Here comes the Judge
Regulators cracking down on auditor independence issues
When PricewaterhouseCoopers (PwC) was censured for violating
auditor independence rules and improper professional conduct,
the shock waves were felt throughout the accounting profession
and beyond. Almost half of PwC partners self-reported at least
one violation. Worse, random tests indicated that 77% of partners
did not disclose all transgressions in the initial reviews. A
total of 8,064 violations involving 87% of PwC partners eventually
surfaced. As a result, the SEC ordered the other big five firms
to conduct their own internal investigations into possible violations.
Public accountancy is under the gun as never before. The increasing
demand for financial information has led regulators in both Canada
and the United States to ask tough questions about whether public
accountants--the traditional gatekeepers to much of that information--are
living up to their end of the bargain.
"The PwC situation is an indication that a lot of the auditing
firms are not taking auditor independence rules very seriously,"
says David Brown, chairman of the Ontario Securities Commission,
and one of the leading voices in Canada calling for a review
of how the profession does business.
But there was more trouble for PwC. In late May, the Wall Street
Journal reported that the SEC was widening its investigation
into the accounting practices of MicroStrategy Inc to include
the software company's auditors--once again PricewaterhouseCoopers.
(PwC, however, denied that it was a target of the investigation.)
In the same WSJ article, MicroStrategy disclosed that the SEC
was investigating the circumstances around its restatement of
revenues and profits, to reflect its new way of booking revenue.
These restatements had the effect of turning two years of profits
into two years of losses. While no one has implied that PwC's
tolerance of MicroStrategy's aggressive revenue recognition is
connected to the independence violations, the fact that the two
situations are unfolding at the same time begs a general question:
Are auditor independence and aggressive accounting issues related?
"Absolutely not," says David Smith, chairman of PricewaterhouseCoopers
here in Canada, who would not comment specifically on MicroStrategy.
"There has never been a court case where auditor independence
issues have been proven to result in a bankruptcy."
But restatements of public companies' prior year's financial
statements have become increasingly frequent; when coupled with
the growing power of consulting and other non-audit partners
within public accountancy firms, many observers are beginning
to have doubts.
"We are seeing an erosion of the confidence the public has
in audited financial statements," says Brown. "We are
seeing it in news reports, from analyst's statements and from
Brown, who heads an organization which constantly reviews audited
financial statements, grabbed headlines with a tough speech he
delivered to the Institute of Chartered Accountants of Ontario
in June 1999. In it, he called for the profession to take a hard
look at itself, and for public accountants and regulators to
"work together to stem the erosion of public confidence."
Auditor independence is not just a philosophical issue. It is
the heart of public accountancy. "If we are not independent,
our opinions have no value," says Colin Taylor managing
partner and chief executive of Deloitte & Touche. Never has
the demand for reliable, independent, timely financial information
been higher. According to a recent survey by the Toronto Stock
Exchange, Canadians are investing in the stock market more than
ever before. Forty-nine per cent of the country's adults now
own equities either directly, or indirectly. This is a significant
jump from the 37 per cent recorded in 1996, and more than double
1989's total of 23 per cent. The increase has been coupled with
a rise in day trading, margin investing and the proliferation
of financial reporting in new publications, television shows
and on the Internet. Markets now focus disproportionately on
quarterly profit performance relative to analyst's expectations,
and CEO's compensation packages are increasingly supplemented
by stock options tied to share prices.
In this environment, the OSC is concerned by the growing number
of times in which auditors stretch the interpretation of accounting
standards beyond all reasonable limits, and, in some cases, act
as the primary advocates for these loose interpretations. "We
see [instances of GAAP stretching] all the time," says John
Carchrae, chief accountant at the OSC. "Since [Brown's]
speech, people are becoming more sensitized to the issue, but
we have a long way to go."
In one case, two different companies with the same "Big
5" auditor (who Brown refused to name), accounted for similar
disbursements in opposite ways: once as an expense, the other
as a capital transaction. Such GAAP stretching is occurring in
an environment where many public accounting firms have broadening
service offerings, and are relying on non-audit revenues for
growth. According to SEC numbers, only 30 per cent of the larger
public accounting firms' revenues are drawn from audit services,
down from 70 per cent in 1977. Since 1993, auditing revenues
have been growing by 9 per cent on average, while consulting
and similar services have been growing at a rate of 27 per cent.
