BA 427 – Assurance and Attestation Services Lecture 27 Auditor Independence
Independence: Introduction • Independence issues might arise from any relationship that exists between an auditor (or the audit firm) and the client. Examples include: • Financial interests in the client, including stock ownership and loans to the client. • Loans from the client to the auditor. • The auditor’s service as director, officer, manager or employee of the client. • Revenue received from the client for professional services rendered
Independence: Introduction • These relationships might compromise independence even if they are not aligned in time with the audit (e.g., the auditor’s future or past employment with the client). • These relationships might compromise independence even when family members are the ones involved in the relationship (e.g., the auditor’s spouse is an employee of the client). • Some would argue that the audit fee itself has the potential to compromise independence.
Independence: Introduction • The most controversial areas have been • stock ownership rules • non-audit (i.e., consulting) services • Independence-in-appearance • This lecture reviews these three areas (mostly the second two), chronologically, from 1960 to 2003.
Non-audit services • 1959: An article appeared in Journal of Accountancy, authored by a CPA from a local firm in Ohio: • “The practicing accountant is urged to make a list of advisory services his clients need, and then compare it with the services he is actually rendering to them. The difference between the two lists represents a potential which is not being tapped. Doing something about it is up to the accountant—not the client. J. W. LaFrance
Non-audit services • 1959: In the same issue of the journal, the following editorial appeared: • It is obvious that selling ability … is an essential ingredient in the provision of the highest quality of professional services. … One of the most important characteristics of a true professional is recognition of the need for services which the layman cannot be expected to be aware of.
Non-audit services • 1963: The AICPA Professional Ethics Committee issued Opinion No. 12 on auditor independence: • “… There is no ethical reason why a member … may not perform … management advisory services, and at the same time serve the same client as independent auditor.” There is no reason the provision of these services should suggest to a reasonable observer a conflict of interest.
Independence-in-Appearance • Independence consists of two components: • Independence-in-fact • Independence-in-appearance • The quote from Opinion No. 12 addressed independence-in-appearance • Independence-in-appearance can only be assessed after we specify who it is that is doing the looking.
Independence-in-Appearance • “reasonable observer” • AICPA Professional Ethics Committee, Opinion No. 12 (1963) • “alert and intelligent outsiders” • Mautz and Sharaf, The Philosophy of Auditing (1964)
Non-audit services • 1965: Research by Arthur Schulte: • 635 surveys from financial institution executives. • “To what extent do you believe that CPAs can perform the managerial consulting type of services to management on a fee basis and still remain completely independent?” • Depending on the respondent subgroup, 17%to39% believe that consulting “may seriously affect” independence.
Non-audit services • January 1966: JOA article by John Cary (Executive Director of the AICPA) and William Doherty (Manager of ethics and legislation of the AICPA): • Article references the study by Schulte. • Asserts that results might be due to use of the term “management consulting.” • Term wasn’t defined. • “management services” would have been more appropriate.
Independence-in-Appearance • January 1966: JOA article by John Cary and William Doherty refers to: • “reasonable observers—stockholders, creditors or other users of financial statements, or the business public generally”
Non-audit services • 1966 research study by Abe Briloff: • 136 surveys from investment analysts, Big 8 auditors, and accounting professors. • 94% of Big 8 auditors believe that the rendering of management services for attest clients is compatible with independence, whereas 58% of financial statement users believe management services are incompatiblewith auditor independence.
Non-audit services • 1966: AICPA created the Ad Hoc Committee on Independence: • The Committee interviewed Schulte and Briloff. It then administered Briloff’s independence question to 16 representatives from various user groups. These participants asked for clarification of terms, but none was given. After the questionnaires were completed, participants were debriefed, and found to be confused.
Non-audit services • 1966: AICPA ad hoc committee on independence: • Committee revised the survey and re-administered it. To the committee’s “surprise,” some participants still expressed concern.
Non-audit services • 1966: AICPA ad hoc committee on independence: • The Committee concluded: • “there is substantial misunderstanding as to the nature of management services rendered by CPAs” • “there are definite limitations on the value of questionnaires on this subject”
Non-audit services: • 1979: Two years after its formation, the Public Oversight Board issued its report Scope of Services by CPA Firms. • As input for the report, the POB held two days of hearings, received 152 comment letters, and conducted an extensive literature review.
Non-audit services • 1979 Scope of Services by CPA Firms report: • While the available empirical evidence does not reveal any actual instances where the furnishing of MAS has impaired indepen-dence, the Board recognizes that the nonexistence of such evidence does not necessarily mean that there have not been instances where independence may have been impaired ….
