By Douglas R. Carmichael

The latest, and perhaps most comprehensive, objective evaluation of the performance of the public accounting profession is out, and it is a mixed review. On the pass/fail system, it is definitely a pass, but this is neither a ringing endorsement nor a condemnation.

The Honorable John D. Dingell, the ranking minority member of the House Committee on Commerce asked for the evaluation back when Congress was considering the legislation that ultimately became the Private Securities Litigation Reform Act of 1995. Congressman Dingell's request was sweeping in both the time span and depth targeted. The U.S. General Accounting Office (GAO) was asked to--

1. identify recommendations made from 1972 through 1995 and actions taken to improve the performance of audits of public companies, including improvement of accounting and auditing standards.

2. identify any unresolved issues and determine their significance to the effectiveness of independent audits and professional standards.

The GAO undertook the monumental task of cataloging all the recommendations made in the last 20 plus years by 37 separate study groups from the Wheat Committee in 1971, which led to the establishment of the FASB, through the Jenkins Committee in 1994 whose recommendations on improving business reporting are still being weighed.

Although the first and last studies focus on accounting, the primary focus of the studies was independent auditing, and the primarily auditing-related recommendations of the Cohen Commission (1978), Treadway Commission (1987), and Kirk Panel (1994) received due attention.

The GAO's report, THE ACCOUNTING PROFESSION, Major Issues: Progress and Concerns, was issued September 24,1996, on the eve of the retirements of Charles A. Bowsher, Comptroller General, and Donald H. Chapin, Chief Accountant.

In all, the GAO identifies 574 individual recommendations in the areas of auditor independence, audit quality, accounting standard setting, auditing standard setting, and expanded reporting and auditor services. Wisely, the GAO refrains from evaluating the profession's performance based on how many recommendations have been completely or partially achieved. This would be a relatively meaningless exercise. For example, the Treadway Commission recommended that auditing standards be revised to restate the auditor's responsibility for fraud detection. This recommendation could be achieved merely by issuing a new pronouncement; but that could not ensure the development of an an unequivocal delineation of responsibilities or ensure that the new SAS would be effectively implemented. Indeed, the Public Oversight Board (POB) felt compelled to call for improved implementation of SAS 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities, in practice and the Auditing Standards Board (ASB) has proposed yet another clarified statement of responsibility.

Major Unresolved Issues

The GAO consigns the laundry list of recommendations to a separate appendix (the second of two volumes) and focuses primary attention on the following major issues:

* Auditor independence

* Responsibilities for fraud and internal controls

* Initiatives to improve audit quality

* Accounting and auditing standard setting and the financial reporting model

* Impact of growing business complexity on the traditional audit function

The GAO gives high marks to the accounting profession's self-regulatory program for achieving a measurable improvement in audit quality, but concludes that serious concerns remain in the other major areas.

Auditor Independence. The GAO believes the accounting profession and others have made progress in strengthening auditor independence but serious questions continue. Over the 20-year study period, various groups questioned the independence and objectivity of auditors due to performance of consulting services, "opinion shopping," and client advocacy issues. In 1992 and again in 1994, the SEC's chief accountant called CPA firms to task for condoning or advocating inappropriate interpretations of accounting standards to benefit clients. These critical comments resulted in yet another study, this one under the auspices of the POB of the SECPS, which raised independence and objectivity issues because of such things as industry specialization and viewing company management as the client. The GAO believes such questions of auditor independence are likely to persist as long as the existing auditor/client relationship continues and supports the POB's proposed solution of a more direct working relationship between the auditor and the board of directors.

The GAO, however, has serious concerns about the POB's view that this goal can be achieved by permitting change to evolve voluntarily. As with many of the major remaining issues, the GAO swings the spotlight to the somewhat reluctant SEC. Currently, the SEC has the authority to more clearly define the roles of boards and audit committees in relations with the independent auditor. The GAO also points to the audit committee requirements that were legislated as part of FDICIA as exemplary. The SEC could seek similar legislation under the securities laws. Alternatively, the SEC could work through the major stock exchanges to establish listing requirements that would effectively mandate the necessary changes.