Here in Canada, only 35.3 per cent of the total CICA membership
is employed in public practice, and even that doesn't tell the
whole story because the percentage includes those who work in
non-audit services such as consulting and valuations. Under pressure
from regulators, several firms have taken steps toward divesting
their non-audit operations, but Carchrae remains skeptical. "(Some)
firms are spinning off (parts) of their consulting groups. But
they are not spinning off all," says the OSC's chief accountant.
"In many cases they are retaining minority interests, and
in others they are getting into new businesses such as the legal
profession." Brown is a lawyer by trade with an LL.B.
from the University of Toronto, and a bachelor's degree in Civil
Engineering from Carleton University. He nevertheless has a good
grasp of the profession and its challenges, much of it due to
his extensive background in mergers and acquisitions, corporate
finance and reorganizations.
"For someone not trained as a public accountant, he has
a remarkable understanding of the financial reporting process,"
says Carchrae. "He is able to analyze a situation and grasp
its implications immediately."
But many in the profession are far from convinced that auditor
independence is a problem, particularly those with extensive
backgrounds in the "big five" firms. Although most
big five partners (either current or retired) interviewed for
this article, gravely paid lip service to the issue, few would
concede that it was much more than a perception problem. Typically
they responded by blaming overly complex SEC rules, and by attempting
to shift to corporate audit committees increased responsibility
for assessing whether auditors are independent. While there is
some merit to both these arguments, their net effect is to deflect
attention away from the profession's responsibility.
In fact, not one of the more than a dozen partners interviewed
for this piece would admit on the record to ever having felt
the slightest bit pressured to accept a client's interpretation
of accounting rules in gray areas in order to keep good relations
with a client. PwC's Smith's response was typical: "We don't
want those kinds of clients." Some reverted to the old "no
one has ever proven in court a case that auditor independence
issues led to poor financial reporting which caused a client
to go bankrupt."
But the OSC's Carchrae is not convinced. "Companies don't
go bankrupt just because of poor financial statements, they would
however go bankrupt because of other problems that poor financial
reporting can camouflage." Of course a client does not even
have to go bankrupt for an audit to be a failure. A material
aggressive application of an accounting principal, say revenue
recognition, could result in market capitalization swings of
tens of millions of dollars in today's volatile markets. And
since revenue recognition errors correct themselves in later
years, fortunes could be made or lost on faulty information,
without anyone ever finding out that the audit standards were
not rigorously applied.
But the profession's attitude south-of-the-border is the same
as here in Canada. Robert Elliott, chairman of the American Institute
of Certified Public Accountants (AICPA), reviewed data on audit
failures in the U.S, and is very skeptical. He defines audit
failure as "an auditor being named in an SEC Accounting
Enforcement Release for "apparent involvement" or a
substandard audit."" Elliot calculates a failure rate
of .0001 for those firms auditing a majority of public companies,
a total he believes is consistent with a high level of audit
However, Brown is not alone in his criticism of the profession.
Many of his views reflect those of SEC chairman Arthur Levitt,
an outspoken critic of financial reporting practices in the U.S.
"I fear that the audit process, long rooted in independence
and forged through professionalism, may be diminished perhaps
even sacrificed in the name of more financial and commercial
opportunities," said Levitt in an October 1999 speech to
the Panel on Audit Effectiveness of the Public Oversight Board,
an independent body charged with overseeing public accounting
in the US. The SEC chairman is concerned about what he calls
accounting "hocus pocus" , and fears that if these
practices came to light in a downturn in the U.S. economy, they
may exacerbate its effects. Like Brown, Levitt's primary concern
is not the many well-publicized fraud cases, but rather those
instances where the line between right and wrong is not so clear.
Closer integration between the Canadian and U.S. operations of
the big five firms, the two economies in general and the large
number of Canadian SEC registrants, means that American standards
and habits tend to flow north. The two regulatory bodies are
thus in constant contact and their approaches tend to converge.
There also appears to be a growing tendency among Canadian public
accountants to treat standards like narrowly written rules, rather
than broad principles, requiring the exercise of sound professional
judgment in their application.
"This rule orientation may be acceptable in the U.S. where
rules abound," says OSC chairman Brown. "But in Canada,
which has favored setting forth broad principles, such an approach
can only be characterized as a loophole mentality."
