May 1999 Issue

In Quotes: The Sec Director of Enforcement
Addresses the importance of being independent.
Auditor Independence: The Issues

In Brief

The Investor's Point of View

In a speech given at a symposium on auditor independence sponsored by The CPA Journal and the New York State Society of CPAs, SEC Director of Enforcement Richard H. Walker made it clear where he stands on the issue: "Investors know that they can trust our auditors because they are--and of equal importance--they appear to be independent. It's not enough that audit quality is maintained and that the numbers are right. It's also necessary that public investors--the users of financial reports--perceive that the numbers are right." Walker's remarks were intended to identify the issues surrounding auditor independence that are key to maintaining the quality of audits of public companies.

Walker reviewed the SEC's role, historically, in the audit process. He stressed the importance of investor confidence in the markets and the necessity of independent auditors to maintain that confidence. The present and future success of our economy is built upon this confidence and trust.

Walker went on to express some concern at the state of independence, at the pressures put upon auditors to compromise with clients, and at the new practice structures that will inevitably lead to conflicts of interest. These are serious issues, Walker continued, and the SEC is prepared to take action where necessary. But he said that involvement by the profession itself is preferable, and noted the example of the ISB. Walker concluded urging the profession to consider the issue from the investor's point of view and reiterating the importance of a partnership with the profession, the eyes and ears behind the scenes at every public corporation.

By Richard H. Walker

Sixty-five years ago, in the depths of the greatest financial dislocation that ever hit this country, Congress passed the federal securities laws. The key objective that Congress had in mind was to put in place a regulatory system that would restore and build investor confidence. Congress knew that only by focusing on investor confidence could it pull the markets out of the depths and bring the nation back to prosperity.

The past 65 years have shown that Congress was right. The system Congress created in those dark times has made our economy the envy of the world today. It has put the United States in first place in what is now a global competition for capital. It has also made our system a model that other nations are quick to copy.

Why the System Works

What is it that lies at the heart of the investor confidence we have built up? The answer is simple. It is the fact that when investors bet their money in our markets, they can reasonably count on a company's numbers being good. This is true in large measure because of the role that independent auditors play. Where there is a problem, independent auditors report it. Where a company is in serious trouble, independent auditors appropriately qualify their opinion.

Investors know that they can trust our auditors because they are--and of equal importance--they appear to be independent. It's not enough that audit quality is maintained and that the numbers are right. It's also necessary that public investors--the users of financial reports--perceive that the numbers are right. The importance of the independence requirement was well summarized by the U.S. Supreme Court about 14 years ago when it said, "Public faith in the reliability of a corporation's financial statements depends upon the public perception of the outside auditor as an independent professional.... If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost" [United States v. Arthur Young & Co., 465 U.S. 805, 819 n. 15 (1984)].

The SEC has a duty, imposed on the agency by statute, to assure that the auditors who opine on the financial statements of public companies are independent. For example, Section 13 of the Securities Exchange Act requires public companies to file annual reports "certified ... by independent public accountants." Regulation S-X requires that accountants be independent, and Commission decisions clearly state that independence in both fact and appearance is required. Regulation S-X also requires accountants to comply with GAAS, which brings the profession's own independence requirements within the ambit of the Commission's regulatory framework.

These independence requirements are particularly important today. Individual investors are presently fueling our bull market by investing a healthy portion of their individually managed retirement and 401(k) accounts in securities. This huge increase in investment activity, so critical for our national prosperity, intensifies the need for good financial reporting. As analysts told the ISB last year, if they perceive an independence problem, they simply "walk away from the stock."

The Changing Profession

At the same time that independence requirements are becoming increasingly important, the auditing profession is facing a changing landscape that is requiring the profession to face complex and difficult issues. Two of these changes have particular relevance for auditor independence: First, there has been a dramatic escalation in competition to obtain and hold onto auditing business. And second, auditors now often find themselves part of huge national (even multinational) organizations that offer a literal supermarket of nonaudit services and present greater opportunities for potential conflicts of interest. Let me discuss each of these phenomena in turn.

New Competition. Approximately 15 or 20 years ago, auditors--like lawyers and other professionals--began actively competing for clients. This competition among auditors over the last decade or two has naturally included price competition, which in turn has led to dwindling profit margins for audit activity, and some would say to cost-cutting and a decrease in the amount of resources that auditors will spend on an audit. All of this leaves auditors in a situation where other auditors are hungry to take away their business, where clients receiving approaches from competing firms are aware of this fact and are placing ever greater demands on their auditors, and where auditors are, at the same time, ever more limited in the amount of time and effort they can spend on a particular audit.

In this environment, what pressure does an auditor feel when a client, for any reason, is unhappy with an auditor's judgment on a matter? What pressure does the auditor feel when it is a major client whose departure will make a real dent in the auditor's practice? The answer, some would suggest, is obvious. And the pressure is made worse by the "lose-your-client-lose-your-job" philosophy that may be found in some quarters of the profession. In these firms, partners without clients can be labeled "nonproductive" and fired, while rainmakers are always prized.

