Recognizing And Addressing Conflicts Of Interest
By Arthur Siegel and Susan McGrath
In his in August 2002 editorial, Editor-in-Chief Bob Colson wisely stated that as a profession, “We have not devoted enough energy to developing our facilities to recognize, debate, and reach personal conclusions about conflicts of interest.”
Our aim here is to help practitioners identify such conflicts so they can better maintain their objectivity—their independence—when auditing a client’s financial statements.
The Conceptual Framework for Auditor Independence (CF) of the Independence Standards Board defines auditor independence as:
This definition uses the term “compromise,” but much of the literature has used the term “impair.” As the CF points out, however, many believe impair means to negatively affect to any degree. Consequently, a standard of unimpaired objectivity would require perfect independence, which is neither attainable nor necessary. We all have our biases, but that doesn’t necessarily mean we cannot perform an effective audit. Therefore, the CF uses compromised to cover circumstances when an impairment of objectivity “rises to the level of precluding unbiased audit decisions.”
Under the current system, regulators and standards setters have assumed some of the responsibility for determining when objectivity has been compromised. The SEC and the AICPA have written numerous rules describing circumstances when an auditor will not be considered independent. Those rules for the most part are based on the views of a hypothetical informed investor as to when an auditor is unlikely to be able to make unbiased audit decisions. This system has served the accounting profession well, because the appearance of independence to investors and other users of financial statements contributes to the credibility of financial information.
Still, rules cannot cover every situation that can affect our objectivity. How, then, do auditors, audit committees, corporate officials, and others identify and evaluate those situations?
The SEC’s new independence rules, issued in November 2000, reiterate its previous guidance that accountants are not independent “if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.” The new rules say that beyond what is specifically prohibited, the SEC will question independence if a relationship or the provision of a service—
Unfortunately, neither this broad guidance nor the AICPA provides help to a practitioner faced with situations not explicitly covered.
The CF, however, when combined with its principles-based definition, offers an approach to thinking about these issues. In particular, it identifies five generic threats to independence:
The CF describes the self-interest threat as: Threats that arise from auditors acting in their own interest. Self-interests include auditors’ emotional, financial, or other personal interests. Auditors may favor, consciously or subconsciously, those self-interests over their interest in performing a quality audit.
The CF presents two categories of the self-interest threat:
Client pays the fees. One self-interest threat that got considerable attention in the Enron case (the media breathlessly reported that Andersen was being paid $1 million a week) is that the client pays the auditor’s fees. We have all recognized as a matter of common sense that this creates a potential “self-interest” threat even though we may not have used those terms. But remarkably, the AICPA provides no guidance on this issue, and the SEC’s only guidance is an old letter saying it may raise independence issues if recurring fees from a related group of clients exceed 15% of firm revenues. The SEC ignored entreaties to develop better guidance in this area when it was developing its new independence rules in the fall of 2000.
What should a practitioner do? The first step must be to acknowledge that the threat is valid and doesn’t exist only at the firm level. If the client’s fees are important to an individual partner, or to the office or practice unit in which she practices, these fees could influence behavior. For example, the partner could be concerned that the client will either ask the firm to appoint a new partner because they can’t “get along,” or will replace the firm. This isn’t far-fetched, either. It was revealed that the Andersen technical partner was removed from the Enron audit because he was giving answers that Enron considered too harsh. More recently, the press reported that an analyst at Merrill Lynch was transferred because Enron officials thought he was not positive enough about the company. Clients will resort to such threats, and firms will sometimes acquiesce.
In those situations, the partner must believe she can count on firm support and that if she irritates a client because she is standing up for what she—and the firm—believes is right, she will not have her income reduced, be transferred to the firm’s most remote outpost, or be fired. And that means that the firm must have a supportive culture and a track record of doing the right thing when similar incidents have occurred, as they surely have. But the firm can and should go further if conditions warrant. If the client is very important to the practice office, the concurring partner, and perhaps others on the audit team, should be from offices that are not dependent on that client.
Other steps the firm can take include encouraging consultation on difficult issues and making sure that everyone understands that the firm views consultation as a strength, not a weakness. Unbiased decisions on contentious issues are more likely if others in the firm, such as technical or industry experts, have agreed on the firm’s position.
Sometimes, however, the self-interest threat from a large fee is so great as to overwhelm normal safeguards. In those cases, the firm should discuss the matter with client officials and the audit committee. The firm could reduce its dependence on the client by lowering the fees received from the client, either by declining to provide some or all nonaudit services or by subcontracting part of the audit to another firm. But even these steps may be inadequate; and if the firm believes that, because the audit fees are so large, maintaining the necessary objectivity will be impossible, it should decline the engagement.
Auditing the work of a relative or a friend. The SEC’s new rules prohibit an auditor from being involved in an audit of a company in which the auditor or a member of her immediate family holds a direct or material indirect investment. They also prohibit involvement in an audit of a company in which a close relative is in “an accounting role or financial reporting oversight role.”
