July 21, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
Re: Revision of the Commission's Independence Requirements
SEC File No. S7-13-00
I appreciate the opportunity to comment on the Commission's proposal to revise the independence requirements for auditors of public companies. The views expressed herein are my own and are not intended to represent the positions of my clients1 or any organizations with which I may be associated.2
At the outset, I would like to applaud the Commission's efforts to make the U.S. securities markets the most efficient and reliable markets in the world and thereby help make the United States the financial capital of the world. As a long-time securities attorney and an adviser to the accounting profession, I also understand the importance of reliable financial information to the securities markets and share the Commission's belief that the accounting profession must continue to stay abreast of changing financial conditions and business practices in order to keep in check those who would issue deceptive financial reports and thereby undermine the confidence which the public places in the nation's capital markets. For the reasons more fully explained below, however, I do not believe that the Commission's proposed new rules for auditor independence represent a positive step; and I implore the Commission to defer action in this area and allow the Independence Standards Board ("ISB") to proceed with its assigned tasks.
The ISB was formed three years ago to carefully rethink the rules for auditor independence in view of the changes that have taken place within the accounting profession. In particular, accounting firms have grown larger and have expanded the scope of their services. In addition, the days that a CPA is the sole breadwinner in a family unit have long passed. These changes alone necessitate a fresh look at the independence rules. Even more importantly, however, the profession has never satisfactorily addressed the issue of the economic importance of a client to the audit firm, with the result that a partner in a CPA firm might derive a substantial (if not a majority) portion of his or her economic importance within the firm to a large audit client and still be deemed "independent." Without addressing this all-important issue, it is foolish to believe that financial statement users would derive much comfort from knowing that not one share of the audit client was owned by the audit firm or anyone associated with it. In short, the time has come to end the fraud that the accounting profession and its regulators have been perpetrating on financial statement users by proclaiming the independence of auditors when there is no system in place to prevent the auditor who renders the report from being economically dependent on the client. Not only does the Commission's new proposal perpetuate that fraud, but it totally undermines the ISB which represents the best hope for formulating a regulatory environment that is capable of addressing this and other difficult issues impacting the reliability of financial data.
I also believe that the Commission's proposals are both myopic and ill-conceived. They are myopic in the sense that they view audit independence as a goal, rather than as a means of enhancing the reliability of audit reports. They are ill-conceived in the sense that they are largely arbitrary, unworkable and, in some cases, counter productive. These comments will be more fully explained below. While I appreciate that these criticisms may sound harsh and are unbecoming to an agency that has done such good work and consistently stands above all other agencies within the federal government, I know of no other way to divert the Commission from its apparent intention to adopt these proposals before the year comes to an end.
Impact on the ISB
Although I serve as an advisor on one of the ISB's task forces, I cannot speak for its members. In fact, I have only met three of its eight members and have not discussed this proposal with any of them. Nevertheless, I can imagine how I would feel after carefully and methodically attempting to devise a workable approach to audit independence over the past three years, only to have my efforts brushed aside by pre-emptory action on the part of the Commission. I would have real difficulty mustering the energy or inclination to tackle my next assignment, knowing that my efforts might again be thwarted by Commission action.
The recent statements emanating from the Commission to the effect that the ISB should have a majority of public members are also unfortunate as they imply that the public members of the ISB are somehow being duped or bullied by the members who come from the profession. I do not, however, disagree with the suggestion that the SEC appoint a majority of the ISB's members because it is critical that the public have confidence in the integrity of the ISB.3 Thus, my concern is not that the suggestion is misguided, but rather that it was made in the context of Commission actions which project a lack of confidence in the ISB. This only further undermines the public's confidence in the ISB, thereby destroying the very confidence in audit reports which the independence rules were intended to forster.
From my perspective, the ISB has approached its task in a thoughtful and methodical manner. It is hard to judge the outcome of this process at this time as the ISB has only issued one substantive standard; and even that standard is clearly temporary as the ISB is yet to even issue an exposure draft on its conceptual framework. Nevertheless, the level of thought reflected in its various discussion memoranda provides confidence that its end-products will be well reasoned. As more fully discussed below, I do not derive the same level of confidence from the proposal which the Commission has published, leading me to believe that the ISB represents the best hope for successfully tackling the issues of audit independence.
The Role of Independence Standards
Independence standards are a means of assuring quality in the audit process by safeguarding auditor integrity and objectivity. As such, they are means to an end and must be devised and interpreted accordingly. Thus, it serves no purpose to achieve perfect independence if, by doing so, audit quality is placed in jeopardy. The rules proposed by the Commission ignore this principle by prohibiting audit firms from providing services which might enable them to achieve a better understanding of their clients' operations and financial information. The Public Oversight Board's Task Force on Audit Effectiveness recognized this principle in suggesting that a distinction be made between those consulting services which enhance the audit process and those which do not. The SEC's proposals, however, ignore this concept and instead seek to achieve audit independence as if it were the ultimate goal.
