PUBLIC OVERSIGHT BOARD

PUBLICOVERSIGHTBOARD

FINALAnnualReport2001

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Members ofthe PublicOversightBoardJanuary 1, 2001 throughMay 1, 2002

PU B L I C OV E R S I G H T B O A R D

CHARLES A. BOWSHERChairman, 1999 - present; joinedBoard in 1997; ComptrollerGeneral of the United States andhead of the General AccountingOffice, 1981-1996; Partner ofArthur Andersen & Co., 1971-1981; Assistant Secretary of theNavy-Financial Management,1967-1971; presently a directorof several public companies.

DONALD J. KIRKVice Chairman, 1999 - January18, 2002; joined Board in 1995;Financial Accounting StandardsBoard, member 1973-1977,Chairman 1978-1986; Partner ofPrice Waterhouse & Co., 1967-1973; Columbia BusinessSchool, Professor 1987-1994,Executive-in-Residence, 1995-2000; presently a director ofseveral public companies;received the AICPA’s Gold MedalAward for Distinguished Service.

NORMAN R. AUGUSTINEJoined Board in 2000; Chairmanof the Executive Committee,Lockheed Martin Corp. since1997; Chairman and CEO, 1996-1997; President, 1995-1996;Chairman and CEO, MartinMarietta Corp., 1987-1995;Lecturer, Princeton University,1997-1999; Assistant Secretaryof the Army, 1973-1975, andUnder Secretary, 1975-1977;presently a director of severalpublic companies.

JOHN H. BIGGSJoined Board in 2001; Chairmanand CEO of TIAA-CREF since1993, President and COO, 1989-1993; President and CEO ofCenterre Trust Company, 1985-1989; presently a director ofseveral public companies.

AULANA L. PETERSJoined Board in 2001; RetiredPartner in law firm of Gibson,Dunn & Crutcher LLP; Memberof the POB’s Panel on AuditEffectiveness, 1998-2000; SECCommissioner, 1984-1988;presently a director of severalpublic companies.

STAFFJERRY D. SULLIVANExecutive Director

CHARLES J. EVERSTechnical Director

JOHN F. CULLENAssistant Technical Director

ALAN H. FELDMANAssistant Technical Director

JOHN C. WEBERAssistant Technical Director

LEGAL COUNSELALAN B. LEVENSONFulbright & Jaworski LLP

A. A. Sommer, Jr.The POB acknowledgeswith regret and sadness thepassing of A. A. Sommer,Jr., former Chairman of thePOB, on January 14, 2002.

Melvin R. Laird, formerPOB member, onceobserved that “during Al’stenure on the Board, whichcoincided with a difficultperiod in the accountingprofession, he inspired hisfellow Board members andthe whole profession withhis leadership. He ap-proached each challengelogically, calmly, cheer-fully and with fullknowledge of the issues,and he always articulatedreasonable solutions todifficult issues.” Mr.Sommer will be missed byall who knew him.

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About thePublicOversightBoard andthe SECPracticeSection


The Public Oversight Board(POB)

An independent privatesector body, the PublicOversight Board was createdin 1977 for the purpose ofoverseeing and reporting onthe self-regulatory programsof the SEC Practice Section(SECPS) of the AmericanInstitute of Certified PublicAccountants (AICPA). InFebruary 2001 the Board’soversight jurisdiction wasexpanded to include theactivities of the AuditingStandards Board (ASB) ofthe AICPA. The POB isresponsible for monitoringand commenting on mattersthat affect public confidencein the integrity of the auditprocess. Funded by duespaid by SECPS members,the Board’s independence isassured by its power to setits own budget, establish itsown operating procedures,and appoint its own mem-bers, chairperson, and staff.The Board consists of fivemembers with a broadspectrum of business,professional, and regulatoryexperience. Pursuant to thenew Charter, the ceiling forthe POB’s funding was

initially set at $5.2 million tocover its expanded oversightresponsibilities. Additionalfunds may be authorizedshould the need arise. TheCharter further provides thatthe POB will select itsmembers from a slateproposed by a nominatingcommittee. As indicatedelsewhere in this report, onJanuary 20, 2002 the Boardvoted its intent to terminateits existence and did so as ofMay 1, 2002.

SEC Practice Section

The SECPS was founded in1977 as part of the Divisionfor CPA Firms of the AICPAand is overseen by thePublic Oversight Board. TheSection imposes member-ship requirements andadministers two majorprograms to help assure thatSEC registrants are auditedby member firms witheffective quality controlsystems. The first is peerreview, a process by whichother accountants assess andtest compliance with thequality control systems forthe accounting and auditingpractices of Section mem-bers. The other is qualitycontrol inquiry, whichreviews allegations of auditfailure contained in litigationfiled against member firmsinvolving SEC clients.

Membership in the SECPS

About 1,200 firms belong tothe SECPS, includingvirtually all of the account-ing firms that audit publiclyheld companies. They auditsome 17,000 public compa-nies that file reports with theSEC. The requirements ofthe SECPS affect more than128,000 professionals atmember firms.

Member firms of the SECPSmust adhere to qualitycontrol standards establishedby the AICPA; have a peerreview every three years, theresults of which are main-tained in a public file thatalso is available on theAICPA’s web site; and reportto the SECPS QualityControl Inquiry Committee(QCIC) litigation against thefirm that alleges deficienciesin the audit of a SEC client.Among other membershiprequirements, firms mustperiodically rotate thepartner in charge of eachSEC audit engagement andconduct a concurring orsecond partner preissuancereview of each SEC auditengagement.

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Letterfrom theBoard

L E T T E R F R O M T H E BO A R D

The past 15 months havebeen a busy and tumultuoustime for the Public OversightBoard. As detailed elsewherein this annual report, theBoard and its staff carriedout their responsibilities tooversee the peer review andquality control inquiryprocesses, to begin theprocess of monitoringimplementation of therecommendations of thePanel on Audit Effective-ness, to oversee the settingof independence andauditing standards, and toattempt to carry out indepen-dence reviews of the largestaccounting firms. In addi-tion, and in accordance withits new Charter, the POBformed and convened aCoordinating Task Forceconsisting of the chairs ofeach body within the POB’soversight jurisdiction toexchange informationrelating to each committee’sactivities.

These activities, however,were overshadowed by thedecision of the POB onJanuary 20, 2002, to termi-nate its existence. Thatdecision was made reluc-tantly and as a matter ofprinciple. The Board hasrepresented the publicinterest in overseeing theself-regulatory programs ofthe accounting professionfor 25 years and has alwayssought to work closely withthe profession and the SECtoward enhancing theeffectiveness of the pro-grams under its purview.

SEC Chairman Harvey Pittannounced on January 17,2002 his proposal for a newprivate sector regulatorystructure - a structure theAICPA said was “unprec-edented in the more than100 year history of theaccounting profession” -without any input or consul-tation with respect to theproposed changes with thePOB.

The proposal announced byChairman Pitt had been thesubject of discussionsbetween the accountingprofession and the SEC forsome time. The POB askedto be included in thesediscussions, but was not.Being excluded from theprocess, effectively undercutthe POB’s legitimacy as an“overseer.” Under thecircumstances, the POBconcluded that to appear tocontinue to conduct over-sight activities could misleadthe public. Furthermore, thePOB was concerned that if itwere to continue during aninterim period before a newgovernance structure were inplace, it would leave theimpression that the POBapproved of the SEC pro-posal, which it did not.Therefore, it felt that in thepublic interest it had nochoice but to disband.

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■ Following the decision towithhold funding of these

special reviews, the Big 5accounting firms agreedwith the SEC that the POB

should instead conduct morelimited independencereviews of the large firms.

Despite this agreement, thenext 21 months were markedby a singular lack of

progress. The POB, in theend, was unable to conductthe reviews.

■ The POB, which for yearshad carried out its oversightresponsibilities under a set

of bylaws adopted after itwas created in 1977,believed that a formal

charter would improve theindependence of the Board.The creation of a charter was

one of the primary recom-mendations in 2000 of thePanel on Audit Effective-

ness. Objections from theAICPA and the firms causednegotiations to drag out for

more than a year. Ultimately,a new charter took effect inFebruary 2001.

Given these and othercircumstances, the POBconcluded that it was notpossible for it to adequatelyoversee the accountingprofession. The five mem-bers of the POB thus unani-mously voted to disbandafter an appropriate periodfor a transition of its respon-sibilities. This step wasconsidered by the POB to beakin to what an auditor doeswhen it believes it mustresign from a client engage-ment because it can nolonger carry out its responsi-bilities. This decision wastaken only after carefuldeliberation in view of theBoard’s high regard for thework of the overwhelmingnumber of professionals inthe accounting and auditingfields and the Board’scommitment to self-regula-tion as one element of anoversight regime. In the end,


While this proposal was theimmediate event that trig-gered the decision to dis-band, three other eventscontributed to the POB’sdecision:

■ On May 3, 2000, the SECPractice Section (SECPS) -

an organization within theAmerican Institute ofCertified Public Accountants

(AICPA) - took the unprec-edented action of notifyingthe POB that it would refuse

to pay, as part of the POBbudget, for the POB’s specialreviews of public account-

ing firms. The specialreviews in question hadbeen sought by the SEC to

determine whether the firmshad complied with SEC andprofessional independence

standards.

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AICPA, the Big 5, and otherfirms. The chair and vicechair would be full timeemployees of the Institute;five other members wouldserve on a part time basis.All would be appointed by apanel composed of the chairof the SEC, the chair of theFederal Reserve Board andthe Secretary of the Treasury.Once named, the chair of theIIA would join these three innaming other members ofthe board. Members of theIIA board could be removedonly by two-thirds vote ofthe board itself.

The SEC would haveoversight of the IIA, and theSEC’s Office of the ChiefAccountant would be theliaison to the IIA. Funding ofthe IIA would be indepen-dent of the firms and theaccounting profession. The


as the “conscience andcritic” of the profession’sself-regulatory system (asthe Securities and ExchangeCommission labeled themission of the POB in1980), the POB felt it had nochoice but to disband.

In deciding to disband, thePOB felt that it had anobligation to provide itsviews on how regulation ofthe accounting professioncould be improved. It hasdone this in the form of aWhite Paper - The Road toReform: A White Paper FromThe Public Oversight BoardOn Legislation to Create aNew Private Sector Regula-tory Structure for the Ac-counting Profession. ThisWhite Paper was released ata hearing before the SenateBanking Committee onMarch 19, 2002, at whichPOB Chairman Bowsher andPOB Member Peters gave

testimony. The White Paperis printed in full and in-cluded in this annual report.

In summary, the PublicOversight Board stronglybelieves that a new regula-tory structure for the ac-counting profession is bothessential and feasible.However, the POB believesthat to be effective and torestore trust in the account-ing profession, such astructure must be totallyindependent of the account-ing profession, althoughwith input from the profes-sion. Further, the structureshould remain in the privatesector and be statutorilybased.

In the White Paper, theBoard recommends thatCongress create a newIndependent Institute ofAccountancy - the IIA - andcenter all regulation under itsauspices. A seven-memberboard would run the Institutetotally independent of the

important functions of theInstitute would includeoversight of all standardsetting bodies, yearly andspecial reviews, investiga-tory powers, internationalliaison, and professionaleducation and training.

Beyond these core func-tions, the POB White Paperalso contains a number ofrecommendations it believesshould be incorporated inany legislative reformpackage. These includecertain limitations on non-audit services to auditclients, rotation of auditorsevery seven years, a twoyear “cooling off” period inwhich engagement and otherpartners associated with anaudit would be prohibitedfrom accepting employmentwith an audit client, ex-panded action to encourageaudit committees to take full

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responsibility for hiring,evaluating, and (if neces-sary) firing auditors, requir-ing more timely and mean-ingful disclosure of relatedparty transactions, andrequiring management ofpublic corporations toprepare annual statements ofcompliance with internalcontrols to be filed with theSEC, signed by the ChiefExecutive Officer and ChiefFinancial Officer, andreviewed by the externalauditor.

The POB feels these reformsare necessary if trust is to berestored in the accountingprofession and the damagedone to the capital marketsby recent events is to berepaired. The Board haspresented what it believes isa sensible, workable plan forreform. It is premised on thefirmly held belief that the

fundamental purpose ofregulation is to serve thepublic interest and that ofinvestors. If this is to beaccomplished, regulationmust be totally independentof the profession, it mustpull together all aspects ofregulation from standards todiscipline, it must be trans-parent, and it must providefor adequate funding andstaff.

In this last annual report, theBoard wishes to thank thePOB’s loyal staff. The Boardhas been fortunate to havethe dedicated support of themen and women who servedthe public interest so wellunder the leadership of POBExecutive Director JerrySullivan. We are pleased thatthey will continue to provideinterim service under anagreement with the SECPractice Section until a newand permanent regulatorystructure is in place.


Respectfully submitted,

Charles A. Bowsher Norman R. AugustineChairman

Aulana L. Peters John H. Biggs

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Functions oftheIndependentInstitute ofAccountancy

Important functions of the

Independent Institute of

Accountancy—the IIA—would

include:

Oversight:

The IIA would exerciseoversight for all standardsetting bodies, which wouldremain in the private sector,for accounting, auditing, andindependence, as well asinterpretations. Accountingstandards are just as impor-tant as auditing and indepen-dence standards. For thisreason, the POB believes theFinancial AccountingStandards Board should bebrought under the umbrellaof the IIA, which would takeresponsibility for its over-sight and funding.

Reviews:

IIA employees wouldconduct thorough andcomprehensive yearlyreviews of the annualinternal inspections of firmsthat audit more than 100public corporations eachyear. Firm-on-firm peerreview would be discontin-ued for such firms. Unlikepeer review, no activities ofa firm would be off limits to

Institute reviewers and theprocess would producedetailed public reports. Forfirms that audit less than 100public corporations yearly,reviews would be performedby other firms selected andpaid by the IIA. Theirreports would be addressedto the IIA as the client of thereviewer. In addition to thereviews, IIA employeeswould conduct specialreviews, when warranted.Similar to those the SECoriginally asked the POB toundertake, these reviews, forexample, could take asystematic, in-depth look ata firm’s systems, policies,procedures, and operations.If necessary, such specialreviews would delve intoquestions affecting the firm’scompliance with applicableprofessional standards. Aswith the yearly reviews,reports of these specialreviews would be public.

Investigations:

An Office of Enforcementand Discipline within the IIAwould have full authority toinvestigate allegations ofwrongdoing by publicaccounting firms and theirpersonnel. The POB recom-mends giving the IIA theprivilege of confidentiality

as well as the power ofsubpoena to compel testi-mony and produce docu-ments. Cases of allegedmisconduct would bebrought before IIA hearingexaminers. When warranted,these examiners wouldrecommend to the IIA boardthe imposition of sanctions,ranging from fines toexpulsion from the profes-sion. Cases could be referredto the Justice Department forpossible prosecution, or tothe SEC, state boards ofaccountancy, or otheragencies, as appropriate.

Funding:

Funding would be providedthrough fees imposed onpublic corporations inamounts sufficient to coverthe costs of the Institute. ThePOB strongly believes thatthe funding mechanism mustbe beyond the reach of theprofession to prevent it fromwithholding necessaryfunds, as it did in May of2000.

International Liaison andProfessional Education:

The IIA would be chargedwith coordinating interna-tional liaison and overseeingcontinuing professionaleducation.

PR O P O S E D PR I VAT E SE C T O R RE G U L AT O R Y ST R U C T U R E

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PR O P O S E D PR I VAT E SE C T O R RE G U L AT O R Y ST R U C T U R E

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POBActivities

During the year endedDecember 31, 2001 theBoard held six regularlyscheduled meetings and twospecial meetings. A signifi-cant portion of the Board’stime at meetings up toDecember 31, 2001 wasdevoted to the initiation ofactivities to discharge theBoard’s expanded responsi-bilities under its new Charter.During those meetings, theBoard followed theprofession’s progress inimplementing the recom-mendations of the Panel onAudit Effectiveness and thestatus of the planning for thespecial reviews of theindependence qualitycontrols of the eight largestfirms that are discussedelsewhere in this report.

As more fully described inlater sections of this report,the POB embraced its newand broadened responsibili-ties under its new Charter,which was adopted February9, 2001, with enthusiasmand took major steps todischarge them in the publicinterest. Those steps in-cluded recruiting andtraining additional highlyexperienced staff to assist inconducting enhancedoversight of traditionalSECPS activities, particularlyearlier and more extensiveoversight of the peer reviews

of the largest firms and pilot-testing of peer reviewenhancements. In addition,our oversight of QCIC caseswas expanded to evaluatethe implementation of thenew disciplinary require-ment. The Board and staffconducted oversight of theASB standards-settingprocess for the first time.While a POB staff represen-tative was assigned oversightover the IndependenceStandards Board’s (ISB)independence standards-setting, that assignmentproved to be short-livedwhen, in July 2001, the ISBvoted to terminate its exist-ence.

In accordance with theBoard’s Charter, the Boardconducted a three-dayoutreach meeting - the firstday in Washington, DC andthe second and third days inNew York City - to solicitviews and recommendationsabout the accountingprofession’s self-regulatoryprogram and the POB’soversight process. Participat-ing in this meeting were theChief Accountant of theSEC, the Comptroller of theCurrency, representativesfrom the GAO, the chiefexecutive officers of theeight largest firms, AICPAand SECPS leadership, andrepresentatives from theASB, the Financial Account-

ing Standards Board (FASB),the Transnational AuditorsCommittee, and academia.Guests were invited to otherBoard meetings to enhancethe Board’s understanding ofissues facing the accountingprofession. We believe theconcept of an outreachmeeting should be givenconsideration by the IIAproposed in our White Paper- The Road to Reform: AWhite Paper From ThePublic Oversight Board OnLegislation to Create a NewPrivate Sector RegulatoryStructure for the AccountingProfession.

Also in accordance with theCharter, the POB formed andconvened a CoordinatingTask Force consisting of thechairs of each body withinthe POB’s oversight jurisdic-tion to exchange informationrelating to each committee’sactivities. The Board’s ViceChairman served as the chairof this task force. The firstmeeting was also attendedby the chairs of severalbodies not within thejurisdiction of the POB-theProfessional Ethics Execu-tive Committee (PEEC), theFASB, the AccountingStandards Executive Com-mittee, and the Peer ReviewBoard.

Sessions were held for theBoard to discuss develop-

POB AC T I V I T I E S

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ments in the Section’s peerreview program and theinnovations being pilot-tested; the QCIC process,particularly the implementa-tion of the new disciplinaryrequirements and coordina-tion with the PEEC; and theprocess of setting auditingstandards. Liaison roles wereassigned to Board membersrelating to oversight of thepeer review, QCIC, andauditing standards-settingprocesses. Board membersalso played active roles inthe oversight of the largefirm full-scope peer reviews.

The Board’s staff activelyparticipated in deliberationsof the various SECPS taskforces, particularly thoserelating to establishingguidelines for conductingthe pilot-tests of the peerreview innovations andevaluating results.

During 2002 the Board heldfive meetings during whichit decided to dissolve andconducted business relatedto transition matters and theissuance of this final annualreport.

POB Actions Relating toEnron Collapse

The Board has taken anumber of actions to protectinvestors and maintainconfidence in our capitalmarkets in light of the Enroncollapse.

On January 17, 2002, theBoard sent individual lettersto the Chairman of the QCICand to the Chairman of theASB requesting that theytake action on a number ofissues raised by Enron’scollapse. (These letters canbe found on the POB’s website.)

