The effects of corporate ownership on public accountants' professionalism and ethics.
A major issue currently facing the accounting profession is the effects of changes in organizational structures on CPA professionalism and ethical standards. Public accountants, like other professionals, historically worked in professional partnerships or sole proprietorships. For many years professional accounting associations effectively controlled the form of CPA organizations through explicit, formal restrictions. Non-CPA ownership of public accounting firms was prohibited and "holding out" or advertising as a CPA was restricted to those employed by one of these firms. However, auditing or attestation is the only professional service for which CPAs have a legal monopoly and the right to place restrictions on the form of practice. Professional associations are therefore unable to dictate the organizational forms through which nonauditing services, such as tax preparation and consulting, are provided.
This lack of control over nonauditing services opened the door for financial service corporations to expand their menus to include accounting and consulting. In the past few years several publicly held "consolidators," including American Express and H&R Block, entered the public accounting market by acquiring the nonattestation practices of CPA firms. American Express mounted a successful legal attack on the "holding out" restrictions in Texas and Florida, and subsequently ran a series of TV commercials touting the fact that they employ CPAs (Pustorino and Rabinowitz 1997).
Given that the performance of attestation engagements is restricted to traditional CPA firms, the consolidators developed a variety of approaches that allow the CPA firm and the financial services corporation to legally coexist subsequent to the consolidation of their practices. In cases like American Express, the employees of the CPA firm work for the consolidator corporation, and the CPA practice leases office space and employees from the corporation to perform attestation engagements. In other cases like H&R Block, the employees continue to work for the CPA firm, and are leased on an as-needed basis to the consolidator corporation. The CPA firm partners still sign the audit reports and are usually employed by both the consolidator corporation and the CPA firm, giving them dual employment status (Independence Standards Board [ISB] 1999).
These arrangements, commonly referred to as alternative practice structures (APS), raise concerns about auditor independence and objectivity. Questions arise over issues such as appropriate compensation schemes for partners with dual employment status, potential financial relationships between the public corporation and audit clients of the CPA firm, and whether independence requirements should be extended to non-CPA supervisors of CPA employees (ISB 1999). Because it can be argued that, in substance, public corporations are performing audit engagements, at a recent New York State Board of Regents Conference on the Professions, the public accounting profession was criticized for allowing audits to be performed through these types of organizational arrangements (Huefner 2000).
Previous discussions of the consolidation movement focus primarily on the implications of APS arrangements for auditor independence (Huefner 1998). This article suggests that corporate ownership poses additional threats to CPA professionalism and ethics. For example, if consolidation places CPAs under the effective control of nonprofessional managers of publicly owned corporations, it may place greater emphasis on commercialism and profitability, in lieu of traditional professional values such as objectivity and integrity. As consolidators grow in size and influence, they may adopt strategies aimed at modifying accepted standards of performance in public accounting. This article develops the case for specific research questions relating to these issues.
CORPORATIZATION AND THE CHANGING FACE OF PROFESSIONALISM
Throughout the latter half of the 20th Century, the U.S. witnessed a societal trend toward the "corporatization" or "bureaucratization" of professions (Hall 1968; Abbott 1991). Arguably, this trend has the effect of delegitimizing professions and forcing many professionals to adopt a more commercial orientation. (1) In many respected professions, such as engineering and teaching, the classic model of the self-employed, autonomous professional never existed (Freidson 1984; Abbott 1988). But even in the legal and medical professions, this formerly prevalent model is now largely supplanted by salaried employment in corporate or state bureaucracies (Abbott 1988; Derber and Schwartz 1991).
Several factors contributed to this shift in organizational arrangements. For example, the profitable markets for professional services became increasingly attractive to corporate enterprises. Professional production and marketing also became more dependent on sophisticated technology and requires a greater level of institutional resources found in corporations (Abbott 1991; Derber and Schwartz 1991). Consequently, many professionals are unable to maintain their economic independence and are employed by bureaucratic organizations. Although most professions manage to maintain their authority over a circumscribed body of technical knowledge within their employing organizations, they arguably are forced to relinquish control over many of the social and moral aspects of their work. As observed by Abbott (1991), many professions have seen a shift from a legitimacy based on character to one based on technique.
In service-oriented professions such as medicine and law, corporatization often results in the loss of control over policies toward clients, including choices of clients to serve, services to provide, and fee policies. For instance, the growing prevalence of salaried employment in for-profit health care organizations considerably reduced physicians' autonomy. They now often face bureaucratic restrictions on the types of services prescribed, and have virtually no discretion over fee policies for individual patients. Empirical studies indicate that corporatization shifts the primary norms and emphases of the medical profession from quality care and service of the public interest to organizational objectives such as cost containment and profit maximization (Alexander and D'Aunno 1990). Corporatization is also extensively debated in the legal profession (Flood 1989; Adams and Matheson 1998), as attorneys now face the specter of employment in multidisciplinary practice units controlled by nonprofessionals.