The stakes on auditor independence issues in both countries were
dramatically raised after the PwC transgressions were made public.
Although many of PwC's independence violations were a result
of a large merger, rapid expansion, and a system of less than
modern regulations, the news nevertheless jolted the accounting
industry. The company, after all, violated the golden rule of
accounting: auditors cannot invest in their clients. Ten people,
including five partners were reportedly fired. It did not help
public confidence in the peer review process that a review conducted
before the SEC probe, cleared Coopers & Lybrand, one of the
two firms that now comprise PricewaterhouseCoopers.
None of the firm's Canadian partners was involved in the SEC
investigation according to PwC's CEO Tom O'Neill, who says that
any of the other big U.S. firms that went through the same process
would also have had violations.
The PwC transgressions marked an important turning point in the
way auditor independence issues are treated in the press. The
benefit of the doubt, long accorded public accountancy, vanished
"What is already clear is the level of complacency that
prevails in firms worldwide is alarming," said an editorial
in the Financial Times "(A)ll the more so, because the changing
culture of the big accountancy firms threatens audit independence."
The Wall Street Journal was no kinder. "The annual audit,
is a ritual that neither companies, nor investors nor the accountants
themselves place much value on," wrote Holman Jenkins, noting
Ernst & Young's decision to quit doing audits for Baan, the
Dutch software firm, because it interfered with the more lucrative
consulting work it was doing,
The PwC revelations spurred Levitt into further action. In May
2000, he called for more effective oversight over the AICPA which
he said " seems unable to discipline its own members for
violations of professional conduct." He also called for
greater public representation on the association's board, as
well as a reorganization of the Independence Standards Board,
which would result in majority representation by individuals
who are unaffiliated with the profession. The combined effect
of Levitt's moves would be to chip way at what for decades has
been one of the cornerstones of public accounting: self regulation.
It is a clear signal to the profession that it was time for action.
Many take it for granted that public accountancy is, and always
will be, self-regulating. Currently the CICA is charged with
setting GAAP and GAAS, which govern the auditing and reporting
of financial statements. However this is by no means written
The Ontario Securities Act gives the OSC rulemaking powers with
respect to accounting and auditing standards to be applied in
financial statements and auditors reports filed with the commission.
The OSC hasn't used these powers to override the handbook, but
the threat remains.
Although self-regulation continues to be, by far, the best route
to go, says Brown, for this to continue, the standards-setting
process and the public accounting firms need to be acting independently
and in the public interest. He feels this may no longer be the
A recent study in the U.S. conducted by Earnscliffe Research
and Communications for the Independence Standards Board, detected
a considerable gap between how public accountants and regulators
perceive the auditor independence issue. Researchers conducted
detailed interviews with 131 stakeholders in the financial reporting
process, including CEOs and CFOs of SEC registrants, buy and
sell side analysts, audit chairs and partners, as well as regulators.
The good news is that most participants felt that public company
auditors perform a valuable task, and do so in a way that reflects
a high degree of integrity, competence and independence. However
most felt that the evolution of audit firms to multi-disciplinary
practices presents problems toward auditor's ability to maintain
the reality and appearance of independence, in particular when
they accept consulting assignments with audit clients.
The study found that there was a wide spectrum of views: on one
end were the public accountants who tended to downplay the issue
and who felt few further regulations or precautions were needed.
At the other end were the regulators who felt the profession
should take more aggressive action to strengthen safeguards voluntarily,
or else should be forced. The other groups interviewed tended
to fall between the extremes, agreeing with the auditors on the
question of recent problems, and agreeing with the regulators
on the need to take action.
The debate between regulators and accountants on the urgency
of auditor independence issues may prove to be moot, because
for the system to work, the public must also perceive
the accountant to be independent.
"It goes back to the old Caesar's wife story," says
David Leslie, chair and CEO of Ernst & Young (To be suspected
is almost as bad as to be convicted). But many practices taken
for granted in the accounting profession, just don't look so
good, once you start talking to people not directly involved
in the process.
"If the Bank of Montreal pays its auditors $6 million in
audit fees, and $12 million in consulting fees (consulting fees
are in fact $10.4 million), or if the consultant recommends the
compensation package for senior executives, that's not independence,"
says Yves Michaud, founder of l'Association de Protection des
Épargnants et Investisseurs du Québec (APEIQ).
