BA 427 – Assurance and
Attestation Services
Lecture 27
Auditor Independence
Independence: Introduction

Independence issues might arise from any
relationship that exists between an auditor (or
the audit firm) and the client. Examples
include:
 Financial interests in the client, including
stock ownership and loans to the client.
 Loans from the client to the auditor.
 The auditor’s service as director, officer,
manager or employee of the client.
 Revenue received from the client for
professional services rendered
Independence: Introduction



These relationships might compromise
independence even if they are not aligned in
time with the audit (e.g., the auditor’s future
or past employment with the client).
These relationships might compromise
independence even when family members are
the ones involved in the relationship (e.g., the
auditor’s spouse is an employee of the client).
Some would argue that the audit fee itself has
the potential to compromise independence.
Independence: Introduction

The most controversial areas have been




stock ownership rules
non-audit (i.e., consulting) services
Independence-in-appearance
This lecture reviews these three areas
(mostly the second two), chronologically,
from 1960 to 2003.
Non-audit services

1959: An article appeared in Journal of
Accountancy, authored by a CPA from
a local firm in Ohio:

“The practicing accountant is urged to make
a list of advisory services his clients need,
and then compare it with the services he is
actually rendering to them. The difference
between the two lists represents a potential
which is not being tapped. Doing something
about it is up to the accountant—not the
client.
J. W. LaFrance
Non-audit services

1959: In the same issue of the journal,
the following editorial appeared:

It is obvious that selling ability … is an
essential ingredient in the provision of the
highest quality of professional services. …
One of the most important characteristics
of a true professional is recognition of the
need for services which the layman cannot
be expected to be aware of.
Non-audit services

1963: The AICPA Professional Ethics
Committee issued Opinion No. 12 on
auditor independence:

“… There is no ethical reason why a member
… may not perform … management advisory
services, and at the same time serve the
same client as independent auditor.” There
is no reason the provision of these services
should suggest to a reasonable observer a
conflict of interest.
Independence-in-Appearance



Independence consists of two
components:
 Independence-in-fact
 Independence-in-appearance
The quote from Opinion No. 12
addressed independence-in-appearance
Independence-in-appearance can only
be assessed after we specify who it is
that is doing the looking.
Independence-in-Appearance

“reasonable observer”


AICPA Professional Ethics Committee,
Opinion No. 12 (1963)
“alert and intelligent outsiders”

Mautz and Sharaf, The Philosophy of
Auditing (1964)
Non-audit services

1965: Research by Arthur Schulte:



635 surveys from financial institution
executives.
“To what extent do you believe that CPAs
can perform the managerial consulting
type of services to management on a fee
basis and still remain completely
independent?”
Depending on the respondent subgroup,
17% to 39% believe that consulting “may
seriously affect” independence.
Non-audit services

January 1966: JOA article by John Cary
(Executive Director of the AICPA) and
William Doherty (Manager of ethics and
legislation of the AICPA):




Article references the study by Schulte.
Asserts that results might be due to use of
the term “management consulting.”
Term wasn’t defined.
“management services” would have been
more appropriate.
Independence-in-Appearance

January 1966: JOA article by John Cary
and William Doherty refers to:

“reasonable observers—stockholders,
creditors or other users of financial
statements, or the business public
generally”
Non-audit services

1966 research study by Abe Briloff:


136 surveys from investment analysts, Big 8
auditors, and accounting professors.
94% of Big 8 auditors believe that the
rendering of management services for attest
clients is compatible with independence,
whereas 58% of financial statement users
believe management services are
incompatible with auditor independence.
Non-audit services

1966: AICPA created the Ad Hoc
Committee on Independence:

The Committee interviewed Schulte and
Briloff. It then administered Briloff’s
independence question to 16
representatives from various user groups.
These participants asked for clarification of
terms, but none was given. After the
questionnaires were completed, participants
were debriefed, and found to be confused.
Non-audit services

1966: AICPA ad hoc committee on
independence:

Committee revised the survey and readministered it. To the committee’s
“surprise,” some participants still
expressed concern.
Non-audit services

1966: AICPA ad hoc committee on
independence:

The Committee concluded:
 “there is substantial misunderstanding as
to the nature of management services
rendered by CPAs”
 “there are definite limitations on the
value of questionnaires on this subject”
Non-audit services:

1979: Two years after its formation, the
Public Oversight Board issued its report
Scope of Services by CPA Firms.

