RECENT DEVELOPMENTS IN INDEPENDENT AUDITING

1. RECENT DEVELOPMENTS IN INDEPENDENT AUDITING N.Nevruz DURSUN Supervisor: Prof. Peter H. KNUTSON April 2003 The Wharton School, University of Pennsylvania

2. CONTENT • Background information • Sarbanes-Oxley Act of 2002 and Related Rules • American Institute of Certified Public Accountants’s (AICPA) Approach • International Organizations’s Approach • International Organization of Securities Commissions (IOSCO) • International Federation of Accountants (IFAC) • Turkey • Conclusion

3. BACKGROUND • Auditing standard setting and auditor oversight system before Sarbanes-Oxley Act of 2002 • Panel on Audit Effectiveness (October 7/8, 1999) • Effects of sudden collapse of USA’s big firms over auditing system (Enron, Worldcom etc.)

4. Auditing System before Sarbanes Oxley Act of 2002 Securities Exchange Commission (SEC) American Institute of Certified Public Accountants (AICPA) Public Oversight Board (POB) Ethics Division Auditing Standards Board (ASB) SEC Practice Section (SECPS) ExecutiveCommittee Peer Review Committee (PRC) Quality Control Inquiry Committee(QCIC) ….. Approves Committee Nominees ____ Direct Reporting ------ Oversees Activities Professional Issues Task Force (PITF) SEC Regulations Committee

5. Panel on Audit Effectiveness • Panel on Audit Effectiveness was formed by Public Oversight Board on October 7/8 1998, in response to a September 28, 1998 request from the SEC. • Panel’s findings and recommendations are numerous and related with many constituencies; standard setters, audit firms, SECPS, audit committees, the SEC and others. • The Panel’s findings and recommendations are almost about; • Auditing and quality control standards should be more specific and definitive, independence standards should be revised, • Auditors should perform some ‘forensic-type’ procedures on every audit to enhance the prospects of detecting material financial statement fraud, • Auditor oversight system should be strengthened, • International auditor oversight system should be established.

6. Effects of Collapse of Big Firms over Auditing System • Enron, Worldcom and other massive audit failures clearly damaged the confidence to the accounting profession as well as accounting profession’s self regulatory system, • A reform in auditing standard setting and auditor oversight system was needed to restore the confidence of investors to USA capital market.

7. SARBANES-OXLEY ACT OF 2002 and RELATED RULES General: • Sarbanes Oxley Act was enacted on July 30, 2002. • The Act contains provisions impacting many of the key players in the capital formation process; auditors, audit committees, attorneys, securities analysts. • SEC issued several rules depending on Sarbanes Oxley Act. Some of these rules are finalized. Independent Auditing: • Sarbanes-Oxley Act’s provision regarding to independent auditing are; • Public Oversight Accounting Oversight Board (PCAOB), • Auditor independence • SEC issued final rules about; • Strengthening the Commission’s Requirements Regarding Auditor Independence, • Retention of Records Relevant to Audits and Reviews. • PCAOB proposed rules about registration of public accounting firms.

8. Public Oversight Accounting Oversight Board (PCAOB)-I Establishment: • Established as an independent, non-profit, quasi-governmental board, • Duties are; • Register public accounting firms, • Establish or adopt auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports, • Conduct inspections of registered public accounting firms, • Conduct investigations and disciplinary proceedings concerning, and impose appropriate sanctions, • Enforce compliance with the Sarbanes-Oxley Act, the rules of the PCAOB, professional standards and securities laws relating to preparation and issuance of audit reports and obligations and liabilities of accountants with respect thereto, • PCAOB will have 5 financially-literate members, appointed for 5 year term. Two of the members must be or have been certified public accountants, remaining three must not be or cannot have been CPAs.

9. PCAOB- II Registration with the PCAOB : • Public accounting firms have to register with the board to perform audits of issuers. • PCAOB’s proposal doesn’t exempt non-US public accounting firms from registration. Auditing, Quality Control and Independence Standards and Rules : • PCAOBshall establish or adopt auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports, • Recently, PCAOB announced that PCAOB will establish its standards by reviewing existing standards, instead of adopting existing standards, with advise from experts. Inspections of Registered Public Accounting Firms : • PCAOB shall conduct a continuing program of inspections to assess the degree of compliance of each public accounting firm and associated persons of that firm with the Act, • Annual quality reviews must be conducted for firms that audit more than 100 registrants, • All others must be conducted every 3 years, • SEC’s new final rule requires public accounting firms to retain for 7 years certain records relevant to their audits and reviews of issuers’ financial statements.

10. PCAOB- III Investigations and Disciplinary Proceedings : • PCAOB shall establish, by rule, fair procedures for investigation and disciplining of registered public accounting firms and associated firms and associated persons of such firm. • PCAOB has not issued any rule yet. Foreign Public Accounting Firms : • Any foreign public accounting firm that prepares or furnishes an audit report with respect to any issuer, shall subject to Sarbanes-Oxley Act like a US public accounting firm. • The SEC and PCAOB has authority to exempt, • The PCAOB’s proposed rules doesn’t exempt non-US public accounting firms. • Foreign countries propose to sign a memorandum of understanding that would allow ‘equivalent regime’ recognition. • Recently, PCAOB grants foreign public accounting firms more time (6 months) than US groups to agree oversight.

