Independence Standards Board

Arthur Siegel, CPA, executive director

Richard H. Towers, CPA, technical director

Susan McGrath, CPA, director

The Independence Standards Board (ISB) was established in 1997 by the AICPA and the SEC to permit timely, thorough, and open study of issues involving auditor independence and to encourage public participation in establishing and improving independence standards for auditors of public companies. In 1999 and culminating last year, the SEC undertook to revise its rules on auditor independence. Many questioned why the project had been wrested from the ISB just when the organization was making real progress in modernizing the independence rules and developing a conceptual framework to guide independence standard setting.

When the SEC issued its new auditor independence rule last November, to take effect in February, the professional community waited for the other shoe to drop: What would happen to the ISB? The new independence rule raised large questions about its role and relevance.

The CPA Journal editors sat down with the ISB’s executive director and other key staff to talk about the ISB in late January, at which time it was clear that the ISB still has much work to do and much to contribute to the profession.

CPAJ: What was your reaction to the new SEC independence rules?

Siegel: Obviously we were disappointed when the SEC undertook this project, and their revision contains some things that we would have done differently. Nevertheless, we were pleased that the SEC adopted the principal decisions of the ISB, in particular, those focusing and limiting restrictions to those who conduct or are able to influence the outcome of the audit. Adopting this “engagement team” focus goes a long way in modernizing the rules on family relationships and financial interests—reforms much needed in view of the size of some firms.

Towers: The revision also gathers the majority of the rules in one place, so that you don’t have to pore through hundreds of “no-action” letters to research the answer to an independence question. This should help auditors, especially those in small firms without national office independence experts, to better understand and apply the rules.

McGrath: The revision’s biggest weakness really lies in the few instances where the SEC declined to provide guidance or a clear framework for resolving a question. For example, the revision directs those looking for guidance on the application of the rules to alternative practice structures to “come and ask the SEC staff.”

CPAJ: Can you tell us about the ISB’s conceptual framework project?

Siegel: We believe the Board’s conceptual framework for auditor independence—currently in exposure draft status—is an important contribution to independence literature and thought. Its model for analyzing independence issues and setting standards may strike some as common sense, but independence issues can be complex, and designing effective restrictions or other safeguards to protect independence requires a disciplined approach to evaluating human motivations, competing incentives, and the sometimes conflicting roles of auditors and their clients’ management.

The framework will remind us that independence is not the ultimate goal; we must not do anything to thwart quality audits, to discourage user reliance on audited financial statements, or to detract from capital market efficiency. The framework forces the standard setter to look at the big picture and consider the unintended consequences of regulation.

CPAJ: What are some examples of unintended consequences?

Siegel: The framework treats independence as a means to an end rather than an end in itself. To give you a real-life example, the ISB concluded that prohibiting audit firm professionals from going to work for firm audit clients would have the unintended consequences of making the accounting profession less attractive and denying clients the ability to hire people they know and have confidence in. That would ultimately detract from both audit quality and the financial reporting expertise of registrants. Those adverse consequences would hit small companies and small CPA firms particularly hard. As a result, in its standard on employment with audit clients, the ISB determined that its mandated safeguards would be just as effective as a “cooling off” period in addressing the potential threats to auditor independence without the unintended consequences.

CPAJ: The new SEC rule reaffirms its “appearance” test by focusing on whether a reasonable investor would conclude that the auditor could make objective judgments. How has the ISB, in the conceptual framework, dealt with the appearance question?

Siegel: The Board agrees that the credibility of financial statements is vital, and therefore an appearance test is appropriate. The conceptual framework words it a little differently—by talking about rationally based beliefs of well-informed investors and other users of financial information, and about the auditor’s objectivity—but the intent is the same.

CPAJ: How was the conceptual framework developed?

Siegel: We looked at FASB’s framework, talked to many people, and reviewed an enormous amount of existing literature, including work performed by IFAC, the U.K., Canada, FEE [Fédération des Experts Comptables Européens—the European Federation of Accountants], and the academic community. As an aside, it’s interesting and encouraging to see the similarity worldwide in the conceptual approach to independence standard setting. At ISB Chairman William T. Allen’s suggestion, we engaged academics to assist us. We also formed a broad-based task force to guide the project. To advise the Board on current thinking in the ethics field, we also engaged an ethicist from outside the profession.

Towers: The project task force and the public gave us many thoughtful comments, and the framework changed a lot from outline to discussion memorandum to exposure draft. In particular, the ED is relatively condensed and readable for this type of document.

