New Standards May Be Required
A number of factors have given a distinct economic advantage to large practice units that, in turn, have raised questions regarding the utility of existing independence standards. The SEC has recognized the need for reassessment of those standards through its involvement in the creation of the Independence Standards Board (ISB).
The alluring growth of the Big Five, particularly in consulting services, prompted American Express and other commercial organizations to acquire accounting practices with the aim of developing a national accounting practice to sell a broad range of business and tax consulting services to mid-sized businesses. In order to acquire larger local or regional firms, American Express began a successful assault on "holding out" regulations and eventually developed an alternative firm structure to deal with ownership requirements.
The ISB has identified two possible approaches to developing independence standards, and there are variations of both. After deciding upon an approach, it must also develop standards addressing the wide variety of consulting services being provided to clients and the nontraditional firm structures employed by consolidators. In developing these standards, the ISB must develop a regulatory scheme for safeguarding auditor independence that will be sufficiently flexible to accommodate the rapid changes in the accounting profession.
The independence of auditors has long been a concern of both the accounting profession and its regulators and serves as a means of providing assurance to the public that relies upon audited financial statements that such reliance is justified. Without independence standards, an accountant's report would provide little credibility as to the reliability of the client's financial statements.
Many of the independence standards in effect today were devised in a very different economic era. In fact, most such standards were placed into effect even before accountants became heavily engaged in tax preparation services, when the principal endeavors of CPAs were accounting and auditing services. Today, accounting firms offer a wide variety of services, many of which have either a direct or indirect effect upon the profitability of their clients. Equally important, the proliferation of professional standards, the growth of business enterprises, and the advent of new technologies have given a distinct economic advantage to larger practice units. This, in turn, has raised additional questions regarding the current utility of existing independence standards. The time has come for those standards to be reassessed. The SEC has demonstrated this need through its involvement in the creation of the Independence Standards Board (ISB).
Changes in Accounting Firm Structure
Accounting firms have traditionally been organized as partnerships, and by the early 1960s, eight firms (dubbed the "Big Eight") had become dominant in the United States, each employing over 5,000 professionals. Following these firms were another eight large firms employing from 750 to 2,000 professionals (commonly referred to as "second tier" firms); and following those were a few dozen other firms with 100 to 300 professionals (generally referred to as large local or regional firms). Over the ensuing 30 years, the ranks of the second tier firms have been greatly depleted, largely by acquisitions by the Big Eight, which have contracted to five through mergers.
Today, only two of the original second tier firms still exist, while three of the former regional firms have grown substantially, although their practices must still be characterized as regional, rather than national, in scope. This has left something of a void in the servicing of mid-size companies that fall below the radar screens of the Big Five and are too large to be successfully serviced by local CPA firms. Moreover, most local firms and many regional CPA firms lack the expertise to offer a full spectrum of services to mid-size companies and do not have the resources necessary to create them. Even those firms that do have adequate resources to fund the creation of specialized practice groups often find that the breadth of their clientele is too small to support such groups. Thus, there is a void within the accounting profession that, until recently, was being serviced by consultants and advisors outside the profession.
Catering to this void has become even more attractive because of the enormous revenue and profit increases being generated by the Big Five, which in the early 1980s had begun expanding the scope of their services. Indeed, the growth experienced by the Big Five, especially in consulting services, has exceeded that of most industries, with the possible exception of the software and telecommunications fields.
These factors prompted American Express, the large financial services firm, to seek acquisition of accounting practices in the hope of developing a national accounting practice that could sell a broad range of business and tax consulting services to mid-size businesses and achieve growth rates rivaling those of the Big Five. American Express further believed that such growth rates would surely be enhanced by its recognized brand name.
This business strategy got off to a slow start, largely because of regulatory impediments that precluded CPAs from holding themselves out as CPAs while working for a non-CPA firm (i.e., a firm not wholly owned by CPAs). Moreover, only CPA firms could issue reports on financial statements, which meant that any firm acquired by American Express would have to relinquish its financial statement (or attest) practice. Thus, American Express' early acquisitions focused on local CPA firms with largely tax-preparation practices.