The Four Principles
The Commission's proposal establishes four guiding principles for determining when audit independence is impaired. They are as follows:
1) The audit firm may not have a mutual or conflicting interest with the audit client;
2) The audit firm may not audit its own work;
3) The audit firm may not function as management or an employee of the audit client; and
4) The audit firm may not act as an advocate for the audit client.
Although these concepts are not novel and can be found throughout the audit literature, they are not particularly useful and certainly should not be adopted as guiding principles to be invoked each time a novel situation is encountered. The fact is that there are numerous situations in which these principles are routinely violated and no reasonable person would consider the audit firm to be unfit to perform audit services. For example, an audit firm has a conflict of interest with its client each time it sends an invoice to the client. Conversely, the audit firm has a mutual interest with the client to uncover client employee thefts. Thus, not every violation of the first principle will undermine the audit process; and the Commission proposal provides no guidance as to how to decide which violations are permissible and which are not.
The remaining three principles are also not particularly useful as there are numerous ways in which these principles are routinely violated and no one would even suggest that they preclude the audit firm's performance of audit services. For example, auditors routinely suggest adjusting journal entries. Some adjustments may be to correct arithmetic errors or mischaracterization of transactions; others may be to adjust estimates where the estimates made by the client cannot be supported. In a sense, the auditor firm is auditing its own work when it makes such suggestions. Similarly, if an auditor recommends that the client modify its business practices so as to enable it to account for its transactions on a more favorable basis, it might be deemed to be auditing its own work. Under such circumstances should the audit firm be precluded from auditing the client's financial statements?
The simple fact is that the users of financial statements want financial statements to be prepared by someone whose honesty, integrity and competence merit their trust. Thus, in a real sense, many financial statement users would actually prefer that accounting estimates be made in the first instance by independent auditors, rather than have those judgments be made by persons who stand to benefit from the reported results and only reviewed for reasonableness by an independent auditor. Thus, there is a serious question as to whether the second principle is even valid when measured against the standards of whether reported results and user confidence will be enhanced.
The Commission should also ask itself why participation in client management should be deemed to impair audit independence. To be sure, an audit firm that participates in a client's management is likely to achieve a much better understanding of (a) the client's business, (b) the client's competitive weaknesses, (c) the honesty and integrity of the client's management and (d) the client's financial reporting systems. All of these are likely to enhance the quality of the firm's audit. The principal danger to audit integrity posed by providing "management services" (whatever that term might encompass) is that the audit firm's compensation might be linked to the financial success of the client. Thus, the problem is not that the performance of management services is per se injurious to the audit process, but rather that compensation based upon the client's financial performance can impair the audit process. Thus, the real guiding principle should not proscribe serving in a management capacity, but rather being compensated based upon the reported results of operations.
It can also be argued that an audit firm that provides management services (even if compensated on a fixed fee basis) has a greater incentive to report favorably on the client's operating results so as to enhance the likelihood of continuance of its own management services. Even this concern is largely misplaced unless the services being rendered (1) are likely to be of a continuing nature and (2) are likely to have a material effect on the client's operating results. Unless both of these conditions are satisfied, even this argument has no validity. In any event, the performance of "management services" should not be proscribed in all cases, but rather only in those limited circumstances where the audit firm has a material economic incentive to misstate the client's operating results.4 In this regard, it should be remembered that because audit firms are engaged by the client, every firm to some degree has an incentive to try to please the client.
The final guiding principle is equally unworkable. To be sure, there are numerous circumstances in which audit firms provide advocacy services for their clients. For example, audit firms routinely handle tax examinations for their clients wherein they are called upon and expected to argue on behalf of their client in order to achieve more favorable treatment for the client. No one has suggested that such services impair an audit firm's ability to conduct a financial statement audit. Similarly, audit firms frequently appear at administrative proceedings involving their clients to explain why they believe the client's financial presentation complies with GAAP or regulatory accounting principles. These roles also involve advocacy. The question is how does one distinguish between these forms of advocacy and the advocacy customarily performed by attorneys. Even if there is a meaningful way to make this distinction, it is not found within the Commission's proposal.
Thus, one must conclude that the guiding principles are largely unworkable as they provide little or no guidance as to how to distinguish between permissible and proscribed activities.
