Statement on the Securities and Exchange Commission's Proposed Auditor Independence Rules

Edward L. Summers, Ph.D., CPA
Thomas Professor of Accounting
McCombs School of Business
The University of Texas at Austin

The author is a CPA in Texas and has taught accounting since 1965. He was Chair of the Department of Accounting at UT Austin for five years, 1975-1980, was President of the Texas Society of CPAs, 1975-6; and will serve on the Texas State Board of Public Accountancy until 2003. The opinions in this Statement are his own, and do not represent the views of any of his academic, professional, or regulatory colleagues.

I. Summary

I commend the Securities and Exchange Commission for addressing the complex problem of auditor independence. I appreciate the opportunity to submit a statement on its proposed Rules for the public record.

The SEC's controlling concern in the proposed rules appears to be the informed public's perception of independence. The author endorses and shares that concern. The SEC should seek to preserve the benefits associated with auditor independence.

The author believes that the four general principles, properly modified, constitute a sound basis for detecting potential threats to independence. It should be possible to build on these principles, to ensure that they are applied within a defined context of materiality and relevancy, so that they do not cripple the capability of auditors to do their work effectively.

In order to do their work effectively, auditors will benefit from simplified rules as to what constitutes an auditor's material financial interest and whom to regard as an "included person" in the circle of those whose interests may compromise the perception of independence. I believe very strongly that the unit of accountability for independence should be the entire accounting firm.

The public will not benefit from provisions in the SEC's proposed rules that make it more difficult for auditors to do their work, without an actual strengthening of independence. The author does not endorse the scope of services limitations in the proposed rules, nor does not endorse a flat prohibition on auditors not to share ownership of their practices with non-CPAs. Although the author does share many of the SEC's concerns about joint ventures, he does not endorse all aspects of the "business relationships" rule (p. 74).

Elaborative comments on some of these positions follow:

II. Revisions to the SEC's "Four Principles"

With additional wording to clarify materiality and scope of application, the four principles will be part of a sound basis for detecting potential threats to independence. I offer the following:

(The auditor would not be independent if the auditor:)

(1) Has a mutual or conflicting interest with the audit client that would favor an audit outcome materially inconsistent with audit evidence the auditor would be expected to collect. Being paid by the client for a service shall not be evidence of a "mutual or conflicting interest."

(2) Audits financial information prepared by the auditor or under direct auditor supervision where such information is a material support for, or part of, the audited financial statements, and the client does not or cannot take responsibility for it.

(3) Functions as management or an employee of the audit client in any material respect. Serving as an independent contractor for the audit and/or for consulting services, including tax advice, shall not be "functioning as management," provided the client takes affirmative responsibility for the services and provides competent oversight throughout the period during which the services are delivered.

(4) Acts as an advocate for an audit client in any way that would permit or favor an audit outcome materially inconsistent with audit evidence the auditor would be expected to collect, interpreted according to generally accepted accounting principles. Tax advocacy and opining on financial statements do not constitute this type of advocacy.

See the following section for an alternative to [c](1)(i) - investment in audit client.

I agree with [c](1)(ii) - other financial interests in audit client.

III. Investments by Auditors

No person associated with an audit firm (including their dependents) should directly hold any instruments of a client or a client affiliate. This is equivalent to saying that the audit firm itself is the unit of account where independence is concerned. The entire audit firm and each of its owners is responsible for its independence in respect to each client individually. Consistent with this, the following arrangement could be adopted to allow indirect investments (the fractions used are illustrative):

Those who wish to invest in clients or client affiliates might be able to do so by investing in one or more independently managed "mutual funds" formed for this purpose. These mutual funds would make investments. The proportion of the fund's investments classified as "audit clients or client affiliates" must be less than one-third of the total assets of the fund. No one client or client affiliate could account for more than 5 percent of a fund's assets. No one could own more than 5 percent of the shares of a fund. No "audit chain of command" person could own shares of a mutual fund if the mutual fund holds securities of the audited entity.

