In the Public Interest - the CPA Journal Symposium.
The CPA Journal sponsored a symposium in July, 1993 to explore the recommendations of the POB and the AICPA to improve financial reporting and the audit process. Auditors, preparers, users, and regulators joined to debate the proposals. Most thought they had the right prescription; soome thought the patient--public confidence in financial reporting-- needed more basic therapy.
Expectation gaps that never seem to narrow, huge settlements of law suits, and cries of "Where were the auditors?" abound on one side of the ledger. On the other side, there are expectation gap Statements on Auditing Standards, requests for relief from the excessive burden of litigation, and cries of, "I followed professional standards, what more could I have done?" Overlaying these two points of view are calls from observers and regulators for the profession to step forward, respond, and resolve these conflicting positions.
First The POB
The call for leadership was answered by the AICPA Public Oversight Board of the SEC Practice Section (POB) in its special report, In the Public Interest, issued March 5, 1993. The POB was asked to support the profession in seeking relief to what was believed to be an excessive burden of litigation. To respond, the POB sought to determine the extent to which litigation was adversely affecting the public interest. The special report is the culmination of the POB's consideration of the issues and sets forth some 25 recommendations to improve the usefulness and reliability of financial statements and the ability of auditors to detect fraud and illegalities. The recommendations are directed to various groups and organizations, such as Congress, the AICPA, and the FASB, who would be able to make the suggested changes.
The POB recommendations focus primarily on public companies and firms that audit those companies. The implications of the recommendations, however, extend to the entire profession, to the preparers and users of financial information, and to regulators of the profession and capital markets that feed on financial information. More importantly the POB's action represents leadership that, in the minds of many, was sorely needed.
Then The AICPA
In June 1993, the AICPA stepped forward by enthusiastically endorsing the POB recommendations. The AICPA also made additional recommendations to demonstrate its commitment and to further enhance public confidence.
But the proposals are from a self-regulator of the profession and the profession itself. What about users, preparers, and regulators of financial reporting? Do they believe the recommendations are meaningful and responsive? The CPA Journal took the lead in providing a vehicle for all voices to be heard.
At The CPA Journal Symposium, "In the Public Interest," on July 19, 1993, Robert L. Gray, Publisher and Editor-in-Chief of the Journal, moderated a discussion of the POB and AICPA recommendations. According to Gray, the stated purpose was, "To examine the proposals, both individually and collectively, to see if they are what they promise--the return of public confidence to financial reporting--and to the extent they are not, what else might be done. We also want to provide a dialogue among those that must participate--preparers, auditors, users, and regulators--in seeing that the various recommendations are implemented." The accompanying sidebar presents the proposals of the POB and the additional proposals of the AICPA.
The symposium opened with six participants making prepared remarks: A.A. Sommer, Chairman of the POB, discussed the development of the POB's proposals and his view of the implementation process. Donald Chapin, Assistant Comptroller General of the U.S. General Accounting Office, focused on where the proposals fell short from his regulatory perspective. Walter Schuetze, Chief Accountant of the SEC, used the Symposium to make a significant policy statement that he did not favor mandatory auditor reporting on internal control. Shaun O'Malley, Joint Chairman, Price Waterhouse World Firm, spoke about the AICPA commitment and how the additional recommendations build upon the POB proposals. James Healey, as spokesperson for the Financial Executives Institute (FEI), restated FEI's opposition to independent auditor internal control reporting. Peter Knutson, representing the Association for Investment Management & Research, endorsed the proposals but discussed the need for more fundamental changes.
Discussants, John C. Burton, a professor at Columbia University and former chief accountant of the SEC, Robert Israeloff, vice chairman- elect of the AICPA and partner of a local firm, and David Eyles, Vice President of Shawmut Bank and representative of Robert Morris Associates, probed the various positions. John Flaherty, chairman of the Institute of Internal Auditors also made a statement generally supporting the proposals.
The Symposium demonstrated much agreement exists among the various constituencies represented as to what needs to be done. There were, however, several areas where significant disagreement was articulated.
