The tussle over auditor independence

Just as the year is coming to a close several serious dramas are beginning to play themselves out in the accounting profession. 

The way some of these matters are dealt with will shape the way the profession views the corporate regulator. In particular, the pirouette of regulators and accounting firms in the area of auditor independence has begun to take an interesting turn domestically and overseas.

Just as the year is coming to a close several serious dramas are beginning to play themselves out in the accounting profession. The way some of these matters are dealt with will shape the way the profession views the corporate regulator. In particular, the pirouette of regulators and accounting firms in the area of auditor independence has begun to take an interesting turn domestically and overseas. The US scene has bubbled furiously during the past year with debates, proposals and negotiations resulting in a proposed rule seeking a middle ground between what the accounting profession would feel comfortable with and the initial militant fervour with which SEC chairman Arthur Levitt pursued the issue. Speeches delivered by Levitt in the past 12 months have focused on audit independence as a crucial issue and the hard line espoused by the SEC has been resisted by the Big Five. Independence was an issue highlighted during his address to the annual meeting of the International Organisation of Securities Commissions in Sydney during May.

He pushed heavily for a ban on firms providing other services to clients, his argument largely based on the fact other services are priced higher than the audits. Other services are, according to Levitt, then proffered to clients as cross-selling opportunities arise. "When performing an audit, auditors are accountable to one master – the audited company's shareholders," he said. "But when auditors engage in extensive services for an audit client truly unrelated to the audit, they must also serve another master – management. In this dual role, the auditor, who guards the integrity of the numbers, now both oversees and answers to management." Levitt ended his brief dissertation on the SEC's concerns on auditor independence by posing several questions to the audience that consisted largely of fellow regulators from around the world. "In my view, any regulatory action must address a few fundamental public policy questions: Should there be more appropriate limits on the types of services that an audit firm can render to a public company client?" he asked. "How should audit firms be structured to assure independence? What are the consequences, if any, of public ownership? Should firms be permitted to affiliate with entities who provide services to the firms' audit clients that the firms themselves would not be allowed to provide?"

In chasing an outcome that suited his position in the early stages of the US-centric debate Levitt raised a huge dust storm from which he and the SEC are yet to recover. The push to ensure firms don't hawk other services to audits clients because it was seen by the US regulator as compromising independence raised the ire of the Big Five. Three of the majors – KPMG, Deloitte Touche Tohmatsu and Arthur Andersen – threatened court action or Congressional pressure in order to stop what was seen as a regulatory offensive against the way accounting firms were doing business. Under threat was the linkage most firms have between audit and management consulting, particularly the work done by the information technology specialists. PricewaterhouseCoopers and Ernst & Young had already started radical restructuring of their firms. For example, Ernst had sold its management consulting services arm to French-based Cap Gemini. That sale has meant the firm is now in a position where any expertise on the management consulting side of the practice would need to be developed internally in a different manner.

E&Y Australian chief executive Brian Schwartz recently told Company Director the firm ensured its audit teams are equipped with individuals that can handle the IT side of the auditing assignments. In other words, there more ways of skinning a cat when you need IT specialists on audit jobs than just having a management or IT consulting services division. In a move widely seen within the profession as a political compromise to get an outcome before the start of the new US presidency the proposed rules released by the SEC on November 15 give the profession a less controversial outcome than was initially expected because of the SEC's strong public stance. There is a revision to rules about how investments and familial relationships impact on independence. Both sides of the argument were keen to see these changes in order to modernise the requirements. One aspect of this, of course, is the fact employee share plans are now more a part of the remuneration scene than before. It is conceivable that draconian regulations affecting the ability of a loved one to get remunerated in a particular way could make life tough.

You could foresee the circumstances where your spouse might be concerned because your professional obligations might not allow him/her to hold shares in a particular company. S/he might rather spend the rest of their life with their investment portfolio. For example, the area of providing other services to clients has largely been left untouched. Auditors can provide IT consulting services for example, but the proposed rules require management to take responsibility for the IT project, all decisions made during the project and any assessment of whether the project was completed satisfactorily. According to the proposed rule, management should not rely solely on the work done and advice given by the audit firm, for which they have probably paid a tidy sum, in determining whether their financial reporting system is adequate. The SEC would require that management "does not rely on the accountant's work as the primary basis for determining the adequacy of its financial reporting system". It makes you wonder why companies call in specialist firms in the first place if they can't place a high degree of reliance on their work.

