Highlights from Treasury Adv. Committee on the Audit Profession - SUMMARY FOR FEI BLOG
October 15, 2007
FEI Summary
Following are some of the highlights from the Oct. 15, 2007 inaugural meeting of Treasury's Advisory Committee on the Audit Profession:
§ Robert K. Steel, U.S. Undersecretary for Domestic Finance, welcomed ACAP on behalf of the Treasury Department. He noted in his introductory remarks, Steel said that Treasury Secretary Henry M. Paulson has asked ACAP to look at the following challenges to the sustainability of the audit profession: is there enough competition, can the audit profession attract high quality auditors, and do auditors focus too much on detailed rules vs. principles-based judgment (and if so, why).
§ Co-Chair Arthur Levitt, Jr. said the public responsibility of auditors must be at the forefront of ACAP’s discussions.
- He emphasized ACAP will explore - in depth - the auditors’ responsibility for detecting fraud.
- Levitt thanked U.S. Treasury Secretary Paulson and Undersecretary Steel for forming ACAP, which he likened to “taking on an extraordinary high wire act, toward the end of their administration, with the odds heavily stacked against doing anything.” In spite of this challenge, Levitt noted Treasury brought together a group of “incredibly talented, nonbashful people with different views” to serve on ACAP.
- “The least we owe to the two of you for this extraordinary gesture,” Levitt said, is, “we’ll look at this de novo, assume you’ve come to us in the spirit of goodwill and fellowship.” He added, “All of us agree the accounting industry is absolutely essential to the primacy of the U.S. capital markets.”
o Levitt spoke of the dual role of ‘trust and obligation.’ [That notion can be said to apply to the audit profession, and ACAP in its proceedings.] “Every decision based on that trust and mandate must be based on what it does in terms of confidence in the system; if it diminishes confidence, it’s bad, if it increases confidence, it’s good.”
o He added, “Our decisions will be made in light of public judgment, and political realities. If we keep that in mind, and focus on the enormous benefits that can come from not just a consensus result, but from the notion of increasing public confidence.”
o Levitt spoke of the need to ‘not delegate to another domicile, nor seek the lowest common denominator to arrive at an illusory consensus, but a real one.”
§ Co-Chair Don Nicolaisen noted “there is some concern out there that perhaps the auditors have become overly interested in protecting their interests, that some of the checklists and things being done are redundant, and have a cost.”
o He said, “My hope is we would focus as a committee on development of recommendations that are more principles based than rules based.”
o Nicolaisen also thanked Paulson and Steel “for the confidence put in us,” and agreed with Levitt’s characterization ‘it’s a real high wire act.” He noted many of the issues they would tackle have been around a long time, but, being an optimist, he added, “I’m extremely hopeful we’ll be able to come up with some meaningful direction to change course in a very positive manner.”
o In his closing remarks, Nicolaisen observed there is ‘a tremendous amount of wisdom here’ and summed up the views stated during the meeting, which he said were ‘spot on,’ as:
§ put the investor first, large or small’
§ pay attention to the investor, but don’t lose sight of the fact there are many others that rely on accurate, complete financial statements
§ pay attention to governance issues at firms
§ get the facts, and
§ don’t prejudge.
§ Alan Beller, former Director of the Division of Corporation Finance and a member of ACAP, summarized ACAP’s 21-page “working discussion outline.” He noted the outline started with ‘over-arching principles,’ leading then into three major areas: human capital (and its impact on audit quality), the auditing firm (and audit organization, financial resources), and structure of the auditing profession (including: competition, concentration, independence, and other professional standards).
§ Ken Goldman, CFO, Fortinet, Inc. (previously CFO at Siebel and other companies; Goldman is has also served as President of FEI’s Santa Clara Chapter and as a member of FASAC), said that with at least ’90 quarters’ (22 years) experience as a CFO, his main observations were:
1. it was a big mistake to go from 8 audit firms (the ‘Big Eight’) to 4
2. Sarbanes-Oxley Section 404 was a real challenge, it was directionally correct, but the question was on implementation, especially as to the definitions. “I would have defined anyone to understand what a Material Weakness was, and a Significant Deficiency was, [as defined] in triple negatives,” he said.