This rule leaves enormous gaps. For example, the previous SEC rule also prohibited auditing a company in which an adult child held an investment interest in an audit client that was material to the child. This rule was too sweeping. A 23-year-old might have a net worth of $10,000, so a $2,000 investment would be material to him. But it would certainly not be material to the audit partner parent, so the old assumption, that a $2,000 investment would influence the partner’s behavior, was bizarre. On the other hand, the rules now seem to permit a partner to be involved in an audit of a company in which a parent has a $5 million investment and the partner is the sole heir; that is, when the investment is material to both the close relative and the auditor. But even though the rules do not specifically prohibit the audit partner from being involved in such an audit, common sense—and a smart audit firm or audit committee—would. The self-interest threat is just too great.
Similarly, the new SEC rules permit an auditor to remain on the audit if she inherits a financial interest in a client if “the financial interest is disposed of as soon as practicable, but no later than 30 days after the person has knowledge of and the right to dispose of the financial interest” (emphasis added). This doesn’t make sense, because an auditor’s interest in whether the inherited stock rises or falls in value doesn’t depend on having the immediate right to dispose of the investment. So notwithstanding the permissiveness of the SEC rule, the smart firm or audit committee will inquire about these types of conflicts of interest, and, when appropriate, prohibit them.
Another hole in the SEC rules involves the employment by a client of relatives such as in-laws and cousins. The rules are also silent on the appropriateness of auditing your best friend, your next-door neighbor, or the coach of your child’s little league team. And there is nothing wrong with that. Writing rules to cover every situation is impossible. But that doesn’t mean that there is no potential self-interest threat in these situations. Judgment will certainly be necessary to make appropriate determinations—your relationship with an estranged brother and his wife may be much less threatening to your objectivity than your continuing close relationship with a childhood friend—but the first step is sunlight. The firm should develop procedures to surface such relationships so they can be thoroughly considered and reported to the client’s management and audit committee. Sometimes sunlight alone will be an adequate disinfectant, but sometimes the auditor should be removed because the threat, or the appearance of the threat, is just too great.
Finally, the SEC rules preclude auditing the financial statements of a client when a “covered person” from the firm has a close relative employed at the audit client in “an accounting role or financial reporting oversight role.” The ISB had proposed that any employment relationship by a member of the immediate family should disqualify someone from being directly on the audit. The thinking was that any employment could create financial or emotional relationships that can compromise objectivity. Many organizations devote considerable resources to developing loyalty in their employees and their families. But this sense of loyalty by a spouse who also is on the audit team will adversely affect objectivity. So the smart firm will develop procedures to identify all such employment relationships and determine whether an unacceptable self-interest risk exists. Whatever the decision, it should be reported to the audit committee; if the decision is to replace the audit professional, the committee will undoubtedly be pleased with the resolution; if the decision is to retain the auditor on the engagement, the audit committee should understand the audit firm’s reasoning and then make its own determination.
The CF describes the self-review threat as follows:
It may be more difficult to evaluate without bias one’s own work, or that of one’s firm, than the work of someone else or of some other firm. Therefore, a self-review threat may arise when auditors review judgments and decisions they, or others in their firm, have made.
The SEC rules have always prohibited auditors from providing bookkeeping services for SEC registrants. The new rules reaffirm the prohibition, and the Sarbanes-Oxley Act makes it law. Nonaudit services prohibited under Sarbanes-Oxley include appraisal, valuation, internal audit, and actuarial services for audit clients. Other nonaudit services are permitted as long as they are “approved in advance by the audit committee of the issuer.” But many services are routinely provided to audit clients as part of the audit (i.e., that are not nonaudit services) that arguably could involve reviewing one’s own work and that are not explicitly covered by any law or rule. For example, auditors frequently—
One way to maintain objectivity in the face of the self-review threat is to simply not provide the service. Although many people argue that this approach is impractical, because the auditor is in the best, most cost-effective position to perform the activity, this argument becomes weaker as the amounts involved get more material. If the amounts are so large (either individually or collectively), then the client should probably have the expertise in-house in order to operate the business effectively. On the other hand, “one-off” matters, such as LIFO provisions or income taxes, are often not so critical to the running of the business that in-house expertise is a commercial necessity.
Even where the auditor is satisfied that providing this service meets an independence cost–benefit test, certain steps can mitigate the risks. The first is to acknowledge that the self-review threat exists, both within the audit team and with client officials and audit committee members. Other steps might include the following:
This is another area where common sense should guide behavior. We should resist the temptation to call for even more detailed rules, which always assume that one size fits all, and are usually overly restrictive in an attempt to capture and preclude all potentially troublesome situations. Such an approach is rarely good public policy.
The advocacy threat is already recognized, although not in those terms, by rules that prohibit the auditor or audit firm from acting as a promoter of the audit client’s securities. Presumably for the same reason, the new SEC rules also prohibit the audit firm from providing legal services to an audit client, but this rule applies broadly only “under circumstances in which the person providing the service must be admitted to practice before the courts of a United States jurisdiction.” Inexplicably, the rule permits legal services provided by non-U.S. lawyers “provided local law does not preclude such services and the services relate to matters that are not material to the consolidated financial statements of an SEC registrant or are routine and ministerial.” The distinction between legal services provided in the United States as opposed to other countries doesn’t seem to be substantive, particularly for foreign registrants. Sarbanes-Oxley resolved this matter by making it illegal for an audit firm to provide an SEC audit client with “legal services and expert services unrelated to the audit.”