As input for the report, the POB held two
days of hearings, received 152 comment
letters, and conducted an extensive
literature review.
Non-audit services

1979 Scope of Services by CPA Firms
report:

While the available empirical evidence does
not reveal any actual instances where the
furnishing of MAS has impaired independence, the Board recognizes that the
nonexistence of such evidence does not
necessarily mean that there have not
been instances where independence
may have been impaired ….
Non-audit services

1979 Scope of Services report:

The lack of incriminating evidence was
mentioned repeatedly at the POB Hearing. …
It is also a recurrent theme in professional
studies on the subject, but the Board is
puzzled as to what weight it should be
given. Specific evidence of loss of
independence through MAS, a so-called
smoking gun, is not likely to be
available even if there is such a loss.
Non-audit services

1979 Scope of Services report:

The Board also considered and rejected the
more extreme view, expressed in the
[Metcalf Report], that auditors be prohibited
from furnishing to audit clients any nonaudit
services …. Such a draconian measure would
not only deprive audit clients of services
that they obviously deem valuable but also
would cause a substantial reduction in
revenues for many CPA firms.
Non-audit services

1979 Scope of Services report:

The Board believes that there is
possibility of damage to the profession
and the users of the profession’s
services in an uncontrolled expansion
of MAS to audit clients. Investors and
others need a public accounting profession
that performs its primary function of
auditing financial statements with both the
fact and the appearance of competence and
independence.
Non-audit services

Internal Audit Outsourcing


This particular consulting service grew
rapidly in the 1990s, and was controversial
in the context of accounting firms providing
internal audit services to attest clients.
In 1984, the SEC responded to an inquiry
by a small accounting firm, indicating that,
in general, internal audit outsourcing
services would compromise the auditor’s
independence.
Independence-in-Appearance


“a member who provides auditing and
other attestation services should be
independent in fact and appearance.”
 AICPA Code of Professional Conduct
(e.g., 1991)
The above quote appears under Section
I—Principles. However, in Section II—
Rules, under Rule 101 Independence,
there is no mention of independencein-appearance whatsoever.
Non-audit services

The 1994 POB Kirk Report:


In 1994, the POB released the report of the
Advisory Panel on Auditor Independence (the Kirk Panel), entitled
Strengthening the Professionalism of the
Independent Auditor (the Kirk Report).
The Panel had been commissioned by the
POB following a speech by SEC Chief
Accountant Walter Schuetze, in which he
criticized the accounting profession for not
standing up to clients on financial reporting
matters.
Non-audit services

The 1994 POB Kirk Report:


“The Panel finds worrisome the trend of
accounting firms, in wanting to grow, to add
or expand nonaudit services and thereby
reduce their reliance on and the relative
importance of auditing.”
“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.”
Non-audit services

The 1996 Ethics Rulings

The Executive Committee of the Professional
Ethics Division of the AICPA issued several
new rulings and interpretations related to
internal audit outsourcing.
 In effect, the new rulings extended
existing principles to internal audit
outsourcing, and asserted that these
services were no different from other
types of consulting services.
Non-audit services

The 1996 Ethics Rulings

The new rulings reaffirmed that the auditor
does not compromise independence as long
as:
 the auditor does not act or appear to act
in a capacity equivalent to management;
 the auditor does not act in a capacity
equivalent to an employee.
The Source of Revenues for
Accounting Firms
Other
Services
Audit
Services
Audit
Services
1976
Other
Services
1998
Independence Standards Board

The ISB




June 1997: The SEC, AICPA and large
accounting firms agree to the formation of
a new self-regulatory body: the ISB.
ISB’s mission: to establish independence
standards for public company auditors.
ISB organizational structure is similar to
the POB. There is an eight-member board,
four from the accounting profession.
October 1997: The ISB begins operations.
Stock ownership rules

Violation of stock ownership rules



In 1997, the SEC received an anonymous
letter alleging that C&L audit staff owned
stock in companies that C&L audited.
C&L then merged with Price Waterhouse.
The SEC required PwC to conduct an
internal investigation; and uncovered 8,000
stock ownership violations involving 50% of
the firm’s partners, including some key
partners.
Stock ownership rules

By the mid-1990s, the independence rules
for stock ownership were outdated.



