Changing the image of the CPA. (Cover Story)by Chapin, Donald H.
In the eyes of the author/regulator, the profession's image is at a low point. He examines the developments that led to this condition and discusses some fundamental issues that have to be addressed for it to change.
I speak today as a long-time member of the profession and with the experience of having been at GAO at a key time in the evolution of the profession. In some ways the profession has changed radically over the last 40 years. Growth, competitiveness, and business emphasis have changed the profession I grew up in. In contrast, the attest function and the related services offered by the CPA have not changed nearly as much. But, the scope and quality of those services, basically unchallenged for much of that 40 years have come under question in the '80s, coincident with the growing number and size of lawsuits against CPAs.
For some years, GAO tried to help close an open door to the public purse by proposing reforms for federally insured depository institutions and for government agencies in ways which strengthen and more fully utilize the audit function. Having accomplished this, we are exploring whether these reforms to strengthen internal controls and compliance with laws and regulations should be legislated by Congress for other industries. We envision reforms which might affect the duties and responsibilities of company management and audit committees as well as those of the independent auditors.
The CPA profession can help with these reforms and in other ways play a more constructive role in shaping its own future. Unfortunately, the history of the profession in that regard is not too encouraging. I offer today for your consideration what I believe to be the keystones to the much-needed, enhanced mission of the CPA in serving U.S. business and its shareholders, the government and the public. I hope the profession will try to work with these ideas and come forward with constructive proposals.
PERCEPTIONS OF THE PROFESSION
Let me start with perceptions. Perceptions of the profession by regulators and Congress are negative--perhaps more negative than most CPAs imagine. The wrong solution would be for the profession to continue trying to close the expectation gap by reducing expectations. Expectations are so unbelievably low that some are questioning whether there is a role for a private sector profession. In fact, failure to try to meet expectations has led to a situation where it is not uncommon in the halls of Congress to hear discussion of possible action to regulate the profession.
It is still conceivable that the profession could achieve its goal of liability limitation, and retain its private sector status. But, to achieve its goal, it will be necessary in its interaction with the government for the profession to take a proactive role and propose both expanding its service to the public and some form of government regulation.
DEVELOPMENTS AFFECTING THE PROFESSION
To understand why congressional action is likely, it is necessary to understand the changing role of the auditor and related developments affecting the status of the profession.
To Whom is Auditor Responsible?
Historically it has been thought that the auditor is responsible either to the management and the company that hired the firm or, more broadly, to the shareholders of that organization. But now the judicial, congressional, and regulatory viewpoint is that the auditor has a broader responsibility. That view is that the auditor has responsibility to the general public and, in the case of regulated institutions, that there is a direct responsibility to the regulators. At times the issue has revolved around whether the auditor has a responsibility to be a "whistle blower" to regulators, but the issue is really more fundamental than that. The U.S. Supreme Court, in the case of U.S. v. Arthur Young, ruled in 1984 that by certifying the public reports that depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client and owes ultimate allegiance to the corporation's creditors and stockholders and to the investing public. Chief Justice Warren Burger wrote, "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."
Is Management the Client?
In certain important respects, management is in conflict with the other parties claiming that they are the client. Management many times does not see the value of the audit other than the need to obtain the required audit opinion and sometimes management wishes to minimize oversight. For these reasons, management frequently has an incentive to reduce audit fees and audit scope. Audit failures have resulted. With this situation, it is not surprising that Congress and others outside the companies' management are increasingly dissatisfied with the profession's public watchdog function. The profession seems to be compounding the problem by its own actions.
Management Consulting Services
Between 1975 and 1990, the large firms' gross fees attributable to accounting and auditing services declined from somewhere between two- thirds and three-quarters of total fees to one-half or less. Management consulting services has become a main line of business. Traditional audit work is increasingly taking a back seat. We have been told that some firms are offering audits--their exclusive franchise--at big discounts to attract clients for their more lucrative consulting services. Some say the profession's traditional function has been downgraded to a loss leader.
Over capacity in the profession and an intense interest in growth has led to a too willing response to pressure from companies to drive down the cost of audits by competitive bidding. As audit firms became more competitive, the pressure to gain clients at the expense of other auditors and retain existing clients at almost any cost has resulted in planned, and no doubt, some unplanned reductions in audit scope. Concerns about quality and service diminished in importance as growth was stressed by the businessmen of the profession.
Demands for New Audit Services
The profession also has been reluctant to respond to demands for new audit services coming from outside the companies they audit--there is concern about what the services will cost and the idea that more legal liability lies in wait. The profession seems to have put its future in the hands of its defense lawyers who do not see that new audit services can increase the auditor's knowledge of the facts, and therefore reduce overall audit risk and the incidence of opinion audit failure. So what are some of these unsatisfied demands?
