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 Professionalism is Primary

DATE Dec. 12, 2003
SPEAKER(S): Douglas R. Carmichael, Chief Auditor and Director of Professional Standards
EVENT: AICPA Annual National Conference
LOCATION: Washington, DC

Instead of focusing narrowly on what the Public Company Accounting Oversight Board has done in standards-setting to date, I want to focus more broadly on what the PCAOB and you - the auditors of public companies - need to do in the future to restore investor confidence. Before going further, I should make clear the views I express are my own and not necessarily those of PCAOB board members or other staff.

Since the early 1970s, the principles section of the AICPA code has stated that members should accept an obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate a commitment to professionalism.

I believe that a renewed commitment to professionalism is essential to restore investor confidence and is, in fact, the primary step necessary to reach that goal. Today I want to talk about how that commitment became diluted and diverted and what has to be done to renew it.

To do that we first need to consider the old, but still very relevant question: What is a profession? Those who have pondered that issue generally agree that a profession exists to fulfill a definite service within society that requires a high degree of skill or knowledge. A profession holds as its first ethical imperative the desire for service.

The definite service of the public accounting profession is providing assurance on the reliability and thereby enhancing the credibility of financial information. In other words, the definite service of the public accounting profession is the audit or review of financial information. It is this service that lead to the view of a CPA as the trusted professional. Some sought to capitalize on this position of trust earned as auditors and transfer that stature to other services. At times it seemed the only criteria for these other services was whether they made money.

This attempted transfer is exemplified by the national professional organization of accountants publishing a practice aid with the title Make Audits Pay: Leveraging the Audit into Consulting Services. It is also demonstrated by the fact that the major firms referred to and thought of themselves as multi-service firms rather than as accountants and auditors. The service ideal changed from the acceptance of an obligation to the public interest and a commitment to professionalism of an auditor to becoming a strategic adviser who understood the business from the management's perspective and who acted in management's best interests.

The first action in making a renewed commitment to professionalism should be to reaffirm the service ideal of the independent auditor. Any firm that performs audits should see itself first and foremost as an independent auditor performing the definite service of auditing financial information. That is not a narrow, dwindling service as some have attempted to portray it.

The PCAOB's first proposed standard on audits of internal control over financial reporting provides the perspective for a revitalized service ideal for audits of public companies. This audit is now an audit of the financial reporting process that includes an audit of the annual financial statements, an audit of the company's controls over the process, and a review of quarterly financial statements.

The annual and quarterly financial statements are the primary outputs of the financial reporting process. Internal control over financial reporting provides discipline and safeguards over the process that produces those financial reports. The ultimate objective of this new audit of a public company is to enhance the credibility and improve the reliability of the outputs of the financial reporting process. Reliable and credible financial information promotes informed investment and lending decisions. Investors need and want assurance that the public company's releases of financial information during the period between audited annual financial statements are reliable.

Because that is the ultimate objective of the new audit, the PCAOB decided that the auditor had to do enough work to provide assurance not just that management's assessment process was adequate, but that the controls over financial reporting process were effective. Anything less would not meet public expectations.

The PCAOB's proposed standard includes many imperatives on the scope of work necessary to give an opinion, but the auditor's best guide is to simply step back and ask what do I have to do to provide warranted assurance that the outputs of the financial reporting process - particularly the quarterly financial statements - are reliable?

Some will say that drawing attention to this ultimate objective will create unreasonable expectations. However, the professional service ideal should be to meet the justified expectations of users of the auditor's work. The issue of how we treat a potential gap between public expectations and auditor performance is one I will return to, but first I want to examine the role of professional standards in reaffirming the commitment to professionalism. Why does a profession need standards - including both ethical and technical standards? One important reason is to solve the ethical dilemma of reconciling the professional service ideal with the legitimate economic interests of the members of the profession. Yes, making a profit and getting more business are legitimate pursuits, but they must be pursued within the constraints of professional standards. Professional standards should not be ignored to achieve a business advantage and they should not be used as a business tool to exact higher fees. Quality ethical and technical standards are also essential to provide a foundation for the confidence of those who rely on the profession's service.

Here we need to distinguish between personal ethics and professional ethics. The two are related, but professional ethics is more than a special application of personal ethics. Personal ethics is the subject of general theories of ethics. The focus of such theories is philosophical inquiry into the rational basis for proper conduct. It is the concept of duty for duty sake. (The Code adopted in 1973 expressed this in the following quote from Marcus Aurelius - "A man should be upright; not be kept upright.")

The goal of a profession's code is something more. It is not aimed at enabling individual members to live a proper life. The goal of the profession's code is to serve as a system of social control. A profession's code describes the duties of members of the entire group to those outside the group. John Carey described this as notifying the public that the profession will protect the public interest, that in return for the trust that the public places in the profession, the members of the profession accept the obligation to behave in a way that will benefit the public.

