Treasury Audit Advisory Committee Releases Draft Report
Preliminary Recommendations Include Big Firm ‘Preservation Mechanism’
By Colleen Lutolf, Trusted Professional Staff
Posted on 4/3/08

WASHINGTON D.C. -- Forget the Bear Stearns bailout. A governmental advisory committee may soon recommend putting in place a mechanism for a Big Four firm bailout —if necessary.

The U.S. Treasury’s Advisory Committee on the Auditing Profession released on March 13 preliminary recommendations designed to “increase investor protection and enhance the sustainability of a strong and vibrant public company auditing profession.”

One of the committee’s 13 preliminary recommendations, and the one the committee deemed “most significant,” was to create a mechanism for the “preservation and rehabilitation of troubled larger public company auditing firms.” A large auditing firm is defined in the report as one with 100 or more public company audit clients that the Public Company Accounting Oversight Board (PCAOB) inspects annually.

The committee, cochaired by Arthur Levitt, Jr., and Donald T. Nicolaisen, is divided into four subcommittees: human capital, firm structure and finance, concentration and competition, and general sustainability, which did not provide preliminary recommendations. The subcommittee on concentration and competition made this particular recommendation.

“The loss of one of the larger auditing firms in the United States would likely cause significant and global market disruptions and limit auditor choice,” the subcommittee stated in its report, adding that losing another large auditing firm could result in decreased competition, which could lead to a decrease in audit quality.

To avoid that, the subcommittee suggested a framework for a two-step plan to rehabilitate and preserve a firm, and, according to Levitt and Nicolaisen in the report’s joint introduction statement, safeguard its “most critical assets: its partners and employees, its reputation, its client base.”

The first step in saving a firm would include encouraging the larger auditing firms to voluntarily adopt a streamlined internal governance mechanism that could be triggered in the event of “threatening circumstances,” according to the report.

If the first step failed in saving the firm, the failure would trigger the second step, which would permit the Securities and Exchange Commission (SEC) to appoint a court-approved trustee to seek to “preserve and rehabilitate the firm by addressing the threatening situation.” If that step was unsuccessful, the subcommittee recommended the SEC pursue reorganization.

Legislation would be necessary to enact the second step, according to the subcommittee; further legislation may be necessary if the law included an element that addresses creditors’ claims so that it may be integrated with the judicial bankruptcy process. The subcommittee said it is “extremely important” that this mechanism not be used as insurance for partner capital.

George I. Victor, chair of the NYSSCPA Accounting and Auditing Oversight Committee, called the recommendation controversial.

“I do not see how this can be implemented in actual practice,” Victor said. “There is a great fear of disaster if any of the larger public firms fail. The government brought down Arthur Anderson by indicting the entire firm for the Enron audit failure. Now there is a complete about-face to protect the larger firms.”

Victor wondered who or what agency would determine when a firm is in “trouble.”

“How do you gauge what trouble is?” he said. “And now you’re going to be appointing someone as a trustee to oversee this operation? It sounds like some kind of bailout for management.”

The Big Four audit 98 percent of the 1,500 largest companies, according to the report’s authors. The big fear for regulators is less competition if one of the big firms fails, Victor said.

“Right now, there are four major firms and a few second-tier firms after the Big Four that are really the only firms that can handle mega companies like Exxon,” he said. “You have to be a Big Four to be able to handle Exxon or Merrill Lynch because of sheer size, not because [their audits] are so technically complex. You have to have the resources to serve that type of account and the Big Four are set up that way.”

The subcommittee included as part of this recommendation a suggestion that the PCAOB “broadly monitor … potential sources of catastrophic risk, which would threaten audit quality.”

Concentration and Competition

The subcommittee on concentration and competition also recommended:

Overall, Victor said he found the advisory committee’s recommendations conceptually well-intentioned; however, in practice, some will be nearly impossible to implement.

“It’s a series of silver bullets, and some may never fire,” he said.

He compared the endeavors suggested by the advisory committee to asking GM and Ford to build a 100 mile–per-gallon car that leaves no trace of pollution, costs half the price of current year models, but uses inexperienced engineers to build it within a three-year deadline.

“Nice idea; however, technologically unrealistic,” he said.

The profession is facing major changes, Victor said, such as the U.S. converging its generally accepted accounting principles (GAAP) with international accounting standards, small firm compliance requirements with section 404 of Sarbanes-Oxley, and complex Financial Accounting Standards Board pronouncements.

“These are real problems,” he said. “However, there does not appear to be a direct connection to these problems and the advisory committee’s recommendations.”

Human Capital

While the committee deemed the large firm–saving mechanism as the most significant recommendation, Victor said the subcommittee on human capital submitted some of the most feasible recommendations in the report.

“Education is fertile ground and academia usually listens,” he said. “They know what’s going on in the profession and even though they’re not in the trenches, they can see what’s going on in there. They have the facility to do it.”

The subcommittee on human capital made four recommendations:

“It would be great if academia could respond instantly,” said Priscilla Z. Wightman, chair of the Society’s Higher Education Committee. “There’s a myriad of structure to the whole academic process. But to make sweeping changes in terms of adding new courses, adding new content—that takes a while to do. My presumption is that academics are current when they teach. … It’s not as if it’s not in the text books, we’re not going to teach it.”

Although there are no courses dedicated solely to international finances at Hartwick College in Oneonta, N.Y., where Wightman is an associate professor, she said International Financial Accounting Standards (IFRS) are covered in advanced courses or in a current issues course. Two of Wightman’s seniors are writing theses on IFRS convergence, she said, “and I’m in a small institution. I’d have to believe the large institutions are as on the ball as we are.”

She said academia is “not that far behind. I’m not sure why there is this inference that we’re not staying current.”

