December 1998 Issue

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In Brief

Up and Running, but First a Conceptual Framework

In October 1997, the accounting profession's first ever standard setting board with equal representation from the public and the profession began operation. Its objective is to establish broad principles relating to auditor independence for audits of companies that are subject to the jurisdiction of the Securities and Exchange Commission. Board members representing the profession comprise three managing partners of Big Five accounting firms and Barry Melancon, president of the AICPA. William T. Allen, one of the four public members, is chair of the board.

The board's administration is in the hands of Executive Director Arthur Siegel, and administrative functions are housed at the AICPA. A separate issues identification committee, made up of practitioners who audit public companies, has the task of identifying practice problems that conceivably can be best resolved through pronouncements of the board. The SEC also refers questions about auditor independence, which it used to deal with, to the staff of the board. For example, the question of independence for "alternative forms of practice," as evidenced in recent acquisitions of accounting practices by American Express Tax and Business Services and HRB Business Services, has been turned over to the board.

CPA Journal editors James L. Craig, Jr., and Douglas R. Carmichael met with William T. Allen to discuss the activities of the Independence Standards Board to date and its timetable for beginning to deal with the sometimes contentious issues surrounding independence, not the least of which is the issue of appearance of independence as opposed to the fact of independence.

The CPA Journal: What are the circumstances that led to your appointment as chair of the Independence Standards Board?

William T. Allen: Clearly it is the present thinking of the SEC that standard setters need to have a strong public interest component. The set of skills that led to my recommendation as a public member of the board and its chair include a general knowledge of business practices and accounting, but more importantly, experience with business problems of the kind that I was exposed to as chancellor of the Chancery Court of the State of Delaware. As you know, Delaware is the place of registration for many of our largest and most successful businesses. Therefore, its Chancery Court is perhaps the nation's foremost court of corporation law and a place, during my twelve years of service, where the reshaping of corporate America because of takeovers, downsizing, and other restructuring was very much in evidence. When my term expired in 1997, as I had planned, I entered the academic world by joining the faculty of New York University. At around the same time I was approached by SEC Chairman Arthur Levitt to chair the Independence Standards Board. He wanted to send a clear message that what is basically a self-regulatory body would have strong and experienced leadership from outside the profession.

CPAJ: What kind of time commitment are we talking about as chair of the board?

Allen: It comes in rushes and bunches. On average I spend six or seven hours a week. I do expect, when we begin to more actively issue pronouncements, it will take more time.

CPAJ: Are the board members compensated?

Allen: The public board members are paid $40,000 per year, with the chair being paid $50,000. The profession's members accept no compensation.

CPAJ: How is the board doing? Is it generally proceeding as you and, perhaps more importantly, the SEC expected?

Allen: I'm satisfied with the progress we have made, with the recognition that in building an institution there is a lot of foundation work that must take place--hiring the staff, finding adequate quarters, developing an agenda--and that such activities take some time. Our staff is fully organized. We are now giving advice on inquiries about independence issues.

CPAJ: How large is the staff?

Allen: We have an executive director, two other professional types, and an executive assistant. We want to add another professional to the staff.

CPAJ: What has the board been doing so far? We have not seen ISBS no. 1 yet.

Allen: The first thing we did was to officially adopt all the existing SEC guidance--rules and regulations--on independence. Then we began an educational process, because the public members knew very little about the internal workings of the accounting profession. We asked to be educated by the large firms and the SEC. In response, we received a white paper from the AICPA, "Serving the Public Interest: A New Conceptual Framework for Auditor Independence." It was written by a law firm and included a number of supporting papers written by academics. We looked at the paper to see if it served as a blueprint for immediate action.

CPAJ: The impression that we received from speaking to Michael Sutton, then chief accountant of the SEC, was that this white paper came as a surprise to him.

Allen: I don't know what Mike knew. But we asked for ideas from the profession. I did not know what form it would take, and I did not know that experts had been retained to develop a study. After we received the study, we asked the SEC to prepare a formal response, which it did.

