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 GAOs 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
  governments 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 Generals 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 EnvironmentComptroller
Generals Response

• Comptroller Generals 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 EnvironmentComptroller
Generals 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 restrictionssome 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
  managements responsibility for and managements
  assessment of the effectiveness of those
  controls.
• The companys auditor is required to attest to,
  and report on managements 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.)
• GAOs view on auditor opinions on internal
  control
• where appropriate, auditor opinions on internal
  control are critical for monitoring an
  organizations 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 FirmsConsolidation
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
Consolidation and Competition Methodology
Communities of Interest

• Fortune 1000 companies
• Government agencies
• Institutional investors
• Trade organizations
• Underwriters/investment banks

• Academics, researchers, and other experts
• Accounting firms
• Audit committee chairs
• Credit rating agencies
• Exchanges/markets

25
Consolidation and Competition Methodology
Economic Analysis Competition

• 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

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

• 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

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

• Firms 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

28
Factors leading to Mergers
Consolidation and Competition Results

• 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
Going Forward

• 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).

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

• 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

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 Andersens 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 FirmsMandatory
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
Mandatory Audit Firm Rotation Methodology

• Surveys of Public Accounting Firms

44
Mandatory Audit Firm Rotation Methodology

• Surveys of Public Companies

45
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 RotationResults

• 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 RotationResults

• 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 companys
  operations, systems, and financial reporting
  practices and thus may not detect a material
  financial reporting issue.

50
Mandatory Audit Firm RotationResults

• 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 firms
  tenure approached under mandatory rotation to
  attract or retain other clients, which they
  acknowledged would increase the risk of an audit
  failure.

51
Mandatory Audit Firm RotationResults

• 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.

52
Mandatory Audit Firm RotationResults

• 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.

53
Mandatory Audit Firm RotationResults

• 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
Mandatory Audit Firm RotationResults

• 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.

55
Mandatory Audit Firm RotationResults

• 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.

56
Mandatory Audit Firm RotationResults

• 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 companys 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.

57
Mandatory Audit Firm RotationResults

• 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 Acts 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.

58
Mandatory Audit Firm RotationResults

• 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.

59
Contact Information

• Jeanette M. Franzel
• Director, Financial Management Assurance
• [phone], franzelj_at_gao.gov
• Richard J. Vagnoni
• Senior Economist, Financial Markets Community
  Investment
• [phone], vagnonir_at_gao.gov
• U.S. General Accounting Office
• 441 G St, N.W.
• Washington, D.C. 20548