At an AICPA conference in January 1994, the Chief Accountant of the SEC, Walter P. Schuetze, raised the question of independence of accounting firms because in several instances, firms appeared to advocate positions to the SEC staff that the staff believed were not in support of accounting literature or were contrary to the spirit of accounting principles.

The Public Oversight Board (POB) of the AICPA SEC Practice Section (SECPS) in its 1993 special report, In the Public Interest: Issues Confronting the Public Accounting Profession, made recommendations for strengthening independence and professionalism.

In February 1994, the POB, strongly motivated by the remarks of the Chief Accountant and anxious to move its recommendations in its special report forward, appointed a three-member Advisory Panel on Auditor Independence. Its charge was to determine whether - the SECPS, the accounting profession or the SEC should take steps to better assure the independence of auditors and the integrity and objectivity of their judgments on the appropriate application of generally accepted accounting principles to financial statements.

The POB asked Donald Kirk, a founding member and former chairman of the FASB, former partner of Price Waterhouse, and currently a professor at the Columbia University Graduate School of Business, to serve as chair of the panel. The two other panelists were George D. Anderson, former chair of the AICPA and a retired partner of Anderson ZurMuehlen & Co., the firm he founded, and Ralph S. Saul, former director of the SEC's Division of Trading and Markets, past president of the American Stock Exchange and former chief executive officer of CIGNA Corporation.

The panel was not an investigatory body: its work consisted of interviewing professionals and others who could contribute to a better understanding of the problem. However, it did review the specific cases that led to Schuetze's criticism.

The panel also had the benefit of a report from the Office of the Chief Accountant (OCA), Staff Report on Audit Independence, which was released in March 1994. That report concluded:

The OCA believes that the combination of the extensive systems of independence requirements issued by the Commission and the AICPA, coupled with the Commission's active enforcement program, provide to investors reasonable safeguards against loss due to the conduct of audits by accountants that lack independence from their audit clients. The enactment of detailed legislation or the promulgation of additional rules is not necessary. The OCA believes that further legislation or fundamental changes in the Commission's regulation are not necessary at this time for the protection of investors.

Armed with the OCA report, the panel no doubt felt comfortable in making the recommendation that no additional regulation or legislation was necessary. A summary of the recommendations of the Kirk Panel is presented as a sidebar.

Editors Douglas R. Carmichael and James L. Craig, Jr., met with Donald Kirk to discuss the panel's report and its recommendations.

The CPA Journal: Please give us some background about the process you followed in reaching your conclusions.

Donald Kirk: When approached to serve as chair of the panel, I was somewhat reluctant to undertake an investigative project of the facts surrounding the four cases that were the basis of Walter Schuetze's criticisms. When we met, it became clear that George Anderson and Ralph Saul were of the same mind. We didn't think those issues were a matter we should reinvestigate. We had a clear understanding with the POB that we were concerned with institutional relationships among standard setters, the profession, the SEC, and the business community to see if there weren't ways to improve those relationships and enhance the objectivity of the auditing profession. We did not want to focus on transitory specific issues of the kind raised by the four cases underlying Schuetze's remarks. We would use the points raised as a jumping-off point, but they would not be the central focus. We wanted to focus on longer-range, longer-lasting issues.

CPAJ: Having decided that, how did you then go about the task of finding out what the problems relating to auditor objectivity were? What did you do to determine if in fact there was a problem?

Kirk: We met with the SEC staff and with representatives of accounting firms in the SECPS. The SEC staff told us about other situations it saw where objectivity of the auditor was in doubt. We sought the views of those suggested by the SEC staff through interviews or by soliciting comment. We spoke to senior partners and top technical partners at the major accounting firms. We obtained the views of approximately 100 people, including two legal experts in the area of corporate governance.

CPAJ: Did you find other instances of auditor independence or objectivity problems?

Kirk: I think the very visible record over a period of time, and not just the results of our work - the S&L crisis is a good example - shows there are situations where auditors have succumbed to pressures from clients and have fallen short in maintaining their objectivity. We didn't uncover any new instances of audit failure, nor would I say that was our objective. Unfortunately, a well-documented record of concern existed.

CPAJ: Your report also referred to a report of The Office of the Chief Accountant of the SEC on independence issues.

Kirk: That report put the kinds of issues Scheutze raised about auditors advocating questionable accounting into perspective. It indicated they were a small fraction of audits performed. Its focus was on the rules of independence and what constitutes a conflict of interest between an auditor and his or her client. It did not deal with the broader issue of objectivity that ended up being our focus. Even though we were named the Advisory Panel on Auditor Independence, our thrust was toward the integrity and objectivity of auditors and not the very rule-driven, technical aspects of independence.

