Oversight Hearing on "Accounting and Investor Protection Issues
Raised by Enron and Other Public Companies

Oversight of the Accounting Profession, Audit Quality and Independence,
and Formulation of Accounting Principles."

Mr. Chairman, I thank you for your invitation to participate in these hearings. I served as the deputy chairman of the Commission on Auditors' Responsibilities, in charge of the day-to-day operations of the Commission and its staff and, with Douglas Carmichael, was the principal writer and editor of the Commission's Report. The group was more commonly known as "The Cohen Commission" after its chairman Manuel F. Cohen. "Manny" unfortunately died in June 1977, shortly after the Commission⁽¹⁾ issued its Report of Tentative Conclusions. Thus, the largely unchanged final Report, Conclusions, and Recommendations of the Cohen Commission reflects the former SEC Chairman's lifelong commitment to the public interest and to improving the functioning of American securities markets.

The Commission was appointed by the American Institute of Certified Public Accountants (AICPA) to:

The seven-member Commission was drawn from the accounting profession, industry, financial services and academe. It met monthly for 66 meeting days between 1974 and 1978. The Commission conducted 26 separate research projects and surveys and held a variety of conferences and interviews with members of government, the accounting and legal professions in the U.S. and Canada, stock exchanges and others. After the Report of Tentative Conclusions was issued, the members of the Commission and staff participated in seminars and made presentations of the Commission's positions to more than 60 meetings of professional and business organizations. The AICPA and state societies of CPAs conducted 123 member forums.

The final Report, Conclusion and Recommendations, 195 pages and approximately 100,000 words, was fully and unanimously agreed to by all the members of the Commission. That there were no dissents was due to the cordial working relationship between the members, the excellent work of the highly qualified, conscientious staff and to Manny Cohen's belief that to be effective we had to be unanimous. We were unanimous, but not necessarily effective. Most of our important recommendations were never acted upon.

Although at times the administration of the AICPA disagreed with many of the conclusions that the Commission was reaching, the Commission received all the resources and the full cooperation it required from the AICPA.

CONCLUSIONS: THE EXPECTATION GAP EXISTS

The fundamental conclusion of the Commission was summarized as:

If a "gap" existed in 1978, it is a chasm in 2001. In a comment that sadly foreshadowed the current furor generated by disclosures about Enron, the Commission noted:

The public accounting profession has failed to react and evolve rapidly enough to keep pace with the speed of change in the American business environment.⁽⁴⁾

As might be expected, until preparing for this testimony I have not reread the Commission's Report for many years. I am pleased to say that in most respects the analyses, conclusions and recommendations in the Report remain valid. I believe that had some of our most critical recommendations been adopted, many of today's issues would not have arisen.

In the following testimony, I will emphasize those recommendations of the Commission, still not adopted by authoritative bodies, that would help close today's chasm and speed the evolution of the accounting profession. In addition I will present several of my own recommendations in areas that were addressed by the Commission, but which today appear to require stronger medicine than was prescribed by the Commission in 1978. The passage of a quarter century (and the difficulty of finding them) has prevented me from reviewing these recommendations with other Commission members. While here I speak only for myself, I believe that my fellow Commission members would agree that changed conditions, the increased complexity of business transactions and the deterioration of many aspects of the accounting profession warrant these more stringent measures.

I hope the actions proposed here will receive early consideration by the Committee. The impacts of Enron, in isolation, while costly to Enron shareholders and devastating to employees' retirement plans, would have had no significant effects on markets or the economy. However, the realization that some other companies use the accounting techniques employed by Enron has already had a short-term impact on market volatility. The validity of the financial reporting of many companies, supposedly in accord with generally accepted accounting principles (GAAP) and audited by independent accountants, is daily questioned by investors and analysts.

In the 1970s, I was the first brokerage analyst to make a specialty of dissecting and challenging the financial reporting of public companies. The then lax accounting rules in franchising, leasing and revenue recognition provided me with easy targets. Many others later followed me into that specialty. I suspect that Enron heralds a revival of "accounting analysis". There is nothing inappropriate about such scrutiny, indeed, it increases market efficiency. However, unless investors perceive that effective action is being taken to remedy these apparently widespread deficiencies and to reduce the frequency of accounting surprises, confidence in the existence of a "fair game" in the market may suffer.

