Public Accountancy

Current Issues in Public Accountancy

New York State Senate Higher Education Committee Testimony

Introduction

Good morning Chairman LaValle and other distinguished members of the Senate Higher Education Committee. It is an honor and a pleasure to have the opportunity to speak with you today. At no other time during its 106-year history, as the fourth oldest licensed profession in New York, has the public focused so much serious attention and concern on the independence of the certified public accountant (CPA). The Enron-Andersen disaster underscores the need for an examination of the regulatory structure in the profession of public accountancy. This case has shaken the profession to its very core, has affected the capital markets, and has traumatically affected many Americans personally. Financial statement adjustments have reduced Enron's net worth by $1.2 billion and net income by $586 million. Thousands have been left unemployed and millions have witnessed the bankruptcy's impact on the value of their pension and profit sharing plans. We applaud this Committee for addressing the core factors that led to the Enron failure and for searching for ways to meaningfully ensure public protection and confidence in our financial markets. We feel that the only way to do that is to strengthen New York's licensure and practice standards for the accounting profession.

CPA Services

The hallmarks of a CPA are: objectivity, integrity, ethics, and independence. The public engages a CPA because they trust the services, because they know those services will meet the high standards of the profession and because they expect that if the CPA is negligent or incompetent, he/she will be held professionally accountable.

In 1896, the New York State Legislature placed the primary responsibility for the regulation of CPAs with the Board of Regents. The Regents regulatory structure, created more than 100 years ago by the Legislature, continues to be held in the highest regard. The well-respected Pew Commission conducted a nationwide independent study of professional regulation and found that governance by a lay body is one of the most appropriate forms of professional governance because it is free of outside interference.

The Board of Regents and the New York State Education Department (SED) effectively regulate the accounting profession and 38 other learned professions, to protect the public interest. For the regulation and public protection to be most effective, we must also endeavor to ensure that oversight evolves in concert with the professions so that there is a comprehensive continuum of public protection throughout the profession.

In our view, a discussion of the factors that must be addressed to strengthen public protection must include:

• Evolving scopes of practice
• Professional oversight
• Non-audit services
• Work paper and record retention

Scope of Practice

Since Section 7401 of the Education Law was first enacted in 1947, the breadth of services provided by CPAs has expanded dramatically to include a number of peripheral services. The focus of today's hearing is on auditors of publicly traded companies and the services that should or should not be preformed for audit clients. A consistent and workable regulatory system requires that CPAs be regulated for every financial service that they provide, regardless of where employed and where the services are provided.

The Need for Legislative Remedy

Four years ago, the Board of Regents, the State Education Department (SED), and the New York State Board for Public Accountancy proposed changes to the Education Law to add clarity to the scope of practice definition to ensure that CPAs are professionally responsible for all of the services that they provide beyond the core audit services, thereby strengthening public protection. The amount and degree to which public accounting firms have expanded the types of peripheral services is staggering. Peripheral services include: management advisory services; financial advisory and planning service; and information technology systems development and consulting services. According to a recent SEC report, from 1990-1999, the ratio of accounting and auditing revenues generated by the Big Five firms from SEC clients dropped from 71% to 48%. In contrast, during the same time period, consulting revenue grew from 12% to 32%. We have attached a chart that summarizes this data.

In November 1999, the SED received a letter from the Chief Accountant and the General Counsel of the U.S. Securities & Exchange Commission focusing on the expansion of the sale of peripheral services by accounting firms and discussing the need for clarity in the Education Law under which the Regents have broad regulatory oversight of the accountancy profession in New York. The letter states, "Your ability to protect the public might be impaired significantly if you are deemed to be precluded by law from looking past the accounting and auditing division and into the larger, more profitable operations of an accounting firm or a corporate parent of an accounting firm. If the blinds are shut when you attempt to look into the marketing and performance of consulting, tax and other activities, you will have neither the information you need nor the power to assure the protection of the public interest in receiving competent and creditable accounting services provided by independent and skeptical accounting professionals." A copy of the letter is attached to this testimony.

In 2000, Senator LaValle held a highly productive roundtable forum on the scope of practice of public accountancy. At that forum, participants from several accounting firms, the New York State Society of CPAs, the State Board for Public Accountancy, and the SED reached a consensus that CPAs should be regulated for all professional services rendered, no matter where employed.

According to a recent SEC administrative proceeding, a CPA employed as an Assistant Controller by a publicly traded company was found to have participated in the preparation of financial statements that she knew or, in the exercise of reasonable care, should have known, were not in conformity with generally accepted accounting principles (GAAP). If that Assistant Controller were a New York licensed CPA, the Regents could not bring unprofessional conduct charges against her because she is not employed in public practice.

