Testimony of William R. Kinney, Jr.
Charles and Elizabeth Prothro Chair in Business
The University of Texas at Austin
On Auditor Independence
Before the Securities and Exchange Commission, September 20, 2000
I am William Kinney, accounting professor at the University of Texas at Austin. I appreciate the opportunity to express my views on the proposed Revision of the Commission's Auditor Independence Requirements. My comments are based on my 32 years of experience as a professor of accounting and as a former member of the AICPA's Auditing Standards Board and Special Committee on Assurance Services. Today I am speaking as a professor: I have not been paid or retained by any firm or professional organization.
In my classes, I tell MBA and accounting students that investors' perceptions of the auditor's independence comprise one of three determinants of the value of audited financial statements (the other two being investors' perceptions of the decision-relevance of the accounting rules used, and care taken in applying the rules). Because a registrant hires an auditor to certify compliance with GAAP, each audit firm has a huge stake in investors' perceptions of their particular audit firm's independence. If investors perceive that the auditor or audit firm has a substantial interest in financial statements other than their quality, the firm's audit cannot add value for the registrant and the audit firm will be fired. I believe that the Commission can leverage this private interest for the benefit of investors.
Below are comments on two of the Commission's proposals. The first is modernization of proscriptions of financial and employment relationships, and the second is proscription of certain non-audit services.
1. I believe that the proposed modernization of proscriptions of financial and employment relationships is in the interest of investors. The modernization reflects large audit firms' dominance of the registrant audit market. Adoption of the proposed changes in proscribed relationships for individuals associated with the audit firm would, in my view, reduce aggregate regulatory compliance without affecting audit quality or increasing independence impairment risk for investors.
2. I do not believe that the proposed proscription of certain non-audit services is in the interest of investors. In my view, its adoption would:
a. Raise costs for small registrants. The independent auditor is often the only outside expert routinely reviewing and advising management of small registrants. Costs will likely rise if, for all consulting engagements, management must locate and engage consultants from a firm other than that of their auditor. I do not see clear offsetting benefits.
b. Narrow the auditor's perspective. Auditors familiar with professional services such as client business risk assessment, performance measurement design, and various information technology services, are more likely to recognize threats to financial reporting (and business viability) as the threats arise. Proscribing such services for audit clients would hamper development of the broad perspective that individual auditors need to recognize and protect investors' interests in a period of rapid change and global competition.
c. Introduce inconsistencies. The proposal would proscribe some services that, in my view, are essentially equivalent to services that are not proscribed. As an example, it would proscribe systems design advice for processing routine accounting transactions, but would not proscribe individual transaction design advice such as advice on how to structure an acquisition to warrant a specified accounting treatment. Similarly, the proposal would not proscribe audit firm preparation of tax return amounts or planning advice to minimize taxes.
Note, I do not advocate that either accounting or tax advice to audit clients be proscribed. Rather, I am noting proscription inconsistencies among and between services that potentially affect financial statement amounts.
d. Possibly create a false sense of security. Some investors may presume incorrectly that eliminating the non-audit services income stream eliminates loss of independence risk for an audit engagement partner. However, a more important risk remains: that of the partner acquiescing inappropriately to management's views for fear of losing the auditing revenue stream.
For a particular client, the present value of the expected (annual) audit revenue stream is typically larger than that of short term, "one off" consulting projects at a point in time. Yet, the proposal is silent on the need to monitor the engagement partner when zero non-audit services are purchased.
As an alternative, the Commission might leverage audit firms' private interests in independence by requiring that each firm demonstrate to regulators effective private mechanisms to monitor the independence of their own partners and employees. The AICPA's 1997 white paper outlines a possible approach.
e. Reduce the benefits of a more comprehensive alternative. Independence Standard No. 1 and other regulations provide a comprehensive means for protecting stockholders' interests through audit firm disclosure of relationships to the independent audit committee. Potentially, these mechanisms can protect stockholder interests regarding all aspects of actual (or perceived) independence without tedious service proscriptions across the market. In my view, IS No. 1 and related regulations should be given a chance to work.
I hope that these comments will be useful to the Commission. (9/25/00)