Order Code RS21120
Updated September 3, 2002
CRS Report for Congress
Received through the CRS Web
Auditing and Its Regulators:
Reforms after Enron
Bob Lyke
Specialist in Social Legislation
Domestic Social Policy Division
Summary
Accounting problems at Enron, WorldCom, and other companies have raised
important questions about the audits of corporate financial statements. These audits
usually are done by independent accountants who are certified public accountants
(CPAs); they are supposed to be carried out in accordance with generally accepted
auditing standards (GAAS), rules which have a carefully defined technical meaning.
The U.S. Securities and Exchange Commission requires audited financial statements
when public companies register to sell new securities and annually thereafter. Auditor
assurances about company financial statements can remove a barrier to the efficient use
of capital and offer some protection to third party investors.
Auditors are regulated by both governmental agencies and professional
organizations, though many question whether this oversight has been adequate. Enron’s
auditor, Arthur Andersen, was investigated by the U.S. Securities and Exchange
Commission (SEC), several congressional committees, and other agencies, and it is
facing numerous law suits. A federal jury convicted the firm on obstruction of justice
charges on June 15, 2002, and it ceased all audit work as of the end of August, 2002.
Numerous accounting and audit reforms have been proposed, including some by
the accounting industry. On July 30th, the President signed the Sarbanes-Oxley Act of
2002 (P.L. 107-204), which among other things creates a new oversight board for
auditors, prohibits auditing firms from providing certain consulting work for audit
clients, and requires rotation of audit partners at least every 5 years. The new law also
imposes new requirements on corporate boards and executives and increases
governmental oversight and criminal penalties. Issues regarding its implementation
have already emerged.
What is Auditing?
Broadly speaking, auditing is a systematic process for obtaining and assessing
evidence regarding assertions of one kind or another in accordance with established
criteria. Serious accounting problems at Enron, WorldCom, and other companies have
Congressional Research Service ˜ The Library of Congress

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raised important questions about financial statement audits of corporations and other
private sector organizations in which accountants express an opinion on financial
representations made by the management of these entities. Other types of audits include
compliance audits, which see if established policies and procedures are being followed,
and operational audits, which see if organizations are efficient and effective. Accountants
are also increasingly engaged in a widening array of other assurance services, which have
different standards and procedures than audits.
Financial statement audits of private sector organizations usually are done by
independent accountants (sometimes called external accountants). Today nearly all of
these audits are carried out or supervised by accountants who are certified public
accountants (CPAs). Independent accountants are owners or employees of private sector
firms that are separate from the entities they audit; they might be distinguished from
internal accountants, who work for the organizations being audited, and government
accountants, who do most auditing of governmental agencies. However, independent
accountants also do internal and government accounting work.
Financial statement audits of private sector organizations are to be conducted in
accordance with generally accepted auditing standards (GAAS); their basic objective
is to see if the balance sheet and related statements about income, retained earnings, and
cash flows are fair presentations, in all material respects, of certain financial information
in conformity with generally accepted accounting principles.
! GAAS are qualitative standards regarding who is to conduct audits, how
audits are to be planned and carried out, and how audit results are to be
reported; they are not lists of specific audit procedures.
! GAAS have a carefully defined technical meaning that clarifies both
what audits do and what they do not do; understanding these standards
is important when questions arise regarding audit engagements.
! GAAS and other standards for private sector audits are established
largely by the American Institute of Certified Public Accountants
(AICPA).
Generally accepted accounting principles (GAAP) are the conventions, rules, and
procedures that define accepted financial accounting practices at a particular time; they
include both broad guidelines as well as detailed procedures.
! The most important source of GAAP for private sector entities is the
statements and interpretations of the Financial Accounting Standards
Board (FASB), a nongovernmental entity that began operating in 1973,
and similar issuances of its predecessors.
! Other sources of GAAP with lesser authority include issuances from
FASB task forces and staff and from the AICPA, widely accepted
industry practices, and other professional positions and literature.
! The U.S. Securities and Exchange Commission (SEC) historically has
accepted GAAP developed from these private sources; however, it has
broad authority to establish accounting principles for the companies
within its jurisdiction (generally, public companies whose securities are
offered or sold in interstate commerce).