At no time has the need for clarity in the scope of practice definition been as great as it is today. We thank you, Senator LaValle and members of the Senate Higher Education Committee, for your continued commitment to finding a solution. Given the evolving concern over accounting practices and the impact that the latest debacle has had on our financial markets, it is time to enact legislation that will protect all the citizens of New York State.

Professional Ethics

Recognizing the evolving practice climate, the Regents, with the assistance of the State Board for Public Accountancy, in addition to proposing legislation that would have clarified the definition of public accountancy, approved an amendment to the Regulation of the Commissioner that requires all registered CPAs to participate in four hours of continuing education focused on ethics during each three-year registration period. We believe that sustained focus on professional ethics through continuing education supports the objectivity, integrity and independence of the accountancy profession, and is keenly relevant to what reportedly occurred in the Enron case.

What is the Perspective of New York CPAs?

Last year, the SED surveyed more than 34,000 New York CPAs and received more than 12,000 responses from a broad cross section of the CPAs licensed and registered in New York. The survey is an independent assessment of the views of individual licensees (survey report). The following are just a few of the responses that indicate that CPAs themselves want to uphold New York State's high licensure and practice standards and ensure that the regulatory structure prevents inherent conflicts of interest:

• More than 90% of the respondents believed that New York's licensure requirement for experience should remain intact.
• More than 72% of the CPAs responding disagreed with the concept that CPAs working in private industry be allowed to perform compilation services for the public on behalf of their corporate employers.
• More than 80% of the respondents stated that Education Law should not be amended to allow non-licensed individuals to become up to 49% owners of public accounting firms.
• Over 75% of the respondents said they believed that New York should not embrace the concept of substantial equivalency to make it easier for out-of-state CPAs to practice in New York if it means lowering some of New York's licensing standards.

There have been many attempts over the last four years to reduce New York's licensing and practice standards that were in conflict with responses to the survey. We thank the Legislature for maintaining New York's high standards of licensing and practice. The Legislature, the Regents, the SED and the State Board for Public Accountancy must remain vigilant in their protection of the public and the integrity of the accounting profession.

Professional Oversight

CPAs employed by public accounting firms provide many different types of services for a variety of clients depending on the service they provide. At times New York CPAs must not only comply with New York's laws, rules and regulations, but must also comply with the rules of practice established by other government regulatory entities and/or their trade associations. For example, CPAs preparing income tax returns may be subject to practice rules established by the U.S. Internal Revenue Service. Similarly, CPAs auditing government agencies must also comply with rules established by the U.S. General Accounting Office. In addition, CPAs who choose to belong to trade associations may also be subject to rules of conduct and ethical standards established by these membership organizations. It is vitally important to remember that while CPAs may provide many types of service under various regulatory structures, these structures do not usurp the authority the legislature granted to the Board of Regents to license and discipline CPAs and/or their firms. Only the Regents, as authorized by the Legislature, may revoke an individual's license for unprofessional or negligent practice.

The National Regulatory Model

The regulatory mechanism for auditors of publicly traded companies is very complex. CPAs and the firms that employ them are subject to not only state regulatory oversight, but also the oversight of the United States Securities and Exchange Commission (SEC) and other private sector regulatory bodies. SEC regulation S-X requires all CPAs practicing before the SEC to be currently registered and in good standing with their state licensing board(s).

SEC oversight of publicly traded companies and the firms that audit them has been focused in two areas: empowering audit committees and peer review. Recently, the SEC made several recommendations related to empowering audit committees, including a recommendation to empower corporate audit committees to curtail corporate management that is guided primarily or solely by earning considerations. The major stock exchanges and the National Association of Securities Dealers have implemented these recommendations. The new requirements strengthen the independence of audit committees and require the independent auditor to evaluate and report the quality of the company's chosen accounting principles to the audit committee. Increasing the responsibilities of audit committees for corporate oversight and monitoring outside auditors is a difficult task under the most ideal conditions, as they are composed of outside directors, who fill part-time board positions. Given the limitations of these committees, this mechanism alone may not result in significantly improved oversight.

