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Nov 1989

A review of the GAO's progress report on initiatives to improve audit quality. (General Accounting Office) (Auditing)

by Apostolou, Nicholas G.

    Abstract- The General Accounting Office was charged by the House Oversight and Investigation Subcommittee with making a report on the progress of the implementation of the Treadway Commission's recommendations on the accounting profession. The GAO report, published in March 1989, expresses satisfaction with progress in the areas of: narrowing the gap between public expectations of the profession and the profession's own perceptions of their role; protection of auditor independence; and mandatory peer review. In the area of responsibility for internal controls, the GAO states that the Security and Exchange Commission's proposed management report would succeed in its aim to make management more accountable for financial reporting.

Audit quality and the integrity of the financial reporting process of public companies have been the focus of widely publicized controversy and debate in recent years. Rep. John Dingell, Chairman of the Subcommittee on Oversight and Investigation, has led a crusade examining the adequacy of auditing and financial reporting. The Dingell Subcommittee has held numerous hearings on the matter since 1985.

Rep. Dingell requested the U.S. General Accounting Office (GAO) to monitor implementation of recommendations affecting the accounting profession for the one-year period between December 1987 and November 1988. The GAO published its report in March 1989. The GAO report summarizes the status of principal recommendations and makes additional suggestions to the Dingell Subcommittee that may require regulatory or legislative action to implement. This article summarizes the findings of the GAO.

Initiatives to Narrow the

Expectation Gap

The so-called expectation gap characterizes the difference between the public's expectations of CPAs and what CPAs believe to be their role. Deficiencies in three areas were identified by the Treadway Commission (Report of the National Commission on Fraudulent Financial Reporting, October, 1987) as principal contributors to the expectation gap:

1. Early warning disclosure;

2. Auditor's duty to detect and report fraud; and

3. Communication of audit results.

Early Warning Disclosure. Early warning disclosure has been addressed by the issuance of SAS 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, effective for audits of financial statements for periods beginning on or after January 1, 1989. SAS 59 requires the auditor to evaluate whether substantial doubt exists about the entity's ability to continue as a going concern for a period not to exceed one year beyond the date of the audited financial statements. (See the Auditing Department in The CPA Journal, July 1989.) If the auditor believes that such doubt does exist, a fourth paragraph should be added to the standard auditor's report. SAS 59 also states that the absence of such a reference does not provide assurance as to the entity's ability to continue as a going concern. Nonetheless, the GAO views this step as narrowing the expectation gap.

Another approach to improving early warning disclosure is through management's discussion and analysis of financial condition and results of operations (MD&A) required by the SEC is its filings. Guidelines for MD&As are currently broad, and companies have often presented a rehash of obvious items. The GAO has recommended that the SEC require management to disclose and discuss significant risks and uncertainties. The SEC is currently involved in a research project to identify guidelines for disclosure of early warnings by management in MD&A. The GAO supports enhanced disclosures by management and stresses the need for the SEC to expendite the promulgation of new and stricter rules in this area.

Auditor's Duty to Detect and Report Fraud. The auditor's duty to detect and report fraud has been increased in accordance with Treadway recommendations. SAS 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities, and SAS 54, Illegal Acts by Clients, require that CPAs design audits to provide reasonable assurance of detecting errors, irregularities, and illegal acts that have a material impact on the financial statements. In addition, SAS 56, Analytical Procedures, has been issued in response to the Treadway recommendation that analytical procedures be required in all audits, since they may reveal variations or trends that could have been caused by fraud. SAS 56 requires that CPAs perform analytical procedures during planning and as an overall review of financial statements in all audits.

The GAO report indicates satisfaction with the increase in the auditor's duty to detect fraud. However, concern was expressed over the issue of reporting fraud. Rep. Ron Wyden introduced legislation in 1986 that would require auditors to report fraudulent activities of clients directly to the appropriate enforcement and regulatory authorities. The accounting profession has taken a small step toward this end with the new requirement that auditors report material errors, irregularities, and illegal acts directly to the audit committee or an equivalent other (SASs 53 and 54). The GAO notes that reporting to officials outside the entity may be necessary and appropriate in certain circumstances. As a result, it has expressed concern over the lack of action taken. Whistle blowing is a controversial matter that may not be settled until issues surrounding auditors' legal liabilities are addressed. Nonetheless, the GAO has emphasized the need for Rep. Dingell to continue to pursue change in this area.

Communication of Audit Results. Communication of audit results has been changed with the issuance of SAS 58, Reports on Audited Financial Statements. The GAO noted that the clarification of the responsibilities of the auditor and management in the financial reporting process contained in the SAS improves communication to users of audit reports and should serve to narrow the expectation gap.

Responsibility for Internal Controls

The Treadway Commission recognized the critical role of internal controls to provide reasonable assurance that fraudulent financial reporting will be prevented or detected in a timely manner. Treadway suggested that management should include a written report in Form 10-K each year that clearly indicates its responsibility for internal controls, an assessment of the effectiveness of internal controls, and a response to internal control weaknesses identified by internal and external auditors. The SEC has taken an initiative to require such a report. The proposed management report would include:

* Description of management's responsibility for the financial statements;

* Description of management's responsibility for maintaining a system of internal controls;

* An assessment by management of the effectiveness of its internal controls; and

* Responses by management to significant recommendations made by internal and external auditors.

