Special Report/Professional Issues

POB Panel Begins Evaluation of Audit Process

A speech by SEC Chairman Arthur Levitt at New York University last September is still reverberating throughout the accounting community nearly a year after it was delivered. (See “Arthur Levitt Addresses Illusions,” JofA , Dec.98, page 17.)

Calling for a “fundamental cultural change on the part of corporate management as well as the whole financial community,” Levitt outlined an action plan to deal with his concern about the declining quality of corporate earnings. The plan included improved outside auditing as part of the financial reporting process. To this end, Levitt proposed that the Public Oversight Board put together a panel to “review the way audits are performed and assess the impact of recent trends on the public interest.”

The result is the Panel on Audit Effectiveness, headed by Shaun F. O’Malley, former chairman of Price Waterhouse, LLP. The panel has been at work since early this year on a project to determine whether the audit processes of large-firm members of the AICPA SEC practice section adequately serve and protect the interests of investors. According to O’Malley, the eight largest CPA firms together audit entities representing about 98% of the value of all public companies.

Auditing the audit model

In an interview with the JofA, O’Malley said the SEC considers the panel’s work to be “vitally important.” The commission had asked the panel to “focus on the problem of managed earnings, cookie-jar reserves, purchased R&D writeoffs and abuse of the materiality concept,” all problems Levitt cited in his speech. According to O’Malley, the SEC “felt these issues—accompanied by audit failures—underscored the need to look at the audit model from top to bottom.” In the SEC’s view, the combination of changes in the audit process and high profile financial frauds has raised questions about the efficacy of the audit process. The commission is concerned about whether today’s audit model, which emphasizes risk assessments and analyses over more intensive fact checking and verification of numbers, can continue to assure investors that auditors have taken the steps necessary to provide the public with reliable financial information.

The panel’s task is to review and evaluate the way independent audits are performed and assess the effects of recent audit trends on the public interest. To this end, O’Malley said the panel will look at the audit climate in major firms as well as audit procedures and any changes that have been made in the audit model to “see whether those changes seem appropriate.” O’Malley said the panel also wants to examine the frequency of alleged audit failures and related litigation vs. their severity. “Are there a whole lot of instances or are there just several big failures that are the cause for concern?”

The panel will survey numerous affected or interested parties, including the securities industry, securities lawyers, the AICPA, the SEC, academics, CPA firms and forensic auditors. Part of the panel’s work will consist of what it calls “quasi-peer-reviews” of audit firms. O’Malley said these reviews will involve looking less at compliance and more at audit procedures, how they have changed and how effective they are. “We hope to drill down into CPA firms and find out what staff attitudes are, what the reward system is and how promotions work to make sure we fully understand what motivates auditors and what their feelings are about the audit function.”

After it has surveyed interested parties and completed firm reviews, the panel will schedule its first round of public hearings—probably in the fall. It will use information from these sessions to draft preliminary findings and recommendations, which will also be the subject of hearings.

Searching for the truth

O’Malley said the panel is “definitely open” in terms of what it might discover. “I’m trying to make sure nobody comes in with a lot of preconceived notions. We’re holding back on reaching conclusions and making sure that whatever we find provides the basis for a report,” he said.

Today’s audit environment is no surprise to anyone, O’Malley said. “There is enormous pressure on companies to report earnings that meet analysts’ expectations instead of just beating the last quarter or the same quarter a year ago. With market multiples at an unprecedented high, a miss of a few cents can cost a company billions of dollars in market capitalization overnight.” In O’Malley’s view, the pressure on companies is even greater when you consider that “vast numbers of a company’s management personnel are being rewarded up to 40% to 50% based on bottom-line earnings or stock price.” He sees the auditors as the “resistors” of this pressure, “making sure the numbers are what they ought to be.” O’Malley emphasizes that while auditors were always subject to pressures in the past, today’s economic and market situations add even more.

Useful recommendations

O’Malley hopes any changes the panel recommends—“whether they’re in audit procedures, independence rules, SEC governance or in some other area—will be useful, make sense and strengthen the audit and increase confidence in it.” He said there already is a high level of confidence in audits today, “which is why U.S. capital markets are the most reliable and the most trusted in the world.” He anticipates that anything the panel recommends will only “increase and strengthen that level of confidence.”

O’Malley said a number of international bodies are watching the panel’s work very closely. “Our final output could have a significant effect on rulemaking in other parts of the world.” The panel is hoping to issue a report by the end of 1999.

—Peter D. Fleming