The SEC’s New Auditor Independence Standard

By Dan L. Goldwasser

In Brief

Be Careful What You Wish For

No one denies that the SEC’s new standards for auditor independence were long overdue. The existing rules had become cumbersome and outdated in many respects, and the auditing profession and business environment itself have changed enormously over the last few years. But no one could have anticipated the result—new standards that apply to the auditors of all SEC registrants, regardless of size, that could dramatically affect all CPA firms if other regulators follow the SEC’s lead.

During public hearings, the SEC had no interest in testimony that claimed nonaudit services improve the quality of audits, and presented no evidence of its own that nonaudit services compromise audit effectiveness. Although nonaudit services are not strictly prohibited, the new rule imposes limitations that raise other questions about the responsibilities of auditors, management, and audit committees, and about the future role of the Independence Standards Board (ISB). One theory put forward by the author: The new rule accomplishes little new, and the SEC did it all as a means of asserting its authority over the Big Five firms and, less directly, the auditing profession as a whole.

When the SEC issued new independence standards for auditors of public companies on November 15, 2000, it marked the culmination of a process that began on June 29, 2000, when the SEC first published its proposal to drastically revamp the standards.

The final rule contains significant differences from the SEC’s initial proposal: Specifically, it significantly relaxes the existing independence standards as they relate to the ownership of financial interests in the client and employment by the client of persons related to members of the audit firm. However, the final rule makes no significant changes in the types of nonaudit services incompatible with auditor independence. Instead, the SEC has made the audit committees of public companies responsible for ascertaining whether nonaudit services (other than those proscribed) impair audit independence, and now requires public companies to publish in their proxy materials the dollar amounts spent for audit, information technology (IT) consulting, and other nonaudit services that its independent auditors provide.

The only significant change in the scope of prohibited services is a requirement that independent auditors not provide more than 40% of the internal audit services of a public company client. The final rule made virtually no change to the attribution rules, meaning that independent auditors generally remain free to enter into joint ventures and strategic alliances with other companies without undue fear that the relationships of their business partners will impair their independence.

Impact of the New Rule

Whether the new rule will significantly impact auditor independence is unclear. The most significant feature is the relaxation of the requirements relating to the ownership of financial interests in clients and employment relationships with clients. The prior rules had become unworkable in an era in which accounting firms have become global organizations and families have multiple breadwinners. In this respect, the new independence standards adopted probably relax, rather than tighten, the rules.

A principal side effect of the new rules is their impact on the Independence Standards Board (ISB), which was created in 1997 by the SEC and the AICPA for the purpose of deriving a set of independence standards (based on a coherent conceptual framework) that would address the changes that have taken place within the accounting profession and the business community. The SEC’s adoption of a wide-ranging set of independence standards before the ISB completed its work clearly undermines the stature of the ISB and raises questions about whether the SEC intends to let the ISB carry out its intended function. More immediately, however, some positions taken by the SEC in its final rule appear to be inconsistent with the conceptual framework of independence that the ISB published in exposure draft form in late November 2000. The ISB’s proposed statement incorporates the concept of safeguards, under which certain potential impairments of independence would be permitted if offset by appropriate safeguards. Not only does the SEC’s final rule reject the safeguard approach, it adopts a disclosure approach to resolving perceived independence problems, which the ISB appears to have rejected. By adopting its new rule the SEC has effectively rejected the conceptual framework that would have provided a foundation for future ISB statements.

Another likely outgrowth of the SEC’s action is a reconsideration of independence standards previously adopted by the various state boards of accountancy. To mobilize public opinion in favor of its proposed independence standard, the SEC sought support from numerous state boards of accountancy. In doing so, however, the SEC raised the state boards’ interest in updating their own independence standards by having them subscribe to the principles underlying the SEC’s proposal. Thus, many state boards now have new interest in adopting independence rules that will greatly restrict CPA firms from performing nonaudit services for their attest clients. This response is not unexpected, because most state boards lack the SEC’s resources to investigate audit failures, hold hearings, and commission academic studies. Thus, when a well respected government agency charged with protecting the public, such as the SEC, goes to the trouble to rethink its accounting standards, state accounting regulators would be remiss in not giving credence to its findings. What is surprising is that the SEC did not foresee that state regulators would feel prompted to follow its lead.

Certainly, accounting regulators and users of financial statements are now much more aware of the auditor independence issue. In four days of public hearings, the SEC invited numerous institutional investors to express their views on auditor independence. Not surprisingly, most of them took the position that independence standards could never be too strict, as the whole financial reporting system relies on the objectivity and integrity of independent auditors. To the extent that the investing public, as well as corporate directors and managers, have become more conscious of auditor independence, the SEC’s activities in this arena were clearly beneficial. To the extent that the SEC caused the investing public to doubt the reliability of audited information, its efforts were clearly counterproductive.