The second method of oversight is mandatory peer review. Accounting firms that audit publicly traded companies must undergo triennial mandatory peer review. The peer review process focuses on the audit firm's quality control system for its accounting and auditing practice, including documentation of the system and compliance by firm personnel. There are at least two criticisms of the current peer review system. First, the audit environment for publicly traded companies is dominated by only eight firms that audit 80% of the publicly traded companies. These firms typically peer review each other. The peer review process may be inherently compromised because there is a limited pool of peer review firms. Firms may hesitate to report quality control violations on the very firm that may be conducting their firm's peer review, believing that criticism invites criticism. Second, peer review of these audit firms is only required on a triennial basis and it should be more frequent. Peer reviews of accounting firms auditing publicly traded companies should be conducted annually to ensure that quality control standards are continually met.

We believe a stronger concept of mandatory peer review should be set in Education Law to improve auditor oversight in New York. The Regents, the State Education Department and the State Board for Public Accountancy are discussing various regulatory models that may resolve these oversight issues, including how peer review firms are selected and mandatory rotation of peer review firms.

Non-audit Services

For more than 35 years many informed bodies, such as Congressional subcommittees, the SEC, expert panels from the profession and the major professional trade association, have conducted numerous studies and debated many of today's issues. Two major themes of these studies have been the regulation of CPAs and the evolution of the practice of public accountancy, primarily the growth of non-audited services and the impact these services may have on an auditor's independence.

Those in favor of unrestricted services contend that there are inherent benefits in providing consulting services to audit clients. These proponents state that there is no empirical evidence that providing consulting services to audit clients affects the quality of their audits. Prohibiting consulting services, they contend, will make it more difficult to attract, retain and motivate audit specialists needed for audit engagements. Further, they believe that auditors gain valuable insights about risks and controls from non-attest work performed by non-audit specialists that are translated into audit engagement planning and execution.

We reject these arguments and favor restrictions on the types of services provided by auditors noting that it is almost impossible to find and prove instances where an auditor's judgement or state of mind has been influenced by the consulting services provided by the audit firm. Instead, we must look at what a well-informed investor would perceive. Furthermore, there is limited dialog between the firm's audit team and consultants and therefore no real audit benefit is derived from the consulting services.

SEC Proxy Rules

Last year, the SEC enacted proxy rules that require the auditor to provide detailed information to the audit committee on fees charged to the audit client. The SEC's new proxy disclosure rules require publicly traded companies to disclose three types of fees: (1) audit fees, the aggregate fees billed for professional services rendered for the audit; (2) the aggregate amount billed for financial information system design and implementation fees; and, (3) all other fees, the aggregate fees billed for other services not included in (1) and (2).

A SEC study entitled: "Independence Rule Proxy Disclosures: Independent Accounting Fees" provides relevant information on the extent of non-audit services provided by independent audit firms. The report summarizes information on the public filings of 563 of the Fortune 1000 companies that submitted data as of April 30, 2001. The report indicates that of the 563 companies documented in the study, Big 5 accounting firms audited all but 6.

The statistics reported in the study show the magnitude of consulting services provided by the Big 5 firms to their publicly traded audit clients. On average, the audit fees earned by the Big 5 accounting firms ranged between $1.5 million to $2.7 million. The "other" firms charged on average $600,000 in audit fees. The Big 5 accounting firms earned on average between $9.7 million and $46.8 million from information technology services sold to their audit clients. The "other" firms earned on average $5,000 from information technology services from their audit clients. Finally, the Big 5 accounting firms earned on average between $42.6 million and $77 million from other fees. The "other" firms earned an average $121,000 on the sale of other services to their audit clients.

Growth of Non-audit Services

In its discussion of its revision of the Commission's auditor independence requirements, the SEC noted the following:

"U.S. revenues for management advisory services and similar services for the largest public accounting firms (the "Big Five") amounted to more that $15 billion in 1999. Moreover, revenues for these service lines are estimated to contribute half of the total revenues for these firms. In contrast, these service lines provided only thirteen percent of total revenues in 1981. From 1993 to 1999, the average annual growth rate for revenues from management advisory and similar services has been twenty-six percent; comparable growth rates have been nine percent for audit and thirteen percent for tax services.

For the largest firms, growth in management advisory and similar services involves both audit clients and non-audit clients. For the largest public accounting firms, MAS (management advisory services) fees from SEC audit clients have increased significantly over the past two decades. In 1984, only one percent of SEC audit clients of the eight largest public accounting firms paid MAS fees that exceeded the audit fee. For the Big Five firms, the percentage of SEC audit clients that paid MAS fees in excess of audit fees did not exceed 1.5% until 1997. In 1999, 4.6% of the Big Five SEC audit clients paid MAS fees in excess of audit fees, an increase of over 200% in two years. For the Big Five firms, average MAS fees received from SEC audit clients amounted to ten percent of all revenues in 1999. Almost three-fourths of Big Five SEC clients purchased no MAS from their auditors in 1999. This means that purchases of MAS services by one-fourth of firms' SEC audit clients account for ten percent of all firm revenues."

