gao update the american accounting association, mid-year auditing section conference january 16,...

GAO Update

The American Accounting Association, Mid-year Auditing Section Conference

January 16, 2004

Jeanette M. FranzelRichard J. Vagnoni

U.S. General Accounting Office

Presentation Framework

• Implications of Sarbanes-Oxley Act for government audits

• Results of GAO’s studies required by Sarbanes-Oxley• Public Accounting Firms: Consolidation and

Competition • Potential Effects of Mandatory Audit Firm Rotation

Accountability Environment

• Major failures in corporate financial reporting led to passage of the Sarbanes-Oxley Act of 2002.

• The act included reforms intended to strengthen auditor independence and to improve audit quality.

• Full, fair, and accurate reporting of financial information

• by publicly traded companies is critical to the effective functioning of U.S. capital and credit markets, and

• by government is critical in fulfilling the government’s responsibility to be accountable to citizens in a democracy.

Accountability Environment

Significant forces impacting government

• demands for government effectiveness and accountability

• fiscal pressures/increasing costs

• financial reporting pressures/incentives

• recent financial reporting and audit problems in the private sector

Comptroller General’s Agenda

“Help to modernize and transform the accountability profession both inside the government and in the private sector, and lead by example in this area.”

• 2003 revision of Government Auditing Standards• work with accountability organizations in the U.S. and

around the world• comments on proposed standards of other

accountability organizations • proposal for the “U.S. Auditing Standards

Coordinating Forum”• monitoring implementation of the Sarbanes-Oxley Act

Sarbanes-Oxley Act of 2002

Sarbanes-Oxley contains sweeping changes for the accounting profession and corporate governance in the following areas:

• oversight of the auditing profession

• auditor independence

• corporate responsibility

• enhanced financial disclosures

Sarbanes-Oxley Act: Oversight of Audits

Title I: Establishes the Public Company Accounting Oversight Board (PCAOB). Principal duties:

• establish or adopt standards for public company audits

• enforce compliance with standards and the Act

• inspect and register public accounting firms

• conduct investigations of firms and disciplinary proceedings

• impose sanctions

Sarbanes-Oxley Act: Implications of Title I for Government Audits

• New standards setting organization could possibly create two, or even three different bodies of audit standards.

• The way audits are done for publicly traded companies WILL change

• Quality control procedures for firms auditing public companies WILL change

Sarbanes-Oxley Act: Implications of Title I for Government Audits (cont.)

• Some firms conducting government audits will receive

both inspection and peer reviews

• Implications for the Yellow Book of the future

Sarbanes-Oxley Act: Implications of Title I on U.S. Audit Environment

U.S. Auditing Standards Setting Organizations

Public Company Accounting Oversight Board (PCAOB)• Audits of publicly traded companies

Auditing Standards Board (ASB) of the AICPA• Privately held companies• Not-for-profit organizations

U.S. General Accounting Office• Federal, state, local governments• Not-for-profit organizations receiving federal funding

U.S. Audit Standards Environment:Comptroller General’s Response

Comptroller General’s proposal for “U.S. Auditing Standards Coordinating Forum.”

• PCAOB, GAO, ASB (AICPA).

• Three principals would meet several times a year.

• Key staff would coordinate regularly to implement agenda.

• Rotating chair, based on who is hosting the meeting.

Audit Standards Environment:Comptroller General’s Response

Purpose of proposed “U.S. Auditing Standards Coordinating Forum”

• maximize complementary standards setting agendas,• minimize duplicative or competing efforts,• Identify any significant gaps not being addressed,• develop strategies for overcoming challenges and barriers to

modernizing the auditing profession in the U.S., and• assure consistency where appropriate for core auditing

standards, while seeking to modernize those standards.

Sarbanes-Oxley Act: Auditor Independence (Title II)

• It is unlawful for a registered accounting firm to provide a number of nonaudit services if that firm is also the auditor for a registrant.

• Audit partner rotation: the lead audit and concurring partner and the reviewing partner must rotate every 5 years.