The first recommendation of the POB is for Congress to ease the financial burden in cases of financial failure or fraudulent financial reporting by passing "separate and proportionate" liability legislation. The AICPA endorses this recommendation for liability reform and points out that it would be applicable in the absence of "knowing fraud." All the participants addressing the issue expressed their belief that liability exposure to the point presently being experienced by the profession can not continue.
Healey pointed out the FEI has publicly expressed its belief the litigation crisis is in need of immediate attention. "A financially sound and properly structured profession is in the best interest of not only the accounting profession but the preparer and user communities as well," said Healey. "No one will be well served if the profession becomes either quasi-governmental through standards issued by a government body or financially non-viable."
Burton, in probing the issues, expressed his view that fundamental changes are necessary to get at the heart and purposes of the recommendations--liability reform. "Accountants are not viewed as needy people," said Burton, "and the legislative environment is such that Congress is not going to take on reform without some real concessions." Burton felt the answer may lie in a self-regulatory organization, established by statute, not in the NASD model, but in a unique format. It will need legislative legitimacy to work to give the organization subpoena and investigatory powers.
Chapin, while acknowledging the liability exposure as a serious matter, expressed concern for the protection of investors. ". . . this is not just a litigation money game with winners and losers," stated Chapin. He believes the increased litigation initiated by users of financial information, ". . . at least in some measure, reflects significant dissatisfaction with the assurance function presently being delivered by the profession." On the other hand, Chapin believes the threat of litigation has caused the profession to withdraw from meeting users' needs in non-traditional areas requiring the assurance function. Chapin's perspective is that the quality of the delivery of the assurance function must be improved before liability reform can be discussed.
O'Malley stressed the need for a rigorous, but fair, liability system. In his view the liability system itself is the cause. "I believe the profession is doing a good job," said O'Malley. ". . . the profession is prepared to do an even better job." O'Malley pointed to the activity of a number of small law firms that make a career of systematically filing securities law suits when stock prices experience a sharp downturn. Normally peripheral deep-pockets such as auditors are brought in as defendants to increase "the 'take' from coerced settlements."
When asked about the SEC's opinion on liability reform, Schuetze referred to the recent testimony of William McLucas, SEC Director, Division of Enforcement, before the Subcommittee on Securities, Senate Committee on Banking, Housing and Urban Affairs. While tending to favor the investor, the need for balance was supported. Schuetze agrees with the need for fairness but noted the problem is very difficult.
Eyles remarked that the cloud of litigation exposure has caused CPAs to be defensive and hesitant in responding to the changing needs of financial statements users for fear of raising the spectre of potential litigation.
The POB and the AICPA call for a statement by management in annual reports (presumably of public companies) on the effectiveness of internal controls over financial reporting, accompanied by an auditor's report on management's assertions. This recommendation has proven to be the most controversial.
Walter Schuetze, chief accountant of the SEC, used the occasion of the symposium to place the significant weight of his office in the "no" column on mandatory auditor reporting on internal control for public companies. Joining in opposition were Healey, representing the views of financial executives, and Flaherty, on behalf of internal auditors. These groups believe there is no evidence to support the view that auditor reporting on internal control will improve such controls or reduce the incidence of audit failure. Flaherty went on to observe that internal control reporting by outside auditors would increase costs but not provide more reliable financial information.
Eyles, giving the view of the credit granter, took a neutral position: "I believe there are higher priorities."
Schuetze said he did not see public reporting on internal controls reducing so-called fraudulent financial reporting and litigation against external auditors. "Fraudulent financial reporting arises primarily because management is cooking the books," said Schuetze, ". . . a well designed and well executed audit provides the best means of detecting these frauds." The complete text of Schuetze's remarks is presented in this issue of The CPA Journal.
On the other hand, Chapin continued to express support for independent auditor reporting on internal control but expressed concern that the definition of internal control contemplated by the proposals of the POB and the AICPA may be too narrow to properly serve the public interest. He cautioned against using the narrowly defined financial reporting controls of the Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Chapin went on to say bank regulators did not accept COSO's view as the proper focus in implementing the 1991 banking reform legislation, and the proposed changes to Government Auditing Standards just recently released include "important advances in auditor responsibility for internal control."
