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Dec 1993

In the Public Interest - a progress report. (recommendations of the Public Oversight Board of the AICPA) (Cover Story)

by Sullivan, Jerry D.

    Abstract- The Public Oversight Board (POB) of the AICPA has continually strived to improve on the recommendations it released on Mar 1993 with the aim of advancing the relevance and reliability of financial reporting. Among the actions taken is the implementation of procedural changes in the Quality Control Inquiry Committee, concurring partner review function and peer review programs of the SEC Practice Section (SECPS) Executive Committee. The AICPA-POB has also asked the Auditing Standards Board to revise its standard report for auditors and create new guidelines for clear communication of assurance limits. Another issue that the POB is concentrating its efforts on is fraudulent financial reporting. It expressed its approval on several initiatives taken by the SECPS in helping auditors detecting signs of fraud. Lastly, the POB requests the assistance of SEC in improving financial reporting.

The POB took a leadership position when it made its 23 recommendations for improving financial reporting and the audit process. The AICPA followed with additional recommendations. The CPA Journal held a symposium on the POB report and the additional AICPA recommendations. A report on the symposium was published in the October issue.

This month the executive director of the POB reports on progress being made by the profession in responding to the recommendations.

In March of this year, the Public Oversight Board (Board) issued a special report In the Public Interest--Issues Confronting the Accounting Profession.

The report included 23 recommendations that address the accounting profession's liability problems, the reliability of financial reporting, and auditor performance.

The Board's special report resulted from a request from the six largest accounting firms to consider whether the Board would be willing to endorse the effort by the firms, the AICPA, and others to secure Federal legislation that would substitute a "separate and proportionate" standard for the current "joint and several" standard for apportioning monetary damages among several defendants.

The Board examined the evidence available on the liability exposure of the accounting profession from the standpoints of fundamental fairness, the future development of the profession and the preservation of a sound accounting profession. From all these perspectives, it concluded the public interest requires remedial legislation leading to legal reform.

The POB also recommended to Congress that legislation be adopted to permit accounting firms to practice in corporate form, thereby potentially protecting personal assets of partners from the ravages of civil litigation.

However, as a result of its deliberations, the Board concluded legislation alone was not going to solve accountants' liability issues. As Al Sommer, the Board's chairman, testified in the recent Senate Subcommittee hearing on liability reform, "Litigation reform must be accompanied by certain reforms within the profession leading to higher quality audits."

Thus, the Board included 23 recommendations in its special report directed at improving the relevance and reliability of financial reporting and audits. Included in the reports were suggested actions to be taken to deter or detect fraudulent financial reporting. Implementation of these recommendations will require action by the SEC Practice Section of the Division for Firms, the AICPA, the SEC, accounting firms, and the FASB.

Initial Reactions

The recommendations are now being deliberated by those to whom they were directed, as well as others involved in the financial reporting process. Endorsement and support for all the special report recommendations was given by the AICPA's Board of Directors and the six largest accounting firms.

The Board has had the opportunity to discuss its special report with Congress, the SEC, and the FASB and to express the rationale behind recommendations directed to each of these entities. The Board has also received comments on its proposal from others, including the Financial Executives Institute (FEI), the Institute of Internal Auditors (IIA), and several public companies.

Initial reactions from those groups include much support, some skepticism, and some opposition to specific recommendations. The Board is encouraged by the public debate that has resulted and believes it can only lead to improvements in financial reporting.

AICPA Actions

However, endorsements alone will not get the job done. Leadership of the AICPA has recognized that action is required. While in office past president Jake Netterville assigned responsibility to the Government Affairs Committee to oversee and monitor implementation of the Board's recommendations that are actionable by the AICPA. That committee also will monitor progress on implementation of recommendations directed to other organizations and act as a catalyst for action when appropriate. The following is a brief progress report.

SEC Practice Section. The Board made several recommendations to improve the SECPS self-regulatory programs. The SECPS Executive Committee formed a task force to study these and other recommendations it could implement. The task force has completed its analysis and the Executive Committee has taken several steps to implement each of the Board's recommendations it is empowered to take action on.

The Board observed the auditing profession does not have a system to dissect its failures, ferret out the causes, identify the symptoms related to those causes, and develop methods to prevent their reoccurrence. Closely related to this, the Board further observed there is a huge absence, of procedural guidance available that would direct the attention of inexperienced auditors to possible implications of matters encountered during an audit and give guidance to the appropriate reaction to be made to those matters.

A case in point: repeatedly, we, the SEC, and the courts have seen instances of premature revenue recognition on the sale of custom-made, high-dollar-cost inventory involving shipments close to year end. This may set off all kinds of alarms and red flags for the experienced auditor. However, the experienced auditor is not performing the audit procedures--an auditor with a few months to two or three years experience is.