Wightman said she believed a “respectful mix” of professionally qualified and academically qualified (interpreted by business school leaders as those who hold PhDs, according to the report) teachers leads to a well-rounded experience for students.

“I am cautious when discussion arises that just because someone has been in practice 25 years that means they are going to be a good teacher,” she said. “I don’t agree with that … A big firm partner with exclusive expertise in oil and gas is going to stand in front of a group of 17 college students and teach the core curriculum?”

Wightman said the subcommittee seems to make the presumption that accounting education is for auditors. “And that’s not the case,” she said. “Accounting education is for accountants.”

The accounting major has a multitude of requirements, Wightman said. “One course is auditing.”

Wightman said students tend to pursue accounting disciplines other than auditing “simply because there is so much work for the risk involved. There are other opportunities they perceive to be more satisfying.”

Years ago, auditing was the cornerstone of the CPA profession, Wightman said.

“The CPA designation has grown and matured and responded to current market developments,” she said. “A CPA wears multiple hats and there are many, many CPAs who do not audit. Has the time come for a certified public auditor?”

Firm Structure and Finances

The subcommittee on firm structure and finances submitted four recommendations:

The subcommittee recommended Congress pass a federal provision requiring the adoption of the mobility provisions in section 23 of the Uniform Accountancy Act for those states that fail to adopt the provisions, which allow CPAs to practice across state lines without giving a notice or a fee to the visiting state, by Dec. 31, 2010.

The NYSSCPA opposes New York state adopting section 23 of the UAA until the state Legislature adopts the accountancy reform bill recently introduced in the State Senate

NYSSCPA President David A. Lifson said mobility only matters to large businesses because section 23 of the UAA still requires a firm to register in foreign states.

“There are 45,000 CPAs in the state, 42,000 of them couldn’t care less if they register the firm or the individual,” he said. “For a small practitioner … it’s the same amount of paperwork and notice. Nobody at the AICPA ever talks about firm registration. So who is section 23 written for and benefit? Fifty firms. Who does it hurt? Everyone else.”

Within the second recommendation, the subcommittee also suggested a required, regular and formal roundtable meeting of the PCAOB, the SEC, the Department of Justice, state boards of accountancy, and state attorneys general, to improve regulatory effectiveness and reduce the incidence of “duplicative and potentially inconsistent enforcement regimes.”

NYSSCPA Executive Director Louis Grumet was one of several panelists who provided the committee with testimony on the future of the auditing profession during a Dec. 3 meeting. Grumet’s testimony focused on the need for uniformed regulation of the auditing profession.

“The profession needs one set of professionally developed standards that can be the basis for regulation on a state, national and international level,” he said. “What it does not need is 50 jurisdictions setting separate regulations.”

John C. Olsen, chair of the New York State Board of Public Accountancy, said these types of meetings already occur in New York.

“Meetings and discussions occur between federal and state regulators whenever necessary,” he said. “In New York, the Office of Professional Discipline has established protocols with federal regulators, such as the SEC, to provide updates on regulatory and disciplinary matters.”

Also included within the second recommendation is to urge the states to create greater financial and operational independence of their state boards of accountancy.

Olsen said he thinks the New York state board operates independently already.

“In recent years, the highly respected Pew Commission found that New York’s regulatory structure was an effective model of professional regulation,” he said.

New York’s regulatory model is unique from other states’ models because professional licensing and regulation are established through the New York State Education Department, which is a constitutional agency and not an executive agency, Olsen said.

“The difference is that the education department is headed by a lay body, the Board of Regents, whose members are appointed by the New York State Legislature, not the governor, as is done in most states with executive branch agencies,” he said.

He said he believes that the state board, in conjunction with the state’s Office of the Professions and Office of Professional Discipline, do a very good job of protecting the public.

The subcommittee made two additional recommendations:

The subcommittee, although considering firm transparency and liability issues, did not include recommendations on them in its preliminary report. The subcommittee is expected to meet in May to discuss these issues.

The General Sustainability Subcommittee did not submit preliminary recommendations.

What About Ethics?

Edwin J. Kliegman, a member and former chair of the Society’s Small Firms Practice Management Committee, said the report is a “well-prepared wish list” of how to improve the auditing profession, but what it is missing are recommendations about firm ethics.

“Audit quality will only be improved when the ethics of the leadership of the largest firms improve, when the ethics are passed through the ranks of all employees of a firm, when ethics become the way of life of the firm, when proper time is allocated to each engagement, when adequate supervision is given to all levels of employees, when the bottom line is not the end-all and be-all of the firms’ existence,” he said.

He echoed Wightman’s sentiments on education.

“The function of the college education of accounting students is to introduce the students to the concepts of accounting and business, not to make them into great auditors,” he said. “Students and new hires learn to perform high quality audits by careful, proper on–the-job training.”

Lifson said he agrees with the recommendations in a “directional way,” but that “the details have to be worked out to be good ideas.”
He said he sees the report as a product of struggle.

“We are undergoing a real struggle in our country over federalism and over the dividing line over state and federal responsibilities,” he said. “There is a natural tension that exists over states’ rights and behaviors.”

“I think the report is baby steps,” he said. “I’m hoping it isn’t relegated to the dust bin. It will depend on the political environment of the next six months whether it is developed.”

The subcommittees are still making changes to their reports. One member said during a public April 1 conference call that there are major issues the committee is still reviewing that could “reshape the emphasis of the report.”

Levitt told committee members that it is important that the subcommittees draw specific conclusions, even if it means those committees differ in their conclusions.

The committee does not want to produce a document that “no one can say has a point of view,” he said. “It’s absolutely essential this document have a point of view.”

The committee is expected to meet again in May.