Demands for Improvement
Peter Scanlon, former Chairman of Coopers & Lybrand, said that the auditor's role is essential in reassuring management and investors as to the financial controls of a company. Without auditors bringing some assurance to the table, the need for the profession is questionable, he said. Inherent in this demand is a call for reasonable assurance about the absence of management fraud and compliance with laws and regulations, as well as the overall soundness of internal accounting controls. Others have pointed to deficiencies in corporate disclosures and have pointed out that the profession is playing a reluctant role in helping to come to grips with demands for improvement. Gaps in financial reporting include the need for
* valued-based financial statements;
* more predictive information such as forecasts and projections;
* more disclosure of risks and uncertainties; and
* performance measures other than the bottom line profit figure.
This reluctance is part of a historical pattern by the profession. The National Commission on Fraudulent Financial Reporting (commonly called the Treadway Commission) inspired statements on auditing procedures that attempted to deal with auditing expectation gaps such as early warning of possible business failures, reporting of related party transactions, and detection of fraud. As it now can be seen, these turned out to be weak medicine. Further, the AICPA position on the more recent Committee of Sponsoring Organizations (COSO) study of internal control is also weak. As one of the sponsoring COSO organizations, the AICPA has taken no position on auditors' attestation of management reports on internal controls. All in all, the Treadway inspired work is turning out to be disappointing, and, I think counterproductive. Certainly not the Treadway Commission's ideas, but the gap between them and the implementation guidance would fill the Grand Canyon.
While these things have been unfolding, the explosion of legal actions has not only put the profession's financial backs against the wall, it has severely damaged the trust and standing of the profession in the minds of their non-management clients and the Congress. I don't have to go into that painful subject, but it is important to note that the profession's power to control its own future has been substantially diminished.
FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991
We at GAO look at the profession as an essential resource needed to properly manage the public purse. Although there were voices who doubted the profession's ability to perform, we advised Congress that the profession had an important role to play. This role was legislated in the Federal Deposit Insurance Corporation Improvement Act of 1991.
This Act is applicable to banks and savings and loans with assets of $150 million or more, or in other words, the 2,000 largest financial institutions in the country. It is directed at management, regulators, and the auditors. The act requires customary financial reporting under GAAP, but permits the regulators to set more stringent accounting principles and expand disclosures for reports filed with them. Also, regulators have the option to request a review and attestation of quarterly financial reports by independent public accountants.
Reporting on Controls and Compliance
More importantly, the act also requires management's assessment of the effectiveness of the institution's internal control structure and its compliance with designated laws and regulations in accordance with accepted standards for attestation engagements. Independent public accountants are required to attest to management's assertions on internal accounting controls and laws and regulations. Regulations will determine the level of attestation for the internal control assertions, while the act specifies agreed upon procedures for compliance assertions. We view the work by the CPAs as an extremely important complement to the regulators' function to identify potentially troubled institutions.
Independent Audit Committee
To improve accountability, the Act also requires an independent audit committee whose duties include reviewing the basis for management's report and the CPA's assessments. For large institutions, audit committee members must have banking or related financial management expertise and the committees have access to their own outside counsel. To enhance independence, the committees may not have large customers as members. We view this at yet almost unnoticed provision on audit committees as a major step. Collaterally, it will enhance auditor independence.
Relationship Between Auditors and Regulators
Exchange of reports and information between the CPAs and the regulators is also required, including notification by the CPA of resignation or dismissal, and a statement of reasons for such change within 15 days of the event. CPAs must have received peer reviews that meet regulators' guidelines and agree to provide work papers, policies and procedures to regulators. Peer review reports are filed with regulators and are available for public inspection. Upon showing good cause, regulators may remove, suspend, or bar a CPA from performing audit services. We view these provisions as important controls to insure the CPA's satisfactory performance of a public duty.
CHIEF FINANCIAL OFFICERS ACT
To complete the picture of what is happening in the public sphere, you should know that we at GAO have helped to place additional performance requirements on auditors of government agencies.
In implementing the Chief Financial Officers (CFO) Act, we have taken the position that appraising the quality of controls has at least equal importance with giving opinions on financial statements. We see the auditor's controls assessment as both an incentive and a basis for improving federal financial management systems. We believe that the auditor should perform sufficient work to form an opinion on the internal controls at the level set by Statement on Auditing Standards (SAS) 30. The fact that one might audit financial statements on a more cost-effective basis by performing substantive procedures rather than making a full evaluation of controls is not the issue. We believe that the auditor should give opinions on controls designated to:
* safeguard assets against loss from unauthorized use or disposition;
* assure the execution of transactions in accordance with budget authority and with other laws and regulations; and
* properly record, process, and summarize transactions for the preparation of financial statements and to maintain accountability for assets.