New Services. Now add to this mix the other big environmental change in the auditing profession. In order to deal both with very thin profit margins in auditing and with litigation risk from auditing activities, firms have increasingly turned to providing clients with far more profitable nonaudit services. This has been a true metamorphosis for accounting firms, and particularly for the big firms, which some estimate now get 30 to 40% of their revenues from consulting and under 40% from accounting and auditing. Some of these firms have come to offer virtual one-stop shopping for all a client's business consulting needs.

This brave new world of highly competitive, full-service accounting/consulting and the potential conflicts and pressures it creates for auditors raises concerns about both the actual quality of financial reporting and the level of investor confidence in this new environment. These concerns are based not just on speculation but on what we're seeing in our investigations and other contacts with the profession.

For example, in one situation, we are told of pressure by a client on the client's auditor to help improve the client's financial performance. The auditor's firm also provides lucrative consulting services to the client and is anxious to provide even more. Although the dialogue between the client and the auditor is free of any overt threats, the clear subtext of the message from the client is: "You help me out with the numbers, and I'll help you out with the business." Implicit in the message is: "If you don't help me out, you will see the business go elsewhere."

In another case, we are confronted with a large financial restatement, purportedly occasioned by imperfections in a company's computer system used to collect financial data. The company's auditors, who failed to detect the problem during the audit, also served as consultants to the company with respect to the computer system.

In yet another case, we see several partners in one office of an accounting firm buying and selling the securities of large corporations that are audit clients of that office and other offices of the firm. The result, of course, is a classic violation of the most fundamental independence rules. The firm does not require its partners to affirmatively disclose their securities holdings, so that they can be computer-matched against a list of the firm's clients. All the partners need do is sign an annual form assuring the firm that they don't own stock in clients. The next question, of course, is how should the SEC respond to this situation. Should we tell the major corporate clients and investors that the financials are now deemed unaudited? Require the firm to resign as auditors for these major clients? Try to cordon the relief just to clients of the office in question? Proceed with an enforcement action?

In still other cases, we see firms setting up all manner of purportedly separate entities--affiliates, allies, spin-offs, whatever--specifically created to engage in businesses that auditors cannot themselves engage in. Some of these new entities may be owned directly or indirectly by the accounting firm, while other such entities may be owned by third parties (or even publicly held) with certain affiliations or ties to the accounting firm. While some of these arrangements between accounting firms and other entities can pass muster under the independence rules, others cannot. Auditors obviously cannot expect to do through a controlled or closely related entity what they cannot do directly and still maintain their independence.

We see the flip side of this issue in the recent interest by certain large public companies--financial services firms--in acquiring accounting firms. These companies want to add to their menu of client services, and in so doing, compete with established professional firms. These ventures can take the form of complex, so-called alternative practice structures, where a public company buys a firm's nonaudit business, hires the firm's partners as employees, and leaves the audit practice in a separate partnership of the firm's original partners. There is here the natural concern that the public company may exert control over the audit partners, who are also the company's employees. And in yet another variation on the theme, we are now seeing proposals to merge legal and accounting professional firms. The American Bar Association is presently considering proposals for combined accounting and legal firms.

The possible number of different kinds of combinations between accountants and other business service providers is endless. But faced with these possibilities, how do we sort out the independence issues? What do we say when 1) lawyers in one part of a firm are ethically bound to advocate a client's interests zealously and to hold information obtained from the client in the strictest confidence; while 2) accountants in another part of the firm are ethically bound to exercise skepticism in dealing with the client's management and must show primary allegiance to the public by disclosing damaging confidential information about the client; while 3) consultants in another part of the firm are giving the client management advice, the results of which may be reviewed during the audit; and while 4) others in the firm are trying to sell expensive new goods and services to the client?

As arrangements with clients become more and more complex, we question whether so-called firewalls can have any realistic possibility of managing all these conflicts. Even with model firewalls, what is the reasonable investor to make of an audit opinion that expresses a view on the results of the accounting firm's management consulting? What is the reasonable investor to think when the audited financials contain an opinion from the accounting firm's law partners on the likely outcome of major litigation? Again, will these reasonable investors--like the analysts we heard from last year--simply "walk away from the stock"? And even if firewalls could actually be effective in dealing with these conflicts--which we would suggest they cannot--these firewalls would then effectively destroy the information sharing and service enhancements that are put forward as the justification for allowing a single firm to offer all these services in the first place.

The SEC's Response

As we move forward in the new auditing environment, I can assure you that when the SEC sees an independence violation affecting a public company, it will be prepared to take action. This may involve discussion and negotiation to avoid the problems, where possible. Where not possible, our response may involve enforcement activity. In October of this year, the SEC amended Rule 102(e), dealing with discipline of professionals that practice before the Commission. The amendments specify that accountants can be held liable for "improper professional conduct" in situations where they have violated their own professional standards, including standards relating to auditor independence, either 1) through repeated negligence, or 2) through a single instance of "highly unreasonable conduct" in circumstances where the accountant should know that "heightened scrutiny" is warranted.

