The Proposed SEC Rule on Auditor Independence and Its Consequences


By Barry Melancon
President, CEO, American Institute of CPAs

Last month members were alerted to a recent SEC proposal* that would place severe limitations on the nonaudit services CPA firms can offer to audit clients (see “The SEC’s Proposed Rule Threatens Our Profession and the Public,” JofA, Sep.00, page 6). Although the proposed rule, S7-13-00, “Revision of the Commission’s Auditor Independence Requirements,” is meant to strengthen auditor independence, we at the AICPA believe the actual effect would be to weaken the quality of financial reporting, limit companies’ choices of outside professionals and damage the economic vitality of many CPA firms without any positive effect on independence. The proposal has dramatic and far-reaching implications, with serious consequences for the future of the accounting profession and the public. We consider it to be the most significant rule proposal on auditor independence since the federal securities laws were enacted in the 1930s.

The SEC’s proposed rule would damage the economic viability of CPA firms of all sizes—from the smallest to the largest.

This radical scope-of-services rule is a solution in search of a problem. Even the SEC enforcement director has admitted the commission has never brought a case alleging that an audit failure occurred as a result of the accounting firm’s lack of independence. The U.S. General Accounting Office, in a 1996 report, concluded that none of the studies relating to auditor independence “reported any conclusive evidence of diminished audit quality, or harm to the public interest, as a consequence of public accounting firms providing advisory or consulting services to their audit clients.” The POB’s Panel on Audit Effectiveness, which was set up at the request of the SEC, found, after reviewing 37 audit engagements involving the provision of nonaudit services to audit clients, not one instance in which nonaudit services “had a negative effect on audit effectiveness.” On the contrary, they concluded that, in 25% of the audits reviewed, nonaudit services had a positive effect. Moreover, in its last 10 annual reports to Congress, the SEC never mentioned any concerns about the scope-of-services issue.

The commission, however, relies on a “common sense” hypothesis that nonaudit services may give the auditor so great a stake in the client relationship as to impair independence or judgment. Similarly, the commission seeks to base its case for the profession to undergo radical surgery on the diagnosis that investor confidence in audited financial information could be compromised by the perception that nonaudit services would have that effect. But the regulators’ perception of what constitutes common sense is no basis for such draconian regulatory action. Moreover, no study of the perceptions of users of audited financial information supports the massive shift in public policy that the proposed rule would enforce.

An issue for all members

Make no mistake about it—the proposed rule is highly likely to affect virtually everyone in the profession, including members at the smallest firms and those working in business and industry. Although the commission has jurisdiction only over SEC registrants, the rule, if adopted, will set the stage for a new round of regulation by state boards of accountancy and other regulatory agencies. In fact, some banking regulators have already indicated they will follow suit, and the Department of Labor likely will adopt the rule for ERISA audits. The proposed rules could influence the regulatory approach to auditor independence outside the United States as well.

The ripple effect of this precedent thus would reach deep into the profession. While many practitioners may see this as a large firm issue, it is potentially most damaging to smaller firms that may well have great difficulty divesting themselves of their consulting practices.

In particular, if such an effect occurs, the proposed rule will have impact on firms providing reviews and compilations. As these services have independence requirements (except for those compilations where disclosure is made), other services for review and compilation clients could be affected. So while the total impact of the ripple effect is impossible to predict with accuracy, it is safe to say that some is likely.

Perhaps as significant, the SEC proposal contains a definition of “affiliate” that could prevent firms from entering critical alliances with other firms to pursue greater practice development opportunities. Indeed, the SEC’s definition of an affiliate is so broad as to preclude virtually any beneficial relationships between an accounting firm and any other entity. In addition, while historical tax compliance work would not be covered by the proposal, the rule doesn’t specifically allow firms to offer tax planning, strategy and advice to audit clients. Further, the proposed rule calls into question the use of value billing for audit clients and their affiliates.

Public policy concerns

At the same time, the proposed rule would mandate that SEC registrants disclose in their annual proxy statements the professional services provided and the fees paid to their auditors. This proposal would reestablish the disclosure system instituted by the SEC in 1978 and rescinded four years later when the SEC concluded that it was “not generally of sufficient utility to investors to justify continuation.” The AICPA played a leadership role in working with the SEC, the ISB, the Blue Ribbon Committee to Improve Corporate Audit Committees and others to design and implement a new regime of targeted disclosure to audit committees of information about professional services provided by accounting firms to their SEC attest clients and strengthened audit committees to evaluate that information. This system, which is targeted to those who are best able to understand and assess this information, has just been put into place. In our view, the public interest in establishing the optimum system for regulating auditor independence requires that these important reforms be allowed some time to work and the results be carefully evaluated before the SEC considers whether to reinstate the requirement for across-the-board disclosure that was rejected as ineffective in 1982.

The proposed rule is not in the public interest.

