Perspectives

February 2004

On High Standards of Auditing Ethics and Behavior

By Charles E. Landes

Editor’s Note: This article is based on Mr. Landes’ remarks delivered before the Conference on Credible Financial Disclosures at the Kellogg School of Management, Northwestern University, on Wednesday, June 26, 2002. It has been modified from its original form to reflect current events. His remarks are his own and are not necessarily reflective of the AICPA or the Auditing Standards Board.

It is not my intention to discuss or provide a technical overview of the AICPA or Auditing Standards Board’s new auditing standards or our projects, nor to point fingers of blame. Nor do I suggest that auditing standards cannot be improved, for I believe they can. I am here to discuss the audit standards-setting process and what I believe to be the inappropriate belief of some that auditing standards are broken to the point that having someone else set the standards will cure the problem. Second, I’d like to discuss rules and behavior.

For those who may not fully understand the different standards-setting bodies, the Auditing Standards Board (ASB) sets auditing and quality-control standards, those standards and procedures that are to be followed by all auditors and CPA firms when performing audits. Currently, the Public Company Accounting Oversight Board (PCAOB) sets auditing and other professional standards for audits and reviews of SEC registrants and the ASB sets auditing and quality control standards as they pertain to audits of non-SEC registrants. The ASB issues these standards after a great deal of deliberation in public meetings; public exposure; and thorough discussions that include gaining the views of the Transition Oversight Staff, formed after the dissolution of the POB, and SEC staff who attend our board meetings.

I need to respond to remarks that have been made here today and that I’ve seen printed recently that are critical of the AICPA, suggesting it is not in favor of reforms. The AICPA and the ASB are not opposed to reforms, and the ASB is certainly not opposed to oversight. In fact, the ASB believes that the POB staff and the Panel on Audit Effectiveness (the O’Malley Panel) staff, as well as the SEC’s staff, have been very helpful in the standards-setting process and add greatly to the quality of auditing standards.

The ASB is made up of 15 of the most knowledgeable, hard working, and ethical individuals you could ever meet. I would say the same for my staff that assists the ASB. The makeup of the board consists not only of practicing CPAs from firms of all sizes but also a member from government (who until just recently was from the GAO, and the government member prior to that was from the OMB), as well as an academic member. The ASB does not set independence or ethical standards, nor does it set the accounting standards that public companies must follow in preparing their financial statements and disclosures. Likewise, the ASB does not investigate, peer review, or otherwise have anything to do with enforcement actions taken against CPAs that do not follow generally accepted auditing standards.

Following the Rules and Serving the Client

We ascribe too much blame to the wrong cause. As James Largay says in “Lessons From Enron” (Accounting Horizons, June 2002): “I doubt there is a group of standard setters on this earth that can enumerate enough rules to contain those who are intent on circumventing full and fair disclosure. The only answer is the rebirth of professional judgment in an environment characterized by incentives that make the prudent exercise of judgment the only viable alternative.”

As someone described it, we sometimes seem to make our most important obligations perfunctory, even trivial, by the very steps we take to observe them. Take religion, for example. Nothing could be more important than a person’s beliefs about the nature of the world, its origin, and the purpose and role we play in it. Organized religions exist to perpetuate their doctrines, by creeds and other forms, to focus the attention of their followers and others on fundamental tenets, and to ensure faithful transmittal of these to future generations. But for many people, the traditions and rituals become the actuality; the form overshadows the substance. They lose sight of the underlying truths and what these should mean in their lives, and they tend to believe that observing the formalities fulfills their obligations.

I believe the same is true for our profession where independence, objectivity, and integrity are concerned. To be independent or objective, auditors must never lose sight of their commitment to call the shots as they see them. That is why society licenses us to practice. It is why auditing is a profession; we must subordinate our commercial instincts and our desires to be helpful to our clients to our overriding public responsibilities for dispassionately and objectively reporting on our client’s financial statements. In carrying out this responsibility, we must remain free from bias or control in any form. An auditor who always bears this in mind and acts accordingly would need no rules, because he would be independent in fact.