The letter to the QCICChairman, copies of whichwere sent to other interestedparties, including membersof Congress, the SEC, theGeneral Accounting Office(GAO), the SECPS, theAICPA, representatives fromthe Big Five accountingfirms, the ASB and theFASB, urged the QCIC toreview “Andersen’s audits ofEnron for the year 2000 andrelevant prior years todetermine whether thealleged audit deficienciesindicate[d] a need forcorrective measures byAndersen in its system ofquality controls and whetherrestrictions should be placedon Enron engagementpersonnel pursuant to theQCIC’s recently adopteddisciplinary process (beyondthose recently taken by

Andersen).” (See “QualityControl Inquiry Process” fora status report of QCIC’sinquiries into the case laterin this report.) The POBalso requested that the QCIClook into discussionsbetween Andersen andEnron’s audit committeeconcerning Andersen’sevaluation of the criticalaccounting policies used inEnron’s financial statements,Andersen’s independence aswell as other matters. Inaddition, the POB urged theQCIC Chairman to “deter-mine if there [were] profes-sion-wide issues that neededto be addressed” and, ifthere were, to identify themand refer them to the stan-dard-setting bodies forconsideration and appropri-ate action.

The January 17, 2002 letterto the ASB Chairman, copiesof which were sent to thesame group of interestedparties as the letter of thesame date to the QCICChairman, requested that theASB review and takeappropriate action on theauditing issues related to theEnron matter, including theadequacy of auditingguidance related to off-balance sheet financing,special purpose entities, andenergy and other commoditycontracts for which there isno readily determinablemarket.


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In addition, the POB wasactively involved in oversee-ing the peer review of ArthurAndersen LLP, Enron’soutside auditors, which wascompleted at the end of lastyear. In connection with thispeer review of Andersen, thepeer reviewers extendedtheir procedures in view ofEnron’s November 2001announcement that it wouldrestate its financial state-ments for 1997 through2000 and also the first twoquarters of 2001. The POBstaff provided substantialoversight for this extendedpeer review, includingdiscussing the extendedprocedures with the peerreviewers and visiting fouradditional offices, one beingthe Houston office thatconducted the Enron audit.The extended peer review ofAndersen included addi-tional procedures thatinvolved reviewingAndersen’s policies, guid-ance materials, trainingprograms and practice aidswith respect to those areasthat had been identified inthe restatements, namely,special purpose entities,issuance of equity instru-ments for receivables,energy trading contracts,related party transactions,and waived adjustments.(See “Oversight of LargeFirms’ Peer Reviews”

elsewhere in this report forfurther discussion of theAndersen extended peerreview.)

In addition, the POB staffwill exercise oversight of theQCIC, which will be consid-ering allegations in theEnron matter to determinewhether the facts indicateddeficiencies in Andersen’ssystem of quality controlsand whether the auditingengagement team compliedwith professional standards.

Oversight of the Self-Regulatory Structure of theAuditing Profession

In last year’s Annual Report,the POB noted that animportant milestone in thehistory of the self-regulatorysystem of the auditingprofession was reached onFebruary 9, 2001, when thePOB announced agreementon a Charter aimed atstrengthening and broaden-ing its oversight of theprofession. In connectionwith the POB’s responsibili-ties under its Charter, setforth below is a status reporton developments relating tothe Panel on Audit Effective-ness Report and Recommen-dations, auditing standardssetting, auditor indepen-dence, and the look-backand special reviews of thelarge firms’ independencequality controls.

Status Report: TheRecommendations of thePanel on Audit Effectiveness

The August 31, 2000 Reportof the Panel on AuditEffectiveness containedrecommendations directed at15 groups of stakeholders inthe financial reportingprocess. The POB stronglybelieves that the publicinterest demands that all therecommendations made bythe Panel should be carefullyconsidered by each stake-holder group and an expla-nation given for non-implementation or a devia-tion from implementation ofthe recommendation.Therefore, the Board urgesthe successor regulatoryorganization to continue tomonitor implementation andto take action to assureappropriate implementationof the Panel’s recommenda-tions.

The Board and its stafffollowed implementation ofthe recommendations during2001. At the direction of theBoard, the staff prepared areport, POB Staff StatusReport: The Recommenda-tions of the Panel on AuditEffectiveness as of February15, 2002. This report isavailable on thePOB’s web sitewww.publicoversightboard.org.It summarizes the extent towhich the various stakehold-ers have responded to the


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most significant of thePanel’s recommendations. Itis intended to be useful tothose responsible for regulat-ing or overseeing theaccounting profession,particularly the SEC, Con-gress, and the GAO.

The Panel’s overall conclu-sions included the following:

■ The risk-based approach to

audits of financial state-ments is appropriate, but itneeds to be enhanced,

updated, and implementedmore consistently.

■ Auditors should perform

“forensic-type” procedureson every audit to enhancethe prospects of detecting

material financial statementfraud.

■ The governance of the

auditing profession shouldbe enhanced through astrengthened POB that

would oversee the setting ofauditing standards, themonitoring of auditor

performance, and thedisciplining of auditors forsubstandard performance, as

well as conduct specialreviews as appropriate.

Although a number of thePanel’s recommendationshave been addressed by thevarious stakeholders in thefinancial reporting process,no conclusions can bedrawn about the extent to

which the actions taken todate have enhanced auditeffectiveness. The Panel’sreport was published lessthan two years ago and, ofthe recommendations thatwere accepted, none of thestakeholders have completedthe process of implemen-tating the Panel’s recommen-dations. In many cases, newstandards or other forms ofguidance or audit policy areat the exposure draft stage;in some cases, newstandards, guidance, orpolicies have beenpromulgated but are not yeteffective; and in most casesaudits have not yet beenperformed under thosestandards, guidance, orpolicies. The POB believesthat the implementation ofthose Panel recommenda-tions will enhance auditeffectiveness; however, itbelieves that sufficient timehas not yet passed for thebenefits of its recommenda-tions to be measured.

Representative John Dingellhas indicated his interest inthe Panel’s recommenda-tions relating to the gover-nance of the auditingprofession and has requestedthat the GAO review andreport on their implementa-tion. In that regard, represen-tatives of the POB met withGAO staff and the POBprepared a comprehensive

response to GAO’s inquiries,The Public OversightBoard’s Response to GAO’sJune 14, 2001 “ApproachQuestions”/Meeting with thePublic Oversight Board(Congressional RequestRelated to Chapter 6 of theAugust 2000 Report of thePanel on Audit Effective-ness). The GAO report isexpected to be issued inMay 2002. In its letter to theSEC Chief Accountant datedApril 4, 2002, the POBrecommended that, in viewof the importance of thePanel’s recommendations,the SEC take appropriatesteps to assure that thePOB’s responsibility formonitoring the implementa-tion of those recommenda-tions is taken on, andfulfilled, by an independententity. (This letter is on thePOB web site.) Such actionby the SEC would serve thepublic interest by promotingimplementation of thePanel’s recommendations,while at the same timeassuring the independenceand objectivity of themonitoring process. ThePOB also recommended thatthe independent entity issueperiodic status reports thatwould be available to the


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public. In addition, the POBrecommended that the SECconsider establishing anindependent entity, like TheCommittee of SponsoringOrganizations of theTreadway Commission(COSO), to take on theresponsibility for monitoringthe Panel’s recommenda-tions.

Auditing Standards-Setting

The POB’s February 2001Charter gave it oversight ofthe ASB for the first time.The ASB promulgatesauditing, attestation, andquality control standards tobe observed by members ofthe AICPA in accordancewith its Bylaws and Code ofProfessional Conduct. TheASB is composed of 15members, including repre-sentatives from international,national, regional, and localfirms, as well as representa-tives from accountingeducation and state govern-ment. The POB’s recom-mendation for a successorprivate sector regulatoryorganization includes theASB under its oversight, asdescribed in the White Paper.

Independence Standards-Setting

The POB’s February 2001Charter gave it oversight ofthe ISB’s independencestandards-setting process.Since the ISB voted toterminate its existence inJuly 2001, the POB staff hasobserved public meetings ofthe AICPA’s ProfessionalEthics Executive Committee.The POB Charter providesthat the POB would monitorthe agenda of PEEC toidentify rule-making,regulatory, and standard-setting activities that relate tothe audit of public compa-nies for the purpose ofcommunicating informationrelating to such activities tothe Coordinating Task Force,formed by the POB, forappropriate consideration.The PEEC sets indepen-dence standards that allAICPA members are obligedto follow in the conduct ofaudits. (If the SEC hasestablished a more stringentindependence requirementin a specified area, auditorsare required to follow theSEC requirement withrespect to their publicclients.)

Look-Back and SpecialReviews of Large Firms’Independence QualityControls

In a letter to the POB datedDecember 9, 1999, thenSEC Chief Accountant LynnTurner expressed concernthat public accounting firmspossibly lacked adequatequality controls for indepen-dence. As a step to “safe-guard the public interest,” he“strongly recommend[ed]”that the POB undertake “aspecial review of SECPSmember firms’ currentcompliance” with indepen-dence requirements. OnDecember 21, 1999, thePOB agreed to do so. Twoweeks later, on January 6,2000, the SEC announcedthat an internal investigationat PricewaterhouseCoopersLLP (PwC) had disclosedmore than 8,000 indepen-dence violations of varyingdegrees of significance. Atthis time, there were publiclyexpressed concerns that thewidespread independenceviolations at PwC might alsobe found at other largeaccounting firms if theywere subject to a similarcompliance review. Againstthis background, the POBcommenced preliminarywork on the special reviewsin January 2000, and hadmeetings with the firms todiscuss the reviews.


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POB. The POB agreed to doso, and commenced prelimi-nary work on these reviewsin November 2000. Betweenthen and January 2002, aperiod of more than a year,the POB did a substantialamount of work preparing toconduct the independencereviews. This work includeda request for documents sentto the firms and the SECstaff in July 2001 as well ascomprehensive workprograms for both phase I(evaluation of design andimplementation effective-ness) and phase II (testingand evaluation of operatingeffectiveness) of the reviews,sent to the firms and SECstaff in October 2001 andJanuary 2002, respectively.In addition, the POB wasinvolved in working with thefirms on a confidentialityagreement for the indepen-dence reviews. The POB’sefforts to enter into a confi-dentiality agreement with thefirms, going back to July2001, met with no success.In addition, by the middle of

January 2002, the POB stillhad not been able to obtainfrom the firms documents ithad requested for theindependence reviews inJuly 2001. This lack ofprogress in conducting theindependence reviews wasone of the factors that led tothe POB voting to terminateits existence.

In its letter of January 21,2002 informing ChairmanPitt of the POB’s decision toterminate, the POB statedthat arrangements had to bemade for a transition of itsresponsibilities. (This letter ison the POB web site.) In thisregard, the POB specificallynoted that plans had to bemade to transfer from thePOB to an independententity the conduct of, andissuance of public reportson, the special independencereviews of the Big 5 ac-counting firms, agreed to bythe SEC and the firms inJune 2000.

In a letter to the SEC and thefirms dated March 5, 2002,the POB set forth its positionon the transfer of its respon-sibility for conducting theindependence reviews andissuing public reports to anindependent person anddiscussed the background ofthe independence reviews.This letter can be found onthe POB’s web site.


Then, in early May 2000,the POB’s work on thespecial reviews was stoppedby a decision of the SECPSto cut off the POB’s fundingfor them. Arthur Levitt, theChairman of the SEC, statedthat this was “a significantsetback to self-regulationand independent oversight”and raised “serious questionsas to the profession’s com-mitment to self-regulation.”Melvin Laird, formerCongressman and Secretaryof Defense and the longest-serving member of the POB,said that this was “the worstincident in my 17 years” onthe POB.

The special reviews did notgo forward, but shortlyafterward, in June 2000, theSEC and the Big 5 firmsentered into a “Term Sheetfor Independence Look-Back Testing Program”(term sheet), which calledfor the POB to conduct morelimited independencereviews.

Subsequently, on October10, 2000, the POB receiveda letter from Mr. Turnerasking that the POB do theindependence reviews calledfor by the term sheet “in lieuof” the special reviewspreviously requested in hisDecember 1999 letter to the

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On March 19, 2002, the SECannounced plans for com-pleting reviews of thedesign, implementation, andoperating effectiveness ofeach of the five largest firms’systems for assuring compli-ance with the independencerules. The POB is hopefulthat these reviews and thereports on the reviews willbe timely completed in amanner consistent with thePOB’s March 5, 2002 letter,particularly with regard tothe scope of the reviews andform and content of thereports.

Efforts to Enhance PeerReview

In response to a Panelrecommendation, during the2001-2002 peer review year,the SECPS pilot-tested anumber of innovations in thepeer reviews of the 13largest firms in recognitionof the greater public interestin their audit practices.These innovations wereintended to make the peerreview process more effec-tive by focusing peerreviewers and the firms’internal inspection programson some of the higher riskareas of audits. Our over-sight of the pilot-tests isdiscussed later in this reportunder “POB Oversight of thePeer Review Process.”

The risk areas covered in thepilot-tests were thoseidentified by the Panel onAudit Effectiveness asrequiring additional attentionby auditors, peer reviewers,and standards-setters.Reviewers made qualitativeassessments of auditingdecisions and communi-cated those assessments tothe reviewed firms. ThePOB believes that focusingon risk areas and the audit-ing decisions in those areasenhances the peer reviewprocess. In addition, a seriesof topics, including “tone atthe top” and independence,were the subject of focusgroup meetings. The goalsof these meetings were toidentify (a) areas where thefirm’s quality controlpolicies and procedurescould be strengthened, (b)auditing or other standardsthat need reconsideration,and (c) best practices thatmight be shared acrossfirms.

In addition, those large firmsthat were not scheduled for atriennial peer review weresubjected to “specifiedannual procedures.” Thoseprocedures focused on thefirms’ internal inspection andmonitoring procedures todetermine whether they weresufficiently comprehensiveto identify the need to (a)revise policies and proce-dures, (b) update guidancematerials and practice aids,(c) improve professionaldevelopment activities, and(d) achieve increasedcompliance with firmpolicies and procedures.

The “specified annualprocedures” reviews weresubstantially completed aspilot-tests. However, thecontemplated non-publicreports were not issued. Thepilot-tests did not contem-plate public reporting; theywere performed to developadditional guidance fordeveloping specified annualprocedures and for develop-ing reports on the results.That guidance has now beendeveloped, with input fromthe POB’s staff, and the PeerReview Committee (PRC)


15

has approved it for imple-mentation in the 2002-2003peer review year.

While the reviewers col-lected some information onbest practices and matters forthe attention of standards-setters, the information wasnot considered by the PRCto be important enough to bereported to others. Thereviewers’ experiences withthe pilot program, however,were discussed at twodebriefing sessions held bythe PRC. The POB encour-ages the PRC to collect suchinformation in a more formalmanner during the 2002peer reviews.

During the year, peer reviewreports reflected the revi-sions the PRC made to thepeer review reportingstandards to provide moreinformation about thereviews. For example, thenew reports better describethe objectives of a peerreview and how they areconducted. In addition, thepeer review reports werestreamlined to make themmore understandable insituations where the reports

are modified or adverse.

The innovations imple-mented in the 2001-2002year have the capability ofenhancing the conduct andtransparency of peer re-views. The Board believes,however, that the size andcomplexity of the largeauditing firms require annualreviews. Our further recom-mendations for enhancingthe reviews of firms andother aspects of the gover-nance of the profession areincluded in The Road toReform: A White Paper FromThe Public Oversight BoardOn Legislation to Create aNew Private Sector Regula-tory Structure for the Ac-counting Profession (theWhite Paper), which isincluded in this report.

The Board believes that it isin the public interest tocontinue the peer reviewprogram during the transi-tion period before theestablishment of a successorregulatory structure. In thatregard, the SECPS ExecutiveCommittee chair stated in aletter to the SEC ChiefAccountant dated February15, 2002 that the SECPSintends to continue the self-regulatory programs,including peer review,during the transition.

The PRC has recentlyapproved enhanced guid-ance for conducting reviewsfor 2002-2003. The PRC hasidentified eleven risk areas,including auditing deriva-tives and special purposeentities, that will be focusedon in both full-scope peerreviews and in the specifiedannual procedures. Weunderstand that the specifiedannual procedures will beperformed for the “Big 5firms” not subject to fullreviews in 2002 and forother firms opting to subjecttheir firms to such reviews,and that the reviewers willissue reports that will beavailable to the PRC and thePOB and SEC staffs, whowill continue to oversee thepeer review process.


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POB RE P O R T S ON

SECPSExecutiveCommittee

The Executive Committee is

responsible for the self-regula-

tory activities of the SEC

Practice Section, which include

setting membership requirements

for member firms. Membership

requirements are intended to

enhance the quality of practice

by CPA firms before the SEC.

A Board member and staffparticipate in each meetingof the SECPS ExecutiveCommittee and its PlanningCommittee. As discussedbelow, since our last AnnualReport:

■ The Executive Committee

updated the independencemembership requirementand amended the concurring

partner review membershiprequirement to coverquarterly reviews.

■ The Professional Issues TaskForce (PITF) issued threePractice Alerts.

■ The public files of SECPSmember firms becameaccessible on the SECPS’s

web site.

As provided in the Board’sCharter, the POB wasconsulted on nominations bythe SECPS for membershipon the Executive Committeeand concurred in the nomi-nations for the chair of thatcommittee, which wereapproved by the committeeand the AICPA board.

Requirements for SpecifiedAnnual Procedures

In January 2002 the SECPSExecutive Committeeapproved a requirement thatfirms meeting certaincriteria, to be established bythe PRC, undergo “specifiedannual procedures” in yearsbetween triennial peerreviews. The PRC voted torequire firms with 500 ormore SEC clients to undergosuch reviews; they areoptional for other firms.

Revised Independence QualityControl Requirements

In November 2000 the SECissued its final rules onauditor independence, whichextensively revised theprevious rules. The Execu-tive Committee consideredthese new rules and onOctober 10, 2001 adoptedan amendment to theindependence qualitycontrol membership require-ment that became effectiveJanuary 1, 2002. Theamendment is intended toenhance compliance withthe SEC’s new rules, particu-larly with respect to amember firm’s foreign-associated firms.

The letter transmitting theamended membershiprequirement to SECPS firmsnoted that the final SEC rulesprovide a safe harbor foraccounting firms for inad-vertent impairments ofindependence by coveredpersons. The impairmentmust be eliminated as soonas possible after discovery,and the accounting firmmust maintain a qualitycontrol system that providesreasonable assurance that thefirm and its personnel do notlack independence.

To qualify for the safeharbor, firms with more than500 SEC attest clients areexpected to include eightspecified features in theirindependence qualitycontrol systems. Other firmsalso should have a system,but it does not have toinclude all eight features toqualify for the safe harbor.The amended membershiprequirement specifies that,effective January 1, 2002,firms with more than 500SEC clients must, amongother things, have anautomated system to identifyinvestments of partners andmanagers that might impairindependence.

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No matter how many SECclients a firm has, for thefirm to qualify for the safeharbor, the SEC rules specifythat the quality controlsystem encompass “at leastall employees and associatedentities of the accountingfirm participating in theengagement, includingemployees and associatedentities located outside theUnited States.” Accountingfirms with more than 500SEC clients have untilDecember 31, 2002 toimplement the eight featuresin offices outside the U.S.Prior to that date, to comewithin the safe harbor, thoseforeign offices must meet a“reasonable assurance”standard for compliancewith independence stan-dards.

Revised Concurring PartnerReview Requirement

At its January 2002 meeting,the Executive Committeeapproved a revision to theconcurring partner reviewrequirement that is designedto enhance the reliability ofinterim financial informa-tion. Effective for quarters

ending on or after March 31,2002, concurring partnersmust be involved in reviewsof interim financial informa-tion in Form 10-Q or 10-QSB. Member firms areexpected to have policiesand procedures in place thatrequire concurring partnersto discuss with the engage-ment team, before complet-ing an interim review, anymatters identified in thereview that involve a signifi-cant risk of material mis-statement of the financialstatements, including thefootnotes. That involvementis required to be docu-mented.