The methods by which individuals invest in
capital markets had changed.
However, the rules were unambiguous, and
the SEC, under Levitt, chose to enforce
them enthusiastically.
The SEC urged the other firms to conduct
investigations of their compliance with the
rules.
Stock ownership rules


At the SEC’s request, the POB agreed to
conduct investigations of compliance by all
of the Big 5 firms with the stock ownership
rules.
In May 2000, the AICPA refused to fund the
POB’s stock ownership probes.
 Where upon Arthur Levitt referred to selfregulation by the public accounting
profession as a “bad joke.”
Independence Standards Board


February 2000: The ISB issued a
Discussion Memorandum for public
comment on a conceptual framework for
auditor independence.
November 2000: The ISB issued an
exposure draft. A final draft would be
issued in 2001.
Independence-in-Appearance

KPMG issued a comment letter to the
ISB:


“appearances, apart from the fact of
independence, cannot affect audit quality ….
They do not affect in any way the reliability
of financial statements.”
The conceptual framework exposure draft
“represents an untenable balance between
the old, insupportable appearance approach
to independence and an approach based on
the risk of compromised objectivity.”
Independence-in-Appearance

The AICPA submitted a White Paper to
the ISB:

Existing SEC and AICPA independence
requirements focus on situations that the
SEC staff perceive to impair independencein-appearance, but “these perceptions
embody assumptions that are highly
subjective, lack any empirical foundation …
and result in arbitrary and unduly restrictive
regulation.”
Independence-in-Appearance

Independence-in-appearance as
defined by the SEC in 2000:


“A reasonable investor, with knowledge of
all relevant facts and circumstances.”
As defined by the ISB in its Conceptual
Framework:

“well-informed investors”
Independence Standards Board


The ISB lost support from both the SEC and
the accounting profession soon after its
formation, in part because the SEC and the
accounting firms held irreconcilable positions
on two critical issues, including independencein-appearance.
The ISB initially attempted to find middle
ground: incorporating in its exposure draft the
concept of independence-in-appearance, but
avoiding the term. This satisfied nobody.
Independence Standards Board




Levitt believed that the accounting firms had
sufficient control of the ISB’s agenda to delay
or avoid meaningful self-regulation.
When the SEC proposed new independence
rules in the summer of 2000, it effectively
preempted the ISB’s role.
July 2001: The ISB voted to dissolve.
The ISB probably would have included
independence-in-appearance in its standard,
had it survived long enough to issue one.
SEC proposed new rules

In the summer of 2000, the SEC
proposed new independence rules.


The proposed rules would prohibit two types
of consulting services:
 internal audit outsourcing
 financial information systems design and
implementation.
The proposal also sought to modernize stock
ownership rules by replacing the old firmwide perspective with an engagementspecific perspective.
SEC proposed new rules


With respect to the restrictions on
consulting services, the AICPA and three
of the Big 5 firms strongly opposed the
SEC proposal.
Arthur Andersen’s CEO Bob Grafton told
Arthur Levitt: “Arthur, if you go ahead
with this, it will be war.” And it was.
SEC proposed new rules

SEC Chairman Arthur Levitt’s position:
•
“Audit fees made up 70 percent of accounting firm
revenues in 1976 but only 31 percent in 1998. …
•
The accountants were also doing internal audits
for companies. That meant that auditors were part
of the very control systems producing the financial
statements that they later audited. By conducting
internal audits as well as external audits for SEC
reports, some auditors were passing judgment on
their own work.”
SEC proposed new rules

SEC Chairman Arthur Levitt’s position:

Each of the three Chief Accountants who
served under Levitt spoke out on internal
audit outsourcing, conveying the SEC’s
concern to the accounting profession.