CPAJ: In your report you referred to the fact the OCA report considered and dismissed certain issues - mandatory rotation of auditors, changes in independence rules. Did this, in some respects, make your job easier in not also having to deal with these controversial issues?

Kirk: Yes it did. The panel never really felt there would be a significant benefit to objectivity through mandatory rotation. And although we were not charged with looking into scope of service issues, you can see by our report we were troubled with the magnitude of nonaudit services the big firms are performing - not so much the nature of the services, but rather the extent of them. We are more concerned by the potential for firms to be dominated by nonaudit activities and whether that would detract from putting resources into the audit function and undermine the focus on the public trust.

CPAJ: Getting back to the process. Having heard what those 100 persons had to say, how did you move forward toward the development of recommendations and a report?

Kirk: We assessed what we heard and added our personal experiences - as professionals and now active members of boards of directors and audit committees - to the mixture. It was understood from the beginning we were not going to go through an exposure process, make transcripts of what was said, nor have a public hearing. It was understood we would present our findings to the POB, and it would be free to decide how it wanted to use them.

CPAJ: What kind of staff help did you have?

Kirk: Staff support was provided by Jerry Sullivan, executive director of the POB, and his staff, and by Paul Pacter, professor at the University of Connecticut. Jerry participated in most of the interviews we conducted and Paul pulled all our thoughts and conclusions together into written form.

CPAJ: Having completed the process, you must have concluded there was a problem with auditor objectivity?

Kirk: There was concern about auditor objectivity, and we also recognized there were ways in which the stature, importance, and contribution of the auditor could be improved or advanced. Together it convinced us there were steps that could be taken to help ensure greater objectivity of the auditor, strengthen corporate governance, and add a dimension to the profession that would help attract the best and brightest into the profession.

The recommendations are not "thou shalt do this," or "thou shalt do that." In part, this is due to the nature of our charge, the time frame under which we were working, and the position we were in relative to other reports and recommendations that had recently been issued, We recognized it was unlikely we would unearth any startling new findings.

CPAJ: The report expresses a concern about the level of consulting practices in many of the large accounting firms. This concern was also expressed in the Cohen Commission report some 15 years ago. At that time the concern was expressed that there could be a point at which consulting services become too great a part of a firm's activity. The consulting practices of many firms today have crossed the threshold level the Cohen Commission considered alarming. Is there any recognition on the part of firms that this may be a problem?

Kirk: We did not see any clear evidence of a problem because of the increased presence of consulting in accounting firms. Keep in mind, however, that all the leaders of the major firms come out of "traditional services" backgrounds. But I can't see any reason why that will continue. We think the problem is with us and that self-regulators and regulators need to think through what kind of organizational structure makes sense going forward from here. There must be a way to keep the audit activity identifiable in a way that is overseeable from let's say the POB's perspective and to protect the independence of that activity. We are concerned that firms are beginning to lump together all their services and not distinguishing audit from other services. We think auditing must be held to a higher standard than consulting activities. The counter argument is that the auditing component would elevate the integrity and objectivity of all the other services of the firm. We were concerned that the greater risk was the dilution of the public trust of the audit function by homogenizing firm-wide services. And so we feel this issue must be addressed now.

CPAJ: We recently had a panel discussion of managing partners of practice units. One panelist from a larger firm indicated that as a result of a recent reorganization along industry lines, he no longer gets a P&L by function - audit, tax, consulting - but rather gets results just by industry grouping.

Kirk: Clearly auditors have to understand industries and be expert in their complexities. However, firms have to be careful not to be seduced by an industry and become so close they begin to lose their objectivity. We believe firms must take a serious look at how they are organized so that the audit function is not in any way threatened or compromised.

CPAJ: A desired outcome of organizing by industries is to get all professionals in the industry group working toward the common goal of growing the industry practice. This would be in whatever direction makes most sense at the moment whether it be audit, tax, or consulting. This thinking could have the effect of making all members of the industry team business getters - cross selling is the term often used.

Kirk: In our view, we need the auditor to bring added value, not as a seller of other services, but by putting to work the skills and judgments gained in dealing with systems of controls and complex accounting issues. Auditing professionals have gotten better in the techniques of doing audits. But what concerns us is they may have abandoned some of the judgmental aspects of dealing with accounting and disclosure principles and practices. In many ways they have become compliance oriented, the result, or possibly the cause, of some of FASB's very rule-oriented financial accounting standards. The SEC also seems to favor very "bright-line" answers that leave little room for interpretation. In my view, that's not the answer. You can't write enough bright-line accounting principles or auditing standards to solve all the problems. We cannot have the profession hiding behind compliance with rules.

