advisory committee on the auditing profession Final Report October 6, 2008 the department of the treasury ◆ Advisory Committee on the Auditing Profession ◆ Final Report of the Advisory Committee on the Auditing Profession to the U.S. Department of the Treasury ◆ Advisory Committee on the Auditing Profession ◆ ◆ Advisory Committee on the Auditing Profession ◆ Final Report of the Advisory Committee on the Auditing Profession to the U.S. Department of the Treasury TABLE OF CONTENTS I. TRANSMITTAL LETTER II. CO-CHAIRS’ STATEMENT III. COMMITTEE MEMBERS, OBSERVERS, AND STAFF IV. COMMITTEE HISTORY V. BACKGROUND VI. HUMAN CAPITAL VII. FIRM STRUCTURE AND FINANCES VIII. CONCENTRATION AND COMPETITION IX. DISSENTING STATEMENT X. APPENDICES A: Official Notice of Establishment of Committee B: Committee Charter C: Treasury Secretary Henry M. Paulson, Jr., Remarks at the Economic Club of New York, New York, NY on Capital Market Competitiveness (Nov. 20, 2006) D: Treasury Secretary Henry M. Paulson, Jr., Opening Remarks at the Treasury De- partment’s Capital Markets Competitiveness Conference at Georgetown University (Mar. 13, 2007) E: Paulson Announces First Stage of Capital Markets Action Plan, Treasury Press Re- lease No. HP-408 (May 17, 2007) F: Paulson: Financial Reporting Vital to US Market Integrity, Strong Economy, Trea- sury Press Release No. HP-407 (May 17, 2008) G: Paulson Announces Auditing Committee Members to Make Recommendations for a More Sustainable, Transparent Industry, Treasury Press Release No. HP-585 (Oct. 2, 2007) H: Under Secretary for Domestic Finance Robert K. Steel, Welcome and Introductory Remarks Before the Initial Meeting of the Department of the Treasury’s Advisory Committee on the Auditing Profession, Treasury Press Release No. HP-610 (Oct. 15, 2007) I: Committee By-Laws J: List of Witnesses K: Working Discussion Outline L: Working Bibliography ◆ Advisory Committee on the Auditing Profession ◆ ◆ Advisory Committee on the Auditing Profession ◆ I. TRANSMITTAL LETTER ADVISORY COMMITTEE ON THE AUDITING PROFESSION October 6, 2008 The Honorable Henry M. Paulson, Jr. Secretary U.S. Department of the Treasury 1500 Pennsylvania Avenue, N.W. Washington, D.C. 20220 Dear Secretary Paulson: It is our pleasure and privilege to present to you on behalf of the Department’s Advisory Committee on the Auditing Profession its Final Report and recommendations to enhance the sustainability of a strong and vibrant public company auditing profession. The Advisory Committee has devoted twelve months to this effort, and we have on numerous occasions solicited public input at various meetings and through written commentary. We have provided a summary of the Advisory Committee’s activities in the Co-Chairs’ Statement, which is included in this Final Report. We commend the Department for its initiative in creating the Advisory Committee, in shap- ing its broad charter, and in supporting its labors. You have been generous in furnishing staff and other resources. We trust that the Final Report and recommendations are worthy of the support and resources which you gave. Each of the Advisory Committee members stands ready to lend whatever further assistance we may be able to render in carrying out the recommendations of this Final Report. Respectfully submitted on behalf of the Advisory Committee, Arthur Levitt, Jr. Donald T. Nicolaisen Advisory Committee Co-Chair Advisory Committee Co-Chair I:1 ◆ Advisory Committee on the Auditing Profession ◆ II: CO-CHAIRS’ STATEMENT The Advisory Committee on the Auditing Profession, appointed by the U.S. Treasury Secre- tary Henry M. Paulson, Jr., was asked to examine comprehensively the condition and future of the auditing profession, with emphasis on the sustainability of a strong and vibrant profes- sion. In conducting its work, the Committee recognized that the prospects for the auditing profession are directly related to the quality and effectiveness, as well as the perceived value, of independent audits. Ultimately, it is a combination of transparency and trust that enables our financial markets to function efficiently. A strong and vibrant auditing profession is a critical element of that regime and especially important to the U.S. capital markets where more than 100 million people invest their savings and retirement assets. While the focus was on the auditing profession in the United States and in particular on the audits of U.S. public companies, the Committee approached its work with the awareness that audits, especially of large capitalization companies, are global in nature and that auditing firms, both here and abroad, rely upon the quality and consistency of their global network firms. For that reason, we reached beyond our borders in seeking input from observers, wit- nesses, and