Early models for embedding professionals within organizations assume that professionals continue to control professionals, even within bureaucratic settings (Leicht and Fennell 1997). For instance, Hall (1968) suggests that professionals can maintain a relatively high degree of autonomy within large bureaucratic organizations, provided those organizations are administered and controlled primarily by the members of a single profession. Freidson (1984) also argues that as long as the control of work remains in the hands of professionals there is no serious threat of deprofessionalization. However, the trend toward the corporatization of professional labor markets led Leicht and Fennell (1997, 219) to suggest that, "at present, indications are that...professional work is slipping firmly into the realm of corporate and bureaucratic control."
The consolidation movement in public accounting reflects this broader societal trend toward professionals' loss of control over their work. Corporatization of highly respected and autonomous professions like medicine makes it more difficult for fields such as accounting to argue a strong case for the necessity of professional privileges, such as prohibitions against non-CPA ownership. As corporatization spreads to professions like accounting, the effect is likely to be similar to that experienced in medicine, with individual practitioners forced to adopt an increasingly commercial orientation.
ALTERNATIVE PRACTICE STRUCTURES: THE CORPORATIZATION OF PUBLIC ACCOUNTING?
Consolidation of CPA Firms
Several evolving forms of organization exist in the public accounting profession today. Even most traditional professional partnerships transformed themselves into large, multiline professional service firms that employ members of many occupations, including accounting, law, information technology, and engineering (Frank et al. 200 1).2 Although each evolving form of firm structure and organization has its own implications for CPA professionalism and ethics, this article focuses on the developing trend toward the use of alternative practice structures, or the consolidation of CPA firms by commercial corporations.
Corporate ownership of CPA firms is one of the most recent and controversial developments affecting the structure and organization of public accounting practices (Huefner 1998, 2000; Goldwasser 1999). A typical corporate purchase of a public accounting firm is structured as follows (ISB 1999): (3)
(1.) Typically a publicly owned company (Public Co.) buys the nonaudit practice of a CPA firm for cash, stock, or a combination of cash and stock. The amount realized by the CPA firm partners is often subject to the future profitability of the business, pursuant to "earn-out" agreements.
(2.) Public Co. usually has several subsidiaries, such as a bank, an insurance company, a securities broker-dealer, and a professional services unit that offers public accounting services in tax planning and consulting.
(3.) Partners and employees of the acquired CPA firm become employees of Public Co., and provide clients with nonaudit accounting and consulting services under the Public Co. name.
(4.) The original CPA firm's audit practice continues in existence (Audit Firm), and is owned by some or all of its original partners. Because the original Audit Firm partners are also employed by Public Co., they have dual employment status.
(5.) Audit Firm provides services by leasing staff below the partner level from Public Co., and paying administrative fees to Public Co. for office space and equipment, secretarial support, and advertising. Audit Firm partners supervise the audit work and sign the audit reports in the partnership name. Audit Firm is legally and financially responsible for this work.
(6.) This transaction may be replicated so that there are several Audit Firms affiliated with Public Co., or these firms may be merged into a single audit firm.
Often-cited motivations for CPA firms to sell their practices to financial service corporations include access to the equity capital needed for technology investments, the ability to develop specialized expertise afforded by larger organizations, greater ability to attract and retain highly qualified personnel, and obtaining funding for partner retirement obligations (ISB 1999). These motivations suggest that, like many other professionals, CPAs find it increasingly difficult to maintain their economic independence in an age of transition to large-scale enterprises. Although consolidation into commercial corporations may provide immediate economic benefits for small CPA firms, it threatens autonomy and traditional adherence to professional standards.
Implications for CPA Professionalism and Ethics
The potential conflict between professional and organizational values resulting from the bureaucratic employment of accountants has been recognized and investigated for many years (Aranya and Ferris 1984; Kalbers and Fogarty 1995). However, corporate ownership of CPA firms is a relatively new development with the potential to significantly impact the professionalism and ethics of public accountants. If the current consolidation movement continues, for the first time a significant number of CPAs who serve the public will be employed by commercial corporations and controlled by nonprofessionals. The public accountant plays a greater role in serving and protecting the public interest than do other accounting professionals. Corporate employment may threaten the ability to appropriately discharge this responsibility by creating and rewarding a more commercial orientation among CPAs.