Sarbanes-Oxley Act: Auditor Independence

• An accounting firm is not allowed to perform an audit of a registrant whose key financial or management personnel were employed by that accounting firm and participated in the audit within one year of the current audit.

• The auditor must report to the audit committee all “critical accounting policies and practices” used in preparing financial statements

Sarbanes-Oxley Act: Implications of Title II for Government Auditors

• Yellow Book Independence Standards

• Implement best practices and relevant standards for dealing with audit committees.

• Report to an appropriate level within the governance structure of the audited entity.

• Audit Partner Rotation– no current requirement.

• Employment restrictions–some related issues could result in appearance of independence problems under current Yellow Book independence standards.

Sarbanes-Oxley Act: Corporate Responsibility (Title III)

Audit Committees

• Members must be on the Board of Directors and be “independent”

• Responsible for the appointment, compensation, and oversight of the auditor

• Must be appropriately funded by the company

Sarbanes-Oxley Act: Corporate Responsibility

Other Corporate Responsibility Requirements

• The company CEO and CFO must certify that financial statements and disclosures are appropriate and fairly present, in all material respects, the operations and financial condition of the company.

• It is unlawful for officers and directors to take any action to “fraudulently influence, coerce, manipulate, or mislead” the auditor

Sarbanes-Oxley Act: Enhanced Disclosures

Internal Control Reporting

• Registrants are required to establish and maintain adequate internal control structure and procedures for financial reporting.

• Include in the annual report, a statement of management’s responsibility for and management’s assessment of the effectiveness of those controls.

• The company’s auditor is required to attest to, and report on management’s assessment of the effectiveness of internal control over financial reporting.

Sarbanes-Oxley Act: Corporate Responsibility and Enhanced Disclosures

Implications of Title III for government auditors:

• Government auditors should encourage good governance practices within the entities they audit.

• audit committees and other governance structures

• Watch for improper management influence or pressure on the auditor.

• Auditor opinion on internal control

• Yellow Book currently does not require an opinion on controls, even though control reporting is required.

Sarbanes-Oxley Act: Corporate Responsibility and Enhanced Disclosures (cont.)

Implications of Title III for Government Auditors (cont.):

• GAO’s view on auditor opinions on internal control:

• where appropriate, auditor opinions on internal control are critical for monitoring an organization’s internal control and accountability.

• auditor opinions on internal control are appropriate and necessary for major public entities.

• auditor opinions on internal control are also appropriate in cases where the process adds value and mitigates risk in a cost beneficial manner.

Studies of Public Accounting Firms:Consolidation and Competition

Public Accounting Firms: Mandated Study on Consolidation and Competition

GAO-03-864, July 30, 2003

Available at: www.gao.gov

GAO Study on Audit Firm Consolidation and Competition: Research Questions

• Factors leading to mergers of large public accounting firms

• Impact of consolidation on competition and choice

• Impact of consolidation on fees, quality, and auditor independence

• Impact of consolidation on capital formation and securities markets

• Potential impediments to competition among public accounting firms

Consolidation and Competition: Methodology

• Data collection, literature review, and empirical research on audit firms, consolidation, competition, and impact on capital formation and securities markets

• Meetings with communities of interest on their views, research, and experience

• Structured interviews with investment banks, credit agencies, and institutional investors

• Surveys to (1) accounting firms and (2) their clients

• Academics, researchers, and other experts

• Accounting firms

• Audit committee chairs

• Credit rating agencies

• Exchanges/markets

• Fortune 1000 companies

• Government agencies

• Institutional investors

• Trade organizations

• Underwriters/investment banks

Communities of Interest

• Data collection on audit firms and the market• Public Accounting Report• Who Audits America

• Literature review• Accounting and economics• Industrial organization

• Structured questionnaires• Empirical work and economic modeling

• Descriptive statistics and trend analysis• Measures of competition and concentration• Economic model of price competition