OUTLINE OF PROPOSED ACTIONS

In the following testimony I will suggest a series of actions to be taken which can be implemented through legislation or regulation. With the exception of those directly related to the proposed statutory self regulatory organization (SRO) and the audit requirement for quarterly reports, they could also be implemented by existing private organizations: the Auditing Standards Board of the AICPA, the FASB or the Public Oversight Board.

INCREASE THE BUDGET OF THE SEC

However, allow me to first present a call to this Committee. The Securities and Exchange Commission has been a critical and effective force for improvement in financial reporting and in the overall functioning of American capital markets. Notwithstanding impression created by the Enron debacle, the U.S. has the best and most comprehensive financial reporting in the world. Much, perhaps most, of the credit for our system must go to the effective work of the SEC. The proposals I am making will add even more to its responsibilities. The SEC's budget is miniscule, compared to the rest of the Federal budget and, more important, to the values in the capital markets it oversees. I urge the Committee to take action to significantly increase the SEC's budget to allow it to continue to protect our capital markets.

My proposals are:

• Enact legislation establishing a statutory self regulatory organization (SRO) with the NASD as a model and, under the direction of the SEC, responsible for financial reporting standards and regulation.
• Move the AICPA's standard setting and regulatory operations out of the Institute and into the new SRO.
• Make the Financial Accounting Standards Board an integral element of the Financial Reporting SRO.
• Replace the present peer reviews of accounting firms by accounting firms with examiners from the SRO staff.
• To reduce the potential corrupting influence of consulting fees, prohibit the performance of nontraditional consulting for audit clients of public companies.⁽⁵⁾
• Require Forms 10-Q and published interim financial statements to be audited as part of a continuing audit process.
• Require audit committee approval to hire former auditors.
• Require auditors to evaluate the financial statements as a whole.
• Require "preferable" rather than "acceptable" to be the standard in the selection and application of accounting principles.
• Require companies to record all clearly correct adjusting entries proposed by auditors, regardless of materiality.

The Commission also addressed significant deficiencies in the education and professional preparation of independent auditors. In retrospect, these recommendations, still not implemented were among the most important made by the Commission for, as discussed below, in the quarter century since they were made the accounting profession has lost a great part of its professionalism. The recommendations are:

• Establish graduate professional schools of accounting.
• Reduce the schism between academic and practicing accountants.

MODEL FOR SELF REGULATION OF FINANCIAL REPORTING

The Cohen Commission studied then current efforts by individual firms and professional organizations to establish quality control policies and procedures to encourage compliance with professional standards. It concluded:

The Commission believes that the oversight of professional practice should remain within the profession and that the concept of individual firms' having responsibility for the quality of their own practice should be retained.⁽⁶⁾

The Commission recommended a number of further steps, including peer review. The recommendation for public presentation of peer review results in a "long form" report has been mostly adopted.⁽⁷⁾ Reports of peer reviews and the related letters of comment are now available on the internet but they provide little specific detail. For example, when deficiencies are noted, the letters do not indicate which offices were involved.

The Commission's recommendation that disciplinary action not be postponed until all litigation was ended ⁽⁸⁾ has been implemented to a limited extent. The Quality Control Inquiry Committee (QCIC) of the SEC Practice Section of the AICPA (SECPS) now investigates substandard audits quickly but the results are reported only to the Public Oversight Board (POB) and the SEC; they are not made public. Of the Commission's most important recommendations, only those asking for greater auditor concern with detecting fraud have been adopted, albeit gradually.