Most organized professions have duties to clients and to the public. A lawyer has responsibilities to the court and the law as well as to individual clients. A doctor has responsibilities for public health as well as to individual patients. Poor management of duties to the public versus to individual clients can cause a lack of respect for a profession.

Some would say that is what happened to independent auditors. Intense pressure on the management of public companies to meet the earnings expectations of analysts lead to intense pressure on auditors to help clients meet those expectations. There were economic incentives to preserve the relationship with the client. Building the client relationship had become the service ideal. Accommodation on questionable accounting practices was one result. There was a widespread erosion of professionalism and the profession lost the confidence of investors. This decline in professionalism did not happen overnight. Some would say it started decades ago. This is not the first crisis of confidence for the accounting profession. Let's go back 30 years to 1973 and consider what happened and why. That time period saw the conjunction of three critical elements.

First, there were a series of alleged audit failures over a period of years beginning with Westec in 1965 and passing through Yale Express (1967), BarChris (1968), Continental Vending/U.S. vs. Simon (1969), National Student Marketing (1969), Penn Central (1970), Sterling Homex (1972), Four Seasons Nursing Homes (1973) and culminating in Equity Funding in 1973 that lead to the appointment of the Cohen Commission.

Second, also in 1973, the Financial Accounting Standards Board was established as a result of a study by a group appointed by the AICPA. The accounting standard-setting function was removed from the accounting profession. Some in retrospect regard that as a serious blow to professionalism. Public accounting firms became one constituency among many in the establishment of accounting standards.

The AICPA at the time regarded the process that lead to the establishment of the FASB as a success and a similar process was the favored solution to deal with the crisis in confidence that resulted from the rash of alleged audit failures. The Cohen Commission was established to study whether there was a gap between reasonable public expectations and the performance of auditors and, if so, to suggest ways of closing the gap.

At the same time, there were other forces at work that resulted in the third element beginning in 1973. Several years before, the Department of Justice had informed the AICPA that the ethics rule prohibiting competitive bidding would likely be deemed a restraint of trade. Shortly it obtained consent decrees related to similar rules of professional societies of engineers and architects. In 1972, after a year of investigation, the Department of Justice informed the AICPA that it was prepared to litigate unless the AICPA entered a consent decree and the AICPA did so. As a result, a new code of conduct was adopted in 1973 without the former rule that prohibited competitive bidding.

However, the new code adopted in 1973 continued to prohibit advertising, solicitation, and other competitive practices that did not reflect the proper professional attitude. For example, Carey argued that soliciting an engagement put an auditor in a subordinate position to the client.

Between 1972 and 1976, the Department of Justice pursued other professions for prohibitions of competitive practices that were considered to be violations of the Federal antitrust laws. For example, the legal profession's prohibition against advertising was successfully attacked. In 1977, the Department of Justice and the Federal Trade Commission began investigation of all of the accounting profession's remaining requirements that might be viewed as restricting competition and in 1978 notified the AICPA that legal action was likely. In 1973 by entering the consent decree the AICPA had already acknowledged the validity of the government's position. By 1979, the AICPA membership had approved repeal of rules prohibiting uninvited solicitations and offers of employment and made substantial changes to prohibitions against advertising and incompatible occupations.

Between 1972 and 1979, virtually all of the profession's anti-competitive restrictions were repealed under threat of legal action.

Now I am not going to advocate that what we have to do to restore professionalism is to revive the constraints on competition. Although I will note that as one result of practices related to Enron, WorldCom, and similar companies, SAS 97 was issued in 2002 to prohibit SAS 50 reports on hypothetical transactions. This occurred without anyone raising a concern about the clear restraint on competition. In fact, one of the things that must be done to restore professionalism is to place further restraints on competitive practices related to consulting on the application of accounting standards. The auditor's participation in providing advice to audit clients or others on how to structure transactions that have no purpose other than achieving a particular accounting or tax result needs further restriction.

After the decision to appoint the Cohen Commission was made in 1973, the Commission began deliberations in 1974 and its final report was released in 1978. During that time, the Commission's staff did a substantial amount of research and analysis. One aspect of this was interviews of auditors, users, and regulators. James Needham was the head of the New York Stock Exchange and had been an SEC Commissioner. He was the first partner of a CPA firm to be appointed to the Commission. Manny Cohen and I interviewed Mr. Needham. His observation to us was probably not original, but it was very accurate. He said that public accounting was once a profession with business overtones, but had become a business with professional overtones. He believed that unless that process could be reversed, there was no hope of closing the gap between the expectations of users and the performance of auditors.