The SEC is studying the objections raised by the many comment letters written in response to the proposal. For instance, the AICPA commented that an assessment of the effectiveness of internal controls is not meaningful without standard evaluation criteria. However, the GAO fully supports the SEC proposal for a management report because it should serve to provide assurance to the public that adequate controls are in place. In addition, the GAO notes that preparation of a report would make management more accountable for accurate financial reporting.

Although the Treadway Commission noted that internal controls were the responsibility of management, it also suggested that auditors be required to evaluate internal controls in all audits. SAS 55, Consideration of the Internal Control Structure in a Financial Statement Audit, and SAS 60, Communication of Internal Control Structure Related Matters Noted in an Audit, were issued to expand the auditor's duty to understand internal control and to communicate certain internal control conditions observed during the audit to the audit committee or equivalent other body. While the GAO recognizes this as an important step, it has recommended to the Dingell Subcommittee that the SEC require auditors to review and publicly report on the proposed management report. However, the SEC proposal for a management report notes that SAS 8, Other Information in Documents Containing Audited Financial Statements (AICPA, 1975), would most likely apply. That is, the auditor would regard management misrepresentations concerning internal control as a material misstatement of fact in the management report. In early 1988 the ASB established a task force to consider the auditor's responsibility for information regarding internal controls contained in a management report. The task force has not yet published its recommendations.

Protection of Auditor Independence

Auditor independence is the fundamental underpinning of a fair and impartial audit. Treadway made two proposals to enhance auditor independence:

1. Improve disclosures regarding changes in auditors (opinion shopping); and

2. Require audit committees.

The SEC responded to the first recommendation above with two distinct actions. The first was to adopt new disclosure requirements when reporting changes in auditors. Consultations with the new auditors within two years of the change must be reported if the consultations:

* Were subject to provisions of SAS 50, Reports on the Application of Accounting Principles; or

* Were the subject of a disagreement with the former accountant. The company must also disclose the circumstances under which the predecessor auditor was terminated and whether permission was granted to the former auditor to respond fully to inquiries made by the new auditors.

The second SEC initiatives regarding improved disclosures was to shorten the period for filing Form 8-K relating to changes in auditors. The following changes became effective on April 7, 1989:

* Period for filing Form 8-K announcing a change in auditors was reduced from 15 calendar days to five business days; and

* Period for filing of the former accountant's letter was reduced from 30 calendar days to 10 business days. The GAO is satisfied that accelerating the reporting period as well as the nature of the disclosures will strengthen auditor independence by making opinion shopping less attractive. However, the GAO has suggested to the Dingell Subcommittee that the SEC require that accountants report their termination and reasons therefore directly to the SEC rather than indirectly through the filing of Form 8-K. The reasoning is that it would be a more effective early warning device.

The Treadway Commission recommended that the SEC require all public companies to establish audit committees composed of independent directors. Audit committees can enhance auditor independence by providing a buffer between the auditor and management. While the SEC supports this recommendation, it requested that the individual securities exchanges re-evaluate their listing requirements regarding audit committees. The GAO is dissatisfied with this approach and reported to the Dingell Subcommittee that the SEC should reverse its decision and require public companies to adopt audit committees. The GAO believes that the role of the independent audit committee in enhancing auditor independence cannot be over-emphasized.

Mandatory Peer Review

The GAO concurs with the Treadway Commission's stance that a peer review program for auditors is the most important aspect of the quality assurance mechanism. Peer review has been a requirement for membership in the SEC practice section of AICPA's Division for CPA Firms. However, not all firms who audit SEC reporting companies belong to that section. In an attempt to satisfy the Treadway recommendations, the AICPA membership is voting on a change in bylaws to require all firms of AICPA members who audit SEC reporting companies to belong to the SEC practice section. However, not all audit firms of public companies are AICPA members, thus, they are excluded from the peer review mandate. The SEC is currently researching the possibility of administering its own peer review program. The proposed rules would require all audit firms of public companies to undergo peer review within three years of the audit date. Action on this proposal is pending resolution of the following issues by the SEC:

* Define the structure of an SEC peer review program;

* Cost versus benefit of mandatory peer review; and

* Evaluate SEC authority to require peer review.

The GAO recommended to the Dingell Subcommittee that the SEC resolve these issues and require peer review for all audit firms of SEC registrants. Furthermore, the GAO believes this mandate should be legislated if found to be outside SEC authority.

Quality of Government Audits

In 1986, the GAO published a report of its review of a sample of 120 CPA audits of government funds. It found that 34% contained departures from applicable auditing standards. The GAO report, coupled with media attention and congressional reaction, spawned the AICPA's Task Force on the Quality of Audits of Governmental Units, in March 1987. This task force issued its recommendations (popularly known as the "5E's") to improve the qualityof governmental audits. The GAO reported to the Dingell Subcommittee that responses to the "5 E's" have been substantial. It also noted that these initiatives, if properly implemented, should significantly strengthen the quality of governmental audits.


The recommendations made by the Treadway Commission and others to improve audit quality have received considerable attention. Sweeping changes have taken place in auditing standards, SEC rules, and professional practices. However, what else needs to be done to accomplish the objective of improved audit quality?

The GAO performed a one-year review of initiatives taken in response to recommendations made by the Treadway Commission and others. While the GAO is satisfied with much of the progress to date, it has identified areas that the Dingell Subcommittee should pursue to continue toward the objective of achieving improved audit quality. The GAO notes that while the initiatives to date, and its own recommendations, demonstrate a commitment to audit quality, continued monitoring is required to ensure the improvement continue.

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