The Commission also studied the sanctions that could and were being imposed on individuals and firms for performance or conduct that violated professional standards. It is not unfair to say that the Commission was disappointed by the then current situation (which does not appear to have changed significantly). It noted:

Failure to address Significant Problems. With a few exceptions, individuals appear to be penalized only for infractions which involve advertising (no longer forbidden) or client solicitation and felony convictions related to the preparation of false tax returns. While not unimportant, those are not major problems facing the profession today. The major problem is substandard performance.⁽⁹⁾

However, after suggesting a number of areas for improvement it concluded, unfortunately incorrectly, that more progress would be made. With this optimistic outlook, the Commission noted:

An organization could be established within the profession that would have the ability to penalize firms for substandard performance. Such organizations do exist in other areas, for example, the National Association of Securities Dealers…. We do not see any promise that the creation of a regulatory body as described above would be a significant improvement on the present mixture of private and public regulation.⁽¹⁰⁾

I now believe that this conclusion, with which I agreed earlier, was wrong. Substandard performance does not appear to have been reduced or curtailed. Indeed, some recent cases are in many respects more egregious than any reviewed by the Cohen Commission.⁽¹¹⁾ I do not like to rely excessively on evidence from one case, but the actions of a major firm, as disclosed in the recent SEC release on Arthur Andersen and Waste Management, strongly suggest that the problems are deeper than any of those contemplated by the Cohen Commission.

The following excerpt from an SEC release on Arthur Andersen and Waste Management summarizes the essence of that case.

The facts of this case are unique, not only in their magnitude, but in the actual accounting proposed. The notion that misstatements could be written off over some future period, rather than immediately corrected, is unsupported, indeed unheard of, anywhere in accounting practice or literature.

Worse yet was the consultation process and the concurrence of those consulted:

Thus, this is not the case of an ignorant or "renegade" partner. Instead, this bizarre accounting was approved by a series of reviewers, all the way to the highest level in the firm.

The Cohen Commission did not find any case exhibiting such pervasive concurrence with such bad accounting. As I said earlier, most of the significant recommendations of the Cohen Commission, made 24 years ago, for reducing substandard performance have not been adopted by the present private financial reporting establishment. I do not know if my other Commission members would concur, but I now believe that a stronger, statutorily directed oversight structure is called for if necessary improvements are to be made.

THE NASD MODEL

A number of proposals for more stringent oversight of the accounting profession have been made in recent weeks, including that of the Chairman of the SEC and in legislation introduced in the House of Representatives.

Both call for new organizations. I have learned that it is usually more efficient to look to and copy existing, successful models rather than invent new devices. I believe:

• The NASD provides a model for a statutory self regulatory organization (SRO) that could be applied to the accounting profession and

• Enacting legislation to transfer the AICPA's standard setting operations and oversight responsibilities to the new self regulatory organization for financial reporting would be the quickest and most efficient way of commencing operations of the SRO.

I make this call for increased regulation of my profession with no small regret. I am a CPA, my father was a CPA. I started my career as an auditor. Such success as I have achieved is heavily due to what I learned as an accountant. I was privileged to work for or with some truly proud professionals and truly independent accountants such as Paul Grady, Philip Defliese, Joseph Cummings, Ray Groves, Robert Hampton and on the Cohen Commission, LeRoy Layton and Kenneth Stringer.

I believe all of them would be truly outraged at many aspects of their profession today. Their firms, once managed by the leading technicians and theoreticians in the profession are now frequently led by "rainmakers" selected for their ability to generate new business, not for their accounting knowledge. Too many firms and practitioners in a profession dedicated to the public interest have become too dedicated to private gain.

I make these comments not because of the Enron case. The gradual deterioration of the professional conscience of at least a sizable minority of public accountants has been continuing for the past several decades. Enron is merely a widely publicized symptom that may at least have the benefit of bringing about long delayed changes in the accounting profession. Ultimately, these changes must come not through regulation but by restoring the sense of professionalism that too many accountants seem to have lost. These are changes that Congress cannot enact, the SEC cannot promulgate. The management of accounting firms must be returned to accountants, not salesmen. Accountants must be educated as professionals in the same manner as the lawyers, doctors and members of the other liberal professions.

THE NASD

I assume there is no need to recount the history and functions of the National Association of Securities Dealers (NASD) for the members of the Committee, but I will give a very brief summary for other readers.

