Auditor Independence: A BIT MORE ROPE.

This past year may well be remembered as a year of some of the biggest changes in public accounting since the 1933 and 1934 Securities Acts. Umbrella professional service organizations have grown out of traditional CPA firms. CPA firms have been acquired by traditional professional and financial service organizations. American Express, Century Business Systems, and H&R Block are now among the largest CPA firms.

The Big Five have evolved into multidisciplinary professional service providers with consulting and other non-audit services accounting for 70 percent of revenues. Allegations abound that audit fees are often set unprofitably low to establish client relationships and then sell other services. The result? A serious question of auditor independence and new SEC regulation.

The Securities and Exchange Commission's (SEC) commitment to auditor independence is not new, but its June 2000 proposal made independence the hottest and perhaps the most controversial topic of the year. Chairman Arthur Levitt asserts that independence is "the core of the accounting profession ... the space to think, to speak, and to act on the truth. And truth is the lifeblood of investor confidence." The auditors' role is to act in the interests of shareholders and the public, not in the interest of management. With today's financial markets bringing enormous pressure on management to meet or exceed analysts' expectations, reports of earnings management (sometimes even fraud) appear to be at an all-time high. The SEC asserts that the audit role must be strong and reliable to assure the integrity of management, the fairness of financial statements and ultimately the integrity of the financial markets, and it believes auditor independence in both fact and appearance to be essential. The November 2000 SEC rul ing both moderates and finalizes the commission's independence stance.

Why is the SEC focused on independence regulation now? One answer appears to come from the proliferation of internal audit outsourcing services. Internal audit outsourcing, one of the fastest-growing services in the Big Five, may be the proverbial straw that broke the camel's back.

In 1996, the American Institute of Certified Public Accountants (AICPA) Ethics Committee revised rules to allow AICPA members to perform extended audit services, including internal audit outsourcing services for audit clients, as long as a member of the firm does not act or appear to act in a capacity equivalent to a member of client management or an employee. Much of corporate America embraced this as a very attractive alternative to staffing the internal audit department, a department for which it is notoriously difficult to hire and retain competent, experienced employees.

In its June 2000 proposal, the SEC asserted that performing an internal audit function results in the audit firm assuming a management function, thereby causing external auditor reliance on a system that the same firm has designed and/or maintains (i.e., auditing its own work). How external auditors performing additional work as internal auditors can be viewed as independent is a mystery to many, but the November regulation reflects a compromise position.

Accounting firms' expanding scope of services is the other primary area apparently prompting SEC concern. While CPA firms have performed non-audit services for audit clients for the past 50 to 100 years, recent growth in this area has been dramatic. In 1999, fees for Management Advisory Services (MAS), which represent non-audit services excluding tax services, accounted for $15 billion of Big Five revenues. From 1981 to 1999, their MAS revenues jumped from 13 percent to 50 percent of total revenues, with MAS fees from current audit clients representing 10 percent of total firm revenues -- even though only 25 percent of audit clients actually received MAS from their auditors.

Of further concern was that by 1999, 4.6 percent of Big Five clients' MAS fees were greater than their audit fees. This was true for only 1.5 percent of clients in 1997 -- a 200 percent increase in just two years. [1] But this concern dates back at least to 1971, when accounting scholar Charles Horngren wrote "of concern and caution that the rise of MAS might erode the independence of the auditor" in the long run. [2] Are these services expanding to the degree that independence is questionable in fact and, to many, nonexistent in appearance? Almost 30 years later, the SEC has answered this question with new regulation.

The SEC's Initial Proposal

In late June, the SEC released its proposed independence rule, sparking a furor of support, criticism and outright rebellion. In fact, the AICPA found the SEC proposal so offensive that it called the proposal "unwarranted and intrusive proposed regulation ... with profound consequences for the future of the accounting profession." The SEC countered that current independence standards were outdated and ineffective in maintaining independence in fact and appearance.