O'Malley, in presenting the AICPA position at the Symposium, took a more needs-oriented approach. In his view "the current complex, rapidly changing, computerized, and risk-laden business environment demands a greater focus on internal control." He sees investors and other users demanding this kind of reporting, joined by boards of directors who are "looking more and more for this type of assurance in fulfilling their fiduciary responsibilities."
The POB and the AICPA call for the establishment of specific responsibilities for audit committees and disclosure in annual reports filed with the SEC of those responsibilities and how they are being discharged. This should encourage audit committees or boards acting in that capacity to conscientiously carry out those responsibilities. To enhance independence of the outside auditor, the AICPA recommends SEC registrants and other publicly accountable organizations have audit committees composed entirely of independent directors, where practicable. Chapin feels these recommendations fall short of providing the corporate governance needed. Chapin turned to the model presented in the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), which requires financial institutions have an independent audit committee made up entirely of outside directors who are independent of management. Under FDICIA, audit committees for large institutions must include members with banking or related financial management expertise, have access to the committee's own outside counsel, and not include any large customers of the institution.
On the other hand, Burton believes greater transparency in auditor/client relationship would improve independence and responsiveness--the disclosure of fees for audit and other services would in Burton's view be very illuminating to users.
Eyles' experience is that some audit committees are better than others. It would be dangerous to legislate audit committee practices.
Healey feels the POB recommendation establishing responsibilities of audit committees puts "the horse in the carriage." The auditor has requirements to communicate to audit committees under auditing standards, and it is his or her job to see that is done, not the audit committee's.
Improving the Accounting Model
The POB recommended the FASB once and for all put the issue of fair value accounting to rest by placing the topic on its agenda. The AICPA refers to the work now under way by the Special Committee on Financial Reporting, which is scheduled to issue its recommendations in 1994. Both support the proposed SOP issued by AcSEC for additional disclosures in the area of risks and uncertainties.
Eyles joins the crowd asking FASB to study values and changes in values and put to an end the current piecemeal approach. "Bankers," said Eyles, "are interested first in the ability of borrowers to repay the loans from cash flows from operations, second in the assets available for liquidation and their values, and third an accurate queue of creditors. Consistency is important. If fair values, however, can not be established with the same degree of reliability as historic cost, they should continue to be shown as supplemental information."
Eyles went on to stress, as part of the user community, that financial reporting must be complete, timely, relevant, reliable, and understandable. Information content is extremely important. For the banking industry, private company information is almost of equal importance. There has been a decline in bankers' confidence in what they are seeing. The leveraging of debt has increased in recent years with a smaller equity cushion. Lenders are receiving fewer audits, with reviews and compilations being substituted. Eyles thinks a greater emphasis needs to be placed on material misstatements and fraud. Ambiguous accounting principles need to be attacked. Expectation gaps exist, are serious, and need to be addressed by all parties.
Healey does not feel the expectation gap can be cured with a new financial reporting model that may be subject to more subjective measurement than a historic-cost model. "It is also very hard to see how a new model would prevent an audit failure involving non-existent inventory," said Healey.
Burton feels the financial-reporting model can be improved on a more evolutionary basis by needling FASB to deal with today's problems more aggressively. Both the SEC and profession must do the needling. "I don't have a framework of some 25 items for them to focus on," said Burton. The FASB "needs to deal with the issue of articulation--the current emphasis on the balance sheet is not right; risks and uncertainties--it is incredible that AcSEC is dealing with that instead of FASB---it needs to more responsive to user needs."
Chapin supported the fair value recommendations and expressed his feeling that some managements use historical-cost statements to "manage earnings and paint rosy pictures for the public. I am concerned that management's opposition to value-based statements cannot be overcome through a POB recommendation to the FASB. The profession will have to assert its independence and weigh in on the side of the users of financial statements and reports."
Catch All Fraud
The POB report recommends the ASB or SECPS develop guidelines to assist auditors in assessing the likelihood that management fraud may be occurring and to specify additional auditing procedures when there is a heightened likelihood of management fraud. The AICPA identified improved prevention and detection of fraud as the number one goal in the reform process. The AICPA introduced the notion of requiring advisers, such as attorneys, and regulators to inform the independent auditor of suspected fraud.