The Disclosure Approach
In its proposal, the Commission also calls for the disclosure of certain relationships between the audit firm and the client even though those relationships are not deemed to impair audit independence. The theory behind this requirement is that some financial statement users might be reluctant to rely upon an audit report under such circumstances and, therefore, should be given an opportunity to make this decision on their own. I believe that this approach has a number of serious problems.
First, it adds to disclosure overload. In this connection, it should be remembered that this type of disclosure is, at best, tertiary disclosure. In today's securities markets, securities are valued on the basis of the issuer's projected profits and cash flows. Thus, even though a company may report significantly higher earnings over the previous year, if the reported earnings do not rise to the level of analysts' estimates, the company's shares are likely to decline in price. In this environment, primary information is that which enables analysts to compile their projections; for example, the relative strength of the issuer's product line, the growth in the market for the issuer's products, and the cost structure of the issuer's operations. In fact, the market will frequently ignore declining operating results if the decline was the result of a non-recurring cost, such as an extraordinary write-off. Thus, historical financial statements themselves are not even primary information because they do not foretell future operating results, but rather only provide information which can be used to test or evaluate projected financial results. Information about the auditor's independence is one step further removed because it does not even address the reliability of the analysts' projections but only the reliability of some of the information used by the analysts in compiling or testing their projections.
If the Commission is going to require disclosure of information about the likely reliability of financial data upon which financial projections are based, why does it not require disclosure of the percentage of the client's inventory and accounts receivable that were tested in the audit or the experience of the key members of the audit team in auditing companies in the same industry as the client. This information might be far more useful to a financial statement user in evaluating the reliability of the auditor's report. In the final analysis, one must conclude that the investing public would be far better served by useful disclosures concerning the issuer than by disclosures relating to the audit firm or the audit process.
The second problem with requiring disclosures of potentially impairing factors is that the financial statement user does not have any choice as to whether he or she wishes to rely on the client's financial statements. With few exceptions, a user cannot require the issuer to provide a report on the same period by another auditor. Even more importantly, virtually all users (even those armed with the proposed disclosures) would have an insufficient basis for even reaching a conclusion as to the reliability of the financial statements as they are not likely to have an appreciation of the extent to which the effected individuals had the power to skew the audited results. Similarly, such disclosures would be one-sided as the audit firm may have adopted a series of quality controls designed to prevent such impairing factors from adversely affecting the firm's audit performance. In the final analysis, the users would undoubtedly come to the conclusion that if the Commission (which requires that audit firms be "independent") accepted the issuer's financial statements, they are likely to be reliable. In short, financial statement users will rely more upon the system than upon the disclosures of potentially impairing factors.
Thirdly, the proposed disclosure requirement is simply a means of discouraging relationships between the audit firm and its clients which the Commission has no legitimate basis for prohibiting. This is because many public companies are likely to insist that disclosable relationships be eliminated out of fear (rational or otherwise) that such disclosures might adversely affect their credibility or even credit worthiness. Moreover, this proposal might deter some companies from using the non-audit services of their outside auditors even though they have determined that it is in the best interest of the company and its shareholders to do so. Thus, the proposal could have an unintended adverse effect.
Lastly, the very notion of publicizing relationships between the audit firm and the issuer which the SEC has deemed not to impair audit independence casts doubts on the entire regulatory process and could undermine user confidence in that process. As discussed below, most users of financial statements have little or no understandings (or even basis of understanding) of what is encompassed by the profession's audit independence standards. They simply rely on the fact that the profession, state regulators and the SEC have established rules regarding the use of the representation "independent certified public accountants." Thus, when they see disclosures of relationships which they had assumed were forbidden, their confidence in the regulatory scheme may well be eroded. Thus, they may wonder what other relationships are not covered under the regulatory requirements and whether those gaps might undermine audit objectivity and integrity. In short, disclosures of the nature proposed by the Commission, while pushing the profession toward higher levels (i.e., higher than otherwise deemed necessary) of independence, may also serve to undermine users' confidence in independent audits and the very purpose for which the independence rules have been established.
Independence In Appearance
The concept of independence in appearance has been in the accounting literature for many decades and at this point seems beyond question. Moreover, since one of the purposes of the independence standards is to encourage the reliance upon financial statement reports by third-parties, the concept has a logical underpinning. Nevertheless, I have recently come to doubt its validity and utility.