What has this inexperienced auditor learned from his or her auditing class about auditing shipments of high-cost inventory to customers? At best he or she might account for the numerical sequence of shipping documents if one of the eleven auditing text books we surveyed was the basis of his or her training. Auditing text books and courses are highly conceptual today--this is not a criticism--but auditors need guidance to help them perform effectively. Now some firms may be providing that guidance; but the record would show most are not. Thus, the Board made several recommendations directed at putting in place mechanisms for the profession to learn from its failures and to provide retrievable procedural guidance to auditors to improve their performances.

The SECPS Executive Committee has agreed to implement procedural changes in the Quality Control Inquiry Committee (QCIC) and peer review programs with the result that--

* The QCIC, in pursuit of its objective to analyze control implications of alleged audit failures, would satisfy itself that firms have performed a complete internal analysis of audits underlying litigation. Among other objectives this analysis will be directed at--

1. Assessing the capabilities of senior audit personnel and determining whether the firm should monitor, reassign, or terminate such personnel;

2. Identifying any problems with the firm's quality-control system or training activities;

3. Identifying any implications of allegations relating to the adequacy of auditing, quality control or accounting standards, as well as the adequacy of guidance on the manner in which audits are conducted and variations in the interpretations of standards that need to be resolved.

* The Executive Committee formed a Professional Issues Task Force (PITF) to consider matters requiring additional guidance, and emerging and/or unresolved practice issues resulting from firms' analysis of its litigation, the QCIC process and other sources (e.g., peer reviews, internal inspections, etc.). PITF would be responsible for developing and disseminating relevant guidance for the staff of SECPS member firms. That guidance will only interpret existing standards and PITF will be required to refer matters warranting reconsideration of existing standards to appropriate bodies (e.g., ASB, AcSEC, FASB, etc.).

* The peer review standards will be amended to require peer reviewers to test firms' compliance with the above modifications to their quality control systems.

On the "preventive side," the SECPS Executive Committee has also agreed to several changes that should strengthen audit performance in the future. These include strengthening the concurring partner review function--the last line of defense for firms. The Executive Committee agreed to amend the section's membership requirements to require the concurring partner provide assurance that those consulted on accounting and auditing matters are aware of all relevant facts and circumstances involving the issue and client so that the conclusion reached about the matter being consulted is an appropriate one--with economic substance. Also, peer reviewers will. be required to evaluate the quality of conclusions reached by firms during the consultation process.

Auditing Standards Board. The Board recommended that the ASB revise the auditor's standard report to make the prospective nature of certain accounting estimates clear, including a caveat that the estimated results may not be achieved. I understand the ASB conceptually agrees with this recommendation to revise the standard report and has formed a task force to deal with reporting on soft information.

Another recommendation to the ASB was to establish standards requiring clear communication of the limits of the assurances being provided to third parties when auditors report on client internal control systems. The ASB believes that its recently issued attestation standard Reporting on an Entity's Internal Control Structure Over Financial Reporting, addresses this recommendation. Further, the ASB is considering a revision to the standard auditor's report that explains the limit of work performed on internal control in an audit of financial statements.

The Board's third recommendation to the ASB is to require auditors to be satisfied the accounting policies adopted by an entity for new types of transactions reflect economic substance. This was referred to the ASB's audit issues task force.

Accounting Standards Executive Committee. The Board's recommendation to AcSEC to adopt the proposed SOP Disclosure of Certain Significant Risks and Uncertainties and Financial Flexibility has proven to be quite controversial. Comment letters received by AcSEC regarding the exposure draft have generally been negative.

However, the Board continues to believe financial statements as now prepared fall woefully short in disclosing risks and uncertainties. We hope AcSEC can appropriately balance the specific meritorious objections to specific provisions of the exposure draft to the needs of the users of financial statements and adapt an SOP that will provide meaningful disclosures in this important area.

Fraudulent Financial Reporting

As is the Board of Directors of the AICPA, the Board is deeply concerned about fraudulent financial reporting. There has been considerable publicity about a number of recent alleged management frauds. These frauds have eroded the public's confidence in the audit function. Many observers question the value of an audit that does not detect material intentional misstatements.

There is no problem confronting the profession that is as demanding, or as difficult to resolve, as the problem of management fraud and its detection by auditors. Before the turn of the century, auditors and users of audited financial information regarded fraud detection as one of the primary purposes of an audit. For many reasons the profession has moved from acceptance of that purpose to the view that its role in detecting fraud is secondary to other purposes. In contrast, the public has continued to regard fraud detection as an important goal of the audit process and now attaches even greater importance to that goal.