11. PCAOB- IV Commission Oversight of the PCAOB : • The SEC shall have “oversight and enforcement authority over the PCAOB” such as NASD. • The PCAOB is required to file proposed rules to SEC. • The PCAOB must notify the SEC when it imposes any final sanction on any accounting firm or associated person. • The SEC may censure or impose limitations upon the activities, functions and operations of the PCAOB. Funding : • The PCAOB shall collect ‘a registration fee’ and ‘an annual fee’ from each registered public accounting firm. • The PCAOB shall also establish by rule a reasonable ‘annual accounting support fee’. This fee will be assessed on issuers only.

12. Auditor Independence-I • Sarbanes Oxley Act also covers auditor independence. • On January 2003, the SEC issued final rule: Strengthening the Commission’s Requirements Regarding Auditor Independence. • Sarbanes-Oxley Act and the SEC final rule address following issues; • Non-audit services, • Audit committee pre-approvals, • Partner rotation, • Cooling-off period, • Communication with the audit committees, • Proxy disclosures, • Partner compensation.

13. Auditor Independence-II Services outside the Scope of Practice of Auditors; • The Act and the SEC rule set forth a prohibited services list. • Principles are that an auditor; • can’t function in the role of management, • Audit his or her work, or • Serve in an advocacy role for the client. • Other non-audit services can be rendered only if the service has been pre-approved by the audit committee. • The SEC rule made clear that all tax services would be among the non-audit services that are permissible. • Recently, the PCAOB re-opened the tax issue. It is stated that the PCAOB want to look at this issue of tax shelters and tax consulting and see whether it creates a particular problem that needs to be addressed. Pre-approval Requirements; • Audit committees have to pre-approve all audit, review and attest services and all other permissible non-audit services to be rendered by the audit firms. • The Act and rule also include a ‘de minimis exception’ to the pre-approval requirement for non-audit services.

14. Auditor Independence-III Disclosure to Investors of Services Provided by the Auditor : • Fees are required to be disclosed in the following categories for each of the two most recent fiscal years: audit fees, audit related fees, tax fees and all other fees. • Fees are required to be disclosed in both proxy statements and annual reports. Audit Partner Rotation : • Lead audit partner/concurring or reviewing audit partner • Rotate after 5 years; time out of 5 years, • Other audit partner • Rotate after 7 years; time out of 2 years, Audit Reports to Audit Committee : • The Act and SEC rule require the independent auditor to make certain timely communications to the audit committee prior to the filing of the audit report with the SEC such as: • All critical accounting policies and practices used by the client, • All alternative treatments that have been discussed with the management, • Other material written communications between auditor and client management.

15. Auditor Independence-IV Conflict of Interest- Cooling Off Period : • A one year cooling-off period will be required before audit engagement team members can accept employment at the issuer in a ‘financial reporting oversight role’. • Certain audit engagement team members are exempted such as persons other than lead or concurring partner who provided less than 10 hours of audit, or attest services. Compensation : • An accountant is not independent if at any point during the audit and professional engagement period, any audit partner earns or receives compensation based on that partner procuring engagements with the audit client to provide any services other than audit, review or attest services.

16. AICPA’S APPROACH • AICPA is aware of the fact that collapse of the big US firms damaged public confidence to accounting profession as well as the accounting profession’s self regulatory system. • AICPA has been carrying out projects to restore the public confidence. • AICPA wants to continue to write audit standards. • However, recently, PCAOB announced that PCAOB will establish its standards by reviewing existing standards, instead of adopting existing standards, with advice from experts.

17. INTERNATIONAL ORGANIZATION’S APPROACH-I International Organization of Securities Commissions (IOSCO) : • IOSCO released two reports on October 2002; • Principles for Auditor Oversight; • IOSCO developed a list of general principles for oversight of audit firm and auditor. • General approach is that auditors should be subject to oversight by a body that acts and seen to act in the public interest. • In relation to companies operating or listing on a cross-border basis, Members are encouraged to provide each other to examine or investigate matters in which improper auditing may have occurred. Members are also encouraged to explore approaches to enhance cooperation among jurisdictions. • Principles of Auditor Independence and the Role of Corporate Governance in Monitoring an Auditor’s Independence; • IOSCO has not prescribed comprehensive standards of auditor independence, • IOSCO recommends the Code of Ethics for Professional Accountants of International Federation of Accountants (IFAC).

18. INTERNATIONAL ORGANIZATION’S APPROACH-II • International Federation of Accountants’s (IFAC) Approach IFAC released comments about SEC Auditor Independence Rule on the following issues: • Principles based approach to Ethics; • Principle-based is better than rule-based. • Rotation of auditors; • second partner review is better than partner rotation. • Provision of tax services by auditors • Tax services do not generally create threats to independence. • Territorial issues • An undertaking that the foreign audit firms are complying with the IFAC Code of Ethics should meet SEC’s needs.