When asked whether the proposals contemplate new audit standards to detect fraud or just doing a job better, O'Malley responded that massive collusive fraud, including outsiders, is very difficult to detect. Auditors can not be held responsible for that--if all the steps have been done. In O'Malley's view, the criminal mind is talented and can conceive of fraud that is very difficult to detect. We accept responsibility if it causes a material misstatement--large collusive fraud needs to be looked at on an individual basis with possible absolution for the auditor. We need to try to do our job better.
A member of the audience, Joseph T. Wells, chairman of the Association of Certified Fraud Examiners, stepped forward to comment on his perspective of fraud detection. He believes in most cases employees in the company know fraud is being perpetrated, all the auditor need do is ask. Internal controls are wonderful, but the main ingredient to prevention is the perception the perpetrator will be caught. If an auditor or an organization is actively seeking to find fraud, it will serve as a deterrent. Therefore Wells believes there is a need to improve auditor interviewing skills.
Beyond the Proposals
Some of the participants asked for changes beyond those recommended in the proposals.
Too little, too late. Peter Knutson, careful to state he was expressing his own views and not those of the Association for Investment Management and Research, stated he felt all the recommendations were eminently sound and address concerns about the accounting profession. His concern, however, was that all the recommendations "are like placing more bandages on an ailing patient. They are only a stopgap until such time as a diagnosis and treatment can begin." Knutson after describing what ails the profession proposed the possible return to an earlier patient/professional arrangement. He reminded the gathering that in the early years of this century when much of the capital in the U.S. came from the United Kingdom, Messrs. Price, Waterhouse, Peat, Marwick, and Mitchell, were sent here to act on behalf of their principals in the U.K. "If matters do not improve soon, financial statement users may again have to underwrite the audit function themselves," said Knutson. The complete text of Knutson's remarks is scheduled for publication in The CPA Journal in a later issue.
Scorekeeper rather than auditor. Burton offered the most radical change in the financial reporting scheme. He suggested the independent accountant become a reporter of financial information instead of attestor. Without giving the mechanics of how this would be accomplished, Burton suggested that the independent accountant independently measure, summarize, and report the results of the entity.
Burton also articulated a worrisome condition where the best people are not being attracted to the profession. The hiring of accounting students by CPA firms from the Columbia University graduate program has dropped from 18% to 2%, and most of the 2% are joining the consulting divisions. Accounting firms are not willing to pay as much as other employers and do not sufficiently challenge the students with the work assigned. Add to this the liability exposure and less transferability to private industry; the result is a decided lack of interest.
Don't forget the little guy. Israeloff, as champion of the accountant for privately owned enterprises, presented some notable statistics. According to Israeloff there are 45,000 practice units. In size it begins with the Big Six, then there are 20 or 30 other firms heavily involved with public companies, followed by 1,000 others with some public-company involvement. That leaves more than 43,900 firms with over 100,000 CPAs that have nothing to do with SEC reporting companies.
In the opinion of Israelloff, many of the enterprises these firms serve have no audit committees, are not a factor in the functioning of capital markets, and satisfy their capital needs from banks. The banker can sit with the owner/manager and demand the financial information it needs. If it is not forthcoming, the loan is not made or the credit is cut off. The efficient market has no place in this setting. If rules and requirements are put in, the costs are there, but not the benefits.
According to Israeloff the solutions proposed here are clearly directed at the public company where the user/preparer/regulator relationships justify more regulation, more auditing, and more disclosure.
Israeloff went on to suggest a parting of the ways between the public reporting enterprise and the privately held entity. For example, Israeloff questioned how an independent accountant would deal with risks and uncertainties when the day-to-day whims of the owner/manager is the critical ingredient. Maybe the FASB, should recognize there is not one global financial model. "One size does not fit all, whether it is internal controls or whether it is accounting principles and financial reporting," said Israeloff. "Events have overtaken the profession because the AICPA has moved slowly, always seeking consensus."
