Independence and the Users of Closely Held Companies’ Financial Statements

By Nicholas J. Mastracchio Jr.

In Brief

Two Standards for Two Environments

Discussions of independence tend to focus on large public companies. The recently released independence rules developed for SEC registrants address the needs of the users of public company financial statements. There has been some concern, however, that the rules developed for publicly traded companies could trickle down to smaller companies, where they may be unwieldy or inappropriate. A survey of small lending institutions, a primary user of audited financial statements of closely held companies, revealed which relationships they consider to compromises independence and which might enhance the value of the financial statements. The results stress the need for independence standards for closely held companies to be distinct from those developed for public companies.

The accounting profession has been awash in independence discussions for the last few years. The focus is almost always on SEC registrants and their auditors. Little concern has been expressed for the independence issues facing closely held companies and their auditors. As rule-making for publicly traded companies proceeds, some have expressed concern that these rules will trickle down to smaller companies unchanged.

Defining the Problem

Earnscliffe Research and Communications reported to the Independence Standards Board in November 1999 that the general consensus on financial statement integrity was that “there might be a slight deterioration of integrity over time, but no more significant in the financial and business sector than in society as a whole.” They also reported that auditors currently meet high standards of independence, but there are growing reasons for concern. The report identified the following pressures on auditor independence:

Earnscliffe found that auditors thought that consulting services do not intrinsically threaten their independence, whereas regulators thought that a problem was emerging that needed sweeping immediate action. Regulators predicted—fairly accurately, in hindsight—that a major prolonged market correction could result in a severe backlash from disappointed investors. The report’s conclusions were based upon interviews with officers of SEC registrants, investment analysts, and audit partners. No consideration was given to closely held companies or their auditors.

The New SEC Independence Rules

The SEC recently amended its auditor independence rules for the first time since 1983. The preamble to the final rule states:

The accounting industry has been transformed by significant changes in the structure of the largest firms. Accounting firms have woven an increasingly complex web of business and financial relationships with their audit clients. The nature of the non-audit services that accounting firms provide to their audit clients has changed, and the revenues from these services have dramatically increased. In addition there is more mobility of employees and an increase in dual-career families.

The new rules identify nine areas of nonaudit services that could impair independence. Not all of these are new; most were in the previous rules and some are in the current AICPA rules. The rules prohibit valuation and appraisal services where it is reasonably likely that the result would be material to the financial statements. Bookkeeping services are prohibited, as is acting as an officer or hiring the chief financial officer. The auditor cannot act as promoter or underwriter. The auditor cannot install the information system that generates the financial information. Outsourcing the internal audit function to the auditor is prohibited if the company has more than $200 dollars in assets. The SEC also requires proxy statement disclosure of the aggregate amount of audit fees, the aggregate amount of fees billed for financial information systems design and implementation, and the aggregate amount of fees for all other services.

SEC Chairman Arthur Levitt pointed out that the SEC rules pertain only to publicly traded companies and had no direct impact on local firms and their clients. Nevertheless, some countered that state regulatory boards would follow the SEC’s lead, under the logic that what is good for the big firms is good for all. Thus, there would be a trickle-down effect to the smaller firms and their clients.

Partnering for CPA Practice, the current name for the AICPA’s private company practice section, was represented at SEC hearings by the chair of its executive committee, Harold L. Monk, Jr. He stated that rules placing restrictions on nonaudit services for audit clients are of great concern for smaller firms. Despite Levitt’s comments, Monk was certain that the rule would trickle down to smaller firms, saying, “We must assume that your rule would become our rule.” SEC Commissioner Hunt responded: “I personally am somewhat concerned about the unintended global consequences of the rule because we are going to have influence, and the unintended consequences [will exist for] the other standard-setters, the state boards of accountants, the people who regulate accounting for banks and others.”

The New York State Board of Accountancy was invited to participate in one of the SEC public hearings and was asked about the probability of the trickle-down effect. The executive secretary of the board, Dan Dustin, pointed out that there were current differences in independence rules now, for example, with regard to bookkeeping services. He did not foresee a trickle-down effect.

In the final rules the SEC states:

The final rule applies to public companies and other entities registered with the Commission or otherwise required to file audited financial statements with the Commission. It does not apply to audits of financial statements not required to be filed with us. … Consequently, we believe there will be only incidental impact on accounting firms that provide audit and non-audit services principally to audit clients that are private companies not registered with the SEC.

Since the Enron case broke, there have been some that claim the SEC yielded too much to pressure from the big accounting firms and their allies, and that rules on consulting should have been tougher.

The POB and AICPA Positions

The Public Oversight Board, at the request of SEC Chairman Levitt, appointed a panel on audit effectiveness, chaired by Shaun F. O’Malley, former chairman of Price Waterhouse, in October 1998. Its report, issued in August 2000, addressed the issue of audit independence. The panel conducted quasi–peer reviews on 37 engagements where services other than audit and tax were provided. It did not find any instances where providing these services had a negative effect, and concluded that such services had a positive effect on the audits of approximately one quarter of the engagements. The panel was split between those who thought that there should be an exclusionary rule to prohibit an audit firm from providing nonaudit nontax services to its publicly traded clients. Other panel members disagreed and thought that, with proper safeguards, nonaudit services should continue.