American Express soon realized that if it was going to create a national practice, it would have to speed up the process. Equally important, if it were to obtain access to mid-size businesses and wealthy individuals, it would need to acquire larger local, or even regional, accounting firms. As a result, it challenged the "holding out" regulations that were imposing a substantial barrier to its acquisitions of larger CPA firms. This barrier was successfully attacked as unconstitutionally impairing commercial free speech in the Miller case that set the stage for American Express' first acquisition of a substantial local firm.
American Express still had to deal with state ownership requirements that stood in the way of its ability to offer attest services. Ownership requirements were well imbedded in state law and not likely to be found to impose an unreasonable restraint on interstate commerce. As a result, American Express had to find a way to live with this restriction. It concluded that it would be feasible to simply acquire the tax and consulting services of an accounting firm and allow the firm to continue to exist for the purpose of rendering attest services. It found, however, that it was difficult to separate the two parts of a CPA practice. In addition, any firm wishing to sell its practice would want to be paid for all of the practice and not merely a portion of it.
The Example of Checkers, Simon & Rosner. A better solution was employed in American Express' first acquisition of a substantial firm (namely, Checkers, Simon & Rosner) in 1997. In that transaction, American Express acquired the entire practice of Checkers and gave Checkers a license to continue to service the attest needs of its former clients. Under this arrangement, the Checkers partners have dual employment (i.e., they remain partners of Checkers and become employees of American Express). Checkers employees became American Express employees and are rented back to Checkers as needed to perform attest services.
The acquisition agreements were also structured so that Checkers maintains its economic independence from American Express. For example, Checkers is free to price its attest services as it chooses and can obtain professional employees and internal office services from sources other than American Express. In addition, Checkers maintains its own bank account and has its own liability insurance coverage. It was felt that this economic independence was essential for Checkers to be viewed as a separate accounting firm. To further assure Checkers' independence, the acquisition agreements made it clear that the Checkers partners were to make all professional decisions, establish their own practice standards and checklists, and specify and design the training of employees they would be renting from American Express.
Although the maintenance of Checkers as an economically viable and separate entity in itself was felt to be adequate to eliminate any impairment of Checkers' independence by reason of American Express' having a proscribed relationship with one of Checkers' attest clients, it was deemed prudent to also establish a series of protocols designed to actually prevent American Express from having any relationship with a Checkers' attest client that was proscribed under the SEC's independence standards. This additional measure was prompted by concern that the SEC might attribute the actions of American Express to Checkers through its partners in the same way that actions of an audit firm employee are attributable to an employer under existing independence standards. To further assure Checkers' independence, the firm agreed not to take on any new SEC attest engagements.
The operating format utilized in the Checkers acquisition has become the model for other such acquisitions, both by American Express and by the other companies currently engaged in programs to purchase accounting firms servicing the middle market. The terms of the Checkers transaction were used by American Express in structuring its subsequent acquisition of Goldstein Golub Kessler & Co., the principal terms of which were published by the New York State Department of Education in a ruling letter approving the transaction. Nevertheless, the specifics of these transactions tend to be well-guarded secrets in an effort to give the acquiring companies flexibility in negotiating future transactions.
Function of the
As noted at the outset, the purpose of the independence standards is to provide the users of financial statements with unquestioned confidence in the objectivity of the auditor issuing a report on financial statements. Thus, the appearance of independence is deemed to be of equal, if not greater, importance than independence in fact. This, in large measure, explains why the independence standards almost myopically emphasize the appearance of independence and why the SEC has spoken out against all attempts to compromise the current independence standards.
It should be appreciated, however, that the credibility of financial statements depends upon a number of factors, of which the auditor's independence is only one, albeit an important one. Also supporting financial statement credibility are the accounting principles employed, the auditor's knowledge of those accounting principles and auditing standards and procedures, the audit firm's internal quality control procedures, and the firm's reputation for honesty and integrity. From a user's perspective, it is clearly more important to know that the audit firm rendering an opinion on financial statements received unfavorable comments on its last peer review report than to know that a partner within the audit firm owns 100 shares of the client's securities or that his brother is a vice president in charge of production for the client enterprise.