First, one must recognize that financial statement users do not actually know whether any partner (much less, a spouse of a partner) of the audit firm has a financial interest in or holds a management position with the issuer. They simply rely on the "system" for assurance that the representation "independent certified public accountant" is true. Similarly, financial statement users also do not know whether the independence rules encompass all firm partners or only those performing audit services with respect to the issuer; nor do they know whether relatives beyond the partner's spouse are included in the prohibitions against financial interests and management services. Again, users rely on the "system;" i.e., the fact that a well-respected regulatory agency with knowledge of the audit process has established, monitors and enforces rules reasonably designed to assure that an individual who holds himself out as an "independent certified public accountant" has no relationship with the issuer that would impair his or her objectivity and integrity in auditing the issuer's financial statements. Considering these realities, is it not sufficient for the Commission to simply adopt rules which it, based upon its own expertise, considers necessary and appropriate to safeguard audit independence? Why must the Commission also consider factors about which others who are less expert and less knowledgeable might have lingering concerns.
This does not mean that the Commission should not err on the side of conservatism. Nor does it mean that the Commission should not be concerned about its own image as being an effective regulator of the financial disclosure process. This Commission, with its constant barrage of public statements attacking the accounting profession, clearly understands that the public is relying upon it to maintain "the system" of financial disclosures. But even this concept can be taken too far. If the public is led to believe that notwithstanding the Commission's zealous efforts to maintain audit integrity, the process is riddled with violations, public confidence in the financial reporting "system" is diminished and not enhanced; and this is particularly true when the violations being publicized are not even material in the Commission's eyes.
In short, by imposing standards which go too far beyond what the Commission itself believes are reasonable and necessary for the protection of the public, the Commission may well invite further situations in which widespread violations of its independence standards will come to light; and this will be far more damaging to investor confidence than learning that a pension plan of an audit partner's spouse owns 100 shares of the audit client.
About the System
At the beginning of this year, the investing public (including the undersigned) was shocked to learn that in a relatively short period there were more than 8,000 violations of the independence standards by one of the nation's most revered accounting firms. If such violations were so rampant at this industry icon, one could only imagine how bad they must be at other lesser known firms engaged to protect the public's interests. To make matters worse, the SEC and the profession have seemingly done little or nothing about those violations. From the public's perspective, the SEC seems to be in bed with the industry, having required no financial statements to be reaudited and no violators to be sanctioned. If this were not bad enough, the Commission has established a program to allow all of the other major firms to confess their violations and to obtain amnesty for doing so. The public thus, must be asking, "Is the SEC really safeguarding the financial disclosure process?"
From my perspective, the Commission has not only damaged public confidence in "the system" by its actions, but is missing a major opportunity to gather useful information about the nature of audit independence. When will the Commission ever get another opportunity to investigate a statistically significant number of independence violations and thereby be in a position to determine what types of actions and relationships really do impair audit objectivity and integrity? I view the independence debacle at PricewaterhouseCoopers to be a once-in-a-lifetime opportunity to perform a definitive study of audit independence, a study upon which the Commission could establish independence standards that would have the respect of both the public and the profession. I am saddened, however, by the growing reality that this is never going to happen.
Instead, what I see in the Commission's proposals is a series of new restrictions, not based upon any empirical findings, which will have a major impact on the future direction of the accounting profession, and which could ultimately prove to be highly detrimental to the financial disclosure system for the reasons more fully explained in the succeeding sections of this letter.
The Commission, bemoaning that auditing has become a "loss leader" for the accounting profession's more profitable consulting services, has proposed rules which will prevent accounting firms from providing some forms of consulting services to their public company audit clients. Although the Commission's proposal enumerates numerous types of consulting services that would fall within this prohibition, it fails to provide any bright-line test for making such a determination. Indeed, I am hard-pressed to see any logical distinction between advice as to ways to minimize taxes by restructuring internal pricing within a multinational corporation and advice about becoming more efficient by restructuring the corporation's financial reporting systems. In fact, the only distinction which I can perceive between those consulting services that are permitted and those which are not is the length of time that they have been commonly performed by accounting firms; i.e., more traditional consulting services are permitted, whereas newer consulting services are not. This distinction is arbitrary and cannot be justified. For this reason alone, the Commission should not proceed with the adoption of its proposals relating to consulting services, even assuming that there is empirical evidence supporting its conclusion that consulting services impair audit objectivity (which I do not believe is the case).
My principal concerns with the proposal's treatment of consulting services is that they are likely to prove counter-productive in two respects: The performance of consulting services enables the audit firm to achieve a better understanding of the client's operations and, in some cases, its system for accumulating and reporting financial data. As such, they enable the audit firm to perform a better audit and thereby enhance the reliability of the client's financial reports which is wholly consistent with the purposes of the independence standards. Thus, rather than construct a barrier between those persons performing audit services and those performing consulting services, I would reinforce the generally accepted auditing standard mandating that information learned in the course of performing services of any type for an audit client (as opposed to another client) be shared with the audit team. Stated another way, such information would be attributable to the audit team, facilitating a finding of scienter where applicable.