CPAJ: The SEC's written response was critical of the study.

Allen: My reaction was that the SEC was not aggressively critical, although it had certain analytical criticisms of the white paper. The board concluded, however, that it would be premature to use the paper as a model, but that there were sound ideas in the paper that warranted consideration.

CPAJ: In a recent CPA Journal interview with Lynn Turner, the present chief accountant of the SEC, we were left with the impression that he thought the paper represented the business interests of the profession and did not fully address the public interest issues.

Allen: I don't think that represents an overall criticism. The notion that the paper presents the business interests of the profession might make me suspicious, to want to look at it more closely. But the mere fact that something is in the business interests of the profession does not necessarily mean it can't also be in the public interest. The issue is "What is the public interest?" It is not damning if that position also matches the business interests of the big firms. In the long run those two have to connect, or the profession will have no value in the marketplace.

CPAJ: But in any event, the board decided to put aside the white paper as an official discussion document.

Allen: We could not invest the time at that point in our existence to decide whether the paper was the right structure within which the public discussion of the issues should occur. We needed to take a less structured approach initially.

CPAJ: What course of action did you choose as an alternative?

Allen: We began a series of projects under the leadership of teams of the board. The first and most important is the development of a conceptual framework within which to evaluate and judge our proposals. The problem with independence guidance as it presently exists is two-dimensional. The firms that are trying to meet the various requirements complain of a lack of clarity and consistency. The SEC, on the other hand, is not sure that the guidance is actually producing the desired result. The firms view that the work of the board is to simplify the guidance and make the process easier to manage. The SEC sees changes taking place in the scope of services being offered by the auditing firms, with the result of a deep suspicion on the part of some there that the quality of services is being affected or under threat to be affected.

The conceptual framework is the place where we get to think deeply about things such as the very nature of independence, the goal of audit efficiency, whether to use the reasonable investor standard or some other standard for judging auditor behavior, and whether materiality thresholds make sense. In the process of developing the framework, we will have received input from a variety of interest groups--investors, accountants, and regulators--and our thinking will be enriched by that input.

CPAJ: What will be the time frame for this?

Allen: We are just getting our conceptual task force set up. There are four board members involved, two public and two profession members on what I call the board task force. Then there will be a staff effort under the direction of the executive director. We have also engaged an academic consultant to work on the project--I view him as the reporter. The FASB took three or four years to develop its conceptual framework; I don't think it will take us as long.

CPAJ: Won't short-term needs arise that will need to be addressed
before the conceptual framework is complete?

Allen: In the perfect world you would have the conceptual framework first. But in some ways it will do us good to deal with real-life problems along the way toward the framework. So yes, we will be dealing with issues as we proceed with the framework.

CPAJ: How will these real-life problems get on your agenda?

Allen: In several ways. We have other board task force level projects underway. One is corporate governance. The SEC is interested in this aspect, as demonstrated in Chairman Levitt's recent speech on the dangers of earnings smoothing when he announced the formation of a blue-ribbon panel to look into practices of audit committees. This very high-level panel was asked to prepare its report within 90 days, the end of calendar year 1998. I believe its findings will be vital input to us, because we feel corporate governance and audit committees are an integral part of validating auditor independence. Our first active project focused on the need for the issuers of financial statements to have guidance in exercising their responsibility that their auditors meet independence guidelines and our standards. We concluded that auditors need to formally affirm to audit committees that they are independent under the requirements of the profession and the SEC. We saw an opportunity to do this by endorsing a proposal of the SEC Practice Section of the AICPA. We feel audit committee members, especially outside directors, need to be mindful and focus upon auditor independence early on in the financial reporting cycle.

CPAJ: The SEC, in reacting to
your proposal, was not completely satisfied.

Allen: The SEC feels that more is required than just a statement from the auditor that the firm is independent. I want audit committees to discuss the issue with the auditors based upon specific criteria.

CPAJ: Why didn't you propose a standard of your own?