The precursor of the NASD was the Code Committee formed by the investment banking business under the National Recovery Act (NRA) in 1933. When the NRA was declared unconstitutional, the members voted to continue the organization on a voluntary basis. That private voluntary organization grew and changed its name to the Investment Bankers Conference. In 1937 the governing committee of the Conference, working with the SEC, drafted legislation to create it as a self regulatory organization. The legislation that came to be know as the Maloney Act was signed by President Roosevelt on June 25, 1938. In 1939 the organization was renamed the National Association of Securities Dealers.

The relationship of the NASD and its subsidiaries to securities markets and participants is, in many ways, comparable to the functions of the AICPA and the Financial Accounting Standards Board (FASB), including development of qualifying examinations, registration of sales and supervisory personnel, regulation of individual ethics and business conduct, education and publications, and establishing rules of fair practice. Of course, it also has other operations, not comparable to the AICPA, such as the NASDAQ market and overseeing the American Stock Exchange.

CREATE A NATIONAL FINANCIAL REPORTING OVERSIGHT BOARD

There have been several proposals to create a new oversight body, some aimed at replacing or expanding the Public Oversight Board of the AICPA. With the evolutionary NASD model in mind, I see no reason to invest the enormous effort that would be involved in creating an entirely new organization.

The AICPA's SEC Practice Section (SECPS), Auditing Standards Board (ASB), Accounting Standards Executive Committee (AcSEC) and Professional Ethics Division are already staffed and operational. The time and money saved by starting with these existing units of the AICPA, which appear to comprise about 30% of the Institute's total expenses, would be significant. The SEC's familiarity with these AICPA groups would conserve the SEC's scarce resources.

I propose that legislation be developed through joint efforts of the AICPA, state CPA societies and boards, other accounting professional organizations and the SEC and enacted in the same manner as the Maloney Act to create a new National Financial Reporting Board (NFRB) based on a core of the appropriate elements of the AICPA. ⁽¹⁴⁾Statutory direction would, hopefully, accelerate the past and current torturously slow rate of improvement in the accounting profession.

The NFRB would fit into and amplify the present structure of professional regulation. CPAs are licensed by state boards of accountancy which system would be undisturbed. Note that individual securities brokers must be licensed by the states in which they deal. The NFRB could license or otherwise qualify firms that audit public corporations in much the same manner that broker-dealers are regulated under SEC Regulation M and by NASD Regulation, Inc. (NASDR, a subsidiary of NASD). The present Public Oversight Board (POB) and the SEC Practice Section (SECPS) of the AICPA would be the basis for an arm comparable to NASDR in the area of regulation of firms auditing public companies. The Quality Control Inquiry Committee (QCIC) of the SECPS already investigates substandard audits and likely would to do so, but having subpoena power and making its findings public.

Financing of the NFRB would logically come from direct charges to public companies and accounting firms qualifying to audit public companies.

PRESERVE STATE SOCIETIES AND REGIONAL FIRMS

State societies and state boards of accountancy play a major role in licensing and maintenance of professional standards. For example, the New York State Society of Certified Public Accountants (NYSSCPA) is active at all levels of professional development. Its magazine, The CPA Journal, is one of the few forums available for the publication of debates and critical comment on issues in financial reporting by practitioners and educators. It is far superior intellectually to The Journal of Accountancy published by the AICPA. State societies are in some ways competitive with the AICPA -they have significant unduplicated memberships - and their continued contribution to professional development must be preserved.

There are high quality local and regional accounting firms, some of which specialize in specific industries and whose practice includes auditing some public companies. Care must be taken to assure that the NFRB makes appropriate allowance for services rendered by CPAs who are not principally occupied with audits of public companies and for the private companies they audit. This care should not include different auditing standards, but would address, for example, different requirements for advice and consulting that private companies require from their accountants.

Hopefully the creation of an NFRB that I am proposing will have the same effect as that suggested by Senator Francis T. Maloney, sponsor of the 1938 Maloney Act Amendment to the Securities Exchange Act of 1934:

This Act is designed to effectuate a system of regulation …in which the members of the industry will themselves exercise as large a measure of authority as their natural genius will permit.

