October 2000

Objectivity and independence: A delicate balance

A New York Times editorial and subsequent commentary covered the SEC’s proposed rulemaking on auditor independence and the ensuing events that have created some unfortunate animosity between the accounting profession and the SEC. The comment, “Auditors are the only profession enshrined in the nation’s securities laws,” brought to mind testimony given by Col. Arthur H. Carter in 1933 before the Senate committee considering how to fulfill the auditing requirements of the new securities regulations. Most senators favored government auditors, but Col. Carter, called before them in his capacity as NYSSCPA president (not as managing partner of Waterhouse and Co.), convinced the committee that private sector auditors would provide a higher-quality financial reporting product.

Objectivity and integrity in professional conduct have fueled the growth of accounting practices. Over time, the CPA’s reputation for “telling it like it is” rather than telling management “what it wants to hear” created myriad opportunities for CPA firms to offer nonaudit services where their knowledge and skills made them a provider of choice. The economic value created by CPAs acting as trusted professionals for millions of clients is reflected today in the health of the U.S. financial markets.

The SEC’s independence regulations have been the practical cornerstone of CPAs’ objectivity and integrity, ensuring that the investing public receives high-quality, trustworthy financial statements. Concerns about auditor independence led to the creation of accounting standard bodies—first the APB and subsequently the FASB—to create a standard set of authoritative principles independent of client management’s preferred accounting practices.

Most people find parts of the SEC’s current proposal—those that attempt to modernize specific rules regarding investments in public companies by partners and employees of their audit firms and their family members—well-founded in the complicated realities of how individuals and families with two working adults hold retirement investments and other portfolios. They are uncontroversial because they are fundamentally reasonable, workable provisions for an increasingly complex world.

The second category of concerns addresses limitations on the scope of services auditors can provide to audit clients. Even those who agree that the growth in size and scope of the services rendered by CPA firms today poses complex, unanticipated challenges to auditor independence question the helpfulness of the SEC’s proposed rulemaking. Their questions center on the following concerns:

  • The proposed rulemaking treats the appearance of independence as a goal to be achieved in itself rather than as a means to achieve the goal of high-quality financial statements. Although most of the largest SEC registrants have accounting and information system personnel of the highest quality, many smaller SEC registrants and aspiring registrants, as well as many other nonregistrant audit clients, look to their auditors for accounting and information-systems expertise. A blanket ban on providing consulting services to audit clients, without addressing whether they enhance or detract from the quality of financial reporting, elevates independence above financial reporting—surely an unintended outcome.
  • The proposal posits four principles to guide the creation of the independence rules that, if taken at face value, cannot help but be violated daily for the most innocuous of reasons. Moreover, it is difficult to see how such violations could be considered a breach of independence. For example, under the proposed rules an audit firm would violate the mutual interest prohibition in its search for employee theft during a client’s audit and the conflicting interest prohibition when it renders an invoice. These principles provide no guidance about which of the inevitable, routine violations would be permitted without the impairment of independence, a problem also shared by the principle prohibiting an audit firm from functioning as management or an employee of an audit client, which fails to indicate how to distinguish management and nonmanagement functions, employees and nonemployees.
  • The proposed rulemaking does not address the fundamental independence issue: Whether an auditor, audit firm office, or audit firm loses objectivity and integrity when it is economically dependent upon a client because of the size of the audit fee. The focus on restricting the scope of CPA firm practice to enshrine the appearance of independence leaves unanswered a fundamental issue that many hoped the SEC would address in the new rulemaking.
  • The proposed rulemaking does not consider its impact on audits of privately held companies. Inevitably, the independence rules for SEC registrants will become the “de facto” standard for the profession and will lead to a chilling effect on the role of the accountant. Discussions with Society members in industry have convinced me that prohibiting businesses from using their CPA firm for both audit and nonaudit services would create significant barriers to business development.

    To create and develop a system that ensures that an auditor rendering an opinion on financial statements is economically independent of the client is certainly within the scope of the SEC’s authority and ability. Such a system, already under consideration by the ISB, would provide guidelines for auditor compensation packages that would mitigate the potential effects of client economic power. SEC support would give this process urgency and credibility.

    In the heat of debate, let us not forget that we all pursue the same goal: high-quality, trustworthy financial information for the investing public. We should pay close attention to the system that supports the objectivity and integrity of CPAs. Chair Arthur Levitt, Chief Accountant Lynn Turner, the SEC commissioners, and the accounting profession all deserve great credit for venturing into this arena.

    Louis Grumet
    Executive Director, NYSSCPA
    Publisher, The CPA Journal

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