David A. Brown, Q.C.
Chair, Ontario Securities Commission
Submission to SEC Auditor Independence Hearing
Wednesday, September 13, 2000
New York, New York
I am pleased to have the opportunity to present the perspective of another North American securities regulator on the important issue of auditor independence.
A key element of the Ontario Securities Commission's legislated mandate is to foster fair and efficient capital markets and confidence in those capital markets. In recent months, we have seen a growing erosion of public confidence in the reliability of the audited financial statement. We are told that sophisticated investors and analysts now place far less reliance on audited statements, preferring instead to develop their own independent views of a company's prospects. But the resources necessary to conduct such exercises are far beyond the means of the average investor.
Although the reasons for this erosion in confidence in the audited statement are likely complex, I believe that a significant factor is a loss of confidence in the auditor as a figure sufficiently independent of company management. Auditor independence is a significant concern to the OSC for the same reason that it is a concern in the United States: the investing public must have confidence in the auditor's ability to exercise objective and independent judgement in difficult situations.
Objectivity is fundamental to the integrity of the external audit. The auditor must avoid both real and perceived impediments to his or her ability to say "no" to management of the corporation being audited. Anything that dilutes either the reality or the perception of objectivity undermines the system. In Canada, for example, the rules of professional conduct for auditors require that they avoid any situation that impairs professional judgement or objectivity or that, in the view of a reasonable observer, would impair professional judgement or objectivity.
The importance of the perception of auditor independence and objectivity cannot be overstated. Audited financial statements are the cornerstone of our disclosure system and the public has to come to place a large measure of reliance on them, in part because of the credibility lent by the report of an independent auditor. This is particularly important in the context of Canadian accounting standards, which place greater reliance on a framework of sound principles rather than the more detailed and specific rules commonly found in the U.S. The inevitable greater scope for auditors to exercise discretionary judgement increases the need for independence in both fact and appearance. As public confidence in the critical role of auditors erodes, investors will be less inclined to rely on audited financial statements and will continue to seek other sources of information in which they believe they can have greater confidence.
The credibility that the auditor lends to financial statements derives from two things - both of which are essential if the audit is to be valued. First, that the auditor is recognised as having the necessary professional expertise to gather and critically evaluate evidence validating the information presented in the financial statements. Second, that the auditor brings to bear an objective state of mind in forming an opinion as to the integrity of management's portrayal of financial performance. Indeed, in my view, the presence of these two factors is fundamental in all aspects of the assurance services segment of the practices of public accounting firms.
While there is certainly scope for healthy debate about the most appropriate way for auditing techniques to evolve, I believe the professional expertise that the public accounting profession brings to its task is largely unquestioned. In contrast, investors seem to be voicing growing concern about potential impediments to the auditor's ability to exercise objectivity and independent judgement.
Unfortunately, no matter what steps we take as regulators, we can never know with certainty that an auditor will be prepared to say "no" under pressure. The reality of independence is a difficult, if not impossible, concept for the public to evaluate and the regulator to regulate. Perceptions of independence therefore become almost equal to reality in their importance.
When it comes to perceptions, I am concerned that consulting relationships and audit responsibilities can be seen as fundamentally at odds with each other. In most circumstances, consultants are hired by management of the corporation. Management works on an ongoing, frequent basis with the consultants - determining their assignments, critiquing their work, reaching agreement on recommendations and approving their fees. The result can be a relationship of consultant loyalty, a commonality of interest, and potentially an element of financial dependence.
In the case of large accounting firms, the incentive to accommodate their audit clients is growing as firms expand their range of services and consulting businesses. Firms may become beholden to their clients in areas that are far more lucrative than the basic audit functions. I am concerned that the audit may become little more than a loss leader as the accounting firms leverage the audit relationship to cross-sell higher margin services. In these circumstances, it seems only natural for shareholders to question whether they can have confidence in the audit when it is carried out by a firm that spends much of the year taking direction from the same managers they are supposed to scrutinize.
The interrelationships within the accounting firms between the audit and consulting sides of the practice may also raise significant issues. As accounting firms have become large multi-disciplinary businesses, and audits have become comparatively less lucrative, it seems likely that auditors will less frequently play the lead role in the partnership. This has two effects: first, partners from other divisions of the firm are more likely to be driving the partnership, and making strategic decisions about client relationships; second, if this trend continues, firms are likely to have difficulty recruiting new talent for the audit department, particularly if new recruits get a sense that other areas of the firm are more highly valued by firm management.
I want to raise two additional points for consideration as part of the larger picture of improving corporate governance.
First, the regulation of independence cannot be sufficient by itself. The mechanisms that the SEC has encouraged to be put in place in the U.S. to ensure that the audit committee exercises effective oversight over the independence of the auditor are an important part of promoting the reality of independence. The audit committee is on the front line and is therefore best placed to identify telltale signs that may suggest the reality of independence is being impaired.
In Canada, the country's two largest stock exchanges and the national body that regulates the accounting profession have created a committee to review the current state of corporate governance in Canada. It is the OSC's hope that this committee will examine the initiatives taken in the U.S. on the recommendations of your "Blue Ribbon Panel" and make recommendations for change that will strengthen the role of audit committees. If public confidence is to improve, audit committees must demonstrate confidence when they report to their full Boards that they have done a thorough job of assessing accounting and disclosure practices and assessing the auditor's independence.
Second, I am hopeful the SEC as an active participant in IOSCO will participate with securities regulators in other countries in building an international consensus on a sound approach to these important issues, which are not unique to North American capital markets. This is particularly important because the extent of direct and indirect participation of foreign companies in U.S. capital markets is such that independence standards established by the SEC will have significant implications in other countries.
For more than a year, the OSC has publicly raised concerns about the issue of auditor independence. We have discussed our concerns with individual firms and the profession's self-regulatory associations and challenged them to find a solution that addresses the issues. So far, the industry has not produced a proposal for consideration.
Although we have not begun to frame a regulatory solution, it is becoming increasingly evident in Canada that some form of regulatory involvement in a solution will be essential. Since most of Canada's large public accounting firms are based in the U.S., the SEC's auditor independence rules will likely shape the corporate governance structure of their Canadian counterparts. Therefore, we are following the SEC's proposal with great interest and will formulate our regulatory response based partly on your experience.