Most concerns expressed in the accounting literature regarding the effects of corporate ownership focus on potential impairments of auditor independence and objectivity. However, greater commercialism has the potential to undermine professional standards for other public accounting services as well. Commercial corporations may pressure CPAs to be more aggressive in generating revenues from tax preparation services, leading to advocating more aggressive return positions in the hope of satisfying clients. For example, a recent series of TV and radio commercials by a corporate tax preparation chain claims that their clients' refunds exceed those received by the clients of a major competitor. Such blatant commercialism certainly violates the spirit, if not the letter, of CPAs' professional standards. Nevertheless, due to competitive pressures, it may only be a matter of time until CPA firm consolidators are running similar advertisements in a wide-open competition for clients attracted by such results.
Corporate managers may also place more emphasis on the cross-selling of other products and services to CPA firm clients. An often-cited benefit of acquiring CPA firms is that it allows financial service corporations to provide their clients with "one-stop shopping" for all their financial needs (Craig 2000). Despite this potential convenience, an increased emphasis on selling commission-generating products to CPA firm clients may lead to a loss of public confidence in CPA integrity and objectivity. Many still believe that commissions are inconsistent with core values of the CPA profession, because they can provide an incentive to sell products that are not the best alternative for a particular client (Huefner 1999). Although this controversial practice is allowed by accountancy laws in all but eight U.S. jurisdictions (Krugmann 2000), a CPA firm cannot be independent of an audit client from which the firm accepts commissions (AICPA 2001b).
Some observers see the pressure to sell a variety of products to public accounting clients increasing in publicly held corporations, due to greater pressure for earnings and profitability (ISB 1999). With public accountants' integrity being openly questioned by regulators and the financial press (Bartlett 1998; Levitt 1998), an increased emphasis on commercialism does not portend well for the future of the profession.
RESEARCH QUESTION DEVELOPMENT
This section outlines the major areas where academic research could clarify the relationship between the organizational structure of accounting practices and their ability to serve the public interest. We separate the discussion into organizational governance and control issues, individual responses to organizational environments, organizational strategies for coping with institutional constraints, and auditor independence and objectivity issues. (4)
Organizational Governance and Control Issues
A critical issue arising from corporate ownership of CPA firms is the effect of these new organizational arrangements on the supervision and control of public accounting work. Barley and Tolbert (1991) distinguish between two broad types of processes that meld organizations and professions together. The first is the bureaucratization of occupations, which occurs when professions become so specialized that there is an enduring division of labor among their members. Such specialization creates the need for an increasingly formalized organization, which serves as a mechanism for integrating professional disciplines. However, since these organizations tend to be staffed and administered primarily by members of a single profession, they are not a serious departure from the ideal of the autonomous professional organization (cf. Hall 1968).
The second process through which organizations and professions are integrated is the occupationalization of organizations, in which authority for organizational functions becomes vested in particular occupational groups. Within this category, considerable variation exists in the relative power of organizations and professions. For instance, key administrative policies in universities and hospitals are usually heavily influenced by professors and physicians, respectively. These differ from professional enclaves within organizations, such as the legal, accounting, and research and development departments found within most large corporations. Such islands of professional activity are often administered based on professionally defined standards and practices, and typically have the status of a formal subunit that is granted authority over a circumscribed organizational domain. Nevertheless, the influence of occupational or professional standards is clearly restricted by the subunit's role in the larger organizati on and by the specific ways that the professional group is asked to serve the corporate mission (Hall 1968; Barley and Tolbert 1991).
Until recently, large public accounting firms were similar to bureaucratized occupations. Although clear divisions of labor existed in these organizations as a result of specializing in audit, tax, or consulting, they were staffed and administered primarily by CPAs. Over the past few decades, CPAs arguably lost some of their control. As firms expanded into nontraditional services, expertise of other sorts became highly valued, eventually leading to increased prevalence of non-CPA owners or pseudo-owners. These organizations are often criticized for adopting an increasingly commercial orientation in their quest for continual growth and expansion into new service lines (Public Oversight Board 2000). Because all U.S. jurisdictions still require that licensed CPAs own at least a simple majority of the equity interests in public accounting firms, though, these firms are still controlled by members of the accounting profession.
APS arrangements raise questions about organizational governance and control. Although attestation practices must be maintained in CPA firms, professional services units that provide tax preparation, financial planning, and consulting may have an organizational status similar to professional departments within corporations. However, unlike most professional departments that grew from within, these new units were from autonomous professional groups imported into corporate bureaucracies. Consequently, their values and ideology may conflict with those of their parent company (cf. Barley and Tolbert 1991). How such conflicts are resolved depends on which group's values are dominant. Social psychology generally predicts that organizational values and goals dominate those of individuals. For instance, theories of ethical decision making in organizations commonly acknowledge the influence of organizational value systems on individual decision making and behavior (Hunt and Vitell 1986).
