly to the audit committee. However, it falls short in other
areas of establishing the specific auditor/audit committee
relationship envisioned by the Kirk Panel.
Another initiative the SEC might take to achieve the objectives of
the Kirk Panel's proposal would be to work through the major stock
exchanges to achieve listing requirements that would more
specifically define audit committee duties and responsibilities and
their relationships with the auditor. The listing agreements of the
major stock exchanges already require members to have audit
committees, so the basic principle has been established. An approach
by the stock exchanges to extend the listing agreement requirements,
backed by the SEC, would not require legislation.
COMMENTS AND OUR EVALUATION
---------------------------------------------------------- Chapter 2:4
The AICPA, the POB, and the SEC Chief Accountant provided comments on
auditor independence. They agreed with our observations on the
importance of this issue for the accounting profession and our
observation supporting the Kirk Panel's idea of bringing the
independent auditor more into a direct working relationship with the
board of directors and emphasizing the role of the independent audit
committee as an overseer of the company's financial reporting
process, as a buffer between management and the auditor, and as a
representative of user interest.
The AICPA stated that it has pledged to work with the POB in
developing an appropriate plan of action for the accounting
profession to achieve the Kirk Panel's recommendation for
strengthening auditor independence. As part of that process, the
AICPA's SEC Practice Section plans to identify best practices in
implementing the Kirk Panel's recommendations. In addition, it is
developing a database of practices relating to auditing firms'
polices and procedures used to conduct internal accounting
consultations. Also, the AICPA believes that SEC registrants and
other publicly accountable organizations should be required to have
independent audit committees charged with specific responsibilities,
including overseeing the financial reporting process and recommending
appointment of the entity's independent auditor.
The POB commented that auditor independence continues to be a major
focus of the POB and that it plans to spend a significant amount of
time dealing with this matter during the next year. The POB
commented that auditor independence must be at the top of the agenda
of everyone concerned with maintaining the viability of the
independent audit process.
The SEC Chief Accountant stated that the concerns over auditor
independence identified in our report must be resolved if the
profession is to be successful in providing expanded assurance
services. He also agreed that the increase in nontraditional
services provided by auditing firms could lead to increased concerns
about auditor independence. The SEC Chief Accountant thought that
the Kirk Panel's recommendation to strengthen auditor independence
was compelling and should be considered. He also pointed out that
the SEC has promoted the establishment of independent audit
committees and the use of the committees to enhance auditor
independence.
Given the agreement between the SEC Chief Accountant and the
accounting profession that auditor independence is a major unresolved
issue affecting the future of the accounting profession, we believe
that the SEC should take a leadership position in working with the
accounting profession to enhance the auditor's independence. The SEC
Chief Accountant stated he would be willing to discuss with GAO and
others ways to strengthen the roles of boards of directors. In
addition to voluntary actions by SEC registrants to enhance auditor
independence, our report provides several alternatives, including
that the SEC more clearly define the roles of the boards of directors
and audit committees, recognizing that the SEC may wish to seek
legislation to achieve that objective. Also, we point out that an
SEC approach of working with the stock exchanges to extend the
listing agreement requirements is another alternative, and one that
would not require legislation.
AUDITORS' RESPONSIBILITIES FOR
FRAUD AND INTERNAL CONTROLS
============================================================ Chapter 3
The Cohen Commission's study in the mid-1970s revealed that some
users of financial statements equate an unqualified audit report with
a guarantee of the accuracy and reliability of the financial
statements and the continued viability of the business under
examination. As evidenced by the media and litigation against
auditors, when a business fails shortly after receiving an
unqualified audit report, the public often perceives the failure as
an audit failure. Investors and others question why they were not
warned about the company's financial difficulties. Likewise, when
charges of fraud are leveled against management or others in a
company, the inevitable question is: Where were the auditors? These
questions and perceptions suggested that an expectation gap existed
between what the public expects of the accounting profession,
especially as it relates to the audit function, and what the
profession understands or believes is its proper role. Changes were
made in auditing standards in the late 1980s to state the auditor's
responsibilities more clearly; however, recent studies and AICPA
initiatives indicate public expectations are still not fully
satisfied by the level of responsibility assumed by auditors.
Numerous examples of internal control weaknesses in financial
institutions and businesses have focused on the importance of
internal controls in ensuring accurate financial reporting and in
preventing fraud, and management's responsibilities for reporting on
the effectiveness of the control system.\1 The occurrence of internal
control weaknesses has also raised questions concerning the auditor's
responsibilities for reviewing and reporting on management's
assertions concerning the effectiveness of internal controls. Many
reforms have been advanced by the accounting profession and others
over the past two decades, but only limited reforms have been
instituted regarding internal controls. Moreover, internal control
reforms have not been linked to the auditor's responsibility for
fraud detection. The problems associated with the auditor's limited
internal control reviews are exacerbated by the continuing advances
in information systems technology and the resultant growing
complexity of auditing financial data.
--------------------
\1 Internal control is a process--effected by an entity's board of
directors, management, and other personnel--designed to provide
reasonable assurance regarding the achievement of objectives in the
following categories: (1) reliability of financial reporting, (2)
effectiveness and efficiency of operations, and (3) compliance with
laws and regulations.
PUBLIC EXPECTATIONS FOR
AUDITORS
---------------------------------------------------------- Chapter 3:1
Over the past 20 or more years, well-publicized cases of financial
irregularities in many companies and financial institutions, and
seemingly unforeseen business failures, have focused unfavorable
attention on the auditor's role in detecting fraud, suggesting a gap
between what the public expects or needs and what auditors can and
should reasonably expect to accomplish. In 1978, the Cohen
Commission concluded that such a gap did exist. The Cohen Commission
felt that in general, users appeared to have reasonable expectations
of the abilities of auditors and the assurances they can give.
However, the Commission concluded that many users appeared to
misunderstand the role of the auditor and the nature of the services
an auditor provides.
For example, the Cohen Commission and other groups studying this
issue found that the public expected the accounting profession to
establish performance standards to reduce the incidence of fraudulent
financial reporting by assuming greater responsibility for fraud
detection. The Cohen Commission stated in its 1978 report that
"significant percentages of those who use and rely on the auditor's
work rank the detection of fraud among the most important objectives
of an audit." The public also expected audited financial statements
to provide an early warning of impending business failures and some
assurance regarding the well-being of the reporting enterprise. The
public did not understand how a company can fail as a result of
management fraud shortly after an unqualified audit report on its
financial statements is issued. Nor did it understand when audited
financial statements did not inform users about all the significant
risks and uncertainties confronting the business enterprise.
The Cohen Commission, along with several other study groups,
including the AICPA Special Committee on Equity Funding,\2 the
Metcalf Subcommittee, Price Waterhouse,\3 the Big 7, GAO, and the
Treadway Commission, advanced proposals to address this expectation
gap.\4
--------------------
\2 The Adequacy of Auditing Standards and Procedures Currently
Applied in the Examination of Financial Statements, Report of the
Special Committee on Equity Funding, AICPA, February 1975.
\3 Challenge and Opportunity for the Accounting Profession:
Strengthening the Public's Confidence, the Price Waterhouse
Proposals, 1985.
\4 Refer to table II.2, appendix II, (GAO/AIMD-96-98A) for the
recommendations made by these study groups that address the auditor's
role and responsibilities.
INITIATIVES TO NARROW THE
EXPECTATION GAP FOR FRAUD
---------------------------------------------------------- Chapter 3:2
Financial statements that are materially misstated as a result of
intentional deception constitute fraudulent financial reporting. The
consequences of fraudulent financial reporting and unexpected
business failures can be widespread and devastating. Those affected
may include the company's stockholders, creditors, and others whose
confidence in the stock market is shaken. Even though the company
has the ultimate responsibility for ensuring accurate financial
reporting, the auditor also plays an important role.
Auditing standards have always acknowledged that the auditor has some
responsibility to consider the existence of fraud in an audit.\5
However, interpretations of these standards seemed to emphasize the
limitations of the auditor's role and, in applying the standards,
searching for and detecting fraud was always seen as a by-product of
the audit process. In 1988, the ASB issued two standards--one on
errors and irregularities and one on illegal acts\6 --which directly
address the auditor's responsibility for fraud detection, and a third
standard on analytical procedures,\7 which relates indirectly to that
responsibility.
The 1988 statement on errors and irregularities requires the auditor
to design the audit to provide reasonable assurance of detecting
material errors and irregularities. The statement requires that the
auditor inform the audit committee or others with equivalent
authority about irregularities that have been detected. The
statement also acknowledges that the auditor should recognize that
certain circumstances may exist that pose a duty for the auditor to
report outside of the client organization. These include reporting
by the entity of an auditor change, responding to a subpoena,
communicating with a successor auditor, and reporting to a funding
agency or others in audits of entities that receive financial
assistance from a government agency.
The 1988 statement on illegal acts also requires the auditor to
design the audit to provide reasonable assurance of detecting
misstatements resulting from illegal acts that have a direct and
material effect on the financial statements and to be aware of the
possibility that illegal acts with an indirect effect may have
occurred. Guidance on detecting illegal acts also requires the
auditor to confirm that the audit committee or others with equivalent
authority are informed of illegal acts, unless the acts are clearly
inconsequential. The same circumstances which pose a duty for the
auditor for reporting irregularities outside of the client's
organization, as noted above, also apply for reporting illegal acts.
The guidance on analytical procedures emphasizes that these
procedures are an important part of the audit process and should be
used in the planning and the overall review stages of all audit
engagements to assist the auditor in obtaining an understanding of
the client, identifying areas of risk, assessing the conclusions
reached, and evaluating the overall financial statement presentation.
The statement further states that analytical procedures may be
effective in detecting potential misstatements, which would not be
apparent using other tools.
In December 1995, the Congress enacted the Private Securities
Litigation Reform Act of 1995 (the Act). Section 301 of the Act
concerns fraud detection and identifies the procedures, evaluations,
and reporting the auditor is required to make in accordance with
GAAS, as may be modified or supplemented by the SEC. The
requirements are similar to those in SAS 53; however, the Act alters
the existing reporting process. The Act requires the auditor, who in
the course of an audit determines that an illegal act likely
occurred, to inform the appropriate level of management as soon as
practicable and ensure that the audit committee (or the board of
directors if there is no audit committee) is adequately informed of
the illegal act. If timely and appropriate remedial actions are not
taken, and the auditor makes certain determinations, including that
the illegal act has a material effect on the financial statements,
the auditor is required to report its conclusions directly to the
board. Upon receipt of the auditor's report, the board is
responsible for notifying the SEC within 1 business day and
furnishing a copy of the notice to the auditor. If the auditor fails
to receive a copy of the notice before the expiration of the
1-business day period, the auditor must either resign from the
engagement or furnish to the SEC a copy of its report not later than
1 business day following such failure to receive notice. An auditor
who chooses to resign from the engagement must still provide a copy
of his or her report to the SEC.
In 1988, in addition to the three auditing standards relating to
fraud, the ASB issued other standards to address the expectation gap.
These standards extend, clarify, or modify the auditor's
responsibilities regarding assessing of internal controls, auditing
accounting estimates, considering an entity's ability to continue as
a going concern, communicating internal control matters, and
communicating with audit committees.\8 The ASB also revised the
statement relating to the wording of audit reports to more explicitly
limit the auditor's responsibility, the procedures the auditor
performs, and the assurances the audit provides.\9
Since 1988, the AICPA has issued additional standards, some of which
amended the auditor's responsibilities for considering internal
controls, for reporting on uncertainties, and for evaluating going
concerns.\10 In addition, in 1994, the AICPA issued a statement of
position to improve and expand disclosure of risks and uncertainties
facing the business as of the date of the financial statements.\11
--------------------
\5 Statement on Auditing Standards No. 16, The Independent Auditor's
Responsibility for the Detection of Errors and Irregularities, and
Statement on Auditing Standards No. 17, Illegal Acts by Clients,
AICPA, January 1977.
\6 Statement on Auditing Standards No. 53, The Auditor's
Responsibility to Detect and Report Errors and Irregularities, and
Statement on Auditing Standards No. 54, Illegal Acts by Clients,
AICPA, April 1988.
\7 Statement on Auditing Standards, No. 56, Analytical Procedures,
AICPA, April 1988.
\8 SAS No. 55, Consideration of the Internal Control Structure in a
Financial Statement Audit; SAS No. 57, Auditing Accounting
Estimates; SAS No. 59, The Auditor's Consideration of an Entity's
Ability to Continue as a Going Concern; SAS No. 60, Communication of
Internal Control Structure Related Matters Noted in an Audit; and SAS
No. 61, Communication With Audit Committees, AICPA, April 1988.
\9 SAS No. 58, Reports on Audited Financial Statements, AICPA, April
1988.
\10 SAS No. 64, Omnibus Statement on Auditing Standards - 1990,
December 1990; SAS No. 77, Amendments to Statements on Auditing
Standards No. 22, "Planning and Supervision," No. 59, "Auditor's
Consideration of an Entity's Ability to Continue as a Going Concern,"
and No. 62, "Special Reports," November 1995; SAS No. 78,
Consideration of Internal Controls in a Financial Statement Audit:
An Amendment to Statement on Auditing Standards No. 55, December
1995; and SAS No. 79, Amendment to Statement on Auditing Standards
No. 58, "Reports on Audited Financial Statements," December 1995.
\11 Statement of Position 94-6, Disclosure of Certain Significant
Risks and Uncertainties, AICPA, December 30, 1994.
AUDITORS' RESPONSIBILITY FOR
FRAUD DETECTION AND REPORTING
AND PUBLIC EXPECTATIONS
---------------------------------------------------------- Chapter 3:3
As stated by the Cohen Commission in 1978, and similarly by the POB
in 1993, no major aspect of the independent auditor's role has caused
more difficulty than the auditor's responsibility for the detection
of fraud. As previously discussed, auditing standards were
strengthened in 1988 to establish a more affirmative responsibility
for fraud detection. However, a study presented at an "Expectation
Gap" conference held by the AICPA in 1992 identified fraud as an area
of continuing concern.\12 The study found that the auditing standard
for errors and irregularities, SAS 53, did not appear to have
narrowed the expectation gap between auditors and users. According
to the study, although SAS 53 required some affirmative duty to
provide reasonable assurance that material irregularities did not
exist, auditors appeared not to have altered their audit planning or
tests. The study also indicated that SAS 53 had not been widely
accepted by public users, the SEC, or the courts. It stated that the
public required the detection of "all material financial statement
fraud," but the standard placed limits on the auditor's
responsibility. For example, it did not hold auditors responsible
for detecting fraud that was concealed by management collusion and
forgery, and placed substantial limitations on the auditor's
obligation to disclose fraud to the investing public. The study
found that placing such limitations on the auditor's responsibilities
was contrary to the expectations of users, who expected all material
fraud to be detected and disclosed.
The POB's 1993 report identified problems with auditor implementation
of SAS 53.\13 In that report, the POB stated that SAS 53, if properly
followed, could enhance the detection of fraud. However, it found
that auditors were not consistently complying with this standard,
especially in exercising the proper degree of professional
skepticism. To improve auditor performance, the POB recommended that
the profession assume more initiative through auditor skepticism and
develop comprehensive guidelines to assist auditors in detecting
fraud. The AICPA's Board of Directors responded by publishing a
position paper that supported the POB's recommendations.\14 The paper
renewed debate within the profession about the auditor's
responsibility for fraud detection by specifically stating that the
public looked to the independent auditor to detect fraud, and it was
the auditor's responsibility to do so. Also, in 1993, the AICPA
commissioned a study to determine user expectations regarding the
auditor's responsibility to detect fraud. The study, which was
performed by a Drexel University professor, found that financial
statement users expected absolute assurance that material
misstatements due to fraud would be detected by auditors, and that
this expectation exceeded the description of the auditor's
responsibilities contained in auditing standards and guidance.\15
The ASB formed a fraud task force in 1994 to address the various
concerns related to the auditor's responsibilities for fraud
detection. The objectives of the task force were to consider
clarifying the auditor's responsibility for detection of fraud,
consider revising factors contained in the standards that may be
indicative of management fraud, and provide separate indicators of
employee fraud. The ASB issued an exposure draft in May 1996 that
proposed revisions to the basic general standards of the auditor's
responsibility\16 and a new standard to replace SAS 53. The proposed
revisions to the general standards include a statement of the
auditor's responsibility for the detection of fraud in a financial
statement audit and a conceptual discussion of due care, assurance,
and professional skepticism relative to fraud detection. The ASB
hopes that elevating the discussion on fraud to the auditor's basic
general standards will heighten the auditor's awareness of the need
to exercise professional skepticism and obtain reasonable assurance
throughout the audit in order to detect all material fraud.
The proposed auditing standard, which would supersede SAS 53,
represents an attempt by the ASB to improve the fieldwork standard
for fraud detection. While it does not increase the level of
auditor's responsibility to find fraud, it includes the term fraud
rather than irregularities,\17 discusses the characteristics of
fraud, identifies fraud risk factors, requires an assessment of fraud
risk on every audit, provides examples of how the auditor might
respond to heightened fraud risk, and requires the auditor to
reassess fraud risk at the end of the audit. According to an ASB
member, the audit risk factors contained in the proposed auditing
standard are based on recent research and will significantly improve
guidance for identifying fraud.
Despite efforts by the profession to improve standards for fraud
detection, substantive progress on expanding the auditor's
responsibilities for fraud detection have been impeded by liability
concerns. The Cohen and Treadway Commissions found that the
profession has been unwilling to define and expand the auditor's
responsibility for detecting fraudulent financial reporting because
of its fear of increasing the liability exposure of auditors. The
recently enacted Private Securities Litigation Reform Act of 1995 may
alleviate some of the profession's liability concerns since Section
201 of the Act provides, in effect, that auditors will now only be
held liable under the Securities Exchange Act of 1934 for their
portion of fault, unless the auditor knowingly violates the
securities laws.\18 The 1995 Act also protects auditors from
liability for making reports of illegal acts to the SEC.
In addition to liability concerns, the current auditor/client
relationship has also posed serious obstacles to fully resolving the
expectation gap issue pertaining to fraud detection and reporting.
As discussed by the Kirk Panel in its 1994 report, the auditor's
public responsibility can be undermined when management becomes the
primary intermediary between companies and auditing firms. The Kirk
Panel also noted that "management has at times, captured the
auditors," and stated that too close a relationship between the
auditor and management can inhibit an auditor's independent judgment.
For example, for frauds committed by management either in the
misappropriation of assets or in fraudulent financial reporting that
come to the auditor's attention,\19 unless auditors do extensive
work, a persuasive management could convince auditors that there is
not a problem. Management abuse of accounting principles can be
particularly difficult for the auditor to challenge as standards may
be general, leaving leeway for judgment in determining their
application to particular transactions. In addition, efforts by
management to reduce audit costs are often a major barrier to the
auditor's thorough pursuit of red flags.
Under current auditing standards, the auditor in planning the audit
is responsible for assessing the risk of material misstatements in
the financial statements and, as appropriate, going into a fraud
detection mode by applying additional procedures and by being more
skeptical. The issue is whether auditors can do this in the current
structural arrangement where they must be cost competitive and
continually stress client service. In its 1994 report, the Kirk
Panel suggested that the auditor report directly to the board of
directors and the audit committee to help reduce pressures stemming
from cost competitiveness and providing services to management. The
AICPA supports the Kirk Panel's suggestion.
--------------------
\12 W. Steve Albrecht and John J. Willingham, "An Evaluation of SAS
No. 53, The Auditor's Responsibility to Detect and Report Errors and
Irregularities," The Expectation Gap Standards -- Progress,
Implementation Issues, Research Opportunities (New York: AICPA,
1993), pp. 102-124.
\13 In the Public Interest, Issues Confronting the Accounting
Profession, a special report by the Public Oversight Board of the SEC
Practice Section, AICPA, March 1993.
\14 Meeting the Financial Reporting Needs of the Future: A Public
Commitment From the Public Accounting Profession, AICPA Board of
Directors, June 1993.
\15 Henry Jaenicke, Users' Expectation of Auditors' Responsibilities
to Detect Fraud, January 1994.
\16 These standards along with standards for fieldwork and reporting
provide the fundamental qualifications and performance conditions to
be met by the auditor in conducting an audit under GAAS.
\17 The ASB's fraud task force believed that the term "fraud" should
be used in a more visible way in the proposed standard to heighten
the auditor's awareness of the risk of fraud in performing a
financial statement audit. SAS 53 did not provide specific guidance
on fraud nor did it specifically mention fraud after the third
paragraph. However, the fraud task force believed that it had to
carefully craft the definition of fraud so that it would not
inadvertently require the auditor to assume the burden of concluding
that fraud in fact exists, such as establishing the presence of
intent, a burden that would be inappropriate or impossible for the
auditor to assume.
