A Conceptual Framework for Independence
Will the new Independence Standards Board provide a breakthrough in the approach to auditor independence, an essential break with tradition and old ways of thinking, or will it be an ephemeral cure-all--a fleeting remedy for all the ills and difficulties that have plagued auditing practice and caused growing concern that existing trends will ultimately and irrevocably impair auditor objectivity and integrity?
The Latest Self-Regulatory Body
In May 1997, the AICPA and SEC announced the creation of a new private-sector body to establish independence standards for auditors of public companies. This new self-regulatory body is called the Independence Standards Board (ISB). It was created within the AICPA and is housed in the SEC Practice Section, but includes public members as well as CPAs. The eight-member body consists of four public members, including the chairman, and four representatives of the SEC Practice Section (SECPS).
The AICPA provides funding and staffing as well as the physical premises. Standard-setting meetings of the ISB are open to the public, and when new independence standards are proposed they will be exposed for public comment before final issuance.
Framework for Independence Standard Setting. The ISB's initial charge is to develop a conceptual framework for independence applicable to audits of public entities that will serve as a foundation for the development of principles-based independence standards.
The rationale for the ISB offered by the AICPA is that many of the SEC's independence regulations were written long ago and no longer provide obvious guidance in the changing environment of modern auditing practice. Because auditors have entered new service areas, merged and restructured operations, and become involved in more complex business and professional relationships, a fresh approach to addressing auditor independence issues is needed.
The ISB is to be assisted in addressing the increasing challenges posed by auditor independence issues by a nine-
member Independence Issues Committee (IIC). The IIC is to identify and discuss emerging independence issues within the framework of existing authoritative literature. It is to be comprised entirely of CPAs from firms that audit SEC registrants.
Recognition by the SEC. The SEC is expected to issue a release in early 1998 that will recognize the ISB as the professional body that sets independence standards for auditors of public companies. Presumably, this release will be similar to ASR 150, the release that recognized pronouncements of the APB and FASB as having substantial authoritative support, i.e., establishing GAAP. The SEC will then exercise an oversight role similar to the one adopted for GAAP standard setting. The SEC will step out of the day-to-day role it currently plays in the independence arena; but everyone will know the SEC is standing in the wings, ready to reassume authority on either an as-needed or once-and-for-all basis if the ISB has a lapse or proves to be an ineffective regulator.
Parallels to Accounting Standard Setting. The framework envisioned for independence standards follows the broad outlines of the formula that has evolved for accounting standards. There is an emerging issues group--the IIC--that will deal with nitty-gritty, day-to-day problems and, if they can be resolved with existing guidance, articulate that resolution. If existing guidance is inadequate, the problem will be passed up to the ISB. In the meantime, the ISB, under the watchful eye of the SEC, will attempt to develop the core principles, or conceptual framework, of auditor independence.
Parallels to accounting standard-setting do not end with this broad overall structure. At the initial meeting of the ISB in October 1997, a white paper was submitted to the ISB on behalf of the AICPA. The white paper was in response to the ISB chairman's call for educational materials bearing on the conceptual framework for protecting and improving auditor independence.
Critical analysis of the white paper is important because it is a significant and meaningful first attempt to identify the issues facing the ISB. But it also demands analysis because it attempts not only to identify the issues but also to propose a solution. The chief accountant of the SEC, Michael Sutton, on behalf of the staff of the SEC, prepared a detailed analysis of the paper, a summary of which is presented in a sidebar accompanying this article. The commentary reflects the SEC staff's feeling that the white paper does not adequately consider the interests of the investing public.
AICPA White Paper--Best New Accounting Idea of 1932
The white paper proposes a plan for the ISB to establish a set of core independence principles and broad guidelines for application. Each CPA firm would then create and adopt an independence code to implement and enforce the ISB core principles. The IIC would create a "drafting guide" to aid firms that require assistance in the formulation of their codes. Presumably, the firms that would require this type of assistance would be smaller CPA firms without any meaningful representation on the ISB or the IIC. Each CPA firm's code would be filed with the ISB and thereby become public, and the ISB would have the authority to review and disapprove firm codes. Enforcement of adherence to the code would be an integral part of peer review. Public filing of the codes would also permit investors and clients to be aware of the safeguards a firm had adopted to deal with risks to the achievement of core principles.