Allen: We may. Some believe this issue is more of a procedural step. That is, that having discussions between the audit committee and the auditor about independence does not rise to the level of a standard. We know what objective we are seeking, but not necessarily the form of the end product. We still have not decided what form of end product makes sense. We have taken the SEC's concerns under advisement and will study the issue. ISB staff will make a recommendation to us.

CPAJ: Has the way you will issue standards been established?

Allen: We will issue standards in the same way that the other standard setters do. But the issue is a matter of governance--not whether a particular auditor is or is not independent but whether that auditor has discussed what does or does not make him or her independent with the audit committee.

The conceptual framework will identify areas where standards are necessary to make the framework operational. In the meantime if we find that there is a need to adjust one of the existing rulings, we will do so in the form of a standard, following the usual due process format.

CPAJ: Where are the existing rules published? Will the ISB issue a codification of the existing rules?

Allen: I don't believe they have ever been published in such format. The SEC from time to time tries to pull them all together in a publication, but the lack of a current authoritative summary of the current rules is part of what is troublesome to some practitioners.

CPAJ: Will you be charging for copies of your standards or a codification should you ever produce one? Such charges are big revenue producers for FASB and the AICPA.

Allen: No, they will be on our website. I view it in the public interest that the standards be available at no charge.

CPAJ: How is the makeup of the board--equal numbers of public and profession members--working out? Will it be a simple majority that will be required to issue standards?

Allen: Time will tell whether this is an effective makeup. Some may feel a four/four split in public and profession members is not an ideal situation for decision making. It, however, represents a delicate equilibrium, achieved as part of the negotiations in establishing the board. So far, in our formative stages we have yet to deal with an issue where there were strongly divided opinions. I will say that we are entering into what could be a testing period. I have requested that the large accounting firms provide information about the contributions various parts of their practices make in the total financial picture. That request is under discussion between me and representatives of the Big Five firms. Votes on standards will require a simple majority.

CPAJ: Who will determine future board members?

Allen: Our operating statement provides that the independent directors will nominate independent members and the profession members will nominate their replacements. The board as a whole will elect from those nominees.

CPAJ: We understand the National Association of State Boards of Accountancy would like representation on the board.

Allen: At present I don't see any likelihood of a change in the board's basic makeup, but we do welcome input from NASBA as well as others.

CPAJ: What other projects are you working on?

Allen: One is whether there need to be any limitations on registrants hiring partners or employees of a CPA firm that were previously involved in the audit of the registrant. This is not a new area; in fact Art Siegel headed a study group of the SECPS on this very issue. We are also looking into the need to modify the rules related to employment of spouses of auditors in this modern age where in more and more families both spouses work outside the home.

There are other issues the staff is working on that have not yet reached the board level. One is the issue of alternative practice forms that have evolved as commercial entities have begun to acquire accounting practices. Our issues committee is addressing this. We hope to move on this within several months, as it will affect registrants that will have to file audited financial statements fairly soon. My view on this is that the burden is on the registrant that uses a firm that is operating in this new way to satisfy itself that the auditor is independent. This issue demonstrates the need for the development of independence rules and standards in such a way that companies and their audit committees feel comfortable with them. It should not be rocket science.

CPAJ: The audit committee becomes an important ingredient in this scenario. But all audit committees are not created equal. Will the board have anything to say about the quality of the audit committee members?

Allen: This is a concern of the board and of the SEC. We have no authority over audit committees per se. We will have to see what the blue-ribbon panel now studying the role of audit committees comes up with. It is conceivable there will be recommendations for stock exchanges to set forth requirements and qualifications for audit committee membership. We will want our requirements to complement what the stock exchanges and others end up doing.

CPAJ: Shouldn't the users have something to say about auditor independence as well?

