Audit Independence: A Myth or Reality?
The Public Company Accounting Oversight Board (PCAOB) that oversees public company audits in the U.S. is concerned that auditors are not independent of their clients. Since independence is the bedrock of the profession, any crack in that foundation threatens the value of the audit and there may be consequences for investors and creditors who rely on accurate and reliable financial statements.
The concern about audit independence is an old one – whether the performance of non-audit services for an audit client impairs audit independence. For years the profession has claimed that it does not. The firms claim they would not compromise their independence by being soft on the client when an audit issue arises because the firm doesn’t want to risk losing lucrative non-audit services by going against the client on an audit issue.
Since the collapse of Enron and its auditor, Arthur Andersen, more than a decade ago, regulators have been cautious about auditors receiving big fees for consulting and other services that could potentially cloud their judgment when auditing a company's financial statements. The Sarbanes-Oxley Act prohibits certain non-audit services for audit clients including financial information systems design and installation, the most lucrative of all such services. This restriction makes sense to me because audit independence may be compromised if the auditors identify weaknesses and flaws in the system that helped to create. The fact that the firm may, in fact, remain independent is not the point. Independence is required both in appearance and fact so by auditing a client for whom the firm helped to install an information system, it may appear in the mind of a reasonable observer that the auditor may not be independent. The appearance of a possible lack of independence is a sufficient conflict to negate independence.
The PCAOB says it has started quizzing accounting firms on whether their fast-growing consulting practices could hurt the quality of their audits. Overseas, the European Parliament is expected to vote in April on legislation that would cap non-audit services provided by a company's auditor at 70% of the audit fee. At least 300 companies in the U.S. and Europe paid their auditors as much for add-on services as they did for audit work, according to public filings from the past two years reviewed separately by data provider Audit Analytics and stock-research firm Exane BNP Paribas.
The capping of non-audit fees, I believe, will not accomplish its goal. Moreover, it is an attempt by the government to interfere in the marketplace for professional services. Non-audit fee controls are fraught with danger for the public interest. The possibility exists that the firms will cut down on staff providing the non-audit services for audit clients by sending in less experienced audit staff and/or a smaller number of staff thereby compromising audit quality. Also, auditors may simply recover from the non-audit fee controls by charging clients for which audits are not performed higher fees when non-audit services (i.e., information systems design and installation) are performed for that client.
One example of the imbalance between fees received for audit and non-audit services is that HSBC Holdings PLC paid its auditor, KPMG LLP, $208 million for "other services" between 2010 and 2012. That's more than five times as much as the U.K. bank paid the firm for auditing its books. The added work included "ad hoc accounting advice," consulting on information-technology security, and subsidiary audits, according to a regulatory filing. The filing added that HSBC only uses KPMG for extra services when it can benefit from the firm's historical knowledge of the bank and when its independence won't be compromised. That seems appropriate to me.
The accounting profession has ethical standards to control for a possible loss of independence when performing non-audit services for an audit client including the auditor should assess whether the client has assumed responsibilities for the services, adequately oversees the performance of such services, evaluates the adequacy and results of the services performed, and the client must accept responsibility for the results of the services.
I do not want to dismiss the concerns of regulators about possible impairments of independence. In fact, in January 2014, KPMG LLP agreed Friday to pay $8.2 million to settle SEC allegations that the Big Four accounting firm violated rules intended to keep outside auditors from getting too close to their clients.
KPMG provided non-audit services such as bookkeeping and payroll to affiliates of two of its audit clients and the firm also hired a recently retired senior-level tax counsel of a third audit client's affiliate only to loan him back to the affiliate to do the same work. Those moves by KPMG between 2007 and 2011, the SEC said, violated "auditor independence" rules that require auditors to avoid conflicts of interest that could compromise their ability to audit a company's financial statements impartially and rigorously.
So what’s the answer to the continuing battle between the accounting profession and SEC about audit independence issues when firms get to close with their audit clients? In the European Union, one approach that has been put forth is to require audit firms to spin off their non-audit divisions and operate solely as audit practitioners. Proponents argue that audit firms can’t be independent as long as they provide (lucrative) non-audit services since there is a conflict of interest. Opponents argue that many talented individuals will leave the profession. This proposal may lead to larger fees for such services and, it seems to me, is unfair to the client that has an ethical right to choose its preferred provider of non-audit services.
Another proposal is for the government to transfer responsibility for financial audits of public companies to a governmental agency. Under this proposal, companies would contribute to a fund used to compensate the government auditor. A company’s contribution to the fund would be determined by the expected complexity of the company’s audit. The government agency would be responsible for auditing only publicly traded companies. My problem with this proposal is history has proven that governmental agencies do not perform as well as private businesses and such a system is likely to be bureaucratic, slow-moving, and inefficient.
The answer always comes down to the ethics of individuals and the firms that provide non-audit services for audit clients. The accounting profession has established ethical standards to counteract any threats to independence and recommends measures that build in safeguards to prevent threats from compromising independence. In fact, the American Institute of CPAs has recently revised its code of conduct to reflect the “threats and safeguards” approach. Just because there may be an occasional lapse in independence, such as in the KPMG case, we should not throw out the baby with the bath water. If the rules need to be tightened, then the profession should do so through its deliberative process that has served the business community well for decades.
Blog posted by Steven Mintz, aka Ethics Sage, on March 6, 2014