Back in 1932, the AICPA's special committee on cooperation with stock exchanges under the leadership of George O. May proposed a program for public companies and their auditors with remarkable similarities to the approach laid out in the white paper.
An authoritative statement of broad accounting principles on which there was fairly general agreement was to be formulated in consultation with a small group of qualified persons, including accountants, lawyers, and corporate executives. Each public corporation, using these accepted principles of accounting as a source, would then adopt its own more detailed code of methods to be followed in preparing its financial statements. These codes would be publicly disclosed and the methods adopted would be consistently followed. An independent auditor's report would provide assurance on whether a particular corporation's code was consistently applied. The stock exchanges would provide overall enforcement by requiring each public corporation to comply to keep its stock listing.
The program in the white paper, however, astutely avoids some of the difficulties that impeded implementation of the special committee's recommendations.
In the 1932 version, nonaccountants did not participate in the articulation of the broad accounting principles. Stock exchanges did not require listed corporations to disclose their codes of accounting methods. The broad principles that were adopted were not sufficiently comprehensive and failed to provide a sound base to serve as a guide to the resolution of day-to-day practice problems.
The ISB includes four public members; thus, meaningful participation by nonaccountants would seem to be assured. Public disclosure of the independence codes of CPA firms is a required and integral part of the plan. The remaining issue is whether the core independence principles and the related ISB developed guidelines for safeguards against risks and threats to independence will be sufficiently comprehensive, but simultaneously provide an effective base to deal with the challenges confronted by auditors in day-to-day practice.
Principles of Independence
The white paper proposes the following core principles of independence as reflecting a broad consensus within the accounting profession of the primary considerations that bear on auditor independence:
1. Auditors and CPA firms should not be financially dependent on an audit client.
2. Auditors and CPA firms should not have conflicting interests that would impair their objectivity with regard to matters affecting the financial statements.
3. Auditors and CPA firms should not have relationships with, or engage in activities for, clients that would entail making managerial decisions or otherwise serve to impair an auditor's objectivity.
These core principles are on the same broad level of generality as generally accepted auditing standards (GAAS). In the same sense as GAAS's standards of fieldwork, they provide an adequate articulation of the goals to be achieved by an auditor and a CPA firm. In a similar sense though, they provide about as much help to the auditor in resolving day-to-day independence problems as the fieldwork standards considered alone do in designing an audit program for a particular account balance of a particular client.
The real challenge for the ISB is in the development of the guidelines that are to identify the types of safeguards necessary to deal with particular risks and threats
to independence that auditors face in
Thus, the aspects of the white paper that should receive critical attention are the precepts and approaches that it urges the ISB to follow in developing the guidelines. The white paper urges recognition of the importance of materiality in evaluating whether a potential threat to an auditor's independence creates an unacceptable risk of impairment of objectivity and also urges adoption of related value judgments.
Attitudes and Approaches
Materiality. Recognition of materiality as a beacon for illuminating the significance of threats to independence leads the preparers of the white paper to propose the following attitudes and approaches for the ISB:
* Immaterial interactions between an auditor or CPA firm and an audit client should be presumed not to impair auditor independence, absent evidence to the contrary.
* Many potential threats to independence can be mitigated by appropriate safeguards.
Threats to Independence. The white paper classifies threats to independence in three categories: 1) Red light for those that are so serious the activity should be prohibited, 2) green light for those with minimal or no threat, and 3) yellow light for those that are serious but
can be mitigated by
Nonaudit Services. The preparers of the white paper also urge the ISB to embrace the value judgments that--
* there has been a misplaced regulatory focus on the threat to independence posed by nonaudit services primarily because there is no evidence that performance of these services impairs independence in fact and the undue regulatory focus diverts attention from more significant independence issues.
* a broad scope of services by CPA firms has a multitude of benefits including enhancement of audit quality and any risks that might be present are countered by the economic incentives a CPA firm has to protect its professional reputation.