Economic Analysis: Competition

Economic Analysis: Capital Formation and Securities Markets

• Literature review• Capital markets research in accounting• Asymmetric information

• Structured interviews and questionnaires• Investment banks, institutional investors, credit rating

agencies, trade groups• Academics, researchers, and other experts

Subject Areas for Surveys of:

Audit Firms Fortune 1000 • Firm’s consolidation

activities and impact on capability

• Consolidation of Big 8: impact on fees, independence, quality

• Competition: trends, reason for change, impact

• Impediments to competition

• Characteristics of auditor, factors in choice

• Consolidation of Big 8: impact on fees, independence, quality

• Competition: trends, options for changing auditors

• Suggestions for increasing competition

Factors leading to Mergers

• Globalization by companies they serve led firms to expand for same geographic coverage

• Expand industry expertise and build industry specialization

• Expand capital base to spread risk and modernize operations

• Increase market share and profitability; economies of scale

• Keep up with the other Big firms that were merging

Consolidation and Competition: Results

Impact on Market Structure

• Audit market concentration has increased, especially for large public companies

• Public company audit market is a tight oligopoly

• Top four firms account for an increasing share of the public company audit market

• 99% (63%) by sales audited in 2002 (1988)

• 78% (51%) by number of clients in 2002 (1988)

• HHIs have increased to well over the 1,800 threshold

2002 C4=.99

PWC34%

KPMG18%

Others1%

1988 C4=.63

Others2% AA

KPMG14%

Four-Firm Concentration Ratios: Public Company Sales Audited, 1988 and 2002

Consolidation and Competition: Results Hirschman-Herfindal Indexes 1988-2002

Impact on Price CompetitionDoes market structure influence conduct and performance?• With respect to audit fees, no clear, definitive link between

accounting market structure and anticompetitive behavior… to date.• Research using various audit fee measures did not provide

conclusive evidence of effects of consolidation.• Some evidence suggests that audit fees were loss leaders

during the 1980s and 1990s.• Doogar and Easley (1998) model of price competition predicted

market shares close to actual market shares in 2002.• Current (i.e., 2002) market structure is not necessarily

inconsistent with a competitive environment.

Limited Audit Firm Choices

• Large public companies appear to have fewer choices…

• Big 4 have few if any real competitors in the market for large public company audits.

• Choices can be further limited by potential conflicts of interest and new independence rules.

• Audit firm industry specialization may also further reduce choice

• … but no systematic problems for companies resulting from fewer choices… to date

Impact on Audit Quality and Auditor Independence

• Research offers competing theories and evidence on audit quality and auditor independence, as well as factors influencing these.

• Mixed evidence using restatements, going-concern opinions, and earnings management

• No consensus among experts

• Factors other than consolidation are cited for perceived changes in quality and independence.

Impact on Capital Formation and Securities Markets

• No direct link between audit industry competitive structure and capital formation and securities markets…

• … but role of auditors generally thought to be critical as information intermediaries between company management and capital markets.

• Market participants generally prefer use of Big 4 firms by companies accessing capital markets.

• The increased degree of concentration coupled with restrictions on the provision of nonaudit services to audit clients could increase the potential for collusive behavior or exercise of market power.

• Concern generally expressed regarding further consolidation among the top firms (e.g., to the “Big 3”).

Going Forward

Barriers to Entry into Top Tier Faced by Smaller Firms

• Reputation

• Size/capacity constraints

• Access to capital

• Litigation risks

• Expertise

• Global networks and alliances

• Varying state licensing requirements and other regulations

• Sarbanes-Oxley and independence requirements

Barriers for Smaller Firms

• Doogar and Easley (1998) model

• Using 2002 data, simulated mergers of the 5 largest firms below the Big 4 to see if the resulting merged firm could win clients from the Big 4

• Various efficiency assumptions, from no gains to strong gains (as efficient as the Big 4)

• Assume competition based solely on price

• Results suggest at best a very slight gain in market share over premerger combined market share for these five firms.

