Auditor Independence Redux

EDITORIAL

Auditor Independence Redux

The In Focus articles by Art Wyatt and Jim Gaa (page 20) raise important questions about the conceptual development of auditor independence. Several fundamental forces have shaped the current principles and rules for auditor independence, whether SEC rules, GAO yellow-book standards, or the code of professional conduct. Two have had a pervasive influence in recent years: conflicts of interest, and the SEC’s efforts to place responsibility for management functions in the hands of registrants’ officers and directors rather than of outside professionals.

Conflicts of Interests

The preamble to the SEC’s independence rules identifies independence principles that arise from mutual or conflicting interests. New York State regulations indicate that a breach of independence can arise from any conflict of interest. The engagement team approach to auditor independence also reflects elements of conflicts of interest. These influences notwithstanding, auditor independence differs from conflicts of interest. The distinction initially limited independence to financial interests, whereas conflicts of interest could encompass advocacy, financial, or employment relationships, as well as the nature of the work performed. Independence presumes the absence of an advocacy position and subordinates employment and the work performed to professional standards. Satisfying independence rules qualifies an accountant narrowly to perform attest functions but does not necessarily rule out other conflicts of interest.

Times change, and in recent years accounting firms have taken advocacy positions for clients on accounting and tax issues. Moreover, the expansion of consulting services transformed client service to mean something close to advocacy. Critics and commentators have reacted by calling for greater restrictions on auditors’ scope of services. Federal regulators have responded with more restrictive rules. Increasingly, they ask independent accountants to be a watchdog on behalf of third parties rather than the objective, nonpartisan, neutral, standards-driven accountant envisioned in the profession’s code of conduct.

Victorian commerce. The CPA profession has its roots in the commercial practices that arose during the Victorian era to oversee British capital investments in current and former colonies. Whereas a firm of British accountants in 1880 might have practiced in New York and received payment from its New York clients, the firm’s primarily responsibilities to the owners back home would have been incontrovertible. Because of the strong directionality of the relationship, the relatively large number of different foreign investments, and the small number of such firms, the same accounting firm would both account for the financial activities of competing entities and work for different investor groups. Most important, the prevailing ethic did not treat accountants as advocates. Instead, they reported to owners about the activities of business managers and the state of the accounts. The owners forbade the accountants from investing or working in the businesses they accounted for, in order to control opportunism and to promote the development of a professional class (as opposed to investor and managerial classes) that was important to Victorians. As long as accountants observed the investment and employment separation, the scope of their accounting services was relatively broad. For example, they would often keep the books and prepare financial statements as part of an engagement.

SEC influence. The SEC’s most important initial effect on independence was its push to create formal general accounting standards. Accountants began placing their allegiance to a set of standards for preparing financial statements, rather than to any of the interested parties, such as owners or management. Primary allegiance to standards removed accountants further from advocacy activities and, unlike their earlier commercial arrangements, established their independence, objectivity, and neutrality.

Another way that SEC activities have influenced independence in the past 20 years is through its policy that officers and directors manage and control registrants’ business functions. The corollary for accountants is a ban from performing management’s accounting functions. Whereas once it was preferred for the independent accountant to control the accounting function, now officers and directors (management) must control it, and the independent accountant provides an outside check.

Infrastructure changes affect standards allegiance. Two other changes in the accounting infrastructure have affected accountant independence since about 1975. The first was the creation of FASB, the first accounting standards setter independent of the accounting firms. From about that time, accounting firms reversed their objective standards orientation and began to advocate for the accounting treatments most preferred by their clients, slowly eroding public belief in their independence: the primary commitment to standards without regard to which party benefited. The second change involved the expansion of consulting services and the gradual change in the culture of accounting firms’ executive suites toward a consulting orientation.

The Changing World

Wyatt and Gaa both see current regulatory actions as attempts to turn back the clock that may eventually prove futile. Wyatt depicts changes in culture that are difficult to reverse. Gaa hopes that deprofessionalizing accounting through federal regulation will have the effect of planting the seeds of “reprofessionalization.” Their remarks provide a provocative backdrop for an important discussion on independence and accountants’ ethics.