Secondly, audit practice alone cannot generate a sufficiently high return to permit accounting firms to attract the quality of persons necessary to provide effective audit services in an increasingly complex business environment. In this connection, the Commission should understand that most corporations do not appreciate the value of reliable financial data. Indeed, the very requirement that the financial statements of public companies must be audited even presupposes that public companies, when left on their own, would misstate their financial results. While audited financial data theoretically will enable public companies to achieve a lower cost of capital, there is a serious question as to whether this is true, especially where the issuer's tradename and financial condition is well-known and respected and the independent audit firm and its financial condition are virtually unknown. For these reasons, most public companies simply view their annual audit as a cost of doing business and prefer to pay as little as possible for that service, even if doing so might cause the audit firm to curtail its tests in order to avoid incurring a loss. Indeed, I have little doubt that the Commission's Enforcement Division has frequently encountered situations in which an audit firm simply did not charge enough to cover the reasonable costs of an effective audit.
As the Commission's release rightly points out, consulting practices tend to be far more profitable than audit services. This is because they are perceived by clients to provide greater economic benefit. Whereas the Commission believes that audit firms are dropping the price of their audit services in order to attract consulting services, I am of the view that audit firms engage in consulting services in order to subsidize an audit practice that cannot command a sufficiently high compensation. Should the Commission have any doubts in this area, it should undertake a study comparing the average audit fees where consulting services are provided to audit clients with those audit engagements in which no consulting services are provided. It is my expectation that with comparable audits (i.e., those involving companies of comparable size in the same industry) there would be no material difference in the average audit fee.
If I am correct in my belief that consulting practices subsidize audit practices, rather than audit practices serving as a loss leader for consulting services5, then the separation of audit and consulting services, in the long-term will surely cause the decline in the profitability of audit firms and relegate them to a lower rung on the economic food chain. Thus, in time, audit firms will be unable to attract high quality employees and audit quality will suffer. This would be a devastating result which would take a full generation to remedy.
The Commission's proposal also ignores the importance of growth to a professional service firm, while at the same time recognizing that there has been only modest growth in the audit practices of the major accounting firms. In reality, however, it is the possibility of future partnership positions that are facilitated by growth that permits professional firms to attract highly qualified individuals. If growth is slow, partnership opportunities largely depend upon the retirement or withdrawal of existing partners. This means that, in a profession in which the ratio of partners to staff accountants is roughly 10 to 1, the vast majority of job applicants have little or no chance of becoming a partner or securing long-term tenure with the firm, and this problem is aggravated when the firm's growth rate is reduced. Moreover, if both the rate of growth, as well as the level of profitability of the firm are decreased, the adverse impact on firm recruiting will be even worse.
In making its proposal with respect to consulting services, the Commission makes the following two basic arguments.
1) Fees from audit services are becoming an increasingly smaller percentage of total audit firm revenues and, therefore, audit firms are likely
a) to devote less attention and care to their delivery of audit services; and
b) to compromise their audit skepticism to secure their clients' continued purchase of consulting services; and
2) "Certain non-audit services, by their very nature, raise independence issues."
These contentions are largely theoretical and there is little or no evidence to support the contention that the accounting profession has been short-changing its audit practice. Spurred by potentially ruinous liability claims and Commission own enforcement actions, the profession has been in a state of constant improvement in its auditing standards and practice and this fact was recognized by the POB's Task Force on Audit Effectiveness. Thus, notwithstanding the relative maturity of this practice area, the profession continues to invest considerable (and perhaps even disproportionate) time and money into improving audit quality. To my knowledge, there is no evidence whatsoever that audit firms have diverted all of their innovative efforts into their consulting practices even though they have clearly invested heavily in their consulting practices.
The accounting profession has frequently pointed out that there is also no evidence that audit skepticism has been compromised where firms provide significant consulting services to their public company audit clients. The Commission's release, in effect, admits this, saying "Studies cannot always confirm what common sense makes clear. (at fn 76). While common sense dictates that audit firms are likely to pursue their economic interests, it must be appreciated that the cost of an audit bust can be hundreds (if not, thousands) of times the fees that might be derived from a consulting engagement. Thus, before the Commission decides to forego empirical evidence in favor of "common sense" to support its rule-making efforts, it should make sure that it is considering all relevant factors.