He made that comment at a time when the constraints on competition were just being removed. Even at that time the Cohen Commission believed that competition was excessive and had a detrimental influence on the quality of auditing. Through a combination of factors the opportunity the Cohen Commission had to reverse the decline in professionalism was lost. The trickle of detrimental effects on professionalism that began in 1973 became a flood over the thirty year period that culminated with Enron, WorldCom, and the other accounting scandals revealed in quick succession by 2002.

Others have chronicled how removal of the accounting standard-setting function from the profession also contributed to the deterioration of professional values. A once vibrant dialogue on accounting principles with active participation by partners of large firms virtually disappeared. These firms were no longer represented on the standard-setting body. A commitment to quality accounting standards gave way to a participation in the process that made accounting standards just one more competitive tool. The rules in the Code that were designed to uphold the spirit of professionalism had been removed and nothing had been done to compensate for that void.

The Cohen Commission did not foresee the consequences of these developments and perhaps no one could have been that clairvoyant.

The Cohen Commission made many significant recommendations. I will not recount them all, but they included making fraud detection an important objective of the audit, requiring the auditor to evaluate the economic substance of transactions in evaluating accounting principles, making the audit committee the primary client relationship, and imposing professional standards on the process of consulting on accounting principles. The Cohen Commission also concluded that there was evidence that providing consulting services had impaired independence, a finding that was not only ignored, but covered up by the repeated bald assertion that there was no such evidence.

In all these areas, however, the Cohen Commission was willing to rely on the voluntary action of the accounting profession to implement the recommendations for change. It drastically underestimated the forces of competition that had been unleashed and the decline in professionalism that was set in motion. The result was that the recommendations were either ignored or adopted in a very watered down fashion.

Even the primary overall conclusion of the Cohen Commission has been forgotten. It concluded that there was a clear gap between public expectations and auditor performance, but it rejected the notion that the answer was to properly educate the public on why expectations were unreasonable. It concluded that the expectations were reasonable in view of the auditor's role in society and that the gap must be closed by improvement in auditor performance.

That brings me to the next steps that need to be taken to improve professionalism in the coming audit season to close the gap and restore professionalism. It will be essential to follow the spirit of the standards and not construe the letter of the requirements to avoid responsibility. I first want to focus on the important topic of fraud detection.

It has been said that one of the important measures of a profession is how it deals with its mistakes. In that regard our professionalism is in need of major repair and the tools are at hand.

This audit season is the first one in which SAS 99 is in effect. Auditors should recognize that detection of fraud is clearly an important objective of an audit. That has been true for over 60 years, but the literature of the profession had not forthrightly acknowledged that objective. It is important that auditors take SAS 99 seriously and conduct audits in a manner that makes it probable fraud will be detected.

The brainstorming session that is now mandatory in preparation for planning the audit, I want to stress, should set aside the neutrality on management honesty and assume that management is inclined to commit fraud and design an audit that is responsive to the areas of vulnerability. This is not an evaluation of the risk that management has committed fraud. It is an analysis of the areas that are vulnerable to fraud if management were so inclined.

One of the key procedures required by SAS 99 is review of journal entries. At a minimum, all journal entries made around the quarterly and annual closing process should be scanned either electronically or visually to identify nonstandard entries for testing. The important part of this is the scanning rather than the testing because problem entries typically are apparent because they are significant or unusual.

It is interesting that the Equity Funding fraud in 1973 included the falsification of general ledger control accounts by recording fictitious journal entries with no supporting documentation. False revenue was recorded by debiting funded loans receivable and crediting commission income. This entry made no sense to someone who understood the business. The key to detecting fraud is usually recognizing the implications of evidence that has been obtained, including particularly detected misstatements. Do as SAS 99 requires and examine them for indications of fraud. Do not rely on the contradictory footnote that says there is no responsibility for determining intent. It does not remove the responsibility to evaluate a misstatement for indications of fraud.

Improving the standards and adhering to their spirit is one important response to dealing with our mistakes. Another is to acknowledge them. It is likely inevitable that there will be a major fraud that an auditor fails to detect. When that happens, a proper professional response for the head of the firm involved is not to invoke the tired litany that an auditor is not responsible for detecting all fraud and that the firm fully adhered to all professional standards even though it failed to find that most of the income was false.

That is not a professional response and it is not a complete and accurate response. The appropriate response is: We are investigating the situation to determine why we failed to detect this major fraud. That is also what the reality should be.

Another closely related topic is related party transactions. The auditor must perform procedures to attempt to identify undisclosed related parties. When related party transactions are identified, the auditor should not view these transactions as benign. They always involve a conflict of interest. When the auditor is aware of them, they should be probed to see whether the substance of the transaction differs from its form. If that is the case, the auditor should seriously evaluate whether the accounting presentation needs to be changed. Disclosure might not be enough.