This call for SEC action may not be warmly embraced by the AICPA and large CPA firms, but historical perspective lends considerable weight to the GAO's position. The Cohen commission recommended similar changes in the auditor/client relationship in 1978 but did not call for new regulations or legislation: The Cohen Commission hoped voluntary action would be stimulated by its commentary. The lack of response in the intervening nearly two decades does not hold significant promise for voluntary change. SEC intervention in some form would seem to be the only effective means of resolution. To counter this potential, the SECPS, the POB, and accounting firms must demonstrate that, through their initiatives to identify and promote "best practices," the desired improvements in corporate governance are being achieved on a timely basis.

Fraud Detection and Internal Control. The GAO believes an expectation gap still exists for auditor responsibilities and performance related to detection of fraud and determining the effectiveness of internal controls. Moreover, the GAO believes that issues on the auditor's responsibility for fraud and internal control overlap to such an extent that successfully addressing the public expectation gap related to fraud detection is not possible without substantially increasing responsibility for internal control evaluation and public reporting.

Under current auditing standards, auditors in a financial statement audit are not required to evaluate internal controls in a manner sufficient to form an opinion on the effectiveness of controls in preventing and detecting fraud or other failures in a company's internal risk-management system. In the GAO's view, mandating the performance of a full evaluation of controls as part of the annual audit would provide greater assurance of detecting and preventing significant fraud.

The GAO has long advocated the importance of effective internal controls as the first line of defense against misstatements in financial reporting. In this report it ratchets the supposed benefits of internal control reporting to a higher level by suggesting that, in the eyes of the public, auditors may not only be responsible for detecting material fraud, but also may be expected to prevent fraud in the first place. It also introduces the idea that auditors may be expected to be responsible for other types of unauthorized behavior resulting from inadequate risk-management controls. Public reporting on internal controls would be necessary to deal with these new expectations. The GAO increased its own focus on internal risk-management policies after its extensive study of derivatives. Sizable losses have been widely publicized resulting from derivatives trading. The GAO concluded controls in the risk-management area are an important factor in minimizing exposures of this kind.

History indicates that this GAO view on internal control reporting is likely to be the most controversial finding. Over the years the AICPA and the SEC have swapped viewpoints on the desirability of mandatory internal control reporting, but corporate management has always steadfastly resisted. Currently the AICPA and accounting firms support internal control reporting. The Association for Investment Management Research (AIMR), a major spokesperson for the investment community, has expressed its view that there are benefits to internal control reporting. But the SEC, while acknowledging some benefits from internal control reporting, says it currently has bigger fish to fry in the form of market-risk issues. However, Federal regulators other than the SEC have consistently supported expansion of responsibilities in this area.

The lack of movement in internal control reporting is but another example of the ability of the well-organized financial statement preparer community to scuttle any expansion of auditor involvement in the financial reporting process. That community seems to fear more auditor involvement and argues that it would not provide a cost justified benefit to themselves or to users.

The GAO observes that greater auditor involvement might have to come from either legislation to mandate control reporting for all public companies or from the changed auditor/client relationship that the GAO calls for the SEC to pursue. In any event the GAO sees the SEC as the key player in providing leadership to bring all the ingredients together that will result in internal control reporting.

Quality Control and Peer Review. The accounting profession's self-regulatory program has improved audit quality. Both the quality-control processes within accounting firms and the overall quality of audits have been positively affected. The GAO reached this conclusion after comparing its own review of 724 peer review reports issued during 1992 through 1994 to the results in 1991 when many auditors of public companies underwent initial peer reviews. The GAO also observed that none of the largest CPA firms (firms that audit 30 or more SEC registrants) received modified peer review reports during its review period. It should be noted that most, if not all, of the larger firms have undergone peer reviews from the inception of the voluntary program in the late 1970s.