But when we hear the terms independence, professional ethics, professional judgment, or professional skepticism, do we think of the basis of our professional role in society? Unfortunately, too often the answer is no. Most of us rather think of the pattern of rules: our code of conduct, SEC rules, accounting rules, auditing rules, or our firm’s guidelines and rules. In other words, professional ethics as well as much of our professional behavior is driven by a list of rules we must follow rather than being the essence or spirit that guides us.

Does this mean that rules are unnecessary? Far from it. Although independence in fact is essential, independence in appearance is also vitally important. For auditors’ work to be credible, the public must perceive them to be independent. There is, however, no way for the public to appraise independence in fact, what is in the mind and the heart of an auditor. An auditor who reports on a company’s financial statements could well be independent in fact even if the auditor owned a large number of client shares. But most observers would understandably suspect the auditor’s objectivity. Many of the rules we have today prohibit activities that, if not followed, could raise doubts in a reasonable person’s mind about an auditor’s independence and objectivity.

We know that people err, we know too that auditors are by no means free from the human trait of rationalizing the propriety of what they want to do. Therefore, written rules spell out actions that our peers and regulators have considered unacceptable, to help keep the well-intentioned auditor from straying. Firms, CPA professionals, educators, and the AICPA must, however, give greater emphasis than we have to the reality that lies behind the rules. In the 25 years I have spent in public accounting, much, if not most, of my time has been spent either learning rules or, most recently, writing auditing rules. I regret that we focus almost entirely on rules rather than on the underlying rationale. We tell people what to do and, more often, what not to do, but we have not sufficiently stressed the whys.

You see, I believe that our professional and ethical behavior, after all, is a matter of morals and we should address it as such. Modern society, unfortunately, seems to be uncomfortable, at times even embarrassed, addressing moral issues head on. As a society, we bend over backwards not to appear judgmental but to be politically correct. Rather than telling someone that his actions are wrong, we prefer to cop out by saying that it is against the rules. By being passive or neutral, we foster an aura of moral ambiguity: “It depends on what the definition of is is.”

As I travel around the country, I hear some auditors proclaim that their job is to determine whether financial statements comply with or violate GAAP, giving little consideration to the phrase in the opinion, “present fairly.” That is the danger with rules, important as they are. They make it easy for persons, corporations, and firms to avoid making tough decisions as long as they behave within the rules. Rules in their final analysis, however, without an underpinning of understood and accepted rationale, are hollow. That is why more standards or standards set by some other body are not the answer. What we and our society must understand is that life is more than using the rules to make a fast buck.

We saw a major crisis leave the careers of Enron’s executives in shambles. There were certainly rules that were intended to prevent this from happening. What was lacking was a personal code of ethics that would tell certain executives that what they were doing was wrong.

We read about a partner at Andersen who admitted to obstructing justice by shredding work papers. But we also read about the efforts of another Andersen partner who supposedly took exception to certain Enron transactions only to be removed from the engagement team because he was getting in the way of “client service.”

The true problem we must face is a casual, and at times cynical, attitude toward auditing and the role of financial statements in society that lets auditors accept something that does not quite pass the smell test merely because it seems to be within the rules, or at least is not prohibited by the rules. Especially with competitive pressures, insensitivity to the underlying substance of professional ethics on the part of individuals and firms is the greatest threat to the future of the profession. It will sap the profession’s strength, our credibility, our very reason for being, if not addressed head on.

I was taught 25 years ago, when there weren’t nearly as many auditing standards, that our professional responsibility is to let the chips fall where they may, without favoritism or other bias, when we report on financial statements. Yet today we are motivated by a desire to give client service—to be helpful and to promote a client’s interests by every appropriate means.

Are the two responsibilities or goals compatible? Or is there such a built-in contradiction as to lead to the ultimate disintegration of the profession as we know it? I don’t believe there is, but this is true only if we sharpen our focus on professional ethics and professional responsibility.

In preparing and reporting on financial statements, the responsibility of the accountant and auditor to the public comes first! The concept of client service as we frequently use the term—meaning that the client’s interest comes first—is not only irrelevant, it is even out of place.