MERGE THE FASB INTO THE NFRB

When the Financial Accounting Standards Board (FASB) was created, essentially by carving the accounting standards setting function out of the AICPA, I wrote an article titled "Goldfish in a Bowl of Sharks."⁽¹⁵⁾ I predicted that the new FASB (the goldfish), no longer enjoying the built in support and shield of the accounting profession and the large accounting firms and the membership of the AICPA, would be highly vulnerable to influence and pressures exerted by all the other parties (the sharks) affected by financial reporting. The AICPA, I suggested, having lost its most important professional function - standard setting - would be reduced greatly in professional status.

Unfortunately, these forecasts were mostly accurate. The FASB has been beset by enormous outside pressures. Returning to being part of the principal accounting professional organization will give it the strong support of the NFRB and a shield against attempts to unduly influence its decisions. In addition, the FASB, alone in bucolic Connecticut, has been somewhat isolated from the mainstream. Integration into the National Financial Reporting Board will provide better direction and focus for the FASB's efforts. With the AICPA's Auditing Standards Board and Accounting Standards Executive Committee also under its umbrella, the NFRB would have the standards setting responsibility for the accounting profession as well as responsibility for overseeing the appropriate application of those standards, under the ultimate direction of the SEC.

I might add that I have heard proposals that the directorship or board of an SRO created in this situation be "independent" of the accounting profession. That is, the membership would not include professional accountants. I disagree strongly with that notion. It is the equivalent of suggesting that the board of directors of a corporation exclude any member with extensive experience in the corporation's industry. To the contrary, the board of the SRO should include a reasonable number of members with strong public accounting backgrounds. Despite the decline in certain aspects of the accounting profession, there are still many highly qualified, independent accountants who can bring leadership talents to a financial reporting SRO.

The FASB is principally funded by contributions from public accounting firms and public companies as well as revenues generated by its publications. As part of the NFRB, its financing would come through the NFRB.

PROFESSIONAL AUDITORS OF AUDITING FIRMS

At present, the Public Oversight Board's (POB) peer reviews of members of the SECPS are performed by their "peers", that is, other accounting firms. Major accounting firms are reviewed by other major accounting firms. Despite a series of SEC cases and private litigation which revealed clearly substandard auditing work, no major firm appears to have been publicly sanctioned as a result of a peer review.

While the major accounting firms are willing to "peer review" each other where the results of specific audits are not disclosed, they are not willing to testify against each other in open court. When the SEC brings charges against a firm of public accountants, other accounting firms will not serve as expert witnesses for the SEC, despite the fact that several firms have sections devoted to litigation support. Most financial accounting professors at universities, apparently unwilling to risk the wrath of the accounting firms who often support their work, also are unwilling to testify against accounting firms.

This situation suggests that when the NFRB is established, it should develop its own auditors to examine public accounting firms and not depend on review by peers.

THE INFLUENCE OF THE FEES ON AUDITOR INDEPENDENCE

The relationship between independent auditor and client is unique in our society. In theory, the auditor works for and protects the shareholders. In practice, the management of the corporation pays the independent auditor to assure that management's financial reporting is accurate. A doctor cures his patients, a lawyer represents his clients but an independent auditor polices the management that pays him.

For this unique relationship to work, the auditor must be truly independent, willing to tell the client what is wrong, to insist that what is wrong be corrected or to walk away from the client…. and from a stream of future fees. The drafters of the Securities Laws understood the value to the capital markets of this independent control over the accuracy of financial statements. By requiring that all companies whose securities were publicly traded have financial statements audited by independent accountants they virtually guaranteed a market for the services of American CPAs. The accounting profession, particularly the larger firms, grew and prospered under this mandate.

