GAO Update

1. GAO Update The American Accounting Association, Mid-year Auditing Section Conference January 16, 2004 Jeanette M. Franzel Richard J. Vagnoni U.S. General Accounting Office

2. 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

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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.

12. 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.

13. 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.

14. 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

15. 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.

16. 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

17. 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

18. 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.

19. 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.

20. 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.

21. 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

22. 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

23. 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

24. 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 Consolidation and Competition: Methodology Communities of Interest

25. Consolidation and Competition: Methodology • 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

26. 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 Economic Analysis: Capital Formation and Securities Markets Consolidation and Competition: Methodology

27. 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 Subject Areas for Surveys of: Audit Firms Fortune 1000 Consolidation and Competition: Methodology

28. Consolidation and Competition: Results Factors leading toMergers • 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

29. Impact on Market Structure Consolidation and Competition: Results • 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

30. Consolidation and Competition: Results Four-Firm Concentration Ratios: Public Company Sales Audited, 1988 and 2002

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

32. Impact on Price Competition Consolidation and Competition: Results Does 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.

33. Limited Audit Firm Choices Consolidation and Competition: Results • 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

34. Impact on Audit Quality and Auditor Independence Consolidation and Competition: Results • 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.

35. Impact on Capital Formation and Securities Markets Consolidation and Competition: Results • 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.

36. Consolidation and Competition: Results • 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

37. 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 to Entry into Top Tier Faced by Smaller Firms Consolidation and Competition: Results

38. Barriers for Smaller Firms Consolidation and Competition: Results • 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.

39. 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.

40. Studies of Public Accounting Firms:Mandatory Audit Firm Rotation Public Accounting Firms: Required Study on the Potential Effects of Mandatory Audit Firm Rotation GAO-04-216, November 2003 Available at: www.gao.gov

41. 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.

42. 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.

43. 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 Accounting Firms

44. 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 Total responses 201 131 99 431 Response rate 60.9% 29.1% 25.3% - - - Mandatory Audit Firm Rotation: Methodology • Surveys of Public Companies

45. 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 Total responses 191 96 63 350 Response rate 57.9% 21.3% 16.1% - - - Mandatory Audit Firm Rotation: Methodology • Surveys of Public Company Audit Committee Chairs

46. 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

47. 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.

48. 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.

49. Mandatory Audit Firm Rotation:Results • 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.

50. Mandatory Audit Firm Rotation:Results • 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.