\18 Previously, each of the defendants was liable for the plaintiff's
entire loss, jointly and severally with each other, irrespective of
relative fault.
\19 Indications of increased risk of inappropriate or illegal actions
by the company, referred to as "red flags," may be more difficult for
the auditor to detect, particularly in cases where frauds are
carefully concealed through forgery or collusion by management.
IMPORTANCE OF INTERNAL CONTROLS
AND COMPLIANCE WITH LAWS AND
REGULATIONS
---------------------------------------------------------- Chapter 3:4
Good internal controls are important to manage properly and
effectively, to ensure corporate accountability and accurate
financial reporting, and to prevent fraud. Internal controls can
help management ensure compliance with laws and regulations that are
fundamental to operations and that may materially affect the
financial statements. Controls are primarily the responsibility of
management, but directors, auditors, and regulators also have
essential roles to play.
Recognizing the importance of effective internal controls, the
Congress passed the Foreign Corrupt Practices Act in 1977. The
Foreign Corrupt Practices Act amended the Securities Exchange Act of
1934 to require that SEC registered companies shall
-- make and keep books, records, and accounts, which, in reasonable
detail, accurately and fairly reflect transactions and
dispositions of assets, and
-- devise and maintain a system of internal accounting controls
sufficient to provide reasonable assurances that (1)
transactions are executed in accordance with management's
general or specific authorizations, (2) transactions are
recorded as necessary to permit preparation of financial
statements in conformity with GAAP or any other criteria
applicable to such statements and to maintain accountability for
assets, (3) access to assets is permitted only in accordance
with management's general or specific authorization, and (4) the
recorded accountability for assets is compared with the existing
assets at reasonable intervals and appropriate action is taken
with respect to any differences.
The Foreign Corrupt Practices Act was the result of numerous
revelations that the falsification of records and improper accounting
had allowed businesses to make millions of dollars in questionable or
illegal payments to facilitate business transactions.
The Foreign Corrupt Practices Act set a statutory mandate for
corporations to maintain effective internal controls, but because the
act did not require reporting on controls, it provided no mechanism
for follow-up by the major players involved in ensuring corporate
accountability--boards of directors, management, auditors, and
regulators. Our work on thrifts\20 and banks\21 that failed in the
1980s revealed that serious internal control deficiencies and
indications of fraud and insider abuse contributed to their failure.
A congressional study\22 and our own work\23 on certain troubled
insurance companies also disclosed how weak internal controls played
a significant role in their decline. Examples where inattention to
internal controls contributed to fraud and unnecessary exposure to
investors can also be found in companies investigated by the SEC.
For example, the Treadway Commission's 1987 report concluded that 45
percent of the 119 cases the SEC brought against public companies
between July 1, 1981, and August 6, 1986, alleged fraud because of
the breakdown in internal controls.
More recently, our work in reviewing significant financial losses
stemming from derivatives activities of certain companies and
municipalities revealed that weaknesses in internal controls were a
contributing factor. In some cases, the losses so significantly
affected the entity's financial condition that the entity failed or
declared bankruptcy. In the cases we reviewed, none of the entities
reported publicly on their internal controls over derivatives
activities. A requirement for such reporting could have identified
areas where controls were weak or did not exist.
The Congress recognized the link between past failures of financial
institutions and weak corporate governance, including weak internal
controls, when it enacted FDICIA. FDICIA requires the management of
large banks and thrifts to report on the effectiveness of the
institution's internal controls, including safeguarding of assets,
and to report on the institution's compliance with those laws and
regulations designated by the regulators. FDICIA also requires an
independent external auditor to attest to management's assertions on
internal controls and compliance in a separate report. Further,
FDICIA requires the institutions to have independent audit committees
and establishes a reporting link between the audit committee and the
external auditor.
The continuing growth of information systems technology places an
even more important emphasis on internal controls, particularly
computer security controls, in preventing and detecting fraud. A
recent study of fraud in the United Kingdom pointed out that the
continuing growth and development in information technology is one of
the main reasons that the level of fraud is high and increasing and
presents the greatest challenge to fraud prevention.\24 The United
Kingdom report explained that computers could enable someone to
manipulate transactions or intercept data without being subject to
traditional forms of supervision. The study recommended that company
directors conduct an annual review of fraud risk to help ensure that
internal controls are designed to prevent and detect fraud. The
United Kingdom is also considering requiring auditors to report, to
directors and audit committees, on existing fraud control systems.
--------------------
\20 Thrift Failures: Costly Failures Resulted From Regulatory
Violations and Unsafe Practices (GAO/AFMD-89-62, June 16, 1989).
\21 Bank Failures: Independent Audits Needed to Strengthen Internal
Control and Bank Management (GAO/AFMD-89-25, May 31, 1989) and Failed
Banks: Accounting and Auditing Reforms Urgently Needed
(GAO/AFMD-91-43, April 22, 1991).
\22 Failed Promises: Insurance Company Insolvencies, Subcommittee on
Oversight and Investigations, House Committee on Energy and Commerce,
February 1990.
\23 Insurer Failures: Regulators Failed to Respond in Timely and
Forceful Manner in Four Large Life Insurer Failures (GAO/T-GGD-92-43,
September 9, 1992).
\24 Taking Fraud Seriously, The Institute of Chartered Accountants in
England and Wales, January 1996.
AUDITORS HAVE LIMITED
RESPONSIBILITIES FOR ASSESSING
INTERNAL CONTROLS
---------------------------------------------------------- Chapter 3:5
Since the passage of the Foreign Corrupt Practices Act in 1977,
numerous proposals have been made by the Cohen and Treadway
Commissions, the SEC, GAO, and congressional committees to strengthen
internal control requirements for the private sector. Such proposals
included (1) requiring both management and auditors to increase
reporting on internal controls to better ensure that they are in
place and working effectively, (2) establishing stronger requirements
for independent audit committees, and (3) requiring direct reporting
by auditors of company's illegal acts to government regulators.\25
In 1988, the ASB issued SAS 55, which requires the auditor, in all
audits, to obtain a sufficient understanding of a company's internal
control structure-- control environment, accounting system, and
control procedures--to assist in planning the audit. The audit
standard requires the auditor to document his or her understanding of
the three elements of the control structure and whether the elements
have been placed in operation. The standard also states that the
auditor should assess control risk; document the basis for
conclusions about the assessed level of control risk for financial
statement assertions; and design substantive tests, based on the
auditor's knowledge of the control structure and assessed risk. The
ASB also issued guidance for auditors to use in identifying and
reporting certain internal control conditions observed during the
audit.\26 These matters, termed "reportable conditions," are matters
that the auditor feels should be reported to the audit committee or
its equivalent because they represent deficiencies that could
adversely affect the organization's ability to produce reliable
financial disclosures.
Also, in 1992\27 and 1994,\28 COSO published integrated guidance on
internal controls. This guidance provides independent auditors and
others with adequate criteria for judging and reporting on the
effectiveness of internal controls over financial reporting and the
safeguarding of assets, as well as operations and compliance
controls. In 1995, the ASB amended auditing standards to recognize
COSO's definition and description of internal control.\29 The revised
description of internal control consists of five components--control
environment, risk assessment, control activities, information and
communication, and monitoring--instead of the three elements
previously described. The revisions also changed certain
terminology, such as internal control structure to internal control
and control procedures to control activities.
In the past, auditor reporting on management's assertion on the
effectiveness of internal controls has met with resistance to some
extent by the accounting profession. Accordingly, current auditing
standards and guidance do not require the auditor to report on the
condition of internal controls, which may hinder the auditor in
detecting fraudulent financial reporting. As stated by the POB in
its 1993 report, "This review of internal controls [as called for in
the auditing standards] is neither sufficient nor intended to provide
a basis for the evaluation of the quality of the client's system of
internal control." For example, the auditor need only test the
operation of those internal accounting controls that are relied upon
based on the assessment of control risk in opining on the annual
financial statements. If auditors rely upon them, then only those
controls that are directly related to the financial statements and
are material in relation to the financial statements need to be
tested and evaluated. If auditors can accomplish the audit by
directly testing account balances on the financial statements, they
need not evaluate or test internal accounting controls. Further,
operations controls, because they are not directly related to the
financial statements, may not be tested by independent auditors.
Therefore, such controls, which might provide reasonable assurance
that the company is in compliance with laws and regulations, may not
be tested.
The POB's 1993 report contains a recommendation to the SEC to require
registrants to include along with the annual financial statements a
report by management and the independent auditor on the entity's
internal control system. The AICPA now believes that the public
expectation of the auditor's role in checking internal controls
places the profession in the position of being best served by
reporting on management's assertion rather than being silent. In its
June 1993 position statement, the AICPA Board of Directors stated,
"To provide further assurance to the investing public, we join the
POB in calling for a statement by management, to be included in the
annual report, on the effectiveness of the company's internal
controls over financial reporting, accompanied by an auditor's report
on management's assertions. An assessment by the independent auditor
will provide greater assurance to investors as to management's
statement. The internal control system is the main line of defense
against fraudulent financial reporting. The investing public
deserves an independent assessment of that line of defense, and
management should benefit from the auditor's perspective and
insights. We urge the SEC to establish this requirement."
We believe FDICIA took a step in the right direction by requiring
internal control reporting by management and the external independent
auditor of large banks and thrifts. In our 1994 report on
derivatives, we recommended that the FDICIA model be extended to
entities involved with complex derivative products.\30 Since that
report, we have been working with the SEC to adopt the FDICIA
internal control model for end users of complex derivatives.
However, the SEC is opposed to requiring similar reporting by all
public companies. The SEC cited two separate instances in the 1980s
in which it withdrew SEC proposals for internal control reporting,
primarily because of concern over the cost of such reporting, and
also because of concern over whether such reporting would constitute
an admission of a violation of the Foreign Corrupt Practices Act. We
recently suggested that instead of requiring internal control
reporting, the SEC could issue guidelines for boards of directors'
oversight of derivatives activities that would accomplish the
objective of assessing and reporting on internal controls. However,
the SEC is concerned about its intrusion in corporate governance if
it were to issue such guidelines.
Although commenters on SEC's past proposals concerning internal
controls opposed auditor reporting on the effectiveness of internal
controls, they supported a requirement for a statement by management
concerning its responsibilities for the establishment and maintenance
of a system of internal controls for financial reporting. Management
believes the value of the requirement is obtained in its review of
controls and that the auditor's review does not enhance that value.
These perspectives are reflected in the results of our 1994 review of
Fortune 1,000 publicly owned companies. The review showed that about
two-thirds of the companies' annual reports that we sampled contained
management reports, but only about one-third of companies' management
reports contained conclusions about the effectiveness of internal
controls, and less than 2 percent of the companies provided audited
reports on the effectiveness of their internal controls.
Notwithstanding the perspective of some companies that audited
internal controls reporting is too costly, the work of the AICPA
Special Committee on Financial Reporting (Jenkins Committee) found
that professional investors and creditors believe that business
reporting would benefit from increased auditor involvement in
internal controls.\31 Its findings were based on an identified users'
need for more comprehensive business reporting that in addition to
traditional financial statements, would include forward-looking and
other financial and nonfinancial information. Similarly, in its 1993
report on financial reporting, the Association for Investment
Management and Research (AIMR), which represents financial analysts,
portfolio managers, and other investment professionals, stated that
it envisioned external auditors being substantially more involved
than at present with the functioning of the internal systems that
produce financial data for external consumption.\32 AIMR felt that
too much attention is paid to the numbers and too little to the
process that produces them. AIMR also pointed out that while audit
costs may increase with increased auditor involvement in internal
controls, the risk of audit failures would decrease. AIMR also
expected that any increase in audit costs would be offset, at least
partially, by the decreased cost of capital resulting from higher
quality and more reliable information being made available to the
financial markets. The Jenkins Committee and AIMR reports are
discussed in more detail in chapters 5 and 6 of this report.
--------------------
\25 Refer to table II.5, appendix II (GAO/AIMD-96-98A) for these and
other recommendations pertaining to internal controls.
\26 SAS 60.
\27 Internal Control - Integrated Framework, Reporting to External
Parties, the Committee of Sponsoring Organizations of the Treadway
Commission, September 1992.
\28 Internal Control - Integrated Framework, Addendum to Reporting
External Parties, the Committee of Sponsoring Organizations of the
Treadway Commission, May 1994.
\29 SAS 78 amended SAS 55 and SAS 60.
\30 Financial Derivatives: Actions Needed to Protect the Financial
System (GAO/GGD-94-133, May 18, 1994).
\31 Improving Business Reporting--A Customer Focus: Meeting the
Information Needs of Investors and Creditors, Comprehensive Report of
the Special Committee on Financial Reporting, AICPA, 1994.
\32 Financial Reporting in the 1990's and Beyond, the Association for
Investment Management and Research, 1993.
ASSESSING INTERNAL CONTROLS
IN FEDERAL ENTITIES
-------------------------------------------------------- Chapter 3:5.1
Our own work on assessing the internal controls of federal government
agencies and corporations has demonstrated the benefits of auditor
involvement. Our reports covering controls over financial reporting,
protection of assets, and compliance with laws and regulations have
stimulated government agencies and corporations to take corrective
action to improve the accuracy of financial reporting, reduce the
risk of loss of assets, and deter violations of laws and regulations.
We believe that expanded auditor involvement with the internal
controls of business entities could produce similar results.
Legislation to strengthen financial management and internal controls
has been enacted for federal entities. For example, the concept for
management reporting is well-established by the Federal Managers'
Financial Integrity Act of 1982 (FMFIA) and the Chief Financial
Officers (CFO) Act of 1990. FMFIA requires ongoing evaluations and
annual public reports by heads of executive branch departments on the
adequacy of internal accounting and administrative controls, as well
as corrective measures to fix identified weaknesses. Moreover, FMFIA
requires that internal controls provide reasonable assurance that
obligations and costs are in compliance with applicable laws. The
CFO Act extends the management reporting concept to government
corporations and requires CFOs of executive branch departments to
issue annual reports on the financial condition of their departments,
including summaries of internal control weaknesses discussed in their
latest FMFIA reports.
Generally accepted government auditing standards (GAGAS), as well as
private sector auditing standards, require the auditor to perform
sufficient internal control work to understand the system of internal
controls and test controls relied on in auditing the financial
statements. However, generally accepted government auditing
standards further require that auditors' findings related to their
examination of internal controls and of compliance with laws and
regulations be publicly reported. These reports on internal controls
and compliance with laws and regulations are made in addition to the
auditor's opinion on the financial statements. Additionally, for
financial statement audits that we conduct, we have adopted a
requirement to perform sufficient audit work to issue an opinion on
the effectiveness of an entity's internal controls.
MORE COMPREHENSIVE
ASSESSMENT OF INTERNAL
CONTROLS WOULD BE NEEDED TO
ASSESS RISK OF COMPLEX
BUSINESS OPERATIONS
-------------------------------------------------------- Chapter 3:5.2
As mentioned above, controls that are not directly relied on in
attesting to financial statements may not be tested by private-sector
auditors. In addition, as discussed further in chapter 6, with the
explosion in information technology, a greatly increased amount and
variety of financial and nonfinancial information is now readily
available to users. If auditors are engaged to provide assurance on
this information, auditors will first need to focus on the
reliability of the internal control systems producing this
information. The losses suffered from derivatives activities is
another example of where risk management policies and procedures are
needed to manage the risks inherent in financial derivatives and
highlights the importance of assessing the quality of risk management
systems to control those risks. A recent publication explored the
nature and consequences of business risks\33 that organizations are
facing in today's environment and concludes that an effective
internal control structure is essential to managing business
risks.\34 The report discussed the need for a shift from evaluating
controls that are focused only on financial risk to include
evaluating controls that also focus on assessing business risk.
--------------------
\33 Business risk is defined as the threat that an event or action
will adversely affect an organization's ability to achieve its
business objectives and execute its strategies successfully.
\34 Managing Business Risks: An Integrated Approach, The Economist
Intelligent Unit, in cooperation with Arthur Andersen, 1995.
OBSERVATIONS
---------------------------------------------------------- Chapter 3:6
The accounting profession's response in the 1980s to the public
expectation gap was a significant effort to clarify the auditor's
responsibilities by issuing revised auditing standards to address
areas of concern. Although these standards helped to clarify the
auditor's role and responsibilities, they have not eliminated the
public expectation gap, particularly with regard to the auditor's
responsibility for fraud detection and determining the effectiveness
of internal controls.
The important issues of the auditor's responsibility for detecting
and reporting fraud and for reporting on internal controls overlap
since effective internal controls are the major line of defense in
preventing and detecting fraud. Taken together, these issues raise
the broader question of determining the proper scope of the auditor's
work in auditing financial statements of publicly owned companies.
We believe that auditor reporting on the effectiveness of internal
controls is fundamental to successfully addressing the public
expectation gap for fraud detection and interest in the effectiveness
of internal controls.
The accounting profession is now publicly supporting auditor
reporting on internal controls and is actively working on new
standards to heighten auditor initiatives in detecting fraud.
However, the important linkage between these initiatives has not been
made, and a major player to achieving success in narrowing the
expectation gap for these responsibilities, the SEC, has not been not
been convinced of the merits of reporting on internal controls. SEC
support is critical to further progress on this important issue, as
is the linkage of fraud detection and internal controls.
The ASB's current proposal to strengthen audit standards for fraud
detection is encouraging, but will not likely fully resolve the
expectation gap. We believe the public may be holding the auditor
responsible for preventing significant fraud as well as detecting and
reporting fraud that is material to the financial statements. It
also may be holding the auditor responsible for addressing other
types of unauthorized behavior resulting from inadequate risk
management controls. Therefore, the public expectation gap may be
wider than the one currently being addressed by the accounting
profession. Another important factor that will likely limit the
effectiveness of already issued and proposed auditing standards
concerning fraud is that auditors do not evaluate internal controls
in a manner sufficient to form an opinion on their effectiveness to
prevent and detect fraud and other types of failures in internal risk
management systems of the companies they audit.
While we support the ASB's current effort to provide more specific
guidance to the auditor in planning and conducting the audit to
detect fraud, we believe that the auditor would be more successful in
preventing and detecting fraud if auditing standards were also
revised for the auditor to accept more responsibility for the
effectiveness of internal controls as a component of financial
statement audits. The proposed guidance emphasizes the need for the
auditor to exercise professional skepticism and pursue red flags to
detect fraud. We believe such guidance is an important component of
assessing risk and, accordingly, planning and conducting the audit.
However, understanding and testing the effectiveness of internal
controls is also critical in assessing risk and, accordingly,
planning and conducting the audit.
Control weaknesses are a major contributing cause of many of the
notorious cases of management fraud, and good controls have long been
recognized as a major line of defense against employee and supplier
fraud. As evidenced by our work in reporting on internal controls
and compliance with laws and regulations, auditors have the capacity
to examine the adequacy of controls to prevent and detect fraud in
financial reporting and in the acquisition, use, and disposition of
assets.
Extending the ASB proposal to include a full evaluation of internal
controls to deter or detect significant fraud would provide greater
assurance of detecting and preventing fraud and increase the chance
of narrowing the expectation gap, but would also add somewhat more
cost to the audit. The proposed ASB standard is likely to result in
increased audit work, especially if conditions show a higher
potential risk of fraud occurring. Likewise, conducting the audit to
assess the effectiveness of internal controls will likely further
increase costs over the current level of required work to meet
auditing standards. For these reasons, the auditors' clients are
likely to resist effective implementation of the proposal as well as
expanding it as we have discussed. Also, even with the recently
enacted Private Securities Litigation Reform Act of 1995, the
profession remains concerned about the threat of litigation, impeding
the profession's willingness to accept additional responsibilities
for fraud detection.
However, the public interest should be considered in addressing the
issue of whether to extend the auditor's responsibility for internal
controls. The savings and loan crisis demonstrated the cost to the
public of weak internal controls. More recently, there have been
large business losses and failures centering on weak controls over
the use of derivatives. We expressed concern that this uncontrolled
use of derivatives poses a systemic risk to the stability of the
entire financial system. Strong internal controls would not only
serve to protect against fraud, but could also serve a broader
function of ensuring that important internal risk management policies
are likely to be followed.
Some bank regulators and managers recognized the value of auditors'
examination of controls in implementing the FDICIA requirements for
auditors to evaluate and report on the effectiveness of internal
controls. The FDICIA reporting model could be extended to apply to
all public companies. Although the auditor's client may not see the
value of extending the auditor responsibility to assessing the
effectiveness of internal controls at the present time, we expect
that shifting the auditor/client relationship more toward the board
of directors and audit committees, as suggested by the Kirk Panel,
would increase the demand for such services. If boards of directors
and their audit committees had the responsibility for overseeing risk
management and the effectiveness of the controls to ensure that risk
management policies were followed, we believe that most boards would
call upon auditors to assist them in discharging that responsibility,
and public reports on internal controls would likely result. We
continue to believe that auditor reporting on the effectiveness of
internal controls is necessary when public funds are at risk.