PITF Practice Alerts

The Executive Committee’sProfessional Issues TaskForce issued three PracticeAlerts: Common Peer ReviewRecommendations, AuditConsiderations in Times ofEconomic Uncertainty, andCommunications with theSecurities and ExchangeCommission. These areavailable on the SECPS website (www.aicpa.org/mem-bers/div/SECPS) and in theAICPA Technical PracticeAids. The Board’s staff

participates in the accumula-tion and consideration ofpractice issues at PITFmeetings.

SECPS Public FileNow on the Web Site

Beginning in December2001 the public files ofSECPS member firmsbecame accessible on theSECPS web site identifiedabove. The available infor-mation includes the mostrecent peer review report,letter of comments (if any),and the firm’s response (ifapplicable). In addition, thefirm’s three most recentannual reports to the PracticeSection and other relevantdocuments are available, forexample, a description of anundertaking by a firm that isnot yet completed to demon-strate to the Peer ReviewCommittee’s satisfaction thatsignificant quality controldeficiencies have beeneliminated.

POB RE P O R T S ON S E C P S EX E C U T I V E CO M M I T T E E

18

PeerReviewProcess

POB RE P O R T S ON

Virtually all U.S. accounting

firms that audit publicly held

companies belong to the SEC

Practice Section and are

required to submit to a triennial

peer review of their accounting

and auditing practice. The

objectives of peer review are to

evaluate whether the reviewed

firm (1) designed its system of

quality control for its account-

ing and auditing practice to

meet the requirements of the

Quality Control Standards

established by the AICPA, (2)

complied with its quality control

policies and procedures to

provide reasonable assurance of

complying with professional

standards, and (3) complied with

the membership requirements of

the SECPS, in all material

respects. A peer review consists

of tests directed at the design of

and compliance with the

reviewed firm’s system of quality

control to provide the firm with

reasonable, not absolute,

assurance of complying with

professional standards. Conse-

quently, an unmodified opinion

on a firm’s system of quality

control is not intended to, and

does not, provide assurance with

respect to any individual audit

conducted by the firm or that

none of the financial statements

audited by the firm will be

restated.

The SECPS Peer Review

Committee sets the standards for

conducting and reporting on

peer reviews and oversees the

administration of the peer

review program. The PRC

considers each peer review,

evaluates the reviewer’s

competency and performance,

and examines every report,

letters of comments if any, and

accompanying response from the

reviewed firm. Once accepted by

the PRC, the reports and letters

of comments and response are

placed in a public file main-

tained at the AICPA and are also

placed on the AICPA web site.

POB Oversight of the PeerReview Process

Over a three-year period, all1,230 U.S. accounting firmsthat belong to the SECPSundergo a peer review. ThisPOB annual report discussesthe peer reviews conductedduring the 2000-2001 peerreview year. The peerreviews were conducted in2000, and were processedby the PRC in 2000 and2001. In addition, the reportdiscusses the significantimprovements in the peerreview process that wereimplemented on selectedreviewed firms in a pilot-testfor peer reviews conducted

in the 2001-2002 peerreview year.

During the 2000-2001 peerreview year, 368 SECPSpeer reviews were per-formed, including 256reviews of firms that auditSEC registrants and 112reviews of firms with noSEC clients. During the2001-2002 peer review year,410 SECPS peer reviewswere scheduled, including274 reviews of firms thataudit SEC registrants and136 reviews of firms with noSEC clients.

The Board’s staff performssome level of oversight ofevery peer review. Thelevels of oversight are: on-site oversight and workingpaper review, working paperreview only, and selectiveworking paper review. Thelevel of oversight varies withthe profile of the firm andthe peer reviewer. Firms withlarge numbers of publicclients, a history of perfor-mance problems (includinglitigation, regulatory en-forcement actions, and priorreviews resulting in modifiedreports), and firms undergo-ing their initial SECPS peerreview receive more inten-sive oversight than otherfirms. Similarly, the Board’s

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staff closely monitors peerreviewers who have had pastperformance problems.

Oversight of Large Firms’Peer Reviews2000-2001 peer review year

During the 2000-2001 peerreview year, there was one“Big 5” firm peer review,that of Pricewater-houseCoopers LLP (PwC).That review resulted in anunmodified report, accom-panied by a letter of com-ment, both of which areavailable on the AICPA website.

The Board’s staff conductedcomprehensive, “real-time”oversight of the PwC peerreview. POB staff wasinvolved in planning thereview, visiting severalpractice offices during theconduct of the review,reviewing detailed andsummarized findings,developing the appropriatereport and letter of comment,and communicating thereview findings to PwC’ssenior management at thefirm-wide exit conference.The Board’s Vice Chairmanserved as the Board’s liaisonmember on this review andparticipated in the firm-wideexit conference.2001-2002 peer review year

As discussed in the Board’s2000 annual report, theSECPS Executive Commit-tee approved the PRC’s plan

to modify significantly theapproach to conducting andreporting on peer reviews.The PRC decided, beforedeveloping new detailedpeer review standards andprocedures, to conduct apilot program during the2001-2002 peer reviewseason on selected large andsmall firms. The largest firmswere identified, at leastinitially, as the 12 firms with100 or more accounting andauditing professionals and30 or more SEC auditclients. Those 12 firms weredesignated as “Tier B” firms.Subsequently, two SECPSmember firms merged and,as a combined firm, met thecriteria for Tier B, increasingthe number to 13.

The disproportionately largenumber of peer reviews ofthe larger firms scheduledfor the 2001-2002 peerreview year made it espe-cially difficult to performexpanded oversight of thepeer review process in aneffective manner. In order toimplement the recommenda-tions of the Panel on AuditEffectiveness and the PeerReview Process Task Forceand effectively monitor theresults, the PRC decided,with the concurrence of theSECPS Executive Commit-tee, to change the peer

review cycle of four largefirms (none of which is a Big5 firm). The peer reviews ofthree of them were deferredto 2002 or 2003, and thepeer review of the fourthwas deferred from 2002 to2003.

On July 20, 2001 the Chairof the PRC wrote to theChief Accountant of the SECand the Managing Director,Financial Management andAssurance, of the U.S.General Accounting Office,informing them of thedecision to defer the fourfirms’ peer reviews. Thoseagencies also were informedthat each of those firmswould have its peer reviewerperform and publicly reporton a review of the design ofthe firm’s system of qualitycontrol for its accountingand auditing practice and onthe firm’s policies andprocedures related to theSECPS membership require-ments. Copies of the letterwere sent to other regulatorybodies, such as the FederalDeposit Insurance Corpora-tion, the Rural UtilitiesService, and the state boardsof accountancy. Also on July20, 2001, the POB’s Chairwrote the same parties

informing them that theBoard concurred with theSECPS’s decision to deferthe triennial peer reviews ofthe four large firms.

Full Scope Reviews. Full scopetriennial peer reviews wereconducted on five Tier Bfirms during the 2001-2002peer review year (ArthurAndersen LLP, Ernst &Young LLP, McGladrey &Pullen LLP, Crowe Chizekand Company, and RichardA. Eisner LLP). Under theactive oversight of the POB,the PRC completed guidanceto be pilot-tested for thesefirms and a sample of otherfirms. Peer reviewers usedthat guidance on a sample ofengagements. They alsoconducted focus groupsessions of seniors andmanagers within the officesreviewed and increased theirinterviews of engagementstaff whose audits werebeing reviewed. The reviewsof the three largest firms arediscussed below.

Andersen Peer Review. Lessthan a week before thescheduled exit conferencefor Deloitte & Touche’s peerreview of Andersen, one ofAndersen’s largest clients,Enron, announced that itwould be restating itsaudited financial statements

POB RE P O R T S ON PE E R RE V I E W PR O C E S S

20

for the prior four years andthe unaudited financialstatements for the first twoquarters of 2001. Shortlythereafter, Andersen wasnamed as a defendant inlitigation alleging, amongother things, deficiencies inits audits of those financialstatements. In connectionwith D&T’s reassessment ofthe scope of its peer reviewprior to concluding on thereview, D&T obtainedinformation related to therestatement and the litiga-tion, and determined that itwould perform additionalreview procedures.Andersen also requested thatD&T perform additionalwork.

The additional proceduresincluded reviewing a sampleof audit engagements inAndersen’s Houston office,which was primarily respon-sible for the Enron audit andwhich had not been previ-ously selected for review.The additional proceduresalso included specificallyreviewing Andersen’spolicies, guidance materials,training programs, andpractice aids with respect tothose areas that had beenidentified in the restate-ments, namely, special

purpose entities, issuance ofequity instruments (e.g.,shares, warrants, and rights)for receivables, energytrading contracts, relatedparty transactions, andwaived adjustments. D&Talso reviewed those areas ona sample of engagements inthe office primarily respon-sible for the Enron audit andin three other offices. Theadditional procedures didnot include reviewingAndersen’s audits of Enron,since engagements forwhich there is pendinglitigation are typicallyexcluded from a peer reviewunder the SECPS’s standardsfor performing peer reviews.In the near future, however,the QCIC will be consider-ing Andersen’s audits ofEnron.

The POB staff extended itsoversight on this peerreview, devoting about 700hours to overseeing this peerreview on a real-time basis,including extensive over-sight of the additional reviewprocedures described above.The staff’s proceduresincluded reviewing D&T’splanning for the peer reviewand its working papers,findings, and analyses ofthose findings; visiting amajority of the offices thatD&T reviewed while the

reviews were in process;attending numerous meet-ings involving D&T andAndersen personnel; beingconsulted during the devel-opment of D&T’s report andletter of comments; andattending, along with amember of the POB, theoverall exit conference withAndersen’s senior manage-ment and the exit conferencefor the Houston office.Based on its oversightprocedures and analyses ofD&T’s findings, the staffconcurred with D&T’sdecision to issue an unmodi-fied peer review report andwith the contents of D&T’sletter of comments andAndersen’s response to thatletter. These documents areavailable on the AICPA website.

Ernst & Young LLP PeerReview. The POB staffdevoted over 400 hours tooverseeing KPMG LLP’speer review of E&Y’squality controls. The staffparticipated in this reviewfrom initial planning throughfinal analysis of the peerreview findings and devel-opment of the report, letterof comments, and exitconference agenda. The staffhad extensive field oversight


21

involvement, monitoringKPMG’s peer review at one-half of the offices that werepeer reviewed. The Board’schairman participated withthe staff in evaluating thepeer review findings andKPMG’s reporting decisionsand communicating severalsuggestions to KPMGrelating to the letter ofcomments before the finalexit conference at whichKPMG reported its peerreview findings to E&Y firmmanagement. The POBchair, another member, andstaff actively participated inthe exit conference. Theunmodified peer reviewreport, the letter of com-ments and the firm’s letter ofresponse are available on theAICPA web site.

McGladrey & Pullen LLPPeer Review. The E&Y peerreview of McGladrey &Pullen resulted in the issu-ance of a modified reportbecause of “instances incertain recently mergedpractices where pre-issuancereviews should have beenmore comprehensive.” Thiscondition resulted in certainengagements (not involvingSEC registrants, insuredfinancial institutions, oraudits performed underGovernment AuditingStandards) not complying

with professional standards,as well as instances of non-compliance with the Firm’spolicies and procedures inseveral quality control areas.

The POB staff devoted about300 hours to overseeing thispeer review, from theplanning phase through thereporting phase. The staffreviewed E&Y’s planningfor the review, attended theWebcast training programfor reviewers, reviewed thefindings and the summariza-tions and analyses of thosefindings, visited several ofthe reviewed offices whilethe reviews were in progress,attended meetings withengagement personnel andfocus group sessions withprofessional staff, attendedmeetings with M&P andE&Y personnel and PeerReview Committee taskforces to consider theappropriateness of thereport, and participated,along with the POB ViceChairman, in a telephonicexit conference withMcGladrey’s senior manage-ment. The modified peerreview report and the firm’sletter of response are avail-able on the AICPA web site.

Design Reviews and SpecifiedAnnual Procedures Reviews.The four Tier B firms thathad their full scope triennialreviews deferred (BDOSeidman LLP, BKD LLP,Grant Thornton LLP, andMoss Adams LLP) under-went design reviews duringthe 2001-2002 peer reviewyear. All received an un-modified peer review reportwithout a letter of comments.The reports are available onthe AICPA web site.

The PRC developed a set ofspecified annual proceduresfor all Tier B firms notundergoing a full scopetriennial peer review or adesign review during the2001-2002 year. However,while substantially all of thereview procedures wereapplied to the four firms(PricewaterhouseCoopersLLP, Deloitte & Touche LLP,KPMG LLP, and J. H. CohnLLP), none of the reviewswas completed or reportedupon. (See “Efforts toEnhance Peer Review”elsewhere in this report.)

The POB staff performedextensive oversight over thedesign reviews and specifiedannual procedures reviews.The oversight proceduresincluded reviewing the


22

standing of the reviewfindings and to test thecomprehensiveness of thereviewers’ work. Twenty ofthe firms visited had morethan five SEC clients, threehad received modified oradverse reports on theirprevious peer review, andeleven were undergoingtheir initial review. TheBoard’s staff visited andparticipated in the reviews of41% of the firms with morethan five SEC clients, 21%of the firms with SEC clientsthat received modifiedreports during their previouspeer review, and 26% of thefirms undergoing their initialpeer review.

In addition to the on-sitevisits, the Board’s staffreviewed the peer reviewreports and all the underly-ing working papers forreviews of 99 firms. Thestaff discussed significantissues and findings with thereview team, determinedwhether the reviewers hadthe industry and regulatoryqualifications to perform thereview, and obtained expla-nations and clarifications ofmatters regarding the scopeof the review, the signifi-cance of systemic and

engagement findings, andthe consistency of findingsin the peer review reports.The Board’s staff concludedthat all significant matterswere properly addressed,resolved, and reported on inaccordance with the peerreview standards.

For the 221 firms (of which112 have SEC clients) notsubject to the more intensivevisitation and working paperreview oversight programs,the POB staff performed areview that was limited toreading the peer reviewreports and selected workingpapers. In those instances,the SECPS staff performedeither an on-site visit or adetailed review of the peerreview reports and workingpapers. The SECPS staffperformed a more limitedreview of the peer reviewreports and working papersfor the peer reviews onwhich the POB staff per-formed either an on-site visitor a working paper review.2001-2002 peer review year

For the 2001-2002 peerreview year, the Board’s staffis currently overseeing thepeer reviews of 398 firms(13 Tier B firms and 385smaller firms) and expects tooversee 12 additional


planning for each of thereviews, the reviewers’working papers, findings,and analyses of thosefindings; visiting an office ofthe reviewed firm while thereviewers were observingand testing the firm’s moni-toring procedures; and, forthe design reviews, review-ing the reports issued andattending the overall exitconference with the firm’ssenior management.

Oversight of the Other Firms’Peer Reviews2000-2001 peer review year

During the 2000-2001 peerreview year, the Board’s staffdirectly participated, throughon-site visits, in the reviewsof 48 other firms with SECclients. During those visits,the staff reviewed the peerreview working papers,evaluated the qualificationsof the reviewers, reviewedthe scope and findings withthe review team, and partici-pated in the final exitconference with representa-tives of the reviewed firm.Also, the staff often re-viewed clients’ financialstatements and the auditors’supporting working papersto obtain a better under-

23

2001 peer review year thatwere subject to such actionshave agreed to accept all theremedial corrective actionsrequested by the Committee.Table I summarizes Commit-tee-imposed correctiveactions.

The PRC and ETF haveconsidered and processed all368 of the 2000-2001 peerreviews and as of March 31,2002, 284 of the anticipated410 2001-2002 peer re-views.

The PRC met four times in2000-2001 and nine times in2001-2002. A Board mem-ber, staff member, or bothparticipated in each of thosemeetings. The ETF met 24times to consider the 2000-2001 peer review reports,and through March 31,2002, 19 times to considerthe 2001-2002 peer reviewreports; the Board’s staffparticipated in all of thosemeetings.

Sanctions Imposed on aMember Firm

One member firm, Harold Y.Spector, CPA, received anadverse report on its 1999peer review. The PRCaccepted the adverse reportwith the understanding that


reviews of Tier A firms thathave not yet been per-formed. The staff partici-pated in on-site oversight of50 of the smaller firms, isreviewing the peer reviewreports and working papersfor 102 firms, and is per-forming a more limitedreview of the peer reviewreports and working papersfor the remaining 233 firms(of which 98 have SECclients).

PRC’s Consideration of PeerReview Reports andImposition and Monitoring ofCorrective Actions

After either the Board’s staffor the SECPS staff reviews apeer review, the report ispresented to either the entirePRC or the Evaluations TaskForce (ETF) of the PRC. TheETF meets once or twice amonth to consider andaccept the individual peerreview reports. Because ofthe high public interest infirms with many SEC clients,reports on firms with 30 ormore SEC clients are consid-ered and accepted by theentire PRC. During thosemeetings, the Board andSECPS staffs participate inthe discussions and commu-nicate significant matters thatarose in the course of their

oversight. Once the ETF orthe PRC accepts the reports,they are placed in the publicfiles at the AICPA and on theAICPA web site.

As part of its processing ofpeer review reports, the PRCand ETF consider whetherthe findings warrant addi-tional follow-up to assurethat the public interest isproperly protected and thefirm is taking appropriatecorrective actions to addressits peer review findings.

When the PRC concludesthat the corrective actionsproposed by a reviewed firmin response to the peerreview findings are notadequate or that similardeficiencies have occurredon successive peer reviews,the committee usuallyrequests that the reviewedfirm implement additionalspecific corrective actions.In addition, if the design orcompliance deficiencies areparticularly severe, the PRCmay ask the firm to demon-strate that the correctiveactions have been imple-mented to the satisfaction ofthe review team captain oranother outside party. Thefirms reviewed in the 2000-

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the firm had agreed tocertain remedial actions.Those actions were nottaken, and as a result thecommittee recommended tothe SECPS ExecutiveCommittee that the firm besanctioned. On December17, 2001 a Hearing Panel ofthe SECPS ExecutiveCommittee voted to expelthe firm from the Section,and to report that expulsionin The CPA Letter. OnFebruary 8, 2002 an AppealPanel upheld the decision ofthe Hearing Panel.

SEC Oversight of PeerReviews

Since 1982, the SECPS andthe Board have had a formal“Memorandum of Under-standing” with the SEC thatprovides it with access to thepeer review process and thePOB staff’s oversightprocedures. The purpose ofSEC oversight, as describedin the Memorandum, is toenable the SEC staff to makeits own independent evalua-tion of the peer reviewstandards, the effectivenessof the application of those

standards in assuring thequality of audits performedby those who practice beforethe SEC, and the effective-ness of the POB’s monitor-ing and oversight of the peerreview program. For the2000-2001 peer review year,the SEC staff visited theBoard’s offices and re-viewed the peer reviewreports, peer review workingpapers, and Board oversightfiles on the reviews of 38firms. The SEC staff alsoreviewed the Board’soversight files on the re-views of an additional 52firms.

In January 2002 the SECpublished its Annual Reportfor the year ended Septem-ber 30, 2001, which dis-cussed the SEC staff’soversight of the SECPS peerreview process and the POBoversight process. As wasthe case with the SEC’s 2000Annual Report and unlike incertain prior years, the SEC’s2001 Annual Report did notprovide an evaluation ofwhether the profession’speer review process is aneffective means of improv-ing the quality controlsystems of member firms.

