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  • 1. STATEMENT OF PHILIP B. LIVINGSTON President and CEO, FINANCIAL EXECUTIVES INSTITUTE To The Public Oversight Board Panel on Audit Effectiveness October 7, 1999 Financial Executives Institute appreciates the opportunity to offer our comments to the POB Panel on Audit Effectiveness. As senior financial executives, the members of FEI are actively involved in the audit process. We rely on audits, and we are frequent users of the audited financial statements of our firms and other enterprises. High-quality audits are important to our membership. We believe that audits today are fundamentally sound, but that there are areas where the audit process and the larger public financial reporting process can be improved. We are here to offer our comments and perspectives to this end. Our comments will present our central views on audit effectiveness, and will also address a number of questions put forth by the Panel prior to this hearing. As to our central views, we would make four points: 1.) High quality audits are important to our membership and are critical to the work we do as financial officers 2.) Auditing and assurance services have diminished in prestige and emphasis, and this needs to be turned around 3.) We would like to see the accounting firms retake their leadership position in the technical accounting process 4.) The external market pressures on company management should not impact the ability of auditors or the results of an audit 1
  • 2. High Quality Audits Are Important to Our Membership FEI and its members need high quality, reliable audits. Audited financial data is essential to the work we do in providing information to the owners of our companies and fellow employees. In today’s increasingly complex business environment that operates around the clock, across the globe, and at a pace that is unprecedented in history, financial officers want that second set of eyes in the reporting process. We look to the public accountants and the engagement partners we work with to provide us with the level of assurance needed. Financial reporting and the audit process is not broken. Contrary to the clamors of some, there is no objective evidence that the rate of financial reporting failures or audit failures has increased. Without objective evidence we believe you cannot extrapolate the few failures to a need for dramatic change in our system. The current stock market levels, low interest rates and the quantity of private investment funds seeking placement are all better objective measures of the health and quality of our reporting and auditing process. Without high levels of confidence, investments would not flow into equity instruments at the unprecedented levels we are experiencing. However, our system is great because we do not collectively sit still and we do not ignore the voice of even a minority of dissatisfied participants. Therefore, we support and actively participate in initiatives such as this one to drive our system to even higher levels of quality. As to audit effectiveness, we do think more can be done to maintain high quality and enhance the stature of this important assurance activity. Auditing Has Diminished in Prestige and Emphasis Our members generally believe that the audit product is still of high quality, but it is widely perceived that the economics of audit and assurance work is much less desirable than consulting engagements 2
  • 3. for the CPA firms. We believe this perception has had some negative effect on the image of auditing inside the CPA firm and on the personnel and resources devoted to audit work. Whether or not this perception is true, the breadth of those holding this view is enough cause for concern. Though we are concerned that an emphasis on non-audit work has caused a diminution of the reputation and desirability of audit staff work, we have not yet seen evidence that this trend has directly impaired audit quality. But we wonder how long it will be possible to attract highly capable new entrants into the audit side of the profession, if the prestige and rewards for this work are lower than for consulting and other professional services. The fact that the auditing profession has come under some attack following a number of highly- publicized audit failures has added to negative images associated with this work. While consulting services are competing with audit services for employee talent, and thereby may directly or indirectly affect audit quality, we do not believe that consulting work is affecting the quality of audits through a stress on auditor independence. Our companies and audit committees monitor spending on audit and non-audit services, as part of recurring controls and oversight on auditor independence. We have not seen a problem here. We would not like to see restrictions on a free market choice of vendors for consulting services. Today’s competitive business environment and cost pressures drive decisions only to those that can provide the best product at the most efficient cost. We would go further and state that we sense, but do not have objective evidence, that the level of work contracted by our companies from the accounting firms that do not also provide the audit services is up dramatically from even ten years ago. It is very common today for different accounting firms to provide consulting, tax or internal audit services. As consulting and other business services are on the rise in the accounting firms, we believe it is important to restore the emphasis on audit and assurance services. The image of the audit business has declined during a period of accounting firm consolidation driven by the need for overhead efficiency in a market with strong price 3