Looking to the future, we believe that more pressure to extend the
profession's responsibility with respect to the adequacy of internal
controls is likely to develop. Business entities are moving into
global markets, changing rapidly to meet customer demands, and
engaging in complex financial transactions. These trends are causing
balance sheet values to change quickly and are decreasing the
relevancy of historical financial statements. As a result,
safeguarding controls over assets becomes more important and the
amount of particular assets at a single point in time becomes less
important. This should increase management's interest in maintaining
adequate controls as well as the interest of directors and users of
financial statements in obtaining more information on the
effectiveness of a company's internal controls. In that respect,
auditors can better serve their business clients and other financial
statement users by having a greater role in providing assurances for
the effectiveness of internal controls in deterring fraudulent
financial reporting, protecting assets, and providing an early
warning of weaknesses that could lead to business failures.
We believe that the accounting profession needs to consider how it
might enhance the value to management of providing assurances on
internal control. The internal control review that auditors make
need not be a passive type of assurance. For example, ideas for
improvements in controls and systems changes to reduce the cost of
effective controls can be part of the product the auditor delivers.
The auditor can also review those controls related to the efficiency
and effectiveness of operations. Increased involvement in assessing
the effectiveness of controls should enable the auditor to suggest
improvements in operations.
The SEC, the AICPA, and boards of directors are each major
stakeholders in achieving audit requirements that are more likely to
be able to provide reasonable assurance of detecting material fraud.
Each of these parties needs to move toward actively supporting
realistic auditing standards for detecting fraud that include
assessing the effectiveness of internal controls. The SEC is a key
player in providing the leadership to bring these parties together,
reach agreement on reasonable auditing standards, and work with the
AICPA to have the standards officially adopted by the ASB through the
standard-setting process. In the long run, we expect that audits
will be expanded to include internal control reporting, either
because of market demand or some systemic crisis.
COMMENTS AND OUR EVALUATION
---------------------------------------------------------- Chapter 3:7
The AICPA, the SEC Chief Accountant, and the POB provided comments on
the major unresolved issue of the auditor's responsibility for
reporting on the effectiveness of internal controls. In addition,
the AICPA commented on the related major unresolved issue of the
auditor's responsibility for detecting and reporting material fraud.
The AICPA commented that it has proposed a new auditing standard to
assist auditors in meeting their existing responsibility for fraud
detection. We support the ASB's effort to provide more specific
guidance to the auditor to detect fraud. However, we believe that
the auditor would be more successful in preventing and detecting
fraud if auditing standards were also revised to require the auditor
to accept more responsibility for reporting on the effectiveness of
internal controls. Our report also recognizes that significant
barriers to achieving that objective exist, such as concerns over
added audit cost and legal liability. However, the AICPA commented
that it supports management and auditors' reports on internal
controls as a means to make a positive, cost-effective contribution
to the assurance system and to improve investor confidence in the
integrity and reliability of the financial reporting process.
Further, the AICPA stated it fully supports the FDICIA management and
auditor reporting model that exists for large banks and thrifts.
The SEC Chief Accountant recognized that there may be benefits
associated with management or auditor reports on SEC registrants'
internal control systems. He stated the SEC is currently focused on
providing investors with enhanced accounting for and disclosure of
market risk, inherent in derivative financial instruments; other
financial instruments; and derivative commodity instruments. He
further stated that without denying the importance of internal
controls over activities involving financial instruments and
assurances that those controls are working, focusing on providing
more information on market risk may be a more appropriate priority
for the SEC at this time.
Providing investors with better information on risks and
uncertainties is an important component of improved financial
reporting as discussed in our report. However, we believe the SEC
should continue to assess ways to bring about reporting on internal
controls as a mandatory component of a financial statement audit.
The POB commented that it was disappointed by the failure of the SEC
to take action to mandate issuer and auditor reporting on internal
controls. The POB agreed with us that such action would add
immeasurably to the ability to prevent and detect fraud and would in
general enhance the quality of financial reporting.
We believe that SEC leadership is necessary to achieve reporting on
the effectiveness of internal controls. The SEC, the AICPA, and
boards of directors are major stakeholders in achieving realistic
auditing standards for fraud and internal controls. However, the SEC
is the key player in providing the leadership and in bringing these
parties together.
In addressing these issues, the SEC should also carefully weigh the
public interest when considering the views of those who oppose
reporting on the effectiveness of internal controls. We also believe
that if the auditor/client relationship were to shift more toward the
board of directors and audit committees, as suggested by the Kirk
Panel, the demand for auditor services related to internal controls
would increase. Further, if boards of directors and audit committees
had the responsibility for the effectiveness of internal controls, we
believe that boards would look to the auditors to assist them in
discharging that responsibility.
INITIATIVES TO IMPROVE AUDIT
QUALITY
============================================================ Chapter 4
The audit is an important element in financial accountability because
it subjects financial statements to scrutiny by an independent,
knowledgeable professional. Problems with audits of public companies
focused attention on the need to improve quality control mechanisms
to ensure that professional audit standards were being met.\1 The
current peer review program was a significant action taken by the
profession to improve the quality of audits. While other issues
discussed in this report, such as the auditor's responsibilities for
fraud and internal controls and auditor independence, relate to the
effectiveness of the audit process, the accounting profession's
self-regulation program directly addresses audit quality. In
addition, the profession's attention to issuing timely audit guidance
and strengthening education requirements should assist in enhancing
audit quality.
Analyses of peer review reports show that the self-regulatory program
is improving audit quality and that 90 percent of accounting firms
that received a peer review during 1992 through 1994 received
unqualified opinions on their quality control systems. Although many
of the reports identified weaknesses, for most accounting firms
reviewed, these weaknesses were not significant enough to result in a
qualified opinion. The reports did show certain types of frequently
recurring weaknesses that offer an opportunity for the accounting
profession to further improve its quality control systems.
--------------------
\1 Refer to table II.2, appendix II (GAO/AIMD-96-98A) for the
recommendations made to improve audit quality.
SELF-REGULATION
---------------------------------------------------------- Chapter 4:1
Certain aspects of the profession's current program of
self-regulation grew out of concerns expressed in the mid-1970s by
some members of the Congress, the SEC, and others. Questions,
prompted by audit failures or purported audit failures, centered on
the credibility of financial statements and related disclosures
issued by public companies and the reliability and quality of the
independent audit process. More specifically, these groups expressed
concern that (1) businesses failed shortly after receiving a "clean"
opinion from the auditor and (2) auditors did not adequately pursue
red flags, properly report on the auditee's financial condition,
and/or adequately document their work.
In 1977, the Metcalf Subcommittee and the Cohen Commission called for
(1) the establishment of an accounting profession oversight
organization with authority to monitor auditor professionalism and
independence, (2) the periodic inspections of the work of independent
auditors, and (3) the preparation and issuance of quality control
reports that are submitted to the SEC and are made available to the
public.\2 In addition, recommendations made by several study groups
called for more timely and detailed audit guidance and enhanced
education and auditor awareness.
To address concerns with audit quality, in 1977, the AICPA
established the Division for CPA Firms with an SEC Practice Section
to administer a voluntary self-regulatory program within the
profession. The SEC Practice Section was designed to oversee the
activities of independent public accounting firms (CPA firms) that
audit companies whose securities are registered with the SEC, with
the objectives of improving the quality of accounting and auditing
practices by CPA firms and establishing and maintaining a system of
self-regulation of member firms. The SEC Practice Section imposes
membership requirements and administers two fundamental programs to
help ensure that SEC registrants are audited by member accounting
firms with adequate quality control systems: (1) peer review and (2)
quality control inquiry. Also in 1977, the AICPA formed the POB,
independent of the Division, to oversee the activities of the SEC
Practice Section and represent the public interest on all matters and
developments that may affect public confidence in the integrity of
the audit process.\3 For example, the POB represents the public
interest when (1) the SEC Practice Section sets, revises, or enforces
standards, membership requirements, and rules or procedures and (2)
when the SEC Practice Section considers the results of individual
peer reviews or the possible quality control implications of
litigation alleging audit failure.
--------------------
\2 The Metcalf Subcommittee intended for these recommendations to be
mandatory for all accounting firms that audit public companies in
order to have an effective program of self-regulation. However, the
Cohen Commission believed that a voluntary program would provide
effective oversight, and, accordingly, stated that its
recommendations in this area could be implemented voluntarily by
individual firms.
\3 The POB is an autonomous body of five members with a broad
spectrum of business, professional, regulatory, and legislative
experience. The Board ensures its independence by appointing its own
members, chairperson, and staff; setting its own budget; and
establishing its own operating procedures.
PEER REVIEW PROGRAM
-------------------------------------------------------- Chapter 4:1.1
To assist the SEC Practice Section in its oversight of the
profession, the AICPA in 1977 initially established a voluntary peer
review program that in 1990 was made mandatory for all SEC Practice
Section members. The objectives of the triennial peer review program
are to determine whether a reviewed firm's system of quality control
for its accounting and auditing practices is appropriately
comprehensive and suitably designed, and whether a firm's quality
control policies and procedures are adequately documented,
communicated to professional personnel, and complied with so as to
provide the firm with reasonable assurance that it is conforming with
professional standards and SEC Practice Section membership
requirements.\4
The SEC Practice Section Peer Review Committee is responsible for
administering the peer review program. Peer reviews are performed by
CPA firms that have received an unqualified report on their own peer
review, by a team appointed by the AICPA, or by an authorized
association of CPA firms. Published standards and guidelines assist
those responsible for conducting and reporting on peer reviews. Upon
completion of a review, the peer review team issues a report to the
reviewed firm containing a statement of the scope of the review, a
description of the general characteristics of a system of quality
control, and the team's opinion as to whether the reviewed firm's
quality control system met the objectives of established quality
control standards and was being complied with to provide the firm
with reasonable assurance of conforming with professional standards
and the SEC Practice Section membership requirements. An unqualified
report indicates satisfaction with the firm's quality control system
and compliance with standards and membership requirements. A report
is modified if the review discloses significant deficiencies in or
lack of compliance with the firm's quality control policies and
procedures, a significant lack of compliance with membership
requirements of the Section; it is also modified if the scope of the
review is limited as to preclude the application of review procedures
considered necessary.\5
Along with the peer review report, the review team will also issue a
letter of comments to the reviewed firm if, during the course of its
review, the team discovers quality control matters that require
action by the firm. A firm will receive a letter of comments when it
has more than a remote chance of not conforming with professional
standards. According to the AICPA's quality control guidance, remote
means the chances are slight that the reviewed firm would not conform
with professional standards on accounting and auditing engagements.
It is considered a low threshold for identifying a weakness, and
therefore, most peer reviews would be expected to result in a letter
of comments to the accounting firm. The letter discusses the matters
that require corrective action and provides recommendations for
improvement in the reviewed firm's quality control system. The
letter of comments is used by the peer review team to address matters
serious enough to modify the peer review report as well as less
significant matters that require corrective action by the accounting
firms. For each item included in the letter of comments, the
reviewed firm is required to respond in writing with its actions
taken or planned with respect to each recommended improvement, or the
reasons the firm disagrees with the conclusions of the review team.
The reviewed firm is responsible for providing the SEC Practice
Section Peer Review Committee the report, letter of comments, and the
firm's responses.
The Peer Review Committee evaluates each report, letter of comments,
and the reviewed firm's response to determine the appropriateness of
the opinion and whether additional corrective action is necessary.
These evaluations require mature and thoughtful judgment because
there are no quantitative criteria that can be used to measure the
significance of perceived deficiencies. Upon final acceptance by the
Committee, the peer review report, letter of comments, and reviewed
firm's responses are considered official and are made available to
the public.
Until 1990, membership in the SEC Practice Section was voluntary. As
a result, many firms auditing SEC registrants were not members and
therefore were not subject to an SEC Practice Section peer review.
However, in response to critics of the profession's program and to
recommendations made in the mid-1980s by GAO, Price Waterhouse, the
Big 7, the AICPA's Anderson Committee, and the Treadway Commission,
the AICPA revised its bylaws so that beginning in 1990, all AICPA
member firms that audit SEC registrants are required to be members of
the SEC Practice Section. This change resulted in an increase in SEC
Practice Section membership from 519 firms in June 1989 to 1,257
firms in August 1995, and a corresponding increase in the number of
firms undergoing a peer review. These firms audit about 97 percent
of SEC registrants.\6 In April 1987, the SEC proposed rules that
would have required all SEC registrants to be audited by a firm that
had undergone a peer review of its accounting and auditing practices
within the last 3 years. However, the SEC decided not to issue any
rules because of questions about the SEC's authority to require
mandatory peer review, along with cost-benefit considerations and
other issues.
Also, in line with recommendations from the Treadway Commission, the
SEC Practice Section peer review standards were revised to place more
emphasis on the audits of a CPA firm's new clients that are SEC
registrants. The new standards were effective for peer review years
beginning after January 1, 1988. In 1995, the SEC Practice Section
revised its concurring partner review requirements to specify that
the concurring partner's review should be sufficient to provide the
member firm with additional assurances that audit risk has been
restricted to a level acceptable to the firm.\7 The revised
requirement suggests the extent of inquiry about the conduct of the
audit that should be made of the engagement partner and documentation
that should be reviewed by the concurring partner.
The peer review program has provided both professional accounting and
auditing-related organizations, such as the AICPA, the POB, and the
SEC, and the individual public accounting firms with critical
information on the quality of work performed and the ability of a
firm's quality control processes to help ensure compliance with GAAS.
These organizations have also said that the SEC Practice Section's
peer review program has resulted in a strengthened audit function.
For example, statistics indicate that firms that received a modified
report on their first peer review are significantly less likely to
receive such a report on their second or later reviews.\8 It is also
important to note that the number of modified peer review reports
(83) was highest in 1991--the year in which the most initial peer
reviews (300) were conducted. In addition, statistics developed by
the SEC Practice Section show that only about 11 percent of the 1,463
peer review reports issued for 1990 through 1993 were modified.
Similarly, our analysis of the 724 peer review reports issued for
accounting firms that audited SEC registrants during 1992 through
1994 showed that about 10 percent of the reports issued were
modified. Our analysis also showed that no large firms (firms that
audit 30 or more SEC registrants received a modified report.
According to September 1995 SEC data, the six largest firms (commonly
referred to as the Big 6 accounting firms) audit approximately 81
percent of all SEC registrants audited by SEC Practice Section
members.
The most frequently cited factor contributing to a modified peer
review opinion was inadequate concurring partner reviews of the audit
work performed and of the related audit report. Other types of
problems frequently identified through peer review, the substance of
which were usually not serious enough to modify the peer review
opinion, included weaknesses in the reviewed firm's quality control
policies and procedures; deficiencies in the audit work performed
and/or related financial statements; and noncompliance with SEC
Practice Section membership requirements, such as auditors of the CPA
firm not meeting continuing education requirements.
The more serious weaknesses that resulted in a modified report as
well as the less significant weaknesses are discussed in a letter of
comments along with recommended corrective actions. For example,
regarding deficiencies in the audit work performed, the peer reviews
found a number of instances of inadequate working paper documentation
that involved not clearly documenting the basis for audit decisions
or insufficient documentation of audit work performed. Such
deficiencies would be included in a letter of comments. However,
widespread documentation deficiencies would be considered a
significant breakdown in the accounting firm's quality control system
and would result in a modified peer review report. We found that,
for SEC Practice Section member firms, 553 of the 724 peer review
reports issued for 1992 through 1994, or about 76 percent, included a
letter of comments. However, 477 of the 553 letter of comments
issued, or about 86 percent, only addressed matters that were not
significant enough to modify the opinion on a firm's quality control
processes.
In response to peer review findings, and depending on the
significance of the weaknesses identified, a variety of actions have
been planned or taken. For example, the audit reports and/or
financial statements were recalled or reissued, the subsequent year
financial statements were corrected, additional audit procedures were
performed, documentation to auditor working papers was added to
evidence audit work performed, and other deficiencies were to be
corrected in future audits. These actions indicate that the peer
review process has helped to ensure that more accurate and
appropriate information is available to investors and other
third-party users.
--------------------
\4 In 1979, the AICPA established quality control standards governing
the conduct of a firm's audit practice as a whole (as compared with
GAAS, which relate to individual audit engagements). The elements of
quality control are currently identified in the AICPA's Statement on
Quality Control Standards No. 2, System of Quality Control for a CPA
Firm's Accounting and Auditing Practice. Adherence to quality
control standards is a membership requirement of the SEC Practice
Section. The quality control standards are broad in nature, covering
all of the firm's activities that have a bearing on the quality of
its accounting and auditing services.
\5 A modified report can either be qualified or adverse, or it may
include a disclaimer of opinion. A qualified opinion identifies
significant deficiencies in the firm's quality control processes or
in compliance with the processes. An adverse opinion indicates the
processes, or compliance with them, are not adequate. A disclaimer
of opinion is issued when limitations on the scope are so significant
that the review team cannot form an overall opinion. No disclaimers
of opinion were issued through 1994.
\6 SEC and SEC Practice Section data as of July and August 1995 show
that of the approximately 16,000 SEC registrants, about 460 are
audited by accounting firms that are not members of the SEC Practice
Section.
\7 A concurrent partner review is a review conducted by another
partner in the CPA firm, in addition to the review conducted by the
partner directly responsible for the audit (the engagement partner).
\8 SEC Practice Section Annual Report, AICPA, June 30, 1994.
QUALITY CONTROL INQUIRY
-------------------------------------------------------- Chapter 4:1.2
The quality control inquiry process, administered by the SEC Practice
Section's Quality Control Inquiry Committee (QCIC)\9 and overseen by
the POB, supplements the peer review process. Members of the SEC
Practice Section are required to report lawsuits made by clients to
the QCIC within 30 days of being served. This requirement includes
all litigation involving the firm or its personnel, or any publicly
announced investigation by a regulatory agency, that alleges
deficiencies in the conduct of an audit of an SEC registrant and
certain other entities.
The QCIC determines whether allegations of audit failure against SEC
Practice Section member firms involving SEC registrants indicate a
need for those firms to take corrective actions to strengthen their
quality control systems or to address personnel deficiencies. In
addition, consideration of such allegations may also raise questions
that lead to reconsideration or interpretation of professional
standards or suggest audit practice issues where practical guidance
would benefit practitioners. The QCIC refers such issues to the
appropriate AICPA technical bodies and/or to the AICPA Professional
Issues Task Force (PITF).\10 The QCIC also occasionally becomes aware
of behavior by individual CPAs that warrants investigation. The QCIC
refers such matters to the AICPA Professional Ethics Division.
According to the POB's 1994-1995 Annual Report, for the period
November 1979 through June 1995, the QCIC took 159 actions related to
member firms including such actions as a special review by the QCIC
or expanding the firm's regularly scheduled peer review. The QCIC
also referred 28 individual CPAs to the AICPA's Professional Ethics
Division for investigation. For this same period, there were 52
instances in which the QCIC asked either an AICPA technical body to
consider the need for changes in, or guidance on, professional
standards or the PITF to consider the issuance of a practice alert.
Accordingly, the QCIC's analysis has acted as an early warning
system, drawing attention to accounting and auditing problems.
--------------------
\9 Formerly known as the AICPA's Special Investigations Committee.
\10 The PITF was established in response to the POB's 1993 report, In
the Public Interest, to accumulate and consider practice issues that
appear to present high audit risk and to disseminate relevant
guidance (via "practice alerts"). The PITF also refers matters that
may require a reconsideration of existing standards to appropriate
standard-setting bodies.
SEC OVERSIGHT
-------------------------------------------------------- Chapter 4:1.3
The SEC also oversees and evaluates the accounting profession's audit
quality programs. For example, each year the SEC's Office of the
Chief Accountant reviews a random sample of the SEC Practice
Section's peer reviews, including a review of peer reviewers' working
papers and the POB's oversight files. The SEC reviews the QCIC
process and related POB activities and also meets periodically with
QCIC staff to discuss matters of mutual interest, including changes
that the SEC believes would make the QCIC process more effective.
STATE BOARDS OF ACCOUNTANCY
-------------------------------------------------------- Chapter 4:1.4
State boards of accountancy also play a role in contributing to
improving the quality of audits. State boards of accountancy,
established by statute, regulate the practice of public accountancy
within their jurisdictions. Each state board has adopted rules of
professional conduct, including audit standards, and can take
disciplinary action against licensees who violate these rules or
standards. This includes the authority to revoke, suspend, or
otherwise impair a CPA's license to practice, assess fines, as well
as to take actions that are more remedial in nature such as
instituting additional continuing professional education requirements
and follow-up reviews of subsequent audits. Referrals of alleged
poor quality audits to a state board of accountancy can be made by
private-sector officials, government officials, or individuals.\11
--------------------
\11 The subject of a referral can be the audit, the individuals
performing the audit, or the audit firm. However, once the referral
is made, state boards determine the responsible individuals involved
in performing the audit.