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(On July 10, 2002, the Subcommittee on Commerce, Trade, and Consumer
Protection of the House Committee on Energy and Commerce approved an amended
version of H.R. 5058 (Stearns) which among other things would establish an Accounting
Reform Commission to study and recommend steps for improving accounting standards
and the process by which they are set. The bill would instruct FASB to complete work
on several projects and develop additional standards regarding off-balance sheet financing
and mark-to-market accounting.)
Auditing plays a critical role in modern economies, which are characterized by large
multi-faceted organizations, complex economic exchanges, and remote relationships
between business managers and the owners and other investors. Managers have the
ability to obtain reliable information about their own organizations, at least in theory, but
it is risky for outside investors and other creditors to rely on managers’ representations
alone. To the extent they provide assurances about these representations, auditors remove
a barrier to the efficient use of capital and offer some protection to parties that could be
indirectly affected by investing decisions. Annual financial statement audits have become
common for nearly all large organizations because of the demands of outside investors
(in the case of business entities), outside supporters (in the case of not-for-profit
organizations), tax authorities, and government regulators. The SEC requires audited
financial statements when public companies register to sell new securities and annually
thereafter.
Who Regulates Auditors?
Currently, auditors are subject to regulatory oversight from both governmental
agencies and professional organizations. In addition, they can sometimes be legally liable
for breach of contract or for a tort (a civil wrong other than breach of contract).
State Boards of Accountancy. These governmental boards (or agencies that
perform similar functions) administer state laws governing accountants and accounting
services. They are responsible for licensing CPAs, for whom there is no national or
federal certification. All states require CPAs to have passed the Uniform CPA
Examination, and most now require new candidates to have at least 150 college credit
hours (i.e., 5 years of college), including courses in accounting subjects. Most states
require CPAs to have 30 to 40 hours of continuing education each year, and some require
practical experience before granting full licenses. State accountancy boards can require
CPAs and their firms to undertake remedial steps to continue their practice, and they
sometimes suspend and terminate licenses. Arthur Andersen, the auditor for Enron,
surrendered its license to practice in all states as of August 31, 2002.
American Institute of Certified Public Accountants. The AICPA is a
professional trade association of certified public accountants. In addition to establishing
auditing standards for the private sector, it has a Code of Professional Conduct for its
members with both general principles and rules of conduct. The six general principles
provide a framework for professional conduct; they deal broadly with CPA
responsibilities, the public interest, integrity, objectivity and independence, due care, and
the scope and nature of services. Members are required to comply with the rules of
conduct (for which formal interpretations provide additional guidance); they include
provisions on independence, engagement standards, confidentiality, contingent fees,
discreditable acts, advertising, etc. Violations are considered by the Professional Ethics

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Division and may result in requirements for continuing education or prior clearance of
future work. Serious misconduct can result in suspension or termination of AICPA
membership. State CPA societies have similar though not always identical rules for their
members. Sometimes state societies and the Professional Ethics Division conduct joint
investigations.
Securities and Exchange Commission. The SEC is an independent federal
regulatory agency responsible for administering federal securities laws. It has authority
to regulate the initial issuance of securities and their subsequent sale; for both, it requires
companies to submit financial statements that have been audited by independent
accountants. Under Regulation S-X, Rule 2-01, it prescribes qualifications for these
accountants, including the rules just mentioned on auditor independence. Historically the
SEC has relied on the AICPA to oversee accountants, including those who audit public
companies, but under Administrative Rule 2(e) it may disqualify from its practice
accountants who are unqualified, lack character or integrity, engage in unethical or
improper professional conduct, or willfully violate (or aid and abet others to violate)
federal securities laws. Other sanctions include peer review, prohibitions on new
engagements, and requirements for continuing education. After its conviction on
obstruction of justice charges, Andersen informed the SEC that it would cease practicing
before it by August 31, 2002.
Other Legal Liability. Auditors can be sued for breach of contract by their clients
(the entities being audited) for failing to carry out their work with due professional care.
Among other things, clients usually must show they suffered damages and that there is a
close causal connection between the breach and the damages. To reduce this risk, most
accounting firms use engagement letters to clarify what they will do and identify client
responsibilities.
Third parties normally can sue auditors only in a tort action, not for breach of
contract. (One exception would be if the third party is a subrogee of the client, such as
a trustee in bankruptcy.) Third parties must also show they suffered damages and that
there is a close causal connection between the auditor’s breach and the damages.
However, in some states, barring a showing of gross negligence or fraud, third parties may
be unsuccessful in their suit unless it is shown that the auditors actually foresaw the
parties would rely on the audit (or in some states, that the auditors might reasonably have
foreseen their reliance). Third parties may also sometimes bring suit against auditors
under provisions of federal securities laws.
What Audit Issues Are Being Raised?
Controversy over corporate accounting practices continues to grow as new
allegations of errors, misstatements, and fraud keep emerging. It is apparent that the audit
problems at Enron were not isolated occurrences, though it remains unclear how
widespread and how material audit shortcomings generally are. Nonetheless, it is
important to distinguish the following kinds of corporate accounting problems since
remedies and steps to prevent future problems would differ:
! was there failure of auditors to select appropriate auditing procedures or
to make particular accounting judgments that would have revealed more
of a corporation’s finances?