Clearly, a law prohibiting audit firms from providing, except in very limited circumstances, non-audit and non-tax services to their publicly traded audit clients would affect a very small number of publicly traded companies. In contrast, such a law may have a significant impact on those accounting firms that have focused their expansion of services into the consulting arena. The SEC report shows that a large percentage of Big 5 clients and presumably smaller accounting firms' clients are not currently using their auditors extensively for consulting services. Without restrictions, these clients represent a large untapped source of revenue to the audit firms. However, the critical question remains: does the expansion of the sale of non-audit services to audit clients impair the objectivity, integrity and independence of the CPA?

Impact on Compensation

Former Securities and Exchange Commission chairman Arthur Levitt recently voiced his concerns about non-audit services and the impact of the sale of these services on compensation, especially among partners. He asked, "What drives their compensation? Is it the audit function, or is the audit merely a conduit to the cross-selling of other, more lucrative firm services?" These questions raise serious concerns about the CPA's personal motivations and their impact on independence, objectivity, and professional integrity. These are the core values of the profession. Lose of independent and objective judgement for the sake of additional compensation will be detrimental to the financial markets and ultimately to the public. It will also undermine the profession.

The Department has closely monitored discussions about restricting auditors of publicly traded companies from providing non-attest, non-tax consulting services to their audit clients and is concerned that the public interest has been lost in a self-serving discussion of outdated reporting models and the needs of the "New Global Economy." We are well aware of the differences between the sophistication and the types of services CPAs provide to publicly traded and closely held businesses. We are also conscious of the impact such rules may have on smaller companies. After careful analysis of data, testimony and articles, we do not believe that the public would be adversely harmed if auditors of publicly traded companies were prohibited from providing certain types of consulting services to their audit clients. We encourage the Legislature to amend the Education Law to limit the amount and types of consulting services CPAs and their firms provide to their publicly traded audit clients. The Regents, the Department and the State Board for Public Accountancy will also be discussing other suggested methods to insure auditor independence, including mandatory rotation of auditors of publicly traded companies. This concept deserves and warrants further discussion. We will be happy to share the results of our discussion or to work with you on this.

Work Paper and Record Retention

One of the most disconcerting actions purported to have occurred in the Enron-Andersen debacle was the supposed destruction of documents. AICPA standards state, "The auditor should adopt reasonable procedures for safe custody of his working papers and should retain them for a period sufficient to meet the needs of his practice and to satisfy any pertinent legal requirements of records retention." Current Rules of the Board of Regents contain provisions that govern record retention in the healthcare professions. Given the ambiguity of current standards regarding which papers must be retained, the Regents and the Department will discuss promulgating work paper and record retention rules for the accountancy profession with the State Board for Public Accountancy. Such rules will add substantial public protection by requiring all CPAs to maintain work papers and other records for a minimum period of time.

Conclusion

An individual becomes licensed as a certified public accountant by meeting rigorous education, examination and experience requirements. In recent years, there have been several attempts to lower New York's licensing standards in an effort to find a common ground in licensure among the 54 licensing jurisdictions. The Regents, the SED and the State Board for Public Accountancy have held firm against attempts to lower New York's professional licensure standards. The public engages a CPA because they trust that the services provided will meet the high standards of the profession. That trust is based on the public's knowledge that the CPA is accountable for the services the licensee provides.

The dramatic expansion of services provided to the public requires an amendment to Education Law to clarify the scope of practice definition and give the State jurisdiction over all services provided to the public by CPAs. The New York State Board of Regents, the State Education Department and the State Board for Public Accountancy have long supported the tenants of the accountancy profession and continue to do so in pursuit of our mission to protect the citizens of New York State and the integrity of the public accountancy profession. The authority granted to the Regents is not taken lightly. The Regents, the Department, and the State Board for Public Accountancy have diligently worked to maintain New York's practice standards. The positions of the Board of Regents, the State Education Department, and the State Board for Public Accountancy have been supported and reinforced by New York State CPAs themselves through their individual responses to the Department's survey.

Thank you for the opportunity to meet with you today and participate in this most important discussion. We look forward to continuing our work with you and your colleagues in the Legislature to enhance the oversight of the vital profession in New York, the financial capital of the world.