Special Report

BY JOFA

Concerns Over Auditing Quality Complicate the Future of Accounting

The accounting profession has come to a strategic fork in the road. One path leads to a future in which the profession accelerates its diversification into new services that complement and build on essential, traditional ones; the other path, an unchanging continuation of the profession’s prior portfolio, is narrower.

While the better course may seem obvious, it involves complex issues, many of which were debated during an October public hearing held in New York by the Panel on Audit Effectiveness, a group established by the Public Oversight Board at the request of SEC Chairman Arthur Levitt to address persistent concerns about the quality of audits conducted on the financial statements of SEC-registered companies.

Attending the panel’s two-day hearing were officials from approximately 20 organizations that represent practitioners, corporate executives, preparers, plaintiff and defense attorneys, academicians, financial analysts and investment bankers.

Because precision and trustworthiness have long been articles of faith for CPAs, self-regulatory bodies such as the AICPA SEC Practice Section (SECPS) have taken practical measures to address SEC complaints about the inadequacy of the audit process as it’s applied today.

A handful of negative news stories about audits whose shortcomings had dire consequences fuels the SEC’s ongoing discomfort about them. Two examples are the situations in which auditors failed to detect misstatements in financial reports, which later seriously weakened the effectiveness of large-scale mergers involving Cendant and McKessonHBOC.

According to statistics from the SECPS, which monitors the activity of all CPA firms auditing SEC registrants, virtually all (99.7%) financial reports are problem-free (each year, on average, suits are filed on, or complaints raised regarding, the financial statements of only 50 of 15,000 SEC registrants.) But because the accounting profession’s credibility and the financial markets’ well-being are at stake, the AICPA and related self-regulatory bodies are redoubling their audit oversight efforts.

Getting to yes

The task involves not only identifying the problems but also maintaining a good working relationship among those who can do something about them. Former SEC Commissioner Aulana L. Peters, a member of the panel, is familiar with the ongoing controversy between the profession and the SEC. “I think both sides have problems with the other,” she said in an interview. Referring to views expressed before the hearing, she added, “That’s clear from the speeches being made by SEC officials and the reactions to those speeches from the profession.”

At the hearing, further comments by SEC officials may have widened the once publicly denied, but now openly admitted, rift between the SEC and the accounting profession. Contributing to the gulf between the two parties, observers said, is the fact that the profession feels it gets mixed messages about its performance from the SEC. In its last annual report (1998) to Congress, the SEC said its accounting staff’s review showed that the AICPA’s audit oversight activities continued to result in improved quality control systems at SECPS member firms’ auditing divisions, which review public companies’ financial statements.

Nevertheless, at the hearing Levitt voiced his “grave concerns that the audit process, long rooted in independence and forged through professionalism, may be diminished—perhaps even sacrificed in the name of more financial and commercial opportunities.” He added that the share of revenue that accounting firms derive from traditional auditing has been decreasing. “Some firms, perhaps preferring to distance themselves from the roots that have given them such opportunities, prefer to think of themselves as ‘multidisciplinary organizations.’”

“Has the accounting profession become so big and complex that we need a full-time SRO?” Levitt asked. “Is the alphabet soup of regulatory bodies—the POB, the AICPA’s PEEC, SECPS, ASB and the ISB—really workable?”

Is more self-regulation the solution?

One of the most important and contentious issues is whether the accounting profession needs a new self-regulatory organization (SRO), and if it does, whether the AICPA is qualified to fill that role. Asked by a panel member whether the AICPA could provide the sort of intermediary services typically rendered by an SRO, Levitt replied, “I am skeptical.” He said it was unrealistic to expect the AICPA to focus on an issue that did not concern the bulk of its membership, which is composed largely of firms that don’t audit public companies.

In response to Levitt’s comments, AICPA President Barry Melancon said Levitt’s proposal for an SRO to monitor the profession was unnecessary. “The POB was created expressly to oversee our self-regulatory activities.” He added that the AICPA has been cooperating with the SEC to strengthen the audit process. In 1997, the AICPA auditing standards board issued Statement on Auditing Standards no. 82, Consideration of Fraud in a Financial Statement Audit, which clarifies the auditor’s role in detecting fraud.

But Melancon also said the relevance of current financial statements needs to be reevaluated to ensure the accounting profession provides its clients and investors alike with information that fully meets their needs. “We’re entering a new age—a much different age,” Melancon said. To illustrate how a forward-looking accounting profession could add value to the reporting process, Melancon painted a picture of the future, five years hence, in which a dramatically improved reporting environment provides all investors with Internet access to real-time financial information about companies.

Robert K. Elliott, a KPMG partner who recently became AICPA board chairman, supported the notion that increasing the supply of relevant, reliable information for investors is more important than a quixotic quest for zero audit defects in traditional financial statements, whose relevance to the modern economy is declining. Today’s financial statements reflect industrial-era assets (such as inventory, machinery, buildings and land), Elliott said, in contrast to the intangible assets (such as information, research and development, customer loyalty, market share, brand, capacity for information and capacity for organizational learning) typical of postindustrial enterprises.

“Where should the next dollar be spent?” he asked. “On seeking additional precision in GAAP financial statements or on enhancing the quantity and quality of more relevant information not found in financial statements?”

Elliott also offered quantitative evidence of why audit firms have little choice but to develop nontraditional services. “Every company that needs an audit has one,” he said, a factor that limits annual growth in audits to roughly the annual growth rate of the gross domestic product — about 2% to 3%. “But the consulting market is not saturated,” Elliott said, “and demand is growing at 30% to 50% annually.”

Philip B. Livingston, president and CEO of the Financial Executives Institute, expressed surprise at Levitt’s remarks to the panel in October. “I think the AICPA has been very effective as an SRO, and I would rather have the Institute make whatever modifications are necessary than have a separate new organization fill that role,” he said.

As some accounting professionals strive to untangle knotty problems in the financial reporting environment, others search for effective ways to persuade members of future graduating classes that a career in accounting will be personally, professionally and monetarily rewarding.

“Once we brand accounting as a multi-career-path profession, as we are trying to do, it will become more attractive to people,” Melancon said in an interview after the hearing. “But if it’s branded as an auditing profession, there are limits to its attractiveness. And so we’re trying to brand the profession as being as broad-based as possible. To the extent we’re pushed back by regulators or others, it makes it more difficult for the profession to attract the top students, and that’s just the pure economics of the employment world today.”

Livingston agreed. “I think that the declining prestige of auditing and the reality of a tight employment market will eventually hurt quality,” he said. “Improved productivity and efficiency can carry you only so far.”

—Robert Tie

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