Determining the extent to which CPAs are influenced and controlled by nonprofessionals and the impact of such influence on their professionalism and ethics requires detailed study of the social and economic structures of the organizations in question, including their modes of organization and management techniques. These issues are not adequately addressed for traditional audit firms (Hopwood 1998), let alone for the emerging CPA firm consolidators. Specific issues to be addressed include the following:
Research Question 1: What types of organizational governance and control mechanisms exist in financial service conglomerates that provide public accounting services? Do they allow for effective control of the public accounting practice by CPAs? Do CPAs employed by these organizations have more or less professional autonomy than those employed in similar positions within professional partnerships?
Research Question 2: How does corporate employment affect the relationship between public accounting professionals and their employers? How are CPAs with dual employment status compensated by their Audit Firms and Public Co. employers? Do these compensation arrangements pose threats to professionalism and ethics that differ from those found in professional partnerships?
Research Question 3: How does corporate employment affect the relationship between public accounting professionals and their clients? Do CPAs employed by financial service corporations face different pressures to market financial products and services to their clients than CPAs who work in professional partnerships? If so, what is the nature of those pressures and what is their effect on the practitioners' professionalism and ethics?
Individual Responses to the Organizational Environment
Derber (1982) suggests that professionals' loss of control over their work leads to their ideological desensitization. This view claims that professionals disengage themselves from any moral, ethical, or social issues relating to their work, and develop a preoccupation with technical skills and knowledge. By abdicating responsibility for the social and ethical implications of their work to their employer, professionals separate themselves from the ideological context of their jobs. Derber (1982) argues that ideological desensitization is a widespread phenomenon in the labor force as a whole. He cites studies supporting the contention that industrial workers generally focus on extrinsic rewards, and exhibit little concern over the social uses or implications of their work product.
Professionals are historically distinguished from nonprofessionals by their focus on intrinsic rewards arising from their work, including serving the public interest and maintaining high ethical standards. This view of professionals suggests that they resist ideological desensitization. Nevertheless, studies document desensitization among professionals that begins as early as the professional education process (Becker and Geer 1958). These findings indicate that the socialization process in many fields does not sufficiently support the idealism of professional recruits.
Ideological desensitization is a defensive response to the loss of control over professional work. By focusing primarily on the development of their technical knowledge and skills, and avoiding recognition of the moral aspects of their work, professionals avoid value conflicts. Another accommodative response to organizational-professional conflict is ideological co-optation, which involves redefining one's goals and objectives to make them compatible with those of the employing organization (Derber 1982). Professionals who adopt this defensive mechanism become increasingly committed to organizational goals and objectives, and less concerned with professional interests. While they may maintain a separate professional identity based on licensing or certification and membership in professional groups, this identity is associated primarily with technical expertise, not the ideals and values of practice.
Ideological desensitization and co-optation of professionals in bureaucratic organizations are part of the broader organizational socialization process. Research finds that socialization processes have a significant influence on professionalism and ethics even in traditional public accounting firms. For example, Ponemon (1992) concludes that employees holding higher ranks in CPA firms possess lower and more homogeneous levels of cognitive moral development, and that managers' promotion decisions in these firms are biased in favor of employees with moral development levels similar to their own. Other researchers, such as Chatman (1991), also document the presence of socialization effects in large public accounting firms, although this process remains poorly understood (Fogarty 1992). It could be argued that greater socialization effects are present in financial service corporations, since these organizations are controlled by nonprofessionals. However, resolution of this issue requires empirical studies of soc ialization within these organizational contexts.
Socialization effects such as desensitization and co-optation are defensive or accommodative mechanisms, whereby professional employees reconcile organizational and professional imperatives. If professionals cannot reconcile such conflicting demands, then they may exhibit negative behavioral responses, such as perceptions of organizational-professional conflict and lower job satisfaction. Organizational-professional conflict is present among accounting professionals employed in a variety of organizations, including traditional public accounting firms and corporate entities (Aranya and Ferris 1984; Kalbers and Fogarty 1995). Due to the likelihood of divergence between organizational and professional goals in financial service corporations, this type of conflict may be more prevalent in these settings.
Leicht and Fennell (1997) suggest that future research on the effects of the changing organizational contexts of professional work use cross-sectional comparisons of professionals working in different organizational settings. This approach is reflected in the following research questions that address the general issue of individual responses to their organizational environment:
Research Question 4: Do the selection/socialization processes within the professional services units of financial service corporations differ significantly from those found in professional partnerships? What are the effects of these differences on the professionalism and ethical standards of CPAs?
