SEC Renews Push for More Oversight of Auditors

I n early May, SEC Chairman Arthur Levitt returned to the speaker’s podium at what has become for him a familiar venue—New York University. It was there, in September 1998, that Levitt charged the accounting profession with failing to ensure the independence of auditors. This and related issues are being examined from several perspectives, four of which are discussed elsewhere in this article.

In his recent speech, Levitt reiterated his view that auditors, in their reluctance to displease clients to whom their firms could provide consulting services, have been overlooking flaws, such as earnings misstatements, in those companies’ financial reports to the SEC. “Too many auditors are being judged not just by how well they manage an audit, but by how well they cross-market their firm’s nonaudit services,” he said, citing statistics showing that accounting firms’ consulting revenue has eclipsed their income from auditing services.

Oversight funding questioned

The week before the speech, the SEC practice section of the AICPA division for firms wrote a letter to the Public Oversight Board, an independent body of observers that monitors the profession’s self-regulatory activities. In it, the SECPS said it would discontinue funding of the POB’s review of auditor independence at the eight largest accounting firms until the SECPS, the POB and the SEC all agreed to the scope and nature of the review. The SEC had requested the review after it found PricewaterhouseCoopers auditors had substantially violated rules restricting their investments in the securities of audit clients.

The immediate result was a storm of protest, despite the SECPS’s explanation that the POB’s funding was only temporarily suspended, not terminated. Levitt said the SECPS’s action raised “serious questions as to the profession’s commitment to self-regulation.” Congressman John D. Dingell (D-Mich.), ranking member of the House Commerce Committee, offered Levitt his support in “getting needed reforms in place.”

Soon after the SECPS letter was sent, the AICPA took steps to ensure the POB could continue its work. According to John Hunnicutt, AICPA senior vice president, funding has been fully reinstated. In a related development, Hunnicutt said the POB had received comments from the AICPA board of directors on a draft of a new charter the POB had designed for itself. Following possible modifications by the POB, the AICPA board, which is a signatory of the charter, will review it once more in July.

Meeting a higher standard

In his remarks at NYU, Levitt said that if investors are to have confidence in auditors’ assessments of financial statements, they first must perceive the auditors as independent.

But some think objective criteria must be established to ensure such independence. Professor Rick Antle of Yale University’s School of Management recently analyzed auditor independence issues for the Big Five. “To the extent that the SEC’s allegations are about perceptions,” he said, “the firms can’t be sure they can do anything to respond effectively.”

In 1999, William T. Allen, chairman of the Independence Standards Board, sent the Big Five a questionnaire concerning auditor independence. Antle collaborated with Mayer, Brown & Platt, a Washington, D.C., law firm the Big Five engaged to analyze their responses to the ISB, a body jointly created by the SEC and the SECPS in 1997 to address long-standing auditor independence issues.

Mayer, Brown found the firms’ gross margin for auditing services was larger than that for consulting services, before compensation. This finding, which measured profitability, differed from the statistics Levitt cited, which measured consulting services revenue. Mayer, Brown also reported the firms said that, since assurance services are a consistent source of revenue, they will continue to work on improving audit performance and ensure consulting services do not jeopardize auditor independence and assurance revenue.

A source familiar with the ISB inquiry said it was designed to gather information on auditor independence from the biggest firms because they perform much of the audit work needed by public companies to satisfy SEC reporting requirements. Information on the ISB’s reaction to the firms’ reply, which was submitted in February, is not yet available. The ISB’s Allen could not be reached for comment.

During the months immediately preceding and following the Big Five’s reply to the ISB, they attempted to address charges that pursuit of consulting-related revenue was undermining their auditors’ independence. Each firm moved, in one way or another, toward divesting itself of its consulting division. Despite these planned actions, Levitt said in his address that the spin-offs “must be accomplished without creating conflicts of interest through long-term financial relationships.”