In short, while it is important that impairments of independence be disclosed to anyone who would engage a particular auditor, it is also important to view independence in terms of a reasonable user's expectations. Standards that preclude a partner from making a nominal investment in an audit client but which do not prohibit the firm from deriving 20% of its revenues from that client, do little to engender user confidence, no matter how vigorously they are enforced. In this regard, it must be appreciated that financial statement users do not currently have an opportunity to look behind the representation in an accounting firm's report that it is "independent."
Approaches to Auditor Independence
The ISB has identified two possible approaches to providing financial statement users with confidence as to an auditor's independence. The first approach is to require the disclosure of all relationships with the client enterprise that might be felt to impair the auditor's independence and to let the user assess how much reliance it is willing to place upon the auditor's report.
Through this process, if the client feels that financial statement users might be reluctant to rely on the auditor's report, it could simply insist upon the elimination of the condition or retain an audit firm that does not have the relationship that is causing an independence question. The advantage of this approach is that it does not require that the threshold for impairing independence be determined in advance and out of context. The problem is that it may require a lot of detailed disclosure, which would obscure more than clarify.
The second approach is to create a series of requirements for independence that are generally known to the public and simply have the audit firm attest that it has met those requirements. This is the system currently in use, and it has the advantage of not miring the financial statement user in a sea of secondary disclosure (primary disclosure being the audit evaluation itself). The problem with this approach is that it requires that criteria for determining independence be established in advance. This poses a further problem, as some factors are clearly more important than others. Moreover, factors that might be sufficient to deter a financial statement user from relying on the report of an unknown accountant might not be of concern to the user with respect to a well-known and highly regarded audit firm. In short, the independence rules make no allowance for a firm's hard-earned reputation for honesty and integrity or for its well-honed internal quality control systems.
The AICPA has proposed a variation on this approach under which each audit firm would be authorized to establish its own rules for safeguarding auditor independence, rules which would be established under ISB guidelines and would be subject to advance review and periodic compliance checks by the ISB or a peer review. Thus, auditor independence would be handled on a decentralized basis, more or less in the same manner as meat or produce is inspected by the Department of Agriculture. Under this approach, the audit firm could establish internal systems for offsetting the possible effects of any factor impairing auditor independence. Thus, if a client represented a significant portion of the revenue base supporting the audit partner's compensation, the audit of that client might have to be reviewed de novo by a firm partner whose compensation would not be affected by the loss of that client. Such a system would not only eliminate the unnecessary restrictions imposed by many of the current independence rules, but more importantly would address many important aspects of independence in fact not addressed under the current independence standards.
Still another approach would be to use a mixture of these approaches. Thus, certain types of impairing relationships might be deemed so fundamental that they must never be compromised. Others of lesser importance might be addressed through offsetting internal safeguards, or through disclosure. In this way, the profession will have a system that is sufficiently flexible to accommodate alternative practice structures as well as to give the user information that might affect reliance on an auditor's report. While the disadvantage of such a system is obviously its complexity, that complexity is borne by the professionals and not by possibly unsophisticated readers of financial statements.
The Impact of Consulting Services
Even after the ISB decides upon an approach to safeguarding audit independence, it must still develop standards addressing the wide variety of consulting services being provided to other clients and the nontraditional firm structures being used by American Express and other consolidators. It is difficult, at best, to assess the overall impact of consulting services on the independence of an accounting firm.
There is a natural tendency to believe an auditor cannot be wholly objective in assessing financial data of a company that her firm has advised on ways to improve efficiency or profitability. No objective evidence, however, exists to support this hypothesis and there is no evidence that the number or percentage of audit failures increases where such services have been performed. Perhaps equally important, the public has shown no reluctance to rely on the financial statements of companies whose auditors perform such services. In fact, lending institutions seem to be comforted by greater involvement of CPA firms in their clients' affairs.