  • 4. competition. Like many of our own companies, this consolidation was needed for continued competitive success of the firms. Similarly, the strategic initiatives to grow non-audit service offerings, while important economically to the firms, has created additional distraction of resources and prestige from the from what was originally the core business. We sense that this decline in prestige and emphasis is broadly existent amongst our members, the employees of the accounting firms, and students considering a future in accounting. Accounting Firms Should Retake Their Leadership Position in The Technical Accounting Process We perceive a shift in the balance of authority on technical matters from the CPA firms to the national standard setters and regulators. Dialogues now almost always involve “checking with the national office” and often “no-name consultations with the SEC”. We recall earlier times when we could readily get expert answers from the audit local firm personnel we dealt with. We would like to encourage the accounting firms to retake their leadership role in the accounting standards-setting and interpretation process. We see increasing the awareness and recognition of accounting and reporting expertise as related to the need to elevate the prestige and recognition of audit services. We don’t see expanding auditing into non-audited areas as a valid quality issue – auditing of Management’s Discussion and Analysis would not improve the quality and value of the audit, nor the discussion. We find in practice that the certified public accountant reviews, checks and critiques MD&A in our publicly held companies. Auditing of this valuable area would discourage unique and thoughtful discourse and move it toward a more routine and compliance- oriented product. If a management team were required to submit more documentation and support for all statements in its view of trends and business outlook, this discussion will only shrink, not expand. What will improve the quality of the audit is increased recognition of its importance, emphasis on the selection and placement of superior personnel, and training of auditors in their role of assurance. Also 4
  • 5. greater study of how technology can enhance risk analysis, testing, and analytical and documentation procedures. In the end, it is high quality personnel and technological innovation that can make the greatest contribution to achieving high performance. External Market Pressures on Management Should Not Affect Audits The pressure to meet quarterly earning targets should not, in itself, be impacting audits. If there is a secondary or indirect impact from these conditions, it will only result in a problem if independence, audit diligence or other professional standards have been compromised. Barring massive fraud, a well functioning audit engagement should be able to take any financial results and determine their reasonableness. The manner and process by which those results were determined should not destroy the potential of a successful independent audit. Nevertheless, current market conditions have created some unusual and, we believe, distorted market pressures. These pressures are most exaggerated in small to medium sized public companies. Many investment fund managers, analysts and the press over-emphasize the importance of quarterly results and openly reward and punish management teams to deliver against expectations. We realize that management is a part of the whole earnings targeting process. It is incumbent upon our membership to stand up to these pressures, especially given our sense that such short-term emphasis is distorted and misguided. Given the normal course of events, full year results are much more representative of the business performance and trends than are quarterly results. But the current quarter is eagerly awaited and treated as an absolute. This is a problem, because all quarters are approximations. Often some event will occur one or two weeks earlier or later than expected, creating a financial impact that receives undue market reaction. Such reaction is not warranted by the degree of precision that exists in quarterly reporting, or auditing. Even in a stable, successful, well-managed company, every operation, every contract, does not always go exactly as anticipated on a daily, weekly, or monthly basis. And auditing is designed to provide reasonable assurance that the financial statements present fairly, “in all material 5
  • 6. aspects” the results of operations and financial position. Present fairly, not exactly. In all material respects. Auditors know that an audit can not be precise and exact to a “penny a share” - as the head of one of the Big-Five firms said so eloquently in a speech at our annual financial reporting conference, where he referred to the penny a share controversy, “our guns don’t shoot that straight.” The occurrence of market overreaction to small misses from earnings targets has led to street punishment for those who do not take steps to bring earnings into line with expectations whenever possible. We are not condoning in any way persons who manage earnings with improper accounting entries. Yet we have heard it said that analysts react so negatively to penny a share misses “because they figure if a company couldn’t find a way to manage around a cent or two under run in EPS, they must really be in trouble”. To us, this indicates a systemic Catch-22, where you are “damned if you do and damned if you don’t”. Creating and driving to quarterly EPS targets as absolute measures of performance every three months has become a U.S. cultural expectation, a constant dance among analysts, pundits, and corporate management that does little to create lasting productivity and real value in the economy. We think it is important for all the stakeholders and participants in the financial reporting and audit process to come together - to restore respect and emphasis for the importance of the financial statement audit, to support continuous improvement in its quality, and to seek ways to reduce unproductive pressures in the larger capital market. This concludes my central remarks. The remainder of FEI’s statement addresses some of the specific questions put forth by the Panel in materials issued prior to this hearing, and I will highlight these briefly. Answers to Questions Put Forth by the Panel 1.) To what extent do analysts’ earnings estimates influence management’s judgements in preparing financial statements and what are the effects on the auditor? 6