What about the trickle-down effect? Section 5.35 of the O’Malley report states: “The Non-Audit Service Rule would have application only to SEC registrants. Of course, the profession would be free to adopt the same or similar rules for application more generally to all audits conducted in the United States.” This statement does not include any discussion or consideration of whether the closely held company and its auditor are in a different set of circumstances from the SEC company and its auditor.

The AICPA has also proposed new auditor independence rules that do not distinguish between SEC clients and closely held companies. The AICPA’s justification for the changes focuses on issues of the large international and national firms. There is no discussion of the impact of the proposed rules on local firms. The AICPA creates something called a “covered member,” an individual on the attest team; an individual in a position to influence the attest engagement; a partner or manager who provides 10 or more hours of attest work to the client; a partner in the office where the lead engagement partner practices; the firm itself; or an entity whose operating, financial, or accounting policies can be controlled by the above. A covered member’s spouse and dependents are covered by the rule, but not other relatives.

In the aftermath of the Enron collapse, auditor independence and consulting fees have reached a new apex of discussion. Many commentators start from the position that Arthur Andersen could not be independent while engaging in the level of consulting with Enron that they did. The fact that this level of consulting is not unusual is rarely acknowledged. Conceding defeat on the issue, four of the Big Five announced a voluntary restriction on the consulting they will do for their audit clients.

These events make the possibility more likely that the independence rules, established for the publicly traded SEC clients, will trickle down to all CPAs for all clients. All investors must feel comfortable with the reliability of financial information. Given the centrality of financial reporting integrity, why should closely held companies and their CPAs have a different set of rules? One essential difference is the users of the financial statements of closely held companies. In most cases the shareholders and the management of closely held companies are the same, and do not rely upon the outside accountant to inform them of company performance. In testimony before Senator LeValle’s New York State Higher Education Committee’s public hearing on “The Purpose and Mission of 21st Century Accounting Firms and the Independence of Certified Public Accountants in the Post-Enron Era,” Louis Lowenstein, Columbia University emeritus professor of law, said that exclusions imposed on publicly traded companies should not be placed on closely held companies, because management and owners are typically the same.

The most likely users of audited financial statements of closely held companies are also likely to have requested the audit; for example, financial institutions that loan the company money. Such a user is typically more sophisticated than the average investor in a publicly held company and has a more intimate knowledge of the company. In many cases, the bank or other lender has had a long-term relationship with the company, knows the officers of the company, and lives in the same community as the owners.

Survey of Financial Statement Users

In considering the rules for SEC registrants, considerable weight was given to what financial statement users thought. In considering the independence rules for closely held companies, the opinion of these financial statement users should also be considered. A survey was conducted of a random sample of lenders with total assets of fewer than $200 million. Fifty-six replies were received; of those that responded, 85% reported that over 75% of their loans were to closely held companies.

Some of the survey questions addressed existing rules, some addressed consulting issues, and some addressed the AICPA proposal. Respondents perceived the overall integrity of the profession as high. Ninety-six percent indicated that generally they thought CPA firms they come in contact with have integrity and that they put some reliance on their work.

The survey asked four questions about referral fees and commissions. The respondents overwhelmingly thought that accepting commissions or referral fees diminished independence, and a majority felt that receiving referral fees also diminished independence. The questions and the responses are shown in Exhibit 1.

The nineteen other questions on the survey had four possible responses.Situations were described and respondents were asked to select their opinion from four options:

Forty-five percent of the respondents thought that the majority of their closely held customers rely on their accounting firm for consulting services beyond tax and financial statements.

Most respondents tolerated CPAs providing consulting services (Exhibit 2). Like the POB panel, some respondents thought certain activities enhanced the quality of the financial statements. Consistent with most views, tax services were not considered to be an impediment to independence. Interestingly, more controversial areas, such as information system design, internal auditing, and valuation services, were considered to enhance the audit. This is in contrast to the SEC’s opinion and the objections of some of the POB panel. Even the hiring of client accounting personnel evenly divided respondents as to its effect on financial statements.

Hiring nonfinancial personnel and bookkeeping without decision making did not pose problems for the respondents. Interestingly, the hiring of nonaccounting staff did not fare as well as the hiring of accounting staff: Fewer respondents thought that hiring nonaccounting staff enhanced the auditors’ activity.

Certain consulting activities, however, did cause the respondents concern. Some of these activities, such as acting as the client’s controller or CEO, were considered to hamper independence.

Other areas of concern were in conflict with the AICPA’s new rules on independence. These included activities by individuals that probably would not be considered covered persons under the AICPA rule. Users of the closely held financial statements were more likely to have CPA firm offices in close proximity to each other, and interoffice work was more likely to affect firm income.

The above survey clearly indicates that the set of rules for the auditors of closely held firms should be different from the set for auditors of publicly traded firms. The restrictions placed on SEC audits should not trickle down. The liberalization embodied in the new AICPA rules, however, should be looked at for their applicability to the small firm.

Nicholas J. Mastracchio Jr., PhD, CPA, is an associate professor of accounting at the University at Albany, N.Y.

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