That's why we think the auditing professional has to step into the role of commenting on the quality of reporting practices. We do not suggest that the auditor select the accounting principle. That is not his or her responsibility. But the auditor adds value to the user and the independent director by stepping forward and expressing views about the quality of choices made, the degree of aggressiveness or conservatism. There should be forthright, candid discussions on those issues. Yes, the financials meet the minimum standards of fair presentation, but what about the choices that were made, and what have been the consequences of those decisions? The boards of directors need to know this.

CPAJ: Now we are getting to the very heart of the recommendations. How does all this happen? Having auditors making these kinds of judgments and commentary sounds wonderful. But as a practical matter, how will it actually work?

Kirk: With some difficulty. It will take commitment on the part of the profession. It will require building a receptivity and expectation level on the part of independent members of boards of directors and audit committees. Auditors will have to work at it, and those on the other side will have to seek it. Those that follow after this report will have to communicate the benefits to be derived from this approach to the user and corporate board community. Boards will have to create an environment where this will work.

CPAJ: How will the user of financial information - the investor or banker - know that this type of communication has occurred and how the board has chosen to respond, for example, having learned that an optimistic, liberal choice has been made to recognizing a particular transaction?

Kirk: If implemented, the user will know that this communication is part of the process. However, we do not think that the auditor's opinion must always prevail. Opinions can differ. The important outcome is a fully informed board, having learned where the company's position falls on the spectrum of acceptable practice, that can challenge and influence management's reporting decisions.

We would expect the SECPS will consider requiring evidence in the peer review process that firms are communicating to boards in the manner we have described.

CPAJ: The process will be very dependent on the good faith efforts of accounting firms and boards of directors and audit committees of the companies they audit. Your report says there will be no "independent auditor's report" that the communications have occurred. Users will not immediately be able to tell who is or who is not complying with the spirit of your recommendation. Can this rather subtle or indirect approach work?

Kirk: We think so, but, it will take time. Eventually, the auditing professional may want to build the requirement for this type of communication into SAS No. 61 (AU Sec. 380), Communications With Audit Committees. It is also possible the SECPS will do something relative to membership requirements. But we are not looking for boiler-plate reporting. We want real communication that can lead to responsible board members and audit committees making the right decisions. We also would like to see the SEC buy into the concept so that it pushes for this kind of communication.

CPAJ: The Cohen Commission made a recommendation that the auditor be accountable to the board of directors but that it was not necessary to make this a regulatory (self- or government-imposed) requirement of auditing standards. The Commission went on to recommend that this accountability arrangement between auditor and board be established immediately. That was 15 years ago. Do you think your report will act as a catalyst to make this happen?

Kirk: Maybe now is the time for some greater pressure on the various players to make it happen.

CPAJ: What has happened since your report was issued?

Kirk: It is still being disseminated and is not well known. The major firms have sent copies to most of their audit partners. The firms are still assessing the recommendations. The AICPA board received the report and asked the SEC practice section to assess and develop a position on the report. The POB has accepted the report and unanimously endorsed it. They are considering what else they might do to enlist support including some sort of communication to the corporate community.

CPAJ: What about the SEC?

Kirk: We met with the Chief Accountant and the Chairman just before the report was finalized. There is no question that our recommendations may not go far without the support of the SEC. We believe the SEC would find it difficult not to support our views on the importance of strengthening corporate governance. But we don't know the SEC's view on the specifics in the report.

CPAJ: It is possible the SEC may like your recommendations so much that it will introduce them into its regulatory scheme. Will that trouble you?

Kirk: That depends on how the regulation was structured. We are not strong believers in a legislative solution. We think it would be self- defeating if boards had to accept what the auditor felt was "best." The decision is not the auditor's to make. The auditors would no doubt cry for more bright-line standards that we are generally opposed to. If upon reflection, the only way to achieve our recommendation is through a regulated/legislated rule-based approach, maybe I would reluctantly agree.

CPAJ: Is it too soon to have a response from the preparer community - the Financial Executives Institute and the like?

Kirk: Yes it is. There is something in the report to offend almost everybody. Therefore, we did not think endorsements would be immediate. The POB recognizes the need to sell these ideas to the corporate community.

CPAJ: Do you feel the report will accomplish the objectives of increasing auditor objectivity and improving financial reporting?

Kirk: I think it opens another avenue that hopefully can add to the strength of the auditing profession and serve corporate boards and ultimately the investing public.

CPAJ: A lot of our readers do not audit public companies. How do you think your recommendations will trickle down to nonpublic entities?

Kirk: Our first concern was with public companies. The problem with privately owned companies is that there is often no counterpart to the independent director. However, much of what we are saying would have applicability in the not-for-profit community, where directors and trustees have a fiduciary responsibility.

A possible implementation track might begin with requirements for SECPS members and then move into generally accepted auditing standards.