Summary and Conclusions

The Board believes that thepeer review process contin-ues to contribute to improve-ments in the quality controlsystems of member firmsand to the quality of auditingperformed in the UnitedStates. The report of thePanel on Audit Effectivenesscontained many recommen-dations to improve theeffectiveness of peer re-views. Unfortunately, someof the major recommenda-tions have not been actedupon and others have beenrejected. By way of ex-ample, the Panel on AuditEffectiveness recommendedthat the SECPS should“[m]ake clear to peer reviewteam captains and reviewersthat the POB, not the firmbeing reviewed, is theprimary client. Peer reviewsare performed to enhancethe public’s confidence inindependent auditors; thePOB, as the public’s repre-sentative, should be viewedas the principal stakeholderin this process.” (Section


25

6.40 of the Panel on AuditEffectiveness Report andRecommendations datedAugust 31, 2000 at page148.) The PRC rejected thePanel’s recommendationsaying that the PRC, not thePOB, is responsible formaintaining and administer-ing the peer review program.The PRC did adopt a relatedPeer Review Process TaskForce recommendation toaddress the peer reviewreports to both the PRC andthe reviewed firm, but didnot adopt the recommenda-tion of the Panel that thePOB be the primary client ofpeer review.

In its White Paper, the POBrecommended that firm-on-

firm peer review be discon-tinued for firms that auditmore than 100 publiccorporations each year. In itsplace, employees of theproposed IIA would conductthorough and comprehen-sive yearly reviews of suchfirms.

The Panel on Audit Effec-tiveness recommended thatthe POB and its staff expandtheir oversight throughoutthe reviews of the largestfirms by attending importantmeetings and interviewswith firm personnel and byreviewing draft peer reviewreports before they areprovided to others. Notwith-standing the increasedinvolvement that the POBand its staff had in their

oversight of the reviews ofthe largest firms, there wereoccasions when discussionsof the preliminary engage-ment findings between thereviewers and engagementpersonnel preceded POBstaff involvement. In addi-tion, the drafts of somereports were discussed withthe reviewed firms beforethey were provided to thePOB.

Table I–Major Corrective Actions Imposed bythe Peer Review Committee to Ensure thatQuality Control Deficiencies are Corrected

Number of Actions

12 Months SinceEnded Inception

Action 6/30/01 (1978)

Accelerated peer review 1 55

Employment of an outside consultant to performpreissuance reviews of financial statements or otherspecified procedures 19 137

Oversight by the peer reviewers or by aPeer Review Committee member to monitor progressmade by the firm in implementing corrective actions 17 251

Oversight of the firm’s internal monitoring program 38 476

Changes made in the firm’s quality control document orother guidance materials 7 51

Continuing professional education in specified areas 21 92*

* Since July 1, 1988, as data for prior years are no longer available.


26

QualityControlInquiryProcess

The Quality Control Inquiry

Committee ascertains whether

allegations of audit failures

against member firms involving

SEC registrants and certain

other entities indicate (a) a need

for the respective firms to take

specific corrective actions to

improve their quality control

systems, or (b) profession-wide

issues that need to be addressed.

The QCIC’s inquiry is suffi-

ciently detailed to determine

whether there are possible

performance issues that the

reporting firms need to address.

The quality control inquiry

process is critical to the

profession’s self-regulatory

program and is a necessary

complement to the peer review

process.

Reporting of Cases

Member firms are requiredto report to the QCIC, withinthirty days of service, alllitigation alleging deficien-cies in the conduct of anaudit of the financial state-ments of a SEC registrant.Pursuant to its organizationaldocument, the QCIC alsomay identify a significantpublic interest in an allegedaudit failure that the memberfirm is otherwise not re-

quired to report. The com-mittee screens those allegedfailures, and if it determinesthat the allegations indicate apossible need for correctivemeasures by the memberfirm, the QCIC requests themember firm to voluntarilyreport the case. If a memberfirm refuses to do so, theSECPS Executive Commit-tee determines whether thecase should be added to theQCIC’s agenda.

This section reports on casesreported to and acted uponby QCIC from July 1, 2000through March 31, 2002.During that period, thecommittee screened twocases that would otherwisenot have been required to bereported. One involvedlitigation by the FDICagainst a member firmalleging an audit failure inthe audit of a bank. Theother involved litigationbrought by a state attorneygeneral against a memberfirm alleging an audit failurein the audit of a large not-for-profit entity. Both firmsvoluntarily reported thecases.

Oversight of the QualityControl Inquiry Process

The Board and its staff haveaccess to the QCIC processand actively participate inthe discussion of the impli-cations of the allegations ineach case that takes place atmeetings of the committee.For each case, the POB staffreviews the complaintssubmitted by the memberfirm, SEC Accounting andAuditing EnforcementReleases against companypersonnel and accountants,relevant financial statementsand regulatory filings, andother publicly availabledocuments. The Board’sstaff participated in virtuallyall QCIC task force meetings(99) with member firmsduring the period coveredby this report. The informa-tion obtained from participa-tion at those meetings andfrom reading the aforemen-tioned documents serves asthe basis for a comprehen-sive report prepared by thePOB staff on each case,which is discussed at aBoard meeting.

POB RE P O R T S ON

27

QCIC Activity

The QCIC began the periodwith 51 cases on its agenda.Ninety-six new cases wereopened during the period,and 95 cases were closed. AtMarch 31, 2002 there were52 open cases.

As part of its initial analysisof each case reported by amember firm, the QCICreviews the complaints,applicable financial state-ments and regulatory filings,and other relevant publicdocuments. During theperiod, the QCIC determinedthat there were no qualitycontrol or personnel issuesto pursue on 7 cases andclosed them after its initialanalysis.

For the other 88 cases thatwere closed, the QCIC taskforces met with firm repre-sentatives to gain an under-standing of the work per-formed in the areas ofalleged audit failure and thepotential implications for thefirm’s quality control poli-cies and procedures. Whereappropriate, the QCIC taskforces reviewed firm guid-ance materials and, onoccasion, selected engage-ment working papersrelevant to particular allega-tions.

Cooperation of Firmswith the QCIC

The QCIC monitors thetimeliness with whichmember firms report cases tothe committee. During theperiod, one Big 5 firmreported a number of caseslate. Senior management ofthe firm was informed, andthey have subsequentlyadvised the committee thatthe firm’s procedures forreporting complaints havebeen revised to ensure futuretimely reporting.

The committee advisedanother Big 5 firm that itspersonnel were not suffi-ciently prepared to respondto the committee’s inquiries,and as a result it was neces-sary to have more than onemeeting for a number of thatfirm’s cases. The firm’sgeneral counsel was in-formed and a liaison auditpartner met with the QCICand POB staffs in an effort tounderstand the committee’sconcerns. It appears that thisfirm is working to improveits communications withQCIC’s task forces.

Enron

As noted earlier under “POBActions Relating To EnronCollapse,” the Board wroteto the QCIC requesting thatit review the performance of

Andersen, the audit partners,and other senior members ofthe audit engagement teamon Enron as soon as possibleto determine if the factsindicate deficiencies inAndersen’s system of qualitycontrols or its performanceon the audits. The POBsuggested that particularattention be given to off-balance sheet financing andenergy trading contracts,among other matters. TheBoard also requested that theQCIC inquire about discus-sions between Andersen andEnron’s audit committeeconcerning Andersen’sevaluation of the criticalaccounting policies used inEnron’s financial statementsand the implications forauditor independence of thenon-audit services providedto the company.

The QCIC has assigned atask force to the case, onemember of which partici-pated in the firm-wide exitconference for Andersen’s2001 peer review in Decem-ber 2001, at which D&Treported the results of itsexpanded peer review toAndersen management. TheQCIC also has forwarded theBoard’s letter to Andersen.The QCIC staff has analyzedthe allegations in the manycomplaints filed to datealleging audit failure. Ameeting with Andersenrepresentatives is plannedfor a future date.

POB RE P O R T S ON QU A L I T Y CO N T R O L I N Q U I R Y PR O C E S S

28

The QCIC considered a casein which the registrantchanged its method ofevaluating certain reservesand recorded a significantincrease in those reserves.The auditor concluded thatthis was a change in estimatethat did not require anexplanatory paragraph in itsreport. The committeequestioned whether thereport should have had anexplanatory paragraphdisclosing a change inaccounting principle insepa-rable from a change inestimate. The QCIC con-ducted a survey of the BigFive firms and only onewould have included anexplanatory paragraph in itsreport. Consequently, theQCIC asked the ASB toconsider this issue. The ASBplans to do so.

The committee noted thatadditional audit guidancealso is needed in the area ofalternative procedures to theconfirmation of receivablesarising from the sale ofsoftware licenses, whenconfirmations are notreceived from customers ordistributors. For example, analternative proceduretypically applied is theexamination of shippingdocuments; however,shipping documents do not

exist for the sale of softwarelicenses. The QCIC plans todiscuss this matter with thechair of the ASB at its May2002 meeting.

The QCIC noted a lack ofuniformity among firms inidentifying and communicat-ing certain internal controlmatters that are defined inthe professional literature as“reportable conditions.” TheQCIC also plans to discussthis matter with the ASBchair.

The QCIC believes thatadditional guidance isnecessary for auditorsperforming interim reviewsin situations where a client’sinternal control system isweak and, accordingly,plans to ask the ASB to giveconsideration to this issueduring its re-evaluation ofSAS 71, Interim FinancialInformation.

Consultation with IndustrySpecialists

The Panel on Audit Effec-tiveness recommended thatthe QCIC establish a panelof industry specialists andexperts, whose memberswould be drawn from theprofession and industry, toconsult with it as required.


Communications withStandards Settersand the PITF

The Panel on Audit Effec-tiveness recommended thatthe QCIC bring its consider-able experience to bear inassisting the AuditingStandards Board in improv-ing auditing standards andother guidance to auditorsregarding fraud detection.The QCIC formed a taskforce that met with the ASB’sFraud Task Force as itprepared the Exposure Draftof a proposed Statement onAuditing Standards (SAS),Consideration of Fraud in aFinancial Statement Audit,which is discussed else-where in this report. Thechair of the ASB’s FraudTask Force also met with theQCIC to discuss proposedprocedures to facilitate thedetection of fraud byauditors.

At the QCIC’s February2002 meeting, the commit-tee decided that the QCICtask force should commenton the Exposure Draft. TheASB Chair plans to attendthe QCIC’s May 2002meeting to discuss this andother matters.

29

Statistical Summary ofClosed Case Questionnaires

The QCIC has established adatabase of informationabout litigation and enforce-ment actions against auditorsto identify problem areasand trends. The databaseincludes information on allcases closed since 1999 and,to the extent information isavailable, on other casesclosed since December1997. It does not identifyeither the registrant or theauditor.

A report, QCIC Summary ofClosed Case Questionnaires,which summarizes informa-tion on 177 cases, wasdistributed to all SECPSmember firms. In 57 cases,the QCIC recommended thatthe Ethics Division eitheropen an investigation orevaluate whether to openone. The QCIC notedindications of managementfraud in 65 cases; neverthe-less, in 34 of these cases, thecommittee questioned theadequacy of the auditors’performance.


Each QCIC member com-pletes a form indicating hisor her industry and func-tional knowledge. Thisinventory is used as the basisfor assigning members tocases and for identifyingmembers who might serveas consultation resources.

In addition, the QCIC looksto the largest firms toprovide consultation onindustry or functional (e.g.,derivative valuation) issues.The committee concludedthat the consultation knowl-edge the QCIC needs can befound within the firms.

Referral of Individuals to theProfessional Ethics Division

In 1998 the QCIC and theProfessional Ethics Divisiondeveloped a Memorandumof Understanding to avoidduplication of efforts and tostreamline the ethics process.Prior to the Memorandum,the Ethics Division openedan investigation in themajority of cases that QCICclosed. The 1998 agreementbetween the two committeeswas designed to focus theEthics Division’s efforts bycategorizing each case theQCIC closes into one of fourcategories, ranging fromfrivolous with a recommen-dation for no action by the

Division with respect toengagement personnel to anexplicit recommendationthat the Division open aninvestigation.

Since July 1, 2000, theQCIC informed the Divisionof 16 cases in which itbelieved there may besignificant engagementpersonnel issues and recom-mended that the Divisiondetermine whether or not toopen an investigation. TheDivision has reviewed all ofthese cases and decided toopen investigations in 15 ofthem. In addition, the QCICrecommended to the Divi-sion that an investigation beinitiated in 12 other cases;the Division opened investi-gations for each of thosecases.

The QCIC also becomesaware of CPAs who areemployed by companies thatare audited by member firmsand whose behavior maywarrant investigation. Duringthe period, the QCIC re-ferred 19 such CPAs,principally chief financialofficers and other account-ing officers, to the EthicsDivision, which openedcases on those individualswho were AICPA members.

30

Registrants in the computerhardware and softwareindustry and other high-techcompanies represented 30%of the cases. Other observa-tions included: (1) 60% ofthe cases involved compa-nies with revenue of lessthan $200 million, (2) 40%of the cases involvedcompanies whose initialpublic offering was withinthe three years preceding thelitigation, (3) 36% of thecases involved restatedfinancial statements, and (4)18% involved a change inauditors during the threeyears prior to the periodcovered by the complaint.

Implementation of NewSelf-Disciplinary MembershipRequirement

A new self-disciplinarymembership requirementwas implemented for casesreported to the QCIC afterJanuary 1, 2001. When theQCIC has concerns aboutthe performance of indi-vidual auditors, it refers thecase to the ProfessionalEthics Division to determinewhether or not individualperformance-specific issueswarrant investigation. TheDivision defers its investiga-tion, however, until alllitigation is concluded, with

deferral often extendingseveral years. The newrequirement is designed toprotect the public frompossible substandard perfor-mance during the periodbetween the referral to theDivision and the conclusionof the Division’s investiga-tion.

Once the deferral takesplace, the member firm mustselect one of three optionswith respect to the auditengagement partner (andsometimes other members ofthe engagement team). Theimplementation of the optionthe member firm selects issubject to review during themember firm’s peer reviewand by the POB. The optionsare:

■ Terminate or retire theindividual from the memberfirm.

■ Remove the individual fromperforming or supervisingaudits of public companies

until the Division’s ethicsenforcement process iscomplete.

■ Subject the individual toadditional oversight on allaudits of public companies

in which the individual isinvolved.

Since January 1, 2001, theeffective date of the newmembership requirement,the QCIC closed 23 cases, ofwhich three were subject tothe requirement, and theDivision decided to investi-gate them at the suggestionof the QCIC. One firm haselected the second optionand another firm has electedthe third option. The firminvolved in the third case hasnot yet elected an option;however, the engagementpartners on the audit inquestion are not presentlyserving as engagementpartners.

This new membershiprequirement has increasedsignificantly the importanceof the QCIC’s evaluation ofthe performance of person-nel involved in alleged auditfailures. The Board supportsthe QCIC’s role in thedisciplinary process, andrecognizes the potentialeffects on the careers ofindividual engagementpartners. The POB believesthat the committee has beendiligent in discharging thisnew responsibility.


31

Table II– QCIC ActivityInception

12 Months 9 Months (11/1/79)ended ended through

6/30/01 3/31/02 3/31/02

Actions Related to FirmsEither a special review was made, the firm’sregularly scheduled peer review was expanded,or other relevant work was inspected 8 1 85

A firm took appropriate corrective measuresthat were responsive to the implications of thespecific case 11 6 152

Actions Related to StandardsAppropriate AICPA technical bodies were askedto consider the need for changes in, or guidance on,professional standards 1 3 54

The Professional Issues Task Force was asked toconsider the issuance of a Practice Alert 2 - 28

Actions Related to IndividualsCases opened by the AICPA Professional EthicsDivision as a result of QCIC’s concern about theperformance of senior audit personnel 19 8 96

41 18 415

(Note: Frequently more than one action is taken by the QCIC or by the firm on an individual case.)

SEC Access to the QCICProcess

As part of its responsibilitiesfor oversight of the account-ing profession, the SECactively monitors the QCICprocess. After each QCICmeeting, the SEC staff visitsthe POB’s offices to reviewthe SECPS’s and the POB’sclosed-case files and todiscuss them with the QCICand POB staffs. The ChiefAccountant of the SECparticipated in a recent SECoversight visit and has beeninvited to attend a portion ofthe QCIC’s May 2002meeting.


The Board believes that theQCIC process is functioningas designed and effectivelycomplements the peerreview process. The Boardbelieves the recent revisionsto the self-disciplinaryprocess are in the publicinterest and commends theQCIC for the work theyhave done this year. TheQCIC process is valuable inidentifying needed improve-ments to the firms’ qualitycontrol systems and areaswhere the profession would

benefit from additionalstandards or guidance.

We note that the QCIC doesnot meet with the individualswho conducted the allegedlydeficient audit, and onlyoccasionally reviews workpapers. The committee’sratings are based largely onthe review of publiclyavailable information andinquiries of firm personnelwho have reviewed the audit(and other audits performedby members of the engage-ment team on the allegedlydeficient audit) so they canrespond to the committee’sinquiries.

In its White Paper, the POBhas recommended that theproposed IIA be given theprivilege of confidentialityas well as the power ofsubpoena to compel testi-mony and produce docu-ments. This would allowinvestigators to interviewindividuals who conductedthe allegedly deficient auditand obtain relevant workpapers.


32

TheAuditingStandardsBoard

POB RE P O R T S ON

The Auditing StandardsBoard promulgates auditing,attestation, and qualitycontrol standards to beobserved by members of theAICPA in accordance withits Bylaws and Code ofProfessional Conduct. TheASB is composed of 15members, including repre-sentatives from international,national, regional, and localfirms, as well as representa-tives from accountingeducation and state govern-ment. The POB’s Charter,adopted in February 2001,expanded the POB’s over-sight authority to include theASB. This oversight in-cludes:

■ Consulting with the AICPA

Board of Directors on new

ASB member nominations

and concurrence with

nominations for the ASB

chair.

■ Attending ASB meetings.

■ Evaluating the implementa-

tion of ASB standards

through the peer review

process.

■ Recommending issues for

consideration for inclusion

on the agenda of the ASB.

■ Evaluating the effectiveness

of the ASB and the ad-

equacy of its resources.

POB Oversight of the ASB’sProcess of Setting AuditingStandards

During 2001 the Board andits staff initiated their over-sight of the ASB. The POB’sprimary concern in itsoversight role is that theprocess of setting auditingstandards is one that pro-motes the public interest byimproving the way thataudits are performed andincreasing the reliability andcredibility of financialstatements.

A POB member reviewedinformation about thequalifications and experi-ence of the five individualsnominated in 2001 formembership on the ASB andconsulted with the AICPAabout them. Members for theASB’s 2001-2002 yearinclude one representativefrom each of the eightlargest accounting firms, fivefrom local or regional firms,one from academia, and onefrom government. The chaircontinued in his second yearin that role.

A Board member and staffattended all meetings of theASB and had the privilegeof the floor to comment andraise questions. A staffmember also attended andparticipated in selected

meetings of ASB task forces,including the:

■ Audit Issues Task Force,whose activities includeoverseeing the ASB’s

planning process.

■ Fraud Task Force, which hasdeveloped proposals for an

auditor’s consideration offraud in a financial state-ment audit.

■ SAS No. 71 Task Force,which is revising standardsfor reviews of interim

financial information.

A staff member also at-tended liaison meetings ofthe ASB with the SEC andthe FASB.

The ASB advises the POB ofits agenda and providescopies of all documents tobe discussed at the meetings.The POB has full access toASB members, including thechair, as well as the AICPAAudit and Attest Standardsstaff to discuss draft docu-ments and offer commentsand suggestions. The POBalso has the opportunity tointeract with the ASBmembers and the AICPAstaff to aid in its evaluations.

We have reported separatelyon the status of responses tothe recommendations of thePanel on Audit Effective-ness, many of which wereaddressed to the ASB. TheASB has devoted significantattention to the recommen-

33

POB RE P O R T S ON TH E A U D I T I N G STA N D A R D S B O A R D

dations and its agenda hasreflected responses to manyof them. Our oversightincludes monitoring theASB’s responses.

Enron

On January 17, 2002, theBoard communicated to thechairs of both the QCIC andthe ASB issues requiringtheir attention relating toalleged deficiencies in theaudits of Enron’s financialstatements. (See “POBActions Related to EnronCollapse” in this report forfurther discussion of thosecommunications.)