The Appearance of Independence. The focus of current independence rules and regulations on the appearance of independence has created a host of problems, particularly including overemphasis on technical compliance with particularized rules at the expense of a focus on achieving underlying policy objectives. These judgments lead the preparers of the white paper to conclude there should be no outright restrictions on providing nonaudit services and any restrictions on CPA firm activities based on perception of auditor independence should be considered only after the completion of a proposed multifaceted, sophisticated, research methodology. The proposed research is described in one of several appendices prepared at the request of the authors of the white paper. If the ISB accepts this recommendation, incorporation in its guidelines of any matters related to appearance-based concerns of threats to independence could be delayed for several years.
Not an Easy Read. The preparers of the white paper present logical arguments buttressed by the analyses of the supporting papers they commissioned for that purpose. Many of the arguments are steeped in the jargon of modern economics, and any practicing accountants who venture to read the white paper will lament its lack of a glossary. The white paper itself runs 140 pages, and the appendices prepared by primarily academic consultants are approximately 100 pages in total, without counting the resumes, which are of suitably impressive length. The main body of the report has a staggering 347 footnotes--some filling two-thirds of the page with dense prose. Even Vice President Al Gore is quoted.
The ISB should certainly give careful consideration to the approaches and attitudes and underlying arguments of the white paper. The time and cost of assembling the white paper must have been substantial. However, I believe the one overriding attitude the ISB should adopt is to make auditor effectiveness the primary consideration.
The Primary Consideration
Making auditor effectiveness the primary consideration requires first identifying the independence issues of real importance, finding out why these issues exist, and then devising solutions that can succeed in the keenly competitive environment of modern auditing practice.
The first step in identifying the independence issues of real importance is to consider the evidence from practice that problems may exist in a particular area of activity. This brings under scrutiny the oft repeated litany in the white paper that there is no evidence that the performance of nonaudit services impairs independence in fact. This bold assertion is examined at some length here because it occupies so much attention in the white paper and has such important consequences for the course set by the ISB.
No Evidence of
Impairment of Independence in Fact--Myth or Reality?
The white paper states that study groups, including the Cohen Commission and others, have examined the issue and found no conclusive evidence of diminished audit quality, harm to the public interest, or any actual impairment of independence from public accounting firms providing consulting services to audit clients. This observation is then later truncated as the assertion that "numerous studies have concurred that there is no known instance in which it can be demonstrated that the provision of nonaudit services to an audit client impaired independence in performing the audit function." The point is also simply repeated in the analyzes by "leading experts" in the appendices and amplified by quoting others parroting the same refrain.
This assertion exaggerates what the Cohen Commission actually said about the empirical evidence of potential impairment of independence from consulting services. The Cohen Commission evaluated four instances alleged by professor Abraham J. Briloff as cases in which independence in fact was impaired by providing what he called peripheral services. However, the Cohen Commission did not give consulting services a clean bill of health as implied by the white paper.
In three of the four instances, the Cohen Commission concluded that an auditor had failed to make prompt disclosure of information obtained in a nonaudit engagement that reflected unfavorably on previously issued audited financial statements. For example, in the Yale Express case--one of Briloff's examples--the service provided was a review of the company's internal accounting procedures made after the audit report had been issued. When this nonaudit consulting service showed that the previous year's audited financial statements were materially misstated, the auditor did not promptly notify the SEC or otherwise seek to prevent continued investor reliance on financial information known to be misleading. The Cohen Commission did not conclude that there was no evidence of impairment of independence in these three cases. The Cohen Commission concluded these cases raised a valid independence issue, but believed impairment of independence had not occurred during the audits at issue and thus had not impaired audit effectiveness. The Cohen Commission believed the moral of these three stories was that nonaudit/consulting services had the potential, if used properly, for enhancing the audit function by providing additional access to the client and additional information that could be used to benefit the audit function.
In the fourth case cited, Westec, the Cohen Commission essentially agreed with Briloff that evidence of impaired audit independence from consulting did, in fact, exist. In Westec the consulting service consisted of advising on the accounting effect of prospective merger transactions and simultaneous involvement in the company's merger and acquisition program. The Cohen Commission stated:
The provision of accounting advice combined with involvement in the merger and acquisition program, it is alleged, reduced the ability to audit
the resulting transactions with
The Cohen Commission went on to observe that "experience suggests that giving advice on accounting principles, whether or not any other services are involved, can conflict with the auditor's other responsibilities."