Now, recent cases and the comments of many critics strongly suggest that this critical independence is being subverted by fear of losing the client and future fees. The following excerpt from the SEC release on Arthur Andersen and Waste Management⁽¹⁶⁾ provides interesting insight into some of the ways in which an auditor's independence was compromised:

* As noted in the order as to Andersen, this conduct took place against the following background:

This excerpt needs little elaboration. Allgyer is described as a marketing man, cross-selling other Andersen services. The audit fee was capped but other fees were not. Thus, if Allgyer were to take a strong stand against the client he would have risked losing not only future audit fees, but also the even larger consulting fees. In addition, one might also ask how objective Allgyer would be in auditing the results of actions taken in accord with his own strategic review.

Given the strong pressures that fees of any sort exert on maintaining independence, it seems logical to eliminate, when possible, fees that bear no relation to the audit function.

PROHIBIT THE PERFORMANCE OF CERTAIN MANAGEMENT CONSULTING FOR AUDIT CLIENTS OF PUBLIC COMPANIES.

The Cohen Commission examined the question of whether performing management consulting impaired the independence of auditors. The Commission staff searched for cases where impairment of independence resulted from management consulting engagements. The Commission also solicited leading critics of the profession for specific cases. With the possible exception of Westec, no cases were found. The Commission analyzed the problems potentially associated with each of the non-audit services then performed by independent auditors. Its conclusion:

However, this conclusion, reached in 1978, should be viewed in the light of another comment in the Commission's report:

However, the business volume relationship between auditing and management consulting has changed since then. Twenty-two years later, the Panel on Audit Effectiveness (PAE) of the Public Oversight Board presented the following figures for the "Big 5" accounting firms in 1999:

The growth in the last decade of the 20^th century was particularly rapid. The PAE reported that the ratio of auditing revenues to consulting revenues from SEC clients went from 6:1 in 1990 to 1.5:1 in 1999.⁽¹⁹⁾

The Cohen Commission did recommend a series of safeguards to reduce the chance that independence would be impaired: increased director and audit committee involvement and public disclosure of other services. These recommendations have been accepted in one form or another.

The PAE examined the same issue of whether the performance of certain management services should be prohibited. The PAE members divided, with some members for exclusion of certain management services and others for no exclusion. The Panel therefore made no recommendation.

IT'S THE FEES, STUPID

In arriving at their conclusions, both the Commission and the PAE took the same approach; search for examples where the performance of management services impaired the appropriate performance of the audit. That is, find instances where, because the auditor's consulting arm had provided services the auditor was compromised in examining or auditing the results of those services. Neither found any examples. In effect, the theory was not supported by empirical evidence. The PAE pointed out the difficulty of actually finding any such "smoking gun".

I would suggest a different framework for viewing the issue: the impact of consulting fees, not consulting work, on the independence of the auditor. As discussed above, an auditor taking a strong stand against a client risks losing a future stream of audit fees from that client. Consider the excerpt above from the Andersen and Waste Management case. A truly independent audit partner would have faced losing a stream of consulting and other fees even greater than the audit fee.

In addition, the audit partner, Allgyer, essentially was the salesman for the consulting services and was compensated for selling them. Recall the comment above that Allgyer had a "personal style that . . . fit well with the Waste Management officers." Would the style of a strong independent auditor have fit as well?

The Panel on Audit Effectiveness noted in its surveys that working auditors received the message that quality audit work was not important, that the audit has little value and that other services were more important.⁽²⁰⁾ Some audit firm partners to whom I have spoken believe that audits are often offered as "loss leaders", in other words, as entry for sales of consulting services. In my capacity as an audit committee chairman soliciting proposals for new independent auditors I witnessed substantial price competition and the submission of bids that were clearly well below normal billing rates. Virtually every audit partner tries, at one time or another, to sell consulting services to audit clients.

I hold an economics degree and am not about to condemn price competition. However, in the auditing context, absent a high level of professional integrity and supervision, it can result in substandard work. For example, the Cohen Commission's extensive survey of working auditors found that fully 58% admitted to having signed off on a required audit step, not covered by another audit step, without completing the work or noting the omission of the procedures. "Time budget pressure", the result of low fees, was by far the most common reason cited.⁽²¹⁾

A second impact of "loss leader" pricing is a potential loss of independence. Professional ethics forbid an auditor to undertake an examination if the client has an unpaid balance from a prior audit. This is logical, since the debt may give the auditor a pecuniary interest in assuring the continuing business of the client. If an auditor has priced an audit so low that it will take two or three years for the original loss to be recovered - a period cited to me by several audit partners - is that not the same position as being unpaid for a prior examination?

