Unsettled Auditor Independence Issues: Life After the ISB

The joint action of the SEC and AICPA to close the Independence Standards Board (ISB) on July 31 is understandable in light of the SEC’s preemptory actions toward the ISB (see “The Rise and Fall of the ISB” by Dan Goldwasser, October 2001). Now, however, there is no authoritative, public, non-governmental body to address auditor independence issues. What remains are the SEC rules, which will be enforced through the Office of the Chief Accountant (OCA) of the SEC, and the accounting profession’s own standards of conduct, which are created by the AICPA’s Professional Ethics Executive Committee (PEEC). Missing is an organization that provides comprehensive, principles-based guidance that helps auditors maintain their independence and that supports and encourages public confidence in the integrity of the financial reporting system.

SEC rules on implementation. The SEC states in its new rule that “registrants and accountants are encouraged to consult with the Commission’s Office of the Chief Accountant before entering into relationships … that are not explicitly described in the Rule.” This “check with me first” approach is highly inefficient and unpredictable. Although the SEC adopted much of the ISB’s conceptual thinking, it did so without articulating, and perhaps without adopting, the ISB’s reasoning. As a result, accounting firms will be unable to plan for new services or arrangements in any systematic way because they will be unable to predict whether the SEC staff will allow them. And with the SEC staff’s limited resources, the delay in getting answers is likely to worsen. Furthermore, decisions made by the chief accountant inevitably will be fact-specific and influenced by the articulateness of the accountant’s proponents. We have a new chief accountant, and we don’t know how he will operate. In the past those decisions were made in private and rarely published. While the larger firms often share their experiences, those not dealing with these issues on a daily basis—including smaller accounting firms, corporate officials, and most notably audit committee members—are in a very difficult position. Without guiding principles or access to current SEC staff thinking, how will they be able to even articulate the questions, much less know which answers will be acceptable?

Burden on PEEC. PEEC provides a general set of independence standards that must apply to all audits by AICPA members. Although PEEC has added a few public members, in response to the O’Malley Panel’s recommendations, its governance remains totally within the AICPA. Although its professional members are talented people, the fact that they constitute a significant majority of the membership means that the investor community may greet their rulings with skepticism. And the SEC staff has been unwilling to delegate independence decision-making to PEEC. Unless those situations change, it is unlikely that PEEC can become a replacement for the ISB.

Unresolved independence issues. In addition to the independence issues that will arise in the future, there remain unresolved concerns requiring systematic, principles-based solutions.

• Many CPA firms that audit public companies have become participants in alternative practice structures (APS). The only guidance in this rapidly evolving area is in some very fact-specific letters issued by OCA and a narrow PEEC interpretation. This issue was on the ISB’s agenda but was dropped because of SEC staff objections. As a result, we are left with no generic guidance and no discussion of the conceptual auditor independence issues and their potential resolution.
• Another issue on the ISB’s agenda when it was dissolved is dependence on the audit client. This difficult issue centers on when objectivity may be compromised, or appear to be compromised, because of the importance of the client to the firm, the practice unit, the engagement partner, or some other relevant subset of the firm. The new SEC rule is silent on this matter, and the only guidance is an old SEC staff letter that says that questions may be raised if fees exceed 15% of firm revenues. This is an unsatisfactory response to an important issue, so hopefully either PEEC or the SEC will take it up in the near future.
• Professional standards have allowed auditors to assist management but not to maintain the accounting records. But where is the line drawn? Can the auditor assist with determining the tax provision? What about calculating the LIFO reserve? If the auditor proposes a large number of adjusting entries, is that effectively “keeping the books”? There is no consistent, conceptual guidance in this area, which, with the growth in complexity of business, is becoming increasingly important. Again, the ISB had this issue on its agenda but was closed before it could deal with it.
• The new SEC rules deem independence compromised if the auditor provides legal services when “the provider of the service must be admitted to practice before the courts of a U.S. jurisdiction.” Otherwise, legal services seem to be permissible “if the services relate to matters that are not material to the consolidated financial statements of an SEC registrant or are routine and ministerial.” There is no underlying principle or rationale offered as to why legal services provided in the United States are suspect but the same services provided somewhere else in the world are not. The danger is that when there no reason is articulated, there is a tendency to cherry-pick by analogy.
• The final unresolved issue concerns whether an audit firm engaged to assist the client in the design or installation of an accounting system can be considered independent. The SEC rule describes the circumstances that would (and should) impair independence. But it also requires proxy statement disclosure of the nature and amount of permitted services, without providing any guidance on how to evaluate that information. Investors, auditors, audit committees, and managements are then left to speculate on what threats are present in these circumstances and whether there are effective safeguards. This is an inevitable result of rule-based, rather than principles-based, standards setting. But how it helps maintain auditor independence or investor confidence in the financial markets remains a mystery.

Unfinished Business

The ISB had issued an exposure draft of its conceptual framework for auditor independence. Although the board was dissolved before it could consider the comments received, the staff could, and the board’s last act was to authorize the staff to issue the revised document as a staff report, which is available on the ISB’s website at www.cpaindependence. org. Unfortunately, then–SEC Chief Accountant Lynn Turner stated his rejection of the approach in the framework in speeches shortly after its issuance. Because international standards setters are also using that approach, including the International Federation of Accountants, we hope that the new chief accountant will reconsider that view.

Nevertheless, whether the ISB staff’s conceptual framework survives or another one takes its place, the need for such a foundation for standards setting remains urgent. FASB’s conceptual framework continually proves its value, and it was no accident that both the SEC and the accounting profession agreed that establishing a conceptual framework for auditor independence was one of the ISB’s highest priorities.

There continues to be a need for a comprehensive set of principles-based standards on independence, rather than a detailed set of rules. Audit committees have been given much greater responsibility to consider independence issues—from ISB Standard No.1 as well as from the stock exchanges—but expecting them to be conversant with the underlying thinking in over 80 pages of small-sized, singe-spaced SEC rules, with almost 700 footnotes, is unreasonable.