The Cohen Commission also concluded that "accounting advocacy" posed special concerns for impairment of independence. It defined accounting advocacy as any instance in which an independent auditor is allied with a client in presenting a particular accounting viewpoint and identified as an example testifying on accounting related issues at a regulatory hearing. This type of testimony would today be identified as a consulting service and is relatively common in practice.
Since the time of the Cohen Commission, accounting advocacy has become an even bigger issue and greater threat to independence. Several SEC staff executives have expressed concern that independent auditors have taken positions in presentations of clients' accounting treatment of potential or completed transactions that appear to be far outside the parameters of GAAP--sometimes referred to as incredible accounting. Advocacy of client accounting positions to SEC staff clearly falls within the Cohen Commission's definition of accounting advocacy. Several key staff of the SEC have been very open in public forums about suspicions that auditor independence had seriously eroded in many of these accounting advocacy presentations.
The Cohen Commission recognized that advising clients on both the accounting and business aspects of proposed transactions and accounting advocacy generally were services that presented serious potential danger to independence, but that these activities could not sensibly be prohibited outright. The white paper category of yellow-light activity might apply to the area of providing advice on application of accounting principles in conjunction with other services or alone. Then the approach recommended by the white paper would be for the ISB to include in its guidelines suggested safeguards to the threat for CPA firms to incorporate in independence codes. Personally, I believe the problems in this area are too complex and too intermingled with performing an effective audit to be dealt with adequately through internal CPA firm safeguards.
Since the Cohen Commission identified the problem approximately 20 years ago, it has only become more difficult as transactions and business arrangements have become ever more complex. Specific professional standards are needed. Internal CPA firm safeguards have been and will continue to be unequal to the task. However, the key point for purposes of analysis of the white paper is that the constant repetition of the clearly overstated notion that there is a lack of evidence of impairment of audit independence in fact from any and all nonaudit services could mislead the ISB and divert its attention from identifying the most important independence issues.
Even more problematic is the following statement in the white paper: "Indeed, there is no evidence that audit failure has been caused by lack of independence." This statement ignores significant history in the development of the auditor's legal liability and the realities of litigation involving alleged auditor malpractice as discussed in the next section.
Audit Failure and
Lack of Independence
Acceptance by the ISB of the notion that there is no evidence that audit failure has been caused by lack of independence would cut off one of the most fertile and essential areas for study in case studies of alleged instances of audit failure in litigation.
There have been legal actions alleging fraud by the auditor in the past and these actions can be expected to increase. Because of Federal securities law reforms and raised hurdles for plaintiffs' claims of negligent misrepresentation in state courts, third party civil plaintiffs must typically bring claims under Section 10(b) of the Securities Exchange Act or common law fraud claims. Plaintiffs must prove that 1) audited financial statements were false in material respects, 2) in reporting on those financial statements the auditor acted with scienter, 3) plaintiffs relied on the audited financial statements and audit report, and 4) plaintiffs suffered losses as a result of that reliance. Scienter means that the auditor acted with actual knowledge of the material falsity of the financial statements or audit report and an intent to deceive investors or with such recklessness that such an intent may be inferred. These matters must be proven by clear and convincing evidence. Essentially, the same matters must be proven in a criminal fraud action, but the burden of proof is the even more challenging threshold of beyond a reasonable doubt.
The burden of proof in both criminal and civil fraud cases is very heavy and can be extraordinarily difficult to meet. When a civil plaintiff or a prosecuting attorney has been able to cross that long and arduous bridge and obtain a court decision that an auditor has committed or is liable for fraud, I submit that is reasonable grounds to conclude the auditor has been found to lack independence, in fact. An unfavorable fraud decision is effectively a finding that the auditor has engaged in something akin to a deliberate lie.
Thus, the ISB should not accept the assertion that there is no evidence of audit failure caused by a lack of independence. Allegations of audit failure in litigation should be investigated by the ISB. SECPS members must already report this information when litigation is started and there is a form of investigation by the QCIC (quality control inquiry committee). However, the ISB should perform its own independent analysis because its objectives are different than the QCIC. To identify the issues of real importance for independence, the investigation should occur after discovery in litigation has concluded rather than early in the litigation process.