3. the concept of the PCAOB is great, as I watch it as a CFO, and from perspective of board, accounting firms are running scared sometimes about how the PCAOB will look at them, has caused changes in thinking
4. restatements have gone way up, maybe down just now, but over time dramatically up; not just the small tech co’s people like to blame, but some very large co’s, have to question why – in part, the:
a. materiality concept/threshold
b. complexity we have today in accounting, in terms of new pronouncements in many cases hundreds of pages long, and there’s no one rulebook
5. litigation is a challenge
6. consider teaching accounting sooner, at the high school level
§ Sarah E. Smith, Controller and Chief Accounting Officer, Goldman Sachs, said, “Those of us in the preparer community are all too aware of [the importance of] independence and a high quality audit, insuring quality of the financial statements and investor confidence.” She added:
o Although ‘retention deserves focus, it is worth noting auditing firms are a training ground for the accounting profession as a whole.” Smith emphasized, “Corporate America is absolutely dependent on a steady stream of auditors from the [audit] firms,” which contributes to companies’ ability to produce high quality financial statements, and assists in the ultimate quality of the audit.
o The question of ‘how do we attract sufficient number of people to the profession, and [get them] sufficiently trained/educated,” she said, “is at least as important as persuading accounting professionals not to leave the [audit] firms.”
o Smith also had a novel idea for the committee to consider: ‘whether auditors should be required to comment on the extent to which financial statements reflect overall economic reality, i.e. is the sum of the parts compiled by a given rule set an accurate picture, or not. She indicated that is a ‘thinly veiled reference’ to fair value.
§ Barry Melancon, President and CEO of the AICPA, noted the AICPA has 335,000 members, about half working in Corporate America, and half in public accounting firms. The top 2 priorities in his view are: people – the pipeline of people into the audit profession, and the quality of audits
§ Damon Silvers, Associate General Counsel of the AFL-CIO said: ‘the real problem with auditing is, like many aspects of corporate governance, [it] is a profound principle-agent problem: the people who select auditors are not by and large those people relying on audited financial statements.”
o He added, “Nothing is more important than the notion of the [audit] profession as a profession,” emphasizing: “That means: auditors are not for sale. They should not be thought to act on an incentive compensation basis.”
o Reiterating comments of others, he said there was a need to get at the facts, of issues like whether liability insurance was available to audit firms, and at what cost. He also wanted to compare lawsuit cost data/insurance cost data to investor loss data.
§ Lynn Turner, Senior Advisor to Kroll Zolfo Cooper, former SEC Chief Accountant, said: “Business has grown extraordinarily complex, yet we expect the audit to be simple.”
o Reflecting on the topic of principles vs. rules, Turner quipped, “I hope when we deal with principles, it will be less than the [SEC’s] 450 page executive compensation rules.” He then noted, “principles and rules are in the eye of the beholder.”
o He agrees that audit firms are ‘doing a better job today than on a pre-Enron basis,” but said, “they can get better.’ He added, “this is all about one thing: investors and investor confidence, and that is not at the forefront and top of these overarching principles.” Describing audits as a ‘public franchise,’ Turner said there was a need to explicitly mention that in ACAP’s ‘overarching principles.’
o Turner stressed that audit firms should incorporate some of the same corporate governance concepts that have taken root in Corporate America. With the perspective of serving as a director of 3 organizations, he said, “[audit] firms need to look at implementing the same types of governance as in Corporate America; what’s good for the gander is good for the goose.” Turner also noted that FEI recommended over two years ago that audit firms ‘should put out the same type of financial reporting that public companies do,” adding, “I think that’s important as well.”
o On consolidation and competition, Turner said, “the [Big] 4 are so big and behemoth, you’re not going to change that. The real question is - how will you give the others more opportunity.”
o Noting that starting salaries with audit firms of are $50-55,000 dollars, Turner said, “if you go into law, or the medical profession, you get more than double that, so where do you think the smartest and brightest kids are going to go?”
o “For the [audit] firms to get competitive, they’ll have to change the structure of how to perform the audit,” he said, and reemphasized the need to address the comparative salary gap issue.
§ Robert Herz, Chairman, FASB (observer on ACAP): Herz noted the concurrent efforts of the SEC Advisory on Improvements to Financial Reporting, led by Robert Pozen (sometimes referred to as ‘the Pozen committee.’)
o As Chairman of the FASB, Herz offered, “Let me know how we can be of help.”
o “I would encourage you to be forward looking,” he added, suggesting ACAP consider “what the world might be in 4, 5, 7 years, and implications for the role of auditors, what is it that investors will be demanding, liking.”