To be sure, there are many trade-offs suggesting that the performance of consulting services has an overall positive impact. These trade-offs include the audit firm's greater--
* understanding of the client's operations and accounting systems;
* profitability, which enables it to hire more qualified individuals and provide those individuals with better training and supervision; and
* exposure to the client's management, which enables it to better assess the integrity of management and the economic pressures placed upon it.
It must also be appreciated that consulting encompasses a vast variety of services, some of which have a more direct impact than others on the operation of the clients' internal accounting system or profitability. Accordingly, some services are likely to be perceived as posing a greater or lesser danger than others to an accounting firm's independence. Thus, even if limitations on consulting services were to be deemed appropriate, a distinction might be discernible between the various classes of consulting services, based upon their likely impact on an audit. To simply outlaw them altogether would appear to be a case of throwing out the good with the bad.
Because of these concerns, a more flexible approach to independence would seem to be called for; one which is capable of focusing on the--
* class of services being provided,
* extent to which those services might affect the client's operations or the audit firm's objectivity, and
* presence of other factors that might mitigate any such adverse effects.
In short, the current "all or nothing" approach to audit independence seems unduly rigid and inappropriate.
The Impact of
Alternative Firm Structures
In the wake of American Express' acquisition of Goldstein Golub Kessler & Co., the SEC voiced concern over whether the "separate practice" structure was sufficient to preserve the firm's independence. This concern has also been voiced by regulators in New York, Ohio, Connecticut, and Texas that have stated that they intend to monitor compliance with the protocol established in consolidator acquisitions of accounting firms to assure the independence of the separate practice units that will continue to provide attest services. The AICPA has attempted to address some of these concerns in an ethics interpretation, The Effect of Alternative Practice Structures on the Applicability of Independence Rules.
Even with this interpretation, there are still two issues with respect to these firm structures. First, there is a question as to whether the separate practices are indeed separate, or whether the employment relationship between the acquiring entity and the partners of the separate practice (together with the employee and facilities lease arrangements) provide the acquiring entity with effective control over the separate practice units. Second, there is a question as to whether being under the effective control of a profit-motivated enterprise impairs or gives the perception of impairing the objectivity and integrity of the partners conducting the separate practice.
To date, there is no empirical evidence directly on point, as these arrangements are relatively novel and the profession has not developed sufficient data with which to evaluate them. It is the author's view that they do not represent such an extreme departure from current practice as to justify their being outlawed altogether. Either such entities will provide a necessary and useful service, justifying their existence, or they will not offer service preferable to existing practices, in which case such entities will be abandoned, as will the need for regulations prohibiting them.
It is hard to criticize these new practice structures for being too commercial. Indeed, it is difficult to envision that they will become any more profit-driven than the large traditional accounting firms currently exploring all avenues of potential revenues and profits without corporate ownership. Indirect control through employment of the partners of the separate practice units is unlikely to have any material effect upon the honesty and integrity of the decision-making processes within the separate practices.
Whether there is any necessity for attributing the relationships of the acquiring company to the separate practice units is perhaps less clear. To be sure, such attribution seems to have a certain element of overkill, in that it assumes that any action taken by the separate practice unit would have an equally severe impact if undertaken by the acquiring company. Since many of the prohibitions designed to maintain auditor independence are themselves overly restrictive (at least, in the absence of a materiality concept), extending them further is questionable. Thus, like the changes in services offered by CPA firms, these alternative practice structures also seem to cry out for a more flexible approach to independence issues, rather than one that simply adds to the regulatory burdens.
Regulatory Scheme Must Be Flexible
To be sure, the ISB will be grappling with these issues for many months, if not years. In doing so, it must bear in mind that the landscape of the accounting profession is changing rapidly and may continue to do so. For this reason, it is particularly important to design a regulatory scheme for safeguarding auditor independence that will be sufficiently flexible to accommodate those changes. *
Dan L. Goldwasser, Esq., is an attorney practicing in the New York office of Vedder, Price, Kaufman & Kammholz. Among his clients are accounting firm consolidators. He is the editor of the Accountant's Liability department of The CPA Journal.
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