  • Effective involvement in the “new economy” requires the formation of a variety of business relationships designed to leverage the assets of the participating entities. No single firm is likely to have the resources to acquire, develop or produce all the competencies needed to meet its clients’ demands. But the proposed rule would severely restrict the ability of accounting firms to enter into such relationships. As a result, these firms face potentially crippling handicaps in participating in the new economy and modernizing financial reporting so that it truly enhances the quality of information for investors.
  • There will be a loss of the synergies that exist when a firm provides a broad array of auditing and nonauditing services to its clients. As a result, audit quality is more likely to be impaired than improved.
  • The reduced size of accounting firms (shorn of their consulting operations) will require each audit client to assume a greater share of the total overhead. In addition, the loss of nonaudit service lines will similarly reduce the scope of knowledge available at the accounting firms. Both of these trends will be detrimental to the quality of audit work, while increasing costs to the clients.
  • Accountants and other experts with particular skills, especially in the technology area, who are needed to perform and assist in audit work for sophisticated clients, will be lost by accounting firms as the quantity and quality of nonaudit work is reduced.
  • Firms will have increasing difficulty recruiting strong employment candidates when firms are subjected to governmental micromanagement that inhibits innovation and participation in the new economy.
  • Despite the suggestion that the rule proposal will improve auditor independence, it will, in fact, result in greater pressures on accounting firms to maintain positive relationships with their audit clients, given the reduction in alternative revenue sources.
  • There will be additional administrative costs to accounting firms associated with monitoring compliance with the new rules, particularly given the low percentage threshold that would cause an entity to be deemed an affiliate of an accounting firm or preclude potential cooperative arrangements with an “investor” or “investee” of an audit client. These added costs to the firms could well mean higher costs to clients.
  • Under the proposed rules, an accounting firm could not have a “mutual or conflicting interest” with an audit client; nor could it act as an “advocate” for the audit client. These terms, part of the “four general principles,” are both vague and undefined, thus providing the SEC staff with open-ended discretion to assert that an accountant or accounting firm lacked independence in a particular instance. Moreover, the ban on certain nonaudit services includes a “catch-all” provision under which the SEC reserves the right to challenge any other nonaudit services (in addition to those specifically banned) as impairing independence based on a “facts and circumstances” standard, applying the four general principles. Given the breadth of these principles, there is no certainty with respect to these proposed rules.
  • As a matter of regulatory process, the proposed rule, with its micromanagement, and its blanket approach, is a throwback to government attempts to intervene in significant market sectors without a clear need to do so or a clear understanding of the least intrusive regulatory solution. Clients want accounting firms to provide nonaudit services because this achieves economic efficiencies, which will be lost if clients are denied this choice. As should be reflected in the proposed release’s cost/benefit analysis, such overregulation can be expected to exact significant costs on the national and global economy and result in the denial of consumer choices.

Due process

The proposed rule, which poses over 400 questions and presents four conceptual alternatives, has only a 75-day comment period, which was scheduled to expire when Congress was not in session. Thus, it would be enacted during the lame-duck period between the presidential election and the start of a new administration. That’s not a sound process for setting public policy—particularly for an issue of such importance and complexity.

An alternative

The AICPA supports reform of the rules governing auditor independence. They are out of date and much in need of modernization. We have worked with the ISB to develop modernized standards governing financial interest in audit clients, employment of family members by such clients and investments in mutual fund families where one of the funds is an audit client. We are pleased that the proposed rule largely adopts the ISB’s work in these areas—with minor changes (changes that, in fact, we believe are not appropriate). We enthusiastically support the development of a principles-based framework for auditor independence—a job entrusted three years ago to the ISB with the mutual agreement of the AICPA and the SEC. The ISB is working on a new conceptual framework document that will address the entire concept of independence in light of today’s dynamic business environment. The public members of the ISB—those who are not CPAs—have invested untold hours becoming educated about the nuances of these issues so they can offer meaningful recommendations on some very difficult problems.

The proposed rule puts the cart before the horse. Without the guidance of a conceptual framework, it would impose sweeping and highly detailed regulations governing virtually every aspect of auditor independence. We propose that, instead, the reforms already developed by the ISB be put into place and the ISB be given the opportunity to do the work for which it was created. Working in this deliberative way, it should be possible, in the near future, to develop a consensus for a new and much improved system of strengthening auditor independence.

The Institute response

We urge members to inform themselves about this issue and to communicate their concerns (see box, below). The AICPA has worked vigorously to draw attention to the proposed rule and its possible consequences. Both the Group B firms and the PCPS executive committee have investigated the issue and are solidly behind our efforts. We have brought the issue to the attention of the media and to members of Congress. Representatives of the profession testified at the SEC public meeting in August and September and shared their concerns with the commission throughout the process.

The Institute will continue to fight for the public interest in the development of new, modern and effective standards for auditor independence. This is our tradition. The AICPA originally proposed many of the recommendations in the recent POB panel report, and we have asked bodies such as the auditing standards board, the SECPS and the professional ethics executive committee to focus on the remaining concerns. We worked cooperatively and constructively with the SEC in creating the ISB. We stand ready to work with the SEC and the ISB on strengthening auditor independence. But we cannot support the SEC’s rush to judgment with an ill-conceived and retrogressive rule that would not serve the public interest.

*The comment period for the proposed SEC rule was to end September 25. When the JofA went to press, the proposal had not yet been adopted.

A Call to Action

Highlights of the SEC proposal to change auditor independence requirements can be found at the AICPA Web site, (The full text of the proposed rule is available on the SEC site, .) To voice your concerns,

  • Write your members of Congress in the U.S. Senate and House of Representatives. To obtain their names and addresses, visit the Library of Congress Web site at or call Vicki Majewski at the AICPA Washington office, 202-434-9223, or e-mail her at . Include representatives not only from your home district or state but also from every area in which you do business.
  • Tell your clients or your employer your opinion about the proposed rule and its possible implications.
  • Although the comment deadline has passed, it’s still appropriate to write letters (from individuals, not firms) to each of the SEC commissioners:

Chairman Arthur Levitt
Commissioner Paul R. Casey
Commissioner Isaac C. Hunt, Jr.
Commissioner Laura S. Unger
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

If you would like to discuss your letter with someone, contact one of the following AICPA staff members:

Please e-mail copies of your letters to


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