In addition to the criticism of the FASB in the staff study, Senator Metcalf's transmittal letter states as one of his principal concerns the delegation by the SEC of its authority over accounting and auditing matters to "private groups.”

The Commission has allowed the accounting profession, and the bodies the profession has organized, to take the initiative in establishing accounting standards. This was done after considerable debate within the Commission by the publication of Accounting Series Release No. 4, and was reconfirmed in 1973, when the Commission issued Accounting Series Release No. 150, by which it announced the policy of not recognizing principles which conflict with pronouncements of the FASB, except in the unusual circumstances stated in Rule 203 of the Code of Professional Ethics of the Institute where the use of another principle is necessary to prevent the statements from being misleading.

There is no evidence in the staff study, or elsewhere to our knowledge, that would justify the conclusion that had the Commission not adopted such a policy the quality of accounting and auditing would be different or better. Furthermore, this relationship between the Commission and the accounting profession has had the express or implied approval of chairmen and commissioners since 1938 with no discernible objection, of all chief accountants of the SEC since then, of virtually all preparers of financial information and of virtually all users of information. In short, the belief has been virtually universal that this relationship has been effective and protective of the public interest.

This practice has of course had the advantage of using the talents and experience of innumerable practitioners in the standard-setting process, at a cost incalculable but very substantial. If the entire activity of the FASB and its predecessors and the auditing standard-setting bodies had been carried out by a governmental body, the taxpayers would have borne a significant financial burden through the years.

However, this relationship has not by any means kept the SEC on the sidelines. Since its inception it has published over 200 accounting releases (78 of them since 1972); in late 1975 it commenced issuing staff interpretations based on experiences in processing filings with the Commission and inquiries from issuers and accountants, and thus far 14 have been published; it adopted Regulation S-X, which sets forth requirements with respect to the contents and format of financial statements filed with the Commission by various types of enterprises and which it has continuously amended to reflect changing needs. It is fair to say that the Commission has by rule making, by enforcement activity, and in other ways been quite aggressive in recent years in meeting its responsibility with respect to accounting matters.

Further, the Commission has maintained close liaison with the standardsetting bodies and has made known its views with respect to accounting principles and auditing practices. This liaison has clearly influenced the conduct of the private bodies.

The Commission and its staff have not been reluctant to take action when they believed the action taken by the private bodies inappropriate or unduly delayed. Thus in 1963 the Commission overrode the Accounting Principles Board with respect to accounting for the investment credit. Again in 1973, the Commission adopted disclosure requirements with respect to leases, notwithstanding the issuance of an Opinion on the subject by the Accounting Principles Board and the pendency of that matter on the agenda of the FASB. In 1975, the Commission became aware that in many cases income from early extinguishment of debt was unduly inflating the earnings of some issuers because existing APB Opinions required it to be reported as ordinary income. It urged the FASB to take action, suggesting that otherwise it would take action itself. The result was FASB Statement No. 4, which satisfied the concerns of the Commission. Similarly, when in an exposure draft the FASB appeared to favor price level accounting, the Commission took steps to require disclosure in footnotes to the financial statements of larger issuers of the replacement costs of inventories and fixed assets to reflect the effects of inflation.

An example of the manner in which the FASB and the SEC interface, and in which the SEC exercises its responsibility, is the release on December 2, 1976, of FASB Statement No. 13, pertaining to the accounting for leases. This provided for prospective application of its principles until 1981, when retroactive application will be required. The SEC is proposing that these principles, which it implicitly endorses, be applied immediately to practically all leases regardless of when they were entered into, thus requiring the application of Statement No. 13 sooner than intended by the FASB.

It is fair to say that the Commission and its staff have not been supine or indifferent to the manner in which private bodies have dealt with standard setting. To a greater extent than may appear from simply reading Accounting Series Releases Nos. 4 and 150, the Commission has actively overseen the development of accounting and auditing standards.

2. Are present auditing standards and the process by which
they are established adequate for protection of the public?
(Recommendations 6, 7, 8, and 10.)

The staff study charges that the process of establishing auditing standards has been dominated by the "Big Eight" and that the standards have not been sufficiently rigorous.

A critical distinction should be noted between auditing and accounting. While intimately related, they are quite different. As mentioned earlier, accounting is the process by which financial accounting standards are applied to business transactions to produce financial statements. Auditing is the process by which someone other than the preparer determines whether the financial statements have been prepared in accordance with appropriate accounting standards.*

Obviously someone performing the audit function must have an intimate acquaintance with the financial accounting standards that were used in preparing the financial statements under review; otherwise, he would be unable to express an opinion that the statements were prepared in accordance with standards indicated as having been followed. Also, there is general agreement that for an auditor to perform his function effectively he must become familiar with the enterprise whose statements are being examined, particularly the system of internal accounting controls; the adequacy of this system will in large measure determine the nature and scope of the auditor's procedures.