CPAJ: Many people in and outside the profession have a presumption that the relationship between an auditor and the management and board of directors is by nature adversarial.

Siegel: Bill Allen, in one of his first speeches as ISB chairman, talked about the auditor’s relationship with management and directors. He said that if their relationship were not collegial, then nothing would get done. In about 2 percent of the cases, the auditor does have to say very firmly, “You can’t go there,” or “You can’t do that.” The other 98 percent of the time, things are constructive and collegial, but sometimes the auditor has to give up being pleasant for being right.

CPAJ: Where is the line drawn? Does a collegial relationship diminish auditor independence?

Siegel: In terms of actual working independence, as opposed to a theoretical construct, the collegial relationship, focusing on common objectives and persuading the client to do the right thing, is really the best way. The client generally wants to do the right thing, anyway. The auditor may have the veto card, but very seldom uses it.

McGrath: That’s right. Without rapport, you get little or no information from the client. Ideally, you want the client to come to you before they make significant decisions about accounting.

CPAJ: Has the significance of switching auditors diminished because of normal competition?

Siegel: At a very large company, neither the company nor the marketplace views auditor changes as a healthy sign. There are sound economic reasons to retain an auditor—there is an investment in getting an auditor up to speed and developing rapport. Companies don’t have to go far to intimidate an individual auditor, though. For example, all they have to do is ask for a new engagement partner. The SEC’s Form 8-K reporting for auditor changes gives the auditor some leverage. The filing calls attention to the change and describes any disagreements between the auditor and client and their resolution.

CPAJ: Can you talk about how the professional environment has changed since the 1970s?

Siegel: In the 1970s, the FTC forced the profession to allow CPA firms to start marketing and promoting, which to a great extent legitimized a more commercial mind-set. But within the audit firms, I worry that messages emphasizing the importance of selling services and growing revenue may drown out messages emphasizing the auditor’s public responsibility.

CPAJ: Where does someone get steeped in that public interest mentality?

Siegel: Several factors contribute to making someone a good professional, first of all, and then a good auditor. I don’t know how or where or when you get it, but if someone isn’t interested in being of service they shouldn’t be in the service professions.

CPAJ: What are firms doing now?

Siegel: We don’t seem to hear about those messages—about ethics, integrity, and public responsibility—as often as we used to or as often as we would like to. When we hear about accounting students in college coming back from internships where they were told that they’d be moved from auditing into something “more interesting” after they’ve put in their obligatory two years, I think that’s sending a very bad message.

CPAJ: What are your thoughts on an auditor’s economic dependence on a client, which many people see as a major threat to independence? Neither the O’Malley Panel report nor the SEC rules address this issue.

Siegel: We think the concern is valid. Our Board asked us to prepare a prospectus for a project on this issue, which we will present to the Board at its next meeting.

Towers: Below the firm level, this is a difficult issue because economic dependence is hard to measure for the individual partner, and what we call the “tone from the top” at the firm is also an important, but subjective, factor.

CPAJ: How is the ISB funded?

Siegel: The ISB is financed by the AICPA’s SEC Practice Section, which collects dues from its member firms based on, among other things, the number of the firm’s public company audit clients.

We receive “no-strings” funding of our budget from the SECPS. That is, they can’t control our activities by denying our budget request or by micromanaging our budget. You can find our operating policies and other information about our activities on our website [www.cpaindependence.org].

CPAJ: Does the ISB have a future?

Siegel: I think it can continue to play an important role. Firms, registrants, audit committees, and others will need assistance in applying the rules to specific facts and circumstances. We provide an important consultation function, and have answered over 400 inquiries in the past three years. With the profession changing so rapidly, guidance will be needed to cover new relationships and forms of practice. We have an infrastructure and process in place to provide this guidance, freeing up the SEC, with its limited resources, to address other issues. The SEC has pressured the profession to strengthen its self-regulatory structure, and a re-assumption by the SEC of the ISB’s independence standard-setting role detracts from an interpretative and rule-making role best provided in the private sector.

Towers: In addition, our conceptual framework will assist in ensuring that standards are principle-based and that rules have some consistency and coherence.

Siegel: If the ISB is to succeed, the SEC must truly delegate standard-setting authority. While we understand that the SEC cannot abdicate its responsibility for ensuring auditor independence, oversight of the process doesn’t mean that the Board should not or cannot adopt a standard unless it conforms in every respect to one that the SEC would have drafted itself. The Commission should determine only whether individual standards are within a range of acceptability, while focusing more broadly on the effectiveness of ISB operations overall. This is the approach that the SEC has taken in its oversight of FASB activities, and it’s worked there.

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