AUDIT STANDARDS AND GUIDANCE
---------------------------------------------------------- Chapter 4:2
Audit standards are necessary to help ensure that audits of financial
statements are conducted in a quality manner. As of June 1996, the
ASB has issued 79 auditing standards that relate to audit quality,
reporting, and related subjects. The ASB also issues attestation
standards for CPAs, providing assurances on representations other
than historical financial statements and in forms other than the
assurance given about financial statements. As of June 30, 1996, the
ASB has issued six attestation standards providing guidance on
engagements concerning topics such as financial forecasts and
projections, pro forma financial statements, reporting on internal
controls, agreed-upon procedures, and compliance attestations.
The AICPA also issues audit interpretations and audit guides to
provide guidance on the application of audit and attest standards.
As of June 30, 1996, there were 25 audit guides in use (20 industry
audit guides and 5 general audit guides). Auditors and others rely
heavily on these audit guides for the specialized accounting and
auditing practices of particular industries. While audit
interpretations and the audit guidance in the audit guides are not as
authoritative as audit standards, auditors may have to justify
departures from the interpretations and guides if the quality of
their work is questioned.
The AICPA has specialized committees that monitor changes in the
industries in order to keep audit guides current. However, several
of our reports on audit quality found that the AICPA had not done a
good job of providing timely, clear, and/or sufficient guidance that
adequately reflected the nature of specific industries or the changes
in the environment affecting those industries.\12 This was
particularly evident in our review of audits of failed savings and
loans and employee benefit plans. Since the issuance of our reports,
the AICPA has issued revised audit guides that were responsive to our
recommendations. In addition, the AICPA has taken steps to improve
the timeliness of audit guidance, such as issuing audit risk alerts
and audit guides in loose-leaf form, which is a more timely process
than, for example, reissuing a particular audit guide.
The AICPA has also issued a number of publications that provide the
latest developments in auditing, in general, and in a number of
specialized industries, and to provide practical assistance. These
publications include audit risk alerts, practice alerts, auditing
procedures studies, and articles published in the AICPA's CPA Letter
and Journal of Accountancy.
--------------------
\12 CPA Audit Quality: Failures of CPA Audits to Identify and Report
Significant Savings and Loan Problems (GAO/AFMD-89-45, February 2,
1989); CPA Audit Quality: Status of Actions Taken to Improve
Auditing and Financial Reporting of Public Companies (GAO/AFMD-89-38,
March 1989); and Employee Benefits: Improved Plan Reporting and CPA
Audits Can Increase Protection Under ERISA (GAO/AFMD-92-14, April 9,
1992).
AUDITOR EDUCATION AND TRAINING
---------------------------------------------------------- Chapter 4:3
The need to expand undergraduate accounting curricula from 4 to 5
years has been a frequent topic of discussion over the years. Some
universities and states now require 5 years of study (or 150 credit
hours) for accounting majors. The AICPA has supported this expansion
and is currently developing strategies to assist states in planning
legislation to enact the 150-hour education requirement by the year
2000 for entry into the accounting profession. The AICPA is
undertaking this initiative to enhance the quality, appropriateness,
and value of the education of accountants.
Continuing professional education (CPE) influences the quality of
work performed by independent public accountants. CPAs are expected
to maintain their professional competence through a regular program
of continuing professional education. Continuing professional
education requirements for CPAs are set by the state board of
accountancy of the jurisdiction licensing the individual professional
as well as indirectly through membership in the SEC Practice Section
of the AICPA.\13
In January 1995, the SEC Practice Section revised its CPE
requirements. These new requirements are designed to ensure that
audit professionals obtain a substantial portion of their required
hours of CPEs in accounting and auditing subjects. Generally, CPA
firm professional staff must obtain at least 20 hours of qualifying
CPEs every year and at least 120 hours every 3 years. Under the new
rules, professionals devoting at least 25 percent of their time to
performing or supervising audits, reviews, or other attest
engagements (excluding compilations) must obtain at least 40 percent
of their required CPEs in subjects related to accounting and
auditing.\14 The AICPA currently is undertaking an initiative to
improve the appropriateness, quality, value, availability, and
delivery of professional education for CPAs.
--------------------
\13 GAGAS, issued by GAO, contain CPE requirements for audits of
government organizations, programs, activities, and functions, and of
government assistance received by contractors, nonprofit
organizations, and other nongovernment organizations.
\14 GAGAS require each auditor conducting audits that must adhere to
the standards to complete at least 80 hours of continuing education
and training every 2 years. At least 20 hours should be completed in
any 1 year of the 2-year period. Auditors responsible for planning
or directing the audit, conducting substantial portions of the
fieldwork, or reporting on the audit should complete at least 24 of
the 80 hours in subjects directly related to the government
environment and to government auditing.
CERTAIN TYPES OF AUDIT QUALITY
CONTROL WEAKNESSES ARE
CONTINUING PROBLEM AREAS
---------------------------------------------------------- Chapter 4:4
As previously discussed, analysis of peer review results shows that
the peer review program has been successful in strengthening the
audit function. Peer review results also show that accounting firms
are continuing to experience audit documentation and audit reporting
problems, areas which have been the concern of past studies of
auditor performance. Although the vast majority of these
deficiencies are not considered serious enough by the peer reviewers
to qualify their reports, repeated finding of these types of
deficiencies is troubling.
GAAS require auditors to obtain and document in the working papers
sufficient evidence to support the auditor's opinion on financial
statements and prescribes specific audit report language. GAAP
prescribes financial statement form and content. Our analysis of the
553 letters of comments issued in conjunction with peer reviews
performed from 1992 through 1994 showed that 402, or about 73
percent, of the letters cited documentation deficiencies, with no
major difference regarding the frequency of such deficiencies among
the smallest CPA firms (firms that audit fewer than five SEC
registrants) and those CPA firms that audit 30 or more SEC
registrants. Documentation deficiencies occurred in important areas
of the audit, such as the analytical procedures performed, accounts
receivable, internal controls, sampling methodologies, risk analysis,
and the establishment of materiality levels used by auditors when
evaluating the significance of financial statement accounts. In
addition, auditors did not always adequately document their
consultations with experts on accounting/auditing issues or their
communications with company audit committee members. Further,
concurring partners did not always document their review in the audit
working papers. Of the 402 letters of comments that disclosed
documentation deficiencies, in 69 cases, or about 17 percent,
documentation problems were considered serious enough to cause a
modified opinion on the firm's quality control processes.
Our analysis also showed that about 214, or about 39 percent, of the
553 letters of comments issued in connection with peer reviews
performed from 1992 through 1994 cited inadequate financial statement
disclosures, departure from required audit reporting language, and
other reporting deficiencies. This percentage was slightly less for
CPA firms that audited 30 or more SEC registrants. Noncompliance
with GAAP and/or GAAS occurred in several areas, including related
party transactions, income taxes, pension funds, and the
concentration of credit risks. In some cases, the reporting
deficiencies identified were serious enough to recall and revise the
audit report and related financial statements to make them conform
with GAAP. Of the 214 letters of comments that disclosed reporting
deficiencies, in 47 cases, or in about 22 percent of the letters,
reporting problems were considered serious enough to cause a modified
opinion on the firm's quality control processes.
During a firm's subsequent peer review, the review team evaluates the
effectiveness of actions taken by the firm in relation to the prior
review's findings. If similar findings reoccur, the subsequent
letter of comments will disclose the fact that a particular
deficiency was also identified in the firm's prior review. Our
review of 553 letters of comments issued for 1992 through 1994 showed
that 73, or about 13 percent of the letters, noted that a specific
deficiency had been cited in the firm's previous peer review report.
Recurring deficiencies raise questions concerning the effectiveness
of the firm's corrective actions.
The AICPA's general audit risk alerts contain a section that sets
forth certain reminders to auditors based on frequently recurring
comments noted in peer review letters of comments. Our review of
audit risk alerts for the last several years highlights the fact that
problems discovered through peer review, even though disclosed in the
audit risk alerts, continue to occur. Types of recurring problems
reported in recent audit risk alerts include deficiencies in working
paper documentation, written audit programs, financial statement
disclosures, communication with audit committees, communication of
internal control related matters, and obtaining and documenting an
understanding of the client's internal control system.
OBSERVATIONS
---------------------------------------------------------- Chapter 4:5
The accounting profession has been responsive to concerns about audit
quality. The AICPA has instituted and strengthened monitoring and
disciplinary mechanisms to improve audit quality. For example, the
AICPA established a peer review program, created the QCIC to
investigate audit deficiencies, and created the POB to represent the
public interest. The AICPA also strengthened concurring partner
review requirements to improve audit quality. To address concerns
about the timeliness of auditing guidance, the AICPA now issues audit
risk alerts and industry accounting and audit guides in a loose-leaf
format. The AICPA also restructured professional standards, which,
among other things, increased continuing education requirements for
its members.
The results of peer reviews show that the AICPA's program has had a
positive impact on audit quality. Firms that audit the vast majority
of SEC registrants are undergoing peer review, and statistics show
that the number of modified peer review reports decreased
substantially since 1991--the year in which most initial peer reviews
were conducted. The percentage of modified peer review reports is
now relatively low. These findings show that the peer review program
is effective in improving and maintaining audit quality.
Generally, the peer review results show that smaller CPA firms (firms
that audit fewer than 30 SEC registrants) have more serious problems
with the quality of audits than the large firms. However, audit
documentation and reporting problems are weaknesses that continue to
be frequently found regardless of the size of the firm. Although
audit documentation deficiencies are occurring in important areas of
the audit, such as risk analysis and setting materiality levels, they
may be considered a less serious problem in that sufficient audit
work was usually done, but the written evidence of the work having
been done was insufficient. These types of deficiencies may be the
result of auditors' emphasis on getting the job done at the least
cost. Reporting problems are more serious, especially those
involving inadequate disclosure, since the public is receiving
information that is not fully presented in accordance with standards.
The accounting profession's efforts to improve audit quality are
impressive. However, continuing reporting and documentation
weaknesses can detract from the credibility of the profession and
expose the firms in the event of a business failure and resulting
lawsuit. Closer attention to audit supervision, which may be
achieved in part through the AICPA's enhanced requirements for
concurrent partner review, should help to prevent or lessen
documentation and reporting deficiencies.
COMMENTS AND OUR EVALUATION
---------------------------------------------------------- Chapter 4:6
The AICPA and the POB provided comments on the accounting
profession's efforts to improve audit quality through the peer review
program. Both the AICPA and the POB were pleased with our positive
findings regarding the effectiveness of the peer review program and
stated they will continue to seek ways to strengthen audit quality.
With respect to the specific audit documentation and reporting
deficiencies we noted, the AICPA stated the SEC Practice Section is
currently considering what additional steps firms or the SEC Practice
Section should take to improve this situation.
ACCOUNTING AND AUDITING STANDARD
SETTING AND THE FINANCIAL
REPORTING MODEL
============================================================ Chapter 5
The structure for setting accounting and auditing standards has
evolved since the SEC was established in 1934. The current
structure, which has resulted from the recommendations of many
studies largely since the 1970s,\1 is designed to include
professional expertise and broad participation in setting standards
in order to be more responsive to the needs of those who rely on
financial statements. Although the accounting profession has taken
efforts to encourage public participation in standard setting, these
efforts have not been as successful compared with participation by
other groups, such as financial statement preparers and accountants.
Further, concerns continue over the timeliness of issuing accounting
standards and the relevance and usefulness of historical cost-based
financial reporting. Pressures from self-interest groups and the
difficulties of working with the current financial reporting model
that is a complex mix of historical and more current values may be
contributing to the accounting profession's difficulty in setting
timely and relevant accounting standards for financial reporting.
However, standard setting is inherently difficult and controversial.
Recent studies have identified the need for a more comprehensive
model of business reporting that would include the current
mixed-attribute financial reporting, but also provide users with
forward-looking information and other financial and nonfinancial
information to help users understand the business.\2 The standard
setters and the SEC are considering the studies, but major barriers,
such as concerns over cost, current financial statement disclosure
overload, and litigation, must be resolved. These are reasonable
concerns, and it will take strong leadership to improve the relevance
and usefulness of financial reporting.
--------------------
\1 Refer to tables II.3 and II.4, appendix II (GAO/AIMD-96-98A) for
the recommendations made to improve standard setting.
\2 Refer to table II.5, appendix II (GAO/AIMD-96-98A) for the
recommendations concerning financial reporting.
FORMING THE STANDARD-SETTING
STRUCTURE AND PROCESSES
---------------------------------------------------------- Chapter 5:1
Since the collapse of the stock market in 1929, the public has looked
to the federal government to protect its interests and particularly
the interests of the investing community. The Securities Exchange
Act of 1934 established the SEC to regulate securities offerings and
capital markets. The Act gave the SEC specific authority to
establish rules governing financial reports of public companies to
ensure full and fair financial reporting. In 1938, the SEC formally
delegated responsibility for establishing financial accounting and
reporting standards for public companies to the accounting profession
and has permitted the accounting profession to set auditing standards
for itself.\3
Acting on this delegation of authority, the accounting profession
over the years has established several standard-setting bodies to set
accounting and auditing standards. In 1938, the AICPA authorized its
Committee on Accounting Procedure (CAP) to issue accounting
standards. The Committee was active for 20 years and issued 51
accounting research bulletins defining "generally accepted accounting
principles." In response to criticisms that the standards issued by
CAP allowed for widely divergent alternative accounting practices,
and the need for a greater full-time research support, in 1959, the
AICPA replaced CAP with the Accounting Principles Board (APB). In
its 14 years of existence, the APB issued 31 opinions dealing with
particular accounting practices before it was replaced in 1973 by
FASB as discussed below.
The development of auditing standards can be traced back to at least
1917, when the American Institute of Accountants (predecessor to the
AICPA) issued a memorandum on balance sheet audits for the Federal
Trade Commission. The movement toward standardization in auditing
resulted primarily from the negative findings in the McKesson &
Robbins fraud case in the late 1930s, which demonstrated that
auditors needed much more guidance to enable them to meet their
responsibilities to stockholders and the general public. In
response, in 1939, the AICPA established the Committee on Auditing
Procedure (CAuP) to provide guidance on the procedures practitioners
should follow in auditing financial statements. In 1972, the AICPA
shifted its emphasis from providing guidance on audit procedures to
defining broad audit standards that practitioners should satisfy.
Reflecting this change, the CAuP was replaced by the Auditing
Standards Executive Committee (AudSEC). As discussed below, the
AudSEC was replaced in 1978 by the current audit standard-setting
body, the ASB.
In the late 1960s, the rapid expansion of accounting firms,
increasingly complex and innovative business practices, and the rise
of corporate mergers caused problems that created a wave of criticism
of corporate financial reporting. Several study groups, formed to
address concerns with the accounting and auditing standard-setting
processes, reported that the processes did not adequately serve the
public interest because groups outside the profession, such as
investors and creditors, did not participate meaningfully in
developing standards. The groups also reported that the accounting
profession's standard setters did not have the necessary means to
develop high-quality standards in a timely manner. Further, several
groups reported that auditing standards did not define the auditor's
responsibilities in accordance with public expectations of auditors.
--------------------
\3 The accounting profession actually began setting accounting
standards in 1934 in conjunction with the New York Stock Exchange.
The SEC's delegation of authority accelerated the AICPA's movement
toward standard setting.
STRUCTURAL CHANGES SINCE 1972
AND USER PARTICIPATION IN
SETTING ACCOUNTING STANDARDS
---------------------------------------------------------- Chapter 5:2
In 1971, the AICPA appointed a study group on the establishment of
accounting principles (Wheat Committee) to make recommendations for
improving the process of setting accounting standards. The Wheat
Committee's 1972 report concluded that the responsibility for
accounting standards should stay within the private sector, but
should be removed from the AICPA and vested in a full-time, salaried,
independent accounting standards board.\4 Appointments to the board
as well as funding for the board and oversight of its operations
would be the responsibility of an independent foundation comprising
several organizations including those representing the profession,
preparers, users, and educators.\5 The Wheat Committee also suggested
that an advisory council be created to advise the accounting
standards board about its priorities, help it to set up task forces,
react to proposed standards, and otherwise assist the board. The
Committee believed its suggested structure would allow for a
standard-setting board that would be seen as independent and that
would be able to attain better results faster. The Committee also
noted that such a structure would facilitate broader participation in
standard setting by drawing on a number of important groups affected
by the standards. In addition, the Committee believed that standards
developed under this arrangement would benefit the public interest
because they would have a broad base of support and be developed by
individuals possessing a wide range of expertise.
The accounting profession responded to the concerns and
recommendations of the Wheat Committee by revamping the accounting
standard-setting process. In 1972, the AICPA and other sponsoring
organizations established a three-part independent organization to
set financial accounting and reporting standards for private-sector
entities, including business and not-for-profit organizations. The
organization is composed of FASB, the Financial Accounting Foundation
(FAF), and the Financial Accounting Standards Advisory Council
(FASAC). FASB, which began operations in 1973, is the private body
that establishes authoritative financial accounting and reporting
standards. FASB is composed of seven full-time members. The members
are required to sever all ties with their former employers upon
appointment. According to the FASB members, this has helped them to
focus on user needs and the public interest while setting
standards.\6 The FASB members are appointed for 5-year terms and are
eligible for reappointment for one additional 5-year term. FAF is
the parent organization.\7 FAF trustees appoint members to FASB,
raise funds for its activities, and exercise general oversight over
the standard-setting process. To help protect FASB from undue
influence by any one group, FAF's trustees are elected by
representatives of FAF's sponsoring organizations.\8 As of June 1996,
membership of FAF's 16-member board of trustees included 5 trustees
who represented preparers, investment professionals, and other
business interests; 4 trustees from the profession; 3 from
government; 1 from academia; and 1 who represented the public
at-large.\9 By nature of that membership, the public was relatively
under-represented. About two-thirds of FASB's funding comes from
sales of subscriptions and publications, with most of the remaining
contributed by the accounting profession and the preparers of
financial statements.\10
FASAC was instituted to provide advice to FASB on technical issues,
project priorities, selection of task forces, and other matters
likely to concern FASB. FAF trustees appoint FASAC members to 1-year
terms (terms are renewable, generally not to exceed four consecutive
terms), and, according to FAF officials, the trustees attempt to
balance views by appointing as members representatives of users,
preparers, auditors, and educators. To increase standard setters'
focus on the information needs of users and to encourage users to
increase the level of their involvement in the standard-setting
process, in 1996, FASAC increased by two the number of seats held by
users and decreased by one the number of seats held by preparers.
However, users of financial statements still have relatively far less
representation which, in part, may be a function of their relatively
lesser expertise in the subject. As of May 1996, there were 33 FASAC
members of whom 12 percent represented users, 43 percent represented
preparers, and 27 percent represented auditors. The remaining 18
percent represented educators and others. Further, although FAF
attempts to balance the interests of members in appointing FASAC
members, as a member of FASAC, we have observed what appear to be
some views expressed at FASAC meetings that do not objectively
address the merits of the accounting issue under discussion.
Reports of the Moss and Metcalf Subcommittees issued in 1976\11 and
1977,\12 respectively, stressed the importance of public
participation in standard setting. For example, the Metcalf
Subcommittee's 1977 staff study stated that public participation and
strong oversight by the Congress are essential to safeguarding the
public interest in any standard-setting procedure adopted. This
statement was made based on the theory that in many cases, the
problems which led to corporate failures and financial difficulties
were caused or aggravated by the use of accounting practices which
failed to reflect accurately the substance of corporate business
activity. The staff study recommended that the federal government,
such as the SEC, GAO, or a federal board, should set accounting
standards in order to ensure that the public interest is protected.
Similarly, the Moss Subcommittee recommended that the SEC, as part of
its role in ensuring an adequate system of corporate accountability,
should set accounting standards. The Metcalf Subcommittee, while
believing it was acceptable for the private sector to set accounting
standards, also felt the SEC needed to more vigorously oversee the
standard-setting process to ensure that the public interest is
protected.
The SEC has taken the position that FASB should continue to set
accounting standards for the private sector. The SEC stated that it
will act directly to establish proper accounting standards if FASB
fails to act within a reasonable time, or when fair presentation of
financial information would not otherwise be achieved.\13 To date,
one case where the SEC "nullified" a FASB statement occurred in the
late 1970s and involved oil and gas accounting. However, the SEC
does express its views on standards proposed by FASB and may not
always fully agree with final standards adopted by FASB. For
example, the SEC believed that a 1994 FASB statement\14 concerning
disclosures of financial instruments did not fully satisfy the need
for qualitative and quantitative disclosures of derivatives policies
and activities. In December 1995, the SEC proposed regulations to
expand requirements for financial statement disclosures of
derivatives policies and activities.
