The Rise and Fall of the ISB

One cannot help but be struck by the high level of hypocrisy found in the recent announcement of the demise of the Independence Standards Board (ISB) and the subsequent remarks of Lynn Turner, the outgoing SEC Chief Accountant. The ISB represented the best, if not the only, means for the accounting profession to address the issue of the economic importance of the client to the auditor. Rather than allow the ISB to confront this issue, the AICPA and the SEC simply proclaimed that the ISB had accomplished its mission and terminated its operations. Turner added to the charade by proclaiming that the SEC had adopted a conceptual framework for resolving independence issues by inserting its “four guiding principles” to the Preliminary Note to SEC Rule 2-01.

The ISB was formed in 1997 for the express purpose of addressing the highly complex issues of accounting independence because the SEC purportedly lacked the staff and resources necessary to carefully consider these issues. With half of its members nominated by the SEC, the ISB would be entrusted with resolving independence issues in a manner that would serve the interests of both the public and the profession. There was a hope that the ISB would, at long last, address the independence issues inherently flowing from the fact that auditors are hired and paid by the companies whose financial statements they audit. In addition, the changes in the size and scope of services offered by accounting firms required that many of the existing independence standards be reevaluated.

Signs of the ISB’s premature demise appeared almost at the outset, when the SEC deferred giving formal recognition to the ISB’s pronouncements, choosing instead to endorse them on an individual basis. In addition, the AICPA soon published a white paper on the purpose and history of accounting independence standards which suggested that independence issues could best be resolved by adopting a flexible conceptual framework in which each accounting firm would be able to adopt its own independence guidelines within parameters established by the ISB. This approach was based upon the theory that the various threats to audit independence could and should be addressed though a system of safeguards specifically designed to counteract each perceived risk. This suggestion was immediately denigrated by the SEC, which characterized it as a suggestion by and for the accounting profession and not in the interests of the investing public. Thus, it was readily apparent that the SEC had created the ISB to absorb the political heat that would be generated if and when independence standards were modified and that the ISB’s continued existence depended upon its willingness to carry out the SEC’s agenda.

The ISB never officially considered the AICPA’s monograph and instead set to work tackling discrete independence issues without the benefit of a conceptual framework. Its initial progress was slow, largely because its public members needed to obtain a thorough understanding of the audit process and the role of independence standards in achieving audit quality. Perhaps more importantly, the ISB encountered immediate objections from the SEC to the paths which it was pursuing, requiring it to proceed in a more deliberate fashion. Nevertheless, by the end of 1999, the ISB had adopted three standards and had published exposure drafts on its conceptual framework and discussion memoranda on three other topics.

By this time, however, it had become clear that the ISB members were operating under a serious misapprehension: namely, that they had been appointed to exercise their own good judgment on a group of difficult issues. Moreover, it was also clear that their approach to audit independence issues was inconsistent with that of the SEC and, in particular, that of SEC Chairman Arthur Levitt. In January 2000, SEC Chief Accountant Lynn Turner announced that he had been requested to propose new SEC rules addressing questions of audit independence. In late June, the SEC published a 105-page release in which it sought comments on over 400 individual issues; the comment period lasted only three months. Much of the SEC’s proposed rule simply adopted (with minor changes) the ISB’s statements on owning financial interests in client enterprises and elements of a mutual fund complex as well as the ISB’s exposure draft on employment relationships with a client enterprise. The balance of the SEC’s proposed rule, however, sought to proscribe a host of non-audit services currently provided by many CPA firms as well as contingent fees with respect to any services the audit firm might provide to an SEC audit client or related entities.

Over the course of the comment period, the SEC held four days of public hearings and received over 3,000 comment letters. For the most part, however, the comment letters were superficial; addressing more than a small fraction of the issues raised in the SEC’s release would have required an extraordinary effort. The hearings themselves were largely filled with speakers hand-picked by the SEC that heartily endorsed the notion of stringent independence standards but exhibited little understanding of the role of independence standards and their impact on the quality of financial statement audits. Perhaps most shocking were the presentations by the four independent members of the ISB that, while requesting that the SEC simply adopt the standards which the ISB had already adopted or proposed, expressed their support for the SEC’s proposals to limit non-audit services. In this respect, the ISB members contributed to their organization’s own demise.

Despite the SEC’s efforts to orchestrate the hearings in support of its proposals, there were numerous heated exchanges between Chairman Levitt and the representatives from the AICPA and three of the Big Five, which denounced the SEC’s proposals as being illogical and misguided. In the end, the SEC negotiated with the dissenters the terms of the final rule, which was published in November 2000. By this time, however, the ISB had published an exposure draft of its conceptual framework that adopted a “threats and safeguards” approach to the formulation of independence standards, even though it did not adopt the AICPA’s earlier suggestion of firm-based independence guidelines within ISB parameters or subject to ISB approval. Nevertheless, the threats and safeguards approach was wholly rejected by the SEC. As for the issue of the economic importance of the client, the SEC’s General Counsel and Chief Accountant simply conceded that the issue was too complex to be addressed in an SEC rule. Thus, the SEC had made it clear that it and the ISB had differing approaches to audit independence and that ISB pronouncements would not be readily endorsed by the SEC.

Faced with this reality, the AICPA understandably saw little benefit in continuing to fund the ISB. It, therefore, sought the SEC’s participation in the announcement that the ISB was being dissolved, which was made in June 2001. While this announcement thanked the members of the ISB for their efforts and praised those ISB statements which had been largely incorporated into the SEC’s rule, it sought to justify the ISB’s dissolution on the grounds that its mission had been accomplished. Nothing could be further from the truth, as the most serious independence issues still remain unaddressed. Moreover, its conceptual framework (along with at least four other ISB projects in various stages of completion) was never adopted, leaving future standards to be addressed ad hoc.

In his subsequent statements, Lynn Turner has not only contended that the ISB fulfilled its mission, but also that the SEC had adopted a conceptual framework and employed a threats and safeguard approach. According to Turner, the conceptual framework can be found in the four guiding principles, which, owing to criticism that they were wholly unworkable, were removed from the operative provisions of the rule and placed in the Preliminary Note. If these principles were to be followed, an audit firm could not have any interests in conflict with its client—presumably meaning that when an audit firm disagrees with its client on a GAAP issue, it must resign because it has a conflicting interest; namely, to protect the public. To call these principles a conceptual framework represents extreme cynicism: They offer no basis for addressing the many unresolved issues of audit independence.

Furthermore, Turner’s assertion that the SEC did adopt a threats and safeguards approach is equally cynical: Nowhere in the SEC’s rule is there a single safeguard mentioned. In short, Turner’s statements are a clumsy attempt to justify the SEC’s undoing of the ISB and the havoc it wreaked in the standards-setting process. Although one can hope that the new SEC Chair Harvey L. Pitt, who, during his confirmation hearings, promised a wholesale review of SEC regulations, will rectify the damage to independence standards inflicted by his predecessor, any such remedial action may not be soon forthcoming. The SEC has numerous other issues on its agenda, including the harmonization of international accounting standards and the ethical standards of securities analysts.

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