The Board believes measures can be taken to improve performance in this difficult area and that, to a greater extent than it now does, the profession must accept responsibility for the detection of fraud by management. The profession cannot be expected to develop methods that will assure that every fraud, no matter how cleverly contrived, will be unearthed in the course of an audit, but it must develop means of increasing significantly the likelihood of detection. Adoption of the Board's recommendation to expand the QCIC's mission to include a more careful analysis of the factors contributing to failed audits should lead to improved guidance to the profession on detection of fraud. Unfortunately, that is not enough.

The Board also recommended that the profession develop comprehensive guidelines to further assist auditors in identifying symptoms that indicate the heightened likelihood of management fraud involving the manipulation of financial information and to specify additional audit procedures that should be performed when such symptoms appear. We believe this undertaking should be broad in scope and include the development of guidance to facilitate the analysis of financial data and nonfinancial factors that may be indicative of management fraud.

The SECPS Executive Committee has formed a Fraudulent Financial Reporting Task Force. Its aim is to develop the kind of guidance that will assist auditors in assessing the likelihood that management fraud is occurring and to specify additional auditing procedures when there is a heightened likelihood of fraudulent financial reporting.

The Board applauds the swift action taken on this and other recommendations and will be monitoring progress closely.

The Board considers four of its recommendations to be interrelated and their implementation is essential for significant improvement in lowering the incidence of fraudulent financial reporting and increasing the likelihood of detection when it does occur. Two were discussed earlier.

* We must provide detailed retrievable guidance to inexperienced auditors on the firing line--guidance developed from lessons learned from past failures including those where there was fraudulent financial reporting. As referred to previously, an SECPS task force is working on this.

* We must develop comprehensive guidance for identifying "red flags" that suggest the heightened possibility of management fraud and procedural guidance on what should be done when the red flags are observed. Another SECPS task force is working on this.

The other two recommendations dealing with fraudulent financial reporting address important matters to help reduce the incidence of fraudulent financial reporting. These are stronger internal control systems and stronger corporate governance.

Stronger Internal Control Systems. The SEC should require management reports on internal controls and auditors to express an opinion on management's assertions. Requiring auditors to assess management's reports on the quality of internal controls will benefit the public. The auditing profession's evaluation of internal control systems will lead to improvements in those systems. With a public reporting obligation, boards and top management will demand improved control systems that make management fraud and manipulation of financial reporting more difficult.

Stronger Corporate Governance. In most corporations the responsibility for scrutiny of financial statements has been delegated by boards to their audit committees. The experience of the members of the Board indicates that in too many instances the audit committees do not perform their duties adequately and in many cases do not understand their responsibilities.

To encourage audit committees to fulfill such responsibilities and to inform investors whether audit committees have performed those responsibilities, the Board calls for the SEC to require registrants to include in a document containing the annual financial statements a statement by the audit committee or the board of directors as to whether its members--

* have reviewed the company's audited financial statements and have conferred with management and the independent auditor concerning them,

* have received from the auditor the information required to be communicated and believe the financial statements are complete and consistent with information known to them and reflect appropriate accounting principles.

Positive Response Needed From SEC. The initial reaction by the Chief Accountant of the SEC to these two proposals has been negative. We believe it is extremely important and of the highest priority for the AICPA through the Government Affairs Committee, the SECPS member firms, and the POB to convince the SEC of the importance of implementing these two recommendations. The Commission must recognize their immediate assistance is required to help reduce undetected fraudulent financial reporting. This is only fair since the profession has initiated a significant effort to improve its detection rate.

We recognize there is controversy and cost associated with our proposal on internal control reporting. Much of the controversy involves the position taken by the FEI and some major corporations. They object to auditor intrusion in what they consider to be a corporate governance matter and, of course, the cost associated with auditor reporting. However, corporate America and auditors, are tainted by undetected fraudulent financial reporting. We hope reasonable people on both sides of this issue can agree to an action plan that is "in the public interest."

The Stakes Are High

In summary, much progress has been made in the few months since the Board's report has been issued. The AICPA and its various committees are to be complimented. We do not underestimate the magnitude of the effort that lies ahead. However, the Board continues to believe the stakes are high.

The integrity and reliability of audited financial statements are critical to the American economy. Trustworthy, quality audits and informative reliable financial reports are essential to the efficient allocation of resources in our capitalistic society. In addition, they also provide protection to audit firms against excessive and unwarranted litigation.

Jerry D. Sullivan, CPA, is Executive Director of the Public Oversight Board. He is a former partner of Coopers & Lybrand and is a past chairman of the Auditing Standards Board of the AICPA. This article was adapted from a speech given by Mr. Sullivan to AICPA council members in September 1993.

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