New Standards

Since our oversight began,the ASB has issued thefollowing new standards:

■ SAS No. 94, The Effect of

Information Technology on

the Auditor’s Consideration

of Internal Control in a

Financial Statement Audit,

which expands existingstandards to provideguidance to auditors about

the effects of informationtechnology on internalcontrol and the assessment

of control risk.

■ SAS No. 95, Generally

Accepted Auditing Stan-

dards, which establishes ahierarchy of auditingliterature by identifying the

body of literature andclarifying the authority of its

various components, therebyreducing uncertainty aboutthose publications with

which the auditor mustcomply.

■ SAS No. 96, Audit Documen-

tation, which replaces a priorSAS on working papers withmore specific guidance and

requirements designed toimprove the quality of auditdocumentation.

Proposed Fraud Standard

In February 2002 the ASBissued an exposure draft of aproposed SAS, Consider-ation of Fraud in a FinancialStatement Audit. Thisproposal would establishstandards and provideguidance to auditors infulfilling their responsibilitiesas they relate to fraud.

The proposed SAS, whichexpands the current guid-ance in SAS No. 82, isintended to effect a substan-tial change in auditors’performance, therebyimproving the likelihood thatthey will detect materialmisstatements due to fraud.The proposal increases thefocus on professionalskepticism. Auditors wouldset aside any prior beliefsthey may have aboutmanagement’s honesty andintegrity when considering

the possibility of fraud, andshould not be satisfied withaudit evidence that is lessthan persuasive because of abelief that management ishonest.

Auditors would plan re-sponses to identified risks ofmaterial misstatement due tofraud, which, in the audits ofmost public companies,would include revenuerecognition. Responding inpart to the risk of manage-ment override of controls,the proposal also specifiesother audit procedures thatwould be applied in the auditof every public company.

If adopted, the proposalwould be effective for auditsof financial statements forperiods beginning on or afterDecember 15, 2002.

Other Publications

Since the POB’s oversightbegan, the ASB has issuedor reviewed a variety ofother documents issued bythe AICPA, including threeinterpretations of the SASs,two Statements of Position,and four Audit Guides.

International Projects

The ASB has undertakenseveral steps to help con-verge national and interna-tional auditing standards.The ASB and the Interna-tional Auditing PracticesCommittee (IAPC) coordi-nate their activities by

attending each other’smeetings, forming jointcommittees, and observingand monitoring the activitiesof each other’s task forces.

In January 2002 the ASBissued an invitation tocomment on an IAPCproposal for auditing fairvalues, with the intent thatboth organizations will issuesimilar standards. The IAPCalso is monitoring closelythe progress of the ASB’sproposed fraud standard.

A major effort is underwayto review and amend thebasic audit risk model, underthe direction of the JointRisk Assessments TaskForce, a combined effort ofthe IAPC and the ASB. Thetask force is reviewing theauditor’s consideration of theaudit risk process, includingthe necessary understandingof the entity and its environ-ment, the entity’s response torisk, and how the auditorshould use risk assessmentsin planning audit proce-dures.


On the basis of our oversightactivities, we believe that (1)the ASB operated effectivelyin 2001, (2) the ASB mem-bers had the appropriatequalifications and performedprofessionally and diligently,and (3) the resources madeavailable to the ASB wereadequate.

34

THE ROAD TO REFORM

A White Paper From

The Public Oversight Board

On

Legislation to Create aNew Private Sector

Regulatory Structure for theAccounting Profession

35

Table of Contents

PAGE

INTRODUCTION 36

EXECUTIVE SUMMARY 36

A BRIEF HISTORY OF SELF-REGULATION 39

The Stock Market Crash of 1929 and Its Aftermath 39

The 1970s - Expansion of the Regulatory Structure 40

The 1980s and 1990s - Congressional Hearings and Legislation 41

Changes in the Practice and Culture of Accounting Firms 42

The SEC’s 1998 and 2000 Initiatives 43

The POB’s Role in the Voluntary Regulatory Structure 44

The Panel on Audit Effectiveness 45

EXPERIENCE WITH SELF-REGULATION 46

PROBLEMS WITH CURRENT SYSTEM OF SELF-REGULATION 46

Auditing Standards and Termination of the ISB 47

The Public Oversight Board Charter 47

Independence Reviews 48

The POB Decision to Terminate 49

THE POB PROPOSAL FOR REFORM 50

The Board 51

Standards and Interpretation 51

Annual and Special Reviews 53

Enforcement and Discipline 53

Funding and Staff 54

International Liaison 55

Continuing Professional Education 55

OTHER MATTERS AFFECTING THE PROFESSION 55

Auditor Independence 55

Auditor Rotation and Retention 57

Cooling Off Period 57

Audit Committees 58

Conflicts of Interest 58

Internal Controls 58

CONCLUSION 59

36

IntroductionOn January 20, 2002, the Public Oversight Board (POB) - created in 1977 to oversee the voluntaryself-regulatory structure for the accounting profession in the United States - voted to terminate its

existence not later than March 31, 2002. For the POB, this action was taken as a matter of conscienceand principle.

In a report prepared for the Senate Committee on Governmental Affairs in August 1980, the Securities

and Exchange Commission (SEC) pointed out that for a self-regulatory program for the accountingprofession to be successful, strong leadership from the POB is essential. The POB, wrote the SEC,“should serve as the conscience and critic of the self-regulatory effort.” The POB’s charter makes it

clear that it is independent and the purpose of its oversight activities is “to represent the publicinterest on all matters that may affect public confidence in the integrity, reliability and credibility ofthe audit process.”

At the time the POB was created, there were concerns that it might not be the right solution. John C.Burton, a distinguished professor of accounting at Columbia University and the chief accountant atthe SEC in 1977, warned in congressional testimony in 1978 that “it is highly doubtful that a part-

time group [POB] can either in fact or perception” provide an effective substitute for statutoryregulation.

Meanwhile, Harold M. Williams, who was chairman of the SEC at the time the current self-regulatory

system was being created in the late 1970s, warned in a speech in January 1978, that “[t]he effective-ness and credibility of the Public Oversight Board depends on its independence, including itswillingness to be critical when called for and its ability to make public its conclusions, recommenda-

tions, and criticisms.” Chairman Williams also made the point that an effective POB could only beeffective “if it is not impeded in performing its functions and responsibilities.”

Following its decision to terminate, the POB decided to prepare this paper to outline its proposals to

create a new regulatory structure for the accounting profession. These proposals stem from the POB’sextensive experience with the profession’s voluntary self-regulatory system, its knowledge ofproblems that confront that system, and its insights on the need for change. The primary purpose of

this paper is to present the case for legislative action creating an independent regulatory organiza-tion in the private sector.

The POB felt it would be helpful to provide a brief history of how the current regulatory structure

came into being; to discuss problems affecting the present regulatory structure; to provide the POB’sviews on enforcement, discipline, and several other issues facing the profession; and to discuss thePOB’s decision to terminate.

Executive SummaryOver the past two years, the POB has faced increasing obstacles that have impeded its ability to carry

out its oversight functions. As a consequence, the POB feels it must perform its role as “conscienceand critic” because events of recent months have demonstrated that the warnings of Dr. Burton andChairman Williams have come to pass.

Three events are noteworthy in how the POB has been frustrated in its ability to effectively carry outits responsibilities.

■ On May 3, 2000, the SEC Practice Section (SECPS) - an organization within the American

Institute of Certified Public Accountants (AICPA) - took the unprecedented step of notifying thePOB that it would refuse to pay for special reviews of public accounting firms. The special

37

reviews in question had been sought by the SEC to determine whether the firms had compliedwith SEC and professional independence standards. The decision of the SECPS to deny funding

to the POB was a serious blow to independent oversight of the accounting profession. MelvinLaird, the former congressman and Secretary of Defense, who served on the POB longer than anyother member, said that this was “the worst incident in my 17 years” on the POB.

■ Following the decision to cut off funding of the POB’s special reviews requested by the SEC, thelargest accounting firms - the Big 5 - agreed with the SEC that the POB should instead conductmore limited independence reviews of the large firms. Despite this agreement, the next 21 months

were marked by delay and lack of progress. The POB, in the end, was unable to conduct thereviews.

■ For years, the POB had carried out its oversight responsibilities under a set of bylaws adopted

after it was created in 1977. The POB felt that a formal charter would improve the independenceof the Board, and a charter was one of the primary recommendations in 2000 of the Panel onAudit Effectiveness, created by the POB at the request of the SEC. However, objections from the

AICPA and the Big 5 caused negotiations to drag on for more than a year. Ultimately, a newcharter took effect in February 2001.

When the POB voted to terminate its existence, the lack of progress in connection with the indepen-

dence reviews and the frustrations that stemmed from the funding cut off and slow negotiations overthe new charter all played a role. But the precipitating factor was the decision of the SEC to developa new regulatory structure in private talks with the AICPA and the Big 5 firms, with no consultation

with the POB. The SEC did not consult with the POB even though the POB had been established bythe AICPA, in consultation with the SEC, to protect the public interest.

When the POB initially learned of these talks, it asked to be included in the process and was prom-

ised that it would be consulted. That consultation never took place. In the end, the POB was simplyinformed - on the day of the announcement of the proposed new structure - that there was no contin-ued role for the POB in this structure, rendering it a “lame duck.” The POB determined that it could

not effectively oversee the activities of the accounting profession under the circumstances, and thatit would mislead the public to appear to do so. Furthermore, the POB was concerned that if it were tocontinue during an interim period before a new governance structure was in place, it would leave the

impression that the POB approved of the SEC proposal, which it did not. Thus, as a matter if prin-ciple, it voted to terminate its existence.

The Public Oversight Board strongly believes that a new regulatory structure for the accounting

profession is essential and that, to be effective, it must be based on the foundation of federal legisla-tion.

The Board recommends that Congress create a new Independent Institute of Accountancy - the IIA -

and center all regulation under its auspices. A seven-member board would run the Institute totallyindependent of the AICPA, the Big 5, and other firms. The chair and vice chair would be full timeemployees of the Institute; five other members would serve on a part time basis. All would be

appointed by a panel composed of the chair of the SEC, the chair of the Federal Reserve Board andthe Secretary of the Treasury. Once named, the chair of the IIA would join these three in naming othermembers of the board. Members of the IIA board could be removed only by a two-thirds vote of the

board itself.

The SEC would have oversight of the IIA, and the SEC’s Office of the Chief Accountant would be theliaison to the IIA.

38

Important functions of the Institute would include:

■ The IIA would exercise oversight for all standard setting for accounting, auditing, and indepen-

dence, and their interpretation. Accounting standards are just as important as auditing andindependence standards. For this reason, the POB believes the Financial Accounting StandardsBoard (FASB) should be brought under the umbrella of the IIA, which would take responsibility

for its oversight and funding.

■ Firm-on-firm peer review would be discontinued for firms that audit more than 100 publiccorporations each year. In its place, IIA employees would conduct comprehensive and thorough

yearly reviews of the annual internal inspections of such firms. Unlike peer review, no activitiesof a firm would be off limits to Institute reviewers and the process would produce informativepublic reports. Substantial staff resources to conduct these reviews will be needed.

In addition to the reviews, IIA employees would conduct special reviews, when warranted. Similarto those the SEC originally asked the POB to undertake, these reviews would take a systemic, in-depth look at a firm’s systems, policies, procedures, and operations. If necessary, such special

reviews would delve into questions affecting the firm’s compliance with applicable professionalstandards. As with the yearly reviews, reports of these special reviews would be public.

■ An Office of Enforcement and Discipline within the IIA would have full authority to investigate

allegations of wrongdoing by public accounting firms and their personnel. The POB recommendsgiving the IIA the privilege of confidentiality as well as the power of subpoena to compeltestimony and produce documents. Cases of alleged misconduct could be brought before hearing

examiners. When warranted, these examiners could recommend to the IIA board the imposition ofsanctions, ranging from fines to expulsion from the profession. Cases could be referred to theJustice Department for possible prosecution, or to the SEC, state boards of accountancy, or other

agencies, as appropriate.

■ Funding would be provided through fees imposed on public corporations in amounts sufficient tocover the costs of the Institute. The POB strongly believes that the funding mechanism must be

beyond the reach of the profession to prevent it from withholding necessary funds, as it did inMay of 2000.

■ The IIA would be charged with coordinating international liaison and overseeing continued

professional education for those in the profession.

Beyond these functions, the POB recommends that:

■ With regard to non-audit services for audit clients, the POB recognizes that there has been

disagreement on restricting scope of services and that various models have been suggested forwhat should be allowed and what should be excluded.

The POB strongly agrees with a point made in President Bush’s 10-point reform plan that “Inves-

tors should have complete confidence in the independence and integrity of companies’ auditors.”The specifics on the President’s plan recognize the importance of prohibiting certain non-auditservices in order to safeguard auditor independence.

The POB takes note of a statement issued by the AICPA on February 1, 2002, in which it affirmedthat it “will not oppose federal legislation restricting the scope of services that accountants mayprovide their public audit clients, specifically in information technology and internal audit

design and implementation.”

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Against this background, the POB proposes that SEC regulations concerning independence belegislatively codified with appropriate revisions to update restrictions on scope of services

involving information technology and internal audit services as noted above. At the same time,the POB believes such legislation should affirm that tax work not involving advocacy and attestwork by audit firms in connection with SEC registration and other SEC filings be allowed. The

POB also believes that small public businesses, to be defined by the SEC, should not be subjectto any restriction on non-audit services for audit clients. Further, with respect to non-publiccorporations, it is the POB’s position that such corporations and the accounting firms that audit

them should not be subject to any restriction on non-audit services. We expressly emphasize thisto avoid misunderstanding and any consequences to small business and small audit firms.

The IIA Office of Standards should be empowered by legislation to promulgate appropriate rules

affecting independence to cover changing circumstances.

The POB believes there should be no prohibition against an audit firm offering non-audit servicesto non-audit clients.

■ Auditors should be rotated every seven years. As a corollary, public corporations would beprohibited from firing auditors during their term of service unless such action is determined bythe audit committee to be in the best interest of shareholders, with prompt notice to the IIA and

the SEC. Such action would be required to be publicly disclosed by corporations in currentreports and proxy statements filed with the SEC.

■ Engagement and other partners who are associated with an audit should be prohibited from taking

employment with the affected firm until a two-year “cooling off” period has expired.

■ The Institute should expand on the recommendations of the recent Blue Ribbon Committeewhich made it clear that the external auditor should be accountable to a firm’s board of directors

and its audit committee and not to management. Specifically, the audit committee should takefull responsibility for hiring, evaluating, and - if necessary - terminating an audit firm.

■ To discourage conflicts of interest involving public corporations, Congress should amend the

Securities Exchange Act of 1934 to require more meaningful and timely disclosure of relatedparty transactions among officers, directors, or other affiliated persons and the public corporation.Such disclosures should be made promptly in current reports as well as in proxy statements filed

with the SEC.

■ Management of public corporations should be required to prepare an annual statement ofcompliance with internal controls to be filed with the SEC. The corporation’s chief financial

officer and chief executive officer should sign this attestation and the auditor should review it.An auditor’s review and report on the effectiveness of internal controls would - as the GeneralAccounting Office (GAO) found in a 1996 report - improve “the auditor’s ability to provide more

relevant and timely assurances on the quality of data beyond that contained in traditionalfinancial statements and disclosures.” Both the POB and the AICPA supported the recommenda-tion when the GAO made it, but the SEC did not adopt it.

A Brief History of Self-RegulationThe Stock Market Crash of 1929 and Its Aftermath

The 1929 crash revealed a general absence of accounting and auditing standards, thereby permittingpublic companies to report financial position and results of operations that sometimes bore little

relation to economic reality. The crash and ensuing depression led to congressional hearings, whichin turn led to several pieces of reform legislation, beginning with the Securities Act of 1933 and the

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Securities Exchange Act of 1934. The Public Utility Holding Company Act of 1935, the TrustIndenture Act of 1939, and the Investment Company Act and Investment Advisers Act of 1940

followed. These acts require, or permit the SEC to require, as the SEC summarized in 1994, “thatfinancial statements filed with the Commission by public companies, investment companies, broker/dealers, public utilities, investment advisors, and others, be certified (or audited) by independent

accountants.”

Although audits of public corporations were common before the federal securities acts of 1933 and1934, they had not been required by statute. Beginning in April 1932, the New York Stock Exchange

(NYSE) requested corporations applying for listing to agree to have their annual financial statementsaudited by independent accountants.

The 1929 market crash revealed improper accounting practices at large public companies that had

become bankrupt. In 1939, the AICPA’s Committee on Accounting Procedure issued the first Ac-counting Research Bulletin and the AICPA’s Committee on Auditing Procedure issued the firstStatement on Auditing Procedure. At present, accounting standards are issued by FASB, auditing

standards are issued by the AICPA’s Auditing Standards Board (ASB), and interpretations of the Codeof Professional Conduct are issued by the AICPA’s Professional Ethics Executive Committee - all ofwhich are private sector bodies.

The 1970s - Expansion of the Regulatory Structure

The major reforms of the 1930s and the regulatory system they created survived for more than 40years with only minor modifications. That the regulation of the accounting profession remained

unchanged for so long may be attributed in part to the relatively few allegations of audit failuresduring most of that period, at least in comparison with later years.

To this day, the responsibility for promulgating auditing and ethical standards resides within the

AICPA. The AICPA also was responsible for promulgating accounting standards until mid-1973through its Committee on Accounting Procedure and its successor body, the Accounting PrinciplesBoard. Both of those committees were comprised principally of practicing auditors, often those who

were responsible for their firms’ accounting policies. In 1973, responsibility for promulgatingaccounting standards passed to FASB in the belief that the setting of accounting standards by anindependent body with no ties to either auditors or preparers of financial statements would enhance

the public’s confidence in the financial reporting process. At the same time, the Financial AccountingFoundation was created to raise funds for FASB, among other tasks, and a Financial AccountingStandards Advisory Council was created to advise FASB on its agenda and deliberations. That

structure remains largely unchanged today.

A series of cases involving alleged audit failures in the 1970s led the AICPA to create the Commis-sion on Auditors’ Responsibilities, chaired by Manuel F. Cohen, a former chairman of the SEC. Those

cases involved fraudulent financial reporting and illegal or questionable corporate acts, such asbribes, political payoffs, and kickbacks. The Cohen Commission’s Report, Conclusions, and Recom-

mendations issued in 1978 made numerous recommendations to improve audit practice in several

areas. Those recommendations led to the promulgation of Statements on Auditing Standards (SAS)that increased the auditor’s responsibility to detect and report fraudulent financial reporting andillegal acts by corporate management. Several other auditing standards can be traced either to Cohen

Commission recommendations or to specific audit failures and the litigation that they spawned.

The same cases that spawned the Cohen Commission also led to hearings by both the Senate andHouse of Representatives in 1977 and 1978. In particular, the Senate’s Subcommittee on Reports,

Accounting, and Management of the Committee on Government Operations (the Metcalf subcommit-

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tee) held hearings to determine whether additional governmental regulation of the accountingprofession was necessary or a system of professional self-regulation was sufficient.

In response to these hearings, the AICPA, in consultation with the SEC, created a voluntary self-regulatory framework consisting of the SEC Practice Section (SECPS) of the Division for CPA Firms,with an independent POB to oversee the activities of the Practice Section and to monitor and

comment on matters that affect the public interest in the integrity of the audit process - a structurethat exists to this day. While no additional governmental regulation was imposed once the voluntaryself-regulatory system was created in the 1970s, Congress did pass the Foreign Corrupt Practices Act

(FCPA) in 1977, following Senate hearings which revealed the payment of bribes by Americancorporations to foreign officials. The FCPA made it clear that bribery of foreign officials by Americancompanies is an unacceptable and illegal practice. The act required SEC registrants to maintain a

system of internal accounting controls to provide reasonable assurance that certain objectives wouldbe achieved. For example, transactions must be executed consistent with management authorizationand be recorded to permit preparation of financial statements in conformity with generally accepted

accounting principles and to maintain accountability for assets. In addition, the FCPA requiredpublic corporations to make and keep books and records which, in reasonable detail, accurately andfairly reflect underlying transactions.