The SEC's initial proposal posited that an auditor is not independent with respect to an audit client if a reasonable investor would conclude that the auditor is incapable of "exercising objective and impartial judgment on all issues." Auditor independence was deemed compromised if the auditor: has a mutual or conflicting interest with the client; audits its own work; functions as management or an employee of the client; or acts as an advocate for the client. Specific applications included proposals to: 1) modernize independence requirements regarding financial and employment relationships of auditors and their families; 2) significantly limit the scope of non-audit services permissible for audit clients; 3) encourage voluntary quality-control programs related to auditor independence; and 4) require disclosure of audit and non-audit fee data.

The SEC's independence proposal was in fact broadly supported by the regulators and the profession; restructuring the regulations related to auditor and family member investments in clients was long overdue and widely endorsed. In reality, existing AICPA independence rules were written for a different economic era and different demographic workforce. Globalization and the proliferation of initial public offerings, along with the rise of two-income families with unrelated retirement plans investing in a multitude of funds, have made family stock ownership in firm-wide audit clients a frequent and inadvertent mistake.

By far the most controversial and widely opposed component of the June proposal was the limitation placed on the scope of services. The proposal banned firms from performing the following services for audit clients: 1) bookkeeping and other accounting or financial statement-type services; 2) financial information systems design and implementation where the system generates information significant to the financial statements; 3) appraisal and valuation services; 4) actuarial services; 5) internal audit outsourcing; 6) performance of management functions; 7) human resources services where the firm recruits, hires or designs compensation packages for officers, directors or managers of the client or affiliate, or if the firm advises on management structures, develops employee evaluation programs or conducts formal testing of employees; 8) broker-dealer, investment advisor or investment banking services; 9) legal services, and 10) expert services.

Critics of the initial proposal fretted about maintaining audit quality, particularly in light of perceived difficulties in hiring and retaining top information technology (IT) professionals to assist in the audit process. They argued that clients would not be as well-served because the auditor has valuable knowledge and a relationship with clients, and its services are enhanced by providing management advisory services. Critics also maintained that the accounting firms' consulting arms would have less incentive to remain attached to the firm if IT advisory services were banned for audit clients. Also critics were quite concerned that limiting MAS for audit clients would further weaken the pool of expertise within the firms.

Some also argued that recent divestitures of consulting divisions by Big Five firms already addressed the independence issue. However, it is interesting to watch as the CPA entity remaining after such divestitures generally reproduces the lost consulting services much like a stone crab grows a new claw when one is removed. Many of the prohibited or limited non-audit services falling under the rule -- such as internal audit outsourcing -- are currently housed in major firms' audit departments, not in the divested consulting divisions.

Moving Toward a Final Rule

After issuing its initial proposal, the SEC solicited comments and held a series of hearings. The hearings generated testimony from a wide array of individuals in the accounting firms, the business community and academia, each arguing his/her particular side of the issue.

The AICPA and many of the Big Five firms recognized that this proposal, if enacted, would likely change market dynamics significantly and curtail CPA services and revenues. That reduction might be partially offset by fees from non-audit clients, but such an offset would by no means be guaranteed. These organizations, and others, argued their case to the SEC and garnered support from several important business and congressional sources also fighting to stop the SEC proposal from becoming final. A key claim: The SEC had no real proof that auditor independence had ever been compromised because of the nature and scope of consulting services rendered by auditors to their clients. Congressional allies of the accounting profession were urging the SEC to go slowly and consider all views and information before making any decision.

At one point in the deliberations, representatives from two of the Big Five offered proposals for compromise. The SEC then entered into an extended period of negotiations with the AICPA and most of the Big Five firms to try to reach a middle ground. These negotiations were broken off by the SEC in early November, and the agency moved to issue its final regulations on Nov. 15. It seemed that time had run out for Chairman Levitt, who is widely believed to be stepping down before the new presidential administration begins. Apparently, he did not want to leave important work undone.

The Final Regulations -- A Compromise

The final regulations contained most of the proposed rules governing investments by auditors and their family members in audit clients, as well as employment relationships between auditors and their family members and audit clients. These provisions were largely non-controversial and were supported by the accounting profession, which had moved to include similar provisions in its own code of ethics.