Internal Audit Outsourcing
When a CPA firm provides extended audit services to an audit client, popularly known as internal audit outsourcing, some have questioned whether a sufficient threat exists to audit independence to warrant prohibition of this service. As the white paper points out, a CPA firm would be expected to have adequate safeguards in place to provide reasonable assurance that there would be no improper assumption of management responsibility. Making managerial decisions would be a prohibited or a "red-light" activity, but in other respects providing this type of extension of auditing services would be a "yellow-light" situation because of the potential for self review.
The expansion of independent auditors into this area actually holds significant potential for increasing the professionalization of internal auditing and would certainly enhance the audit function. For example, the on-site presence of auditors from an independent CPA firm and increased involvement in testing and evaluating internal control that are part of extended audit services should enhance the independent auditor's ability to detect fraud.
When emphasis is placed on the effect of an activity on audit effectiveness, extended audit services are something to be encouraged and fostered.
Equity for Smaller CPA Firms
The ISB public members should be mindful of the divergence of interests between the largest and other CPA firms in considering auditor independence. The white paper does not address the need for the ISB to attempt to be evenhanded in balancing the interests of smaller and larger CPA firms in establishing the guidelines for codes of independence. The white paper, as mentioned earlier, contemplates that the IIC will create a drafting guide for CPA firms that require that type of assistance. But that is the only nod to easing the increased burden of compliance that will fall with much greater weight on smaller firms if the approach recommended by the white paper is implemented by the ISB.
Of even greater significance is one of the illustrative guidelines proposed by the white paper as a safeguard to ensure lack of financial dependence on a particular audit client. The white paper suggests that the level of revenues that a firm derives from a particular client may create an unacceptable threat of financial dependence.
The white paper proposes that receiving 15% or possibly 10% of revenues from a particular audit client would create financial dependence on that client. Large firms could maintain that the compensation of partners is not made dependent on obtaining and retaining specific audit clients. Therefore there would be no financial dependence on a client that represents 15% of the revenue of a particular practice office. A smaller firm with a single or relatively few offices would be at a significant disadvantage. This approach would foster further concentration of auditing practice in larger CPA firms.
If financial dependence standards tied to revenue are deemed to be appropriate, then they should be designed in a manner that measures the pressures on the partner in charge of the engagement. Whether partner compensation is based on office, regional, or national profits does not matter given the realities of practice. If financial dependence standards are needed, some measure such as the ratio of the revenue from a particular client to total billings for which the partner is responsible is a better gauge of the pressure on the partner to keep the client. I am by no means convinced that this type of measure of financial dependence is necessary. However, whatever measures are adopted should not be structured in a manner that provides an unfair advantage to large firms.
The ISB holds significant promise for providing a necessary break with tradition and a new way of thinking about the best manner of assuring the public that audits are performed with objectivity. The structure of the standard-setting mechanism borrows liberally from the ideas--past and present--of leaders of the accounting profession.
In a bold, but essential, move the ISB membership includes equal representation of public members. There is an emerging issue group--the IIC--to help assure early identification of developing independence issues. The structure does not incorporate any obvious safeguards against the potential erosion of the ability of smaller CPA firms to remain competitive in auditing practice. However, this impression is drawn from the AICPA white paper and not any action or inclination of the ISB itself.
The suggested approach in the white paper of adoption of core principles of independence by the ISB and allowing CPA firms to adopt individual codes with safeguards to assure adherence to the core principles is also promising. An approach that would put emphasis on achieving the policy objectives of independence in fact rather than mechanical compliance with overly detailed rules is a real breakthrough.
The ISB needs to be wary in guiding the establishment of this meritorious conceptual framework to be sure that it gets first-hand knowledge of what the independence issues of real importance are and that it examines the evidence for the costs and benefits associated with greenlighting, red-lighting, or yellow-lighting CPA firm activities. *
Douglas R. Carmichael, PhD, CPA, CFE, is the Wollman Distinguished
Professor of Accountancy at Baruch
College, CUNY, and an editor of The CPA Journal.