Walther Scheutze
Michael Sutton
Lynn Turner
Neither the AICPA nor the Big 5 firms
showed any inclination to change ethics
standards or their business model with
respect to consulting services.
SEC proposed new rules

On Levitt’s side:





John Hawke, U.S. Comptroller of the
Currency
The Institute of Management Accountants
The Institute of Internal Auditors
Three ISB Board Members
PriceWaterhouseCoopers and E&Y (sort of)
SEC proposed new rules

On the AICPA’s side:





KPMG
Arthur Andersen
Deloitte & Touche
46 member of Congress, including 2/3rds of
the Securities Subcommittee of the Senate
Banking Committee
The GAO (sort of)
SEC proposed new rules

On Levitt’s side:

John Hawke, U.S. Comptroller of the
Currency

The possibility for inherent conflicts and
impairment of auditor independence and audit
integrity is greatest when a bank outsources its
internal audit function to the same firm that
performs the bank’s external audit.
SEC proposed new rules

On Levitt’s side:

The Institute of Management Accountants


Went on record in 1996 stating that outsourcing
internal auditing to a company’s external
auditors compromises independence-inappearance.
The IIA

went on record in 1996 opposing total
outsourcing.
SEC proposed new rules

On the AICPA’s side:

The GAO (sort of):
 In 1996, the GAO reaffirmed a 1991
position that considered but rejected a
recommendation to limit the scope of
nonaudit services.
 The GAO will change its mind in 2002.
The AICPA comments on the
proposed SEC rules
“Putting the very future of the CPA profession on the
line, the SEC in late June [2000] proposed sweeping
rules that, if enacted in their current form, would force a
restructuring of the accounting profession. The most
threatening rule would prohibit accounting firms
performing audits for SEC registrants from providing
most non-audit services for those clients …. The SEC’s
new proposals are draconian and unwarranted ….”
The AICPA comments on the
proposed SEC rules
“The [AICPA Board of Directors] concluded that …
the proposed restrictions on non-audit services
were not in the public interest, as they would
strip the profession of skills needed to meet its
auditing responsibilities in the New Economy.”
As reported in the CPA Letter, 9/00
Testimony to the SEC by Barry
Melancon, AICPA President and CEO
“… clearly, the overwhelming
response of our profession is of grave
concern for the proposed rule.”
Testimony to the SEC by Phil
Laskawy, CEO of E&Y
“I do not agree with the approach taken by
others in the profession, including the AICPA,
in making harsh attacks against the
Commission …. In fact, I am quite troubled
that the AICPA, which has an obligation to
represent all of its members, would take
sides in a fashion that can only weaken
public confidence in the accounting
profession.”
Testimony to the SEC by Jim Schiro,
CEO of PwC
“… I am extremely disappointed that a group
that is to represent the members does not
solicit the views of all the members before
promulgating a position. … I find that some
of the actions of the leadership of that
organization have not been representative
… of our two firms and did not engage us as
they were adopting this position.”
Michael Cook versus James Copeland
Cook, the former Chairman of D&T, supports
the rules: “some action on the part of the
Commission is probably the only practical and
feasible way to deal with the issue. … the status
quo is not an acceptable answer.”
Copeland, who succeeded Cook as Chairman
of D&T, opposes the rules: “I firmly believe that
the unintended consequences of this bright line
limitation on services will be significant and far
reaching, resulting in a lessening of audit quality
….
Testimony by Robert Elliott,
AICPA Chairman and KPMG partner
We in the AICPA are disappointed in the rush
to judgment manifest in the SEC’s premature
issuance of a hastily and poorly drafted rule
proposal followed by an inadequate comment
period. … There is no evidence that lack
of auditor independence is even an
infrequent problem, let alone a current
crisis.
The Panel on Audit Effectiveness
Report and Recommendations
August 2000
The Panel is not aware of any instances of non-audit
services having caused or contributed to an audit
failure or the actual loss of auditor independence.
However, as the POB noted in its study on scope of
services, “Specific evidence of loss of
independence through MAS …, a so-called
smoking gun, is not likely to be available even
if there is such a loss.”
Testimony by Robert Elliott,
AICPA Chairman and KPMG partner
We are not here simply because we believe
that auditors … are underpaid. We’d all like
to be paid more. This is not about how
much accountants are paid. This is about
our ability to provide the profession the same
level of high quality information for investors
that has enabled the American economy to
zoom ahead of the rest of the world.
POB 1979 Scope of Services Report
The Board also considered and rejected the more
extreme view, expressed in the [Metcalf Report], that
auditors be prohibited from furnishing to audit clients
any nonaudit services …. Such a draconian measure
would not only deprive audit clients of services that
they obviously deem valuable but also would cause
a substantial reduction in revenues for many CPA
firms.
Testimony by Robert Elliott,
AICPA Chairman and KPMG partner
… you say witnesses come and say we should
have audit only firms, firms that are
essentially statutory auditors. We want to
make as clear as possible to you that we
believe that if audit firms were solely
audit firms, solely statutory audit firms,
that the quality of accounting in
auditing in the United States would go
down, and it would go down increasingly
quickly in the future for two reasons.
Testimony by Robert Elliott,
AICPA Chairman and KPMG partner
The first reason is that the process of
describing increasingly complex and high
technology businesses, which are the
backbone of our economy, will now be done
by a bunch of narrowly focused auditors.
And secondly, the appeal of the
profession of statutory auditing for new
talent coming to the profession would
be approximately zero.
Testimony by Michael Cook, former
CEO of D&T
“[An] assertion, often made …, is that these
audit-dominated firms of the future will be
unattractive and, therefore, will be unable to
attract and retain the best and brightest
people. … I’m a bit personally disappointed
by this assertion, since it was just one of those
firms or a firm very much like that that I joined
about 35 years ago and that I found to be very
challenging and very satisfying professionally for
a 35-year career.”
A compromise: The SEC’s
independence rules of 2000