The Commission's release also contends that auditors would be likely to compromise their objectivity in order to maintain a client relationship that enables them to sell high-profit consulting services. While this too may seem logical, it is a conclusion that is difficult to reach without an understanding of the compensation systems used by each firm. Indeed, such an assumption might be appropriate if each partner were compensated based upon the profits generated from those public company clients for which he or she is the relationship partner. It would not be appropriate, however, if audit partners were compensated solely on the basis of his or her billable time. Thus, rather than ban all consulting relationships (and thereby discard the baby with the bath water), the Commission might be better advised to prohibit the use of compensation systems which could encourage the type of behavior which the Commission seeks to avoid. As more fully discussed below, the prohibition against contingent fees does not achieve this result.
As a practical matter, however, I doubt very seriously whether audit partners abandon their audit objectivity simply to be able to have the opportunity to sell consulting services as opposed to other firm services. This almost presupposes that accounting firms make a conscious decision to cause clients to channel their professional service purchases into those service areas generating the highest hourly billing rates. In reality, accounting firms encourage their clients to satisfy all of their accounting, tax and consulting needs with services which they provide without regard to the relative profitability of each variety of service. Thus, the Commission should not concern itself with the amount of consulting services purchased by an audit client or even the level of those services in relationship to the firm's audit services. Instead the Commission should concern itself with the level of total fees derived from the client and the relative financial importance of the client (a) to the firm, (b) to the office servicing the client and (c) to the partner or partners in charge of providing audit services to the client. No audit partner is likely to compromise his or her audit objectivity and jeopardize his or her future livelihood for a client whose total use of firm services is relatively modest. On the other hand, a large user of firm services poses a serious potential threat to audit objectivity. It is indeed perplexing that the Commission has chosen not to even address this fundamental issue in its proposal.
What makes this issue problematic is that there are some public company clients that are so large in terms of the partner-in-charge, firm office or even the entire firm that any arbitrary rule will not work in all situations. For example, any Fortune 50 client is likely to be the dominant client in any office of any Big Five firm that is engaged to audit it. How then can audit independence be assured with respect to such clients since the departure of any such client would be an enormous (if not fatal) set back for the office servicing that client? The difficulty of adequately addressing this issue, however, does not excuse the Commission's failure to do so.
The only solution to this issue offered to date is the one proposed by the AICPA in its "white paper" published shortly after the creation of the ISB, a proposal which the Commission denounced as being self-serving and not in the public interest. Under that proposal, there could be quantitative restrictions on the fees derived from audit clients in relationship to the total fees of the audit partner, the office of the audit firm responsible for the audit and the audit firm itself. Where those quantitative limits were exceeded, the audit would have to be subjected to certain additional safeguards, such as having the audit reviewed by a regional or national review partner whose compensation was not dependent upon the retention of the client. The AICPA proposal, recognizing that it would be difficult to fashion a single set of rules that would meet the needs of all firms, suggested that each firm be allowed to establish its own set of compensating safeguards within parameters established by the ISB and which would be subject to the approval of the ISB. Because of the ISB's participation in this process, the public would derive the necessary level of assurance to rely on financial statements audited by accounting firms. In short, the public would rely on the "system" for maintaining audit objectivity.
To be sure, not all consulting services are the same, and some are likely to cause the person providing those services to be more closely allied with the client's management than others. For example, advice as to how to turn around the client's business is more likely to cause the consultant to associate himself or herself with the client than evaluating the client's interest in a non-public enterprise. Nevertheless, because these services are likely to be performed by persons who do not participate in the rendering of audit services, the likelihood that the auditors will associate themselves with client management seems relatively remote.
This does not mean that the performance of some services cannot affect audit objectivity. For example, where the audit firms stands to benefit or incur substantial liability based upon the results of the client's operations, there is a distinct possibility that audit objectivity could be compromised. This concept, however, is also notably absent from the Commission's proposed rule.
The Commission's proposal would also prohibit audit firms from offering legal services to a public company audit client. I am sure that most of my partners (if not most of the organized bar) would welcome the adoption of this prohibition as it would bring to an abrupt halt the accounting profession's push for the adoption of multi-disciplinary practice ("MDP") units. On the other hand, most of my clients oppose this measure. My own view is that MDP's may be in the public interest (still yet to be proven) because they offer the possibility of more coordinated professional services which will result in more effective and more efficient professional services. Thus, I believe that audit firms should only be precluded from offering legal services where there is good reason for doing so.
The Commission's release contends that legal services should be prohibited because they represent "management" activities and involve advocacy on behalf of the client. These are more rationales than reasons. The fact is that legal services are no more management services than an auditor's advising a client about the requirements of generally accepted accounting principles. Moreover, there are many services routinely rendered by accounting firms (such as tax audit services) which entail far more advocacy than many legal services, such as preparing a public disclosure document or advising a public company as to what activities must be disclosed.
