Auditing

In May, after 18 months of study, a panel appointed by the Public Oversight Board to examine the effectiveness of independent audits released a draft statement of its findings. Representatives of the SEC, the AICPA and several audit firms testified at hearings in June regarding the panel’s report and recommendations.

Formed in 1998 at the request of SEC Chairman Arthur Levitt, the POB’s Panel on Audit Effectiveness studied the audit process and the effect of recent auditing trends on the public interest. It found that the auditing profession and the quality of its work were fundamentally sound.

Nevertheless, regulators, audit clients and investors have voiced concerns that auditors have not been dealing effectively with “illegitimate earnings management” and other forms of fraudulent financial reporting. In its report, the panel made the following recommendations, among others, to improve audit quality and help auditors perform at consistently high levels:

• To increase their chances of detecting instances of material financial statement fraud, auditors should use forensic accounting methods on every audit they perform.
• The AICPA Auditing Standards Board (ASB) should make auditing and quality control standards more specific and definitive.
• In certain areas, firms should review and strengthen their audit methodologies, guidance and training materials. Peer reviewers then should report how those materials are being used during audit engagements.
• Audit firms, through their communications, performance evaluations, training, compensation and promotion policies, should reinforce to their employees the importance of conducting high-quality audits.
• The POB, the AICPA, the SEC practice section (SECPS) and the SEC should agree on a new charter for the POB—one that would give it the authority and independence to oversee standard setting for auditing, independence and quality control, as well as monitoring, discipline and special reviews.
• A majority of the members of the Independence Standards Board (ISB) should be from outside the profession, and the SEC should support it in its mission.
• The SECPS should strengthen the peer review process, including requiring annual reviews of the largest firms, which perform most independent audits. The POB should also increase its oversight of those reviews.
• The SECPS should strengthen its disciplinary process.
• Audit committees should preapprove nonaudit services that exceed a threshold amount and, in the process, consider certain factors, which the ISB should identify.
• The International Federation of Accountants should establish an international self-regulatory system for the auditing profession.

At the hearings, SEC Chairman Levitt expressed support for the proposed new POB charter. He urged the firms and the AICPA to immediately endorse it and warned that if they didn’t join in giving the POB the additional authority it needs to oversee the audit process, the alternative would be a “legislative solution.”

In his testimony, AICPA President and CEO Barry C. Melancon said the AICPA too is in favor of a strong POB. “To the extent those words support independence and oversight, not management,” he said, “I don’t think we’re going to have any problems.” He added that “the ISB is the body that should issue independence standards for auditors of publicly held companies.”

Melancon also stressed the importance of allowing audit firms to meet the needs of the “new economy” by providing nonaudit services, which he said could have a positive influence on the effectiveness of audits and attract more students and qualified specialists to the profession. Further, he warned that overreliance on specific standards could lead to an homogenization of the audit and recommended that firms be allowed to “differentiate themselves according to their specialties, strengths and competencies.” This will maintain the value of audits, he said, and help prevent them from becoming a commodity.