Disclosure. The SEC’s adoption of a disclosure approach to auditor independence was a highly dubious choice. Through the disclosure of nonaudit services performed by a company’s auditors, creditors and investors would theoretically be able to better evaluate the reliability of the audit reports on the company’s financial statements. Thus, investors and creditors that believe the disclosed nonaudit services could impair the auditors’ objectivity and integrity would presumably demand a greater return on their investments, greater security for their loans, or simply choose not to do business with the company. As a practical matter, however, the disclosure of nonaudit services accomplishes very little and could be counterproductive, because vendors, creditors, and investors are unlikely to be deterred by the disclosure of nonaudit services. Indeed, the disclosure of nonaudit services provides financial statement users with little basis for judging the reliability of the auditor’s report. The required disclosures will not reveal the extent of the auditors’ testing or the training or quality of the staff accountants. Moreover, financial statement users will not know what safeguards the audit firm used to ensure the objectivity and integrity of its audit staff. Most importantly, they will not learn the economic importance of the client to the audit firm or the persons that performed the audit. In the final analysis, investors and creditors will have to rely on the reputation of the audit firm, just as they have done in the past.

Disclosure of the audit firm’s revenues from nonaudit services will also add to the clutter of current disclosure documents . Disclosures relating to auditor independence, however, do not enhance the reader’s knowledge of the company, but rather relate only to the quality of the information about the company. In that sense, such disclosures provide, at best, only secondary information. Indeed, more relevant disclosures might include the extent of the auditor’s testing of important accounts or the number of adjusting journal entries needed to provide a clean opinion. Finally, disclosures regarding nonaudit services will call into question the entire regulatory scheme of auditor independence. To the extent that financial statement users believe such nonaudit services to impair auditor independence, the now-required disclosures will place doubts in their minds regarding the overall effectiveness of the SEC’s regulation of the accounting profession. These doubts will in turn adversely affect all public companies.

The SEC’s new rule undoubtedly eliminates many irrational aspects of current independence standards that had become unworkable in the context of global accounting firms and families with two breadwinners. In this sense, the SEC’s new rule will have a positive effect, but one that could have been accomplished by letting the ISB continue its work: Most of these reforms were taken directly from the ISB’s statements on financial interests and employment relationships with the client.

Anticipated Changes Within the Profession

Although the SEC’s new rule addresses only independence issues, the hearings leading up to its adoption touched on a broad range of topics, including how the profession will continue to govern itself. Throughout the hearings, SEC Chairman Arthur Levitt openly criticized the AICPA for its failure to effectively regulate its members. Moreover, Levitt pushed the Public Oversight Board (POB) into establishing a Panel on Audit Effectiveness, chaired by Shaun O’Malley, which sought to reexamine the effectiveness of financial statement audits of public companies. Although the O’Malley Panel concluded that financial statement audits were generally effective, its final report also made certain suggestions, including changes to the AICPA, POB, and ISB. Throughout the SEC’s hearings, Levitt continually questioned why the profession had not acted on the recommendations of the O’Malley Panel.

It is no secret that the final rule was arrived at through negotiations between the SEC, the AICPA, and the Big Five accounting firms. Thus, it seems likely that, in return for substantial modifications of the proposed rules, the AICPA and the large accounting firms were forced to agree to implementing the changes recommended by the O’Malley Panel. This means that there will likely be an increase in the public representation on the AICPA’s Trial Board (which hears disciplinary charges against CPAs). In addition, the AICPA’s practice of deferring disciplinary proceedings during the pendency of related civil litigation and other disciplinary proceedings is likely to be modified, if not abandoned. These changes could, in turn, cause many small CPA firms to abandon membership in the AICPA and those state societies that participate in the AICPA’s Joint Ethics Enforcement Program.

The POB itself is also likely to be expanded, with more public members being appointed to better ensure that the profession subjects itself to effective regulatory oversight. Moreover, the POB’s scope of authority will likely expand and, under the recommendations of the O’Malley Panel, so will the POB’s oversight authority over the ISB, the Accounting Standards Board (ASB), and the AICPA’s disciplinary processes.

