How objective are outside auditors?

In a speech in early 1994, Walter Schuetze, then chief accountant of the Securities and Exchange Commission, questioned the objectivity and independence of outside auditors. His comments triggered a wave of reaction from the accounting profession. The Public Oversight Board of the American Institute of CPAs SEC practice section responded by appointing an advisory panel on auditor independence to assess the dimensions of the problem and recommend steps to bolster the professionalism of the independent auditor. The panel's report, Strengthening the Professionalism of the Independent Auditor, suggested ways to maintain and enhance the quality of financial reporting by public companies by examining the roles of boards of directors and outside auditors. A subsequent POB report, Directors, Management, And Auditors--Allies in Protecting Shareholder Interests, urged financial reporting process participants to implement the advisory panel's recommendations. The SEC Practice Section Response to the Public Oversight Board Advisory Panel on Auditor Independence commended the work of the POB advisory panel and pledged to develop an appropriate plan of action to address that panel's concerns. (See JofA, Jan.96, page 53, for information on ordering these reports.

The Journal spoke with three people directly involved in the financial reporting process to hear what they thought of both Schuetze's remarks and the POB and SECPS responses.

Kathryn D. Wriston Director of various organizations New York City 

My own experience with independent auditors has been excellent. On the audit committees on which I serve, I have always thought of the auditor as my best ally and the company's best protector. In my experience, I have had no reason to question the objectivity of the independent auditors.

I agree with the advisory panel's emphasis that good communication is critical in the financial reporting process. It is one of the most important aspects of any audit committee's meeting. The audit committee has to understand the accounting principles and what is behind the numbers. It must exercise oversight with respect to significant internal control weaknesses identified by the independent or internal auditors, how these are dealt with, the reasonableness of management's significant judgments and estimates and the accounting treatment for, and disclosure of, significant contingencies or uncertainties. The advisory panel suggested that independent auditors meet with the entire board of directors. In my experience, this is not an unusual practice. Generally, the auditors come to the meeting in which the board reviews form 10K. There usually is not enough time to go into financial statement matters in depth during this meeting, but board members not on the audit committee have the opportunity to talk with the auditors directly.

MORE INDEPENDENCE FOR BOARDS

It is always good to strengthen the independence of boards of directors. However, I am concerned that an adversarial situation could be created by saying that the auditor's client is the board of directors. I think independent auditors consider the public to be their client--recognizing their public interest responsibilities--in addition to boards, their audit committees, management and shareholders, depending on the context of what they are doing. For an effective and high quality audit, the independent auditors need the full cooperation of management, the board and its audit committee.

ASKING THE RIGHT QUESTION

Most directors who serve on audit committees have a list of questions for the independent auditors. Those I have asked include:

* Were there any changes in the company's accounting principles or practices?

* How do our accounting practices compare with those of other companies in our industry or those of other well regarded companies?

* Have we made the best accounting choices?

* Are they consistent with or different from the rest of our industry or industry in general?

* Is the quality of earning consistent with previous years?

* Have any of our financial reporting standards been compromised?

It is important to remember that auditors and controllers know a lot more about accounting principles than most audit committee members. Generally speaking, committee members may not know there is more than one acceptable practice in a particular situation but that one is considered preferable unless they have been informed by the comptroller or the auditor.

AN OPEN DIALOGUE

Both the POB and SECPS think implementation of the advisory panel's recommendation to elevate the standards of communication should be a matter of best practices that boards and their audit committees follow and that regulatory action is not necessary. I agree with the POB and the SEPCS that it is a good idea for audit committees to reexamine their practices from time to time to ensure they are following best practices as these evolve.

Some of the concerns raised by a more open dialogue include increased costs and liability exposure. The POB advisory panel and the POB say that they do not intend to increase auditing procedures and cost. They say they are trying to encourage better communications, and I take that at face value.

The POB said it did not believe increased board member liability exposure would be likely, because the procedures recommended would reduce the possibility that the financial statements are misleading. The POB also said that the additional steps taken by board members should help to convince the courts and juries of the due care with which the financial statements were prepared. I hope the POB is right!

PRACTICES IN PLACE

I am confident that independent auditors are already making qualitative judgments. In fact, there are a number of recommendations in the advisory panel's report that are in place. For example, the independent auditor signs an opinion that includes a statement that the audit included assessing the accounting principles used and the significant estimates made by management. And Statement on Auditing Standards no. 61, Communications With Audit Committees, says that the auditor should determine that the audit committee is informed about the process management uses in formulating sensitive accounting estimates and about the auditor's conclusion regarding the reasonableness of these estimates.

On the audit committees on which I serve, the conversations between the auditor, the committee and management about internal control deficiencies are not limited to material or reportable conditions. If an auditor sees any significant weakness--even one that does not constitute a reportable weakness--I want to know what is being done to correct it. The audit committee wants to head something off before it becomes a reportable condition and clearly before it becomes material.