According to Arthur Levitt, the SEC received a
great deal of political pressure to back down
from its proposed rules.
Where did this pressure come from?
 Each of the Big 5 was one of Bush’s top 20
campaign contributors in 2000.
 The AICPA contributed $14.5 million in the
2000 elections.
 The accounting profession was 27 out of 122
sectors of the economy in terms of
campaign contributions.
A compromise: The SEC’s
independence rules of 2000

Internal audit outsourcing



No ban on internal audit services provided
to companies with less than $200 million
in assets.
For companies with more than $200
million in assets, up to 40% of the
internal audit function can be outsourced
to the company’s public accounting firm.
Information technology

No blanket ban
The rhetoric continues from the AICPA
Our key issues included avoiding a blanket ban on …
internal audit outsourcing services. … We believe
considerable progress was made. … Shielding smaller
firms from the potential crippling effect of the new rule
was--and is--a high priority.
The rhetoric continues from the AICPA
“The SEC initially proposed to completely prohibit firms
from providing information technology and internal audit
outsourcing services. … under the new rule an audit firm
will be allowed to perform up to 40% of an audit client’s
internal audit work when the client has $200 million or
more in assets. There is no limit on the amount of
internal audit work for a client with less than $200
million in assets.”
The rhetoric continues from the AICPA
While this approach is not what we were seeking, in that
it departs from current AICPA standards, it is a vast
improvement over the proposed blanket ban.
Obviously, the SEC recognized, as a result of comment
letters and testimony in its public hearings, that internal
audit outsourcing is a very important service ….”
Richard I. Miller, AICPA General Counsel & Secretary,
January 2001
And then came Enron . . .
Enron:
Audit Fees = $25,000,000 Other fees = $27,000,000

Joe Berardino, 15 months prior to the Enron
bankruptcy, testified to the SEC:
 “As a firm, then, we find that internal audit
outsourcing increases our knowledge of the
processes our clients employ. … What we
feel we are doing is simply auditing more of
the client’s business.”
And then came Enron . . .

Ken Lay submitted a comment letter to
Arthur Levitt, dated the same day as
Berardino’s testimony:

“Enron has found its “integrated audit”
arrangement to be more efficient and costeffective than the more traditional roles of
separate internal and external auditing
functions. Frankly, I fail to understand how
extending the scope of what is
independently audited can be anything but
positive.”
Congressional Testimony on
Enron

Charles Bowsher, Chairman of the POB:


The Public Oversight Board strongly believes that a
new regulatory structure for the accounting
profession is essential. However, we believe that to
be effective, it must be totally independent of the
accounting profession and it must be based on the
foundation of congressional action creating a
statutory self-regulatory organization.
The POB proposes that SEC regulations concerning
independence be legislatively codified with
appropriate revisions to update restrictions on
scope of services involving … internal audit
services …
Congressional Testimony on
Enron

Six current and former Chairmen of the SEC
testify.
 Rod Hills, 1975-77: “The sad truth is that
the [accounting] profession has lost sight
of the significance of the signature line of
the opinions they give to their clients.”
Congressional Testimony on
Enron

