The Big-Five battle: CPAs and non-CPAs square off on auditor independence.

The 1990s have been a turning point for large CPA firms, whose fast-growing consulting practices are gradually overtaking audit as the most profitable - and, in some cases, largest - segments of their business. It's a matter of time until the principal owners of firms providing CPA services will be non-CPAs. In fact, this is happening already.

American Express, for example, is the parent of one of the largest groups of CPA firms in the United States. To avert challenges from state regulators, the attest portion of the business is separated from the non-attest (mostly financial services) business, with leased employees, cost-sharing agreements, non-compete contracts, separate letterheads and similar measures. Given the economic incentives, we can expect many more such instances of in-substance ownership of CPA firms by non-CPAs.

In the information technology arena, consider, too, the well-publicized disputes within Andersen Worldwide. As the consulting practice has grown faster and more profitably than the attest business, CPA partners and IT partners disagree about who owns whom, and who owes whom what. With the advent of strong consulting practices in most CPA firms, the Andersen tug-of-war may well be replicated elsewhere in the profession.

Both examples suggest that, in time, the strong brands and efficient distribution channels of IT and financial services businesses will put them in a good position to dominate the accounting and auditing industry. That raises a number of difficult independence questions - with no clear answers - like this one: What's the effect of the increasing influence of non-CPAs on how auditing firms serve clients and the public?

Some experts warn of real changes in the profession and, indeed, in the proper functioning of financial markets if non-CPA owners compromise the CPA's reputation for objectivity and independence. Others observe that the CPA doesn't have a monopoly on integrity and independence of thought; it may be self-serving for the CPA to assert that financial services and IT giants can't instill and preserve these values. After all, they point out, emerging competitors like American Express have long operated in regulated industries and will no doubt conduct themselves ethically and professionally. Still other pundits say any threat to independence is just an additional risk that business will have to manage - one that's far outweighed by the capital efficiencies, operating synergies and ability to attract talented professionals that will ultimately flow to clients and the public.

The Burning Questions

So should financial services and IT companies in the auditing business be governed by the same rules that apply to traditional CPA firms? Just take a look at each sector's conventions regarding contingent or performance fees, joint ventures with or extension of credit to clients, stock ownership/employee compensation schemes and outsourcing to understand how different the rules are in many substantive respects. On one hand, CPA firm owners in the financial services and IT sectors propose only their CPA operations be bound by the CPA rules, arguing they won't be able to compete worldwide against CPA-less rivals not bound by the CPA's unique rules. On the other are those concerned about letting those sectors "have their cake and eat it, too": If you want the CPA's distribution channel, you also get the CPA's rules.

Whichever camp you're in, the inevitable and probably most important question is: How will changes in the structure of CPA firms affect auditor independence? The profession's independence rules have become a fulcrum, balancing those who support increasing expansion of non-CPA services and those who condemn it. Complicating the debate are myriad state rules regulating non-CPA ownership of CPA firms. These may fail under various constitutional rights arguments and, in any event, certainly have no small potential for artful manipulation.

With each side seeking to move the fulcrum in its favor, whither goest independence? The recently formed Independence Standards Board, which includes public-interest representatives and accounting leaders as well as SEC participants, is the referee addressing this question. Many difficult independence issues have come to the fore, most of which are driven by attest-vs.-non-attest, scope-of-services issues.

Here are a few of the questions that will shape the debate.

Has the size of today's multinational, multidimensional CPA firms rendered many independence rules unrealistic or irrelevant?

Business growth and megamergers have reduced the percentage of individual partners' interests in the overall business of a firm, and have eliminated financial dependence on any one client. This phenomenon suggests substituting materiality, or de minimus, tests for absolute tests in such areas as stockholdings in clients. The rules precluding firm employees from holding any amounts of a client's stock (even when they have no direct relationship with the client or when they obtain the stock by inheritance) may no longer make sense, given the shrinking significance of individual holdings and the stringent insider-trading laws that guard against abuses.

There seems to be consensus that there's a difference between shareholdings in clients served directly by the CPA vs. clients to whom one has no personal connection. Should tens of thousands of non-CPAs, with no current or anticipated connection to attest work, be held to the strict standards of the audit practice? This may be an anachronistic policy that bears re-examination.

Should the "appearance" test for independence be abandoned?

Two tests govern independence: independence in fact and independence in appearance. Some question whether the appearance test is a proper check or just a stalking horse for the real issue - non-attest services by CPAs. Remember, the appearance test wasn't incorporated in the securities regulations until the 1970s, coincident with the advent of widespread IT consulting by CPA firms. Ask yourself whether strategic tax advice, financial systems implementation and the judgmental aspects of due diligence would pass today's prohibition against consulting reviews involving management-type decision-making (or the appearance thereof). Arguably not, yet these services go back many decades and are generally not perceived to have created independence problems. Interestingly, the legal profession considered adopting the appearance test but quickly rejected it as a worthwhile ideal but unattainable as a realistic and workable standard.

We need to revisit the appearance test. Public perception is important and can't be trivialized. Yet, as professional opinion researchers note, it's problematic when one group (say the regulators) sets out to determine the possible perceptions of another (the public). Perception-of-perception is dangerous territory, especially when the public is, itself, somewhat ill-defined. If the appearance test were set up to limit the advancing tide of non-audit services by CPAs, so be it. But let's address this issue head-on, rather than obfuscating it as a matter of "appearance."