One Australian Big Five senior audit practitioner recently noted that in practice those conditions requiring management to take responsibility were likely to be honored in the breach. Another interesting decision is the arbitrary 40 percent rule on internal audit. Firms can do 40 percent of the available internal audit work on a client in addition to the external audit. So, technically speaking, a firm of accountants can end up auditing at least in part its own work. How could the external auditor assess whether his firm has done 40 percent of the available internal audit work on a client engagement? Valuation services provided to audit clients are also okay provided the valuation relates to numbers that are unlikely to be material or significant to the audit. It remains to be seen whether the audit independence rules as proposed mid-November improve practice or even generally enhance the profile of auditors. Contrast the cut and thrust debate in the US with the symbolism of the covenant agreed between Deloitte Touche Tohmatsu and the ASIC.

That covenant is the phoenix arising from the ashes of the Adsteam settlement and, despite the fact it applies only to Deloitte, other firms are closely watching the implications. In essence, the covenant, which is freely available on the ASIC website for all to see, sets out or codifies what Deloitte is doing to ensure audits are conducted in accordance with best practice guidelines. There are some interesting aspects to the ASIC/Deloitte memorandum that have caused some raised eyebrows in the audit divisions of other firms, Big Five and second tier alike. Most comments on the covenant itself have been background concerns. None of the firms have come out publicly, although senior partners do acknowledge their top brass are concerned about aspects of the agreement. The two independent reviews to be held as a part of the understanding between the two parties are, to say the least, novel. Some observers have been critical of the additional review process, particularly because of all the other usual checks such as the peer review processes already in place.

Auditor rotation, which takes place to avoid auditors becoming too familiar with one client, is no big deal. It is established procedure in most firms already, but the covenant details a rotation regime that is tighter than most firms have in place already. Deloitte has outlined a five-year rotation process. Most firms have a seven-year rotation policy and the tighter engagement turnaround has come as a surprise. Another dilemma for some is the fact Deloitte's covenant with ASIC requires audit partners and staff to get material reviewed by the national technical division. Views on this aspect of the covenant differ. One school of thought says that's normal and "my firm is already doing that" to the other extreme where national technical partners are called in only when an audit engagement partner or audit staffer has an issue needing resolution. The covenant will probably be on the agenda between new ASIC chief accountant Ian Mackintosh and the auditing heavies. Mackintosh has already signalled he wants high audit quality across the board and the covenant is probably a good excuse to talk to the firms about independence and quality issues.

The year hasn't just been concerns about independence. A new standards board has begun to settle down despite having its deliberations significantly delayed by the Federal Treasurer's knack of taking time to formally appoint people to statutory positions. It was nearly two months from the announcement of the Australian Accounting Standards Board composition – minus the chairman – to the formal appointment of Keith Alfredson as first AASB full-time chairman. There has also been the criticism of the Financial Reporting Council, the new body that is charged with overseeing the AASB, and its failure to find alternative sources of funding for the board. Funding has largely been drawn from the "usual suspects" – the two main accounting bodies, the Federal Government and the State treasuries – with one exception. The National Institute of Accountants has given an undisclosed amount to the standard setting structure for the first time. Its contribution further confirms the commitment of the accounting profession to the process and all indications are that the NIA might be in line to get a spot on the Urgent Issues Group.

However, it appears not all funding was given to the new structure without strings attached. The State Treasuries, according to several accounts, had placed an ultimatum on the table. Their $500,000 contribution, part of the AASB's $2.9 million per year for three years, was tied to their getting an additional spot on the AASB. More than anything else, that sort of treatment of a once independent process poses the question: is the oversight body there to oversee the structure for the benefit of all users and stakeholders? Or is it going to be susceptible to particular pressure groups such as the public sector because of the poor history of funding that has dogged accounting standard setting in Australia for aeons? That move more than any other has illustrates the threats that exist to the independence of the board. It has set a precedent. Just imagine if a significant corporate lobby group decided to try to buy an outcome by putting money on the table in order to achieve an end. It just might be a good idea if some people spent a part of the holiday break thinking about what that sort of thing could do to our international reputation.

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