Research Question 5: Do accounting professionals employed by professional partnerships and those employed by financial service corporations exhibit different professional or commercial orientations? Do they exhibit different perceptions of organizational-professional conflict or related employment outcomes, such as work motivation and job satisfaction?
Organizational Responses to the Institutional Environment
Another issue with implications for CPA professionalism and ethics is the nature of the consolidators' strategic responses to their institutional environment. (5) Oliver (1991) proposes a typology of strategic responses to institutional pressures that includes acquiescence, compromise, avoidance, defiance, and manipulation. Acquiescence might involve mimicry of existing institutional models, or a conscious attempt to obey or incorporate institutional values and norms into the organization. Acquiescence is based on the perceived survival value of conformity with the institutional environment (Meyer and Rowan 1977). For example, if consolidators feel that the maintenance of traditional professional norms of behavior within their professional services unit will enhance their legitimacy and thereby contribute to their success, then they might initially adopt a strategy of acquiescence.
Although acquiescence appears to be the safest strategy in the short-term, consolidators may not maintain their unqualified support for CPAs' professional norms. Organizations forced to balance the competing objectives of different constituencies often engage in strategies of compromise (Oliver 1991). Consolidators may find such an approach necessary if they perceive the presence of competing demands from their shareholders who seek to maximize earnings and the CPA profession that seeks to maintain high professional standards. Organizations may also actively engage in bargaining with institutions to obtain concessions in their expectations. For example, consolidators may actively bargain with regulatory (IRS, SEC) or professional (AICPA) authorities to achieve reductions in their standards of performance or accountability. Compromising tactics are employed in the spirit of conformity with institutional norms, but in contrast to acquiescence, compliance is only partial.
Organizations finding institutional requirements to be too onerous might engage in strategies of avoidance (Meyer and Rowan 1977; Oliver 1991). Several possible avoidance strategies can be employed. Companies sometimes engage in concealment tactics to disguise noncompliance, such as "window dressing," ceremonial pretense, or merely symbolic acceptance of institutional norms. An example is the creation of internal standards such as formal codes of conduct that mirror institutional expectations, without an effective enforcement mechanism. Organizations may also adopt buffering strategies in which they attempt to insulate themselves from external review or scrutiny. This attempt may be combined with plans to escape or exit the domain within which pressure is exerted to avoid the necessity of compliance. The strategy of creating an artificial wall around the entity that performs audits could be seen as an example of avoidance by consolidators.
If an organization's objectives conflict sharply with institutional requirements or expectations, then strategies of active defiance of norms may be used (Oliver 1991). When the likelihood of external enforcement or sanctions is perceived to be low, the organization simply ignores or dismisses external standards. Organizations also actively challenge or even attack institutional requirements by belittling or denouncing them. Such strategies are more likely when the perceived cost of noncompliance is low and the organization feels that it can justify the rationality or righteousness of its actions. It is not expected that the regulations surrounding auditing are so weak and ineffectual that consolidators will pursue this strategy.
Manipulation is the most active response to institutional pressures, and may be defined as the intentional and opportunistic attempt to co-opt, influence, or control the organization's constituents (Oliver 1991). Because standards of acceptable performance are institutionally defined, they are subject to strategic renegotiation or reinterpretation. Co-optation may involve attempts to persuade constituents to join the organization or its board of directors, in order to neutralize institutional opposition and enhance the organization's legitimacy. For example, consolidators might ask leaders of the accounting profession to serve on their boards in an attempt to gain their tacit support. Organizations may also use various tactics to manipulate institutionalized norms and beliefs--lobbying to influence regulators to change performance standards or expectations is an example.
Financial service corporations' strategies for coping with their institutional environments will likely evolve over time, particularly if their power and influence increases. As they gain broader market acceptance, they may pursue more active strategies designed to manipulate or influence professional or regulatory standards. Few would argue with the assertion that large public accounting firms currently exert considerable influence over their institutional environment, and it may only be a matter of time until consolidators achieve similar power. Because these organizations are owned and operated by nonprofessionals, they may attempt to secure changes that relax professional standards and induce CPAs to adopt an increasingly commercial orientation. Detailed studies of consolidators' strategic initiatives within the institutional environment may illuminate these issues. The following research question addresses the general inquiry regarding consolidators' influence over their institutional environment. (6)
Research Question 6: What types of strategies will financial service corporations adopt to cope with institutional constraints on their operations? Will these strategies differ from those adopted by traditional professional partnerships? Will demands exist among consolidators' stakeholders to adopt strategies aimed toward the compromise or manipulation of professional standards? What impact will these developments have on the professionalism and ethics of other public accounting practitioners?