While one would not want to interfere with price competition, some steps can be taken to alleviate the problems described just above. First, the NFRB should extend the rule against commencing a subsequent audit when a prior year's fees remain unpaid to also apply when the prior year's costs are unrecovered.

Audit committees generally now have the responsibility for engaging the independent auditor. Well before the current requirements for audit committees of public companies were instituted, the Cohen Commission recommended that audit committees carefully consider the tradeoffs between price and quality in audit proposals.⁽²²⁾ In doing so, audit committees should emphasize the quality and capability of different firms before considering price. When negotiating fees, audit committees, interested in assuring that they are receiving truly independent audits, should eschew arrangements that will tend to compromise independence, such as fixed fees for a period of years.

WHICH CONSULTING SERVICES TO PERMIT? WHICH TO PROHIBIT?

This testimony is not the place to provide a detailed answer to these questions. However, some general concepts may be developed here which could be amplified by NFRB, SEC or legislative action.

First, we are considering only auditors of public companies with shareholders or creditors removed from direct contact with or control over management. The owners and creditors of private businesses are capable of making their own decisions as to what consulting is appropriate.

Second, audit partners frequently are highly knowledgeable about the business and industries they audit. They should be encouraged to give management and the board of directors the full benefit of that knowledge as advice and counsel. For example, it may be decided to forbid management consultants associated with accounting firms to take M&A engagements similar to those undertaken by investment bankers, but nothing should prevent an audit partner from giving a board of directors advice about a proposed merger or acquisition.

In short, those services that an audit partner (or senior audit staff) can render themselves should not be prohibited. The Panel on Audit Effectiveness, noting the increasing complexity of business systems and the need for specialized knowledge to audit them,

listed a series of "audit support" consulting services.⁽²³⁾ Such services should be permitted.

There are "traditional" non-auditing services offered by accountants; the most significant of which is providing tax advice, planning and return preparation. There is no logical reason to forbid such services which have been offered without problems for decades. However, the structuring, by accounting firms often employing lawyers, of sophisticated, complex, sometimes marginally legal tax shelters (for high fees) recently has become an issue. This would be the type of "nontraditional" consulting, along with strategic planning, business reengineering, investment banking, executive placement, legal and actuarial services, that will warrant consideration as being prohibited for firms performing independent audits of public companies.

REQUIRE FORMS 10-Q AND INTERIM FINANCIAL STATEMENTS TO BE AUDITED AS PART OF A CONTINUING AUDIT PROCESS .

The Commission recommended:

This call for a change in the nature of the audit was considered radical at the time. Although proposed again by Robert Elliott, a recent chairman of the AICPA, the concept has not been embraced by the profession. However, in discussions following the Enron disclosures, there have been repeated calls for release of more current financial information.

It will take time to develop standards for auditor association with "current" financial information. However, a first and significant step would be to require, by statute or regulation, that quarterly reports of public companies be "audited". Such reports are currently "reviewed" on a timely basis under procedures set forth in SAS No. 71 (1992). It should not be difficult to modify SAS No. 71 to integrate the procedures called for therein with the annual audit, as envisioned by the Commission.

It will take a greater, but by no means an insurmountable effort, to develop a framework for the "audit function" envisioned by the Commission. With such a structure in place, rapid progress could be made to provide forms of assurance on more financial information that may be more current than quarterly reports.

FORMER AUDITORS WORKING FOR CLIENTS: NOTIFY THE AUDIT COMMITTEE

The previously cited SEC release on Arthur Andersen and Waste Management noted that a significant number of former Andersen auditors occupied high level financial positions in Waste Management. The same appears to have been true in Enron. This migration from auditor to financial management is neither new nor unusual. The accounting profession has traditionally been a source of talent for companies, with individuals often moving to the same companies they audited.