Domenick J. Esposito Managing Partner/Northeast Area Grant Thornton New York City

I think the system in place today is working well. I work with small- to midsized companies that generally do not have sophisticated board structures. The advisory panel's report and the subsequent POB and SECPS reports make theoretical sense but are not practical for owner-managed, entrepreneurial companies. I also do not think the recommendation that the board of directors examine accounting principles in greater detail is the answer for better governance for small to midsized companies.

There have been some mistakes in the past, but I see them as isolated instances. Walter Schuetze's remark was perhaps an unfortunate exaggeration of what actually is going on. Certainly there are situations in which an auditor is not as objective as he or she could be, but this is a matter of individual failures and not the product of a bad system. In my experience I have found auditors to be very objective. I also think the SEC has come down too hard on certain accounting firms.

DOES A CALL FOR OPEN DIALOGUE REALLY HELP?

The advisory panel's recommendation that boards of directors take more of a role in understanding the different options a company has in selecting accounting principles is admirable but not very practical. The board is not in a position to fully understand a company's accounting principles. If the auditor has difficulty deciding whether an accounting principle is appropriate, the auditor will tell the company. The recommendation that the board of directors increase its role puts it in the very difficult position of becoming the policeman.

Of course, an open dialogue between the board and the independent auditor always will enhance the auditor's objectivity. But a board of directors for a small or midsized company does not have enough experience or time to judge the quality of the company's accounting principles.

The advisory panel recommended that the auditor be held to a new standard of communication, particularly with certain choices within generally accepted accounting principles. Communication is already mandated by SAS no. 61, which lists opportunities for dialogue, such as discussing management disagreements, significant items that affect the financial statements and major internal control weaknesses. This vehicle has proven to be very effective.

A DIFFERENT TYPE OF INDEPENDENCE

The independence of the board of directors for owner-managed, entrepreneurial companies could be strengthened. It is difficult to find people to serve on the boards of smaller companies--exposure and the potential for liability are high, the fees are low and smaller companies sometimes are controlled by a strong entrepreneur who owns a lot of the stock. These boards do not function in the same way as do Fortune 100 boards. For example, many people on boards of small companies are business associates or relatives of the CEO--a situation that could render the boards somewhat ineffective. They are not truly independent and, as a result, they do not ask penetrating questions to management or the auditors. Other than having the SEC elect board members for small companies, which I think is the wrong approach, it is hard to envision how the system can improve.

I do think the mechanism is in place. It is common practice for management and the independent auditor to meet with the audit committee. This communication is subject to considerable scrutiny if the board chooses to get involved. Determining whether the company is using the best accounting principles is really the job of management and the independent auditor, and I think this is being handled well.

John L Fox Consultant and director of Bona Shipholding New York City

I do not agree with the advisory panel's conclusion that auditing needs to return to the mainstream of corporate governance and that its important role in our society needs to be restored. Auditing is in the mainstream of corporate governance. It plays an important role not only in our society but in the global economy. The worldwide use of U.S. GAAP and US. financial markets has given auditing a more important role than it had in 1950s.

The issues raised by Walter Schuetze have been around for over 40 years because there is always subjectivity in decision making. I am not skeptical of the objectivity of the independent auditor. I think the problem lies less with the independent auditor than with the competence of the corporate financial staff and the selection, within acceptable GAAP, of alternatives when companies prepare their business plans. The final check rests with the independent auditor and with nonexecutive directors on audit committees, who can ask the auditor about internal controls and estimates. Therefore, it is very important to have competent nonexecutive directors.

I do not agree with the panel's conclusion that independent auditors should discuss the appropriateness of accounting principles with the corporate boards and audit committees. The interaction between the audit committee and the auditors cannot be legislated. The appropriateness of accounting principles should be addressed when the company does its business plan. I fully expect corporate management to consult with its auditors as it builds a business plan to see if they object to financial management's choices of appropriate accounting principles. In the real world, mandating the communication process recommended by the panel would not work.

The report's call for the auditor to express qualitative judgments about the company's choices of principles, disclosures and estimates is not new. I think that accounting under GAAP has always called for qualitative as well as quantitative judgments.

Again, the real issue is the competence of the company's financial staff. The important role of the auditor is to communicate with an informed audit committee that is sufficiently competent to ask the right questions. The board members must be a diverse group willing to maintain a good dialogue with the auditors. But, you cannot change a life-insurance salesman into a competent questioner overnight.

The final checkpoint is the opinion. You cannot legislate the interaction between audit committees and auditors. I have always asked the auditors what they thought of the level of competence within the company when I worked with them as a member of management or as chair of the audit committee. Again, the crucial starting point for good internal controls should not be the independent auditor but the corporate financial staff.