others and in considering the future of the profession. The four largest firms audit approximately 98% of the market capitalization of U.S. public companies, a concentration generally comparable to their participation in other major capital markets. The auditing firms also examine and issue audit reports on privately owned enti- ties, joint ventures, investment vehicles, employee benefit plans, and governmental and other entities. The requirements for such audits vary, but the objective is generally consistent, to provide an independent and objective test of the accounting policies, procedures, and judg- ment used by management in preparing the financial statements. In addition to audit and audit-related services, the largest auditing firms also provide a range of tax, advisory, and other professional services. In 2007, the four largest global network firms reported, in the aggregate, approximately $90 billion in total revenues. Total revenue reported by the U.S. af- filiates of the four largest firms was $31.2 billion, of which approximately $11.8 billion (37.8%) was for audits of U.S. public companies. This is the first major study of the U.S. auditing profession since enactment of the Sarbanes- Oxley Act of 2002 (Sarbanes-Oxley) and the Committee heard of many positive develop- ments within the auditing profession in recent years and of a generally positive impact the Public Company Accounting Oversight Board (PCAOB) has had on audits. The Commit- tee was also informed that actions have also been taken by foreign regulators and others to strengthen audits in other countries. The auditing profession has been studied extensively in the past, but was previously self-regulated and implementation of recommendations was not consistent. Under the oversight of the PCAOB, we are optimistic that recommendations of this Committee will receive appropriate attention. We believe the U.S. standard setters and regulators, including the PCAOB should be involved on international matters, working to ensure a positive interchange and consideration of experience and expertise from within and outside the United States to help inform global de- II:1 ◆ Advisory Committee on the Auditing Profession ◆ ◆ Advisory Committee on the Auditing Profession ◆ velopments, with the objective of strengthening financial reporting and auditing worldwide. Because a substantial portion of the audits of U.S. public companies occur outside the United States, our capital markets benefit when standard setters work with regulators in other coun- tries and with international agencies. We believe that the United States should take a leader- ship role in ensuring the highest quality accounting and auditing standards. An important requirement of Sarbanes-Oxley is that audits of U.S. public companies are to include evaluation by the independent auditor of the effectiveness of a company’s system of internal control. While there were initial complications in implementing this requirement, it now seems to be working generally as intended and is a watershed event that has improved and will continue to improve financial reporting. An effective system of internal control is critical to the timely and accurate recording of transactions, to the safeguarding of assets, and ultimately to reliable financial reporting. Due to Sarbanes-Oxley, independent audit committees in the United States now engage the independent auditor and manage the relationship. Audit scope under Sarbanes-Oxley has been expanded to include reporting on internal controls, and audit fees for U.S. public com- panies have increased significantly. At the same time, fees billed to audit clients for non-audit services have declined, a result generally appreciated by investors as strengthening auditor in- dependence. Pre-Sarbanes-Oxley, audit fees were on average approximately only 50% of total fees charged to audit clients. That percentage increased dramatically to approximately 80% by 2006. We believe it important that audit fees continue to provide a fair return to auditors and we would not wish to see a return to the situation pre-Sarbanes-Oxley when audits were sometimes viewed as a commodity and priced accordingly. Now that evaluation of internal controls has been integrated into the audit, it appears that the scope of work and the result- ing audit fees have generally stabilized and auditing firms are looking to areas beyond audit to profitably grow their practices. The rate of growth for non-audit services, especially advisory services offered to non-audit clients, now exceeds the rate of growth for audit services. We realize that the allocation of investment dollars and professional talent is in many cases inter- changeable, and that some auditing firms are working a delicate balance in allocating