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The Current Environment

Auditing in the Post Enron World Phil Schimmel PIC, Assurance & Advisory Services Western Area (Los Angeles) KPMG LLP Mid-Year Meeting of the Auditing Section of the AAA Huntington Beach, CA January 17, 2003. The Current Environment. The Current Environment.

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The Current Environment

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  1. Auditing in the Post Enron WorldPhil SchimmelPIC, Assurance & Advisory ServicesWestern Area (Los Angeles) KPMG LLP Mid-Year Meeting of the Auditing Section of the AAAHuntington Beach, CAJanuary 17, 2003

  2. The Current Environment

  3. The Current Environment • Alleged financial reporting crisis – “infectious greed” • More stringent regulation – globally • Rapid change, increasing complexity and disintegration of Arthur Andersen • Tarnished image of the profession

  4. The Current Environment • Restatements up dramatically • Approaching 4% of NYSE-listed companies and 3% of NASDAQ-listed companies (Projected)

  5. The Current Environment • Percent Restatements by Reason, 1997 – June 2002 • Revenue……………………………………… 37.9% • Cost/expense………………………………… 15.7% • Restructuring/assets/inventory…………….. 8.9% • Acquisition/merger………………………….. 5.9% • Securities-related……………………………. 5.4% • Reclassification……………………………… 5.1% • IPR&D………………………………………… 3.6% • Related-party transactions…………………. 3.0% • Other………………………………………….. 14.5%

  6. The Current Environment • Market Cap (Decrease) Increase by Reason, 1997 – March 27, 2002 (In Billions) • Revenue……………………………………… (56.4) • Cost/expense………………………………... (4.8) • Restructuring/assets/inventory…………….. 2.9 • Acquisition/merger………………………….. (19.3) • Securities-related…………………………… (2.3) • Reclassification……………………………… (1.2) • IPR&D………………………………………… (4.4) • Related-party transactions…………………. (2.1) • Other………………………………………….(12.6)

  7. The Current Environment • Regulatory trends (global): • More independent regulatory bodies with more power • Improved corporate governance and “transparent” financial reporting • Auditor independence (scope of services, partner rotation, firm rotation, partners/employees joining clients, etc.) • Expanded auditor responsibilities (fraud, internal controls, laws/regulation compliance, etc.) • Tougher standards for Firm quality controls and inspection by others for compliance • Harsher disciplinary proceedings and sanctions impacting firms and individuals

  8. The Current Environment • Increasing complexity for auditors • Difficult worldwide economy • Rapidly changing business models • Troubled and rapidly changing industries • Increasingly complex transactions • Tracked by increasingly complex systems • Accounted for by increasingly complex rules • Pressure for increasingly quick audit sign-offs

  9. Market Demands

  10. Market Demands on Public Companies • Corporate integrity • Severe penalties for wrongdoing • Ethical corporate governance for benefit of shareholders and other stakeholders, not management • Improved audit committee oversight of financial reporting & audit processes • “Transparent” financial disclosure • Reported earnings that reflect reality • Reformed executive compensation and incentives, including expensing stock options • More timely and accurate information, including non-financial information

  11. Market Demands on Auditors • No audit failures • Detect fraud and senior management misconduct • “Transparent” financial disclosure • Reported earnings that reflect reality • Assurance on internal controls • Greater independence in appearance as well as fact

  12. What This Means to Audit Firms

  13. What This Means to Audit Firms • High media/public profile • Cost of future audit failure • Protection from catastrophic events • Audit relationship shift • Effective and independent audit • Increased audit consultation with CEOs & audit committees • Increased legal consideration • Audit scope & fee increases

  14. What This Means to Audit Firms: Expectations of CEO • Auditor assurances to support CEO certification • Low/no tolerance for restatements • Expanded quarterly reviews • Expanded internal controls assurance • Assurance on non-financial information in SEC filings • Increased consultation • Creation of appropriate “tone at the top” • Risk identification and risk management processes • Systems and controls to manage risks