Behind the SEC’s quest

Earlier this year, the SEC conducted a special review of PricewaterhouseCoopers that uncovered more than 8,000 violations of auditor independence rules governing investments by auditors and their relatives in the securities of the companies whose financial statements they audit. As a result of these findings, Levitt asked the other Big Five firms to perform self-assessments of their past compliance with the financial investment rules. Each of the firms agreed to take part in the voluntary review program, which began on June 15, 2000, and is open to all accounting firms that practice before the SEC. ( Click here for additional information. ) Levitt also said the SEC would update the rules to recognize, among other things, increased independent investment by partners’ spouses—a factor complicating the impact of the rules on relatives’ investments.

Further, Levitt called for limits on the kinds of consulting services firms can perform for their audit clients, recommended that a majority of the ISB’s members be drawn from outside the profession and expressed his support for the new POB charter, which would expand its power to issue and enforce auditor independence rules.

But while Levitt pursued his goals, others stood in line for his attention. Members of the House Commerce Committee waited for a response to questions they had addressed to the SEC in April about its research into auditor independence activities. Congressman Tom Bliley (R-Va., chairman of the committee) gave Levitt two weeks to respond. A spokesman for Bliley said the committee is confident the SEC soon will supply any evidence it has of a causal relationship between consulting engagements and audit failures.

Putting the facts in perspective

According to a report published on March 31 by the Public Accounting Report, a newsletter focusing on the profession, Big Five growth in management and consulting services in fiscal year 1999 slowed to its lowest rate in five years. Although some might see this as proof the profession is not overly dependent on consulting revenue, the report attributes the slowdown to a Y2K-related pause in consulting engagements—a trend not expected to continue in 2000.

A study conducted recently by the Financial Executives Institute, an international trade association for senior financial executives, offered another view. According to the FEI, 85% of the more than 200 large companies it surveyed said they buy consulting services from the firms that audit their financial statements.

In a related finding, the Big Five’s responses to the ISB’s questionnaire indicated their assurance revenue grew by almost 10% in 1997 and 15% in 1998, ending a period of stagnation that began in the early 1990s.

Consulting and auditing a good mix?

Phillip Livingston, president of the FEI, said companies responding to the FEI study indicated they are very selective about the consulting work for which they engage their auditors’ firm. For example, although respondents said they wouldn’t employ an audit firm’s consultants to work on an activity or product of theirs the firm audits, such as derivatives, they don’t feel that way about other services, such as systems consulting, which they think the audit firm’s consultants are often best qualified to provide.

According to Livingston, most CFOs would cancel a proposed consulting engagement if even one member of their audit committee had misgivings about its effect on the auditor’s independence. Livingston said the FEI supports companies’ freedom to obtain consulting services from any firm they wish and that he hoped the SEC would, through its rulemaking process, codify best practices for choosing consultants, rather than pursue additional means of oversight. He suggested, as an example of a best practice, that proposed consulting contracts exceeding a certain dollar amount should automatically be referred to the audit committee for approval.

Meanwhile, as the JofA went to press, the Panel on Audit Effectiveness, which the POB convened to assess independence issues, released an exposure draft of a report stating that “both the profession and the quality of its audits are fundamentally sound” and that the POB’s research did not “identify any instances in which providing nonaudit services had a negative effect on audit effectiveness.” The report also said “the profession needs to address vigorously the issue of fraudulent financial reporting.” The panel will hold hearings this month to discuss its findings.

Adding value to the profession

Professor John C. (“Sandy”) Burton of Columbia University’s School of Business told the JofA that, in addition to solving its current problems, the profession also must plan its future boldly. “I advocate the accounting profession’s development of an expanded financial reporting function,” the former SEC chief accountant and member of the Accounting Hall of Fame said. “By that I mean an activity that not only would say whether a company’s financial statements are accurate, but also would assimilate and interpret them,” he said. “If the accounting profession is going to continue to have a significant role, it’s got to be willing to step forward.”

—Robert Tie


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