Audit Reform Panel Tepid on Liability Caps

The U.S. Treasury Department’s advisory committee on how to prop up the audit profession recently gave a sneak peak at the recommendations it’s preparing, and notable was one thing not included in the package: liability protection.

The Advisory Committee on the Auditing Profession is crafting a number of suggestions for how to make the auditing profession sustainable for the long haul, despite the bruising it has taken in recent years following catastrophic audit failures and the subsequent journey to becoming a regulated profession.

One of the biggest forces driving the review is fear of losing another major global audit network to the kind of meltdown that dissolved Arthur Andersen following the collapse of Enron. That would reduce the Big 4 to an even smaller number of firms able to conduct public company audit work, a prospect that has driven many in capital markets to call for protection from legal liability claims of the size that could put a Big 4 firm out of business.

The advisory committee, however, is mulling no outright protections. Instead, the group is focused on recommendations that would modify audit firm governance, promote a closer examination of the assessment and management of failure risk, and beef up auditor education and training. The committee also is preparing suggestions for how to nurture smaller audit firms for the long-term, so they could more realistically compete for public-company audit work.

The committee met earlier in March to allow its three sub-committees to check their planned proposals with the whole panel. The sub-committees will fine-tune their proposals before they are offered by the advisory panel to Treasury Secretary Henry Paulson in final form.

The committee is planning to suggest the creation of a professional center for best practices in fraud prevention and detection, which ideally would encourage market players to share information and also help close the “expectations gap” regarding the level of assurance an audit is supposed to provide. The committee also plans to recommend that the Public Company Accounting Oversight Board and the Securities and Exchange Commission work on the language of the audit report to help investors better understand that a clean audit does not provide ironclad protection against fraud.

PRELIMINARY THOUGHTS

Below is a summary of the preliminary recommendations from the Advisory Committee on the Auditing Profession.

1. Promote the growth of smaller auditing firms consistent with the overall policy goal of promoting audit quality. Because smaller firms are likely to become significant competitors in the market for large company audits only in the long term, the Subcommittee recognizes that Recommendation 2 will be a higher priority in the near term.

(a) Require disclosure by public companies in their proxy reports of any provisions in material agreements with third parties limiting auditor choice.

2. Create a mechanism for the preservation and rehabilitation of troubled larger public company auditing firms.

(a) Broadly monitor, through the Public Company Accounting Oversight Board (PCAOB) authority over registered firms, potential sources of catastrophic risk, which would threaten audit quality.

(b) Establish a mechanism to assist in the preservation and rehabilitation of a troubled larger auditing firm. A first step would encourage larger auditing firms to adopt voluntarily a contingent streamlined internal governance mechanism that could be triggered in the event of threatening circumstances. If the governance mechanism failed to stabilize the firm, a second step would permit the Securities and Exchange Commission (SEC) to appoint a court-approved trustee to seek to preserve and rehabilitate the firm by addressing the threatening situation, or if such a step were unsuccessful, to pursue a reorganization.

3. Promote the understanding of and compliance with auditor independence requirements among auditors, investors, public companies, audit committees, and boards of directors, in order to maintain investor confidence in the quality of audit processes and audits.

(a) Compile the SEC and PCAOB independence requirements into a single document and make this document Website accessible. The American Institute of Certified Public Accountants (AICPA) and states should clarify and prominently note that differences exist between their standards and those of the SEC and the PCAOB and indicate, at each place in their standards where differences exist, that additional SEC and PCAOB independence requirements applicable to public company auditors may supersede or supplement the stated requirements. This compilation should not require rulemaking by either the SEC or the PCAOB because it assembles existing rules.

(b) Develop training materials to help foster and maintain the application of healthy professional skepticism with respect to issues of independence among public company auditors, and inspect auditing firms, through the PCAOB inspection process, for independence training of partners and mid-career professionals.

4. Adopt annual shareholder ratification of public company auditors by all public companies.

5. Enhance continuously regulatory collaboration and coordination between the PCAOB and its foreign counterparts, consistent with the PCAOB mission of promoting quality audits of public companies in the United States.

Source

Treasury Agenda and Meeting Materials (March 13, 2008).

Damon Silvers, associate general counsel of the AFL-CIO, said auditors have long been dissatisfied with standards around this issue. “The recommendations, directionally, are very welcome,” he said at the advisory committee meeting. “I don’t believe it makes sense to have absolute liability here. We shouldn’t say to the audit firms, ‘You must generate a specific outcome or we’ll punish you.’ The issue is what is the standard of effort that goes into this and communicating that standard clearly to investors. Investors believe today that standard is completely opaque, and that it’s inadequate.”

Palmrose

Paul Volker, former chairman of the Federal Reserve, said he would welcome clarification from the PCAOB and the SEC on what role the auditor should play in detecting fraud, but he wondered whether the agencies have a clear understanding themselves on what that role should be. Mark Olson, chairman of the PCAOB, and Zoe-Vonna Palmrose, deputy chief accountant for the SEC, acknowledged the task and agreed it needs to be addressed.

Beyond Liability Worries

The committee’s working proposal also includes some potentially controversial recommendations that public companies and auditors be required to disclose the cause behind auditor changes and that shareholders have a say in auditor appointments. The Sub-committee on Firm Structure and Finances says investors should have more information about why an auditor might quit or get fired.

Jeff Mahoney, general counsel for the Council of Institutional Investors, said the CII has lobbied for such a requirement as part of a “best practices” policy its members adopted based on extensive research and analysis.

“That research revealed that the SEC’s existing disclosure rules in this area include serious deficiencies, that every year permit hundreds of public companies to conceal from investors the truth about why their external auditors were dismissed or resigned,” he said. “Requiring the disclosure of this information will provide valuable data to investors, auditors, and others about the quality of audit committees, the quality of external audits, and the quality of audit firms.”

Perhaps not surprisingly, corporate representatives were cool to the idea. “It’s already very difficult to change auditing firms as we’ve seen,” said Ken Goldman, CFO of Fortinet. “I wonder if it will add more friction to the ability to consider changing audit firms, which is done very rarely now for a lot of reasons by large companies.”

Mary Bush, president of Bush International, was equally skeptical. “I can see that it would set up all kinds of arguments and disagreements between the auditing firm and the company,” she said. “There would be lengthy negotiations as to what the disclosure looks like without getting into suits.”

Ann Mulcahy, CEO of Xerox Corp., said a disclosure requirement would chill even the best-intended auditor changes. “You will clearly just kill any market-based orientation to make that change,” she said. “It would be a huge dis-enabler for making that change, which could be very healthy.”

Levitt

Committee co-chairman Arthur Levitt (head of the SEC in the Clinton Administration) acknowledged corporate resistance, but said the gains in investor confidence trump corporate concerns. “It would be very difficult to explain to investors in the kinds of environments we’ve seen and are going to see why we would resist such a change,” he said.

To guard against another Andersen-like implosion, the committee plans to recommend a mechanism for spotting potential trouble at a Big 4 firm and working it out before disaster strikes. The committee plans to suggest some kind of broad risk monitoring by the PCAOB, along with a means for rescuing and rehabilitating a large firm under regulatory governance or a court-appointed trustee rather than allowing it to dissolve.

The committee also plans to recommend that regulators study whether audit firms should be required to appoint independent board members to improve governance and transparency at audit firms. In addition, the panel plans to suggest streamlining the audit regulatory process, better coordinating the efforts of the SEC, PCAOB, and state boards of accountancy.