Non-audit services • 1979 Scope of Services report: • The lack of incriminating evidence was mentioned repeatedly at the POB Hearing. … It is also a recurrent theme in professional studies on the subject, but the Board is puzzled as to what weight it should be given. Specific evidence of loss of independence through MAS, a so-called smoking gun, is not likely to be available even if there is such a loss.
Non-audit services • 1979 Scope of Services report: • The Board also considered and rejected the more extreme view, expressed in the [Metcalf Report], that auditors be prohibited from furnishing to audit clients any nonaudit services …. Such a draconian measure would not only deprive audit clients of services that they obviously deem valuable but also would cause a substantial reduction in revenues for many CPA firms.
Non-audit services • 1979 Scope of Services report: • The Board believes that there is possibility of damage to the profession and the users of the profession’s services in an uncontrolled expansion of MAS to audit clients. Investors and others need a public accounting profession that performs its primary function of auditing financial statements with both the fact and the appearance of competence and independence.
Non-audit services • Internal Audit Outsourcing • This particular consulting service grew rapidly in the 1990s, and was controversial in the context of accounting firms providing internal audit services to attest clients. • In 1984, the SEC responded to an inquiry by a small accounting firm, indicating that, in general, internal audit outsourcing services would compromise the auditor’s independence.
Independence-in-Appearance • “a member who provides auditing and other attestation services should be independent in fact and appearance.” • AICPA Code of Professional Conduct (e.g., 1991) • The above quote appears under Section I—Principles. However, in Section II—Rules, under Rule 101 Independence, there is no mention of independence-in-appearance whatsoever.
Non-audit services • The 1994 POB Kirk Report: • In 1994, the POB released the report of the Advisory Panel on Auditor Independ-ence (the Kirk Panel), entitled Strengthening the Professionalism of the Independent Auditor (the Kirk Report). • The Panel had been commissioned by the POB following a speech by SEC Chief Accountant Walter Schuetze, in which he criticized the accounting profession for not standing up to clients on financial reporting matters.
Non-audit services • The 1994 POB Kirk Report: • “The Panel finds worrisome the trend of accounting firms, in wanting to grow, to add or expand nonaudit services and thereby reduce their reliance on and the relative importance of auditing.” • “Growing reliance on nonaudit services has the potential to compromise the objectivity or independence of the auditor by diverting firm leadership away from the public responsibility associated with the independent audit function.”
Non-audit services • The 1996 Ethics Rulings • The Executive Committee of the Professional Ethics Division of the AICPA issued several new rulings and interpretations related to internal audit outsourcing. • In effect, the new rulings extended existing principles to internal audit outsourcing, and asserted that these services were no different from other types of consulting services.
Non-audit services • The 1996 Ethics Rulings • The new rulings reaffirmed that the auditor does not compromise independence as long as: • the auditor does not act or appear to act in a capacity equivalent to management; • the auditor does not act in a capacity equivalent to an employee.
Independence Standards Board • The ISB • June 1997: The SEC, AICPA and large accounting firms agree to the formation of a new self-regulatory body: the ISB. • ISB’s mission: to establish independence standards for public company auditors. • ISB organizational structure is similar to the POB. There is an eight-member board, four from the accounting profession. • October 1997: The ISB begins operations.
Stock ownership rules • Violation of stock ownership rules • In 1997, the SEC received an anonymous letter alleging that C&L audit staff owned stock in companies that C&L audited. • C&L then merged with Price Waterhouse. • The SEC required PwC to conduct an internal investigation; and uncovered 8,000 stock ownership violations involving 50% of the firm’s partners, including some key partners.
Stock ownership rules • By the mid-1990s, the independence rules for stock ownership were outdated. • The methods by which individuals invest in capital markets had changed. • However, the rules were unambiguous, and the SEC, under Levitt, chose to enforce them enthusiastically. • The SEC urged the other firms to conduct investigations of their compliance with the rules.
Stock ownership rules • At the SEC’s request, the POB agreed to conduct investigations of compliance by all of the Big 5 firms with the stock ownership rules. • In May 2000, the AICPA refused to fund the POB’s stock ownership probes. • Where upon Arthur Levitt referred to self-regulation by the public accounting profession as a “bad joke.”
Independence Standards Board • February 2000: The ISB issued a Discussion Memorandum for public comment on a conceptual framework for auditor independence. • November 2000: The ISB issued an exposure draft. A final draft would be issued in 2001.
Independence-in-Appearance • KPMG issued a comment letter to the ISB: • “appearances, apart from the fact of independence, cannot affect audit quality …. They do not affect in any way the reliability of financial statements.” • The conceptual framework exposure draft “represents an untenable balance between the old, insupportable appearance approach to independence and an approach based on the risk of compromised objectivity.”