This does not mean that I do not see problems associated with MDPs. I am quite concerned over the conflict between an attorney's unqualified duty to maintain client confidences and the auditor's duty to disclose all material information. I resolve this conflict, however, by requiring attorneys employed audit firms to disclose all information known to them to their firm's auditors. This, in turn, requires the client, if it chooses to retain an audit firm's attorneys, to waive confidentiality as the price for obtaining "seamless services." This is only appropriate as it is the client that benefits from the greater effectiveness and efficiency of those "seamless services." This not only resolves the conflict between the ethical standards of the two professions, but is also likely to increase the effectiveness of the firm's audit by assuring greater and more candid communications between the client's attorneys and the client's auditors. Whether audit clients will be willing to pay this price remains to be seen.
In one or more places within the Commissions release, comments are solicited regarding the use of firewalls as a means of assuring audit independence. This is a good example of independence solely for the sake of independence. In fact, there is no good reason why persons performing non-audit services for an audit client should not communicate with the members of the firm's team. Are such communications any more pernicious than communications between the audit team and the client's management? Therefore, it is simply silly to think that creating a firewall between the audit team and other firm employees who render services to the client will somehow taint the audit. Moreover, such a rule would preclude the audit team from obtaining additional information that might otherwise enable it to render more effective audit services. Thus, rather than prohibit such communications, they should be (and are) a mandated audit procedure.
Alternative Practice Structure
I do not have any problems with the general approach taken in the Commission's proposal with respect to alternative practice structures. There is no question that as long as CPAs receive their daily livelihood from an employer other than their CPA practice, they will be subject to influence by that employer and, therefore, that employer (and certain persons within that employer) should be brought within the coverage of the independence rules. I do, however, differ with the proposed rule as to the scope of the persons associated with that employer who should be brought within the regulated group. In my opinion, the Commission proposal is much too broad. Instead, I prefer the rule adopted by the AICPA Ethics Committee (Rule 101-14) which seems to strike an appropriate balance.
I appreciate that in fashioning its rule on this subject the Commission was seeking to cover a much broader class of non-traditional firm arrangements (which is appropriate) than may be comprehended by AICPA Rule 101-14. In doing so, however, the Commission has made two important errors. First, it uses the term "affiliate" (which already has an established meaning within the securities laws) in a manner different than that term is defined in Rule 12(b)-2 under the Securities Exchange Act of 1934. This is not a wise approach as it will undoubtedly cause confusion. Secondly, that term, as defined in the proposal, includes controlling persons as well as controlled entities, and many of the restrictions in the proposal should only relate to controlled entities. For example, why should an audit firm be prohibited from performing internal audit services for an entity which has a control position with a public company which it audits?
Therefore, I believe that this concept requires further consideration.
The Financial Relationship Provisions
Many of my colleagues within the accounting profession welcome the Commission's effort to eliminate some (but certainly not all) of the irrational aspects of the financial interest rules which were not designed with multi-national accounting firms in mind. Clearly this is a change that has been long overdue. While I too welcome these changes, I am also strongly of the view that even this change should be set aside so that the ISB will have a free hand in fashioning a rule that is consistent with its conceptual framework even if this means that the profession must wait another year or two for relief from the current regulatory scheme.
While fees which are contingent upon the results of an audit client's operations (or any major element thereof) are essentially incompatible with audit objectivity, I see no reason to proscribe all contingent fees. For example, a fee which is contingent upon the audit client's receipt of cash payments or a reduction in its cash obligations should have no impact on audit independence since no judgment made by the auditor will or could have any impact on the amount of the audit firm's compensation. Thus, a blanket ban on all contingent fees would appear to be without a logical basis. If contingent fees are to be deemed a violation of auditor independence, a contingent fee should be redefined as a fee which would be affected by the outcome of the client's reportable results of operations.
Conclusion and Further Action
While there are some good features of the Commission's proposals to update its audit independence standards, there is far too much that is wrong. Most importantly, however, the very publication of these proposals was a mistake as it greatly undermines the efforts of the ISB which, under the proposals, would be relegated to a minor role and its commendable efforts to rethink independence standards would come to naught.
I, therefore, hope and recommend that the Commission would
1) Withdraw its proposals;
2) Reaffirm its support for the ISB and the work that it has been doing; and
3) Begin discussions with the AICPA for increasing the public representation on the ISB.
Again, I appreciate the opportunity to comment on the Commission's proposals.