The 1980s and 1990s - Congressional Hearings and Legislation

As noted in a September 1996 report of the GAO, The Accounting Profession - Major Issues: Progress

and Concerns, “In the 1980s, continued business failures, particularly those involving financial

institutions, led to a series of congressional hearings on auditing and financial reporting under thefederal securities laws.” Two major pieces of legislation resulted from those hearings: the FederalDeposit Insurance Corporation Improvement Act of 1991 (FDICIA) and the Private Securities

Litigation Reform Act of 1995. While those laws increased responsibilities for auditors, they did notaddress the regulatory structure of the accounting profession.

FDICIA added Section 36 to the Federal Deposit Insurance Act to provide early identification of

needed improvement in financial management at banks and savings and loan institutions.Management’s responsibilities under regulations implementing Section 36, which apply to institu-tions with total assets of $500 million or more, include reporting on management’s responsibility for

and assessment of the effectiveness of the institution’s internal controls over financial reporting.Each institution is required to have an audit committee composed of outside directors independentof management. Audit committees of institutions with $3 billion or more in assets must include

members with relevant banking or financial expertise, have access to their own outside counsel, andexclude large customers. Under Section 36, the independent accountant must examine and report onmanagement’s assertions about the institution’s internal controls over financial reporting, using the

AICPA attestation standards. This requirement constitutes one of the few statutory or regulatoryrequirements that independent auditors report publicly on client internal controls.

The Private Securities Litigation Reform Act of 1995 addressed the concerns of Congress and

regulators about auditors’ responsibilities with respect to their clients’ compliance with laws andregulations and about how instances of noncompliance were reported. Those concerns led toinclusion in the act of a requirement that auditors of public companies notify the SEC of material

illegal acts when an entity’s management and board of directors have failed to take timely andappropriate remedial action.

The 1996 GAO report, which was commissioned by Rep. John Dingell (D-Mich.), the ranking

minority member of the House Committee on Energy and Commerce, identified five major issuesdiscussed in the various studies concerning the accounting profession from 1972 through 1995: (1)auditor independence, (2) auditor responsibilities for fraud and internal controls, (3) audit quality, (4)

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the accounting and auditing standard-setting processes and the effectiveness of financial reporting,and (5) the role of the auditor in the further enhancement of financial reporting.

The report summarized the results of these reviews as follows:

GAO’s analysis of the actions taken by the accounting profession in response to the majorissues raised by the many studies from 1972 through 1995 shows that the profession has been

responsive in making changes to improve financial reporting and auditing of public compa-nies. Further, GAO’s analysis of statistical data on the results of peer reviews of accountingfirms that audit public companies registered with the SEC shows that most firms now have

effective quality control programs to ensure adherence with professional standards. How-ever, GAO’s review of the studies’ findings shows that the actions of the accounting profes-sion have not been totally effective in resolving several major issues. Issues remain about

auditor independence, auditor responsibility for detecting fraud and reporting on internalcontrols, public participation in standard setting, the timeliness and relevancy of accountingstandards, and maintaining the independence of FASB.

While the profession and the SEC subsequently have addressed several of the issues that the GAOreview identified as being unresolved in 1996, a number of them, such as reporting on internalcontrols, remain unresolved in 2002.

Changes in the Practice and Culture of Accounting Firms

The business model that describes the practice of the large accounting firms - a wide array of finan-cial services performed both domestically and internationally for both audit clients and others - has

existed for many years.

Each of the large public accounting firms provide accounting and auditing services, tax services, andmanagement consulting services, and the largest firms provide those services globally through

overseas offices and foreign affiliates. These characteristics have existed for decades. As the CohenCommission noted in 1978:

Before independent audits became widespread in the United States, public accountants were

already performing a variety of other services. Public accountants in the early 1900s offeredadvice on accounting systems, kept accounting records, prepared financial statements andtax returns, and performed a variety of consulting services, including appraisals.

The Cohen Commission also noted that “large corporations typically operate at a number of differentlocations. A public accounting firm must provide services at many places throughout the country andthe world.” The Panel on Audit Effectiveness, citing SEC data, noted in its 2000 report that:

the number of foreign companies that have registered securities in the United States hasalmost tripled since 1990. . . . The securities of many U.S. companies registered with the SECare traded outside of the United States, and the financial statements of those companies may

be filed with non-U.S. regulators. The financial statements of many U.S. companies andforeign companies are available to investors or creditors in numerous countries, irrespectiveof the jurisdiction that regulates such companies.

While multi-faceted practices of the international accounting firms described above have existed formany years, the extent to which non-audit services are provided to audit clients and the globaliza-tion of the profession have changed over the years. Superimposed on the growth of non-audit

services and globalization is the high level of competition among the firms for audit clients in recentyears that many believe has changed the culture of auditing practice.

Certain non-audit services provided to audit clients - particularly the design and implementation of

large integrated information systems and internal audit and valuation services - have long raised

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concerns about both the fact and the appearance of auditor independence, and thus about the qualityof audits. The size of the fees from those services in many cases and their relationship to the amount

of audit fees from the same client has added to those concerns. Similar concerns about audit qualityare a natural result of a firm’s international practice in countries that do not have the same level ofaccounting, auditing, and quality control standards as the United States. Lastly, some fear that

excessive competition for audit clients has driven audit fees down to a level that cannot support aquality audit but that serves primarily to provide the firm with “a foot in the door” for marketingother services.

Some have suggested that an increasing appetite for growth and profits is now driving the “culture”and “tone” of most accounting firms. Accounting firms sometimes seem to view their clients - eventheir audit clients - as “business partners.” There are also those who contend that audits are some-

times used as “loss leaders” to build a relationship with a client for the marketing of the accountingfirm’s non-audit services.

One can question whether, together with the natural reluctance to lose the audit fee, a diminished

professionalism makes it more difficult for a firm to reject a client’s proposed accounting treatment.There seems to be little doubt that the forces described in this section as presenting challenges toaudit quality were present in several of the widely publicized recent business and audit failures. And

that, in turn, suggests the need for additional regulation of the profession and a degree of oversightthat significantly exceeds what exists at present.

The SEC’s 1998 and 2000 Initiatives

In a September 1998 speech at the New York University (NYU) Center for Law and Business, SECChairman Arthur Levitt noted that “qualified, committed, independent and tough-minded auditcommittees represent the most reliable guardians of the public interest.” He announced that the

NYSE and the National Association of Securities Dealers had agreed to sponsor a “blue-ribbon”panel to develop recommendations “to empower audit committees and function as the ultimateguardian of investor interests and corporate accountability.” The committee’s report was issued in

February 1999.

The SEC responded with new disclosure rules in December 1999. Among them is the requirementthat a report by the audit committee be included in the company’s proxy statement, indicating

whether the audit committee has, among other things:

■ reviewed and discussed the audited financial statements with management;

■ discussed with the independent auditors the matters required to be discussed by auditing stan-

dards (which includes the quality of the accounting principles and underlying estimates reflectedin the financial statements); and

■ discussed with the auditors their independence.

In addition, the SEC adopted a rule requiring that independent accountants review a company’sinterim financial information before the company’s quarterly report is filed.

The major stock exchanges also responded to the committee’s recommendations by enacting rules

covering the independence, qualifications, and composition of audit committees, including arequirement that committee members be financially literate. The exchanges further required that theaudit committee adopt a formal written charter approved by the board of directors; the exchanges

also specified that the charter should contain minimum audit committee responsibilities.

Also in 1999, the Independence Standards Board (ISB) adopted Independence Standard No. 1,Independence Discussions with Audit Committees. The standard requires that, at least annually, an

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auditor intending to be considered an independent accountant with respect to a specific entity underthe federal securities acts shall:

a. disclose to the audit committee of the company (or the board of directors if there is no auditcommittee), in writing, all relationships between the auditor and its related entities and thecompany and its related entities that in the auditor’s professional judgment may reasonably be

thought to bear on independence;

b. confirm in the letter that, in its professional judgment, it is independent of the company withinthe meaning of the Acts; and

c. discuss the auditor’s independence with the audit committee.

In his 1998 NYU remarks, Chairman Levitt also proposed that “the Public Oversight Board form agroup of all the major constituencies to review the way audits are performed and assess the impact of

recent trends on the public interest.” In response, the POB formed the Panel on Audit Effectiveness.Its report and recommendations, issued in August 2000, are discussed below.

In November 2000, the SEC adopted amendments to its auditor independence rules. These amend-

ments to the independence requirements placed limits on certain services, particularly informationtechnology and internal audit services, that accounting firms may provide to their audit clientswithout impairing their independence. In those two areas in particular, the final independence rule

was not as restrictive as the rule originally proposed - it did not completely prohibit auditors fromproviding them to their audit clients. In early 2002, in apparent response to concerns emanating fromthe Enron collapse, the five largest accounting firms announced their intent to no longer provide any

internal audit or certain information technology services to their audit clients.

The release containing the SEC’s revised independence rules noted the risk of compromised indepen-dence when a former partner, principal, stockholder, or professional employee of an accounting firm

is hired by an audit client of the firm. Accordingly, under the Commission’s final rule, as under thethen existing requirements, an auditor’s independence is impaired when such an individual isemployed in an accounting or financial oversight role at an audit client, unless certain conditions are

met. Both the SEC and the ISB considered the notion of a mandatory “cooling off” period beforeaccounting firm personnel join an audit client. Neither body adopted it because of concerns it wouldunnecessarily restrict the employment opportunities of former firm professionals.

The POB’s Role in the Voluntary Regulatory Structure

As previously noted, the POB is a private sector body - independent of the accounting firms, theAICPA, and the SEC - that was created in 1977 by the AICPA in consultation with the SEC for the

purpose of overseeing and reporting on the self-regulatory programs of the SECPS.

In addition to its ongoing monitoring and oversight responsibilities, the POB has undertaken orcommissioned special studies and reviews over the years. The reports emanating from them have had

a significant effect on regulation of the accounting profession and the quality of audits. The follow-ing are examples of these reports:

■ In the Public Interest: Issues Confronting the Accounting Profession, which contained recommen-

dations designed to enhance the usefulness and reliability of financial statements, strengthen theperformance and professionalism of auditors, and improve self-regulation (1993).

■ Strengthening the Professionalism of the Independent Auditor, which contained recommenda-

tions in the areas of auditor independence, involvement of audit committees and boards ofdirectors with independent auditors, litigation reform, and the relationships among the account-ing profession, standard-setting bodies, and the SEC (1994).

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■ Report and Recommendations of the Panel on Audit Effectiveness, which is discussed below(2000).

In addition to its ongoing oversight of the peer review and quality control inquiry processes, thePOB’s principal activities in 2001 and 2002 centered around monitoring the implementation of therecommendations of the Panel on Audit Effectiveness, overseeing the ASB, and preparing for the

reviews of the firms’ systems, procedures, and internal controls relating to independence, as dis-cussed below. Over the past year, the POB has made significant additions to its full-time and part-time staff to carry out expanded oversight and monitoring responsibilities called for in the new

charter.

The POB’s charter affirms that it is independent and specifies that the purpose of the POB’s oversightactivities is, as noted above, “to represent the public interest on all matters that may affect public

confidence in the integrity, reliability and credibility of the audit process.” The public interest isrepresented by the quality, breadth, integrity, and stature of the members of the POB, which theBoard believes should serve as a model for the future membership of any successor oversight body.

The POB’s first chairman was John J. McCloy, former high commissioner for Germany who alsoserved his country in many other capacities over a long and distinguished career. He was followed byArthur Wood, former CEO and chairman of Sears, Roebuck & Co., and then by another distinguished

public servant, A. A. Sommer, a former SEC commissioner and securities lawyer. Other former boardmembers included Melvin R. Laird, former member of Congress and Secretary of Defense, who servedon the POB for 17 years, and Paul H. O’Neill, who resigned from the board to become Secretary of the

Treasury. The current Board consists of Charles A. Bowsher, former Comptroller General of the UnitedStates, who was appointed to the Board in 1999 to serve as its chairman; Norman R. Augustine,former chairman and CEO of Lockheed Martin; Aulana L. Peters, former SEC commissioner; and

John H. Biggs, chairman and CEO of TIAA-CREF. Donald J. Kirk, former chairman of FASB, resignedas vice chairman on January 18, 2002.

The Panel on Audit Effectiveness

As previously indicated, in October 1998, at the request of SEC Chairman Arthur Levitt, the POBappointed the Panel on Audit Effectiveness to examine the way independent audits are performedand to assess the effects of recent trends in auditing on the public interest. The panel issued its report

and recommendations on August 31, 2000. Its recommendations were addressed to many constituen-cies - standard setters, accounting firms, the SECPS, audit committees, the SEC, and others - andcovered a wide range of matters, including:

■ Conduct of audits, including the auditor’s responsibility for the detection of fraud(including earnings management when it constitutes fraud).

■ Leadership and practices of audit firms.

■ Effects on auditor independence of non-audit services provided to audit clients.

■ Governance of the auditing profession.

■ Strengthening the auditing profession internationally.

The panel’s report received widespread endorsement. SEC Chairman Levitt, for example, stated that“[i]mplementation of the specific recommendations made by the [p]anel to improve the audit processthrough more comprehensive and vigorous audit methodologies and standards will engender greater

confidence among investors that they are receiving high-quality audits.” He also commended the

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members of the panel “for their proposals to improve the self-regulatory framework of the profes-sion.” POB Chairman Bowsher predicted that the report would play an important part in setting a

future course for the accounting profession.

No conclusions can yet be drawn about the extent to which the actions taken to date to implementthe panel’s recommendations have enhanced audit effectiveness. The panel’s report was published

less than two years ago, and the process of responding to the panel’s recommendations is incomplete.

Experience With Self-RegulationThe POB experience with self-regulation of the accounting profession has varied throughout theperiod of its existence. For years, the profession and the AICPA were responsive to the POB and the

need to improve audits to enhance investor confidence in financial statements of public corpora-tions.

The environment changed in recent years as accounting firms expanded greatly the scope of their

services which, in turn, led to a re-examination of the concept of independence by the SEC. Duringthe late 1990’s, the relationship between the accounting profession and the SEC became verystrained, with division among the Big 5 on whether to support or oppose the SEC.

During the same period, the relationship between the accounting profession and the POB alsobecame strained over the adoption of a charter for the POB, particularly with respect to the section inthe charter dealing with funding. In effect, the proposed POB charter became hostage to the dispute

among the accounting profession and the SEC over resolution of proposed revisions to the indepen-dence requirements and rules. But, even during this period, several of the Big 5 supported the POB.

The relationship between the accounting profession and the POB was further strained when the POB,

at the SEC’s request, attempted to conduct reviews of the Big 5 firms’ policies, procedures andinternal controls related to independence. The SEC and the firms had agreed to these reviews, andrequested the POB to conduct such reviews and issue written reports on them. Some of the firms,

unfortunately, adopted an approach that resulted in delay and a lack of progress. This did not permitthe POB to conduct the reviews.

In the final analysis, the experience with voluntary self-regulation has been mixed in recent years.

The AICPA and several of the Big 5 firms, in the view of some, saw the POB’s role as one of a“shield” for the profession rather than as an independent overseer.

Mr. Levitt, the former SEC chairman, also described this problem in testimony before the Senate

Banking Committee in February 2002. “More than three decades ago,” he said, “Leonard Spacek, avisionary accounting industry leader, stated that the profession couldn’t ‘survive as a group, obtain-ing the confidence of the public…unless as a profession we have a workable plan of self-regulation.’

Yet, all along the profession has resisted meaningful oversight.”

Problems with Current System of Self-RegulationThe current system of self-regulation of the accounting profession has significant problems.

First, the funding of the POB is subject to control by the firms through the SECPS, which in the pasthas cut off that funding in an effort to restrict POB activities.

Second, the disciplinary system is not timely or effective. Disciplinary proceedings are deferredwhile litigation or regulatory proceedings are in process. This results in years of delay and sanctionshave not been meaningful. The Professional Ethics Division of the AICPA, which handles disciplin-

ary matters against individuals, does not have adequate public representation on its Board. Investiga-

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tions by the Quality Control Inquiry Committee of the SECPS, which handles allegations of impro-prieties in litigation against member firms arising out of audits of SEC clients, do not normally

include access to firm personnel and work papers. The disciplinary system does not include thepower to issue subpoenas or compel testimony. Thus, investigators must rely on the cooperation ofthe individual being investigated. The QCIC has no access to the complaining party or the client

involved. Furthermore, there is no privilege or confidentiality protection for investigations ordisciplinary proceedings, and disciplinary actions are often not made public.

Another problem is that monitoring of firms’ accounting and auditing practices by the peer review

process has come to be viewed as ineffective, as either a diagnostic or remedial tool. More important,the process has lost credibility because it is perceived as being “clubby” and not sufficientlyrigorous. Finally, the peer review team does not examine the work of an audit that is under investiga-

tion or in litigation.

Other problems include the fact that the current governance structure does not have the weight of acongressional mandate behind it. There is also a perceived lack of candid and timely public report-

ing of why and how highly publicized audit failures and fraud occurred and what actions have or willbe taken to ensure that such problems do not recur.

Auditing Standards and Termination of the ISB

The Auditing Standards Board (ASB) was not subject to oversight by an independent entity until itwas put under the oversight of the POB in February 2001. In contrast, under the SEC’s proposedgovernance structure for the accounting profession announced in January by SEC Chairman Harvey

Pitt, there will be no oversight of the ASB other than by the profession’s trade association, the AICPA.Most of the members of the ASB are associated with the eight largest public accounting firms.

The auditing standards promulgated by the ASB have not provided sufficiently specific and defini-

tive guidance, a weakness noted in the Panel on Audit Effectiveness Report and Recommendationsissued on August 31, 2000.

During a speech in January 1978, then-SEC Chairman Harold Williams stated, “The issue of indepen-

dence is the key one” for the accounting profession. The Independence Standards Board (ISB), whichwas established in 1997, was terminated in July 2001 because both the AICPA and SEC, for differentreasons, did not agree with what the ISB had done. The ISB was established to create, codify, and

interpret independence standards for auditors of public companies. Its termination has left a signifi-cant void.

The Public Oversight Board Charter

For more than two decades, the POB operated under a set of bylaws, but without the benefit of acharter. Creation of a charter to provide expanded and greater assurances of POB independencebecame a priority of the Board in December 1999, and was one of the key recommendations of the

Panel on Audit Effectiveness, which issued its draft report in May of 2000 and its final report inAugust of the same year. Yet it took over a year - from December 1999 to February 2001 - to negoti-ate a new charter.

The primary reason for this delay was the resistance of the AICPA and the large firms to variouspoints. For example, the AICPA and accounting profession, contrary to the recommendation of thePanel on Audit Effectiveness, wanted limitations on POB funding. In addition, for many months they

opposed giving the POB authority to approve nominations for the chairs of the SECPS executivecommittee and the ASB, even though they acknowledged that in the past, the POB, in effect, hadapproved those nominations informally.

In the end, the POB adopted a pragmatic attitude in order to further the public interest. A charter was

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approved which gave the POB expanded oversight and an enlarged budget and staff. It took effect inFebruary 2001.

The recommendations of the Panel on Audit Effectiveness, including a formal charter for the POB,were designed to improve the existing voluntary self-regulatory system, not to create a new regula-tory structure for the profession. At the time of the panel’s recommendations in August 2000, neither

the POB nor members of the panel thought it was likely that Congress would approve a statutoryregulatory organization to govern the profession.