CPAJ: Do we need liability reform before your recommendations are operative?

Kirk: We think not. If anything, the kinds of things we are recommending should offer some protection to the auditor by demonstrating the auditor considered the quality of choices made by the entity and discussed those choices with the independent board members. The POB has done more work on the potential liability effects and will have more to say on this subject. But as our report acknowledges, we believe a better legal environment will help auditor professionalism.

CPAJ: The report closes by recommending that the SEC and the POB need to allocate more resources to keeping informed about developments in the profession and the market for audit services. What gave rise to this recommendation?

Kirk: Much of what happens in the profession is on a fragmented basis. We have AcSEC and the Auditing Standards Board setting standards. We have the ethics committee revising the Code of Conduct. Audit oversight comes to some extent from the POB. And of course, we have the FASB setting broader accounting standards. All these matters being dealt with by various committees and boards are interrelated. There has to be a concerted effort for all these activities to be coordinated, rather than the episodic approach we now see.

CPAJ: When the Emerging Issues Task Force looked at the issue of construction loans, the staff of the auditing standards board observed that this was an auditing problem disguised as an accounting issue. This is an example of the fragmentation you mentioned. Is there a solution to this problem?

Kirk: Even the AICPA with its various divisions deals with these matters in a fragmented way. We considered whether we should say something about reorganizing the private sector oversight and self-regulatory process. We concluded this was a bit beyond our scope but clearly something that requires attention. We need to think about ways to better coordinate all these activities that are aimed at improving the quality of financial reporting.

CPAJ: There is no question that if the recommendations of your panel are followed, the professionalism of the auditor will be elevated and enhanced. The question remains whether it can be done without a regulatory solution. We hope it can.

Thank you very much, Don, for meeting with us.

RELATED ARTICLE: THE PANEL'S PRINCIPAL CONCLUSIONS

* There is no need at this time for additional rules, regulations, or legislation dealing with the conflict-of-interest aspect of auditor independence. There are, however, important steps that should be taken in other ways to strengthen the professionalism of independent auditors.

* Auditing is different from other services accounting firms render. It imposes special and higher responsibilities. Independent auditing firms, regulators, and overseers of the public accounting profession need to focus on how the audit function can be enhanced and not submerged in large multiline public accounting/management consulting firms.

* The Public Oversight Board, the SEC, and others should support proposals to enhance the independence of boards of directors and their accountability to shareholders. Stronger, more accountable corporate boards of directors will strengthen the professionalism of the outside auditor, enhance the value of the independent audit, and serve the investing public.

* To increase the value of the independent audit, corporate boards of directors and their audit committees must hear from independent auditors their views as professional advisers on the appropriateness of the accounting principles used or proposed to be adopted by the company, the clarity of its financial disclosures, and the degree of aggressiveness or conservatism of the company's accounting principles and underlying estimates.

* Auditors should look to the representatives of the shareholders - the board of directors - as the client, not corporate management. Boards and auditors are, or should be, natural allies in protecting shareholder interests.

* Auditors must assume the obligation to communicate qualitative judgments about accounting principles, disclosures, and estimates. By doing so, independent auditors can add to the effectiveness of boards of directors in monitoring corporate performance on behalf of shareholders and in assuring that shareholders receive relevant and reliable financial information about company performance and financial condition.

* By making these suggestions to boards and auditors, the panel's objective is not to narrow the range of acceptable accounting practices (that may follow in due course) but to give directors a better basis for influencing corporate practices. These suggestions should also enhance the objectivity and strengthen the professionalism of the auditor.

* Because they share the objective of providing the public with relevant and reliable financial information, the public accounting profession, the standard setters, and the SEC must have more cooperative, less adversarial relationships. CPA firms should be careful in how they communicate their views to the FASB, the SEC, their clients, and the public at large. The SEC should help identify accounting practice problems and look to the private-sector standard setters to solve them. It should only be a standard setter of "last resort" and then only after appropriate due process.

* It is urgent that the SEC take the lead in helping the profession to reduce exposure to unwarranted litigation. There are dangers, not just to the profession but to the investing public, if the current liability, situation continues to drift without SEC leadership.

* While tort reform is necessary, the other suggestions in this report can be considered separately from, and need not await, legislative action on litigation reform.

For the future, the panel believes that the SEC and the POB should consider devoting resources to stay informed on a continuing basis about developments in the auditing profession and in the market for audit services. As described in this report, some of those developments could materially affect the viability of the independent audit as a private- sector activity. By having the facts, the SEC and the POB will be in a position to anticipate and take appropriate steps to strengthen auditor professionalism.

Source: Strengthening the Professionalism of the Independent Auditor, September 13, 1994.