A Recommendation to The Treasury Department's

Advisory Committee on the Auditing Profession

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Improving the

Transparency and Sustainability

Of the Audit Profession

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November 2007

I am a recently retired audit partner from one of the Big Four audit
firms. My observations and recommendation are based on my personal
experience in public accounting as well as the discussions I have had
with CFOs and controllers of both clients and non-clients.

Common complaints from public company CFOs and controllers about their
audit firms regularly include the following:

-   "We don't have good continuity of audit team personnel from year to
    year."

-   "We are a training ground for young auditors."

-   "Your audit team doesn't seem to understand what they are doing."

-   "I get asked the same questions over and over."

-   "I don't see enough of the partner and manager."

A major contributing factor to these observations is the high turnover /
high workload business model that the Big Four audit firms follow. This
was one of the primary reasons I retired from public accounting when I
did. The combination of high workloads, high leverage, low experience,
and high turnover were not conducive to audit quality. The large firms
have been following the same business model that existed when I started
my career in public accounting over 29 years ago. Hire young kids just
out of college, work them to death, pay them less than they can make in
industry -- and sure enough -- they leave the large audit firms once
they get their CPA certificate. The one element that used to
counter-balance this situation was that nearly everyone that started in
public accounting 29 years ago had the ambition of becoming a partner.
Today, that ambition is waning because the audit partners are overworked
and under a lot of stress. Very few of the younger people these days
desire to become an audit manager in public accounting, let alone an
audit partner.

The end result is high turnover and higher workloads at all levels. The
environment I am describing is not conducive to achieving high audit
quality. My personal view is that a number of audit failures have their
roots in excessive workloads, high turnover, and inexperience.

I have asked myself why the Big Firms have settled into such an
unhealthy equilibrium point. My conclusion is this: The leaders of the
large firms are held accountable for current year profits -- and they
are not held accountable for reducing turnover or increasing the average
years of experience of their professional staff. Granted, audit quality
has an impact on profits -- but the impact of legal settlements is
typically not fully measured until several years have passed and the
existing leaders have moved on.

I've thought about measures that could make the leaders of the large
firms more accountable for turnover, reasonable workloads and retaining
more experienced professionals. I think I have a simple solution that
can have a profound effect.

**Measuring and Reporting Audit Quality Drivers**

Each of the large audit firms distribute information to the audit
committees of their public company audit clients describing their
processes to ensure audit quality. This information is distributed
pursuant to the requirements of the New York Stock Exchange Listing
Standards. This information includes, among other things, the audit
firm's commitment to hiring, training, performance evaluation, and
compensation. The information provided by the Big Four audit firms leads
the readers of this information to conclude that each firm is completely
committed to quality and implies that each firm must truly be a
wonderful place to work. Unfortunately, I believe the large firms are
painting an incomplete picture. Each firm does not talk about the
relatively low experience levels of its professional staff, the heavy
workloads, the high turnover, and the high ratio of professional staff
to experienced audit partners.

Audit quality is not easily measured. However, I believe there are six
drivers of audit quality which can be measured readily and publicly
reported by each audit firm on an annual basis. These statistics will
enable the consumers of audit services to gauge the degree to which each
audit firm has created an environment conducive to audit quality.
Competition will drive each of the Big Four audit firms to alter their
business models to improve the reported statistics. I suspect that none
of the Big Four CEOs will want to be in last place when these statistics
are reported. I also believe that audit committees will be reluctant to
hire an audit firm that does not compare favorably to the statistics
achieved by the other large audit firms. The end result is that
competitive forces will drive improvements to each firm's business model
-- resulting in a healthier balance between profitability and the audit
quality drivers. The six audit quality drivers and a brief description
of their importance are summarized below:

-   **The average years of experience of audit professionals** -- The
    experience level of the audit professionals is a key driver of audit
    quality. The complexity of accounting and high public expectations
    all point to the need for more experienced professionals. By and
    large, corporate America is audited by young men and women just out
    of college -- supervised by a limited number of experienced
    partners. My preference would be to measure this statistic only
    counting years of experience subsequent to the employee becoming
    licensed as a CPA. This will draw attention to the fact that much of
    the audit field work is conducted by employees who have not yet
    become CPAs. It will also drive the large Firms to encourage their
    employees to become licensed CPA's sooner and will reinforce the
    importance of technical excellence.

-   **Ratio of professional staff to audit partners** (using FTEs)
    **--** A favorable ratio of audit professionals to audit partners
    can be a good indicator of an appropriate level of partner
    involvement and partner supervision of less experienced employees.

-   **Chargeable hours per audit professional** (using FTEs) -- When the
    staff workloads become excessive, audit quality suffers. The old
    saying, "The devil is in the details," is especially true about
    auditing. When workloads become excessive, attention to detail
    suffers. This means less attention is paid to critical items such as
    contract reviews, complex accounting matters, and supervisory
    reviews of the work conducted by lower level professionals.

-   **Professional chargeable hours managed per audit partner** (using
    FTEs) -- The average hours managed per audit partner is a critical
    metric. It speaks volumes about the reasonableness of the partner
    workloads. When the audit partner workloads are excessive, audit
    quality suffers because the audit partner doesn't have enough hours
    in the day to assure that a suitable level of audit quality has been
    achieved.