19. INTERNATIONAL ORGANIZATION’S APPROACH-III • Foreign countries’s approach: • Foreign countries (such as EU, Canada, Japan, Australia) don’t want the US oversight, because the Sarbanes-Oxley Act and the PCAOB’s proposed rule; • leads to serious conflicts with national laws about the issues of client and third party confidentiality, data protection and employment law, • cause dual oversight, • increase costs, • infringe upon national sovereignty • Foreign countries propose to sign a memorandum of understanding that would allow ‘equivalent regime’ recognition, enabling foreign auditing firms which audit SEC registrants to be exempted from the PCAOB rules. • Recently, PCAOB grants foreign public accounting firms more time (6 months) than US groups to agree oversight.

20. TURKEY-I Institutional Framework • Accounting profession’s self regulatory body (TURMOB) operates a self-regulatory framework to maintain high professional standards for accountants. • Capital Market Law grants Capital Market Board of Turkey (the CMB) the authority • to determine the principles related to independent auditing operations in the capital markets; • to determine the conditions for establishment and the working principles of independent auditing firms with respect to the capital market. • Upon this authority, CMB issued communique of “Independent Auditing in Capital Markets”. According to this communiqué, • Independent auditing firms that wants to audit issuers should register with the CMB. • Registered independent auditing firms should operate according the working principles determined by the CMB. • Oversight of registered auditing firms with respect to capital market are done by the CMB.

21. TURKEY-II Recent developments : • The CMB revised its independent auditing regulation in the light of recent developments in the world. • On November 2002, the CMB issued a communiqué aimed at strengthening auditor independence. • Prohibited activities; • tax services is not a prohibited activity • consultation services couldn’t be rendered to the audit client. • Rotation of independent auditing firms • rotate after 5 years; time out of 2 years. • Audit Committee and pre-approval requirement; • Should be established, • Pre-approve the selection of independent auditing firm and services to be rendered by the independent auditing firm. • Audit reports to Audit Committee • Independent auditing firm shall make certain timely communications to the audit committee such as critical accounting policies, alternative treatment etc.

22. TURKEY-III General Evaluation : • The CMB has been carrying out the mission of the PCAOB in Turkey for several years successfully, so there is no need a new body in Turkey. • The CMB has recently revised its independent auditing regulation and regulates new rules aimed at strengthening auditor independence. Although most of the new rules are parallel to the Sarbanes-Oxley Act, there are some differences. • There is only one Turkish publicly held company whose stocks are traded in US stock exchanges. I think that audit of Turkcell will be costly if the Sarbanes-Oxley Act is applied to independent audit firm of Turkcell. • United States and Turkey share the same regulatory objectives. I believe that the PCAOB and the CMB should communicate about these matters. Information sharing between US and Turkey covered by a memorandum of understanding may be good solution. • However, if registration is required by the PCAOB, exemption from some provisions of the Sarbanes-Oxley Act and the rules of the PCAOB and SEC could be provided to Turkish audit firms.

23. CONCLUSION-I • The Sarbanes-Oxley Act aims at restoring investors’ confidence in U.S. capital markets. It appropriately reflects the fact that the US investors have a right to rely on high quality financial audits no matter where the audit is performed. • However, there are some limitations imposed by both the existence of local laws and regulatory bodies. • The IOSCO has developed a list of general principles for oversight of audit firms and auditors that audit financial statements of companies whose securities are publicly traded in the capital markets. • The IOSCO recommends the IFAC Code of Ethics for Professional Accountants about auditor independence. • The IFAC suggests that an undertaking that the foreign audit firms are complying with the IFAC Code of Ethics for Professional Accountants, should meet the SEC’s needs.

24. CONCLUSION-II • According to my view, best solution is that all countries should restructure their auditor oversight system according to globally accepted rules and adopt globally accepted accounting and auditing standards. • However, this situation couldn’t be obtained until today. • One of the problems is that international organizations have not an effective compliance mechanism, commitment or responsibility. • The other problem is related with implication of the international standards. Important thing is that international standards should be supported by an infrastructure that ensures uniform and timely implementation of standards. • There is need an international mechanism that will solve these problems. Achieving this mechanism requires an enormous effort by all participants and takes times.

25. CONCLUSION-III • However, the PCAOB should have mechanisms to ensure adherence by foreign public accounting firms to high standards of quality, ethics and independence as soon as possible. • The PCAOB should identify the primary regulatory body that oversees the accounting profession in each significant jurisdiction, and communicate directly with such regulators about these matters. • I believe that the inspection of foreign public accounting firms should be exercised by a competent regulatory authority either national or supranational (such as the EU). There will be at least three benefits of this approach. • First, it will make foreign regulatory authorities into partners in helping to promote the integrity of the capital markets throughout the world. • Second, it will almost certainly minimize delays and objections to production of work papers and testimony and will facilitate inspections of foreign firms. • And third, it will eliminate many foreign law obstacles to compliance by foreign accountants with the PCAOB’s requirements.