  • 7. Pressure for economic performance is appropriate and expected – it is what business is all about and it stimulates innovation and excellence. However, the level of focus that some analysts place on each quarter’s EPS, as opposed to annual earnings, is often misguided and unhealthy. It has worked to encourage management practices of driving toward quarterly EPS regardless of what unexpected conditions arise in each three-month period. While there are acceptable ways to promote earnings stability and achieve performance goals, i.e., operational approaches such as varying production levels, cutting back expenditures to reduce costs, special sales promotions, timing of asset sales and other perfectly legitimate actions, often these actions are not sensitive enough to make a change in a few days or weeks. When overly-intense EPS expectations exist, they create a climate that can drive behaviors that are not value-creating. People need to “make their numbers” in the right way, not in an artificial way, but too much stress in the system serves to increase the opportunity for problems. As our U.S. companies seek to achieve success in selling their products and services in the global marketplace, we also have the pressures of additional obligations for prompt quarterly reporting of detailed financial results, obligations that many of our competitors in foreign lands who report on a six-month or even less frequent basis and/or in less detail do not have. We recognize that much of the U.S. reporting obligation serves to provide the financial transparency that supports our successful and liquid capital market. However, each quarter companies are put to the test of how close they can come to estimates, even though the normal course of events would tend to make it unlikely that estimates would be exactly achieved in every quarter. The pressure to meet quarterly earning targets sometimes creates an excessive and negative impact on management, but should not, in itself, be impacting audits. If there is a secondary or indirect impact from economic stress on a company, it will only result in a problem if independence, audit diligence or other professional standards have been compromised. Barring massive fraud and collusion, a well functioning audit engagement should be able to take any financial results and determine their reasonableness. 7
  • 8. As business executives, we accept whatever competitive challenges are put before us. We are here to excel and create value for shareholders. But some of our members have noted that the “EPS dance” at times grows to the point where the effort associated with it consumes value rather than creates value. We think it would be in the interest of all involved in the U.S. financial reporting and auditing environment, and in the U.S. capital market, for influential groups such as this panel, study groups, and regulators, to seek ways to ease undue stress and unrealistic expectations in the capital marketplace. 2.) Are auditors devoting sufficient attention to areas where management discretion and judgment are required in financial reporting [to provide reasonable assurance that the financial statements are free of material misstatement]? We believe they are. Our experience indicates that there is a very comprehensive set of inquiries and requests for supporting data to support estimates and judgements, that auditors seek to add to their examination and workpapers. We also are party to frequent discussions with auditors on the selection of accounting policies and the treatment of particular transactions. The existing process does provide for significant attention to judgmental areas and probing of management’s decisions by the auditors; at the same time, it should be noted that this entire effort is subject to the backdrop of the unrealistic expectations stress we described in our response to the first question. 3.) Under the “Audit Risk Model”, where auditors vary their procedures based on their judgments of the level of risk in a company, are auditors doing enough today to detect fraud and/or accidental misstatement of financial results? More and more, the pace, the scope and the complexity of business operations do not permit attention to every area, all the time. Management must run the business by prioritizing areas needing attention and it seems reasonable to us that auditors should do the same with audit operations. Risk management approaches which 8
  • 9. evaluate differential opportunities for failures and assign more audit attention to high risk areas are not new concepts. We think such actions are reasonable and appropriate, so long as situations do not arise where a low-risk area can be presumed never to receive test attention. This in itself would create a higher risk. When an audit has a capable lead partner in charge and is planned and conducted in accordance with auditing professional standards, we believe that auditors are doing enough to detect fraud and/or or accidental misstatement of results. We are not aware of significant audit quality problems except for the occasional audit failures that we have all read about in the press - in the audits we receive, our overall perception is that the quality seems very good. The level of compliance with auditing professional standards and other quality issues in audits is a question that we would expect to be more definitively answerable by the internal peer review and standards groups within the public accounting profession. 4.) What is the experience of the business community as to the quality of personnel and level of knowledge being encountered in audit staffs? Our members have mixed views on the quality and knowledge of audit personnel below the engagement partner level today. Some would say it has declined, others not. Many of our members have commented upon the fact that audit engagement staff seem to have to ask questions of the audit firm’s national accounting and SEC practice office much more frequently that we remember in earlier years. They note that it is more difficult to have a detailed dialogue on complex accounting issues at the local team and audit senior level, and that even partners consult much more frequently with the firm national office than in the past. Our members have several opinions about what is causing or contributing to this trend, as follows: A.)Accounting rules are becoming more complex and the sheer volume of the overall body of knowledge generated from multiple sources is becoming more and more difficult to master. This is one subject on which ALL of our members are in agreement. As one member put it, “ten or twenty 9
