August 2000

Who needs facts when you have common sense? Thoughts on the SEC’s proposal on auditor independence

By Robert N. Waxman, CPA

The Commission will not recognize any certified public independent who is not in fact independent.

-SEC Reg. S-X, Rule 2-01(b)

Last year, SEC Chief Accountant Lynn Turner sent the American Accounting Association (AAA) a letter suggesting various areas for research on auditing and other issues, including whether users of financial statements consider non-audit services to impair independence, and how disclosure of all non-audit services would affect investors’ perceptions regarding independence.

Then in June of this year, without benefit of the AAA research, the SEC released a proposal (34-42994) calling for new disclosures in annual proxy statements directly aimed at non-audit services. To justify the need for this disclosure, the SEC said it has “become increasingly concerned that the dramatic increase in the nature, number, and monetary value of non-audit services that accounting firms provide to audit clients may affect their independence.” As for the lack of research, the SEC said, “Some argue that no empirical evidence justifies our concerns. They argue that there is no evidence that providing non-audit services in general--much less particular types of non-audit services--leads to false financial reporting. Without this evidence, the argument goes, the Commission should not take steps to protect auditor independence.” The SEC argues that “[i]t is common sense ... and confirmed by studies, that a person’s decision changes when he or she has a stake in the outcome of that decision. Furthermore, common sense dictates that the more someone--including an auditor--has at stake, the more likely his or her decision is to be affected.”

Questions raised by the SEC’s “common sense”

The SEC poses many questions about the impact of nonaudit services on independence. They ask -:

  • If there was a ban on all nonaudit services to audit clients, should the ban exclude tax services?
  • Does providing tax opinions (including opinions on tax shelters) to an audit client or an affiliate of an audit client impair an auditor’s independence?
  • Should the rules provide that independence is impaired whenever the auditor provides any tax opinion or any tax opinion affecting the audit client’s financial statements?
  • Does rendering a tax opinion to an audit client affect an auditor’s independence, considering that the auditor must reach an opinion that the financial statements taken as a whole, including the tax accounts, are fairly presented?
  • Are there certain circumstances in which providing audit clients with tax opinions should not be deemed to impair independence? Are there tax-related services that would impair the auditor’s independence if provided to an audit client?
  • Will providing legal services to an audit client (or an affiliate of the client) impair the auditor’s independence? Would any particular legal services not impair independence? Should an exception be made for legal services provided in foreign jurisdictions?
  • Will providing expert services on behalf of an audit client impair independence? Under what circumstances might providing audit clients with expert services in legal, administrative, or regulatory filings or proceedings be deemed not to impair independence?
  • Should an auditor be permitted to serve as a nontestifying expert for an audit client in connection with a proceeding in which the auditor’s work does not provide a basis for testimony by an expert?
  • Is independence impaired when the auditor issues an opinion on the application of an accounting principle that is used primarily to market a product to third parties?
  • If an auditor has a client who is a broker-dealer or an investment adviser and the auditor designs the client’s system for regulatory compliance, will the financial audit necessarily encompass reviewing or auditing any aspect of that system or its performance? If so, would designing such a system impair the auditor’s independence?

    Usefulness of disclosures? Debatable

    The SEC believes that its proposed disclosures about non-audit services would improve investors’ understanding of the auditor-registrant relationship and help shareholders decide how to vote their proxies in ratifying management’s selection of an auditor.

    What the proposal does not explain is exactly how investors and other “stakeholders in auditor independence” can and will use these new disclosures to determine whether an auditor is independent. The auditor either is or is not independent--a yes-or-no issue. But, without specific guidance from the SEC or the Independence Standards Board (ISB), the various stakeholders are likely to disagree on when an auditor has “crossed the line.” So, absent any guidance on how investors can use the new information (other than by making a subjective evaluation of the auditor/registrant relationship), the benefits of the proposed disclosures cannot be discerned.

    Nor do the new disclosures offer guidance on how much or what kind of non-audit services blemish auditor independence, and we do not know enough about the investing public’s perception of the propriety of non-audit services.

    Obviously, if the list of non-audit services spells out an engagement that is already forbidden (e.g., bookkeeping, advocacy) then the disclosures would be useful to regulators. But auditors would be unlikely to undertake services that so clearly compromise their independence in the first place.

    The proposal itself does not answer the following questions raised by these new disclosures:

  • Will these disclosures change perceptions of independence? Does not a mere detailed listing of these services make them suspect?
  • Is disclosure alone enough to preserve investor confidence in financial information? Can an impairment of auditor independence be avoided merely by disclosing it? (These two questions are in the proposal, but not answered.)
  • Where does the burden of proof fall? On auditors, or regulators?
  • Do the disclosures really add anything to the knowledge mix of investors? (Note the lack of research in this area.)
  • Which non-audit services will taint auditor credibility? The proposal asks the following questions, but gives no answers or guidance: Does the size of the consulting fees relative to audit fees affect independence? Is the proposed fee comparison the appropriate way to determine whether independence is impaired? If not, what proportion of non-audit service fees triggers impairment of independence?

    These questions have no immediate answers, and I suspect they never will. What we do know is that the proposed rules, because they lack sufficient guidance for registrants, raise implementation issues. Without guidance, the final rules will be applied inconsistently, disclosures will range from overly detailed to practically boilerplate, registrants may not have the appropriate management policies in place, and registrants will implement systems to capture data that no one will need or use.

    A Return to Common Sense?

    . I am not yet convinced that these rules will not serve any useful purpose except to highlight that auditors may indeed perform non-audit services, and the amounts involved may be greater than the audit fee. What is more important, but is not disclosed, is how the audit partners and staff of the principal auditor are compensated. Can they share (directly or indirectly) in a bonus pool for “selling” or having “sold” non-audit services? Just how does cross-selling of services specifically damage independence? Is the sole issue perception, and if so, whose perception? Does a problem really exist? Again, more questions than answers.

    The effect of non-audit services on independence is complex and irresolvably ambiguous. The only solution is for management to engage firms other than the principal auditor to perform these services, with exceptions (outlined in the release as “exclusionary rules”). The disclosures alone will not solve the problem, real or perceived. The Exhibit shows one scenario--my own: a disclosure statement, corresponding statement for audit services, and comments and observations. The SEC has not reviewed this example, and would likely suggest major revisions if it did.

    From reading the proposed rulemaking, my impression is that the SEC is on a fact-finding mission. It has posed many difficult questions and is seeking input on the answers. The CPA community has an opportunity to influence the final rules and help the SEC find its way by sending the Commission comments and constructive suggestions.

    Robert N. Waxman, CPA, is chair of the NYSSCPA SEC Practice Committee.

    Editor’s Note: The SEC’s proposed rulemaking and additional material, including comments received to date and reports from public hearings held, are posted at According to the website’s information at press time, comments are due on or before September 25.

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