Prepared Statement of Douglas R. Carmichael
Securities and Exchange Commission Hearings on Release No. 33-7872
(July 26, 2000)
Revision of the Commission's Auditor Independence Requirements
I am Douglas R. Carmichael, the Wollman Distinguished Professor of Accountancy at Baruch College (CUNY). Thank you for the privilege of commenting on the proposed revision of the Commission's independence requirements for auditors.
My comments are based on my experience, research, and writing over the last thirty years. My first published article on independence concerned the effect of management, or consulting, services on independence. It appeared in 1968. However, my comments today - unlike that article - are not an academic treatise. Rather they are based on the following first-hand experience:
The proposed approach of articulating basic principles and building implementation guidance on them is a sound and essential improvement. The current independence requirements have been criticized as being too rule-oriented and resulting in auditors viewing independence as a list of things to avoid rather than a positive obligation that is an integral part of a professional credo.
The essence of independence is feeling a keen sense of responsibility to users of audited financial statements to apply objective judgment to difficult financial reporting and auditing issues. Increasingly detailed rules have, in fact, taken on a life of their own and detract from independence as a core value.
The proposed approach of articulating the basic principles and building implementation guidance on them will go a long way toward changing auditors' viewpoints and restoring independence as a core value.
The four basic principles are appropriate and comprehensive. The basic principle of no mutual or conflicting interest with the audit client has been criticized because -
This criticism is pedantic and takes too literal a view of the principle of mutual or conflicting interests. The basic principle is clearly directed at mutual or conflicting interests that would impair the auditor's ability to act in the interests of users of audited financial statements to ensure the information is reliable for decision making.
The possible additional principle of not subordinating professional judgment is not really a basic principle, but rather a natural result of not having a mutual interest that would impair objective judgment.
The rule proposal is a logical and integrated approach that should not be considered on a piecemeal basis. Some have criticized the proposal for coupling the liberalization of rules on investments by personnel of CPA firms with the more controversial restrictions on professional services to audit clients.
This is not a valid criticism. It is based on the clearly discredited view of independence as a collection of prohibitions with no underlying rationale. The rule proposal furnishes a supporting framework of basic principles. The changes in restrictions on investments and restrictions on services both flow logically from those basic principles. Separating the changes in restrictions on investments from other parts of the proposal would be a step backward.
Detailed evidence that consulting services have actually impaired independence should not be a prerequisite for restriction of these services. Critics of the proposal have stated that there is no evidence that a single audit has been compromised by the audit firm having performed consulting services for the client. They insist clear evidence of actual impairment of independence must exist before any consulting services can be prohibited. This criticism is coupled with the assertion that consulting actually improves audit quality because "the more you know about the client, the better the audit will be."
The remainder of my prepared remarks are directed to these criticisms because the restrictions on nonaudit services are not only the most controversial aspect of the proposal, but an aspect that is, in my opinion, integral to restoring independence as a core value of the auditing profession.
There is evidence that consulting services have impaired independence. The Cohen Commission report issued in 1978 expressed the conclusion of that independent group that in the Westec case, the provision of consulting services had impaired audit independence. The audit firm was extensively involved in the client's merger and acquisition program providing advice on making and structuring acquisitions and in providing accounting advice on the accounting treatment of acquisitions. The Cohen Commission concluded that these nonaudit services impaired audit independence. The conclusion was based on an extensive investigation that included examination of the underlying evidence and not just reading a legal opinion.
The SEC Practice Section (SECPS) of the AICPA subsequently adopted a membership requirement that prohibits merger and acquisition assistance for a finder's fee for public audit clients. This action was a necessary, but not a sufficient response. [As an aside, I suggest that merger and acquisition assistance be added to the proposal's list of prohibited nonaudit services.] My point is not, however, that this one type of service must be prohibited, but that there was evidence that consulting services could impair independence that has been systematically ignored by those who advocate no restrictions on nonaudit services.
Also, I want to make clear that I am not suggesting that one case that occurred some years ago is by itself sufficient to meet the critics call for substantial concrete evidence of impairment of audit independence from consulting. However, I believe there are several aspects of the Cohen Commission's conclusion worth highlighting.
Even though the Cohen Commission concluded that there was at least one clear instance of actual impairment of audit independence by consulting services, every AICPA committee or POB committee that has spoken on the topic has refused to acknowledge the existence of the conclusion. Throughout the time since 1978, there has been a constant refrain that there has never been a single instance in which consulting practice has compromised audit independence. At a minimum, there is reason to question the intellectual honesty of those who continued to espouse this false position.
Having steadfastly ignored the Cohen Commission's conclusion for over thirty years, these groups are likely to say today that one case over thirty years old is not a sufficient basis to set policy. However, there are important reasons that a current case with a "smoking gun" is not likely to be found in the current litigation environment.
The realities of litigation against independent auditors make it unlikely that a "smoking gun" linking impaired independence and consulting services will be documented. To begin with, most cases are settled rather than being litigated to a conclusion. For example, teachers in California recently sued KPMG Peat Marwick for losses suffered as limited partners of real estate ventures run by the Teachers Management and Investment Corporation and audited by KPMG. Several conflicts of interest were alleged, including that lucrative consulting work for the client and the prospect of future consulting assignments impaired audit independence. This case was scheduled for trial in early 1998, but was settled shortly before it was due to begin. When cases are settled and records sealed, the ability to document likely instances of impairment is seriously impeded.
When cases are litigated to a conclusion, the plaintiff's lawyers must focus on proving the audited financial statements were materially misstated and that a proper audit would have detected the misstatement. Because independence in fact is ultimately a state of mind, an impairment of independence for any reason is extremely difficult to prove by clear and convincing evidence; and, for that reason, it is typically not even alleged. Lawyers and experts are understandably sensitive about making allegations that a judge or jury may regard as not having been clearly proven. Doing so can weaken an otherwise solid case.