  • 10. years ago, you could come out of a good accounting education and within a few years answer nearly every question that came up with a combination of your past training and common sense - nowhere is that true anymore. Common sense will not take you very far today in evaluating what is required on a challenging transaction”. B.)Many members cite a growing uncertainty over “what the rules really are”, both in management and in audit firms, as previous interpretations are overturned by multiple regulators and standards setting and interpretation bodies. In recent times we have seen more of this than we can recall in earlier years, which is creating doubt among many parties. C.)Public accounting firms are reacting to complexity and managing liability risks by centralizing expertise and decision making on accounting issues and transactions, and are requiring audit field personnel to check in this way D.)Audit field personnel lack confidence to make these kinds of decisions because of the difficulty involved and their own perception that they do not know enough from their experience and training to give firm answers On the last two possible factors (C) and (D), some members believe these are significant contributing factors in addition to the growing complexity and volume of accounting rules, while other members believe that it is accounting complexity and uncertainty that is the sole “root cause”. 5.) Should auditors be selected and trained to be more involved in and familiar with their clients’ business and operational matters and communications with the investment community? Why or why not? We believe that part of a good audit involves the audit staff acquiring a good general knowledge of the client company and of the client’s industry, and that audit firms should install internal practices and procedures for staff that accomplish this end. However, we put the emphasis on “general knowledge”, not detailed knowledge. We do not think it is cost effective, nor desirable for a good audit, for auditors to receive detailed training to become “more involved in and familiar with” client business and operational matters and 10
  • 11. communications with the investment community. Acquiring knowledge and involvement to this degree is more appropriate to a consulting and business advisory services engagement than to an auditing engagement. Business and operational matters and communications with the investment community are responsibilities of management, for which management is held accountable by the Board and shareholders. We do not believe it is appropriate for auditors to become more and more involved in these business areas. Existing auditing standards and practices address the need to understand the client company and its industry in order to be effective in identifying risk factors, analyzing trends and ratios, and other actions that are needed in a good financial statement audit. We think this level of coverage and focus is appropriate and should not be expanded. 6.) Should auditors be more involved with information that is not audited today, such as Management’s Discussion and Analysis and non-financial operating measures reported inside or outside a company? Would greater involvement in these areas improve the value of the independent audit? What would be the relationship of costs and benefits of greater auditor involvement? We do not believe auditors should expand their present level of involvement in Management’s Discussion and Analysis. An important part of the value that this reported item brings to investors is “a picture of management”, that is, a clear understanding of management’s perspective of the business and the results being reported, what management thinks are the implications, causes, effects of financial events and trends, and what management is doing about them. Any movement to expand auditing in this area will inevitably lead to a more standardized and “compliance oriented” approach to MD&A, and the unique information content of management presenting its own “discussion and analysis” will be lost. 11
  • 12. Today, the SEC requirements for MD&A specify core content that companies must meet in supplying information details and explanations of trends, financial position, and prospects. Beyond this base level of information, the background, the level of candor, the degree to which management gives explanations and insights which are credible and competent to analysts - all these and other unique and company-specific factors assist financial data users in making judgements about a company. The market sets its own high standard in this area. In addition to SEC requirements and market evaluation, MD&A does receive significant attention by auditors today on an “non-audited” basis. Auditing standards require the auditor to read MD&A and any other “unaudited” information that is supplied with the financial statements but not a part of the statements “to ensure that the information is not inconsistent with what appears in the financial statements”. We can assure you that MD&A gets attention on a “non-audited” basis in the audit. We already get questions and supply information to support the statements we make in this analysis. For the reasons just outlined, we have opposed, and will strongly continue to oppose, any efforts to expand MD&A to become an audited item. Such action would not be cost-effective and would cause information content to be lost. Beyond the issue of MD&A, the Panel’s questions ask about auditor involvement in non-financial operating measures used inside and outside a company. We have viewed this subject area with a great deal of wariness and concern since the first major effort, the AICPA Special Committee on Financial Reporting (“Jenkins Committee”) was convened several years ago. We are aware that there are now many initiatives underway in accounting standards-setting bodies, public accounting professional groups, and other institutions to study the reporting of non-financial data and how best practices and standard definitions and approaches – and potentially auditing of same – might come about. We also know that that non-financial operating information is used and useful, both inside and outside of the business, and have begun to conduct studies and discussions of our own. 12