In evaluating management's selection and application of accounting principles, the auditor's overriding responsibility is to assess whether the economic substance of transactions and events is adequately presented. The auditor should not accept a financial statement presentation that is not representationally faithful. The GAAP hierarchy puts FASB statements of concepts in the "may consider" rather than the "must know" category. Nevertheless, the notion that an auditor could give a clean opinion while knowing the financial statements are not representationally faithful is not compatible with professionalism.

The SEC staff has recommended, as part of the move to an objectives-oriented principles-based accounting framework, that FASB Statements of Concepts after improvement be moved to the top of the hierarchy. That is an excellent recommendation. Restoring professionalism will require embracing the SEC staff recommendations in this area. Management would be responsible for capturing in the financial statements the economic substance of transactions as defined by the accounting standards. The auditor would be responsible for reporting on whether management fulfilled that responsibility.

Another audit area of focus in the coming audit season should be financial instruments and other assets or liabilities measured at fair value. If observable market prices are not available to support fair value, the auditor must recognize the increased risk of material misstatement due to both fraud and error and devise an adequate audit response.

If fair value was determined using a model, the auditor should challenge the appropriateness of the model and the reasonableness of management's assumptions. If management's intent is relevant to the determination of fair value, the auditor should obtain better evidence than simply management's representations. Management's representations are always an extremely weak form of evidence and the auditor should corroborate them by examining management's relevant performance history and challenging management's ability to carry out its stated intentions.

The work of a valuation specialist could be relevant to substantiating fair value measurements. Auditors should recognize that in the future, valuation expertise should become part of the working knowledge of auditors. A profession has to expand its skills to meet its responsibilities. In the meantime, if a valuation specialist has to be used, that specialist should be engaged by the auditor and supervised in the same manner and to the same extent as other members of the engagement team.

The final area I want to mention for the coming audit season is communications with audit committees about matters bearing on independence as required by ISB Standard No. 1. The auditor should discuss with the audit committee all matters that might reasonably be considered to bear on the auditor's independence in fact or appearance.

This responsibility should not be viewed narrowly. The issue is a particularly fact intensive one for assistance on documenting or testing internal control related to management's Section 404 responsibilities.

This type of assistance can easily evolve into performing management functions or auditing one's own work. For this reason, the PCAOB's proposed standard takes the position that the audit committee must specifically pre-approve any services in this area and not do so in advance by category. The audit committee should be fully informed of all aspects of the engagement and the circumstances that lead to the independent auditor being considered for this work.

If management needs this type of assistance so that an outside provider is essential, and the independent auditor has told management that the auditor could not sign off on management's Section 404 assessment unless the auditor provided that assistance, that is perilously close to an outright admission of lack of independence.

The audit committee among other matters needs to be fully informed about all fee arrangements for all services that the auditor's firm has or will provide to the company or its officers. If a fee that is effectively a contingent fee is involved for any of these services, independence is impaired. It is the responsibility of the lead partner to find out about these fee arrangements as well as all other relationships with the client and to see that the audit committee is adequately informed. Professionalism would require that the auditor recognize that merely calling the arrangement a complexity fee or having an allied entity collect and distribute the fee does not change the basic character of the fee.

These comments on independence are directed to particular abuses, but I want to stress that independence in both fact and appearance must be approached as an issue of substance and not be viewed simply as a matter of compliance with rules.

In closing, let me summarize the elements that came together beginning in 1973.

  • The profession lost the responsibility for setting accounting standards which contributed to an attitude of accommodation and compromise on accounting standards.
  • All the ethical rules designed to uphold the spirit of professionalism were removed and no compensating mechanism was put in place.
  • The Cohen Commission was appointed to devise a plan to restore confidence in auditors, but mistakenly relied on voluntary actions to implement its recommendations.

The profession's loss of the responsibility for setting auditing standards in 2003 is probably even more momentous than the loss of responsibility for setting accounting standards thirty years ago.

The PCAOB has already changed the public dialogue on auditing standards and those changes can be expected to grow. My hope is that the direction of the effect on professionalism of auditors will be the opposite of what some see as the effect of losing accounting standard setting. My hope is that auditors will respond to their new role as an essential contributor to the development of professional standards and that the result will be a renewed spirit of professionalism and a dedication to the auditor's role of protecting investors and furthering the public interest.

One step that could be taken is to amend the ten basic auditing standards to add a new general standard that might be worded as follows:

The auditor shall, in all matters related to the audit, act in a manner that places primary emphasis on protection of investors and the furtherance of the public interest in the issuance of informative, fair, and independent audit reports.

This would make dedication to professionalism an overriding and mandatory obligation for the auditor of a public company.

 

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