The AICPA White Paper Recommendations to the Independence Standards Board
The Independence Standards Board (ISB) is a new private-sector body to establish independence standards for auditors of public companies. One of its first jobs is to gain an understanding of the issues. To this end, an AICPA white paper was presented to the board that not only identifies the issues but also proposes a framework for solutions. The board, after considering the paper, decided it was premature to broadly distribute the paper as a work of the board. Author Carmichael, in analyzing the white paper, points out where the framework may need some additional timbers. He goes on to identify auditor effectiveness as the primary consideration for the ISB in its deliberations. Also presented is a sidebar with the SEC's comments on the white paper from the viewpoint and interests of the investor.
Next month in The CPA Journal, Robert Elliot and Peter Jacobson discuss some of the concerns raised by the SEC and seek to shed light on the "appearance of independence" issue.
Paradigm shift or shaky start?
THE SEC COMMENTS ON WHITE PAPER
By John F. Burke, The CPA Journal
Under cover of a letter dated December 11, 1997, from then-chief accountant, Michael H. Sutton, to the chairman of the Independence Standards Board, the SEC presented its comments on the white paper submitted by the AICPA.
There are two main points made in both the letter and accompanying appendix. The first is that the paper is presented from the point of view of the practicing profession. As such, it does not present a balanced view. Sutton's letter suggests that a more neutral document, similar to an FASB discussion memorandum, be developed before soliciting public comment. The second point is the need for more research, "focused on identifying and gaining a better understanding of the issues that affect investors' confidence in financial reports." The SEC's main focus is the investor's point of view and it is clear the research would involve most of the points raised in the white paper.
The appendix is primarily a point-by-point rebuttal of the positions taken made in the white paper. The following are some of the points raised by the SEC staff.
Need for Interpretative Guidance. The proposal for a short list of independence principles together with some guidelines could, in the long run, lead back to what exists today.
Materiality. Any discussion of materiality should include both its qualitative and quantitative aspects and to whom it should apply, e.g., firm, audit partners, registrants, etc.
Legislative Intent. The SEC's insistence on the maintenance of the appearance, as well as the fact, of independence, is consistent with the intent of Congress in enacting the Federal securities laws.
Disclosure of Nonaudit Services. The requirement for disclosure of nonaudit fees that was withdrawn by the SEC related to the fees themselves rather than the nature of the services. The staff suggests to assist in the research in this area: Perhaps the SEC should reinstate a disclosure requirement.
Joint Business Ventures. The SEC had previously rejected a proposal that would permit direct business relationships with a client as long as the relationship was not material to either the auditor or the client. The staff believes significant research may be appropriate before the ISB considers changing existing regulations.
The Appearance of Auditor Independence. "The sense of investor trust and confidence will endure only so long as auditors not only are, in fact, independent, but also perceived to be independent."
Competition. "The white paper seems to approach the issues from a 'Big Firm' point of view."
Enforceability of the White Paper Approach. Different codes among firms could yield to inconsistency in determining acceptable or unacceptable conduct.
Fire Walls. The recommendation that the use of a fire wall between consultants and auditors may preserve auditor independence is inconsistent with another suggestion that the use of consultants may improve the knowledge base of the auditor and increase audit efficiency.
Managerial Functions. Having management approve decisions made by the auditor does not offset the fact that the auditor has assumed a management function and ignores investor's concerns about auditors looking objectively at decisions they have made or recommended to management.
The appendix also has a section on the need to remain focused on investor confidence. This section focuses on the following points raised in the white paper:
* Technical skills
* Firm's economic interest
* Audit quality
* Free riding
* Legal liability-litigation risks (issues raised in the white paper are not relevant)
* Other self-regulatory examples (not appropriate to regulation of auditor independence)
* Abandoning the current system (current system may be working)
The conclusion in the appendix indicated that "the staff's review and analysis does not suggest that approaching the issues through a concise set of independence principles, coupled with more precise 'guidelines' and encouragement for each firm to have an auditor independence code, is inappropriate." This double negative is about the best thing the SEC has to say about the paper. *
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