  15. What This Means to Audit Firms: Expectations of Audit Committee • The Committee is the client; hires and fires the auditors • Real dialogue and tough questions • Consultations on business risks, audit risks & audit scope required to reduce audit risk to a low level • Frequent communications on interim audit findings & interim changes to audit scope • Information/assurance on - • Critical accounting policy choices • Financial reporting quality • Resolution of issues with management • Senior management integrity and misconduct • Completeness of information from management • Internal controls

  16. Causes of Audit Failures

  17. Causes of Audit Failure Audit failures frequently relate to inadequate industry expertise Failure to - Industry-related • Understand the entity’s business model • Understand changes in the entity’s operating environment • Fully understand the nature and business purpose of transactions • Perform appropriate client acceptance/continuance procedures • Reconsider prior year judgments or assumptions • Involve specialists Other • Be sufficiently firm with client • Corroborate explanations given by client • Appropriately consider corporate governance • Consult on issues and judgments • Arrange realistic deadlines Audit failures are generally execution failures, not methodology failures

  18. KPMG’s Response – Post Enron

  19. KPMG’s Response – Post Enron • Task force of senior partners (U.S. and International) to took a fresh look at KPMG’s BMP audit methodology in the light of current environment and professional issues Task force conclusion: “BMP methodology is sound and even more appropriate in today’s environment.” “Focus should be on continuous improvements to execution.”

  20. Other KPMG Responses • Increase professional skepticism • Learn from audit failures – ours and those of our competitors • Expand audit program that addresses risk of fraud • Adapt controls evaluation and testing methods, policies and procedures for attestation on management’s reporting on internal controls • New model for audit committee collaborations & deliverables • More involvement of experienced audit team members • More involvement of specialists, particularly IT and Forensic specialists • Recruit, develop and retain the best people • More hours more fees

  21. Proposed Authoritative GuidanceAligns GAAS with BMP

  22. Proposed Guidance Aligns GAAS With BMP • Exposure draft on Understanding the Entity and Its Environment and Assessing the Risk of Material Misstatement • Examples of proposed requirements under the ED aligned with BMP’s business modeling, strategic analysis and process analysis methodologies: • Obtain understanding of: • Objectives and strategies and the related business risks, including the entity’s risk assessment process • Industry, regulatory & other external factors • Measurement & review of the entity’s financial performance (KPIs) • Controls relating to operations & compliance pertaining to data the auditor uses in applying analytical procedures • How transactions are generated within the entity’s business processes

  23. Proposed Guidance Aligns GAAS With BMP • ED also: • Recognizes that information obtained and evaluated to assess the risk of material misstatement constitutes audit evidence • Requires iterative revisions to risk assessments when additional audit evidence contradicts prior assessments • Requires exchange of information about risk assessments through discussions among audit team members to achieve shared awareness • Requires the auditor to document the: • understanding obtained through risk assessment • discussions among audit team members and how and when they occur • risks identified • results of the risk assessment • linkages between identified risks and additional audit procedures

  24. Support for Higher Education • KPMG Foundation Programs – • Matching gifts • PhD Project • Minority Doctoral Scholarships • Sponsorship of Key Conferences & Organizations • KPMG/UIUC Business Measurement Case Develop & Research Program

  25. Support for Higher Education • Cases are available from the KPMG/University of Illinois Business Measurement Case Development & Research Program to assist you in helping students develop the critical systems-thinking and business analysis skills needed to perform risk assessment effectively in today’s complex audit environment. • To-date, over 70,000 copies of the cases have been downloaded from the Program’s web site. MBUSI – 10,522 Reiter – 4,883 Trigon – 2,980 Loblaws – 7,295 Lincoln S&L – 4,332 Qantas – 4,826 IDEC – 5,412 CVS – 17,300 U.S. Prem. Beef – 1.034 Wells Fargo – 8,706 VCC – 3,268

  26. Thank You

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