Consolidation and Competition: Suggestions for Future Research• In light of recent significant changes in market structure

and regulation, revisit studies of audit firm behavior.

• For example, is there any evidence of collusive behavior or exercise of market power in the wake of Andersen’s dissolution and the restrictions on nonaudit services?

• Given the important role played by the auditor in the capital markets, research into the connection among audit market structure, auditor behavior, and the capital markets.

• Can we establish an empirically testable link?

• Example hypothesis: Fewer audit firms lead to reduced audit quality, which in turn leads to a higher cost of capital.

Public Accounting Firms: Required Study on the Potential Effects of Mandatory Audit Firm Rotation

GAO-04-216, November 2003

Available at: www.gao.gov

Studies of Public Accounting Firms:Mandatory Audit Firm Rotation

GAO Study on Potential Effects of Mandatory Audit Firm Rotation

• Section 207 of the Sarbanes-Oxley Act required GAO to study the potential effects of requiring rotation of registered public accounting firms.

• The arguments for and against mandatory rotation concern whether the independence of a public accounting firm auditing a company's financial statements is adversely affected by a firm's long-term relationship with the client and the desire to retain the client.

Mandatory Audit Firm Rotation: Methodology

• Identified and reviewed research studies and related literature that addressed issues concerning auditor independence and audit quality related to firm tenure, and the costs and benefits of mandatory audit firm rotation.

• Analyzed the issues identified in the literature to develop survey instruments.

• Conducted a statistical survey of audit committees, CFOs and CPA firms to obtain experience-based views on the potential effects, cost, and benefits of mandatory audit firm rotation.

Mandatory Audit Firm Rotation: Methodology• Surveys of Public Accounting Firms

Tier 1 firms Tier 2 firms Tier 3 firms Totals

Population size 97 604 421 1,122

Sample size 97 282 237 616

Total responses 74 85 52 211

Response rate 76.3% 30.1% 21.9% - - -

Mandatory Audit Firm Rotation: Methodology• Surveys of Public Companies

Fortune 1000

companies

Domestic public companies and

mutual funds

Foreign public

companies

Totals

Population size 960 14,887 2,141 17,988

Sample size 330 450 391 1,171

Response rate 60.9% 29.1% 25.3% - - -

Mandatory Audit Firm Rotation: Methodology• Surveys of Public Company Audit Committee Chairs

Fortune 1000

companies

Domestic public companies and

mutual funds

Foreign public

companies

Totals

Population size 960 14,887 2,141 17,988

Sample size 330 450 391 1,171

Response rate 57.9% 21.3% 16.1% - - -

Mandatory Audit Firm Rotation: Methodology• Held interviews and discussions with a broad range of

communities of interest to obtain different perspectives:• Institutional investors (pension funds, mutual funds,

and insurance companies)• The stock exchanges• Consumer Advocacy Groups• Regulator (state boards of accountancy, banking

regulators)• AICPA• SEC• PCAOB• Recognized experts in Corporate Governance

Mandatory Audit Firm Rotation: Methodology• Made inquiries of securities requlators of the Group of

Seven Industrialized Nations (G-7) and members of the International Organization of Securities Commissions in order to obtain other countries’ experience with mandatory audit firm rotation.

• Analyzed 2001 and 2002 restatements of Fortune 1000 public companies reported to the SEC through August 2003 and compared rates for companies that changed auditors versus those that did not change auditors, in order to obtain insight into the potential value of the “fresh look” provided by a new auditor.

Mandatory Audit Firm Rotation:Results

• Nearly all of the largest public accounting firms and Fortune 1000 publicly traded companies and their audit committee chairs believe that the costs of mandatory rotation are likely to exceed the benefits.

• Most believe that the Sarbanes-Oxley requirements for audit partner rotation, auditor independence, and other reforms, when fully implemented, will sufficiently achieve the intended benefits of mandatory rotation.

• The views of other stakeholders, including institutional investors, stock market regulators, bankers, accountants, and consumer advocacy groups, to be consistent with the overall views of those who responded to its surveys.