There are positive aspects to this flow. The company hires people already familiar with operations. If the auditor retains the professional sense of being a CPA as well as being a corporate manager such employment is likely to be a positive force for integrity of the company's financial reporting.

There are also negatives. In the worst case, the former auditor knows exactly how his or her former firm conducts the audit, and how to conceal information from them. In a less ominous sense, the former auditor knows how far former compatriots can be pushed to accept results preferred by management. In general, "we are all friends", is not exactly the appropriate relationship between independent auditor and client. Recall that Allgyer, the Andersen audit partner had a "personal style that …fit well with the Waste Management officers."

The Commission noted:

The Commission said no more about this issue. However, there should be a safeguard against its getting out of control. Management should be required to notify and receive advance approval from the audit committee whenever a former auditor is engaged in a financial management position.

REQUIRE AUDITORS TO EVALUATE THE FINANCIAL STATEMENTS AS A WHOLE

The Commission recommended:

This recommendation, which has never been accepted, was called "the smell test" by Commission member LeRoy Layton.

The profession's position is:

Professional standards do require the auditor to evaluate the aggregate effect of uncorrected misstatements on the financial statements as a whole.⁽²⁸⁾ Layton's "Smell test" calls for a broader look at the financial statements. It is possible for financial statements to be "unfair", even if there are no misstatements and they are generally in conformity with GAAP. For example, it appears that Enron's accounting for certain energy contracts in accord with SFAS No. 133 (on derivatives) and other transactions greatly inflated the Company's apparent total size (revenues)⁽²⁹⁾.

This recommendation was in accord with a general theme that runs through the Cohen Commission report; auditors must be made to exercise more independent judgment. As Enron has demonstrated, specific accounting rules cannot keep pace with the rapid evolution of business practices and the ingenuity of determined managements. The last line of defense of fair financial reporting is a well trained, informed auditor exercising independent judgement.

AUDITORS SHOULD ALWAYS BE REQUIRED TO DETERMINE THAT ACCOUNTING PRINCIPLES SELECTED BY COMPANIES ARE "PREFERABLE"

When the Commission issued its report, and today, companies are only required to apply generally accepted accounting principles that are acceptable. If acceptable alternatives exist and a company is applying one of them, there is no requirement to determine whether one of the acceptable alternatives is better. It is only when a company changes accounting principles that a preferability test is required. The Commission noted:

This would appear to be a simple suggestion, not subject to a great deal of debate. When alternatives exist, the company must always use the preferable alternative. The Commission logically modified its recommendation to exclude those situations where authoritative bodies or extensive analysis had given full consideration to a particular set of alternatives and could not determine that one was preferable.

Nevertheless, no action has been taken on this suggestion since the Report was issued in 1978.

This issue relates also to the question of independent accountants giving advice on the structuring of certain transactions. It is legitimate and probably desirable for an auditor to give a client advice on structuring new transactions so that the accounting for the transaction will be acceptable. However, it is not desirable for that advice to produce accounting that is "barely acceptable". A preferability standard should apply to advice as well.

REQUIRE COMPANIES TO RECORD ALL AUDIT ADJUSTING ENTRIES REGARDLESS OF MATERIALITY.

Materiality is the most powerful of all elements in GAAP. Every Statement issued by the FASB (and its predecessors) includes:

In effect, a materiality decision - or more precisely, a decision that a matter is not material -- may outweigh the most authoritative accounting standard or the most egregious accounting. Recall the bizarre accounting in the quotes above from the SEC Release on Arthur Andersen. The Andersen partners accepted it on the grounds that it was "immaterial". Yet, there is no practical, clearly applicable definition of materiality. The standard definition is:

This definition was cited by the AICPA in SAS No. 47, by the FASB in Concepts 2 and by the Canadian Institute of Chartered Accountants. It does not provide an adequate basis for making practical accounting decisions; it is essentially a legal construct.

In March 1975, the FASB issued a discussion memorandum "An Analysis of Issues Related to Criteria for Determining Materiality". In 1978 the Cohen Commission said: