Volume:
                   10
Issue:
                   2
Start Page:
                   131
ISSN:
                   08887993
Subject Terms:
                   SEC accounting policies
                   Auditing profession
                   Accounting firms
                   Accountant independence
                   SEC accounting policies
                   Auditing profession
                   Accounting firms
                   Accountant independence
Classification Codes:
                   9190: US
                   8305: Professional services
                   4130: Auditing
                   4110: Accountants
Geographic Names:
                   US
                   US

Abstract:
Accountancy appears the least likely of all professions to be in a state of ferment.
However, contrary to appearances, significant developments within the profession could
profoundly affect the vital interests of the investing public and of corporate America.
Observations about what is happening to the independent audit of the publicly-held
corporation are presented. An advisory panel concluded that the profession is at a critical
juncture. Forces at work both within and outside the profession could erode its
independent role as watchdog for the public. The SEC bears a heavy responsibility for
restoring the importance of the independent audit. Rather than bypassing the established
mechanisms for setting accounting standards, defending the tort system to remedy audit
failures and expressing cynicism about auditing firms, it should seek ways to strengthen
the independent audit by an open dialogue with the profession.

Full Text:
Copyright American Accounting Association Jun 1996
 

Accounting appears the least likely of all professions to be in a state of ferment. However, contrary to
appearances, significant developments within the profession could profoundly affect the vital interests
of the investing public and of corporate America.

Over many years, I have had an opportunity to observe the profession from a number of different
perspectives-as chief executive of a publicly held corporation, a director and member of audit
committees, a regulator and a public participant in the profession's governance. Most recently, I
served as a member of an Advisory Panel to review the issue of auditor independence.l From these
experiences, I have gained great respect both for the importance of the profession to our capital
markets and for the high quality of the people laboring in its vineyards. This article reflects my
observations as a non-accountant about what is happening to the independent audit of the publicly
held corporation and expresses my concerns about what I see. I hope these observations will stimulate
further debate about the future of a profession in which the investing public and corporate America
have a profound interest.

BACKGROUND

Our Advisory Panel concluded that the profession is at a critical juncture. Forces at work both within
and outside the profession could erode its independent role as watchdog for the public. That role
needs buttressing by measures that go beyond changes in processes or procedures.

There has been no shortage of thoughtful studies of the profession over the past 25 years, all aimed at
strengthening the independent audit. Yet, the same issue persists-making certain that the auditor can
act as independent professional advisor to the board and its audit committee, able, where necessary,
to challenge management's views and stand firm where they breach professional standards.

Most of the recommendations in prior studies have not dealt head-on with that issue. Rather, they
have focused more on improvements in procedures-in setting accounting and auditing standards, in
requiring reports to shareholders by the board and management and in strengthening the audit
committee in corporate governance. While adoption of most of these recommendations has
substantially improved the audits of corporate financial statements, some have had the inadvertent
effect of making audits more rule driven and compliance oriented, diverting attention away from the
harder issue of professional independence.

The stakes in this matter are very high. The investing public relies upon the integrity of financial
statements and, despite audit failures, they continue to repose great trust and confidence in the
independence and objectivity of the profession. For this reason, anything that threatens to undermine
that trust and confidence has an impact far beyond the narrow interests of accountants.

Corporate America has a stake in the independence of its auditors. That independence enhances the
reliability of management's financial statements and gives them a credibility which they would not have
would not have without certification. If the relationship between management and the auditors works
as it should, the board and shareholders have, through the independent audit, an important check and
balance in the reporting processa check and balance that works to the advantage of all parties.

THE RELATIONSHIP BETWEEN AUDITORS AND MANAGEMENT

It is important to start from a fundamental proposition-corporate management has the responsibility for
preparing the financial statements. The auditor's responsibility is to express an opinion that the
statements present fairly the financial position of the enterprise in conformity with GAAP and are
audited in accordance with generally accepted auditing standards. This division of responsibility builds
a tension into management's relationship with the auditors, who must both work closely and
harmoniously with management and at the same time preserve professional objectivity and
independence. This tension is a fact of corporate life-one that must be lived with because the
alternatives are so much worse. Proposals to change the relationship by, for example, having auditors
prepare the financials or shifting responsibility for auditing to a government regulated entity have so
many disadvantages that they cannot be taken seriously.

In preparing the financials, management makes judgments about the selection and application of
accounting principles, the nature and extent of disclosures, and estimates of balance sheet and profit
and loss items. Top corporate management cannot avoid getting involved in accounting issues such as
revenue recognition, expense accruals, reserves, writeoffs, inventory valuations and tax liabilities. As
the financial markets have become more of a focus of interest, corporate management has shown
increasing sophistication in understanding and resolving accounting issues.

It is sometimes overlooked by the investing public that management publishes its financial results on an
unaudited basis (other than the annual audited financials or financials in connection with a registration
statement). The auditors and the board audit committee review these reports usually after publication.

There are, of course, managements that regularly consult with their auditors in preparing unaudited
financials. These managements look to their auditors as an important resource and want their input on
accounting and auditing matters. Also, there are vigorous audit committees that reach out to the
auditors for their professional judgments and take an active role in the reporting process. These cases
are more exception than rule.

When the auditor is consulted by management, management usually doesn't want to know what is
preferable but whether its accounting judgments are acceptable under GAAP. Management is
primarily interested in achieving a result, not being told what is the best practice. Auditors are also
under enormous time pressures to respond when the client asks, before the release of annual earnings,
whether there are any audit adjustments that might affect the numbers. Once published, the auditors
bear an unusual burden if they recommend restatement.

This is not to say that managements care little about accounting principles. Managements want their
financial statements to have credibility. Nor is this to say that auditors do not stand up to their clients.
They do, but the nature of the relationship between management and the auditor imposes a heavy
burden upon the latter to stand firm. It is a tribute to the quality of the people in the profession that
many continue to do so.

The auditor's relationship with management has built into it other handicaps that work against
independence. Financial management serves as the intermediary between the company and its
auditors. It recommends to the audit committee the auditing firm, negotiates its fees and guides the
audit. Moreover, financial management retains the auditor's firm for non-audit services-a growing
source of revenues for these firms. In most companies, financial management sets the agenda for audit
committee meetings and serves as the primary interface between the audit committee and the auditors.
A knowledgeable observer interviewed by our Panel described the current situation as one where
"financial management has captured the auditors," despite the safeguards built into the relationship.

THE CHANGING ROLE OF AUDITORS

At one time, the external auditor served as the primary source of expertise on accounting and auditing
issues. Now corporate financial officers have competencies in these areas which more than match
those of their auditors. These competencies are also backed by an intimate knowledge of the company
and by internal audit staffs that perform much of the work formerly performed by the external auditor.
Moreover, financial officers use this expertise to take a greater role in the accounting and auditing
standard setting process. In larger companies, financial personnel monitor and influence the work of
the FASB and other bodies that deal with accounting and auditing issues. As clients have become
more aggressive, accounting firms have come under real or perceived pressures to support client
positions. A good illustration is the active participation of both corporate managements and the major
accounting firms in opposing the FASB's original stock compensation proposal.

Clients expect their auditors to be specialists and firms have responded by organizing their auditing
activities by industry. In some firms, each industry group serves as a combined profit center for tax
and consulting as well as audit. However, specialization by industry has a downside. Auditors may be
so close to the industry that they become proponents of industry practices and find themselves drifting
into taking positions that fall short of providing the most relevant and reliable accounting information.

There are other factors limiting the ability of outside auditors to act as professional advisors to the
board and financial management. As government and the courts have placed more responsibility upon
corporations to comply with laws and regulations, the outside auditor has been drawn into acting as
compliance officers in areas, such as derivatives, government contracts and risk management. It is not
that accounting firms should not supply these services, but in supplying them, the effect is to detract
from their primary mission as professional accountants. Also, the recent emphasis by the Congress and
regulators on the detection of fraud has placed auditors in the role of sleuths. Here again,
over-emphasis on an ancillary role has the subtle effect of downgrading the auditor's primary
responsibility.

Unfortunately, as a result of all these factors, the outside audit has become a commodity-its value
marginalized as the financial officer has the same or greater capability than the auditors. The financial
officer tends to see little or no value added in the audit other than certification of financials prepared in
accordance with GAAP that stops at the water's edge. Turning the audit into a commodity has other
damaging effects. Auditing firms compete on the basis of price with the result that firms engage in
destructive price competition for clients. Under pressure from competitors and their clients, auditors
want detailed tests for every accounting and auditing question that arises. Tests that try to cover every
conceivable situation help eliminate the risk of drawing lines with clients based on accounting
judgments and eliminate the possibility of a competitor not drawing the same line.

No one argues that management should have a reduced role in accounting and auditing . On the
contrary, the complexity of managing and controlling a business in today's environment, the growth of
new financial instruments and transactions, and the speed with which decisions must be made requires
strong, competent financial management. It is this very complexity, novelty and speed which increases
the need for independent advice to the board and its audit committee.

What is happening to the independent auditor mirrors the decline in outside corporate counsel. As one
observer notes, "preventive lawyering" and independent counseling to clients at one time served as
guideposts for outside counsel (Glenden 1993, 34-35). While these guideposts may not have always
been observed in practice, they did honor the idea of telling clients how to avoid litigation or of
deliberating on proposed courses of action. However, the idea of outside counsel serving as the
trusted advisor to the board and management has, by and large, disappeared. Now, outside counsel is
usually retained by house counsel and hired on a short term, specialized basis to get results, not to
deliberate with the board or management.

The independent auditor has not fallen as far as outside counsel. But, without major change, the
auditor seems to be headed in the same direction.

THE HIGH RISKS OF AUDITING

The huge judgments against accounting firms, for real or perceived audit failures over the past several
years, have had a profound impact upon the profession. Accounting firms are frequently named as
defendants whenever there is a business failure or transgression because they may be the only
defendant that is not judgment proof.

The organized plaintiff's bar has singled out accountants as prime targets in securities fraud cases.
Attempts by the profession over the past decade to interest the SEC in proposing reasonable limits on
litigation have until recently been unsuccessful. The SEC has feared any limitation on private litigants
enforcing the securities laws, viewing private litigation as an important adjunct of the agency's
enforcement program.

However, by exposing the independent auditor to the vagaries of the tort system, the SEC failed to
take into account the effect upon auditor behavior. The ever present threat of litigation discourages
new entrants into the profession, encourages a proliferation of standards to serve as a protection
against second guessing, and creates an atmosphere where auditors are reluctant to make professional
judgments. Most important, it accelerated changes in the business strategies of the major accounting
firms away from auditing to non-audit services entailing less risk.

Over 60 years ago, the SEC made the policy decision to use private accounting firms rather than a
public agency to audit the financial statements filed by SEC registered companies. The independent
audit conducted by private accounting firms forms an essential part of the present corporate disclosure
system. Unfortunately, the disciplining of audit failures has been largely left to a tort system which
treats auditors in the same way as corrupt management or stock promoters. In hindsight, it strikes me
as a major policy mistake to leave auditors to the mercies of the plaintiffs' bar when other disciplinary
tools would be more effective. The plaintiffs' bar has so distorted and misused private enforcement
that reform had to come.

The profession, until recently, has also had to face an antagonistic Congress hardly supportive of the
profession's special role. The tendency has been to blame auditors for failures such as the S&L
debacle which had more to do with misguided Congressional and regulatory policies than with audit
lapses.

How can a profession attract qualified people if the Congress and the SEC treat accountants as
suspects? It is important to call the profession to account where it has failed in its responsibilities to the
public. But it is dangerous to let an attitude of hostility and cynicism undermine a profession upon
whom the SEC and the public rely for the integrity of financial statements.

THE CHANGING ECONOMICS OF AUDITING

Senior management in the major accounting firms have had to attune their business strategies to a
market where auditing is subject to intense price competition, appears to have lost value to financial
officers and carries with it higher risks than other service businesses.

The six major accounting firms audit 90 percent of the publicly traded companies in the United States.
However, a major transformation of their businesses away from auditing is now underway. These firms
earn only half of their revenues from auditing and accounting services and some considerably less.
Several are now the world's leading consulting firms. Based upon the increasing allocation of resources
in capital and personnel to non-audit services, these firms have become multi-line service organizations
in which accounting and auditing are rapidly becoming secondary activities.

Managing partners of accounting firms have to say to themselves "why should we expand a business
that carries such high risks, that is priced like a commodity when there are other service businesses
with higher margins and less risk."

The best and the brightest who might become auditors observe what is happening. Auditing attracts a
declining percentage of the top college graduates and it is becoming a less attractive profession,
particularly in beginning assignments. Talented newcomers are attracted to non-auditing services
where there is more growth and greater compensation opportunities. Rhetoric about the special
responsibilities of auditors will not change these economics.

Nothing on the horizon gives promise that the major accounting firms will change their business
strategies. In fact, as the officers and partners who generate more profitable nonaudit services come to
dominate their firms, the movement away from accounting and auditing will accelerate. A business
culture oriented towards management consulting and other non-audit services has different
professional standards and incentives with the potential for future conflicts on management and
compensation issues.

It is likely that major changes in the organization and management structures of larger accounting firms
will accelerate as auditing assumes a less important role. Auditing services may have to be separated
either in another affiliated entity, as some firms have already done, or spun off completely as a limited
liability company, as tensions between the auditing and non-auditing businesses grow.

HOW TO STRENGTHEN THE INDEPENDENT AUDIT

Our Panel concluded that as a first step, the outside auditor must be brought into the mainstream of
corporate governance. The board of directors, as the elected representative of the shareholders, is the
client-not corporate management. If auditors are not to assume the same fate as outside counsel, the
board must interject itself into the client-auditor relationship.

The board recommendation to shareholders in the proxy for the appointment (or ratification of the
appointment) of outside auditors is more than a symbolic act. While the board's audit committee meets
with the auditors, it is rare for the board to do so. At the very least, the board, as well as the audit
committee, ought to meet the professionals appointed to protect shareholder interests. Consistent with
the importance of seeking shareholder approval or ratification, the board, at least once a year, should
meet with the auditors in executive session to obtain their views as professionals on the
appropriateness of accounting principles used or proposed to be used by the company, the clarity and
adequacy of its financial disclosures and the degree of aggressiveness or conservatism of the
company's accounting principles and underlying estimates. By having direct exposure to the board as
well as the audit committee, the board sends the signal that it looks to the auditors for outside
professional advice and counsel on accounting and auditing matters.

Some have argued that this kind of interaction between the board and auditors exposes the directors
to additional liabilities. On the contrary, greater involvement by the board and audit committee in
accounting and auditing issues reduces the possibility that the financial statements are in fact
misleading, thus lessening the danger of finding the directors at fault. It is hard to believe that directors
reduce their liabilities by acknowledging that they do not communicate with the auditors. Another
argument against direct communication between directors and auditors is that directors do not have
the experience or knowledge to make judgments on accounting issues. This disingenuous argument
ignores the fact that most outside directors run businesses. They would be startled by the notion that
they cannot understand accounting issues.