This does not mean that we have to be rigid and self-righteous in our role as auditors. There is room for acceptable alternatives in today’s GAAP. Where accepted alternatives that can be applied to the same factual situations exist, the auditor is not only entitled to let the client make a choice, but obligated to do so. And there are always areas in which reasonable judgments may differ; as long as the client’s judgment is sincere and soundly based, the auditor may accept it even if he might have come to a somewhat different answer.

Yielding to the client’s desire becomes unethical, however, when the client goes beyond choosing among acceptable alternatives, or supports a position with inadequate or one-sided evidence. When the auditor, in the name of client service, helps a client find a loophole in existing standards that they know were designed to cover the situation in question, the auditor is clearly out of bounds.

The proliferation of auditing as well as accounting and reporting rules over the last two decades, coupled with the growing complexity of business, has, in my opinion, clearly aggravated the problem. Although the auditors of not too long ago had fewer rules to follow, they seemed to be able to get to the best answer. And with far less significance attached to performance trends and earnings per share, clients offered less resistance to proposed adjustments even when they might not agree.

How different is the situation today! The intricate network of rules, some so complex as to require experienced accountants and auditors to seek consultation with experts, tends to make accountants and auditors focus on the rules themselves rather than on the substance that lies behind them. And clients, particularly large ones, frequently have a sophisticated understanding of these rules and how they affect their earnings, ratios, and other performance indicators that are so important today. All too frequently today auditors hear clients ask, “Where does it say that I can’t do this?”

With this situation prevailing, it becomes easy for an auditor to regard the rules as ends in themselves and to see nothing wrong in finding ways to avoid them without breaking them.

Does this mean the term client service should be considered unacceptable, to be expunged from the public accountant’s vocabulary, and the approach it connotes eliminated? No. The auditor should be free—indeed, expected—to offer constructive recommendations that come to his attention in the course of an audit.

Similarly, performing nonaudit services that benefit the client but, in my view, do not entail exercising management decision-making creates no ethical problems. But someone might logically ask whether the distinctions are too subtle to be observed in practice. Therefore, auditors must constantly keep in mind our basic obligation to maintain strict impartiality in all aspects of audits or other work that involves reporting to third parties. If the public perception is that we may not be objective, then separating external auditing from internal auditing or IT consulting over the financial reporting process can hardly be considered too onerous or complex for a profession that has accepted the role of the public watchdog.

Firms and corporations, as well as individuals, need to be made more sensitive to ethical imperatives. Many professional CPA firms, as well as corporations, have issued codes of conduct—and this is important. Their actions, however, must leave no doubt in the minds of members and employees that they mean what they say, that they are totally committed to high ethical standards. I was encouraged when I read an article on the front page of the Wall Street Journal, “Why the Bad Guys of the Boardroom Emerged en Masse”; also to hear many of the remarks today, because it seems that we are finally turning the public’s attention to the real problem, professional ethical behavior.

Confidence in the Future

I recently had the pleasure of addressing a young group of future CPAs at a fraternity induction dinner at my alma mater, Miami University. The opportunity to discuss our professional issues with our future superstars gave me great confidence in the future of this profession. I asked what they thought caused the Enron failure, and they responded unanimously: greed and poor judgment. Not one student implied that auditing standards were the cause.

Earlier, I asked, Can auditing standards be improved? Of course they can, and the public should know that we have a continuous improvement process in place to make certain that auditing standards are of the highest quality and provide the needed guidance to auditors. As part of this continuous improvement process, we know, for example, that we can do a better job in terms of our fraud detection and risk assessment guidance, two projects that we started before the Enron crisis. We also know that we need to take a serious look at the auditor’s communication responsibilities.

But as we move forward and this debate continues, I only hope that we do not fall into the trap of thinking that by more rules we can legislate behavior. I also hope that the American public doesn’t come to believe that the silver bullet is moving the audit standards-setting process out from under the ASB to another board whose expertise does not include auditing.

Conversely, I hope that this learned profession and the hard-working men and women who every day do the right thing to earn the public’s trust will constantly keep in mind that ethical behavior, coupled with intelligent, competent service, is the foundation of our practice. Responsibility to the public for objective financial reporting must always come first. Only if we demonstrate this by our behavior will the profession regain the credibility needed for our existence.

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