The ISB. Perhaps the biggest changes are in store for the ISB, whose future remains clouded. Why would a member of the ISB continue to serve knowing that at any time the board’s efforts could be nullified by the actions of the SEC? Who would be willing to serve on the ISB if it is to be subject to further oversight by an expanded POB? More importantly, the SEC’s rule strikes a crippling blow to the ISB’s attempts to formulate a conceptual framework for independence standards. It is also unclear how the SEC’s new rule will impact the consulting practices of CPA firms. Although the final rule, unlike the original proposal, does not prohibit all IT consulting, business valuation, or internal audit services to audit clients, it does place limitations on business valuation and internal audit services. Firms that have been providing these services would not be required to divest themselves of those capabilities. Indeed, many believe that the ability to perform such services is critical to the performance of quality audits because future financial statement frauds will almost invariably include the manipulation of data stored in the client’s information systems or erroneous accounting estimates.

What Did the SEC Accomplish?

It is difficult to judge whether the SEC’s efforts to modify the independence standards will have a net positive impact. Modernizing the outdated standards for investment and family relationships is a helpful reform, but one that would have been accomplished by the accounting profession through its normal channels. The list of prohibited services codified by the new SEC rule basically mirrors that already in place, with some minor additions. Perhaps more important, however, the SEC’s new rule did not even attempt to answer the most important independence question facing the accounting profession: At what point does the client’s own economic importance to the accounting firm and the auditors impair the audit independence? When questioned about this, senior SEC staff members simply admitted that they thought that this problem was too complex to be addressed—a devastating admission, particularly if the SEC’s actions have doomed the one organization (the ISB) capable of addressing this issue. At this point, the

ISB continues to function and none of its members have resigned. Even assuming that the ISB tries to continue its work, the SEC’s rejection of the ISB’s chosen, and promising, safeguards approach could keep it from accomplishing its intended goals.

The SEC, in seeking adoption of a radical independence standard, has clearly poisoned its relationship with the accounting profession. During the course of the hearings on the standard, both sides made harsh accusations. In particular, Chairman Levitt encouraged AICPA members to reject the positions taken by the AICPA’s leadership. Even though the final rule was a largely negotiated result, the relationships between the SEC and the profession appear to remain tense. Curing the damage done to this relationship may take some time—and new SEC leadership.

Perhaps the biggest impact of the entire exercise was that it brought independence issues to the forefront. The accounting profession is undoubtedly now more mindful of the importance of auditor independence. The investing public has become aware of the issue and may now be disillusioned by what it has found auditor independence to actually mean. Many of those that testified at the hearings offered an idealistic (and perhaps unrealistic) view of the meaning of auditor independence; the healthy dose of realism that they have received in the process may cause the public to view audited financial data more skeptically. In this respect, the rule-making process will have been completely counterproductive, decreasing, rather than increasing, the public’s confidence in audited financial statements.

Why Did the SEC Do It?

It is impossible to know whether the SEC would have embarked on this mission had it known what the end result would be. Considering certain SEC actions and statements throughout the process, one also has to question whether enhancing auditor independence was really the primary goal. A number of signs indicate that it was not. One need only to have sat through a small segment of the hearings to get a sense of the fervor with which the SEC was pursuing its proposal. Notwithstanding the emotion in Chairman Levitt’s voice, the SEC was unable to identify a single case in which the performance of consulting or other nonaudit services had led to an audit failure. Similarly, no evidence was presented to indicate that audit failures were more likely where an audit firm had performed significant nonaudit services. Prior to the SEC’s publication of its proposed rule, no public outcry was heard for curbing the scope of services by public company auditors. For the SEC to devote so much time and political capital to an arguably unimportant issue was uncharacteristic, especially when it is currently faced with so many important issues (such as Internet fraud and the changing nature of financial securities markets).

As noted, the SEC did not even attempt to address the single most significant independence issue—the economic importance of the client—and has perhaps doomed the ISB, the one body capable of addressing this issue. Moreover, the SEC has seemingly made no attempt to commence disciplinary actions against those partners and employees of PricewaterhouseCoopers who were found to have violated existing independence standards. When asked about this at the hearings, Levitt stated that those violations would not be deemed to impair audit independence under the proposed rule. But his statement was not wholly correct, because approximately 40 such violations would be proscribed under the new rule. In this light, one must question whether reform of the independence standards was in fact the SEC’s primary objective. Robert Elliott, outgoing AICPA chair, characterized the SEC’s proposed rule as a “solution in search of a problem.”

If audit independence was not the problem, what was? The answer to this question may lie in the SEC’s own actions and statements. Throughout the hearings and in its promulgating release, the SEC recognized that as recently as 1994 it had concluded that consulting services did not impair auditor independence. In its proposing release, however, the SEC contended that the magnitude of nonaudit services had increased substantially since 1994 and consulting services now represent the majority of the Big Five’s revenues and revenues from audit services had declined to approximately one-third of total revenues. Moreover, revenues from nonaudit services continue to grow at a rate substantially higher than revenues from audit services, leading to further decline. The SEC also pointed out that audit services tend to be less profitable than other services; while audit services currently represent approximately 20% of the Big Five firms’ profits, this figure would likely decline in the future.

