Peer review: Reality or fiction?

In December 1972, as president of the New York State Society of CPAs, I proposed to the state society's board a program of quality review for society members.

The program was to be voluntary and at no cost to members. The following month, I appointed a Quality Review Task Force with Dean Emanuel Saxe of Baruch College as chairman; other members were Max Block, editor of The CPA Journal; Warren Cutting, a past president of the state society; and Benjamin Neuwirth, a practitioner with years of audit experience who passed away recently at the age of 103, and who continued to reconcile his bank account until the end.

The state society newsletter announced that society members who desired a quality review by this distinguished panel should contact the society and arrangements would be made. To our pleasure and satisfaction, several dozen members signed up, mainly from smaller firms, and were told to bring examples of their financial reports along with supporting workpapers.

They had the unusual experience of their work products being reviewed by an expert. The experience proved that practitioners wanted a quality review, which was performed by capable CPAs. It took many years before the profession considered and adopted a program of peer review.

Early in the 1970s, as a member of the State Board for Public Accountancy in New York, I recommended that CPAs or licensed public accountants who breached accounting or auditing standards must undergo a mandatory quality review. Members of the state board would visit the office of the errant accountant and conduct a review of the accountant's work products. In one case, an accountant who specialized in audits of labor unions issued unqualified opinions with no back-up workpapers - he said that he did not know that they were required.

In 1978, the profession adopted a nationwide system of peer review with new verbiage i.e., team captains, review cycles, exit conferences, letters of comment, and voluminous instructions, directions and explanations of this new peer review process.

Our time machine now goes fast forward to Aug. 22, 2001, when an Enron executive, Sherron Watkins, sent a six-page e-mail to chairman Kenneth Lay warning of Enron's pending implosion. In her concluding paragraph, after listing Enron's financial malfeasances, she wrote, "... it can't be that bad, that's just too bad, too fraudulent, surely AA & Co. wouldn't let them get away with that?"

Unfortunately, Watkins was not in the loop with other Andersen clients, including WorldCom, or she might have written a "Dear Mr. Ebbers" letter. It is almost unbelievable and inconceivable that with the Enron mess proclaimed all over the world, during December 2001, Andersen's managing partner, Joseph Berardino, received a letter of congratulations for the "unmodified" peer review conducted by Deloitte & Touche.

On Dec. 10, 2001, Ernst & Young's managing partner, James S. Turley, also received a letter of congratulations on its "unmodified" peer review, which was conducted by KPMG.

Is anyone embarrassed by Ernst & Young's record in CUC, HealthSouth and Sprint, or its six-month suspension by the Securities and Exchange Commission for lack of independence in its PeopleSoft audit? Should not the reviewers of the quality of an accounting firm be concerned with the flagrant abuses in marketing of tax shelters to its clients, which are now the subject of a federal grand jury investigation?

On Dec. 11, 2002, KPMG's managing partner, Eugene D. O'Kelly, also received a letter of congratulations on its "unmodified" peer review despite the Xerox cause celebre, and KPMG's flagrant abuses in marketing of tax shelters to its clients, which are also being investigated by a federal grand jury.

In a letter recently sent to me by a former Arthur Andersen senior partner, he wrote, "The other major point is that there are a significant number of large companies that can't be and are not audited by any definition that you, I or the public thinks is an audit. ... You simply can't audit billions of dollars of transactions and get the report out on a timely basis with the limited number of people you can throw at the project. So, the auditors are auditing a system, but not the numbers, and the public thinks they are auditing the numbers."

If the foregoing is true, were the so-called peer reviews a mockery intended to confuse and deceive those who believed that the profession had put in place a program that would elevate the public's perception and confidence in the audit process?

July 30, 2002, will go down in the annals of the accounting profession as the day President George W. Bush signed the earth-shattering Sarbanes-Oxley Act that created the Public Company Accounting Oversight Board.

One of the remarkable facets of the legislation was that it was sponsored by Sen. Paul Sarbanes, a liberal Democrat from Maryland, and Rep. Michael Oxley, a conservative Republican from Ohio. The latter had authored a stinging letter to former SEC Chairman Arthur Levitt Jr. in 2000 threatening, among other things, to cut the SEC's budget because of Levitt's campaign against certain consulting services rendered by accounting firms.

The act has literally turned the practice of those who audit public companies upside down. The chief auditor of the PCAOB is Dr. Douglas R. Carmichael, CPA, a brilliant technician who had previously chaired the Center for Integrity in Financial Reporting and whose staff has already commenced inspections of the work performed by independent accountants.

In all likelihood, the Big Four firms experienced considerable unease when they learned that Sarbanes-Oxley charged the PCAOB to conduct a continuing program of inspections to assess compliance with the act, the rules of the board, the rules of the SEC and professional standards. The PCAOB determined that conducting limited inspections of the largest firms was feasible in 2003. It developed inspection procedures and work programs and conducted four scaled-down versions of the types of inspections that the board intends to conduct going forward (and that are currently underway for 2004).

The board conducted these limited inspections with respect to each of the four largest accounting firms in the U.S. The PCAOB conducted a limited inspection of Deloitte & Touche and issued a 23-page draft report on June 22, 2004. On July 22, 2004, Deloitte & Touche, in a three-page letter, responded to the comments and criticisms made by the PCAOB inspectors. Deloitte & Touche's letter included, "We believe inspections by the board are of considerable value to the public and its confidence in the integrity of the independent audit process and we are supportive of the board's new responsibilities."

The board also conducted a limited inspection of Ernst & Young and issued a 25-page report. On July 22, 2004, Ernst & Young, in a seven-page letter, responded to the comments and criticisms made by the inspectors. Ernst & Young's letter included, "We are respectful of the PCAOB's inspection process and understand that judgments are involved."

The board also conducted a limited inspection of KPMG and issued a 27-page report. On July 22, 2004, KPMG, in a four-page letter, responded to the comments and criticisms made by the PCAOB inspectors. KPMG's letter included, "Furthermore, we at KPMG were impressed with the qualifications of the PCAOB staff and their thoroughness, dedication and attention to detail in conducting this initial limited inspection."

The board also conducted a limited inspection of PricewaterhouseCoopers and issued a 27-page report. On July 22, 2004, PricewaterhouseCoopers, in an eight-page letter, responded to the comments and criticisms made by the PCAOB inspectors. The PwC letter included, "We strongly believe in and support the PCAOB's mission. As we have stated many times, we share with the PCAOB the goals of restoring investor confidence and public trust in our profession."

The inspection reports and the responses from the Big Four firms are interesting as to content and style. The Big Four, who wallowed for years in "unmodified" peer reviews, now love these new PCAOB quality reviews. The Big Four letters contain varying degrees of self-praise and references to their high standards. It remains to be seen how future inspection reports will be formulated when the PCAOB has a full complement of inspectors and facilities.

As the man said, "It ain't over 'til it's over."

Eli Mason is a past president of the New York State Society of CPAs, a past chairman of the New York State Board for Public Accountancy, and a past vice president of the American Institute of CPAs. He is also the author of Conscience of the Profession.