Six current and former Chairmen of the SEC
testify.
 Harold Williams, 1977-81: “The case for
insisting that an auditor not provide other
services to the client it audits is a strong
one. … Perception is now as important—
perhaps more important—than reality.”
Congressional Testimony on
Enron

Six current and former Chairmen of the SEC
testify.
 David Ruder, 1987-89: Urges all of the
Big 5 to “refrain from offering management
consulting services to audit clients.” “The
commission’s rule regarding internal audit
services seems to recognize that
outsourcing … to the company’s external
auditors creates conflicts or appearances of
conflicts because the external auditor
eventually will be auditing its own work.”
Congressional Testimony on
Enron

Six current and former Chairmen of the SEC
testify.
 Richard Breeden, 1989-1993: “At a
minimum, the auditing firms should be
prohibited from providing financial
structuring, investment banking, internal
audit, data processing systems, and legal
services for audit clients, and perhaps for
any client.
Congressional Testimony on
Enron

Six current and former Chairmen of the SEC
testify.
 Arthur Levitt, 1993-2000: “It’s well past
time to recognize that the accounting
profession’s independence has been
compromised.” “All along the profession has
resisted meaningful oversight.”
Congressional Testimony on
Enron

Six current and former Chairmen of the SEC
testify.
 Harvey Pitt, current Chairman as of
2002: adopts a wait-and-see attitude with
respect to the 2000 rules.
Congressional Testimony on
Enron

Shaun O’Malley, Chair of the Panel on
Audit Effectiveness (and former Chair of
Price Waterhouse):

“… two important services were not adequately
addressed in the [SEC 2000] rule. These services
constitute a significant part of the nonaudit services
being performed by audit firms: 1) financial
information systems design and implementation,
and 2) internal audit outsourcing. … both services
should typically be performed by the management
of an issuer, not by its auditors.”
Congressional Testimony on
Enron

Bevis Longstreth, Former SEC
Commissioner and former member of the
Panel on Audit Effectiveness:
 My thesis is simple. The profession needs
reform in two major respects:
1.
2.
An effective rule preventing the delivery of nonaudit services to audit clients; and
An effective system of self-regulation
… Indeed, I believe that, without these
reforms, the profession, which has been its
own worst enemy, will continue to spiral
downwards ….
Congressional Testimony on
Enron

John Whitehead, former Co-Chair of
Goldman Sachs and former Co-Chair of
the Blue Ribbon Committee on Improving
the Effectiveness of Corporate Audit
Committees:

“Having given the matter a lot of thought in recent
years, … I have reached the conclusion that the
accounting firm that does the audit should not do
other advisory work for the company. Without that,
the independence of the auditor’s work will always
be suspect.”
The Sarbanes-Oxley Act

Title II

Prohibited Services: auditors are prohibited
from providing the following services to their
public company audit clients:






Bookkeeping services
Financial information systems design and
implementation
Appraisal or valuation services
Actuarial services
Internal audit services
Various others
The Sarbanes-Oxley Act

Title II

Prohibited Services: all non-audit services
not specifically prohibited by Title II (e.g.,
tax services) require pre-approval by the
audit committee.


An exception is provided for very minor services.
The PCAOB is granted exemption authority
on a case by case basis.
In the aftermath of SOX:

At the end of 2002, the three SEC Chief
Accountants who served under Levitt
(1993 – 2001) submit a joint letter to
the PCAOB:

“If investors believe that a particular service
conflicts with an auditor’s ability to be
independent, then that service should be
prohibited.”
In the aftermath of SOX:
When the big audit failures of Enron Corp. and
WorldCom Inc. came to light, the last person the
American Institute of Certified Public Accountants
needed as their chief executive was Barry C.
Melancon.
In the aftermath of SOX:
Melancon still argues that accountants should
be allowed to solicit lucrative consulting deals
from the companies they audit. Melancon
insists there is no proof that Andersen's
auditors were influenced by the firm's side
deals. His stance left AICPA with little say as
Congress drafted reforms.
In the aftermath of SOX:
Melancon, who earns $600,000 a year, signed
a second five-year contract in 2000. "I am
very passionate about this profession and this
organization," he says. "I am a change agent."
If accountants really want to win back trust,
they should change agents.