When the auditors are "captured" by financial management, they cannot fulfill their responsibilities as
independent watchdogs on behalf of shareholders. They will continue to remain bogged down on
issues unrelated to what is really important-how management deals with accounting principles,
disclosures and estimates. For financial managers, this closer relationship between boards and auditors
may appear disruptive and adversarialeven revolutionary. But mature and self-confident chief financial
officers should see the enhanced position of the auditor as an important balancing factor in preparing
reliable financial statements. The board and the audit committee should judge the maturity of the chief
financial officer by how well he or she handles a relationship in which his or her judgments are subject
to more active oversight.

Financial officers sometimes complain that the audit adds little value and that it has become a
commodity. To make it more valuable requires a new relationship to the corporation in which the
auditor can act as professional advisor. When the client-the board and its audit committee-challenges
the auditor to act as a professional, firms will respond by adding value, repricing audit services and
attracting more talent. Fortunately, there are efforts underway both within and outside the profession
to rethink financial reporting and the scope of audits by, for example, including more forward-looking
information in financial reports and developing international accounting standards which provide a
basis for worldwide certification of-financial statements. By challenging auditors to make financial
statements and audits more valuable, boards, audit committees and financial managements will, I am
certain, see the profession rise to that challenge.

Without the vigorous support of boards and audit committees of publicly held corporations, the
independent audit will continue to lose ground in the corporate reporting process. If present trends
continue, I can see the possibility of the external audit being replaced almost entirely by internal audit
just as outside counsel has been replaced by house counsel. Auditors will end up supplying only a
"boiler plate" certification to satisfy regulatory requirements. This result would be a major loss for the
investing public.

Greater board and audit committee involvement with the auditors does not mean more written reports.
What is not needed are more reports and footnote disclosures to shareholders. There are already
enough of these. Rather, the need is for more effective use of the auditor as a professional. Written
reports cannot substitute for face-to-face meetings where people of good will and intelligence discuss
matters with openness and candor. Overemphasis on process and mechanics can detract from what
boards and audit committees should be doing and creates an atmosphere where rituals, rather than
open discussion, dominate the relationship.

The SEC bears a heavy responsibility for restoring the importance of the independent audit. Rather
than bypassing the established mechanisms for setting accounting standards, defending the tort system
to remedy audit failures and expressing cynicism about auditing firms, it should seek ways to
strengthen the independent audit by an open dialogue with the profession where it believes that the
profession has fallen down. At the same time, it should support the profession's efforts to improve the
value of audits for boards and shareholders.

The SEC and the profession should think about how audit failures can be dealt with largely outside of
the tort system-a blunt and capricious tool to deal with audit problems. The SEC might more
effectively use its own administrative remedies to discipline unprofessional conduct. Similarly, it should
encourage the profession through self-regulation to take disciplinary action with the understanding that
such actions could not be used as the basis for private lawsuits seeking damages. Whatever the
outcome of the current debate on tort reform, there will still be a need for the profession to do a better
job of regulating itself.

Finally, the profession itself must help restore its vision of excellence for the independent auditor.
Clients, regulators and the investing public cannot change that vision if the profession feels that its
self-interest lies in pursuing another course. Such a course is dangerous and will lead to a far different
profession-one that, over the long run, would command the respect of neither clients nor the investing
public. However, I am confident that the profession is now more than ever aware of the threats to tis
independence and that it will respond in ways that will strengthen the role of the independent auditor.

[Footnote]
Report to the Public Oversight Board, "Strengthening the Professionalism of the Independent Auditor,"
September 1994. This article builds upon the primary conclusions and recommendations of the Panel.
However, many of the observations in this article are my own and should not be attributed to my colleagues
on the Panel or to the Public Oversight Board.

[Reference]
REFERENCE
Glenden, M. A. 1993. A Nation Under Lawyers. New York, NY: Farrar, Straus and Giroux.

[Author note]
Ralph S. Saul was the director of the SEC's Division of Trading Markets; associate director of the SEC's Special
Study of the Securities Markets; president of the American Stock Exchange; and chief executive officer of
CIGNA Corp.