Prognosis for the Future
Whether bandages or a life-saving operation, the recommendations of the POB and the AICPA are thoughtful, comprehensive, and an act of leadership. Some of the most important recommendations--enhanced self- discipline, professional skepticism and independence; reporting illegal acts to third parties, if necessary; and systematic review of audit failures--have been readily accepted by most observers. The areas of disagreement--mandatory reporting of internal control and a new model for financial reporting--will not make or break the program. If the public and users of financial information want auditor reports on internal control or a new financial model, they will get them. In the area of internal control, regulators may very well lead the movement, especially if GAO has anything to say about it.
That leaves the area of liability reform. The large firms, with the huge exposures they face, seem to feel it is essential for the profession to move forward and begin to give the public additional assurance services today's complex markets demand. The hoped for benefit is liability reform. The POB report, which began this dialogue, was initiated in response to the liability problem. But it appears the recommendations will take on a life of their own. The recommendations cannot wait for a legislative response.
The POB has promised to periodically report on the progress being made on its recommendations. Such periodic reporting should put pressure on organizations to continue to pursue reform. The AICPA needs to further articulate its commitment and additional recommendations, especially as they relate to the 43,900 firms identified by Robert Israeloff as not serving SEC reporting companies. Clearly, the public interest goes way beyond SEC reporting companies. This will be the most difficult diagnosis to make.
PROPOSALS TO IMPROVE FINANCIAL REPORTING
The POB's Proposal
Enact legislation to eliminate separate and proportionate liability and treble damages in Federal securities cases.
Enact legislation to permit practice in a form that limits liability of individual members of firm.
Require disclosures re peer review.
Require disclosure in annual report of responsibilities of audit committee.
Require report by management in annual report on internal control.
Require report by auditor on entity's internal control.
SEC PRACTICE SECTION
Firms to be required to perform specific procedures when litigation arises.
Peer reviewers to test compliance with above.
QCIC to develop procedures to facilitate resolution of unresolved audit practice issues.
Expand work by peer reviewers of consultation process.
Membership requirements be modified to require CPE in accounting and auditing
Require explanation of the limitations of financial statements.
Study requiring market value accounting
Adopt SOP re risks and uncertainties
Revise audit report re accounting estimates
Adopt policy requiring auditor to be satisfied re economic substance of new accounting policies.
Establish standards on the limits of assurance in reporting on internal control.
AICPA & FIRMS
Assure auditors implement need to exercise professional skepticism.
Develop guidelines for assessing likelihood of management fraud.
Sharpen the distinction between client advocacy and client service.
Support legislation for auditors to report illegalities.
Ensure participation in standard setting is objective and professional.
Ensure client accounting issues are subject to consultation before going to SEC.
Expanded requirements of concurring partners.
Specific requirements for reviewing financial statements.
Should be satisfied that audit fee is sufficient for proper audit.
Additional AICPA Proposals
Establish a new national disciplinary system.
Bar public companies from hiring the partner responsible for their audit for one year.
Establish new fraud reporting rules requiring all participants in financial reporting system to notify auditors of possible fraud.
Require public companies to have audit committees composed entirely of independent directors.
PARTICIPANTS AT THE SYMPOSIUM
Robert L. Gray, CPA, is Publisher and Editor-in-Chief of The CPA Journal and Executive Director of the New York State Society of Certified Public Accountants and its Foundation for Accounting Education. In addition to carrying out the duties of those positions, Mr. Gray is a frequent moderator, speaker, and lecturer at conferences and seminars addressing the important issues affecting the accounting profession.
James E. Healey, CPA, is comptroller/chief accounting officer of CPC International Inc. He serves on the Corporate Reporting and Government Liaison Committees of the Financial Executives Institute. He is also a member of the AICPA Accounting Standards Executive Committee--its senior accounting technical committee--the AICPA, and the New Jersey Society of CPAs.
Shaun F. O'Malley, CPA, is senior partner of the U.S. firm of Price Waterhouse and joint chairman of Price Waterhouse World Firm. The president of the Financial Accounting Foundation from 1990-92, Mr. O'Malley currently serves on the SEC's Emerging Markets Advisory Committee, the Advisory Board of the National Center on the Educational Quality of the Workforce, and the Ethics Resource Center Board. He is also vice-chair of the New York City International Business Initiative. He is a frequent speaker before business and professional groups and his views have been published in a variety of business and professional publications, including The CPA Journal.