In adopting this standard of highly unreasonable conduct in circumstances requiring heightened scrutiny, the Commission made clear that auditor independence was one of the particular circumstances it had in mind. The Commission's October release containing the Rule 102(e) amendment states as follows:

Because of the importance of an accountant's independence to the integrity of the financial reporting system, the Commission has concluded that circumstances that raise questions about an accountant's independence always merit heightened scrutiny. Therefore, if an accountant acts highly unreasonably with respect to an independence issue, that accountant has engaged in "improper professional conduct."

The SEC's October 1998 release also stated that the Commission's law enforcement proceedings against accountants will not be limited to cases involving at least "highly unreasonable conduct." Rather, where an accountant has engaged in even a single act of negligent conduct, the Commission remains prepared to use its cease-and-desist remedy, a separate type of proceeding explicitly provided for by Congress in section 21C of the Securities Exchange Act.


While we are prepared to enforce the auditing profession's independence requirements when they impact public companies, we would much rather deal with independence issues upstream, before they become problems. In this vein, we are encouraged by the profession's recent focus on independence. Informed discussion by leaders of the profession will facilitate responsible solutions to these issues.

The Independence Standards Board. We especially look forward to hearing from William T. Allen and his colleagues on the Independence Standards Board as they carry their efforts forward in the coming months. As you know, the SEC worked with the AICPA to create the ISB last year to be a vehicle for the profession to consider these important issues and to propose a new codification of the profession's independence rules.

At this stage, it is too early to predict where the ISB, the SEC, and the profession will ultimately go on independence. Some may advocate fine-tuning existing rules on independence, basically taking the position that the current system works. Others may propose more radical alternatives, some trusting more to individual firms and auditors, and others advocating even greater safeguards to meet new challenges. We may even see proposals for more organic changes, such as a separation of auditing practice into stand-alone firms that are public or quasi-public in character, with the remainder of the accounting profession then free to offer the full range of business services, with all of the benefits that these services can bring to clients. But while we don't know where the profession will ultimately come out on all of this, we already are seeing the process beginning and the ideas flowing.

Just last month, the ISB proposed a creative new way to incorporate a formal consideration of independence issues into every audit. Under this proposed standard, auditors would be required to sit down with their client's audit committee during the course of the audit "to discuss the auditor's independence." The auditor would also have to provide written disclosure of all relationships between the auditor and the client "that may be reasonably thought to bear on independence." This proposal closely resembles a portion of a remedial provision that we suggested in pending litigation last summer, and we think that rolling this requirement out to the profession as a whole is a great way to promote a considered look at independence issues in each and every audit. We believe that during these annual conversations, auditors should be required both to describe in detail their consulting services and other ties to the client over the past year, as well as the cost of the consulting services, and to explain to the client why the auditors believe their consulting work and fees do not affect their independence as auditors.

Separately, we are very interested in recent proposals by the ISB and others that there be a prohibition for some reasonable period against an auditor accepting employment with an audit client. Employment following close on the heels of an audit opinion creates the potential for actual independence problems and, in many cases, creates the appearance of a quid pro quo that diminishes the credibility of financial reporting and hurts investor confidence.

Materiality Concerns. On another recent topic of ISB discussion--expansion of the use of materiality concepts in assessing auditor independence--I must sound a note of alarm. Some have proposed that even direct interests in audit clients should be subject to a materiality test. I question whether applying a materiality test so broadly in the independence area would create too much uncertainty and too much of a temptation for some firms to ride the edge of what is allowed for materiality. There is also some concern that a broad materiality excuse could embolden clients to demand more of auditors. In short, I believe that an expanded materiality analysis is plainly not a road we should take when our concern is auditor independence, though perhaps there should be some allowance for consideration of materiality in determining the remedy for cases involving inadvertent independence violations.

And whatever place materiality may have in independence analysis--such as the present use of materiality to assess indirect interests in audit clients--I would stress that the focus should include both the qualitative and quantitative aspects of materiality. Where materiality is appropriately considered at all, it cannot be limited to mathematical analysis. Rather, it depends upon an evaluation of all relevant facts and circumstances.

The Investor's Point of View

Most important of all, as you consider all of these ideas, and many others in these exciting times for auditor independence, we at the SEC would urge you to consider each proposal from the investor's point of view, as well as from the auditor's point of view.

In conclusion, I will go back to the SEC's October 1998 release amending Rule 102(e) that I mentioned a few moments ago. In that release, the Commission stressed the obvious importance of accountants to the investing public. But the Commission went on to make the point that "[b]ecause the Commission has limited resources, it cannot closely scrutinize every financial statement. Consequently, the Commission must rely on the competence and independence of the auditors who certify, and the accountants who prepare, financial statements." In short, you are the SEC's and the public investor's eyes and ears behind the scenes in every public corporation. *

Richard H. Walker is director of the SEC's Division of Enforcement. The preceding is adapted from a speech given by Walker on December 17, 1998, at a symposium on auditor independence sponsored by the New York State Society of CPAs and The CPA Journal. Walker's remarks reflect his own views and not necessarily those of the SEC or its staff.

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