The GAO did identify some audit documentation and financial reporting and disclosure deficiencies that turned up in peer reviews. The AICPA's comments to the GAO in response to a draft of the report indicate it is considering additional steps to improve these areas of the audit.

Accounting and Auditing Standard Setting. The GAO compliments the FASB and AICPA on their achievements in the difficult task of addressing important and controversial issues and resolving them with conceptually sound standards. However, the GAO expresses serious concern about failure to adequately increase user participation, slowness in standard setting, and the threat that special interest pressures pose to the ability of standard setters to objectively set standards.

The GAO endorses the SEC's recent attention to strengthening standard setting by achieving a better balance between constituent and public interest members among the FAF trustees. The GAO warns that the SEC's continued monitoring of the accounting standard-setting process is important to ensure the FASB's ability to objectively set standards.

The GAO observes that audit standard setting has remained primarily the domain of the public accounting profession. Lack of user representation makes it difficult to produce standards that have a balanced perspective in meeting users' needs. Also, auditing standards may have been unduly influenced by auditors' concerns about legal liability.

Financial Reporting Model. Some of the GAO's most pointed criticisms are aimed at the current mixed model of financial reporting. The current model mixes historical cost and market values in a manner that sometimes obscures economic substance. For example, by not requiring all financial instruments to be valued at market value, the current model results in financial reports that do not reflect economic reality.

The current reporting model excludes some important economic values and forward-looking information that is significant to investors and other users of financial statements. The GAO believes there is a clear need for a more comprehensive reporting model that would provide users with more current values and more timely and forward-looking information.

In October 1996, the AICPA and several other organizations including the FASB, IMA, FEI, and AIMR, held a symposium to discuss the implementation of the recommendations of the AICPA special committee on financial reporting (the Jenkins committee). The report of that committee included a new "business" reporting model that would include nonfinancial and forward-looking information. Both the user (investment and creditor) and preparer communities expressed no great interest in expanding the reporting model (they think the SEC 10K format is quite adequate) or increasing auditor involvement. The SEC representatives attending expressed their personal views that it was up to private sector groups to change the reporting model. Strong market influences and the leadership of FASB will be essential to move this project further in the immediate future.

Expanded Assurance Services. The AICPA is currently studying the role auditors should play, given the changing business world and advances in information technology, in providing assurances on information outside financial statements. The GAO believes the accounting profession must become more involved with auditing internal control systems to be in a sound position to provide assurance in new areas that are highly systems
dependent.

Underlying Premises and
Fundamental Issues

The accounting profession and those charged by law with protecting the public interest approach certain fundamental issues from an entirely different perspective. These differences have been major contributors to the persistence of issues such as reporting on internal control and fraud detection that the GAO regards as continuing unresolved problems. Exploration of these differences can help to put the GAO's evaluation of the accounting profession in perspective.

Importance of Internal Control. The accounting profession and Federal regulators have been talking past each other about internal control--proverbial ships passing in the night--for so long that there is a good chance the GAO's observations will be dismissed as the same old refrain. That would be a big mistake.

To back up its comments on the need for reporting on internal control, the GAO points to the savings and loan crisis in the 1980s, as demonstrable proof of the cost to the public of weak internal controls. The crux of the differences in viewpoint toward internal control is highlighted by focusing on the relationship between internal control and the adequacy of the loan loss allowance of a financial institution. An adequate loan loss allowance is critical to the fair presentation of a financial institution's financial statements in conformity with GAAP. Accountants and auditors generally recognize that, to determine an adequate allowance, a financial institution needs a systematic methodology to help ensure that all matters affecting loan collectibility are consistently identified and subjected to a detailed management review. The institution's system should document the performance of periodic detailed reviews to identify risks inherent in the institution's loan portfolio and the link between the findings of the review and the reported loan loss allowance. The controls over this process are indispensable for the continued safety and soundness of the institution as well as the reliability of the estimate of the loan loss provision and allowance in the financial statements.