Donald H. Chapin, CPA, is Assistant Comptroller General for Accounting and Financial Management, U.S. General Accounting Office (GAO). Among other things, he is responsible for financial audits of Federal agencies conducted by the GAO, government auditing standards setting, and advising Congress on auditing, accounting, and information technology issues. He is a former partner of Ernst & Young and a former member of the AICPA's Accounting Standards Executive Committee. Mr. Chapin has been an outspoken critic of the accounting profession's ability to respond to the changing needs of the public. His speech, "Changing the Image of the CPA" appeared in the December 1992 issue of The CPA Journal.
Peter H. Knutson, PhD, CPA, is associate professor of accounting at the Wharton School of the University of Pennsylvania. He is a member of the Financial Accounting Policy Committee of the Association for Investment Management and Research (AIMR) and is accounting consultant to the Robert Morris Associates, the national association of bank credit executives. He is the principal author of the AIMR report Financial Reporting in the 1990s and Beyond.
Walter P. Schuetze, CPA, was appointed chief accountant to the Securities and Exchange Commission on January 2, 1992. Prior to his appointment he was a partner of KPMG Peat Marwick. He was a charter member of the FASB from 1973 to mid-1976. Mr. Schuetze has served on many committees of the AICPA and the American Accounting Association and was chair of the AICPA's Accounting Standards Executive Committee. He has also served on the Financial Accounting Standards Advisory Council.
A. A. Sommer, Jr., Esq., is chairman of the AICPA Public Oversight Board of the SEC Practice Section and a partner of Morgan, Lewis & Bockius, Washington, D.C. From 1973 to 1976, he was a commissioner of the SEC. Mr. Sommer has been extremely active in his own profession serving or having served in numerous capacities with the American Bar Association, American Law Institute, the Ohio State Bar Association, and the International Bar Association. He has also been active in securities industry groups and, of course, the accounting profession. He is a former member of the Board of Governors of the American Bar Association, the Financial Accounting Standards Board's advisory council, and the Board of Directors of the AICPA. He has written extensively and lectured frequently with respect to accounting, corporate, and securities matters.
John C. Burton, PhD, CPA, is Ernst & Young Professor of Accounting and Finance at the Columbia University Graduate School of Business. He served as dean of the school from 1982 to 1988. Before returning to Columbia in 1978, he served as Deputy Mayor for Finance of The City of New York and as Chief Accountant of the SEC. He is a member of the Consultants' Panel of the U.S. Comptroller General and a public governor of the National Association of Securities Dealers.
David L. Eyles is vice chairman of Shawmut National Corporation with company-wide responsibility for the credit process, from consumer loans to commercial and large corporate lending. He is chairman of Shawmut's Credit Policy Committee. He has been in banking since 1961, principally with Chemical Banking Corporation and later with Mellon Bank Corporation. He is active with Robert Morris Associates, having served on many of its committees.
Robert L. Israeloff, CPA, is chairman of the board of Israeloff Trattner & Co., CPAs, P.C., and vice chairman of the AICPA. He will become chairman in 1994. He is a member of the AICPA Council, its SEC Practice Section Executive Committee, and its Special Committee on Financial Reporting. A former member of the AICPA Board of Directors, he is also past president of the NYSSCPA and past chairman of the AICPA Private Companies Practice Section Executive Committee. He has also served as president of the Intercontinental Accounting Associates and of the Continental Association of CPA Firms.
THE AICPA'S PRINCIPAL GOALS FOR REFORM IN FINANCIAL REPORTING
* Improve the prevention and detection of fraud;
* Enhance the utility of financial reporting to those who rely on it;
* Assure the independence and objectivity of the independent auditor;
* Discourage unwarranted litigation that inhibits innovation and undermines the profession's ability to meet evolving financial reporting needs; and
* Strengthen the accounting profession's disciplinary system.
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