· Mark Olson, Chairman, PCAOB (observer on ACAP):
o Olson added some levity to the Levitt-Nicolaisen led proceedings, stating “Bob Herz and I decided the 5 minute recommendation [i.e. suggested 5 minute time limit for each person’s remarks] was principles based, not rules based.”
o On a more serious note, Olson stated, “Something is very clear. You have leadership that is very focused on the financial markets, the relevance of financial markets both domestically and internationally, and good stewards of resources of this Treasury.”
o Noting the ‘talent we see around this table,’ Olson said, “that’s all the indication we need that this is a critical issue and a critical industry.”
o “If we do our jobs even remotely correctly,” he added, “this should assure it will be profession that will attract the best and brightest over time.”
o Olson gave the analogy of the banking industry - one he watched up close and personally during his career, including a stint with the Federal Reserve, on staff with the Senate Banking Committee, and as a bank president. “I watched the banking industry change in a radical way, 25 years ago,” said Olson. “It was clear to everybody it was going to change, just not clear how.” He said changes occurred ‘not because new rules were imposed, but there was a fundamental look at the appropriateness of rules, to reassess what the appropriate public policy role is, to insure viability.”
o “We will not be able to decide among ourselves what the end result will be,” he said, “but we ought to look at legal liability and the competitive environment.”
· Zoe-Vonna Palmrose, Deputy Chief Accountant, SEC (ACAP observer)
o Palmrose reiterated that ‘full and fair disclosure is a critical component’ of financial reporting and audits, noting the securities laws ‘recognize having financial statements audited by knowledgeable, independent, objective’ auditors is a ‘bedrock principle.’ The benefit of audits can be seen in the fact that even in unregulated and emerging markets, companies voluntarily contract for audits, demonstrating the audit as a value added activity, not just a compliance activity.
o The federal securities laws give monopoly to the audit profession, she noted, but those laws “provide a floor.”
o Noting next year will be the 75th anniversary of the securities acts, Palmrose said it is a natural time for reflection, and after the challenges of the past decade which have ‘significantly impacted the audit process,’ she said, “now is the right time to focus on maintaining and improving audits.”
o “Audit effectiveness involves not just the audit firms,” said Palmrose, a former professor at USC, “but also those that educate and train auditors over a lifetime process.” Additionally, she includes among those that influence the audit process, “clients, audit committees and investors, conditions influencing the markets, and regulation.”
o Palmrose then quoted recent remarks of SEC Chairman Christopher Cox [from a speech he made on Oct. 9]: “As regulators, we have to be aggressive in our role as market referees and protectors of investors' interests. And at the same time we have to be humble in recognizing that regulation is not the fuel that drives our markets — though it undoubtedly is the oil that greases the gears.”
· Alan Beller, Cleary Gottlieb
- Beller was given a chance to give personal comments at the end of the meeting, having walked the committee through the working discussion outline at the beginning of the meeting.
- “An important issue, a front and center issue for audit quality, is fraud detection,” he said.
- “Most important,” Beller said, “is that this be a fact driven exercise… to try to get our arms around the facts… derive recommendations from the facts, and not the other way around. Our only hope is to be true to that process,” he said.
- He described the committee’s work as ‘getting the right people operating in the right framework.’
- As to ‘what we mean by effective audits,’ Beller said, it’s about: what are the standards by which we judge audit effectiveness, and what are the expectations of any audit?
- “Finally, even if we deal with all these issues of audit effectiveness,” said Beller, the committee must consider, “is that enough?” Although audit effectiveness is ‘the most important part, it is not the only part’ of what the committee needs to address, with other issues being: liability issues that transcend the quality issue - “we ought to get facts on that,” he said- and, transparency and governance issues at audit firms. Beller said ‘there is a lot of opaqueness in the auditing profession, vis-à-vis what investors and others know about it.’
- Additional considerations include competition, concentration, complexity and globalization
Some, but not all, of the ACAP members’ comments are included above. (Other ACAP members also spoke during the program.) For further details, you can view the archived webcast of the ACAP meeting, and additional resources relating to ACAP are posted on Treasury’s website here.
Prepared Oct. 15, 2007 by Edith Orenstein, Director, Technical Policy Analysis, Financial Executives International (FEI). This summary does not repreesent FEI opinion unless specifically noted above.