Independence Reviews

In a letter to the POB dated December 9, 1999, then SEC Chief Accountant Lynn Turner expressedconcern that public accounting firms possibly lacked adequate quality controls for independence. Asa step to “safeguard the public interest,” he “strongly recommend[ed]” that the POB undertake “a

special review of SECPS member firms’ current compliance” with independence requirements. OnDecember 21, 1999, the POB agreed to do so. Two weeks later, on January 6, 2000, the SEC an-nounced that an internal investigation at PricewaterhouseCoopers LLP (PwC) had disclosed more

than 8,000 independence violations there. At this time, there were publicly expressed concerns thatthe widespread independence violations at PwC might also be found at other large accounting firmsif they were subject to a similar compliance review. Against this background, the POB commenced

preliminary work on the special reviews in January 2000, and had meetings with the firms to discussthe reviews.

Then, in early May 2000, the POB’s work on the special reviews was stopped by a decision of the

SECPS to cut off funding for them. Mr. Levitt, the Chairman of the SEC, stated that this was “asignificant setback to self-regulation and independent oversight” and raised “serious questions as tothe profession’s commitment to self-regulation.” Melvin Laird, former Congressman and Secretary of

Defense and the longest-serving member of the POB, said that this was “the worst incident in my 17years” on the POB.

The special reviews did not go forward, but shortly afterward, in June 2000, the SEC and the Big 5

firms entered into a “Term Sheet for Independence Look-Back Testing Program” (term sheet), whichcalled for the POB to conduct more limited independence reviews.

Subsequently, on October 10, 2000, the POB received a letter from Mr. Turner asking that the POB do

the independence reviews called for by the term sheet “in lieu of” the special reviews previouslyrequested in his December 1999 letter to the POB. The POB agreed to do so, and commencedpreliminary work on these reviews in November 2000. Between then and January 2002, a period of

more than a year, the POB did a substantial amount of work preparing to conduct the independencereviews. This work included a request for documents sent to the firms and the SEC staff in July 2001as well as comprehensive work programs for both phase I (evaluation of design and implementation

effectiveness) and phase II (testing and evaluation of operating effectiveness) of the reviews, sent tothe firms and SEC staff in October 2001 and January 2002, respectively. In addition, the POB wasinvolved in working with the firms on a confidentiality agreement for the independence reviews. The

POB’s efforts to enter into a confidentiality agreement with the firms, going back to July 2001, metwith no success. In addition, by the middle of January 2002, the POB still had not been able toobtain from the firms documents it had requested for the independence reviews in July 2001. This

lack of progress in conducting the independence reviews was one of the factors that led to the POBvoting to terminate its existence.

In a letter to the SEC and the firms dated March 5, 2002, the POB set forth its position on the transfer

of its responsibility for conducting the independence reviews to an independent person and dis-cussed the background of the independence reviews. This letter can be found on the POB’s web siteat www.publicoversightboard.org.

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The POB Decision to Terminate

As noted above, although the POB commenced preliminary work on the independence reviews in

November 2000, by January 2002, it still had not been able to obtain information and documents ithad requested from the firms in July 2001. The POB was concerned that the lack of progress on theindependence reviews would continue. This lack of progress was one of the considerations that

caused the POB to vote its intention to terminate its existence no later than March 31, 2002.

However, the precipitating factor in the POB’s decision to terminate was the announcement of aproposed new self-regulatory structure by SEC Chairman Pitt. The POB was not consulted on this

new proposed governance structure for the accounting profession, announced by Mr. Pitt at a pressconference on January 17, 2002, even though the POB had requested and been assured that it wouldhave the opportunity to provide input as the proposals were being developed and prior to any public

announcement. Instead, without including the POB in the process, the SEC worked privately withrepresentatives of the AICPA and the Big 5 firms and developed the new SEC proposal. Thus, theprivate sector entity which was charged with oversight of the profession’s self-regulatory activities

and with representing the public interest had no input into what may well be the most significantchange in regulating the accounting profession in the last 30 years.

A January 23, 2002 article in The Wall Street Journal reported that a spokesman for PwC confirmed

that chief executives of the Big 5 firms, including PwC, had held a series of private meetings with theSEC chairman in Washington between December 4, 2001, and January 17, 2002, on this matter, andthat the gatherings “took place at Mr. Pitt’s invitation.”

On the same day that one of these meetings was being held, December 4, 2001, Charles Bowsher,Chairman of the POB, had a discussion with Barry Melancon, President and CEO of the AICPA, at theJohn J. McCloy dinner hosted by the POB. During this discussion, which also included James

Castellano, Chairman of the AICPA, Mr. Melancon told Mr. Bowsher that the profession and the SECwere working on proposed changes to the governance structure of the accounting profession. Mr.Bowsher specifically asked that the POB be included in any such discussions so that it would be able

to provide input before any public announcement of a proposed new structure. Mr. Melancon assuredMr. Bowsher that this would be done.

At a meeting of the SECPS executive committee on January 4, 2002, Mr. Bowsher, Aulana Peters, a

POB member, and Jerry Sullivan, the POB Executive Director, were told that a proposed governancestructure for the profession would be announced within a month. Messrs. Bowsher and Sullivan andMs. Peters asked that the POB be “brought in the loop” and be given an opportunity to participate.

They were told the POB would be consulted.

The SEC did not seek input from the POB on the new regulatory structure. While Chairman Pitt hadleft a voice message for Mr. Bowsher on January 10, 2002, and Mr. Bowsher had called back twice, in

the end Mr. Bowsher did not receive a return call and the two men did not speak before the pressconference.

On January 17, 2002, Mr. Bowsher received a call from Mr. Melancon and Robert Kueppers, Chair-

man of the SECPS executive committee, a few hours before Mr. Pitt announced the new SEC proposalat a press conference. In this call, Mr. Bowsher asked specifically if there would be a place for thePOB in the new structure. Mr. Melancon replied that there was no place for the POB in the new

regulatory structure to be announced by Mr. Pitt and that the POB would be a redundancy. Subse-quently, the POB was advised by the Chairman of the SECPS that the SECPS working group hadprovided the SEC with an outline of a proposal a week before the January 17, 2002 press conference.

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The POB believes that one of its primary functions is to facilitate communication. The Panel onAudit Effectiveness found that “The POB should serve as the oversight body to whom the SEC, the

state boards of accountancy, the auditing profession and the public should look for leadership. Thisleadership position is intended to enhance communications among the profession’s self-regulatorybodies in order to facilitate the profession’s continuous improvement efforts and identify and resolve

important issues on a timely basis.” The panel recommended that the SEC should “[s]upport thePOB’s authority as enumerated in its charter to enable the POB to serve as an independent, effective,unifying leader of the profession’s voluntary self-regulatory process.”

During Chairman Pitt’s press conference on January 17, he was specifically asked whether therewould be a role for the POB in the new SEC proposal. He did not answer the question.

John Coffee, the distinguished Columbia Law School professor who has written extensively about

securities regulation, faulted the SEC chair for the way in which the new regulatory structure wascreated. Professor Coffee said that “It’s not the high watermark of public accountability when theindustry to be regulated designs its own regulatory structure in negotiations with its former lawyer.”

The foregoing was the context in which the POB voted unanimously on January 20, 2002, itsintention to terminate its existence pursuant to Section IX of the POB’s charter no later than March31, 2002. The reason for this action was that the new SEC proposal had been worked out by the SEC,

in collaboration with the AICPA, SECPS executive committee and representatives of the Big 5 firms,without any consultation with the POB, which is charged with representing the public interest. Thenew proposal rendered the POB a “lame duck”. In making its decision, the POB was also cognizant of

the experience of negotiating its new charter, the fact that the SECPS had cut off funds for the specialreviews, and that there had not been progress in connection with the reviews to which they hadagreed. The POB believed it could not effectively oversee the activities of the accounting profession

under the circumstances and that it would mislead the public to appear to do so. Furthermore, if thePOB were to continue during an interim period before a new governance structure were in place, itbelieved it would leave the impression that it approved of the Pitt proposal. As the “conscience and

critic” of the profession, the POB felt it had no choice but to terminate its existence to protect thepublic interest. What the POB did was akin to what an auditor does when it believes it must resignfrom a client engagement because of a fundamental disagreement.

The POB Proposal for ReformThe Public Oversight Board is mindful that there are many suitable models that could be adopted aspart of a reform program for regulation of the accounting profession. Congress will undoubtedlyconsider many of the available options in coming weeks as decisions are made on regulatory changes

in the aftermath of the Enron debacle. Whatever the details of reform, the POB strongly believes thata legislative foundation for any future regulatory structure is crucial.

Because it has had oversight responsibility for a good portion of the voluntary self-regulatory

structure of the accounting profession for the past 25 years, the POB has first-hand knowledge of thestrengths and weaknesses of the existing system and, thus, a unique perspective on regulatory reform.The POB considered a number of options for reform based on the present system, but ultimately came

to the conclusion that a complete overhaul is essential. The Board believes that the existing systemhas become ineffective.

Dating back to the 1970s, when bribery of foreign officials by American corporations was first

uncovered, followed by the audit failures associated with the bankruptcy of the Penn Central railroad- the Enron failure of its day - reforms have been largely incremental and piecemeal. The creation ofthe POB and other early reforms grew out of hearings in the House and Senate that followed the Penn

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Central bankruptcy and the “sensitive payments” scandal. While the POB believes that many ofthese early reforms served a useful purpose and strengthened the profession, it is also clear that in

recent years, regulatory oversight and attempts at further reforms have been met with resistance oroutright rejection by the profession. As noted earlier in this paper, the profession over the past twoyears has acted to preserve the status quo and has resisted major reform efforts.

Faced with this opposition, the Public Oversight Board believes the time for legislative action hascome. The current system needs to be replaced. To accomplish this, the POB believes it is essentialthat all critical elements of regulation - including all standard setting, inspections and reviews of

accounting firms, enforcement and discipline, and other functions - be placed under the aegis of asingle regulator operating under statutory authority. This new entity - an Independent Institute ofAccountancy (IIA) - would employ a professional staff of individuals unaffiliated with the profession

or any of the Big 5 accounting firms and would be run by a seven-member Board, which itself wouldbe totally independent of the profession.

The SEC would have oversight of the IIA, and the SEC’s Office of the Chief Accountant would be the

liaison to the IIA. A chart showing the organizational structure of the IIA is attached as Appendix A.

The Board

Under the POB’s model, the chair and vice chair of the IIA board would be employed on a full-time

basis. Five other members would serve on a part-time basis. Each member, including the chair andvice chair, would serve a five year term and no member could serve more than two consecutive terms.To assure future continuity, it is anticipated that the initial membership of the Board would have

staggered terms. While qualified persons with accounting experience, such as retired accountingprofessionals, would be allowed to serve on the Board, the majority of members would have no tieswhatever to the profession.

The importance of independence cannot be stressed enough. Independence removes any conflict ofinterest - real and apparent - on the part of Board members. Independence enhances the likelihoodthat when the narrow needs of the profession conflict with the broader public interest, it is the public

interest that will be served. Independence will also serve the interests of the accounting professionitself. Because the accounting profession depends on the trust of investors and the public, that trustwill wither and die if the profession is seen to be self-serving in its actions. The best way to keep that

trust is to place regulatory decisions at arms-length in an independent, legislatively mandatedoversight structure within the private sector.

The chair of the Board would be selected by a committee composed of the chair of the SEC, the chair

of the Federal Reserve Board and the Secretary of the Treasury. Once named, the IIA chair wouldbecome a member of the selection committee and would join in selecting the vice-chairman and theother members. To assure independence, members could be removed only by a two-thirds vote of the

IIA board itself. Having a selection committee of these individuals would enhance the credibility ofthe Institute.

Standards and Interpretation

The POB charter gave it authority to oversee the issuance and interpretation of auditing and inde-pendence standards for the profession by the ASB and the ISB. Accounting standards have been setfor nearly three decades by FASB.

The POB believes it is time to consolidate all standard setting bodies under one roof. Thus, a basicand critical function of the new Institute would be oversight of the issuance and interpretation ofaccounting, auditing and independence standards for the profession. To accomplish this end, an

Office of Standards would be created by the IIA board and would report to it. Within the Office of

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Standards, separate bodies would be created to issue accounting standards, auditing standards, andindependence standards. While the POB envisions a system in which the IIA board would have

overall authority to create the structure under which standard setting would take place and to makeappropriate rules for the standard setting process, the standard setting bodies within the Office ofStandards would be given considerable autonomy in carrying out their work. A well-staffed and

funded research arm within the Office of Standards would support the standard setting entities. TheOffice of Standards would also be charged with issuing interpretations of standards and be subject tomonitoring by the IIA board.

With respect to FASB, the POB is cognizant of its hard work in setting accounting standards fornearly three decades, but believes it should be integrated along with all standard setting bodies intoone unified and coordinated structure under the aegis of the IIA. Placing the responsibilities of FASB

under the new IIA would lessen the chances of it being influenced by those whose its standards affectand could likely help alleviate what some - including the current SEC chairman - have said is a slowprocess for promulgating standards. As Lee Seidler, Deputy Chairman of the 1978 AICPA Commis-

sion on Auditor’s Responsibilities, testified before the Senate Banking Committee in March 2002,“FASB has been beset by enormous outside pressures.” Also, former SEC Chairman David Ruderexpressed similar concerns before the same committee in February 2002, noting that “FASB continu-

ally faces difficulties in financing its operations.”

These problems would be alleviated because FASB’s independent funding would be guaranteed bythe IIA. Further, one of the major advantages to placing the activities of FASB under the new IIA

would, as Mr. Turner testified before that committee in February 2002, be “the accounting standardsetting, and enforcement of those standards, residing within a single organization. In turn, when thedisciplinary process identifies shortcomings in the standards, they could then be promptly referred to

the standard setter for timely action.”

With respect to auditing standards, the POB believes that standards promulgated by the current ASBhave not provided guidance that is sufficiently specific and definitive, a problem noted in the

recommendations of the Panel on Audit Effectiveness. The ASB is controlled by the AICPA, and eightof its 15 members are partners of the eight largest accounting firms. As with other standard settingentities, it should be placed under the aegis of the newly created Institute.

As discussed earlier, the termination of the ISB - established to create, codify and interpret indepen-dence standards for auditors of public corporations - has left a significant void. The POB believesthis void should be filled by creating a new entity independent of the profession and operating under

the aegis of the Institute, with sufficient resources and staff to issue clear, unambiguous standards ofindependence.

As to the membership of the separate bodies that would be created under the Office of Standards of

the IIA, the POB believes a majority of their members should be independent of the profession. Thenew Office of Standards with separate bodies would help alleviate the concerns expressed by formerSEC Chief Accountant Michael Sutton, who testified in February 2002 before the Senate Banking

Committee that “standard setters too often pull their punches, backing down from solutions theybelieve are best - perhaps because of a perceived threat to the viability of private sector standardssetting - perhaps because of the sometimes withering strains of managing controversial, but needed

change - perhaps because of a loss of focus on mission and concepts that are supposed to guide theiractions.” Public representation would assure that, at the least, the public had a voice and a vote in theprocess.

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Annual and Special Reviews

Since 1977, peer review of one accounting firm by another has been the backbone of the voluntary

self-regulatory system in the United States, and the POB has been charged with overseeing thisprocess. The POB believes that peer review resulted in major improvements in the profession. Therecommendations that flowed from peer reviews in the early days led to substantive improvements in

the quality controls at accounting firms, large and small. At the same time, as former SEC ChairmanWilliams testified on February 12, 2002, before the Senate Banking Committee, peer review “in itspresent form [has become] too incestuous. A system needs to be established which is independent of

the accounting profession.”

Because it is not a transparent system (details of peer reviews are not made public) and is limited inscope (audits subject to investigation or litigation are not looked at as part of a peer review), peer

review has come under considerable criticism from members of Congress, the media, and others. “Youscratch my back, I’ll scratch yours” is the prevailing cynical opinion of peer review raised by many.

The Public Oversight Board is of the opinion that peer review, as it has been conducted, should be

discontinued in favor of a more thorough, independent, and transparent system. Each accountingfirm now carries out an internal inspection each year. The POB would mandate that, for firms thataudit more than 100 public corporations each year, these inspections would be subject to a compre-

hensive and thorough review, carried out by an independent professional staff hired by the Institute.While these reviews would usually look at a representative sample of a firm’s work, IIA reviewerswould have the authority, unlike current peer reviewers, to look at any aspect of a firm’s operations it

might find appropriate. Details would be compiled in reports that would be made available to thepublic. Reviews of smaller audit firms would be performed by other firms selected and paid by theIIA. Their reports would be addressed to the IIA as the client of the reviewer.

Professor Joel Seligman, who testified before the Senate Banking Committee in March 2002 statedthat “the most significant issue may prove to be who conducts periodic examinations and inspec-tions. To paraphrase the classical adage: Who will audit the auditors? I would urge serious consider-

ation be devoted to replacing peer review with a professional examination staff in the new SRO. Peerreview has been, to some degree, unfairly maligned. But even at its best it involves competitorsreviewing competitors. The temptation to go easy on the firm you review lest it be too critical of you

is an unavoidable one.”

But these reviews are only one piece of an updated oversight structure. To supplement them, the POBbelieves that special reviews should be carried out, when warranted, on a case-by-case basis. These

special reviews, similar to those the SEC originally asked the POB to undertake of the Big 5 firms,could take a more systemic and in-depth look at a firm’s systems, policies, procedures and opera-tions. If necessary, they would delve deeply into questions affecting a firm’s compliance with SEC

rules and applicable professional standards. As with annual reviews, an independent professionalstaff hired by the Institute would carry out any special reviews and results would be public.

Enforcement and Discipline

One of the most pervasive complaints about the current voluntary system is that firms and theirpersonnel are rarely disciplined by the profession for infractions in carrying out audits or other work.

Dave Cotton, a member of the AICPA’s Professional Ethics Committee’s Technical Standards Sub-

committee, wrote in a January 2002 Washington Post article that, while the Ethics Committee expelssomeone from the AICPA five to 10 times a year, “[m]ore typically, when [that] committee finds that aCPA has violated professional standards, it orders continuing professional education classes. A CPA

found to have violated an accounting standard in connection with a multibillion-dollar corporatecollapse, causing massive damage to investors and the public, might receive this sort of minimalsanction.”

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When discipline is imposed by the present system, it almost always comes years after the factbecause of procedures which delay the process, including sanctions, until after the outcome of

litigation. Mr. Cotton noted in the Washington Post article cited above that, as a result of delays inthe disciplinary system, “accountants who have committed the most egregious ethical lapses - theones resulting in SEC investigations, bankruptcy and litigation - can often continue to practice for

10 years or more after the alleged violation until all the cases are resolved.” Bevis Longstreth, aformer SEC commissioner and member of the POB’s Panel on Audit Effectiveness, stated in hiscongressional testimony in February 2002 that the present system “results in long delays in investi-

gation and, as a practical matter, renders the disciplinary function a nullity in almost all instances.”

The POB believes these concerns about the present system have validity and that an effectivemechanism for timely and effective discipline is essential to any reform effort.

One reason for the delay in the current system stems from the fact that those charged with administer-ing the system lack privilege to ascertain facts. Privilege would give the investigative entity theauthority to protect information it uncovers from outside demands until any enforcement action is

concluded. At present, firms will not disclose documents or other information that is likely to windup in the hands of litigants in legal proceedings. As Shaun O’Malley, Chairman of the POB’s Panelon Audit Effectiveness and former Chairman of Price Waterhouse, pointed out in his testimony in

March 2002 before the Senate Banking Committee, the present system has been “hampered bydistrust and by concerns that the materials developed were not protected. Providing confidentialitywill expedite and vastly improve the review, investigatory, and disciplinary processes.”