One area not covered by the SEC rules, and left uncertain in the Sarbanes-Oxley law, involves tax services. History and precedent argue for allowing an auditor to assist a client in planning a transaction so as to obtain the most advantageous tax outcome and still be independent. Audit firms have always provided them and to the authors’ knowledge no auditor-litigation cases have involved tax-planning services. On the other hand, ignoring the threats to objectivity that arise from providing such services would be irresponsible.
Thinking about the issue from the perspective of the advocacy threat, experts are supposed to be neutral parties, although when acting as an advisor to a client one inevitably becomes an advocate for the view that is most helpful to the client and still within the rules. Therefore, because virtually all tax services directly affect the financial statements, the prudent auditor would recognize the advocacy threat when the firm provides such services and take steps to mitigate any risk. For example, the auditor could assess whether the amounts involved were material to the financial statements; if they were not, the threat might be insignificant. If the amounts involved in the planned tax transaction were material, the auditor should determine how judgmental the matter is. If it is very controversial, the auditor might want to employ another expert from within, or if it is very material, from outside the firm to provide a second opinion about the appropriateness of the client’s (and firm’s) position. Of course, under some circumstances, the correct position would be to decline the tax consulting assignment. Finally, under any circumstances the identified threats to independence and the safeguards adopted should be aired thoroughly both within the audit firm and with client management and its audit committee.
The CF says the familiarity threat is present when auditors are not sufficiently skeptical of an auditee’s assertions and, as a result, too readily accept an auditee’s viewpoint because of their familiarity or trust in the auditee. For example, a familiarity threat may arise when an auditor has a particularly close or long-standing personal or professional relationship with an auditee.
For years the profession recognized this threat by limiting service as the lead audit partner on an SEC registrant to seven years, and more recently by prohibiting that partner from continuing in a role on the audit as concurring partner for at least two years.
Although the Sarbanes-Oxley Act shortens that seven-year period to five, it doesn’t go far enough. The authors believe the rotation requirement should be extended to all audit partners participating in the examination. Key decisions are made at the subsidiary and division levels and by “working” partners; a fresh viewpoint, free of the familiarity bias, is necessary.
Furthermore, the threat can be made worse by actions taken by firm and client officials. It is natural, and usually desirable, for the audit team and client officials to have a cordial and cooperative relationship, but this can go too far. We have heard about audit partners going with senior client officials to the Super Bowl or similar lavish events, sometimes at the firm’s expense, sometimes at the client’s. Legislating rules in this area is unrealistic because the possibilities are endless. But firms must ask themselves at what point this kind of joint entertainment crosses the line, in appearance as well as in reality: Doesn’t it become harder to say no to a client official who has become a good friend through these activities? Would an auditor not be especially reluctant to expose an accounting error, perhaps embarrassing the controller with senior management, if the two were going to the World Series the following week?
In any event, if these or similar activities are to continue, they should be thoroughly discussed with the audit committee beforehand, including the safeguards established by the firm to mitigate the familiarity threat.
The CF describes the intimidation threat as follows:
Such a threat may arise, for example, if an auditing firm is threatened with replacement over a disagreement about an auditee’s application of an accounting principle, or if an auditor believes that an auditee’s expression of client dissatisfaction would damage his or her career within the firm.
The wise firm will counter this potential threat by having a supportive culture and by not tolerating clients that use intimidation to persuade. Additionally, the smart audit committee will inquire into the nature of the relationship between the auditors and client officials, and make clear to client executives that cooperation, not intimidation, is what the audit committee expects and demands.
Although not mentioned explicitly in the CF, much has been written in the ethics and behavioral literature about cognitive threats that may impair objectivity. These threats, closely related to those described above, include the following:
The smart firm will train its auditors to be aware of and to compensate for these human weaknesses in their interpretation of facts and decision-making.
The Hallmark of Independence
ISB Standard 1, Independence Dis-cussions with Audit Committees, requires that, at least annually, an auditor of an SEC registrant shall:
In enacting this rule, the ISB said—
[T]he proposed pronouncement will improve corporate governance by affording to audit committees a mandated opportunity to deepen their understanding of auditor independence issues … The Board also believes that a mandate that audit firms describe and discuss the judgmental matters that might impact on independence will bring more focus within firms on this important issue.
ISB Standard 1 arguably requires the discussions with the audit committee urged throughout this article, and in any event such discussion will serve to “deepen [audit committees’] understanding of auditor independence issues” and “will bring more focus within firms on this important issue.”
Auditor independence—objectivity—has been the hallmark of the accounting profession for more than a century. We believe sensitivity to the issues discussed here will serve to reinforce this core value.
©2006 The CPA Journal. Legal Notices
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