Michaud's group, has been active in several dossiers involving
public accountancy, and lead a fight earlier his year to have
the big banks disclose all payments to their auditors.
Spurred on by the campaign's success, APEIQ plans to turn up
the heat on the country's securities commissions. "We are
drafting a proposal calling for a true inquiry into the independence
of public accounting firms, which should be answering to shareholders,
not board's of directors," says Michaud.
When you get right down to it, the public's most pressing need
is for accurate, reliable and independently verified financial
statements. The profession's growth into ancillary services over
past several decades is of secondary importance to non-accountants
and is only tolerable inasmuch as it does not affect public accountancy's
In an ideal world, auditor independence would be guaranteed by
public accountants performing audits, and nothing but audits.
At a minimum in the current environment, auditors should be avoiding
obvious potential conflicts such as certain valuation services,
bookkeeping and excessive consulting engagements with audit clients.
"There is a perception problem among the public. But you
have to be careful how you define the public," says PwC's
O'Neill. "There were 100,000 people who went to pay their
respects to Rocket Richard at the Forum, and I'll bet you that
not many of them understand the issues involved."
"The average guy could not care less about the issue. On
the other hand when you talk about the much narrower public,
that uses financial statements, the investing public and the
regulators, then it's a different story," concludes PwC's
CEO. While O'Neill's assessment is correct as far as it goes,
the increasing number of Canadians participating in equities
and mutual funds markets means that the amount of people with
a direct stake in the issue is rising. The country's financial
press is unlikely to provide much relief to public accountancy.
Most journalists, even those who cover business exclusively,
are only vaguely aware of the complexities of the issue, and
are likely to rely on critics like Michaud to give perspective
and balance to their stories.
Should auditor independence issues move further in the public
spotlight, journalists are likely to compare auditors with other
public figures that must remain independent such as politicians
and judges. Judges for example are restricted from doing legal
work for people who appear before them in court. Yet that is
almost exactly what happens when auditors perform consulting
engagements for client's whose financial statements they "judge"
in an audit.
By all accounts the relationship between the accounting bodies
and regulators is much more cooperative in Canada than in the
U.S. This is very much to the advantage of public accountancy.
Because APEIQ's emergence as a force for reform, is a harbinger
of things to come should the auditor independence debate move
further in the public arena. Partly as a result of regulatory
and public pressure, Canadian public accountancy's professional
bodies are engaged in a multitude of initiatives designed to
address the auditor independence issue.
"To minimize perception difficulties, action must be taken
in two key areas," says Bob Rutherford, vice president of
standards at the CICA. "We first have to update guidelines
and harmonize them with the provincial bodies, but we also need
to look more closely at the role audit committees play in the
process." The institute's Assurance Standards Board's Audit
Committee Task Force has been working on revisions to AuG-11,
Communications with Audit Committees, and although these were
not finalized at publication date they will likely reflect the
requirements in ISB Statement No. 1. These include the requirement
that the auditor meet with the audit committee at least once
a year to disclose all relationships with the entity that might
affect his independence, confirm in writing that he is independent,
and discuss his independence with the audit committee. The CICA's
Public Interest and Integrity Committee (PIIC), has also set
up a two-person task force on auditor independence headed by
Morley Lemon, Director of the School of Accounting, University
of Waterloo. The task force's first mandate was to conduct an
environmental scan of action being taken by other bodies, such
as ISB in the U.S, and the International Federation of Accountants
(IFAC), both of which are in the process of redrafting their
regulations. The idea is to integrate any resulting rulemaking
to conform to international standards.
Here in Canada, the relationship between most regulatory and
professional bodies continues to be more cooperative than that
south-of the border. But in a rapidly changing world, where the
need for financial information is increasingly felt, the auditor's
role will likely grow.
In a speech this May, Brown alluded to the possibility that external
auditors be required to review interim financial statements before
they are distributed to the shareholders, a move that would inevitably
boost audit fees. But before thinking about new mandates, public
accountancy would be wise to take another good look at auditor
independence issues. Or else the regulators like Brown and Levitt
are going to do the looking for them.
You can contact Peter Diekmeyer at firstname.lastname@example.org