Dan L. Goldwasser
|1||I represent approximately 125 accounting firms, most of which are small firms which do not audit the financial statements of public companies. Included among my clients are one consolidator of accounting practices, one national (non-"Big Five") firm, approximately 25 mid-size firms with one or more public company clients and the New York Sate Society of Certified Public Accountants.|
|2||I am a long-time member of the Committees on Federal Regulation of Securities and Law and Accounting of the Section of Business Law of the American Bar Association and currently serve as a Co-chair of the National Conference of Lawyers and Certified Public Accountants.|
|3||Public confidence in the financial reporting systems is derived from the perception that the system for maintaining audit objectivity and integrity has been established in an appropriate manner and is overseen and regulated by persons with the public interest in mind. The vast majority of financial statement users do not know or even care about the details of the independence standards.|
|4||A prohibition against management services might be supportable upon the belief that the financial disclosure process would be enhanced by having two sets of eyes pass on each financial issue, and that when an audit firm performs a management function, effectively only one set of eyes will have prepared/reviewed the resulting disclosures. While this argument has some logical basis, it is flawed because it assumes that there is no qualitative difference between management prepared financial statements and statements prepared by outside professionals. In reality, however, financial statements prepared by outside experts are not only likely to be more expertly prepared, but are also likely to be free of biases and intimidation that are likely to affect financial statements prepared by client employees who receive stock options and other forms of incentive compensation. This even assumes that audit procedures relating to financial determinations performed by the audit firm's consulting personnel will not be subjected to equally rigorous audit procedures as are accorded determinations made by client management.|
|5||This does not include those situations in which initial audit fees are reduced to entice a long-term audit relationship -- a practice which has been prevalent within the accounting profession for the past 25 years.|
Dan L. Goldwasser, a graduate of Harvard College (Class of 1961) and Columbia Law School (Class of 1966), is a partner in the New York office of Vedder, Price, Kaufman & Kammholz where he heads his firm's professional liability litigation group. Since the late 1970s Mr. Goldwasser has largely devoted his time to advising and defending members of the accounting profession and their insurers against professional liability claims. In this regard, he currently counsels and represents the New York State Society of CPAs and approximately 125 professional firms. He also counsels two companies in the business of acquiring accounting firms on accounting regulatory issues.
He is an acknowledged leader in the field of accountants' liability, having chaired and appeared on scores of symposia on this subject over the past twenty years for the Practising Law Institute, the American Bar Association, the AICPA, various state CPA societies and other organizations. During each of the last six years he was named by the Editors of Accounting Today as one of (and the only attorney among) the "100 Most Influential Persons in Accounting." In addition, he is currently the American Bar Association's Co-chair of the National Conference of Lawyers and Certified Public Accountants. From 1992 to 1995 he also served as a non-CPA member of the AICPA's Subcommittee on Accountant's Legal Liability; and from 1994 through 1998 he chaired the ABA's Committee on Law & Accounting. He currently serves as a member of the Legal Services Task Force of the Independence Standards Board.
He has been a pioneer in loss prevention for the accounting profession, having written and presented dozens of loss prevention courses. In addition, he has co-authored a treatise entitled Accountants' Liability for the Practising Law Institute and has written loss prevention manuals for three professional liability insurance programs as well as the chapter on loss prevention for the PPC Guide to Managing an Accounting Practice. He also operates loss prevention hotlines for the New York State Society of CPAs and two liability insurers, answering the calls of CPAs and advising the callers how they can avoid liability claims. For the past ten years he has written a quarterly newsletter for the American Society of Accountants and has been the author of a number of feature articles in professional publications. Among his other writings are a treatise entitled "A Guide to Rule 144" and a chapter on "Underwritten Offerings" in Matthew Bender's treatise entitled Securities Law Techniques.
Mr. Goldwasser and his practice group have defended over 200 lawsuits against professional firms ranging from simple negligence cases to complex securities law class actions. In addition, he has authored successful amicus briefs on behalf of the NYSSCPA in the New York Court of Appeals on three critical decisions on the privity issue (including Credit Alliance v. Arthur Andersen and Security Pacific Business Credit v. KPMG Peat Marwick Mitchell & Co.) and one on the statute of limitations in tax preparation engagements (Ackerman v. Price Waterhouse). More recently, he submitted an amicus brief on behalf of the NYSSCPA in BDO Seidman v. Hirshberg in which the New York Court of Appeals upheld the right of an accounting firm to charge former employees for servicing firm clients after leaving the firm.
He has also defended CPAs in a variety of disciplinary proceeding brought by the SEC, the AICPA, the New York State Society of CPAs, the New York State Education Department and the California State Board of Accountancy. These proceeding covered a broad variety of issues including violations of professional and ethical standards.