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! was there failure of auditors to follow generally accepted auditing
standards?
! was there failure or weakness of the auditing standards themselves?
! was there failure or weakness of the accounting standards?
! was there failure of the corporation to provide material information?
Audits do not prevent bad business decisions, let alone shield firms from bankruptcy. To
some, Enron’s bankruptcy might be attributed primarily to its trading in the derivatives
market and its continual need for capital. However, others ask whether audit problems
may have contributed to both the rapid rise and sharp fall of Enron’s stock prices.
Questions regarding the Enron audits have received widespread publicity. Perhaps
the most important for the accounting industry is whether Andersen’s extensive
consulting work for Enron – $27 million in its last audit year alone – compromised the
independence it should have maintained throughout its work. The AICPA has long had
rules on independence (codified in Rule 101 of the Code of Professional Conduct), and
it had been cooperating with the SEC to strengthen them for audits of public companies.
Nonetheless, criticism of independence standards has increased in recent years as
accounting firms have expanded their consulting work. In June 2000, the SEC proposed
substantially more restrictive rules for audits of public companies, though the final
provisions adopted that November were generally seen as favorable for the accounting
firms. For further information about this particular controversy, see CRS Report
RS20707, Auditor Independence: the SEC’s New Rule, by Mark Jickling.
What Reforms Have Been Proposed?
Numerous accounting and auditing reforms have been proposed, including some by
the accounting industry. Most of the leading proposals would establish a new oversight
board for auditors of public companies, though they differ on the scope of its powers and
the degree of its independence from the SEC and from the firms and accountants it would
regulate.
House Legislation. The leading House bill was an amended version of H.R. 3763
(Oxley), which the House approved on April 24, 2002. Other relevant House bills include
H.R. 3617 (Markey), H.R. 3671 (Hastings), H.R. 3693 (Jackson-Lee); H.R. 3736
(Ackerman); H.R. 3795 (Kucinich), H.R. 3818 (LaFalce), H.R. 3829 (Stupak), H.R. 3970
(Dingell), and H.R. 4083 (LaFalce).
Senate Legislation. The leading Senate bill (S. 2673) was reported by the
Committee on Banking, Housing, and Urban Affairs on June 25, 2002. Floor debate
began on July 8, and an amended version passed on July 15. Other relevant Senate bills
include S. 1896 (Boxer), S. 1933 (Shelby), S. 2004 (Dodd), S. 2056 (Nelson), S. 2247
(Durbin), and S. 2460 (Levin).
Conference Agreement. On July 24, a conference committee reached agreement
on the differences between the bills passed by the House (H.R. 3763) and the Senate (S.
2673, formally an amendment to H.R. 3763). The agreement, the Sarbanes-Oxley Act of
2002, largely follows the Senate amendment, though some modifications proposed by the
House were accepted. Both the House and Senate approved the agreement on July 25, and
the President signed it on July 30th (P.L. 107-204). Among other things, the agreement

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creates a new oversight board for auditors, prohibits auditing firms from providing certain
consulting work for audit clients, and requires rotation of audit partners at least every 5
years. The law also imposes new requirements on corporate boards and executives and
increases governmental oversight and criminal penalties. For details, see CRS Report
RL31483, Auditor Reform Proposals: A Side-by-Side Comparison, by Mark Jickling.
How the Sarbanes-Oxley Act will be implemented has already become an issue.
Within a week of the signing ceremony, some Members of Congress accused the
Administration of taking a narrow view of provisions regarding securities fraud, whistle-
blower protection, and punishment for shredding documents. There is also growing
interest in whom the SEC will name to the new oversight board.
The SEC. On June 26, 2002, the Commission published proposed rules to reform
oversight and improve accountability of auditors of public companies. For details, see
[http://www.sec.gov/rules/proposed/33-8109.htm]. The central part of the proposal, a
requirement that companies’ auditors be members of a new independent public
accountability board (PAB), was largely superceded by the Sarbanes-Oxley Act. On June
28, the Commission identified 945 companies with annual revenues exceeding $1.2
billion whose chief executive and chief financial officers would have to personally certify
that the most recent reports filed with the Commission are both complete and accurate.
For most of these companies, the deadline for these certifications is August 14, 2002.
Since the Enron controversy broke, the SEC has stepped up its review of company
financial statements and started investigations of a number of accounting irregularities.
Some question whether the agency has enough resources to monitor accounting practices
at all public companies, let alone take on new oversight responsibilities. The U.S.
General Accounting Office (GAO) has found that the SEC does not have sufficient staff
or authority even for all of its current work and that it lacks a comprehensive strategy for
dealing with these problems (GAO-02-483T). The Sarbanes-Oxley Act increased the
authorization for SEC appropriations.
The President. On March 7, 2002, President Bush outlined a 10-point plan to
improve corporate responsibility and shareholder protections. Included were proposals
for an independent regulatory board for the accounting profession, for greater investor
confidence in auditor independence and integrity, and for accounting standards more
responsive to investor needs. On July 9, the President called for longer prison sentences
for executives convicted of fraud, a new task force to pursue and prosecute criminal
activity, and additional personnel and funding for the SEC.
The Accounting Industry. The AICPA and the largest accounting firms
generally opposed strict external oversight of auditing, arguing that new regulatory bodies
would be cumbersome and lack professional expertise. They generally opposed wide
bans on providing consulting services for audit clients. For the most part, they favored
the House bill (H.R. 3763) rather than the Senate bill (S. 2673). Since Arthur Andersen
can no longer perform audits, the so-called “Big-5" accounting firms have been reduced
to four: PricewaterhouseCoopers, Deloitte and Touche, KPMG, and Ernst and Young.

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