In addition, the four general standards for evaluating auditor independence, in fact and appearance, were left unchanged. However, in the application of these principles to specific professional services, the SEC took a much more moderate view than it had in its initial proposal, especially as it relates to non-audit services. Its final regulations deal with nine such services where auditor independence could be impaired, six of which have long been viewed as prohibited services by the AICPA or the SEC. Continuing prohibitions in these six areas are not particularly controversial.

The major compromises in the independence regulation permit auditors: (1) to offer IT consulting services to audit clients under certain criteria, including separate disclosure of fees paid in annual proxy statements; (2) to perform internal audit services valued at up to 40 percent of an audit client's total internal audit work. For companies with assets under $200 million, there is no restriction on internal audit services.

Additionally, the regulations provide that appraisal and valuation services would not hurt auditor independence when such services were immaterial to clients' financial statements or would not be subsequently audited by the same auditor. The rules also make it clear that independence would not be impaired when auditors perform consulting services involving assessment, design and implementation of internal accounting and/or risk management controls, or perform operational audits unrelated to accounting or financial matters.

An important win for the accounting profession is that the final regulation allows auditors to continue providing IT services to audit clients. Such services are allowable if the clients acknowledge responsibility for their control systems, identify a management person to make all decisions with respect to the service provided, independently evaluate the adequacy and results of the service, and disclose the total fees for these services in a proxy statement. Importantly, the final regulations make it clear that auditors can provide assessment, design and implementation of internal accounting and risk management controls without restrictions.

Many observers have expressed concern about the disclosure requirement for IT service fees. Undoubtedly, some companies will be troubled by this requirement. However, disclosure itself is not expected to stop companies from using their auditors for such services when they believe it is advantageous to do so and would not adversely impact auditor independence.

Interestingly, the proxy rules were also modified to require disclosure when a company's auditors use staff borrowed from other organizations, such as affiliated financial services organizations (American Express, etc.), to perform more than 50 percent of the audit work. While several compromises were made in determining which advisory services would be permitted, the SEC gave the final determination on the impact of allowable management advisory services to the audit committee. The regulation specifically requires audit committees to consider whether non-audit services are consistent with maintaining auditor independence. Finally, the regulation permits limited exceptions for unintentional independence violations where firms have in place appropriate quality-control procedures and promptly correct such violations.

Is the Battle Really Over?

Despite the eventual compromise, the independence controversy has clearly widened the gap between the SEC and the accounting profession. The final regulation was met with some apprehension, and only time will tell how compliance and enforcement will be handled. The regulation is likely to become the benchmark for all auditors, and it is expected to filter down to non-public companies as other organizations, such as state boards of accountancy, departments of labor and banking regulators, attempt to "harmonize" their rules with the SEC's.

In summary, this final regulation carries two important implications. First, it reaffirms the SEC stance that auditors must remain independent in both fact and appearance. The commission has made it very clear that despite calls from the public accounting community to focus only on independence, the SEC will continue to seek both. Second, it seems that the appropriate groundwork has been laid for close monitoring of IT consulting activities, as well as alternative business practice arrangements. It is a distinct possibility that the SEC is waiting for irrefutable evidence of whether or not such services actually impair auditor independence.

In a few years, adequate data should be available to enable researchers to investigate any relationship between audit failure and IT consulting. Such a study has not been possible to date due to a lack of publicly available data. The SEC may then have the proof it needs to remove the perpetual thorn from its side -- the fact that it did not have proof such services ever compromised auditor independence. If such a relationship is ever demonstrated, the SEC may eventually take another hard look at whether or not such services should be available for audit clients. In the meantime, it is likely that the agency will put proxy disclosures under close scrutiny.

Joanne Rockness is Cameron Professor of Accounting at the University of North Carolina at Wilmington, where Susan Ivancevich is Assistant Professor of Accounting and Thomas Keaveney, a retired partner at KPMG, is an instructor.

(1.) Source: Public Accounting Report (Mar. 31, 2000) as quoted in SEC Proposed Rule "Revision of the Commission's Auditor Independence Requirements."

(2.) Horagren, C. 1971 "The Accounting Profession in 1999"; The Accounting Review (January), p. 2.