FASB members and their staff told us that they have continued to seek
ways to broaden participation in standard setting. These efforts are
reflected in FASB's mission statement, its formal standard-setting
process, and its strategic planning initiative.\15 FASB's stated
mission is to establish and improve standards of financial accounting
and reporting for the guidance and education of the public, including
issuers, auditors, and users of financial information. To achieve
this, the FAF trustees have appointed CPAs, financial statement
preparers and users, and educators to FASB. FAF officials and FASB
members stated that this has allowed FASB to draw on a broad range of
expertise and has encouraged all constituency groups to participate
in setting standards. In addition, FASB has developed an extensive
deliberative process, which in its view includes more demanding
requirements to enable public participation than are included in the
Administrative Procedure Act.\16 FASB's rules of procedure require
that all its meetings be open to the public. Its deliberative
process includes preliminary evaluation of a problem, admission of a
project to its agenda, early deliberations, tentative resolution,
further deliberations, and final resolution.
According to FASB members and their staff, obtaining input from
various constituency groups is a key activity, especially during
their deliberations. FASB solicits participation by issuing
discussion memorandums, invitations to comment, and exposure drafts
of proposed standards. FASB members told us that users have not
participated in standard setting to the extent of preparers and
auditors, and that they have made special efforts to obtain input
from this constituency group. Also, as mentioned above, FASB's
current strategic planning initiative includes as one of its
objectives to build broader acceptance for its process among
constituents, including users, preparers, academicians, and auditors.
--------------------
\4 Establishing Financial Accounting Standards, Report of the Study
on Establishment of Accounting Principles, AICPA, March 1972.
\5 At the time the Wheat Committee reviewed the standard-setting
process, the APB, composed of 18 part-time volunteer members--all of
whom were AICPA members--set accounting standards.
\6 Use of the reference to FASB board members in this report refers
to the views of individual board members whom we interviewed and does
not represent the official position of FASB.
\7 FAF is organized as a not-for-profit corporation under Section
501(c)(3) of the Internal Revenue Code.
\8 FAF consists of 16 trustees, 13 of whom are elected by
representatives of FAF's sponsoring organizations and 3 of whom are
elected by the other trustees. The sponsoring organizations are the
AICPA; the American Accounting Association; AIMR; the Financial
Executives Institute; the Securities Industry Association; the
National Association of State Auditors, Controllers, and Treasurers;
the Institute of Management Accountants; and the Government Finance
Officers Association.
\9 At that time, FAF, at the urging of the SEC, was considering the
appointment of four additional public representatives to replace two
vacant positions previously held by preparers of financial statements
and two positions currently held by a preparer and a representative
of the accounting profession. A later section of this chapter,
"Pressures Challenge FASB's Independence," discusses the agreement
reached by FAF and the SEC.
\10 According to FAF's 1995 annual report, contributions to FASB,
which accounted for 32 percent of FASB's operating revenue in 1995,
were received from the following groups: 55 percent from the
accounting profession, 37 percent from industry, and 8 percent from
other groups. Sales of subscriptions and publications accounted for
68 percent of FASB's operating revenue in 1995.
\11 Federal Regulation and Regulatory Reform, Report by the
Subcommittee on Oversight and Investigations of the House Committee
on Interstate and Foreign Commerce, October 1976.
\12 The Accounting Establishment, Staff Study prepared by the
Subcommittee on Reports, Accounting, and Management of the Senate
Committee on Government Operations, printed March 31, 1977, and
Improving the Accountability of Publicly Owned Corporations and Their
Auditors, Report of the Subcommittee on Reports, Accounting, and
Management of the Senate Committee on Governmental Affairs, November
1977.
\13 SEC testimony before the Subcommittee on Reports, Accounting, and
Management, Senate Committee on Governmental Affairs, June 13, 1977.
\14 Statement of Financial Accounting Standards No. 119, SFAS
Disclosure About Derivative Financial Instruments and Fair Value of
Financial Instruments, FASB, October 1994.
\15 In 1995, FASB undertook a strategic planning initiative to
develop a vision to carry the organization into the next century and
to identify several strategic directions to achieve that vision.
\16 The Administrative Procedure Act governs rule-making by the
federal government and exists to ensure that all affected parties
have an opportunity to participate in the rule-making process.
ACTIONS BY STANDARD SETTERS TO
ADDRESS QUALITY AND TIMELINESS
OF ACCOUNTING STANDARDS
---------------------------------------------------------- Chapter 5:3
To address concerns about the quality and timeliness of accounting
standards, the AICPA Study Group on The Objectives of Financial
Statements (Trueblood Committee) in 1973 recommended that FASB
consider its findings on the objectives of financial reporting in
developing a conceptual framework to improve the quality of
accounting standards.\17 The Metcalf Subcommittee in 1977, and FAF\18
at various times, recommended additional staff resources for setting
standards. Also, in 1982, FAF recommended that FASB develop a plan
to identify and provide timely guidance on emerging accounting issues
that have important financial reporting implications.\19
--------------------
\17 Objectives of Financial Statements, Report of the Study Group on
the Objectives of Financial Statements, AICPA, October 1973.
\18 The Structure of Establishing Financial Accounting Standards,
April 1977; Interim Review of the FASB and FASAC, May 1979; and
Reports of the Special Review Committee, Financial Accounting
Foundation, July and December 1985.
\19 Operating Efficiency of the FASB, Report of the Structure
Committee, Financial Accounting Foundation, August 1982.
ACCOUNTING CONCEPTS
DEVELOPED
-------------------------------------------------------- Chapter 5:3.1
In response to the recommendation of the Trueblood Committee, FASB
developed six Statements of Financial Accounting Concepts that are
intended to serve as the theoretical basis for its pronouncements.
The purpose of the statements is to set forth the objectives of
financial accounting and reporting and provide a conceptual framework
for deliberations about accounting matters. The Board believed that
the statements would enhance the consistency of its official
pronouncements and improve the efficiency of the standard-setting
process. However, in developing the statements, the Board recognized
that there was significant support for a mixed model of financial
reporting that measured some transactions and balances on the basis
of historical costs and others on the basis of market values, and
expected such mixed model accounting and reporting to continue. As
discussed later, acceptance of the mixed model leads to standards
which may not always be consistent, and adds complexity and the need
to overly supplement financial statements with footnote disclosures.
The model also enables what is referred to as "cherry picking" or
managed earnings (selectively picking a financial reporting time to
recognize gains or losses in financial statements) and has
contributed to indecision on some urgent issues and resulting delays
in setting needed standards.
FASB STAFF RESOURCES
-------------------------------------------------------- Chapter 5:3.2
FASB responded to recommendations for more staff resources by
establishing and maintaining a staff of 40 to 50 professional
individuals to facilitate the standard-setting process. The staff is
headed by a director who holds equal status with Board members
regarding compensation and participation in the Board's proceedings.
FASB attempts to control the quality of its staff by selecting as
project managers individuals who have achieved the equivalent of
manager status in large accounting firms. According to most Board
members and others we interviewed, FASB staff is sufficient. Through
our activities with FASAC and through other contacts with the staff,
we agree.
FASB CREATES EMERGING ISSUES
TASK FORCE TO IMPROVE
TIMELINESS OF STANDARDS
-------------------------------------------------------- Chapter 5:3.3
In 1984, FASB responded to recommendations to improve the timeliness
of standards by creating the Emerging Issues Task Force (EITF) to
provide timely accounting and reporting guidance for new and
different types of transactions, and by relying on the AICPA's
Accounting Standards Executive Committee (AcSEC) to set standards for
certain issues. FASB established EITF as a permanent task force.
FASB selects the EITF's current 13 members primarily from public
accounting firms and also from public companies and major
associations of financial statement preparers, such as the Financial
Executives Institute. Auditors and preparers are selected because
FASB believes they are in the best position to identify new
accounting issues early and determine the appropriate accounting and
reporting treatment before divergent practices become entrenched.
The EITF membership terms are not limited. The members of EITF
attempt to resolve issues quickly by reaching consensus as to how to
account and report for new and different transactions using existing
authoritative pronouncements.\20 If the members fail to reach a
consensus about how a new or different transaction should be treated,
or FASB disagrees with an EITF consensus, FASB may choose to add a
project to its agenda to resolve the issue. Proceedings of the EITF
are documented in EITF Abstracts.
FASB members stated that they are also improving the timeliness of
standards by relying on AcSEC to develop standards for specific
industries and narrowly focused accounting issues.\21 By relying on
AcSEC to set certain standards, FASB attempts to improve its
efficiency by focusing on high-priority and broader accounting and
reporting issues. To ensure that AcSEC's pronouncements do not
conflict with its own, FASB clears all AcSEC proposals and
pronouncements before they are issued.
In spite of FASB's efforts to address new and emerging issues in a
timely manner, several representatives of preparer and user groups
told us that FASB is still not proactive enough in addressing
emerging accounting questions and takes too long to issue standards.
In FASB's 23 years of existence, it has issued over 120 financial
accounting standards. According to the FASB records, it has taken on
average 2 years to issue specific standards. But for some of the
more complex, controversial accounting treatments, such as standards
for employers' accounting for pensions, stock options, and
derivatives transactions, it has taken much longer. For example,
FASB's financial instruments project has been ongoing for about 10
years. Although certain standards related to derivatives have been
issued, FASB has not yet issued a comprehensive standard for
accounting for derivatives transactions.\22
Several FASB members stated that the deliberative process, which
includes public comment on proposed standards, is often very lengthy.
Similarly, the SEC Chairman recently stated that FASB's use of
lengthy comment periods and public hearings sometimes has caused its
rule-making process to drag on for many years. However, according to
FASB officials, a lack of timeliness is the price that must often be
paid in order to ensure that each of FASB's diverse constituency
groups has an adequate opportunity to provide input into the
establishment of a specific standard. Further, some current and
prior FASB members stated that the 5 to 2 super majority rule, which
was reinstated by the FAF trustees in 1990, slows the
standard-setting process down.\23 They stated that this rule was
backed strongly by the preparer community and is not likely to be
changed. Although some prior board members stated that the
two-thirds majority rule was reinstated to simply limit the number of
new standards, several representatives of major preparer groups
stated that it functions primarily to ensure that only standards that
will result in long-term improvements in financial reporting will be
issued.
In 1990, we supported the super majority rule as being beneficial in
helping to achieve quality of standards and their general acceptance.
However, we recognized that this super majority vote could add to the
difficulty and timeliness of obtaining FASB approval, particularly on
very complex, critical, and controversial issues. Based on our
activities with FASAC, we also believe that the complexities of
setting standards using a mixed attribute financial reporting model
and the lack of consistency it causes in standard setting adds to the
length of time to develop standards. Also, we believe that
self-interest pressures brought at times by preparers and their
auditors adds to the debate and, accordingly, the time to set
standards. For example, discussions related to measurement of some
financial instruments at fair market value and the effects of that
measurement in preparing financial statements have taken considerable
time.\24 Also, as previously mentioned, views expressed at FASAC
meetings at times do not objectively address the merits of the
accounting issue under discussion. While some bias can be expected,
we believe that such views add to the length of time to issue
standards, as efforts are devoted by FASB and other FASAC members, as
well as staff, to addressing such comments.
FAF and FASB have acknowledged the concern over the timeliness of
issuing standards. Accordingly, FASB has adopted, as part of its
strategic planning initiative, an objective to make standard setting
more timely and efficient. FASB's strategic plan states that FASB,
"along with the FAF Trustees, are committed to improving independent,
private-sector standard setting and providing leadership in shaping
the debate over the future of financial reporting." The plan
acknowledges that improvements can and should be made to build
broader acceptance for FASB's process and make standard setting more
timely and efficient. According to FAF, FASB has adopted and is now
implementing specific strategies to improve its agenda-setting
process, to make FASB standards easier to understand and implement,
and to complete projects more rapidly.
--------------------
\20 A consensus of EITF is deemed to exist when not more than 2 of
the 13 members disagree with the suggested accounting approach. An
EITF consensus is considered to be GAAP under SAS No. 69, The
Meaning of "Present Fairly in Conformity With Generally Accepted
Accounting Principles" in the Auditor's Report, which was issued by
the AICPA in 1992. Moreover, the SEC has said that it will question
registrants' accounting practices that differ from an EITF consensus.
\21 The AICPA established the AcSEC in 1973 to serve as its official
voice on accounting matters before FASB. Over time it has assumed
the role of a standard setter primarily due to FASB's heavy caseload.
According to SAS 69, pronouncements issued by AcSEC, such as
Statements of Position and Industry Accounting and Auditing Guides,
are GAAP.
\22 During its work on financial instruments, FASB has issued
Statement of Financial Accounting Standards (SFAS) No. 105,
Disclosure of Information About Financial Instruments With
Off-Balance-Sheet Risk and Financial Instruments With Concentrations
of Credit Risk, 1990; SFAS No. 107, Disclosures About Fair Value of
Financial Instruments,1991; and SFAS No. 119, Disclosure About
Derivative Financial Instruments and Fair Value of Financial
Instruments, 1994. FASB has not yet issued a standard for accounting
for derivatives. However, on June 20, 1996, FASB issued an exposure
draft seeking comments on proposed accounting standards for
derivatives.
\23 In May 1990, FAF trustees changed FASB's voting rule to a super
majority (5 of 7 members) from the simple majority (4 of 7 members)
that had existed since 1978. Before 1978, the 5 to 2 vote had been
required.
\24 Market value is based on the concept of fair value, which is
generally defined as the price that could be obtained in an arms
length transaction between willing parties in other than a forced or
liquidation sale.
PRESSURES CHALLENGE FASB'S
INDEPENDENCE
---------------------------------------------------------- Chapter 5:4
In obtaining views of constituency groups as part of FASB's due
process, FASB has at times been confronted by strong opposition to
draft standards that it is considering. For example, the debate over
accounting for stock options produced a great deal of controversy
among businesses, the Congress, and FASB's trustees. Such pressures
challenge FASB's ability to maintain its objectivity in setting
accounting rules that will be generally accepted and provide relevant
financial reporting for users.
To be successful, FASB must be responsive to the broad public
interest, and it must be able to carry out its mandate in the face of
strong, honestly held disagreement on virtually every important
issue. The SEC Chairman recently stated that "to be effective, FASB
must be able to address important, and usually controversial,
accounting issues on a timely basis and to resolve those issues with
credible, conceptually sound accounting standards that serve the
interest of investors, the public, and the numerous constituencies
involved."\25 In a recent speech, the SEC Chairman stated that the
independence of FASB is of extreme importance and if standards are
drawn, or even seem to be drawn, to favor corporate interests over
those of investors, faith in our markets will erode.\26 Also, the SEC
Chairman recently restated the SEC's support for keeping accounting
rule-setting in the private sector--but free of heavy pressures from
business.\27 The SEC Chairman suggested that a good way to strengthen
both the substance and perception of FASB's independence and the
overall effectiveness of the standard-setting process would be to
increase public representation among the trustees of FAF. The
Chairman requested that FAF have a majority of public representatives
as opposed to representatives of various groups with a stake in
accounting rules. Further, the Chairman wanted the SEC to have the
power to approve the trustees of FAF.
In recent correspondence to the SEC, FAF stated its intentions to
promptly appoint two at-large public trustees to replace positions
previously held by preparers of financial statements.\28 However, as
noted in its letter to the SEC, FAF also expressed concern that a
controlling majority of public interest trustees would exclude from
consideration many dedicated individuals who have the knowledge,
experience, and perspective needed to best serve the public interest.
The SEC Chairman recently advised us that he is not pressing the
issue of the SEC's approval of the trustees, but he believes the
public interest could be further enhanced by a public representative
being the leader of FAF since a public leader could enhance FAF's
ability to increase user participation in standard setting. On July
8, 1996, FAF announced that, in consultation with the SEC, it had
named three individuals as public members of the board of trustees of
FAF and planned to extend an offer to a fourth public member. With
this change in composition, the SEC and FAF reached agreement that
the FAF trustee membership will be balanced between constituent and
public members.
--------------------
\25 Letter from the Chairman, SEC, to the President, Financial
Executives Institute, dated February 7, 1996.
\26 Speech by SEC Chairman Arthur Levitt on April 24, 1996, before
the Economic Club of Chicago.
\27 The SEC Chairman made this statement in response to recent
recommendations made by the Financial Executives Institute, an
organization of corporate financial executives, to reduce the size of
FASB and to increase business's influence on FASB's rule-setting
process. The Financial Executives Institute, which has recently
expressed concern that FASB is too big, moves too slowly, and often
reflects an antibusiness bias, felt that these recommendations would
strengthen FASB and expedite the standard-setting process.
\28 Letter from the President, FAF, to the Chairman, SEC, dated May
20, 1996.
EFFORTS TO IMPROVE THE QUALITY
AND TIMELINESS OF AUDITING
STANDARDS
---------------------------------------------------------- Chapter 5:5
The quality and timeliness of auditing standards have been the
subject of congressional reports and studies conducted by the Cohen
Commission, the Special Committee of the AICPA to Study the Structure
of the Auditing Standards Executive Committee (Oliphant
Committee),\29 and the Treadway Commission. These groups found that
the resources and structure for the auditing standard-setting process
needed to be enhanced to optimize the quality and timeliness of
standards. The studies made recommendations for more staff resources
and a smaller standard-setting body to improve the efficiency of the
process. In 1978, the Cohen Commission recommended that this smaller
standard-setting body be composed of full-time members compensated
only by the AICPA. In 1987, the Treadway Commission recommended that
the chairman and vice chairman of auditing standards should serve
full time and that the AICPA should sufficiently compensate both
full-time and part-time members in order to draw top talent from
firms of all sizes. In contrast, the Oliphant Committee, in 1978,
suggested that the standard-setting body be composed of only
part-time members and that the AICPA compensate members at their
request.\30
--------------------
\29 Report of the Special Committee of the AICPA to Study the
Structure of the Auditing Standards Executive Committee, AICPA, May
1978.
\30 The Oliphant Committee was established by the AICPA as a result
of the Cohen Commission's recommendations concerning the setting of
auditing standards. Specifically, the AICPA was not convinced of the
soundness of the Cohen Commission's recommendation that AudSEC should
be replaced with a full-time board. The AICPA established the
Oliphant Committee to study the restructuring of AudSEC.
AICPA CREATES THE AUDITING
STANDARDS BOARD
-------------------------------------------------------- Chapter 5:5.1
In response to the concerns over setting auditing standards, in 1979,
the AICPA reorganized the 21-member AudSEC into a smaller
standard-setting body, the ASB. The purpose for establishing the ASB
was to have a more efficient standard-setting body composed of
representatives from firms of all sizes and from nonpublic accounting
organizations. The ASB is typically composed of 15 volunteer members
all of whom are CPAs but come from a diverse background (6
representatives from large firms, 1 representative from a
medium-sized firm, 6 representatives from small firms, an
academician, and a government official). The members are appointed
by the AICPA's Board of Directors and usually serve for three
consecutive 1-year terms. Although the AICPA Board of Directors
believes that limited terms encourage participation on the ASB,
several ASB members stated that current terms are too short and
result in turnover that impedes the effectiveness of the ASB.
To encourage small accounting firm practitioners to be involved in
the auditing standard-setting process, ASB members can request
compensation of up to $40,000 annually from the AICPA. Currently,
only members of small firms and the academic representative are
compensated. According to ASB members and AICPA officials, the AICPA
chose not to implement the Cohen Commission's recommendation to
establish a full-time standard-setting board because it believed that
it was important for members to continue to practice while serving as
standard setters in order to stay on top of important auditing
issues. Further, according to several ASB members, part-time
membership with limited terms encourages firms of all sizes to
contribute time and resources to the standard-setting process.
Currently, ASB members contribute substantial amounts of time to
standard setting. According to the ASB Chairman and other Board
members, the Chairman spends about 70 percent of his time on standard
setting, while the other members devote about 25 percent of their
time to the process.
ASB ESTABLISHES THE AUDIT
ISSUES TASK FORCE
-------------------------------------------------------- Chapter 5:5.2
To further improve the quality and timeliness of auditing standards,
the ASB also created the Audit Issues Task Force (AITF). AITF issues
interpretations of auditing standards, monitors the work of the ASB's
various task forces, and helps ASB monitor emerging auditing issues.
The AITF chairman selects several board members to serve with him or
her on AITF.
STAFFING FOR AUDIT STANDARD
SETTING IS LIMITED
-------------------------------------------------------- Chapter 5:5.3
Notwithstanding the fact that several studies specifically called for
more staff resources to improve the quality and timeliness of
auditing standards, board members stated that staffing levels for
auditing standards at the AICPA have decreased over the last 5 years.