The auditing process consists of two parts: (1) Performing the various procedures and tests necessary to form an opinion about whether the financial statements are properly presented, and (2) reporting on the financial statements as the result of that examination.

The standards by which independent auditors make their examination, the procedures they use, and the contents of their report have evolved over a period of time under the aegis of the committees of the Institute. Ten basic generally accepted auditing standards are contained in Statement on Auditing Standards No. 1 (in view of the staff study's allegation that the "Big Eight" dominate the establishment of standards, it should be noted these most important basic standards were adopted by the membership of the Institute in the late forties). Interpretations of those standards are proposed and adopted by the Auditing Standards Executive Committee of the Institute as business and economic development require. For instance, in response to a perceived need, the Committee has recently issued two statements-one relating to the detection of errors or irregularities in financial statements and the other relating to illegal acts by clients. Another statement has been proposed that would require the auditor to inform management of significant weaknesses of internal

* A more technical definition is contained in Paragraph 110.01 of Statement on Auditing Standards No. 1 published by the Institute in 1972:

The objective of the ordinary examination of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present the financial position, results of operations, and changes in financial position in conformity with generally accepted accounting principles.

accounting controls discerned during an audit, thus making mandatory a practice now followed by most auditors.

The principal, though not the exclusive, purpose of the audit is to express an opinion on the financial statements prepared by management, thereby contributing to their credibility. Without the expectation that a disinterested party would test the reliability of the statements, management might be tempted to prepare its financial reports in a self-serving fashion. Thus, the independence of the auditor is critical to the process.

Also of importance in conducting a proper audit are such matters as the training of auditors, experience in performing audits, sufficient personnel (often audits of large companies require hundreds of professionals), supervision of the audit staff, controls to assure adherence to standards, appropriate reviews by persons not involved in the actual audit work itself, and other steps to remove as much as possible subjective elements from the process and the report.

The auditor's examination involves the use of various methods to secure information concerning the numbers and explanations reflected in the financial statements under review and the transactions which they summarize. An auditor could review every transaction, regardless of size, and obtain objective evidence of its elements-in effect, retrace transaction by transaction the entire operations of the company for the period under consideration. Obviously this would be inordinately expensive; simply reflecting on what would be involved to review one's own transactions during a year and to secure confirmation from external sources that each was properly recorded on one's financial records suggests what an overwhelming task this would be for a large business enterprise.

To prevent audit costs from being grossly excessive in relation to benefits, the accounting profession through the years has developed various methods of testing the information reflected in the financial statements. These techniques, while not giving the same assurance as an audit of every transaction, have provided in the combined experience of the profession a high degree of assurance in determining whether matters happened as represented. For instance, in testing the accuracy of accounts receivable reflected in financial statements, a standard procedure is to ask debtors whether the amounts shown on the books of the company being examined are accurate. From experience, auditors know they will not get a 100 percent response to confirmation requests; also, by experience, they know that with a sufficiently high response, together with other procedures, they may reasonably conclude whether the accounts receivable figure is reasonably accurate.

Similarly, they observe the counting of selected inventory items. With respect to reviewing some items, such as cash or marketable securities, a

more reliable determination can be made, because of their nature, by actual counts, or bank or depository confirmations.

Methods of external checking have been developed with respect to virtually every item subject to such verification in financial statements.

If, as can be demonstrated, auditing standards have through the years become increasingly demanding, how is it that there have been audits that did not detect and report that the financial statements were not properly prepared or properly reflective of transactions, that in some cases they concealed illegal management conduct and even fraud?

First, of course, auditing is done by human beings and involves a multitude of "judgment calls" with respect to such matters as classification of items, reasonableness of management estimates, bona fides of transactions, and the like; hence, there is ever present in the auditing process the danger of a human error, a mistake in judgment, a simple oversight-errors that can occur, and do occur, in every profession and every human enterprise and undertaking. While controls, training, and supervision may reduce them, errors are always possible in human endeavors.

In a number of cases, faulty financial statements resulted where auditing procedures to identify and test certain types of transactions, such as transactions between related parties, had not been developed because the phenomenon had not been widely encountered or a source of misleading financial statements; hence, individual auditors were not aware of the need to search for such transactions. In every such case where it has appeared that absence of sufficiently articulated auditing standards and procedures. has contributed to a problem, the Institute's Auditing Standards Executive Committee has actively considered and issued pronouncements to provide the needed guidance. Even in the absence of business failures or misleading financial statements pointing to a problem, the Committee has, relying on the combined experience of the members of the Institute, issued pronouncements to head off possible problems.

However, of greater importance than human failure or a lack of standards is the danger of deception practiced by unscrupulous managements on the auditor in a way that defies discovery by even the most skilled investigator. These deceptions have been present in several of the allegedly "bad" audits.

The starting point of any audit is the books and records of the company, although this is not the end point, by any means. Thus, to take the simplest case, if a transaction was never entered on the books of the company, the auditor might only become aware of it through happenstance. In many cases, the misconduct which has been exposed was committed completely outside the books and records of the company;