Auditor Independence and Objectivity
Perhaps the most immediate concern arising from corporate ownership of public accounting practices is the potential impact on auditor independence and objectivity. Auditing or attestation is a stronghold of professional autonomy in accounting, due to proscriptions against non-CPA ownership of auditing firms. However, the advent of alternative practice structures poses the threat of corporatization of the auditing profession, in economic substance if not in legal form. The issue of auditor independence within traditional CPA firms is the topic of much recent discussion and concern among regulators (POB 2000; SEC 2000). However, independence concerns appear to be even more salient in the context of APSs.
Threats to Independence
Questions are often raised about whether the "separate practice" units used in APS arrangements are in fact separate, or whether the acquiring company exerts effective control over related CPA firms (Goldwasser 1999). The employment of Audit Firm partners by Public Co., coupled with the fact that most of the audit revenues are transferred to Public Co. in the form of "lease payments" for employees and administrative services, suggests that Public Co. has a significant degree of control over Audit Firm. If this is the case, and Public Co. is permitted to have financial relationships with Audit Firm clients, then the potential to degrade independence and objectivity is great. The problem could be further exacerbated if Audit Firm partners own stock in Public Co., which is normally the case (ISB 1999). Under these circumstances, Audit Firm partners also have an incentive to avoid disputes with the audit client in order to maintain nonaudit revenues and maximize the value of their stock holdings.
Some observers also feel that employees of publicly owned corporations face greater pressure to meet earnings and profitability expectations (ISB 1999). In addition, corporate managers who are not CPAs do not fear the threat of professional disciplinary actions involving loss of license. Thus, they have less incentive to adhere to professional accounting standards when client disputes arise. Recent research suggests that the threat of disciplinary measures such as negative peer review results serves as a significant deterrent to unethical behavior by CPA/auditors (Shafer et al. 1999). It seems unlikely that the threat of professional disciplinary measures will have a similar deterrent effect for nonprofessionals. Consequently, if CPA/auditors are supervised by corporate managers not subject to independence requirements, the potential for conflict between organizational and professional values is relatively high.
As the foregoing discussion suggests, the issue of what parties to extend the independence requirements to is of paramount importance in APS arrangements. For instance, should the requirements apply to all employees and managers of publicly held consolidators, or only to those individuals in a position to influence the outcome of the audit? In addition to the corporate entity and its subsidiaries, should the restrictions also extend to major shareholders of these companies?
To illustrate the types of relationships between financial service corporations and clients of affiliated CPA firms that could impair auditor independence and objectivity, consider the following scenarios (ISB 1999):
1. A broker/dealer subsidiary of Public Co. wishes to sell financial products, such as mutual fund shares, to a client of Audit Firm. Under these circumstances, Public Co. would earn commissions prohibited for Audit Firm.
2. A financial institution subsidiary of Public Co. could make a loan to a client of Audit Firm. Audit Firm is prohibited from making such a loan directly, since it gives the firm a vested interest in the financial well being of the client.
3. An accounting subsidiary of Public Co. desires to provide bookkeeping services for Audit Firm clients. CPA firms cannot provide extensive accounting or bookkeeping services for publicly held audit clients, since this places them in a position of opining on their own work.
4. A subsidiary of Public Co. wants to provide retirement plan management services for Audit Firm clients, which could entail having custody of plan assets and authority to make investments of those assets. Such services violate independence if performed by Audit Firm, because they involve functions similar to those of a client employee or manager.
Current and Potential Safeguards
The potential for conflicts of interest prompts some observers to suggest that Public Co. not be permitted to have any relationships with Audit Firm clients that are proscribed for Audit Firm itself (ISB 1999). In essence, this is the approach adopted by the SEC. The Commission's definition of "accounting firm" includes any entity engaged in the practice of public accounting that furnishes reports or other documents filed with the SEC, and all of the organization's departments, divisions, parents, subsidiaries, and "associated entities" (SEC 2000). Also included in the SEC guidance on this issue are three letters dated November 2, 1998, addressed to employees of American Express Financial Advisors, Century Business Services Inc, and H&R Block Business Services (SEC 1998). These letters indicate that, pending further guidance from the ISB, "any accounting firm and the acquirer...of that accounting firm that employs any accountants that work on SEC clients of the accounting firm should continue to fully comply with the SEC's independence requirements" (SEC 1998).