Currently, there are six staff members (one director and five
technical managers), all of whom are CPAs, specifically assigned to
the ASB. The director and technical managers each typically supports
three or more task forces, and at least two AICPA teams, such as a
fraud team or a training team. The ASB staff is also responsible for
issuing nonauthoritative auditing guidance such as audit risk alerts
and practice aids as well as reports and newsletters on ASB
activities. Some board members believe that with additional
qualified staff, the ASB could be much more timely in issuing
standards. However, members of the AICPA's Board of Directors
believe that staffing levels are sufficient at current levels because
auditing issues are addressed by other groups within the AICPA, such
as the Ethics Committee, the POB, and the specific industry
committees. We did not attempt to resolve the question of the
adequacy of staffing levels for setting auditing standards. However,
we believe there are other factors which may also limit the ability
to set standards which are timely and of high quality. Pressures
brought by audit clients concerning potentially added audit cost and
auditors' concern with additional exposure to unwarranted litigation
tend to make it difficult to expand the standards of professional
work.
USER PARTICIPATION IN
SETTING AUDITING STANDARDS
IS STILL LOW
-------------------------------------------------------- Chapter 5:5.4
As with accounting standards, the Moss Subcommittee and the Metcalf
Subcommittee's staff study recommended that auditing standards also
be established by the federal government\31 in order to increase
public participation in standard setting. The Metcalf Subcommittee
felt that participation by all segments of the public is necessary to
develop auditing standards that will restore public confidence in the
integrity of corporate reports. Other study groups, namely the Cohen
Commission, the Oliphant Committee, and the Treadway Commission did
not support making the process independent of the profession. In
fact, the Cohen Commission felt that removing standard setting from
the profession could have an adverse effect on the professionalism
and on auditors' motivation to accept and support auditing
pronouncements. All three of these groups believed that auditing
pronouncements would benefit from the participation of knowledgeable
people outside the profession and therefore believed that all
affected and interested parties should be encouraged to become more
involved in the auditing standard-setting process. The Oliphant
Committee specifically recommended that an advisory council, whose
members might include preparers, users, academicians, lawyers, and
other public representatives, be established to consult standard
setters about their agenda and auditing issues. The Treadway
Commission went further and recommended that either non-CPAs or CPAs
no longer in public practice represent about half of the ASB members.
The Treadway Commission recognized that ASB receives input from many
sectors, but felt that actual participation would enhance the value
and effectiveness of this input. The Commission believed that such a
board would look beyond the technical aspects of auditing and set an
agenda which reflects a broad range of needs, serving public and
private interest.
In response to concerns about lack of participation in the
standard-setting process, the AICPA took several actions to encourage
more participation by individuals outside the profession. For
example, all ASB meetings are required to be open to the public. In
addition, the ASB issues exposure drafts for all proposed
authoritative pronouncements to anyone who requests them and
generally allows 60 to 90 days for public comment. The AICPA chose
not to fully implement the Treadway Commission's recommendation to
have half of the ASB members be nonpractitioners because it believes
that auditors' experience places them in a better position to
establish standards that can be implemented in the field. Instead,
on two separate occasions, the AICPA attempted to encourage public
participation in the auditing standard-setting process by
establishing advisory committees composed partly of public
representatives. The AICPA intended the committees to advise
standard setters about priority issues and oversee the functioning of
project task forces. However, both committees were disbanded because
of low levels of input from the public representatives. According to
AICPA officials and one of the public representatives, the
committees' agendas focused primarily on technical issues and,
consequently, the public representatives were not able to provide
meaningful input into the standard-setting process. Subsequent to
disbanding the second advisory committee, the AICPA intended to hold
periodic symposiums to obtain public input on issues related to
auditing standards. Some AICPA officials and members of the ASB
stated that because of a lack of resources, few symposiums have been
held.
--------------------
\31 The Moss Subcommittee recommended that auditing standards be set
by the SEC. The Metcalf Subcommittee staff recommended that auditing
standards be established by GAO, the SEC, or by federal statute.
PRESENT FINANCIAL REPORTING
MODEL DOES NOT FULLY MEET
USERS' NEEDS
---------------------------------------------------------- Chapter 5:6
Business reporting is critical in promoting an effective allocation
of capital among companies. Therefore, financial statements, which
are at the center of present-day business reporting, must be relevant
and reliable to be useful for decision-making. Standard setters, the
SEC, and others have devoted considerable resources to maintaining
and improving financial statements. However, despite the continuing
efforts to enhance financial reporting, changes in the business
environment, such as the growth in information technology, new types
of relationships between companies, and the increasing use of complex
business transactions, constantly threaten the relevance of financial
statements and pose a formidable challenge for standard setters. In
addition, financial statements present the business entity's
financial position and results of its operations largely on the basis
of historical costs, which do not fully meet the broad range of user
needs for financial information.\32 Also, decisionmakers are placing
more importance on the values of companies' internally-generated
intangible or soft assets, which are generally not captured by the
current reporting model.\33 As a result, users have turned to other
information sources to obtain decision-related information.
Further, the current mixed model of financial reporting has had some
negative impacts in delaying FASB's decision-making as Board members
debate proposed accounting standards. For example, the Board, as it
continues deliberations to develop accounting standards for
derivatives, has debated the effects on financial statements of
mark-to-market accounting for derivatives that are not traded.\34
Mark-to-market accounting for all financial instruments would resolve
many of the issues the Board has been confronted with in developing
accounting rules for derivatives, but it is a very controversial
solution. For example, preparers believe that mark-to-market
accounting could result in inappropriate swings in earnings that do
not reflect actual transactions or management's intent as to when
such transactions would be closed and gains or losses actually
incurred.
In its 1993 report, the POB recommended that FASB add a project to
its agenda to study comprehensively the possibility of requiring the
reporting of fair value and changes in fair value rather than
historical transaction prices, either as a basis to propose changes
to financial accounting standards or to explain publicly why such a
change in accounting standards is impractical or otherwise
inappropriate. The POB did not take a position on the issue of
value-based versus historical cost-based accounting, but warned "as
long as a constant flow of criticism directed at the present
accounting model appears in journals and is espoused in speeches, the
public will remain confused and its confidence in accounting will
decrease." In response to the POB's report, FASB stated that it would
be beneficial to review the final reports of the AICPA's Special
Committee on Financial Reporting (Jenkins Committee) and of AIMR as
discussed below before considering whether to add a project on
comprehensive measurement. Recently the Wall Street Journal reported
that the average price of Dow Jones industrial stocks was 4.3 times
the stocks' average book value.\35 Although various factors can
affect a stock's market price, we believe the size of the margin
between the average book value and stock price is an indicator that
some important information used by investors is not in the financial
statements and that the historical cost-based values reported in
financial statements may not reflect economic reality for some
financial statements.
In 1991, the AICPA created the Jenkins Committee to address concerns
over the relevance and usefulness of financial reporting. Based on
its study of the information needs of professional investors and
creditors,\36 the Committee identified information gaps resulting
from the current reporting model, which focuses on financial
statements rather than on a broad range of users' information needs.
It also found that users view the current mixed attribute reporting
model as a generally satisfactory component of a comprehensive
reporting model and concluded that the historical cost benchmarks
provided by the current accounting model should continue for
measuring core assets and liabilities.\37 The current model provides
a reliable information base for analysts and does not have the degree
of volatility which mark-to-market accounting would have on reported
earnings. Accordingly, in its 1994 report, the Committee recommended
that standard setters develop a comprehensive reporting model that
includes both financial information and nonfinancial information.\38
In addition to financial statements and related disclosures, the
recommended model includes high-level operating data and performance
measures that management uses to manage the business, management's
analysis of changes in financial and nonfinancial data,
forward-looking information about opportunities, risks, and
management plans including discussions about critical success
factors, information about management and shareholders, and
background about the company including a description of the business,
its industry, and its objectives and strategies. Although the
Jenkins Committee acknowledged that many business entities already
provide much of this information in one form or another, it stressed
the need to develop a comprehensive reporting package that would
promote consistent reporting and the need to have auditors involved
in providing some level of assurance for each of the model's
elements. The Committee did not address the issue of adding internal
control reporting to the proposed comprehensive model.
The Jenkins Committee's report also points out that the importance of
intangible assets and the competitive advantage they may create for a
company appear to be increasing with the growing importance of
service companies in the economy, which tend to be intangible-asset
intensive. The Committee noted that even tangible-asset intensive
businesses appear to be competing in the marketplace by relying more
on technology, information, and speed than on heavy investment in
tangible assets. Despite the importance of intangible assets, the
Committee found that users generally oppose recognizing those assets
in the financial statements for several reasons, including that users
consider the valuation of intangible assets to be inherently
unreliable and their contribution to future cash flows difficult to
quantify. However, the Committee found that users would welcome
improvements in disclosures about the identity, source, and life of
intangible assets. According to the Committee, improved disclosures
in this area are consistent with its proposed model, which would
provide insight into the identity, importance, and sustainability of
a company's competitive advantage.
Though the Committee accepted forward-looking information as
desirable if there were more effective deterrents to unwarranted
litigation, it rejected company-prepared forecasts. Current
information, some of it nonpublic information, is available to
analysts who have the ability to interpret it and to forecast
earnings. With analysts' ability to make earnings forecasts and the
accounting profession's long-standing concern about the potential
liabilities flowing from forecasts, it is not surprising the
Committee did not include company-prepared forecasts as a part of the
reporting model. We believe that including such forecasts as a
component of the reporting model may result in better information.
Company preparers should have a better information base than analysts
to construct forecasts and the ability to make those forecasts
available to all readers of companies' annual reports. However, on
balance, the Jenkins Committee recognized a broad range of
information needs, as discussed above, that the current accounting
model does not provide.
In 1993, AIMR reached conclusions similar to the Jenkins Committee's
findings regarding the need for a comprehensive model of business
reporting.\39 AIMR's 1993 report recognized that globalization of the
capital markets and the spread of free enterprise throughout the
world had enormous implications for analysts, and that the rapid
accessibility of computing power was placing increasing the demand
for and use of financial information. AIMR also reported that the
current accounting model was developed to fit enterprises whose
economic activity was primarily in manufacturing or merchandising.
Today, services of all types--business, personal, and
financial--constitute a major portion of economic endeavors.
Although AIMR considered the current accounting model to be
fundamentally sound, it identified many areas that need improvement
to better capture the economic substance of transactions, such as
those involving intangible assets, and to meet the data needs of
financial analysts. AIMR did not support changing to mark-to-market
accounting, although it recognized the need for more current data,
particularly for financial services firms whose assets and
liabilities are composed almost entirely of financial instruments,
such as derivatives. AIMR also recognized the need for users' views
in the standard-setting process. It stated the primary purpose of
financial reporting is to provide information that is valuable to
financial statement users. AIMR stated that financial statement
users need much more of a direct voice in the process than they have
been given in the past.
We agree with the basic findings of both the Jenkins Committee and
the AIMR that the financial statement data provided by the current
financial model is a valuable component of the more comprehensive
model needed to meet users' needs. However, our work also shows the
problems that have arisen in the financial services industries from
the application of the mixed model where, inappropriately, financial
losses have not been recognized under historical cost-based
accounting while gains are recognized. For example, our reviews of
failed banks showed that flexible accounting rules for debt
investment securities allowed management in some cases not to
recognize losses in investment securities due to decreases in market
values.\40 We also believe that more direct users' input, including
more user membership on standard-setting boards and committees, is
needed to facilitate achieving an accepted comprehensive reporting
model.
One of FASB's strategic planning initiatives is to develop and
enhance the reporting model as a tool for decision-making in a
rapidly changing and technological environment. On February 29,
1996, FASB issued an invitation to comment on the reports of the
Jenkins Committee and AIMR.\41 FASB plans on using the responses to
this request to assist it in setting its agenda. In our earlier
interviews with representatives of preparer groups, they stated that
they will likely oppose many of the Jenkins Committee's
recommendations, including measuring noncore assets and liabilities
at fair value, disclosing forward-looking information about
opportunities and risks, and accounting for specific operational
performance. They stated that such information would be either too
costly to prepare for public dissemination or would put business
entities at a competitive disadvantage with foreign competitors.
Further, the representatives stated that many preparers are still
concerned about liability exposure and would be opposed to requiring
disclosure of information not currently disclosed in cases where the
facts or premises for their viewpoints could change markedly over
time. However, the Private Securities Litigation Reform Act of 1995
provided companies and certain persons acting on their behalf a safe
harbor for certain forward-looking information that may help to
reduce concerns about such liability exposure.\42
In 1994, in response to a study by the AICPA Task Force on Risks and
Uncertainties,\43 the AICPA's AcSEC took action to improve
disclosures to help users assess risks and uncertainties that face
business enterprises. The new disclosure requirements, issued in a
statement of position (SOP), require businesses to disclose in their
financial statements (1) the nature of their operations, (2) the use
of estimates in the preparation of financial statements, (3) certain
significant estimates, and (4) current vulnerability due to certain
concentrations.\44 This SOP does not include the controversial
requirement, which we supported, to require disclosure of
management's expected course of action if it is at least reasonably
possible that the entity will not continue as a going concern without
taking significant actions (referred to in the exposure drafts of the
SOP as a disclosure of "financial flexibility").\45 AcSEC does,
however, continue to consider financial flexibility disclosures to be
relevant early warnings for financial statement users and believes
that disclosure requirements, such as those currently included in
auditing standards, should instead be included in accounting
standards.\46 This SOP also does not require disclosure of risk
associated with any material weaknesses in internal controls known as
control risk. As evidenced by the savings and loan crisis and
currently by the losses and failures of businesses resulting from
weak corporate governance and internal controls over derivatives,
significant deficiencies in controls could adversely affect not only
the reliability of financial information, but also the viability of
the entity itself.
--------------------
\32 The accounting and reporting model under GAAP is actually a
mixed-attribute model. Although most transactions and balances are
measured on the basis of historical cost, which is the amount of cash
or its equivalent originally paid to acquire an asset, certain assets
and liabilities are reported at current values either in the
financial statements or related notes. For example, certain
investments in debt and equity securities are currently reported at
fair value, receivables are reported at net realizable value, and
inventories are reported at the lower of cost or market value.
Further, certain industries such as brokerage houses and mutual funds
prepare financial statements on a fair value basis.
\33 Intangible or soft assets include, for example, brand names,
goodwill, technology related to products and processes that provide
competitive advantage, intellectual capital (i.e., "know how"),
patents, trademarks, franchises, copyrights, and research and
development. Most intangible assets that are internally generated
are not recognized in the financial statements. Intangible assets
that are purchased are generally recognized, such as purchases of
goodwill and brand names.
\34 Under market value accounting, the values of assets and
liabilities would be periodically increased or reduced as their
estimated market values changed.
\35 Book value is corporate net worth (assets minus liabilities).
\36 The Jenkins Committee focused only on the information needs of
professional investors and creditors and their advisers. These users
follow fundamental approaches that seek to value companies by
assessing the amount, timing, and uncertainty of a business entity's
future cash flows or income.
\37 According to the Jenkins Committee Report, core assets and
liabilities result from a company's usual or recurring activities,
transactions, and events. Conversely, noncore assets and liabilities
for which the Committee recommended fair value measurement result
from unusual or nonrecurring activities, transactions, and events.
\38 Improving Business Reporting--A Customer Focus: Meeting the
Information Needs of Investors and Creditors, Comprehensive Report of
the Special Committee on Financial Reporting, AICPA, 1994.
\39 Financial Reporting in the 1990s and Beyond, Association for
Investment Management and Research, 1993. AIMR comprises the
Institute of Chartered Financial Analysts and the Financial Analysts
Federation. Its members include financial analysts, portfolio
managers, and other investment professionals.
\40 Failed Banks: Accounting and Auditing Reforms Urgently Needed
(GAO/AFMD-91-43, April 22, 1991).
\41 The comment period ended July 31, 1996.
\42 The Private Securities Litigation Reform Act of 1995, Section
102, provides a safe harbor protecting certain forward-looking
information from liability in private actions under the Securities
Act of 1933 and the Securities Exchange Act of 1934. Forward-looking
statements protected from liability generally are written or oral
statements that project, estimate, or describe future events which
are accompanied by a notice that the information is forward-looking
and by meaningful cautionary statements that actual results may
materially differ from such statements. Forward-looking statements
included in the financial statements prepared in accordance with GAAP
are not protected under this section.
\43 Report of the Task Force on Risks and Uncertainties, AICPA, July
1987.
\44 Statement of Position 94-6, Disclosure of Certain Significant
Risks and Uncertainties, AICPA, December 30, 1994.
\45 The exposure draft's disclosure requirement for financial
flexibility was controversial, mainly because of concerns about the
cost of compliance. Also, concerns were expressed regarding the
overlap between the exposure draft's requirements and the
requirements of SAS 59, and the ability of the exposure draft's
criteria to highlight meaningful information and to differentiate
among entities that have different risks.
\46 SAS 59 provides a specific list of information that could be
disclosed when there is substantial doubt about the entity's ability
to continue as a going concern.
FINANCIAL STATEMENT
DISCLOSURE OVERLOAD
-------------------------------------------------------- Chapter 5:6.1
Over time, the cumulative effect of disclosure standards has resulted
in a significant increase in the volume of information disclosed.
The Jenkins Committee reported that the expansion in business
reporting has been well-received by users. However, the Committee
acknowledged that "disclosure overload" is a barrier to achieving
acceptance of the Committee's recommended reporting model because of
concerns about the cost of preparing and auditing additional
disclosures. Accordingly, the Committee recommended that standard
setters and regulators expand their efforts to eliminate disclosures
that are less useful. The Jenkins Committee believes that
eliminating less useful disclosures would (1) reduce the costs of
statement preparation and auditing without significant loss of
benefit, (2) reduce the need for users to wade through excess
material, and (3) make room for what the Committee believes is more
useful information, such as that in its proposed reporting model.
The Committee also believes that efforts to eliminate less useful
disclosures would demonstrate the standard setters' concern for
reducing costs associated with business reporting.
FASB is studying the issue of disclosure overload, which it calls
"disclosure effectiveness." In a May 18, 1995, letter to FASAC, we
provided some ideas for designing a study to address the issue by
dividing users into two groups: those who have a detailed need for
information, such as financial analysts, and a much larger group that
relies, for the most part, on the first group, such as small
investors in stocks and bonds. We believe that such groups may
provide insight into better specifying their data needs and
efficiencies in providing necessary data. We also stated that it
would be especially important to ensure that information vital for
assessing financial condition and performance is not eliminated.
Disclosures about risks and uncertainties is an example where
progress is being made, but we believe further improvements in
disclosures are needed, not fewer disclosures. FASB is currently
considering comments received on its prospectus on the subject.
The SEC is also attempting to reduce and/or simplify disclosures. In
1995, the SEC issued proposed rules for comment which call for
abbreviated financial statements to be included in proxy statements,
and other reports issued to shareholders. The abbreviated financial
statements would exclude a substantial number of footnote
disclosures. The SEC withdrew this proposal based on the negative
comments received. The SEC currently is considering comments on
another proposed rule that would streamline accounting disclosures
through the elimination and/or modification of SEC accounting rules
that are outdated or duplicative of the requirements of GAAP.
LIMITED PROGRESS IN WORKING
TO ACHIEVE A COMPREHENSIVE
REPORTING MODEL
-------------------------------------------------------- Chapter 5:6.2
Disagreement currently exists among various groups as to who should
take responsibility for leading the effort to implement a
comprehensive reporting model. Some members of FASB stated that the
Board has the authority to develop standards covering all aspects of
the model. Other Board members were less certain of FASB's authority
to establish standards for the nonfinancial aspects contained in the
comprehensive model. Some preparer and user groups believe that the
SEC's regulatory role makes it better suited for implementing the
nonfinancial elements of the model. The SEC has not stated whether
it will take responsibility for implementing any of the Jenkins
Committee's recommendations.
OBSERVATIONS
---------------------------------------------------------- Chapter 5:7
The accounting profession has been responsive to the recommendations
made by various groups over the years in developing a structure and
processes for setting accounting and auditing standards that have
served our nation well in providing generally accepted standards.
This is no easy task since, to be effective, standard setters must be
able to address important, and usually controversial, accounting and
auditing issues on a timely basis and to resolve those issues with
credible, conceptually sound standards that serve the public
interest.
Today, standard setters are facing significant challenges that must
be successfully resolved to ensure the adequacy of standards as a
basis for producing relevant financial reports. User participation
in setting accounting and auditing standards, timeliness of
accounting standards, and pressures brought by groups that attempt to
influence accounting standards are significant continuing concerns.
Further, changing business operations accelerated by advances in
information technology are challenging the standard setters'
abilities to efficiently and effectively maintain standards that
facilitate relevant and useful financial reporting. In addition, the
mixed-attribute reporting model limits the understandability and
relevance of financial reports for nonprofessional users and
contributes to the time needed to develop, propose, and adopt
standards. Overcoming these difficult issues will require a
cooperative effort by the standard setters, the accounting
profession, and other affected parties, as well as strong SEC
leadership.