  • 13. Obviously, this will continue to be an area of interest, as it should be. But we know from preparing and using non-financial operating data to operate the business that it has important qualities that could be seriously damaged by over-exposure and standardization: - Non-financial data is highly specific to a company’s current strategy, circumstances, operating challenges, and the organizational emphasis at any point in time - The collection and reporting of non-financial data, and the costs associated with this collection effort, can be started and stopped whenever the internal need for it changes - Company priorities, operational challenges and internal needs do change. Much of what might be reported as non- financial data in given years one and two, will be supplanted by different measures reflecting new operational priorities in year three and beyond - Some non-financial operating data is prepared for internal company use on a “directional”, “best effort in the time available” basis for cost and time urgency reasons. It is used for decision making with employee awareness of its limitations. If such data were to need to be prepared to public reporting quality levels, it would become much more costly - Non-financial operating data can get into the very proprietary “guts of the business” and be very useful to competitors, especially foreign competitors Given what we know about non-financial data, we are very skeptical about the value to shareowners of standardizing and reporting quantities of information with the above characteristics, and we are even more skeptical of the value that additional auditing could provide. But we are looking at the issue of reporting and use of non- financial operating data, as well as participating in and/or evaluating the studies and projects being conducted by others. 7.) Do auditors today communicate sufficiently and effectively with management? With audit committees and boards of directors? With stockholders and other investors? 13
  • 14. We believe that auditors communicate sufficiently and effectively with management, the audit committee, and the board of directors. Of course there are opportunities for continuous improvement in communications among all these parties. As for auditor communications to stockholders and other investors, we assume this question refers to the auditor’s principal communication, the Report of the Independent Auditor. The experience of our members is that seldom or never do we receive a question or other communication from our shareholders on the audit opinion. We think most reasonably informed people understand what it means and it serves the purpose intended. A few of our members have commented that less sophisticated investors may not fully understand the concept of “reasonable assurance” and what auditors do and do not do insofar as detecting fraud is concerned. In the overall, we do not see any need for the auditor to expand communications to investors on matters covered by the audit. Beyond the communications which occur within the context of the individual audit engagement, we would like to note that audit firms conduct many information and education outreach activities outside the audit process. The major accounting firms collaborate with us and with other business and professional groups in programs and services that increase our members’ knowledge and professional skills. We don’t always agree with the accounting firms on technical and professional issues because we come from different perspectives, but we welcome and appreciate their support as participants and sponsors of many of our national and local programs. 8.) Are audit committees effective in promoting quality audits? How can they be more effective? The first question is one that has more than one answer. In well- established companies, where controls and practices have been institutionalized and regularly reviewed and improved, we would answer a definite “yes” – the audit committtee is very effective in promoting a quality audit. But in some newer public companies and other firms where formal financial control and corporate governance practices have not been firmly established, the answer would 14
  • 15. sometimes have to be “no”. And there are some extreme examples of failure - probably most of us have heard or read of companies whose audit committees clearly do not function as intended, in some cases, do not even meet. The way that audit committees can be more effective is through a combination of education, communication, peer leadership and regulatory oversight. In addition to existing requirements and guidance for audit committees, we can expect to see more coming about as a consequence of the efforts of the Blue Ribbon Committee on Audit Committee Effectiveness. We await the opportunity to evaluate and comment upon specific proposals. There needs to be education on matters pertaining to audit committee responsibilities, for all the stakeholders and participants involved. Open and candid communication between management, the audit committee, and the auditor will be important in achieving ongoing improvement. And appropriate oversight by the SEC and the stock exchanges will also play an important role. In FEI, we have embarked upon a project to develop a model for today’s audit committee and management’s interactions with it, as part of our education and support for the financial reporting process. 9.) What is the business community’s impression of the importance (stature, compensation, advancement, investments, etc.) that audit firms place on audit work relative to the other services they offer, and how, if at all, does this affect the quality of audits? We have a perception that the audit side of the CPA firm business is not as prestigious, as recognized, and as rewarded internally as the consulting and business advisory side of the business. We do not know what actual effect, if any, this may have had on the quality of audits. We have not seen any direct effects yet, but we are concerned about the ability to attract capable entrants into the auditing profession if this continues, and the ultimate impact that could have on quality. 10.)Do you think that there is the right balance between regulation 15
  • 16. and self-regulation, insofar as preserving and enhancing audit quality is concerned? Yes, we do. We think the right balance exists and that it provides good support and guidance to achieving and maintaining quality audits. In Conclusion Today we have noted the importance of the audit process and the need to restore the image of audit work and accounting technical leadership in the public accounting firms. We have made a number of comments about what we think is going well, and what can be improved. We would like to close with an offer to use the resources of our professional organization and our membership to participate in whatever public and private sector efforts are carried out to enhance audit effectiveness. Thank you. Statement of Financial Executives Institute, October 7, 1999 For further information, contact Chris Allen, Manager of Communications, FEI, at 973-898-4658 16

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