IV. Non-Audit Services by Auditors to Audit Clients

I have heard all my adult life that non-audit services to an audit client will compromise audit independence. While the occasional loss of independence may happen this way, everything I have learned and heard about the reality of public accounting practice suggests that the charge is, at worst, only infrequently true. It is not necessary, nor does it strengthen independence or audit effectiveness, to introduce the blanket ban of (4) - Non-audit services. The auditor's legal liability in the event of non-independence has ensured, and will continue to ensure, as much independence as is humanly possible.

Nevertheless, in the interest of clarifying when non-audit services do threaten independence, I offer the following:

I agree that (A) 1,2, and 3 do make the accountant not independent, with the exception of journal entries and other corrections proposed as a result of conducting an audit.

I accept the list of services (B) through (J) as impairing independence if, individually or collectively, the services to an audit client are material; UNLESS:

If the services are collectively not material, there should be no independence problem with the auditor's providing them.

V. Other Matters

A. Non-CPA Ownership. I favor the formation of multidisciplinary practices. I have conducted research which has convinced me that such practices would not threaten the values of the auditing or legal professions. (For details, please see this link [at ""].) I am not in favor of public ownership of audit practices.

B. Investment banking. I do not believe auditors should participate in investment banking, whether with clients or non-clients. Period.

C. Joint ventures with audit clients. I do not believe an audit firm can audit a partner with whom it has material business relationships. Where these relationships would be undertaken to gain specialized knowledge of an industry or technology, etc., I believe the appropriate model would be that of SEMATECH, the semiconductor consortium that was formed to allow the American semiconductor industry to collaborate against what was perceived in the 1980s as a threat from foreign competition. If an "Assurance-Business" research consortium were formed, its management could attract sponsored projects and manage them, charging fees and remitting profits, and disseminating information along guidelines similar to those used by SEMATECH. The auditors would receive substantially all of the synergistic audit-capability-enhancement benefits they claim for joint ventures, without the independence impairment. The SEC could facilitate formation and monitor operation of this entity.

However, the SEC rules should not excessively restrict auditor access to business and professional relationships for the purposes of enhancing knowledge, personnel, and capital resources; so long as audit independence is not impaired (the "co-branding rule" that some feel would prevent CPA firms from joining the AICPA is one example). The burden of proof would always be on the auditor to show that no impairment has occurred. Auditors should pursue benefits that would require independence-impairing business relationships through the consortium framework described above, or not at all.

D. Peer Review. The history of peer review shows that it is a weak and ineffective instrument of oversight and/or reform. If peer review were be transformed into genuine public oversight, then the public oversight reviewers could be empowered and required to probe in detail, and then opine on (among other things), the independence of the firm under review in respect to each audit of a publicly-held client which accounts for more than $X in combined audit and non-audit fees (say, X=$100,000). These reviews should take place annually or biannually, and a summary of the information they develop should be released to the public. The reviewers should include respected non-accountants. The AICPA and CPA firms that offer audit services should make long-term unbreakable financial commitments to fund public oversight reviews. The SEC can and should impose meaningful sanctions, such as a ban on new clients, when a public oversight review finds material and avoidable independence compromises.

E. Disclosure. Disclosure has been offered as an alternative for restrictive regulation. I would be in favor of more disclosure of fees, and a breakdown of fees. Disclosure, however, cannot be a substitute for needed regulation, and it cannot mitigate the effects of poor regulation. Its proper role is as a supplement to effective regulation.

F. Concern for Auditor Viability. The challenge presented by auditing large and complex clients may outgrow the resources auditors can muster to meet it. Auditors must attract extensive intellectual, technological, organizational, and material resources in order to audit successfully. Accounting education plus audit experience cannot completely equip auditors for the challenges of real world auditing. In competing for the necessary resources, the auditing profession works under the disadvantage of its professional nature. The form of the accounting profession - practice units owned by CPAs active in the practice itself and regulated by 54 unique jurisdictions, plus assorted Federal and foreign agencies - inherently complicates raising capital and retaining human resources. This inherent complication constitutes a reason the SEC should allow auditors to operate in nontraditional ways that do not compromise independence. I ask that the SEC keep future auditor viability in mind during its rulemaking processes.