The opportunity for user participation is available as part of the
process for setting standards. Both FASB and the AICPA have
encouraged increased user participation in standard setting, but
these efforts have not been successful relative to other groups'
participation. For example, preparers of financial statements,
relative to users of financial statements, are heavily involved in
accounting standard setting through participation in FASAC and by
responding to proposed standards. Also, they informally participate
through contacts with others, such as independent public accountants,
the SEC, and the Congress. We believe that preparers' interest in
having flexible standards and in keeping accounting and auditing
costs down has led them to take positions that are not always
constructive and objective and at times result in delaying the
issuance of needed accounting standards. In practice, audit standard
setting has been primarily the domain of the accounting profession.
In that respect, auditing standards have been influenced by auditors'
liability concerns. However, the scope of audits has also been
constrained by preparers' cost-benefit concerns about expanded
audits.
We believe that the independence of FASB members is critical to
achieving acceptance of the standard-setting process. Also, for the
standard setters to produce relevant standards that have a balanced
perspective in meeting users' needs, the parties affected by the
standards, and others who ultimately determine general acceptance,
should have a greater influence on the standard-setting process.
User under-representation has thrown the standard-setting process
somewhat out of balance. The SEC, which has the ultimate authority
for standard setting and responsibility to protect the public
interest, has not always strongly asserted that role in its
relationship with the standard setters. The SEC's recent actions to
increase public representation among the trustees of FAF is a step in
the right direction. With regard to the SEC Chairman's belief that
standard setting would be further strengthened if the leader of FAF
were a public representative, we believe the experience in the
federal arena, in which the Chairman of the Federal Accounting
Standards Advisory Board (FASAB) is a public member, has been
positive.\47
We also believe that opportunity exists in setting auditing standards
to better meet the public interest perspective through having more
ASB members who are knowledgeable of standards but are not public
practitioners.
SEC intervention to protect the interests of small investors is
particularly important because they play virtually no role in the
standard-setting process. SEC intervention could take the form of
working more closely with FASB to influence the underlying accounting
concepts as well as FASB's position on particular issues. We believe
that a stronger SEC presence on behalf of users would not take the
standard-setting function out of the hands of the private sector.
Timeliness of accounting standards is a factor that has been
sacrificed by FASB to obtain quality of standards and their general
acceptance. FASB's timeliness is problematic, and at times causes
serious concern, such as the current need for accounting standards
for derivatives. FASB recognizes the urgency of setting such
standards and is currently designing strategies to make standard
setting more timely, but is cautious to ensure quality and accepted
resolution of the complex issues involved. We agree that these are
important trade-offs but encourage FASB to continue to seek ways to
improve timeliness. We believe FASAC, which was formed to assist
FASB, contributes to the time needed to develop standards since
objectivity may not always exist for views expressed, and
deliberations to deal with those views are time-consuming.
FASB has responded professionally to concerns that have been raised
over positions it has taken in developing proposed standards. FASB's
mixed-attribute financial reporting model and the difficulties
perceived by preparers in implementing proposed standards that
perpetuate the model contribute to the pressures brought to bear on
FASB in developing standards. Resolving issues surrounding the
mixed-attribute model would help alleviate such pressures. However,
as previously stated, standard setting is inherently controversial,
and pressures on FASB can be expected to continue. The SEC needs to
carefully monitor the pressures brought to bear on FASB by those
groups attempting to influence the setting of standards to ensure
that FASB's ability to objectively set accounting standards
continues. The SEC can also play an important role in working with
FASB to address questions that have been raised about the efficiency
of FASB's operations. It is essential that any changes made to
improve FASB's efficiency do not adversely affect its independence.
The conceptual basis for accounting and the reporting model are
becoming increasingly problematic as the nature of business changes.
Present-day accounting reflects conflicting concepts of historical
cost and market valuation--concepts that do not recognize some
important economic values--and lacks forward-looking information that
is important to investors and other financial statement users.
Reporting historical cost data provides an important foundation for
accountability and for auditing with respect to fixed assets and
other nonfinancial assets, and liabilities. However, it does not
fully serve to provide needed information to users of financial
statements in today's world. Analysts and others who can integrate
other information, much of which is not public, and interpret the
financial statements in light of information from other sources may
find historical cost data in financial statements to be less
problematic than other users do. How useful such financial
statements are to the general public is more questionable, as
illustrated by the current wide disparity between the market price of
publicly traded stocks and their book values, indicating that
economic reality might be lacking in some financial statements.
Not requiring all financial instruments to be valued at market values
allows values that do not reflect reality to be reported on these
assets. In such instances, the mixed-attribute reporting model can
facilitate earnings management and, in egregious cases, the model can
facilitate manipulation of earnings and cover up of business
failures. Requiring extensive and burdensome footnotes and other
types of disclosures to supplement information in the financial
statements is not an acceptable substitute for adequate accounting.
Soft assets, such as trademarks and other similar intangibles, are
another example where the accounting model does not provide
information about increasingly important business assets. Soft
assets are significant assets for many public companies that are
generally not recognized under the present conceptual basis of
accounting. We believe it should be possible to express these values
in an expanded reporting model without losing the historical
foundation and auditability of financial statements.
Recognizing deficiencies in the current accounting model, the Jenkins
Committee and AIMR studies have proposed to broaden the present
reporting model to include forward-looking information and other
financial and nonfinancial information. We believe that overall, the
studies represent a significant step in improving information for
users. However, the studies do not address the issue of adding
internal control reporting to the financial reporting model.
FASB is undertaking further study of the Jenkins Committee and AIMR
recommendations. Concerns over disclosure overload and costs of
providing additional financial and nonfinancial data are major
barriers to achieving a more comprehensive reporting model. Also, it
is unlikely that the other concerns over the current mixed-attribute
model, such as the need for market value measurement of all financial
instruments and expanded disclosures beyond those currently required
regarding the reporting entity's risks and uncertainties, will be
resolved as the issues surrounding the comprehensive reporting model
are considered. FASB needs to continue to focus its efforts on
resolving these issues to improve the existing financial reporting
model. However, FASB alone should not be expected to resolve these
issues.
These issues are best resolved by the accounting profession, the SEC,
and other interested parties joining together with FASB to address
the broad issues of the conceptual basis of accounting and the
composition of its reporting model to meet the information needs of
the modern financial statement user. The accounting profession has
an important role to play in determining a better conceptual
framework for accounting and the construction of a new reporting
model that better meets users' needs. How the profession handles
this issue will affect the nature and extent of its future role in
providing business information to users. Continuing concerns about
liability may limit the profession's willingness to make the
necessary changes to satisfy users' need for reliable as well as
informative data. The issues are both fundamental and far-reaching
and require a concerted effort by all the major players, including
strong SEC leadership, to achieve a comprehensive reporting model
that is relevant to today's financial statement users.
--------------------
\47 FASAB recommends accounting standards to its principals (GAO, the
Office of Management and Budget (OMB), and the Treasury) for adoption
by the federal government.
COMMENTS AND OUR EVALUATION
---------------------------------------------------------- Chapter 5:8
FASB, the AICPA, and the SEC Chief Accountant provided comments on
accounting and auditing standard setting. Each of the entities
provided specific comments on certain aspects of the financial
reporting model and the related findings of the Jenkins Committee.
FASB and the SEC Chief Accountant provided comments on our
observations on FASAC. The AICPA also commented that it supported
the recent restructuring of FAF, and the SEC Chief Accountant
commented on the membership of the ASB. The SEC Chief Accountant
also pointed out how the SEC works closely with the standard setters.
FASB stated that it agreed with many of our criticisms of the
mixed-attribute financial reporting model. However, FASB commented
that adopting fair value accounting for all financial instruments
would not resolve all major issues and would raise additional issues.
Also, FASB stated that its experience suggests adopting fair value
accounting would not reduce controversy and speed up the
standard-setting process. However, FASB stated that some Board
members fully share our interest in fair value accounting for all
financial instruments and that the Board is studying that possibility
again.
We agree that adopting fair value accounting for all financial
instruments would still leave some difficult accounting issues, such
as the hedging of forecasted transactions with derivatives, how to
report unrecognized gains and losses in the financial statements, and
how to determine values when market prices are not readily available.
However, we believe that the benefit of having more current values
recognized in the financial statements outweighs the effort necessary
to satisfactorily resolve such remaining issues. Also, we agree that
adopting fair value accounting for all financial instruments would be
controversial. We believe that in the long term, after such
accounting is adopted, the overall time spent in adopting accounting
standards may be reduced since studying financial instruments has
been a major effort by the Board with much attention focused on the
current mixed-attribute model.
The SEC Chief Accountant commented on another aspect of the current
mixed-attribute financial reporting model: the recognition of soft
assets in entities' financial statements. He agreed that this issue
is important and recognized that information about these assets may
be significant to the investment decision-making process. The SEC
Chief Accountant noted that most participants at a symposium it held
in April 1996 on this issue thought that intangible assets were
important drivers, in many cases, of value for certain companies. He
also stated that it was currently difficult to arrive at a consensus
on how such information should be presented. The SEC Chief
Accountant believes that the symposium has resulted in additional
academic research into new ways to present this information. He
encourages such research as an important first step in addressing the
accounting and reporting for soft assets. We agree with the SEC
Chief Accountant and believe that the SEC should work with FASB to
ensure the adequacy of the research and to develop specific plans and
milestones to appropriately consider how information on intangible
assets can best be reported.
FASB noted that although our draft report stated that, overall, the
Jenkins Committee's comprehensive reporting model represents a
significant step in improving information for users, comments it
received on the Jenkins Committee's recommendations suggested that
not all users agreed with certain specific recommendations. We
believe that such comments are consistent with the findings of the
Jenkins Committee and the 1993 report of AIMR. The findings of both
major studies supported the need for a comprehensive reporting model,
but found disagreement on certain specific components. Opposition to
certain of the Jenkins Committee's recommendations included measuring
noncore assets and liabilities at fair value, reporting
forward-looking information about opportunities and risks, and
accounting for specific operational performance. The reasons for
such opposition included cost, competitive disadvantage, and
liability concerns. We believe that FASB needs to carefully consider
such concerns, but should explore ways to resolve them.
The AICPA commented that it strongly supports FASB undertaking a
project to implement the comprehensive reporting model suggested by
the Jenkins Committee. The AICPA stated that it has recently urged
FASB to accelerate its review of the Jenkins Committee's
recommendations and to proceed to the implementation stage of the
comprehensive model as promptly as possible. As our report points
out, we believe FASB should not be expected to resolve these issues
by itself. These issues are far-reaching and require a concerted
effort by all the major players, including strong SEC leadership, to
achieve a comprehensive reporting model that is relevant to today's
financial statement users.
FASB also commented on our observation that the FASAC members'
comments do not always objectively address the merits of the
accounting issue under discussion and that such comments add to the
Board's time in resolving issues and reaching consensus on accounting
issues. FASB commented that the FASAC members are there to express
their views freely and that the Board members can make their own
judgments about the merit of FASAC members' comments. We raised this
issue for the Board to consider whether it is in fact getting the
best professional advice obtainable from a group established to help
the Board resolve accounting issues. It is our view that FASAC is
not working as effectively as it could and the Board may wish to
revisit what it expects from FASAC and whether that is being
efficiently and effectively achieved. The SEC Chief Accountant
commented that FASAC's membership may not be balanced appropriately
to provide guidance to FASB and stated that his office would support
a reconsideration of the FASAC membership criteria.
The SEC Chief Accountant agreed with our observation that opportunity
exists in setting auditing standards to better meet the public
interest by having more ASB members who are knowledgeable of
standards but are not public practitioners. He recognized the
difficulties of attracting qualified, nonpracticing individuals to
participate on the ASB, but stated that his office supports increased
user and public participation in all private-sector standard-setting
processes. The AICPA, in expressing its support for the recent
restructuring of FAF, commented that it gave up one of its three
seats on FAF to help accomplish the restructuring. We believe the
AICPA should continue such support in working to increase user and
public participation on the ASB.
The SEC Chief Accountant commented that our discussion of the SEC
relationship with the standard-setting bodies implied that there has
been a transfer of official, statutory responsibility from the SEC to
FASB and that SEC oversight has been sporadic. The SEC provided
several examples of how it works with the standard setters and stated
that its oversight has been vigilant. Our report points out in
practice how standard setting has worked. The SEC, through its
responsibilities for administering and enforcing the federal
securities laws, is the primary federal agency involved in accounting
and auditing requirements for publicly traded companies. Our report
recognizes that while the SEC has delegated much of its
responsibility for setting standards for financial reporting and
independent audits under the securities laws to the private sector
standard setters, it exercises oversight of the standard-setting
processes of both FASB and the AICPA.
Our report also points out, as the SEC has noted, that
notwithstanding these delegations and practices, ultimate authority
for standard setting and the responsibility to protect the public
interest rests with the SEC. It is in that respect that we believe
the SEC has not always strongly asserted leadership in its
relationship with the standard setters. Although the SEC is actively
involved in monitoring and overseeing the work of the standard
setters, we believe that more progress could be achieved in resolving
the major issues facing the standard setters if the SEC would exert
more of a leadership role in working with the standard setters. For
example, the SEC asserted strong leadership in achieving the
restructuring of FAF. Similar leadership is needed in working with
FASB and the AICPA to address the major accounting and auditing
issues discussed in this report. We believe that such leadership by
the SEC can be provided effectively without taking standard setting
out of the private sector, since private-sector standard setting has
worked rather well.
IMPACT OF GROWING BUSINESS
COMPLEXITY ON THE TRADITIONAL
AUDIT FUNCTION
============================================================ Chapter 6
Audited financial statements are important to our financial markets
and a valuable component of our economy, in that they facilitate the
allocation of capital among businesses and industries through the
independent assurance of the reliability of the financial data
presented. Over the years, recommendations have been made to improve
financial statements and disclosures and expand the auditor's
association with the financial reporting process. However, the
limitations of financial statements for making investment, credit,
and other decisions are both more widely appreciated and growing as
technological innovations have improved the timeliness and
accessibility of information, and as businesses engage in more
complex business transactions. In addition, decisionmakers are
placing more importance on the value of companies' intangible and
soft assets, which are often not reflected in the financial
statements.
As a result of these changes, users are increasingly turning to
unaudited information sources to obtain information for making
business decisions. This practice in the investment and credit
communities is raising important questions for the accounting
profession, not only regarding the appropriate reporting model for
business, but also the role auditors should have in providing
adequate assurances for information beyond that contained in the
present, primarily historical cost-based, financial statements. The
prominent role of unaudited information in facilitating business
decisions in today's economy also raises questions for the SEC about
whether the basic audit requirements for financial statements that
grew out of the 1930s economic conditions need to be revisited to
better protect shareholders in a much different information world.
The AICPA is currently taking a critical look at the future of the
auditing profession so that the profession can respond to these
trends and be able to provide the services necessary to assure the
usefulness of information used for decision-making. However, the
fear of litigation has restrained the accounting profession from
expanding assurance services. Other barriers, such as increased
audit costs and related auditor/client relationships, have also
tended to discourage the profession from assuming a larger role in
providing assurance services.
INFORMATION NEEDS AND
AVAILABILITY ARE CHALLENGING
THE TRADITIONAL AUDIT FUNCTION
---------------------------------------------------------- Chapter 6:1
Early in the century, financial statements represented a large part
of the information available to investors and creditors. Today,
financial statements are still at the center of business reporting
and an audit of the financial statements still fills an important
need--audited financial statements provide accountability, reduce
information asymmetry between buyers and sellers of capital, and
lessen uncertainty, thus reducing the cost of capital. However, as
more and more timely information flows outside of them, audited
financial statements play more of a role of confirming previously
available information and are no longer the primary source of
information for the capital markets. As a result, the financial
markets and other financial activities, such as stock sales and
purchases and business transactions, are operating increasingly on
the basis of current information not captured in the reporting model
until sometime long after the fact, if the information is included at
all. This was confirmed by the recent work of the Jenkins Committee
and AIMR, which revealed that in today's economy, users have
considerable information needs beyond the information provided in
historical cost-based financial statements. Accordingly, users have
become increasingly critical of certain aspects of financial
statements.
As reported in 1994 by the Jenkins Committee, more than ever before,
business entities are providing services in volatile global markets,
streamlining and segmenting their business activities, developing
product lines that must change rapidly to meet customer demands, and
creating complex financial instruments. In addition, decisionmakers
are now relying much more than in the past on information concerning
human resources, research, and innovation. Information that
adequately portrays and measures these activities and the resultant
intangible and soft assets, such as the value of brand names and
patents, is often not captured in traditional historical cost-based
financial statements.
To satisfy their need for more relevant, complete, and current
information about business entities, many users, particularly
professional investors and creditors, are turning to alternative
information sources, which are becoming more available as a result of
the growth of information technology and electronic commerce, such as
the Internet, and accessibility of computing power. Advances in
telecommunications have also enabled business entities to send
decision-related information to analysts in a more timely way. For
example, analysts and other professional investors and creditors are
turning more and more to corporate conference calls to obtain
management's most current perspective on earnings trends and other
key developments that influence corporate performance. Such forms of
communication are controlled by management, and information provided
through them is not subject to audit or other independent
verification.
In addition, a vast array of financial and operating statistics about
industries and specific companies is now available, although not
necessarily on a real-time basis, through on-line public databases.\1
The availability of this information, coupled with advances in
analytical software, has assisted analysts in forecasting company
earnings and trends and in estimating stock prices. In the future,
investors, creditors, and others with a valid interest may be allowed
real-time access to key financial information, operating statistics,
and performance measures directly from companies' databases.
Currently, many business entities are already directly linked with
their major suppliers and customers through electronic data
interchange, which enables them to hold down costs and manage
obsolescence risk by monitoring the physical flows of products and
services on-line. It may be only a matter of time before capital
suppliers are similarly linked to business entities to track their
cash needs and liquidity in real time. It is important to note that
most information obtained through database access is not the
traditional financial data associated with financial statements and
therefore is not covered by the annual independent audit of financial
statements. Thus, suppliers and others might be interested in
real-time assurance from the auditor that either the information in
the company's database is reliable or the system itself is highly
likely to produce reliable data.
Federal securities laws and regulations first enacted in the 1930s to
protect the public's securities transactions required independent
audits of public companies' financial statements to ensure companies
disclosed information that accurately depicted the financial
condition and results of company activities. However, as discussed
above, information that is not contained in financial statements and
therefore not audited is increasingly flowing into the markets and
influencing investment and other business decisions. Further, since
much information that is now reported in financial statements is
accessible earlier than the release of the financial statements, an
audit of the financial statements is basically serving as a
validation of previously released data.
Because the audit function is tied to a financial reporting model
that is no longer fully meeting users' needs for relevant
information, the accounting profession's role in providing a
value-added service may be declining.\2 The AICPA recognizes that the
accounting profession must provide its services in a fashion that
responds to users' needs, or, as recently stated by the AICPA
Chairman, the profession will not survive.\3 The AICPA also
recognizes that in addition to the traditional audit of financial
statements, users may also have a need for assurances pertaining to
the reliability of data, both financial and nonfinancial, beyond that
provided in financial statements. The question is what role the
auditor can play to provide assurance with respect to this flow of
current or real-time information.
--------------------
\1 One such public database is Compustat, which contains financial
statistics of more than 10,000 U.S. companies. The statistics are
organized by industry and arranged in a standard financial statement
format.
\2 The CPA Letter, AICPA, January/February 1996.
\3 "AICPA Chairman Lays the Foundation for the Future," Journal of
Accountancy, AICPA, November 1995.
EMERGING ENVIRONMENT FOR
ASSURANCE SERVICES
---------------------------------------------------------- Chapter 6:2
The 1990s have seen a dramatic shift in power from producers of
information to consumers of information.\4 Information technology has
allowed consumers to decide for themselves what information is
important instead of producers deciding what information would be
available. Accordingly, technological innovations, coupled with
complex business structures and other economic forces, are impacting
the traditional audit function. These developments have already
resulted in demands for a wide range of nonaudit services, such as
management consulting services. These developments are also creating
opportunities for the profession for new value-added assurance
services that go beyond the traditional audit of historical
cost-based financial statements.
As users become dependent on information systems that rely on little
or no human intervention, the issues surrounding system integrity and
security will become even more important. The Jenkins Committee
found that professional investors and creditors want auditors to be
substantially more involved than at present with the functioning of
the business entity's systems that produce financial data for
external consumption. In its 1993 report on users' needs, AIMR
stated that auditors pay too much attention to the numbers and too
little to the process that produces them.