Independence-in-Appearance • The AICPA submitted a White Paper to the ISB: • Existing SEC and AICPA independence requirements focus on situations that the SEC staff perceive to impair independence- in-appearance, but “these perceptions embody assumptions that are highly subjective, lack any empirical foundation … and result in arbitrary and unduly restrictive regulation.”
Independence-in-Appearance • Independence-in-appearance as defined by the SEC in 2000: • “A reasonable investor, with knowledge of all relevant facts and circumstances.” • As defined by the ISB in its Conceptual Framework: • “well-informed investors”
Independence Standards Board • The ISB lost support from both the SEC and the accounting profession soon after its formation, in part because the SEC and the accounting firms held irreconcilable positions on two critical issues, including independence-in-appearance. • The ISB initially attempted to find middle ground: incorporating in its exposure draft the concept of independence-in-appearance, but avoiding the term. This satisfied nobody.
Independence Standards Board • Levitt believed that the accounting firms had sufficient control of the ISB’s agenda to delay or avoid meaningful self-regulation. • When the SEC proposed new independence rules in the summer of 2000, it effectively preempted the ISB’s role. • July 2001: The ISB voted to dissolve. • The ISB probably would have included independence-in-appearance in its standard, had it survived long enough to issue one.
SEC proposed new rules • In the summer of 2000, the SEC proposed new independence rules. • The proposed rules would prohibit two types of consulting services: • internal audit outsourcing • financial information systems design and implementation. • The proposal also sought to modernize stock ownership rules by replacing the old firm-wide perspective with an engagement-specific perspective.
SEC proposed new rules • With respect to the restrictions on consulting services, the AICPA and three of the Big 5 firms strongly opposed the SEC proposal. • Arthur Andersen’s CEO Bob Grafton told Arthur Levitt: “Arthur, if you go ahead with this, it will be war.” And it was.
SEC proposed new rules • SEC Chairman Arthur Levitt’s position: • “Audit fees made up 70 percent of accounting firm revenues in 1976 but only 31 percent in 1998. … • The accountants were also doing internal audits for companies. That meant that auditors were part of the very control systems producing the financial statements that they later audited. By conducting internal audits as well as external audits for SEC reports, some auditors were passing judgment on their own work.”
SEC proposed new rules • SEC Chairman Arthur Levitt’s position: • Each of the three Chief Accountants who served under Levitt spoke out on internal audit outsourcing, conveying the SEC’s concern to the accounting profession. • Walther Scheutze • Michael Sutton • Lynn Turner • Neither the AICPA nor the Big 5 firms showed any inclination to change ethics standards or their business model with respect to consulting services.
SEC proposed new rules • On Levitt’s side: • John Hawke, U.S. Comptroller of the Currency • The Institute of Management Accountants • The Institute of Internal Auditors • Three ISB Board Members • PriceWaterhouseCoopers and E&Y (sort of)
SEC proposed new rules • On the AICPA’s side: • KPMG • Arthur Andersen • Deloitte & Touche • 46 member of Congress, including 2/3rds of the Securities Subcommittee of the Senate Banking Committee • The GAO (sort of)
SEC proposed new rules • On Levitt’s side: • John Hawke, U.S. Comptroller of the Currency • The possibility for inherent conflicts and impairment of auditor independence and audit integrity is greatest when a bank outsources its internal audit function to the same firm that performs the bank’s external audit.
SEC proposed new rules • On Levitt’s side: • The Institute of Management Accountants • Went on record in 1996 stating that outsourcing internal auditing to a company’s external auditors compromises independence-in-appearance. • The IIA • went on record in 1996 opposing total outsourcing.
SEC proposed new rules • On the AICPA’s side: • The GAO (sort of): • In 1996, the GAO reaffirmed a 1991 position that considered but rejected a recommendation to limit the scope of nonaudit services. • The GAO will change its mind in 2002.
The AICPA comments on the proposed SEC rules “Putting the very future of the CPA profession on the line, the SEC in late June  proposed sweeping rules that, if enacted in their current form, would force a restructuring of the accounting profession. The most threatening rule would prohibit accounting firms performing audits for SEC registrants from providing most non-audit services for those clients …. The SEC’s new proposals are draconian and unwarranted ….”
The AICPA comments on the proposed SEC rules “The [AICPA Board of Directors] concluded that … the proposed restrictions on non-audit services were not in the public interest, as they would strip the profession of skills needed to meet its auditing responsibilities in the New Economy.” As reported in the CPA Letter, 9/00
Testimony to the SEC by Barry Melancon, AICPA President and CEO “… clearly, the overwhelming response of our profession is of grave concern for the proposed rule.”