In the AUSA v. Ernst & Young (1994) case, for example, the federal judge who decided the case in the initial trial clearly concluded that the auditor lacked independence. Among other blasts at the audit partner's lack of backbone, he stated: "Obviously an audit becomes a pointless exercise if the auditor, after discovering substantial errors in a publicly owned company's financial statements supinely acquiesces in the client's refusal to correct the errors and certifies the statements anyway." Even though the CPA firm had provided substantial consulting services to the client and had other potential conflicts of interest, the plaintiffs' expert did not testify at trial about any alleged lack of independence. When I asked the plaintiffs' attorney and expert why this lack of independence issue was not raised at trial, they said - why struggle to get to first base on proving lack of independence when you have a home run based on the poor quality of the audit.
Finally, I'd like to relate my own experience in a case that I'm currently working on. The auditor failed to adequately investigate an audit difference detected near the conclusion of the audit. At the same time, the firm was negotiating with the client for a large consulting engagement. Was the failure to pursue adequate evidence caused by the knowledge that the consulting engagement would likely be lost if the client became angered at the delay in the earnings announcement that would be caused by performing an adequate investigation? Absent an admission by the engagement team management that the objectivity of their audit judgment was impaired, sustaining the burden of proof that would be required to support an allegation of impaired independence is unlikely even in these extreme circumstances.
The counter argument that consulting improves audit quality is also unproven and does not provide a basis for eliminating the proposed restrictions.
In the same breath that critics condemn the proposed restriction on services because it has not been conclusively proven to be necessary, they assert, without proof, that consulting improves audit quality.
In the larger firms, consulting services are provided by a separate group of professionals who have little interaction with audit teams other than to urge cross-selling of services. The separation between consultants and auditors within the same firm has existed for many years and has grown over that time. For example, another of the alleged instances of independence impairment investigated by the Cohen Commission was the Yale Express (Fischer v. Kletz) case. The Cohen Commission concluded there was a deplorable subordination of the audit function in that case. While providing consulting services, the audit firm learned that financial statements on which it had expressed a clean opinion were materially misstated, yet failed to notify anyone for several months. The firm argued it had no duty to inform anyone because the consulting service was a separate engagement performed as a consultant and not an auditor. This case is an extreme example of separation of consulting and auditing, but the attitudes it reflects still prevail in current practice.
In the many cases I have worked on involving alleged auditor malpractice, the auditors have not made use of the knowledge of consultants providing services to audit clients. In a few instances, in fact, the personnel providing nonaudit services had information that would have aroused suspicions of management fraud had the auditors known. However, the information was not shared with the audit team. One reason it was not shared may have been because the firms had not made the personnel providing the services sensitive to what the auditors would need or want to know. Another possible reason is that the firms did not structure the engagements to inform the audit teams.
At one time, for example, I believed that outsourcing of internal audit services was a service that should not be restricted. My reason was that, conceptually at least, the information learned through internal audit work should improve the quality of the audit. Internal auditors are on site for a greater time and more involved in the company's business processes. However, after observing some instances of internal audit outsourcing, my view has changed. Knowledge obtained in internal audit work did not inform the audit team. Often there is no direct communication between the personnel providing internal audit services and those doing the audit. The external audit team is dependent on a member of client management - the director of internal audit - to inform it of internal audit findings. The personnel providing internal audit services function as an arm of management and the identification with the client fosters a mutuality of interest that could impair independence.
There are other reasons that restrictions on nonaudit services are necessary. The POB's Advisory Panel on Auditor Independence after its careful study of independence issues observed as follows:
Growing reliance on nonaudit services has the potential to compromise the objectivity or independence of the auditor by diverting firm leadership away from the public responsibility associated with the independent audit function by allocating disproportionate resources to other lines of business within the firm, and by seeing the audit function as necessary just to get the benefit of being considered objective and to serve as an entrée to sell other services.
In other words, firm management will not focus properly on the audit function if it is submerged in a large multi-line professional services firm.
The significance of this aspect of the risk to independence can be more readily understood by looking at another profession, such as journalism. Mergers such as those between AOL and TimeWarner, and Disney and ABC, threaten the journalistic values of the journalism organizations. The reason is that an organization not devoted exclusively to journalism has other priorities that dilute traditional journalistic values. When ABC kills a story that is damaging to the interest of Disney, we have no difficulty seeing how other priorities can override the core values of journalism. In a similar manner, when the audit function is only one of many professional services, the core values of auditing are threatened.
While the rule proposal does not prohibit all nonaudit services, that is suggested as a possible alternative. Ensuring the maintenance of independence as a core value of the auditing profession would be a justification for a prohibition of all nonaudit services.
The proposed restrictions on services are reasonable and clearly related to the basic principles. Of the ten services identified in the proposal as incompatible with the basic principles, eight are already deemed to impair audit independence under existing requirements of the AICPA-SECPS or the SEC. Thus, painting the rule proposal as a stretch is an unwarranted criticism. All the proposal does is to supply an underlying rationale of basic principles that provide a much needed logical framework for existing requirements.
There should be little disagreement with the basic principles. If that is the case, disagreement with the results of applying those principles to the issue of whether certain nonaudit services should be restricted is suspect. A possible reason that this aspect of the rule proposal is so controversial is that the traditional core value of independence has in fact eroded and must be restored. Too much protesting from the auditing profession may be taken legitimately as a sign that the restrictions on nonaudit services in the rule proposal do not come too soon.