AIMR advocated continual auditor involvement in the process that
generates financial information rather than verification of only
output or results, and envisioned independent auditors being
substantially more involved than at present with the functioning of
the internal systems that produce financial data for external
consumption. Former SEC Chief Accountant John C. Burton once put
forth the notion of an "auditor of record," a firm that would take
responsibility for the quality and content of an enterprise's
publicly released financial information well beyond the mere annual
blessing of management's representations in the financial statements.
The impetus for these views was that business entities have the
technology to produce significant amounts of information beyond what
is contained in their financial statements and annual reports, and
users have the computing power to access it. As users of various
types get more and more of their decision-related information from
systems grounded in the latest technology, they will need to know
that the systems are reliable.
Another future role of the auditor stems from the sheer volume of
available data. Decisionmakers are increasingly connected to on-line
information sources that can overwhelm them in data--making it
difficult to sort out which data are relevant and to be certain the
most relevant data have been obtained. Auditors could assist these
users, particularly those who are not professional investors or
creditors, in identifying information that is relevant to their
specific needs. Some users will also likely need to have some of the
data interpreted for them because the presentation format may be very
broad and general.
Further, the attest function can be applied to an array of
information broader than just financial information. For example,
the Jenkins Committee recommended that enterprises increase their
disclosures of forward-looking information about risks and
opportunities facing the company and management's plans, and other
nonfinancial information, such as performance measures, operating
data, and information about directors and management. The Jenkins
Committee also recommended that auditors be prepared to provide
assurances on this information. Other assurance services that CPAs
might provide include interpreting financial statements and adding
qualitative information about an enterprise and its prospects. For
example, the Jenkins Committee found that a majority of the
professional investors and creditors it surveyed supported expanding
auditor reporting to include some form of analytical commentary on
areas that would assist them in evaluating the quality of a company's
earnings. Such areas would include the audit scope and findings, the
business entity's use of accounting standards in relation to
alternative standards, the reasonableness of significant assumptions
and estimates used by management in the preparation of financial
statements, and the risks related to realizing recorded assets.
The AICPA Special Committee on Assurance Services (Elliott
Committee), appointed in 1994, is exploring new ways, such as those
described above, for auditors to provide value to their clients and
the public they serve. The Committee has been studying the audit and
attestation field and the trends shaping the profession's
environment, focusing on the changing needs of users of
decision-making information. In its interim report, the Elliott
Committee discussed the economic, political, and social trends that
will affect the need for information and assurance in the future.
For example, the Committee identified trends in information
technology, corporate structure, accountability, investment capital,
the aging of America, and globalization, which suggest new service
opportunities for the profession.\5
The Elliott Committee plans to identify these new service
opportunities, determine what barriers stand in the way of providing
these services, and develop recommendations. The Committee expects
to issue its final report in the fall of 1996. In the meantime, the
AICPA Chairman is encouraging all members of the profession to focus
on making themselves better competitors; more highly skilled; more
well-known to the public for personal objectivity, integrity,
competence, and independence; more attuned to users needs; and more
relevant in an increasingly complex economic environment.\6
--------------------
\4 The CPA Letter, AICPA, January/February 1996.
\5 The CPA Letter, AICPA, January/February 1996.
\6 The CPA Letter, AICPA, May 1996.
LITIGATION CONCERNS HAVE
HINDERED AUDITORS' WILLINGNESS
TO EXPAND RESPONSIBILITIES
---------------------------------------------------------- Chapter 6:3
The auditor's role in the financial reporting process has been the
subject of many studies over the past 20 years. To better meet
public needs and expectations for reliable information, many
recommendations have been made to expand auditors' association with
financial reporting.\7 For example, as discussed in chapter 3,
recommendations have been made to expand auditors' responsibilities
for detecting and reporting fraud, to require auditor reporting on
the effectiveness of a company's internal control systems, and to
expand auditor reporting in areas such as risks and uncertainties
facing the company. In addition, recent work of the Jenkins
Committee suggests that auditors should also be prepared to be
associated with forward-looking and other nonfinancial data reported
by management.
However, primarily because of fear of litigation, the accounting
profession has been unwilling to expand its responsibilities in these
areas. According to the Kirk Panel, the fear of litigation has
resulted in detailed auditing standards regarding the auditor's
responsibilities and standards that create highly standardized
auditor reporting. Such standards narrow the scope of professional
judgment that might be questioned by a litigant alleging a loss due
to a negligent audit. However, we believe these limited standards
and responsibilities, coupled with the decrease in the usefulness of
traditional cost-based financial statements, have also resulted in
missed opportunities to enhance the value of the audit function.
The Congress recently passed the Private Securities Litigation Reform
Act of 1995, which generally limits each defendant's liability for
fraud, under the Securities Exchange Act of 1934, to the defendant's
percentage of responsibility for the violation if the violation was
not knowingly committed. The 1995 Act also provides a safe harbor
for certain forward-looking information. While it is not clear yet
what effect this legislation will have on the accounting profession's
willingness to provide additional assurance services or to expand
auditor reporting, it is clear by the appointments of the Jenkins and
Elliott Committees that the leaders of the profession want to do
something to deal with the profession's diminishing role in providing
users with relevant, reliable, and timely information.
--------------------
\7 Refer to table II.5, appendix II (GAO/AIMD-96-98A) for the
recommendations made to expand auditor's association with financial
reporting.
EXPANDED ASSURANCE SERVICES
WILL REQUIRE FOCUS ON SYSTEMS
AND PROFESSIONAL STANDARDS
---------------------------------------------------------- Chapter 6:4
If auditors are to provide timely assurance services on financial
data as well as nonfinancial data, auditors will need to focus on the
reliability of the systems producing the data. Our own belief and
that of the Jenkins Committee is that the auditor's work on financial
statements and the related system of internal control provides the
foundation on which other work is based. The Jenkins Committee
concluded that the level of assurance on elements outside the
financial statements could be no stronger than that foundation. For
example, the Committee believes that if auditors did not report on
financial statements, they could not report on any of the other
elements of information presented in business reporting.
However, as noted by the Jenkins Committee, auditors rarely report
publicly on internal controls even when management does. Currently
the auditor, in conducting a traditional financial statement audit,
obtains an understanding of internal controls over financial
reporting, but only thoroughly tests those controls necessary to
efficiently conduct the audit, except in audits of certain financial
institutions in which internal control reporting is mandatory.\8 We
have advocated that auditor reporting on internal controls should be
a mandatory component of a financial statement audit.
Reviewing the effectiveness of internal controls can be done through
management's assessment of controls and auditor reporting on
management's assertion, or the board of directors can report on the
effectiveness of internal controls. Under the latter method, the
board of directors could use the independent public accountant to
assist it in obtaining the necessary understanding and testing of
controls. In 1993, the AICPA Board of Directors publicly supported
an auditor's report on management's assertions on the effectiveness
of a company's internal controls over financial reporting,
recognizing that such a report would provide further assurance to the
investing public. The AICPA urged the SEC to establish such a
requirement; however, to date, no action has been taken by the SEC on
auditor reporting on internal controls.
According to the Jenkins Committee, current audit standards and
guidance are not sufficient for auditors to attest to the varying
nature of information outside of the financial statements that is
considered by users to be relevant.\9 For example, some of the
information that would be included in a comprehensive reporting model
proposed by the Jenkins Committee is composed almost entirely of
management's beliefs, intentions, and predictions. There will likely
be less empirical evidence than the auditor is accustomed to having
to support those assertions, such as opportunities and risks,
including those resulting from key trends; management's plans,
including critical success factors; broad objectives and strategies;
and the impact of industry structures on the business entity.
Further, the Jenkins Committee believed that auditors could have
difficulty in determining whether the disclosures are complete. In
such situations, the Jenkins Committee explained that the auditor may
need to focus on the reliability of the processes that management
used to arrive at this information as well as the reasonableness of
management's underlying assumptions. Accordingly, the Jenkins
Committee noted that auditing standards and guidance would need to be
developed to provide for an adequate level of assurance or
verification on this type of "soft" information. However, as we
previously discussed, the fear of litigation has deterred the
profession from issuing auditing standards that place less emphasis
on verification and more emphasis on judgment, or that expand
auditor's responsibilities.
Even if the profession were to endorse this change in assurances,
there is some question as to whether the SEC would encourage auditing
standards that would permit the auditor to include all soft asset
valuations in an overall opinion on the fairness of the financial
statements. For example, a recent SEC proposal for disclosure of
qualitative and quantitative information about market risk inherent
in derivative financial instruments would put such disclosure outside
the financial statements.
The Jenkins Committee recommended, in the elements of its proposed
reporting model, a different level of assurance for subjective
information, concluding that the need to reach for an opinion of
"fairness" on all information may be unnecessary. Under this
approach, the auditor would report that the element is presented in
conformity with the respective standards of presentation and that
management has a reasonable basis for the underlying assumptions and
analyses reflected in that element. In contrast, the audit of more
objective information states that the element is fairly presented, in
all material respects, in conformity with applicable standards.
Given adequate implementation time, the Committee believes that users
will be able to understand the inherent differences in the nature of
the information being audited.
In the federal arena, FASAB has adopted this approach to separating
out judgmental values from transaction-driven and more easily
verifiable values. For example, federal government investments in
research and development, intellectual capital, and state and local
infrastructure, cannot be valued on the basis of potential future
cash flows. Instead, the values of these investments can be measured
by the outcomes of the federal expenditures. FASAB's solution to
this accounting problem is to accumulate expenditures by type of
investment project over an appropriate period of time and try to
correlate the expenditures over time with the outputs and outcomes of
the projects. For human capital expenditures, for example, this
might be the years of education added to the overall population of
the United States every 5 years. To separate out these very
judgmental values, federal investments were designated as
"stewardship information" and presented separately in the financial
statements.\10 GAO and OMB will try to set auditing requirements
appropriate for such information.
--------------------
\8 FDICIA requires that audits of large banks and savings and loans
include an auditor's report attesting to management's assertions on
the institutions' internal controls.
\9 According to the AICPA's Vice President for Professional Standards
and Technical Services, the AICPA attestation standards that are
applied by CPAs for engagements involving reporting by auditors on
information outside the financial statements, such as financial
projections and forecasts and pro forma financial information, are
relevant to reporting on the types of information discussed by the
Jenkins Committee.
\10 Statement of Recommended Accounting Standards, Number 8,
Supplementary Stewardship Reporting, FASAB, 1996.
OTHER CONSTRAINTS ON EXPANDING
ASSURANCE SERVICES
---------------------------------------------------------- Chapter 6:5
It is not clear whether there is a market demand for expanded
assurance services, or, if there is, whether these new services will
undercut the economic value of the current audit function. Audit
costs are cited by preparers as a reason for not expanding the
auditor's scope of work. More auditor involvement with the
functioning of the internal systems that produce financial data could
be costly. However, AIMR points out that while audit costs may
increase, the risk of audit failures would decrease. Therefore, AIMR
contends that the increased audit costs would be offset, at least
partially, by the decreased cost of capital resulting from higher
quality and more reliable information being made available to the
financial markets.
The Jenkins Committee found that users are divided over the
usefulness of expanding the scope of audits to include new types of
information not now audited.\11 In fact, the Jenkins Committee
pointed out that creditors are concerned that companies may reduce
the extent of auditor involvement to offset increased costs if
accounting requirements are increased. Although users are not
enthusiastic about expanding the scope of audits, one exception
relates to internal controls. Both the Jenkins Committee and AIMR
reported that users believe business reporting would benefit from
increased auditor involvement in internal controls.
We believe that shifting the auditor/client relationship more toward
the boards of directors and their audit committees, as envisioned by
the Kirk Panel, may result in requests for assistance in meeting the
boards of directors' responsibilities to shareholders. One area of
assistance could be internal control. For example, if boards and
their audit committees had the responsibility for overseeing risk
management and the effectiveness of the controls to ensure the risk
management policies were followed, we believe the boards would likely
call upon the independent auditor to assist them in discharging that
responsibility.
As previously discussed, the Jenkins Committee also found that a
majority of users support expanding the auditor's reporting to
include some form of analytical commentary on areas that would assist
them in evaluating the quality of a company's earnings. However,
many preparers, who like to control the information that is provided,
may not welcome either extending audit coverage to information
outside the financial statements or including an independent view in
the auditor's report. Also, the fear of litigation has resulted in
standardized reporting, which discourages auditor commentary.
As mentioned earlier, an expanded role of the auditor will need to
encompass a sufficient level of involvement in the business entity's
information systems to satisfy the needs of users. However,
according to the Jenkins Committee, users are already concerned about
pressures on auditor independence. The Committee reported that users
believe the need to maintain a good business relationship with
clients in a competitive audit environment could, over time, erode
auditor independence. The Committee also reported that users are
concerned that auditors may accept audit engagements at marginal
profits to obtain more profitable consulting engagements from the
client, and that auditors may be reluctant to irritate management to
protect the consultant relationship.
However, "continuous involvement," as used by AIMR, implies that
auditors will need to have a greater presence at their clients'
business sites and cooperate more with their clients' own
professionals. If this happens, the fine line between
consulting-related assignments and independent verification
assignments will likely grow more blurred. Further, with increased
auditor involvement in systems, users may come to expect auditors to
ensure the reliability of the data as opposed to providing more
limited assurances regarding management's assertions. Having the
auditor report to the board of directors versus corporate management
as envisioned by the Kirk Panel may help to alleviate independence
concerns that may arise.
--------------------
\11 Only 57 percent of those who participated in the Committee's
survey agreed that auditors should provide some level of assurance
about disclosures of forward-looking information. Further, only 52
percent agreed that auditors should provide some level of assurance
on nonfinancial business information disclosed by management.
AUDITOR SKILLS AND EXPERTISE
FOR EXPANDED SERVICES
---------------------------------------------------------- Chapter 6:6
Both the Jenkins Committee and Elliott Committee have indicated that
auditors may not have the skills and expertise to be associated with
some types of information outside the financial statements. Some of
the information on which auditors may be asked to provide assurance,
such as management's beliefs and predictions that may concern
technological achievements or expectations, may be beyond the ability
of current auditors to evaluate. In addition, many of the new
services that may present an opportunity to the profession, such as
providing assurances about the reliability of real-time information,
require expertise in information systems.
The AICPA Chairman recently stated his intention to get more
accounting faculty involved in the AICPA committee structure to
better integrate education and practice.\12 The AICPA Chairman also
stated that he wants a technology focus on all AICPA initiatives and
that the AICPA must see to it that its members acquire the skills,
knowledge, and support they need to be "empowered--not
overpowered--by technology."
--------------------
\12 "AICPA Chairman Lays the Foundation for the Future," Journal of
Accountancy, AICPA, November 1995.
OBSERVATIONS
---------------------------------------------------------- Chapter 6:7
Changing business operations and the tremendous advancement of
information technology are greatly influencing users' needs for data
that are more real-time and comprehensive than those provided by
current financial reporting. Users need audited financial
information because it provides independent assurance of the
reliability of amounts reported that are not otherwise verifiable by
third-party users. The attest function is already being challenged
by the increase in the use of market values for financial
instruments, which are at times difficult to determine. Demands for
increased auditor services will likely present even more difficult
challenges for the accounting profession as it is called upon to
attest to nonfinancial data that may involve forward-looking
information and soft business assets that are not currently reflected
on the financial statements or in related disclosures and that are
difficult to value.
Extending the financial statements to include a company's soft assets
would change the present balance between reliability and relevance of
the information presented. With such a shift, the auditor would need
to have professional standards governing auditor assurance concerning
data that are not susceptible to traditional methods of verification.
Therefore, successfully responding to this market for expanded
assurance services will require the accounting profession to
effectively address some difficult issues affecting the culture of
the accounting profession. The SEC will also be challenged in
fulfilling its responsibilities to protect investors under the
securities laws.
The long-standing, difficult issues for the accounting profession
concerning auditor independence and the auditor's responsibilities
for internal controls and fraud detection are barriers that could
limit expanded assurance services if not successfully resolved by the
accounting profession. Also, the value of the traditional annual
financial statement audit in attesting to the reliability of data
used by investors is more limited relative to its origin in the
1930s, considering the widespread use today of nonaudited data in
commerce. This is an important issue for the SEC as its
responsibilities for protecting investors are being challenged by
current trends in the use of nonaudited data and the future role of
the traditional annual audit.
The accounting profession operates in a liability risk aversion mode
that has been a barrier to offering services that increase auditor
responsibility. For example, until 1993, the accounting profession
has been reluctant to evaluate and report on the effectiveness of
internal controls. Internal control evaluations are now being
provided by auditors for large banks and thrifts as required by law.
The envisioned expanded assurance services are likely to focus
auditing services more on the condition of information systems and
related internal controls in order to provide timely assurances on
the reliability of the systems, and less on the specific data
provided by that system, which are the focus of a traditional
financial statement audit. We believe auditor knowledge of internal
controls is an essential foundation for the future expansion of
assurance services. Some relief from liability, coupled with
diminishing demands for traditional attest services and new
opportunities for services stemming from changing business and
advances in technology, may change the accounting profession's
posture with regard to expanded responsibilities.
We believe the current auditor/client relationship and the perception
of independence concerns that it raises is worth examining very
closely because it is a significant barrier to having auditors accept
more responsibility for internal controls and the quality of
decision-related information and soft asset values provided by
management. Auditor independence may become a greater issue for the
accounting profession if auditors are not fully trusted by potential
consumers of an expanded attest function. The auditor's traditional
values of being objective, skeptical, and even critical are important
aspects to providing assurance services. The accounting profession
needs to be attentive to the concerns over independence to ensure
that services are not expanded into new areas where these critical
auditor assets may be diminished in value. Further, as emphasized by
the Jenkins Committee, auditor commentary on the appropriateness of
management's use of accounting standards and other nonfinancial
information would require a substantial change in the relationship
between management and the auditor because the presence of such
commentary in today's environment may be considered intrusive by
management.
Accordingly, we support the Kirk Panel's suggestions regarding the
current auditor/client relationship and the need for a more direct
auditor relationship with the business entity's board of directors
and audit committees in order to strengthen auditor independence and
enhance the auditor's role in these areas. Expanded auditor
assurance services may actually help to facilitate this more direct
relationship because, in addition to management, the board of
directors should be attracted to the expanded assurance service since
it will enable the board to do a more effective job of overseeing
management's operations and running the business.
While the present limitations on skills and expertise need attention,
we do not believe that they are a major constraint to providing
expanded assurance services. We believe CPAs are capable of
analyzing businesses' financial operations. We also believe large
accounting firms, which have more capital and training capacity
relative to other firms, should assume a leadership role to deal
expeditiously with any limitations. Accounting firms have developed
groups of individuals with skills other than accounting and auditing,
such as actuaries and operations research analysts, whose skills are
already being applied in unique audit situations. Accounting firms
have also trained individuals to meet the increasing market demands
for consulting services. Many of the skills used in consulting
services are similar to those needed for other assurance services.
The AICPA and state societies also have a large education and
training infrastructure to provide any needed professional education
in these areas.
Full, fair, and accurate disclosure of financial information is a
cornerstone of our system of public securities markets. The rules
and regulations established in the 1930s for public disclosure and
independent audits were put in place to protect the public in their
securities transactions. However, much of the information used today
for business decisions is outside the traditional financial
statements and therefore is unaudited. In the future, the SEC will
need to play a dominant role in deciding whether auditors' assurances
about systems integrity are needed to help the SEC discharge its
responsibilities for full and fair disclosure in the securities
markets. The demand for expanded assurance services should not only
be a function of management demand. Users' needs are also important.
It is clear that the future of the accounting profession is not all
in its own hands. We support the Elliott Committee's efforts to
explore the auditor's ability to accept more responsibilities for
decision-related information and internal controls. The profession's
strategies need to be carefully thought out and expressed in terms of
the quality of information needed by investors, creditors, and others
for decision-making. The accounting profession has not effectively
resolved public expectations in key areas, such as internal controls
and fraud, and auditor independence still remains a concern. The
accounting profession must effectively resolve such fundamental
concerns if it is to be successful in providing expanded assurance
services.
COMMENTS AND OUR EVALUATION
---------------------------------------------------------- Chapter 6:8
The AICPA and the SEC Chief Accountant provided comments on the role
of the auditor in further enhancing of the financial reporting
process. The AICPA commented that it expects its Elliott Committee
to complete its work and report to the AICPA in October 1996. The
AICPA stated the Elliott Committee studied, among other things,
recent trends in information technology, corporate structures,
accountability, investment capital, the aging of Americans, and
globablization of markets that suggest a growing evolution in the way
CPAs will serve the public in the future. The SEC Chief Accountant
stated that the concerns over auditor independence discussed in our
report must be resolved if the accounting profession is to be
successful in providing expanded assurance services. We would add
that public expectations in the key areas of auditor's
responsibilities for reporting on the effectiveness of internal
controls and detecting material fraud must also be resolved.
*** End of document. ***