Auditors are also aware that controls over accounting estimates, including the provision and allowance for loan loss, are subject to inherent limitations. Management can make mistakes in judgment and, because of the authority invested in senior management, can override controls. Because of these inherent limitations of internal control, auditors usually take a primarily substantive approach to auditing the loan loss allowance. Using this approach, the auditor learns relatively little about the financial institution's controls over the determination
of the allowance and need not test
the controls.

Because the auditor does not focus on controls, differences in the quality of controls may have little audit significance. In fact, there is no way to tell from the audit report whether the financial institution has a well or poorly controlled process for estimating the loan loss allowance. An institution with a poorly controlled estimating process gets the same clean opinion as one with an extremely well controlled process. Accountants and auditors accept this as simply the way things are under current standards. To the Federal regulator concerned with the safety and soundness of the institution, however, there is a vast difference between these two institutions. The institution with poor controls is a more likely candidate for insolvency and regulatory bailout.

The public accounting profession, the investment analysts, and preparers of financial information need to be more open to the regulators' perspective on internal control and work toward effective public reporting on controls. Forcing reporting on controls into the mold of an opinion on financial statements is unlikely to produce meaningful reports. If the basis for reporting is strictly a choice between a clean or qualified opinion on controls, the criteria for a clean opinion are likely to be so broad that few, if any, public companies would ever receive other than a clean opinion. The goal should be an informative type of report that allows users to understand the wide variations in the quality of internal controls that exist in practice.

Market-Value Reporting. As noted earlier, the GAO is very critical of the current mixed model of financial reporting. Past SEC chairmen, commissioners, and chief accountants have also been highly critical of the mixed model and called for swifter adoption of a market-value-based financial reporting model.

Again, differences in viewpoint create misunderstandings and confusion. The current accounting model is a legacy of the Industrial Revolution when manufacturing companies dominated the economy. Because the long-term assets of a manufacturing company are used in production rather than held for sale, fluctuation in the economic value of these assets has relatively little bearing on the going concern value of the company. Systematic and rational allocation of historical costs among periods provides information sufficiently relevant for measuring performance and assessing earnings-generating ability.

For financial services companies with significant lending or investing activities, the mixed accounting model inherited from the Industrial Age is a poor fit indeed. Appreciation and depreciation in the loan and investment portfolios of these entities are the essence of their operating activity. Historical cost accounting permits these changes in portfolio valuation to go largely unrecognized. Some financial services companies, such as investment companies, use valuation accounting for their loan and investment portfolios. However, most financial services companies use a mixed accounting model that permits delays in recognition of valuation changes and opportunities for management's manipulation of the earnings-generating activity presented by the income statement.

The GAO believes that mark-to-market accounting would resolve many of the issues the FASB has confronted in developing accounting rules for derivatives, but recognizes the controversy of the solution. Opponents of mark-to-market accounting point out that the historical cost benchmark provides a reliable information base for analysts and does not have the volatile effect on reported earnings of mark-to-market accounting. The GAO responds that the current model may be sufficient for analysts and other sophisticated investors, but that usefulness to the general public is less likely. The foundation for accountability provided by historical cost data can be retained, but the model must be expanded to provide market value information.

Auditor/Client Relationship. The GAO has long sought answers to the perennial problem of the auditor/client relationship. A major unstated concern in the report is the fundamental relationship in which management, a principal focus of the audit effort, very often controls the payment of the fees of the auditor. The GAO raises the possibilities of mandatory rotation of auditors or the restricting of nonaudit services to attest clients but rejects these two notions on the grounds that the public benefits
from nonaudit services and continuing auditor/client relationships outweigh
the risks.