-   **Annual professional staff retention** (i.e., What percentage of
    professionals employed a year ago are still employed today?) -- The
    reason the experience level is so low among the Big Four audit firms
    is because of high staff turnover. The lack of work life balance,
    high stress and lower than market salaries cause many employees to
    leave public accounting after just 3 to 5 years of experience --
    just when they start to possess a meaningful level of experience.
    The downside to high turnover is 1) low audit team continuity from
    year to year and 2) reduced experience levels. This increases the
    risk that audit work is conducted by less experienced audit team
    members who may be unfamiliar with the business being audited or the
    issues encountered on the audit in the prior year.

-   **Average annual training hours per audit professional** **--** When
    workloads become excessive, audit professionals tend to cancel
    scheduled training because completing existing assignments is seen
    as a higher priority. This might seem like the right thing to do in
    the short run, but insufficient training undermines audit quality
    over the longer term.

These statistics should be reported by each large audit firm on an
annual basis with comparison to the prior year's statistics. This would
enable the consumers of audit services to judge whether the trend is
favorable, neutral, or unfavorable. I would welcome each audit firm to
provide their own Management Discussion and Analysis of these
statistics. I would imagine that it wouldn't take long for the financial
press to provide side-by-side comparisons of each of the firm's metrics
for the audit quality drivers.

If I were on an audit committee and was considering alternative
proposals from competing firms, I would certainly favor the firm that
brought the most experience to the table, set reasonable workload
expectations, achieved a suitable level of continuity year over year,
provided for a high degree of partner involvement in the audit process,
provided for proper supervision of its professionals, and invested
appropriately in the training of its younger professionals.

The airlines publish "On Time Departure Statistics" to help consumers
make more informed choices about which airline to fly. Consumer Reports
publishes a wealth of information to help consumers make informed buying
decisions about cars, appliances and consumer electronics. Shouldn't
audit committees be entitled to receive better information about the
audit services they are procuring?

One of my favorite sayings is "That which gets measured -- improves." In
this case, I am confident that competition will motivate a change in
each firm's behavior. None of the big firm leaders will want to be in
last place when the statistics on audit quality drivers are published.

I would anticipate that several computational issues may arise impacting
the reliability and comparability of these statistics between firms.
However, I am confident that these issues can be resolved with
appropriate oversight from an independent third party.

**Defining the Safe Zone of Operation**

The large firms all tend to run very lean on headcount -- both at the
employee level and at the partner level. This is largely because the
office and regional managing partners are measured on bottom line
contribution. There is not much of a safety net when turnover runs high
or unexpected new work comes in the door. One of the ironies here is
that the audit firms tend to be the most profitable when turnover is at
its highest. The revenues are relatively fixed in the near term based on
the client book of business. If turnover is high, two factors drive down
payroll costs and increase profits. The obvious factor is lower
headcount which lowers payroll costs. The less obvious factor is that
the departed experienced employees (who tend to be more expensive) are
replaced by less experienced employees who are less expensive.

To better manage the risks described above, I am recommending that the
large firms use the metrics I have described herein to define **safe
zones of operation** at the office and individual partner level. When
the metrics indicate operation outside the safe zone, I would expect the
firm to implement safety measures to mitigate the risk associated with
operating outside the safe zone. Such measures might include expanded
second partner concurring reviews equivalent to the review expected of
the engagement partner -- to assure that audit quality has not been
compromised.

**The Audit Firm Quadropoly -- Sustainability and Transparency**

Much has been said in the financial press about the dangers of having
only four large audit firms. There is criticism about the lack of
competition, escalating fees and deteriorating service due to the
so-called "quadropoly." There is also concern about "What happens if one
of the Big Four should go out of business?"

Publication of the metrics I am recommending will drive the large audit
firms to improve how they perform with respect to the drivers of audit
quality described herein. This means that service levels and audit
quality will improve, benefiting the consumers of audit services. It
also means that the probability of audit failures will be reduced --
thereby enhancing the long term sustainability of each firm.

Much has also been said about requiring the audit firms to provide
transparency about their financial results. It is already well known
that the large CPA firms are very profitable. I do not foresee that the
publication of the large firm financial results will accomplish a lot.
On the other hand, providing transparency to the metrics impacting audit
quality has the potential drive fundamental changes to the large audit
firm business models which can significantly improve audit quality and
long term sustainability.

We all agree that monopolistic situations require regulation. Otherwise,
service levels deteriorate while monopolistic pricing generates excess
profits for the monopoly owner. I am not suggesting full scale
regulation, merely the reporting of information which will enhance
competition and drive the audit firms toward a **safer zone of
operation**. I am not denying that the large audit firm partners should
be well compensated for their expertise and hard work. But there needs
to be a balance between the profitability of the quadropoly and finding
the **safe zone of operation**. This not a time to be sheepish about
asking for more information (aka regulation) which will benefit the
consumers of audit services and make the audit firms safer and more
viable in the long run. The consequences of not acting now are far too
grave to continue with business as usual.