Further hampering those charged with discipline in today’s system is the lack of subpoena power.Because of this, the system may not be able to obtain important information from auditors or auditclients. Also, sanctions are limited; the most that can be done is expel someone from membership in

the AICPA. Further, the disciplinary process is not transparent, so the public is often unable todetermine what, if any, action has been taken, even with respect to major audit failures.

The POB suggests that an Office of Enforcement and Discipline be formed within the new IIA to have

full legal authority to investigate allegations of wrongdoing by public accounting firms and theirpersonnel, including subpoena power. The office would be staffed by accounting and other profes-sionals, as well as investigators. Cases of alleged improper professional conduct would be brought

before IIA hearing officers, who would be charged with recommending, where warranted -after publicnotice and opportunity for public hearing - that the IIA board impose sanctions that would rangefrom fines to suspension or expulsion from the profession. Cases could be referred to the Justice

Department for possible prosecution, or to the SEC, state boards of accountancy, or other agencies, asappropriate.

Allegations brought before the Office of Enforcement and Discipline would go forward to investiga-

tion regardless of any pending litigation, unlike the present system. Disciplinary hearings anddecisions would be public.

Funding and Staff

If the Institute is to be successful in all that it is charged with overseeing and regulating, it must beappropriately funded and it must have an adequate, well-trained staff. It is clear that to attract atalented staff, competitive salaries must be available. Further, the Institute must be assured that the

funds will be there when needed.

Former SEC Chairman Williams testified before the Senate Banking Committee in February 2002that the POB “is not adequately funded and is beholden for its funding to the very people it is

supposed to oversee. I suggest that the SEC consider a requirement that a percentage of the audit feesof public companies be assessed to pay for independent oversight, whether it is the Public OversightBoard or a successor body, so that its funding is assured.”

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Another former Chairman of the SEC, David Ruder, said in testimony the same day that: “Indepen-dent and adequate funding is crucial. An independent body that depends upon sporadic voluntary

contributions from industry or the financial community may risk loss of financial support if it takespositions seen as contrary to the best interest of those it regulates.”

The POB recommends that funding be provided through fees imposed on public corporations in an

amount that would be sufficient to cover the costs of the Institute. The fees would vary according tothe total revenues of the corporation. The POB strongly believes that the funding mechanism must bebeyond the reach of the profession to prevent it from withholding necessary funds, as it did in May

of 2000.

International Liaison

Convergence of international accounting and auditing standards is one of the most pressing issues

facing the profession. In an era when major firms either own or are affiliated with large accountingentities throughout the world and major corporations engage in global trade, common accountingand auditing standards are fast becoming a critical need. The Public Oversight Board believes that

international liaison should be a primary function of the Institute.

Paul Volcker, the former Federal Reserve Chairman and Chairman of the trustees of the InternationalAccounting Standards Board (IASB), told the Senate Banking Committee in February 2002 that

FASB and IASB were working together on a number of issues and that the “result should be conver-gence and significant improvement in both bodies of standards.” Since the IIA would overseeaccounting standard setting as well as auditing and independence standard setting, the Institute

would be in the best position to act as international liaison to promote convergence and significantimprovement to U.S. and international standards. This is a POB function under its charter and shouldbe transitioned to a new regulatory body.

Continuing Professional Education

Education has always been a hallmark of the accounting profession, and accountants and auditors arerequired to accumulate 80 hours of continuing professional education credits every two years. As

important as education has been in the past, however, it will become even more crucial in years tocome. The ability of auditors to deal with audits of companies involved in cross border offerings andderivatives and other new financial instruments that are constantly being invented is largely depen-

dent upon their ability to understand them - and that is a function of education. Similarly, conver-gence of standards across international boundaries will present new and unprecedented challenges toaccountants and auditors and only continuing education will make it possible for the profession to

remain on top of new developments. For these reasons, continuing education should be a primaryfocus of the new Institute.

Other Matters Affecting the ProfessionBeyond the regulatory structure of a new system, the POB believes there are a number of other issues

that should be addressed as part of legislation creating a charter for the new Institute.

Auditor Independence

The POB recognizes that there are several models available to deal with the matter of auditor

independence and that there continue to be disagreements on this matter.

The Panel on Audit Effectiveness, for example, was split on the issue of scope of services for auditclients. Some panel members wanted to essentially ban non-audit services for audit clients. But these

members would have allowed a “carefully circumscribed exception” if the client’s audit committee

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(composed only of independent directors) found that the best interests of the company and itsshareholders would be served by retaining its auditor to render such non-audit services in cases

where “no other vendor of such service can serve those interests as well.” This proposal would alsohave required submission of such a finding to the SEC and POB and disclosure in the corporation’sproxy statement of the finding and the amount paid for the non-audit services.

On the other hand, those on the panel who opposed restricting non-audit services - a majority - heldthat “audit firms can provide both audit and non-audit services to the same public audit client, andwith proper safeguards and disclosures, can maintain independence and objectivity.” Those taking

this view believed that “nothing in the long history of the profession’s providing non-audit serviceshas indicated otherwise.”

Mr. Volcker said during the September 2000 public hearings on the SEC’s proposed independence

rules that

The extent to which the conflict has in practice actually distorted auditing practice is con-tested. And surely, instances of overt and flagrant violations of auditing standards in return

for contractual favors-an auditing capital offense so to speak-must be rare. But more insidi-ous, hard-to-pin down, not clearly articulated or even consciously realized, influences onaudit practices are another matter.

Importantly, President Bush’s 10-point plan “to improve corporate responsibility and protectAmerica’s shareholders,” announced in March 2002, provides that “Investors should have completeconfidence in the independence and integrity of companies’ auditors.” The specifics on this plan

recognize the importance of prohibiting certain non-audit services in order to safeguard auditorindependence.

On February 1, 2002, the AICPA issued a statement, which said it “will not oppose federal legislation

restricting the scope of services that accountants may provide their public audit clients, specificallyin information technology and internal audit design and implementation.”

In considering this matter, the POB started from the premise that the accountant’s audit and report

add significant credibility and reliability to a corporation’s financial statements in the process ofcapital formation and that the foundation of that credibility is auditor independence.

To effectively assure independence, the POB believes legislation governing non-audit services to

audit clients is necessary. The POB proposes that SEC regulations concerning independence belegislatively codified with appropriate revisions to update restrictions on scope of services involvinginformation technology and internal audit services as noted above.

The POB believes such legislation should also affirm that tax work not involving advocacy andattest work in connection with SEC registration and other SEC filings be allowed, and that smallpublic businesses, to be defined by the SEC, should not be subject to any restriction on non-audit

services. Further, with respect to non-public corporations, it is the POB’s position that such corpora-tions and the accounting firms that audit them should not be subject to any restriction on non-auditservices. We expressly emphasize this to avoid misunderstanding and any consequences to small

business and small audit firms.

The IIA Office of Standards should be empowered to promulgate appropriate rules affecting indepen-dence to cover changing circumstances. The POB also believes that non-restricted, non-audit

services should require approval by the audit committee if it finds such services to be compatiblewith maintaining independence. Also required would be prompt notification to the IIA Office ofStandards and public disclosure in current reports and proxy statements filed with the SEC.

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The POB believes there should be no prohibition against an audit firm offering non-audit services tonon-audit clients.

Auditor Rotation and Retention

The POB believes that the time has come to require rotation of auditors every seven years. The oneeffective way to prevent the emergence of too close a relationship between a corporation and its

auditor is to make certain that auditors are rotated periodically. While there is merit to the argumentthat a long-term relationship helps the auditor do a better job, it is also true that a new auditor everyseven years would provide the corporation with the benefit of a fresh perspective.

The POB agrees with its member, John Biggs, who testified in February 2002 before the SenateBanking Committee that auditor rotation is a “powerful antidote” to auditor conflicts of interest,which “reduces dramatically the financial incentives for the audit firms to placate management”. In

addition, as Mr. Biggs stated, rotation “reduces the problem of cross-selling other services and islikely to eliminate the revolving door that allows former auditors to become the top financial officersof the audited company.” The POB also supports Mr. Biggs’ idea, described in his testimony, that the

new auditor at the time of rotation should do “an exhaustive review of the former audit work papers”that would assure “transactions and documentation were fully transparent.” In addition, the newauditor could do “a brief, signed peer review report” on its predecessor.

As a corollary to auditor rotation, the POB recommends that public corporations be prohibited fromfiring auditors during their term of service. As former SEC Chairman Williams stated in his testimonybefore the Senate Banking Committee, the benefit of such a retention requirement is that “the auditor

would be assured of the assignment and, therefore, would not be threatened with the loss of the clientand could exercise truly independent judgment.”

The POB recommends allowing an exception to this retention requirement if the audit committee

determines that an exception is in the best interest of shareholders, with prompt notice to the IIA andthe SEC. Such action would be required to be publicly disclosed by corporations in current reportsand proxy statements filed with the SEC. The POB also believes that audit committees, in engaging

the auditor, should give primary consideration to the quality of the audit firm and its audit plan, andnot to the lowest price.

The POB is cognizant that if an auditor rotation regulation is included in legislation, action will

have to be taken to phase in the new system. The POB recommends giving the IIA authority topromulgate new rules governing the transition to an auditor rotation system. Actual rotation ofauditors would begin only after those rules are in place.

Cooling Off Period

For many years, members of Congress and senior federal government officials have been required toenter a “cooling off” period during which they are prohibited from taking certain actions, such as

lobbying, on behalf of their new employer. The objective is obvious: to guard against undueinfluence by former colleagues and friends when it comes to making government decisions thatcould benefit the new employer of the former official.

The POB believes such a cooling off period is sound policy and feels a variant of it should beapplied to the accounting profession when senior partners leave their firms. Specifically, the POBrecommends that engagement and other partners who are associated with an audit be prohibited from

taking employment with the affected firm until a two-year period has expired. This would end thecurrent situation in which there is at least the appearance of impropriety in audit firms being undulyinfluenced by former colleagues who have taken senior positions with existing audit clients.

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As Mr. Seidler said in his testimony this February, “the former auditor knows exactly how his or herformer firm conducts the audit,” and also “knows how far former compatriots can be pushed to accept

results preferred by management.” Mr. Seidler added that “’we are all friends’, is not exactly theappropriate relationship between independent auditor and client.”

It is also important to recognize that in the cases of Lincoln Savings and Loan, Waste Management

and, most recently, Enron and Global Crossing, senior financial officers at the company came fromthe outside audit firm.

Under the POB proposal, the IIA board would have the authority to adopt specific rules affecting this

proposed cooling off period.

Audit Committees

The POB believes that the Institute should expand on the recommendations of the Report and

Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit

Committees, which made it clear that the external auditor should be accountable to a firm’s board ofdirectors and its audit committee and not to management. Specifically, the POB believes audit

committees should take full responsibility for hiring, evaluating, and - if necessary - terminating anaudit firm.

Conflicts of Interest

To discourage conflicts of interest involving public corporations, Congress should amend theSecurities Exchange Act of 1934 to require more meaningful and timely disclosure of related partytransactions among officers, directors, or other affiliated persons and the public corporation. Such

disclosures should be made promptly in current reports as well as in proxy statements filed with theSEC.

Internal Controls

In the 1980s, a series of major business failures, particularly those involving financial institutions,led to congressional hearings on auditing and financial reporting matters. Out of those hearings, theFDICIA became law. This Act required among other things, that management report on internal

controls and, further, that the independent auditors examine and report on those managementassertions.

The Special Report by the POB dated March 5, 1993 on “Issues Confronting the Accounting

Profession” recommended that the SEC require public companies to include with their annualfinancial statements “(a) a report by management on the effectiveness of the entity’s internal controlsystem relating to financial reporting; and (b) a report by the [entity’s] independent accountant on

the entity’s internal control system relating to financial reporting.” The POB, in support of thisrecommendation, stated: “The Board believes that requiring auditors to assess management’s reportson the quality of internal controls will benefit the public. First, the auditing profession’s evaluation

of internal control systems will lead to improvements in those systems. Second, as long as compa-nies’ boards and top management demand conformity with those systems, the improved systems willmake management fraud and manipulation of financial reporting more difficult.”

Just a few months later, in a June 1993 position statement, the AICPA Board of Directors stated:

To provide further assurance to the investing public, we join the POB in calling for a state-ment by management, to be included in the annual report, on the effectiveness of the company’s

internal controls over financial reporting, accompanied by an auditor’s report on management’sassertions. An assessment by the independent auditor will provide greater assurance to inves-tors as to management’s statement. The internal control system is the main line of defense

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against fraudulent financial reporting. The investing public deserves an independent assess-ment of that line of defense, and management should benefit from the auditor’s perspective

and insights. We urge the SEC to establish this requirement.

The General Accounting Office discussed this issue of reporting on internal controls in its 1996report, “The Accounting Profession”. The GAO pointed out that the POB had said “it was disap-

pointed by the failure of the SEC to take action to mandate issuer and auditor reporting on internalcontrols. The POB agreed with us that such action would add immeasurably to the ability to preventand detect fraud and would in general enhance the quality of finance reporting.” The GAO stated that

the SEC was “the key player” here and, further, that the SEC should move forward on this importantissue. So far, the SEC has not done so.

Management of public corporations should be required to prepare an annual statement of compliance

with internal controls to be filed with the SEC. The corporation’s chief financial officer and chiefexecutive officer should sign this attestation and the auditor should review it. An auditor’s reviewand report on the effectiveness of internal controls would - as the GAO found in its report - improve

“the auditor’s ability to provide more relevant and timely assurances on the quality of data beyondthat contained in traditional financial statements and disclosures.”

In addition, strengthened internal controls over financial reporting should improve quarterly

statements, interim disclosures and earnings estimates that are the basis for many market pricechanges during the year. They should also be helpful in avoiding restatements that are now seen sofrequently.

ConclusionThe Public Oversight Board has not come lightly to its recommendations for reform. For manymonths, members of the POB hoped that patient negotiation and discussion would prevail. In theend, however, it became apparent to the POB that real reform will take place only when Congress

requires it through legislative action.

A decade ago Congress acted in the public interest when it voted major reforms in the bankingindustry - reforms that were widely opposed by the banks and their lobbyists. Opponents then

predicted gloom and doom for the industry should the proposed reforms be enacted. In reality, thereforms contained in the FDICIA repaired flaws in regulation of the nation’s banking industry. Moreimportant, they significantly strengthened the industry.

Today the Congress again is called upon to institute reform. In the wake of the Enron debacle, thePOB, acting as the “conscience and critic” of the profession, strongly believes that to protectinvestors and the public, the old system of voluntary self-regulation for the accounting industry must

be replaced. While many will urge that Congress act with caution and that the profession be againgiven the opportunity to fix the present system with marginal changes, the POB believes it is time toresist the continuation of the status quo and move ahead with fundamental change.

In short, the POB believes it is time for Congress to enact the kind of reform that will make a realdifference.

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Previous Recipients:

1988 - Donald L. Neebes andJames B. Luton, Jr.

1989 - LeRoy Layton

1990 - Thomas L. Holton

1991 - Barbara H. Franklin

1992 - A. Clarence Sampson

1993 - Wallace E. Olson

1994 - Philip L. Defliese

The John J. McCloy AwardIn 1988, the POB initiated a program to honor those who

have made significant contributions to strengthening audit

quality control and effectiveness in the United States.

2001 Recipient

The Public Oversight Board selected J. Michael Cook asthe recipient of the 2001 John J. McCloy Award for out-standing contributions to the auditing profession in the

U.S.

His leadership and commitment to improving the reliabilityand enhancing the credibility of the financial reporting

process have characterized Mr. Cook’s career. That leader-ship and commitment have been exhibited through hisoutstanding contributions to his firm, the accounting and

auditing standards-setting processes, the governance of theprofession, and the business community at large.

Mr. Cook served as Deloitte & Touche’s Chairman and

Chief Executive Officer from June 1986 until May 1999.He has served on the Board of the AICPA, and as theInstitute’s Chairman. He served as the Chairman of the

Board of Trustees of the Financial Accounting Foundation -the overseer of the FASB and the GASB. On the interna-tional level, he has chaired the World Congress of Accoun-

tants.

Mr. Cook currently is the Chairman of the General Account-ing Office’s Accountability Advisory Panel, which provides

guidance to the Comptroller General and other GAOexecutives.

1995 - David B. Pearson

1996 - David L. Landsittel

1997 - Vincent M. O’Reilly

1998 - Dan M. Guy

1999 - Ralph S. Saul

2000 - Shaun F. O’Malley

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JOHN J. McCLOY(1978 - 1984)One of the original Boardmembers; POB Chairman frominception to 1984; former Partnerin law firm of Milbank, Tweed,Hadley & McCloy; AssistantSecretary of War during WorldWar II; received AICPA’s Medalof Honor for distinguishedservice to the accountingprofession. Mr. McCloy’s serviceto the profession is honored eachyear with the POB’s McCloyaward, presented to a distin-guished individual from theaccounting profession. Died onMarch 11, 1989.

RAY GARRETT, JR.(1978 - 1980)One of the original Boardmembers; POB Vice-Chairmanfrom its inception to February1980; Chairman of the Securitiesand Exchange Commission,1973-1975; retired Partner of lawfirm, Carton & Douglas. Died onFebruary 3, 1980.

WILLIAM L. CARY(1978 - 1982)One of the original Boardmembers; Chairman of theSecurities and ExchangeCommission, 1961-1964; formerProfessor of Law, ColumbiaUniversity. Died on February 7,1983.

JOHN D. HARPER(1978 - 1985)One of the original Boardmembers; former Chairman of theBoard and Chief ExecutiveOfficer of ALCOA, 1970-1975;member of a PresidentialCommission; a director ofseveral public companies. Diedon July 26, 1985.

ARTHUR M. WOOD(1978 - 1986)One of the original Boardmembers; POB Chairman, 1984-1986; POB Vice Chairman, 1982-1984; former Chairman of theBoard and Chief ExecutiveOfficer of Sears, Roebuck & Co.,1973-1978; a director of severalpublic companies.

ROBERT K. MAUTZ(1981 - 1995)Vice Chairman, 1987-1995;former Director of the PatonAccounting Center and Professorof Accounting, University ofMichigan; former Professor,University of Illinois; formerPresident of the AmericanAccounting Association; formermember of AICPA Board ofDirectors; former member of theCost Accounting StandardsBoard; received the AICPA’sGold Medal Award for Distin-guished Service.

A. A. SOMMER, JR.(1983-1999)Chairman, 1986-1999, ViceChairman, 1985-1986; receivedthe AICPA’s Medal of Honor forhis distinguished service to theaccounting profession; Partnerwith the law firm of Morgan,Lewis & Bockius; SEC Commis-sioner, 1973-1976. Died onJanuary 14, 2002.

MELVIN R. LAIRD(1984-2001)Served as the Vice Chairmanfrom 1997-1999. Mr. Lairdserved as Representative in theU.S. Congress from Wisconsin fornine terms (1953-1969),Secretary of Defense from 1969to 1973, and Counselor to thePresident for Domestic Affairs,1973-1974.

PAUL W. McCRACKEN(1985-1997)Vice Chairman from 1995-1997;Chairman of the President’sCouncil of Economic Advisers,1969-1971; President of theAmerican Enterprise Institute forPublic Policy Research, 1986;distinguished Professor Emeritusof Business Administration,Economic and Public Policy,University of Michigan.

ROBERT F. FROEHLKE(1987-2000)Secretary of the Army, 1971-1973; Chairman of the Board ofEquitable Life Assurance Society1982-1987; former President andCEO of IDS Mutual Fund Group.

PAUL H. O’NEILL(2000-December 31, 2000)Chair and CEO of ALCOA,1987-2000; President ofInternational Paper Company,1977-1987; Deputy Director ofU.S. Office of Management andBudget, 1974-1977; resigned tobecome the U.S. Secretary of theTreasury.

OtherMembersWho ServedThroughDecember31, 2000


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