• About 79 percent of Tier 1 firms and Fortune 1000 public companies (CFOs and audit committee chairs) believe that changing audit firms increases the risk of an audit failure in the early years of the audit as the new auditor acquires the necessary knowledge of the company’s operations, systems, and financial reporting practices and thus may not detect a material financial reporting issue.

• Most Tier 1 firms and Fortune 1000 public companies (CFOs and audit committee chairs) believe that mandatory rotation would not have much effect on the pressures faced by the audit engagement partner in appropriately dealing with material financial reporting issues.

• About 59 percent of Tier 1 firms reported they would likely move their most knowledgeable and experienced audit staff as the end of the firm’s tenure approached under mandatory rotation to attract or retain other clients, which they acknowledged would increase the risk of an audit failure.

• Tier 1 firms and Fortune 1000 public companies expect that mandatory rotation would lead to more costly audits.

• Nearly all Tier 1 firms estimated that initial years’ audit fees under mandatory rotation would increase by at least 20 percent to acquire the necessary knowledge of the public company.

• Most Fortune 1000 public companies estimated that under mandatory rotation, they would incur auditor selection costs and additional auditor support costs totaling at least 17 percent or higher as a percentage of initial year audit fees.

• Based on estimates of possible increased audit-related costs from survey responses from Tier 1 firms and Fortune 1000 public companies, mandatory audit firm rotation could increase these audit-related costs from 43 percent to 128 percent of the recurring annual audit fees.

• 54 percent of Tier 1 firms believe mandatory rotation would decrease the number of firms willing and able to compete for audits of public companies.

• 83 percent of Tier 1 firms believe that the market share of public company audits would either become more concentrated in a small number of public accounting firms or would remain the same.

• The number of public accounting firms providing audit services to public companies is highly concentrated with the 4 largest firms auditing over 78 percent of all U.S. public companies and 99 percent of public company sales.

• Many Fortune 1000 public companies said they will only use Big 4 firms for a variety of reasons, including the firms’ ability to provide audit services and the expectations of the capital markets that they will use Big 4 firms.

• Mandatory rotation would further decrease their choices for an auditor of record, and Sarbanes-Oxley Act auditor independence requirements for prohibited nonaudit services may also further limit the public companies’ choices of an auditor of record.

• Tier1firms expected that public companies in specialized industries, which sometimes have more limited choices for an auditor of record, could be more affected by mandatory rotation than other public companies.

• GAO believes that mandatory rotation may not be the most efficient way to strengthen auditor independence and improve audit quality, considering the loss of institutional knowledge of the public company’s previous auditor of record, and the current reforms being implemented.

• The potential benefits of mandatory rotation are harder to predict and quantify while we are fairly certain that there will be additional costs.

• The Sarbanes-Oxley Act contains significant reforms aimed at enhancing auditor independence and audit quality, and several years’ experience implementing is needed before the full effect of the Act’s reforms can be assessed.

• The most prudent course of action now is for the SEC and the PCAOB to monitor and evaluate the effectiveness of existing requirements for enhancing auditor independence and audit quality.

• This information will help in considering whether changes, including mandatory rotation, may be needed to further protect the public interest.

• GAO believes audit committees, with their increased responsibilities under the act, can also play an important role in ensuring auditor independence and audit quality.

• To fulfill this role, audit committees must maintain independence and have adequate resources.

• Finally, for any system to function effectively, there must be incentives for parties to do the right thing, adequate transparency over what is being done, and appropriate accountability if the right things are not done.

Contact InformationJeanette M. FranzelDirector, Financial Management & Assurance(202) 512-9471, franzelj@gao.gov

Richard J. VagnoniSenior Economist, Financial Markets & Community Investment(202) 512-5776, vagnonir@gao.gov

U.S. General Accounting Office441 G St, N.W.Washington, D.C. 20548

gao update the american accounting association, mid-year auditing section conference january 16,...

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