The ISB ceased operations on July 31, 2001 with the aforementioned guidance in effect (ISB 2001). Accordingly, business relationships prohibited for an Audit Firm are also prohibited for consolidators that acquired the nonattestation practice of a predecessor firm, provided accounting employees of the consolidator work on the audits of SEC registrants. This suggests that dual employment of Audit Firm partners or employee leasing arrangements between the Audit Firm and consolidators extends the auditor independence requirements to Public Co. However, since the SEC regulations only apply to audits of publicly held companies, CPAs must look to the guidance of the AICPA and their state boards of accountancy for engagements involving nonpublic clients.
In the latest revision of its Code of Professional Conduct, the AICPA (2001a) shifts from a firm focus to an engagement team focus in the definition of "covered members" for purposes of determining independence on attestation engagements. Under the new rules, covered members include: (1) individuals on the attest engagement team; (2) individuals in a position to influence the attest engagement; (3) any partner or manager who provides more than 10 hours of nonattest services to the attest client; (4) any partner practicing in the same office in which the lead attest engagement partner practices; (5) the firm, including its employee benefit plans; and (6) any entity that can be controlled by a covered member (AICPA 2001a). The definition of "member" in an APS includes all individuals who qualify under the above rules, regardless of whether they are permanent employees of Audit Firm or they are leased from Public Co. or another entity. We summarize the rules with respect to persons and entities other than member s as follows (AICPA 2001b, ET 101.16):
1. Direct Superiors. All independence restrictions that apply to members also apply to Public Co. employees who are direct superiors of members. Direct superiors are defined as persons who can directly control the activities of either Audit Firm partners or Audit Firm employees with managerial positions in an Audit Firm office that participates in a significant portion of the engagement. In addition, all independence restrictions are extended to all entities that can be significantly influenced by direct superiors.
2. Indirect Superiors and Other Public Co. Entities. All independence restrictions are also extended to indirect superiors and other Public Co. entities, but only if their relationships with the audit client are material. Indirect superiors are defined as Public Co. employees at least one level above direct superiors in the organizational chain of command. To establish materiality for relationships between indirect superiors and an audit client, all such relationships must be aggregated and assessed in relation to the indirect superior's net worth. In the case of relationships between other Public Co. entities and an audit client, all such relationships are aggregated and assessed in relation to the consolidated financial statements of Public Co. In addition, indirect superiors and other Public Co. entities should not be able to exert significant influence over audit clients, and no Public Co. entity or employee can be connected with an audit client as a promoter, underwriter, voting trustee, director, or off icer.
Some question whether the AICPA rules are sufficient to ensure auditor independence (ISB 1999). The rules permit subsidiaries of Public Co. to provide nonaudit services to clients of Audit Firm, provided the amounts involved are not material to the consolidated financial statements of Public Co. However, profit and loss contributions that are considered immaterial to the consolidated entity's financial statements can nevertheless have a significant impact on the performance evaluations of subunit managers, who might be in a position to exert some influence over Audit Firm partners. Under the AICPA rules, indirect superiors of audit partners could also own "immaterial" stock investments in an audit client. Many argue that, under these circumstances, it seems likely that superiors have an incentive to dissuade the auditors from issuing an unfavorable opinion on the client's financial statements, despite the immaterial impact on their personal net worth.
There are other measures that could be taken by the consolidators to mitigate auditor independence concerns. For example, in its Discussion Memorandum on APS, the ISB (1999) identifies potential safeguards designed to preserve auditor independence and objectivity, including the following policies:
1. Management of Public Co.'s professional services subsidiary by CPAs. This policy is founded on the belief that licensed CPAs are more likely to understand ethical standards and work to preserve the professionalism of the independent auditor. CPA managers may also offer some protection against pressure from non-CPA corporate employees.
2. Separate CPA management of Audit Firm and the professional services subsidiary of Public Co. This suggestion is based on the belief that, if top management of Audit Firm is also responsible for promoting the financial interests of the corporate entity, then this could lead to conflicts between organizational and professional duties. For instance, CPAs with dual management responsibilities might be motivated to compromise audit quality in order to increase revenues from nonaudit services provided by the corporate entity.
3. Separate and distinct names, logos, and marketing for Audit Firm and the professional services subsidiary, to maintain the appearance of auditor independence. When the entities serve joint clients, they could also use separate engagement letters and invoices.
4. Flexible employee leasing and administrative agreements that allow Audit Firm to choose between hiring its own staff and administrative personnel, purchasing these services from Public Co., or purchasing them from other providers. Fees charged under leasing and administrative agreements should be based on fair market rates to avoid profit sharing. For example, payment of excessive rates allows Public Co. to realize all or part of the profit from the audit engagement.
5. Adoption of quality control standards by the professional services subsidiary to ensure that all employees closely associated with Audit Firm understand auditor independence requirements.