Allen: We have thought about that in a very preliminary way. One possibility is to require disclosures about relationships and the like and let the user decide. This is a different model. Right now we deal with independence in rather simplistic terms. Either the auditor is independent or the auditor is not. But the truth of the matter is independence has a continuum of possibilities. On the one side we have some who are clearly not independent. On the other we have those who clearly are--the auditor operating on a one-year assignment with the fee being paid for by a third party. And then there is everything in between. Our current technique is to save the world the trouble of having to analyze the facts and determine for itself if an auditor is independent. The present system says it is the auditors themselves who determine whether they are independent.

CPAJ: In a conversation we had with the chief accountant of the SEC, he gave his view that the key factor in auditor effectiveness is the mindset of the partner making the decisions. That partner will be influenced by the importance of that client to his or her career goals. The issue is not the amount of consulting fees being earned or the other business activities of the firm. It is the importance of the client to that individual partner that matters.

Allen: This is part of the attractive side of the AICPA white paper. The firm as a whole probably has the right set of incentives to act objectively and without bias. Preserving its reputation is a major part of that. But to the individual partner, the business aspects of the individual client may be a strong influence.

CPAJ: One of the arguments the paper made was the benefit to audit efficiency that was achieved because a firm also performed consulting work for the same client. Personal experience says that in many cases there is very little interaction between the consultants and auditors from the same firm.

Allen: There must be some synergy between the audit and consulting practices of firms--is it just the marketing aspects? We are being told that audit effectiveness is part of the synergy. Part of our work will be to get a better understanding of the influences of nonaudit services on the audit, both good and bad.

CPAJ: We are seeing a major difference of opinion on auditor independence between some thinkers on the profession's side and the SEC over the issue of appearance of independence versus the fact of independence. Have you begun to think about this distinction?

Allen: I am open-minded on this. I gave a speech last year that tends to support the reality of independence over the appearance. That does not make me a committed advocate. My judge's training and experience causes me to want to continue to examine issues. I am open. It is no question that markets are epiphenomenal--they are based upon perceptions. I see attractions on both sides.

CPAJ: What about the rest of the public members of the board? Are they beginning to understand the issues?

Allen: They are a very talented group. One is John Bogle, a very astute investor--he started the Vanguard Funds. He knows the capital markets at the most sophisticated level. Another is Robert Denham, the former chair of Solomon Smith Barney and an attorney. He is now back practicing law. The third is Manual Johnson, former vice chair of the Federal Reserve Board and chair of the Financial Accounting Foundation. They are very savvy people and not in any way tied or connected to the profession or firms represented by the profession's representatives on the board. They are very independent-minded and not intimidated by the stature and business success of the other members of the board.

CPAJ: Will the work of the board involve independent research to help identify the issues?

Allen: We expect that the large firms that audit most of the public companies will give us information to help us understand the impact on audit effectiveness caused by the changes in what they do. Contrary to much of the correspondence I get, I see no need or benefit to returning the profession to the way it was in the past. Questions that must be addressed are whether, with the way the profession is evolving, are audits as good as they were, and have the capital markets been affected or will they be affected in the future. So far we don't really have an answer. We may have to begin to look at what the SECPS's Quality Control Inquiry Committee is finding, or to court cases as well.

We have a budget for research, and we have just engaged Katherine Schipper, an academic, to act as a research consultant for us.

CPAJ: Are you satisfied with the resources of the board to do its job?

Allen: I have not asked for something that has not been forthcoming. We are at this time adequately funded. I am prepared to speak out if I find we don't have the resources to do our job.

CPAJ: What are your personal goals with respect to the work of the board?

Allen: The chair of the SEC and the business journalists share at least one thing in common. They are looking for results. Because of the time it has taken for us to get going, some observers are suggesting it is time to see some fruits of our labors. As a judge, this does not trouble me. If it takes four or five years and we come up with a meaningful framework, I will consider the board successful and my contribution finished. I do not plan to make the board a lifelong activity for me.

CPAJ: Chairman Allen, thank you for meeting with us today, and every success to you and the board. Your demonstrated openness to the various constituencies and willingness to discuss the issues will benefit the process of finding solutions. *  About William T. Allen  William T. Allen, chair

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