Our efforts as government auditors are designed to provide reasonable assurance that losses, noncompliance or misstatements that are material in relation to the financial statements would be prevented or detected. For internal control weaknesses that are noted, the threshold for reporting them is that set by SAS 60.
For practical purposes and for now, we anticipate work on compliance with specified laws and regulations at the relatively low level of attestation described in SAS 68. We plan to look for compliance failures which would have a material effect on the financial statements, but we will not limit our report to those which only have a direct effect.
In addition to these responsibilities, we also believe that we have a responsibility to consider and report the impact of discovered misstatements and internal control weaknesses on:
* the achievement of operational objectives;
* the fairness of reports prepared by the entity other than the financial statements, and
* budget formulation to the extent based on historical financial information.
FUNDAMENTAL ISSUES TO BE ADDRESSED
The auditing provisions for financial institutions and for government agencies which I have described seek to more fully utilize the talents of auditors to improve regulation and management of these entities. This is a critical issue for the profession to effectively fulfill this role, but there are also other fundamental issues to be addressed.
Separating Auditors From Management Control
I believe that it is very important for the profession to come up with a plan for reform which deals with survival issues. One of these issues is facilitating recognition of the public interest. How to free the profession to take on this role involves separating auditors from management control. Truly independent audit committees could serve as a proxy for those outside the company who either explicitly or implicitly are clients. But to date, audit committees, like auditors, have not met expectations.
Members of the 50 largest banks' audit committees told GAO that they lack true independence from management, lack competence to do the job, and have unclear and unmandated responsibilities. While audit committee roles exist for many large companies, as a result of Stock Exchange influence, the committees' role and powers are not well defined. Most serve mainly as a communication link between the board of directors and the independent auditor without any formal responsibility for an independent review of the financial statements and auditor's report. Further, there are no audit committee requirements for oversight of the internal control function and the company's compliance with laws and regulations. Nor is there any requirement to supervise top management's internal control function, and specifically, to prevent top management from overriding the company's controls. As a result, the auditor remains in fact primarily responsible to management. To make audit committees and independent auditors more effective monitors of public corporations, I believe it will be necessary to enact legislation to strengthen formally the outside directors' independence from management and to enhance the role and power of the audit committee.
Supervising the Profession
Another survival issue is assuring those who are concerned that the profession is properly performing its functions.We considered several options when formulating recommendations to strengthen the oversight of financial institutions. For example, we considered a limitation on management services work, required rotation of auditors, and other possible steps to strengthen independence. These ideas were set aside in the particular circumstances because there were active regulators and we thought of better alternatives. We choose inspection of work papers, disciplinary measures, and controlled peer reviews. There are other proposals that might provide some of the answers like the Wyden direct reporting requirement. But that alone is not enough. Perhaps a collection of regulatory processes packaged in a government-sponsored, self-regulatory body similar to the National Association of Securities Dealers is the answer. We have not yet studied exactly how that might be done, but there seems to be developing support for legislation to require that kind of supervisory arrangement.
Expanding Services to the Public
Another survival issue is expanding service to the public. Particularly important, in my view, is the additional controls and compliance work of the kind now required for financial institutions and being applied to U.S. government agencies. In approaching this issue, the profession would do well to try to expand the scope of the work rather than restrict it. You know if you don't look thoroughly you may miss the problem that sinks that ship. It won't matter much if the CPA says that only very limited procedures were applied. I would think that it might be acceptable to have a transition period for CPAs to get up to speed before assuming full legal responsibility. Although we think these controls and compliance issues are paramount, there are, as I have said, other expanded service needs out there.
Federal Deposit Insurance Corporation Improvement Act
In a recent article, Joe Moraglio at the AICPA, suggested that the Federal Deposit Insurance Corporation Improvement Act might be a model for the future. Perhaps, with some modifications, it is. Should the profession propose legislation for SEC registrants based on this model? The solution has been accepted by Congress as an appropriate one for the banks. It fits some recent complaints about out-of-control CEOs as well as the obvious exposure presented by their unsupervised power over internal controls and compliance with laws and regulations. This power has been at the heart of some major non-bank failures as well as the proven cause of some spectacular bank failures. But, is the Act the complete solution to persistent audit failure and risk of failures across many industries? Does it fully answer the need for expanded services? What are the cost benefit considerations involved considering all aspects of this equation, including whether the securities markets are properly informed so that non-insiders are not disadvantaged in trading?
I suggest you think it through without delay. Examine the alternative steps. But take the initiative before others step in and formulate a solution for you. This time, don't try for a minimalist solution. The time and the patience for that is over. If you want to shape the future, make a responsible proposal that deals with and meets the public need for service, provides for your independence of action, and recognizes that more regulation of the profession is inevitable.
Donald H. Chapin is Assistant Comptroller General for Accounting and Financial Management at the U.S. General Accounting Office.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.