However, the effect of such policies on auditor independence and objectivity remains an open question, particularly because of the dearth of empirical evidence on the extent to which consolidators are implementing these types of policies, and their perceived effectiveness. These observations suggest the following research question:
Research Question 7: What types of safeguards do CPA firm consolidators have in place to mitigate threats to auditor independence? What types of quality control standards have the consolidators implemented to ensure that employees closely associated with Audit Firm understand independence requirements? How effective are these policies?
User Perceptions of Independence
In addition to threats to actual auditor independence, APS arrangements may reduce public confidence in the integrity and reliability of audited financial statements. Professional auditing standards recognize that independence in fact and appearance is critical for maintaining public confidence in the financial-reporting process (AICPA 2001b, AU 220.03). In an APS, the Public Co. may provide virtually all the professionals and resources to perform the audit. Under these circumstances, the ability to maintain public confidence in the audit process is questionable, particularly when the financial statement users are aware of financial or other relationships between Public Co. and the audit client (ISB 1999). The SEC addressed this issue by requiring disclosure of instances where the percentage of audit hours spent on an engagement by persons other than full-time, permanent employees of Audit Firm exceeds 50 percent (SEC 2000). Such disclosures provide information that market participants may consider relevant in evaluating auditor independence. However, understanding the effects of such information on user perceptions must await empirical study. Concerns regarding user perceptions of auditor independence raise the following research question:
Research Question 8: Do APS arrangements affect user perceptions of auditor independence? Specific issues regarding user perceptions include (cf. ISB 1999):
a. Do relationships between Public Co. employers and clients of affiliated Audit Firms affect perceptions of independence? Does the materiality of these relationships matter?
b. Do perceptions differ when Audit Firm partners own a significant portion of Public Co.'s stock, and the investments are material to the partners?
c. Do relationships between Public Co. officers, directors, or significant shareholders and clients of affiliated Audit Firms affect perceptions of independence? Does the materiality of these relationships matter?
d. What are the effects of employee leasing and administrative arrangements on perceptions of auditor independence? Do perceptions differ depending on factors such as the flexibility of these arrangements?
e. What are the perceived effects of potential safeguards against the loss of auditor independence in APS arrangements?
This article argues that the emerging trend toward corporate ownership of CPA firms has important implications for professionalism and ethics in public accounting. If CPAs are under the effective control of nonprofessional managers of publicly owned corporations, then professional ideals may be subordinated to organizational objectives such as commercialism and profitability. Assessing the effects of the transition of public accounting practice from organizations owned and operated by professionals to publicly held financial service corporations requires detailed study of the social and economic structures of these organizations. Future research on the effects of this transition on CPA professionalism and ethical standards should provide insights into the benefits, if any, of the classic professional model that proscribes non-CPA ownership of public accounting practices. Although it is frequently argued that salaried employment in bureaucratic organizations contributes to the decline of professional standards , inadequate attention is paid to the nature of the processes involved when professional roles change (Greenwood and Lachman 1996). Accordingly, detailed studies of changes in the nature of professional control resulting from CPA firm consolidations are necessary to provide a solid basis for policy decisions on this issue.
Submitted: June 2001
Accepted: January 2002
(1.) The discussion in this section assumes, in line with much of the literature on professions, that corporatization or bureaucratization contributes to the delegitimization of professional roles. Although other social or economic forces may also contribute to these developments, these factors are beyond the scope of the current paper.
(2.) In an apparent effort to allay independence concerns, some of these firms recently began "spinning-off" their consulting divisions by selling shares in those specific businesses to public or private investors and retaining a minority ownership interest.
(3.) The corporate purchase transaction described here is presented simply to illustrate one common form of APS arrangement. Significant differences among these transactions are found in practice. For instance, in some cases the public accounting personnel remain employed by Audit Firm, and are leased on an as-needed basis to the corporate entity.
(4.) For ease of exposition, this section assumes that all APS arrangements are essentially the same. The potential for significant structural or cultural variations among the consolidators suggests that research issues involving differences between APSs and traditional professional partnerships also be extended to the study of variations among organizations that pursue APS arrangements.
(5.) Following Oliver (1991), the institutional environment is defined as regulatory structures, governmental regulations, and professional demands.
(6.) We recognize that this issue is future-oriented, and empirical studies may need to await further developments in the consolidation movement. However, it addresses a concern of which accounting researchers should be aware.
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William E. Shafer is a Professor at Pepperdine University, D. Jordan Lowe is an Associate Professor at the University of Nevada, Las Vegas, and Timothy J. Fogarty is a Professor at Case Western Reserve University.
Corresponding author: William E. Shafer
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|Author:||Shafer, William E.; Lowe, D. Jordan; Fogarty, Timothy J.|
|Date:||Jun 1, 2002|
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