Throughout the hearings, Chairman Levitt and other commissioners emphasized that the proposed rule would apply only to the Big Five firms and would not affect the activities of smaller CPA firms. This statement, while reassuring to witnesses from small CPA firms, was seemingly without basis: The proposed rule was drafted to cover firms of all sizes and makes no exclusion for small firms or small public companies. To the contrary, the testimony of members of various state boards of accountancy indicated that they would likely adopt whichever rule the SEC adopted, affecting all CPA firms, irrespective of whether they audit public companies.

Throughout the hearings, numerous speakers pointed out how providing a variety of nonaudit services actually enhances audit effectiveness by giving the audit firm more exposure to the client’s operations, business plans, and management. In addition, they argued that without providing a variety of nonaudit services, audit firms would not even be able to understand the capabilities and limitations of their clients’ IT systems. Others argued that the economic growth and profitability provided by nonaudit services better equipped accounting firms to compete for and retain high-quality employees. The SEC, however, gave little credence to these arguments, subordinating them to their own concerns of impaired independence, even though the SEC has instituted no disciplinary proceedings for recent independence violations by Big Five accounting firms. To the contrary, following the report of the independent investigator regarding independence violations at PricewaterhouseCoopers, the SEC persuaded the other Big Five firms to enter into a voluntary program pursuant to which they would submit to a similar investigation in return for absolution from all but clearly serious violations. Approximately two days before this voluntary program was to be implemented, in what was clearly an afterthought, the SEC extended its offer to the next three largest firms. No similar offer was made to any of the other roughly 1,200 accounting firms that audit public companies. One must seriously question whether the SEC is really serious about independence violations and whether it cares about the non–Big Five firms.

The Economic Power of the Big Five

The probable reason behind the SEC limiting the scope of nonaudit services was to enhance the audit practices of the Big Five firms in order to make their regulation more effective. For example, if a time came when audit services represented only a relatively small percentage (perhaps 10%) of the profits of the Big Five firms, the SEC would have difficulty compelling those firms to comply with its regulations—they could simply decide to abandon their public company audit practices. The fact that Andersen Consulting was willing to break away from Arthur Andersen proves that very soon the consulting practices of the Big Five firms will not need referrals from their audit partners in order to thrive. Quite possibly the SEC’s real goal for the new independence rule was to ensure the future effectiveness of its regulatory powers over the firms that audit more than 90% of U.S. public companies.

This theory may seem far-fetched, but it does explain many seeming inconsistencies in the SEC’s actions, such as why the SEC did not include a restriction on the economic importance of an audit client—even though that is clearly the most important independence issue confronting the profession. It also explains why the Commission would be willing to jeopardize the future of the ISB and why Levitt was adamant that the proposed rule would not apply to second-tier accounting firms even though it would probably be adopted by the state boards for general use throughout the profession. This theory also explains why the SEC was so quick to give credence to the unproven assertion that consulting services could impair independence while dismissing the profession’s arguments that providing consulting services actually enhances audit effectiveness. This theory further explains other inconsistencies in the rule itself, such as why rendering tax advice is permitted while rendering legal advice is not. It also explains why the SEC would be willing to relax attributions among members of the audit firm regarding financial interest restrictions but not regarding various joint venture and strategic alliance relationships.

The Final Analysis

The SEC’ accomplished very little because its new independence standards will likely have little impact on the future growth of nonaudit services, even among the Big Five. The adoption of a disclosure approach may discourage audit committees from using their company’s outside auditors to provide needed nonaudit services.

The biggest impact of the new rule may be making audit committees the gatekeepers of audit independence. Unfortunately, however, the new rule and the promulgating release provide few, if any, standards by which audit committees can judge whether permitted nonaudit services adversely affect the independence of outside auditors. Audit committees may face a higher liability exposure as a result of the SEC’s action, possibly discouraging qualified individuals from assuming the responsibility. When questioned about this possible result, a senior SEC staff member stated that whether nonaudit services impair independence is not a legal question but a business one. By this, one must conclude that the performance of nonaudit services cannot be deemed to impair auditor independence except as expressly provided in the rule, and that it is simply a question for the audit committee to determine whether the disclosure of nonaudit services provided by the company’s outside auditors will adversely affect the company’s cost of capital.