Should there be different independence standards for SEC registrants?

Today's AICPA and individual firm guidelines permit a number of business relationships with non-SEC registrants that aren't permitted for public registrants. For example, auditors can't enter into subcontractor relationships with SEC-registered clients, yet do so routinely with non-public entities (for instance, when a non-public company and its auditor jointly or as prime/subcontractor carry out consulting arrangements for a third parry). Other examples? The harsher rules that apply to relatives working for publicly traded clients vs. non-public companies, and so-called bookkeeping services prohibited by the SEC yet routinely performed for nonregistrants, especially outside the United States.

It's a bit of a strained argument to say the users of financial statements of non-public organizations have significantly different perceptions than users of financial statements of public companies. Therefore, it may be time to reconcile rules based less on whether the client is privately or publicly held than on fact-finding regarding which practices can, in fact, impair the objectivity of the auditor. Of course, the result may well be stricter rules for non-public clients.

Should independence standards differ by country?

There are significant international differences in independence rules. The rules on contingent fees and bookkeeping services are well-known - but far from unique - examples. The fact that rules differ could be due to different cultures having differing views of what constitutes ethical behavior, or it could be a function of the relative stage of maturity of different capital markets and related expectations, or it could be a function of different regulators having different interpretations, agendas and viewpoints. It's probably a combination of these and other factors, all understandable and well-intentioned.

But many businesspeople and investors are calling for uniform standards to promote consistency, transparency and well-informed decisions in an increasingly global economy. Other, perhaps more patient, observers note - not entirely tongue-in-cheek - we should get state-by-state differences sorted out before we tackle the world. Momentum seems to be on the side of consistency across all borders, and client and investor demands may well accelerate the harmonization.

Should independence be a matter of absolute principle, or should it be based on materiality?

Today's rules are a bit of a mix between those materiality-driven (the 5-percent family net worth test for a spouse's interest in client stock-based retirement plans or other benefits from a client employer, for example) and absolute tests (no direct client stock ownership no matter how de minimus). Some have argued we should move to a blanket concept that independence rules shouldn't apply in clearly immaterial situations, as is the norm in the FASB's accounting pronouncements. Others suggest differing rules only reflect the relative strength of the appearance-of-conflict test. That is, if there's doubt whether an appearance issue really has any basis in substance, then a materiality test pragmatically softens the impact of the rule - somewhat of a compromise.

Those in favor of liberalizing the independence rules prefer the materiality-type tests, of course, and cite the complexities of applying strict rules in all circumstances, no matter how minor. It may be time to adopt a more consistent, pragmatic approach to this issue.

Would scrapping detailed independence rules and adopting an interpretive (or so-called "question-and-answer") approach to guidance be effective or an invitation to abuse and litigation?

Both those in favor of liberalizing and those in favor of tightening independence rules are dissatisfied with the "Q-&-A" approach to rule-setting used by the SEC and the profession. Those who favor liberalizing say the rules have been established on such a piecemeal basis that a generally restrictive framework exists with no practical structure for revisiting past rules or looking at the big picture. They also believe there's an analogy to the legal profession's "good verdict, bad precedent" axiom because many independence questions arise from gray areas that are then given black-and-white interpretations.

Those who favor tightening the rules believe this format has encouraged the use of precise interpretations and minor deviations of fact to justify exceptions in practice or interpretation. Detailed guidance encourages loophole-type behavior, they say.

Both groups believe a principles-based approach to guidance that could then be followed in spirit would be an improvement - but so far, such an approach has proven impracticable. The reality has been that black-and-white concepts soon take on a gray tinge, inviting some impartial group to make the close call. Presto, back to Q&A guidance! There's also concern that scrapping tried and true independence rules will invite litigation - and interpretation by jury! In any event, if the profession moves to an interpretive approach, we'll need to pay more attention to instilling independence as a core business value. This is especially true as the non-CPA portion of the practice continues to grow.

Would a "firewall" separation of the CPA and non-CPA promote independence?

If the linkage between the CPA and non-CPA divisions could be reduced by "firewalls," the result would be two parallel yet differing sets of standards: one for the attest function and one for the non-attest function in the same firm. Where to draw the line? Can there be common management of a holding company? If CPA teams can't share information with non-attest teams, what's the value of common ownership to the client?

Contingent fees, joint ventures with clients, the outsourcing of key business processes and so on would be acceptable as long as the firewall were well established. This approach is attractive to all, with the proviso that such a firewall have the substance to be effective. That leads to questions about whether there can be any economic sharing, either of profits or costs.

It also leads to questions about compensation. Historically, auditors have been compensated based on overall firm performance; any linkage, explicit or implicit, with sales or profits from non-audit services to their audit clients has been incidental. This model is in contrast to that used in some other industries, where the professional's compensation is based on the profitability of specific accounts. This distinction has been a subtle reminder of the difference between independence and advocacy.

No Crystal Ball

Will clients and the public really accept the new structure of large CPA firms where consulting services dominate? If the answer is yes, then independence rules probably need to be relaxed - and many abolished. If the answer is no, then the rules should be tightened and ownership rules addressed.

The accounting profession is prepared to explore issues openly and honestly. The SEC, the AICPA's ethics committee and the Independence Standards Board all have announced examinations of these issues. The debate promises to be heated and certainly healthy.

Mr. Ward, CPA, is a partner with Pricewaterhouse-Coopers in New York City and a member of the independence issues committee of the newly created Independence Standards Board.