The GAO is concerned about client advocacy by the auditor, and it is not alone. CPA firm advocacy of inappropriate interpretations of accounting standards to benefit audit clients was identified as a significant problem by the Cohen Commission in 1978, criticized as a major practice issue by the SEC's chief accountant, and acknowledged as a continuing problem by the Kirk Panel in 1994. It has now been underlined as an unresolved major issue by the GAO's conclusion that the solution proposed by the Kirk Panel and adopted by the POB requires the SEC's intervention to implement.

Participation in Standard Setting. Federal regulators have not been immune from standard setting failures. One cause of the savings and loan crisis was regulatory approval of statutory accounting practices that concealed early warnings of impending financial danger. However, private sector standard setters share the blame, for example, by not addressing savings and loan management's use of gains trading and similar tactics to manipulate the picture of earnings-generating ability in the mixed model income statement. Was this a problem that should have been solved promptly by auditing standard setters, specialized industry standard setters, or accounting standard setters? The issue is complex and the GAO's evaluation touches only the tangents of the problem.

The GAO, however, does highlight one significant aspect of the problem--the need for increased user participation in setting standards. This participation is important not only to provide a user perspective so that proposed solutions better meet user needs, but also to ensure attention to the public interest in standard setting. The FASB, the GAO notes, has a strategic plan that includes building broader acceptance from users, as well as preparers, educators, and auditors for the accounting standard setting process and the resultant accounting standards. However, in my view, the AICPA has consistently sidestepped calls for greater user-interest-oriented participants in audit standard setting.

Who Will Take the Initiative?

The GAO report, in effect, says that the accounting profession is on the right track and has been responsive to the recommendations of commissions and panels such as Cohen, Treadway, and Kirk. However, there are major unresolved problems. The GAO believes they will continue unless the SEC takes a more decisive and affirmative approach to its oversight of the financial regulatory process for public
companies.

In my view, a major contributor to the perceived differences in how the unresolved major issues are viewed is the dramatically different perspective of the accounting profession and Federal regulators. This is particularly evident on the fundamental matters of internal control reporting and the market-value based accounting model. The accounting profession has been slow to acknowledge the legitimacy of the regulatory perspective or to treat Federal regulators as permanent stakeholders in the financial reporting process. This perspective ignores the significance of Federally mandated audits in the growth and success of public accounting practice.

The GAO does not dwell on the topic of fault for the existence of major unresolved issues. The report takes a constructive approach. While the call for increased SEC involvement is firm, there is no hint of the need for radical change such as mandatory auditor rotation or limitations on scope of services. I hope the accounting profession will grasp the hand the GAO has extended for cooperative action by the profession and Federal regulators to strengthen public accounting practice. *

Douglas R. Carmichael, PhD, CPA, is the Wollman Distinguished Professor of Accountancy at Baruch College, CUNY, and an editor of The CPA Journal. He served as a consultant to the GAO on this report.

In Brief

A Passing Grade

Congressman John Dingell (D-MI), while in control of his Congressional committee, asked the GAO to evaluate how well the profession had responded to changing needs to better protect the public interest. He planned to use the information in deciding how to move forward on the profession's proposal to obtain some litigation relief. The GAO took over two years to conclude the profession has been responsive, but that there are some very significant unresolved issues to address in the areas of auditor independence and the auditor-client relationship, the effectiveness with which auditors deal with misstatements of financial statements due to management fraud, the need for public reports on internal control of public companies and enterprises with a strong public interest, user participation in setting professional standards, and the need for a comprehensive financial reporting model to reduce the problems inherent in today's mixed presentation of fair values and historic cost.

The GAO makes no "recommendations" but does offer observations on what might be done to deal with these major unresolved issues. Throughout its report it stresses the importance, in its view, of strong SEC leadership. The report does a masterful job of identifying the issues; it presents the perspective of the regulator in addressing solutions. The number one question raised is whether the remaining issues can be addressed adequately through the self-regulatory systems. If not, securities and other regulators should step in to protect the public interest.